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 in 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 51 company-owned district offices used for agency sales personnel.
(1) SFAS 115 is an accounting rule requiring fixed maturities to be revalued at fair value each period. The effect of SFAS 115 on equity per share reflects the amount added or (deducted) under SFAS 115 to produce GAAP Shareholders’ equity. Please see the explanation and discussion under the caption Capital Resources in Management’s Discussion and Analysis in this report concerning the effect this rule has on Torchmark’s equity.
Forward-looking statements are based upon estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond Torchmark’s control. If these estimates or assumptions prove to be incorrect, the actual results of Torchmark may differ materially from the forward-looking statements made on the basis of such estimates or assumptions. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments, which may be national in scope, related to the insurance industry generally, or applicable to Torchmark specifically. Such events or developments could include, but are not necessarily limited to:
How Torchmark Views Its Operations: Torchmark consists of a group of life insurance companies which market primarily individual life and supplemental health insurance and annuities to a limited extent throughout the United States. As a group of insurance carriers, Torchmark collects premium as revenue from policyholders for the eventual payment of policyholder benefits. As part of its insurance operations, Torchmark pays policy benefits, incurs operating expenses, including policy acquisition costs, administrative expenses, and taxes. Life and health insurance contracts can be long-term. Therefore, premium receipts in excess of current expenses are invested. The resulting investment income is a component of revenue. Torchmark’s investment activities focus on seeking quality investments to provide an appropriate yield to support its insurance products. Torchmark does not engage in trading investments for profit, and generally holds investments over long periods. Torchmark considers its “core operations” to be its insurance operations and the associated investment activities to provide a yield to support those products. While realized gains and losses do occur from time to time, they are not considered in the determination of insurance premium pricing or product profitability. These periodic gains or losses can be material in relation to core results, however, having a considerable positive or negative impact on Torchmark’s net income. Therefore, Torchmark management does not consider realized gains and losses from portfolio management to be part of ongoing investment operations. Please refer to the discussion of Realized Gains and Losses in this report.
Torchmark’s management views its operations in accordance with the manner in which its business is segmented. As fully described in Note 16-Business Segments in the Notes to the Consolidated Financial Statements, Torchmark’s core operations are divided into two major categories, insurance underwriting and investments. Insurance underwriting operations are segmented according to general product type: life insurance, health insurance, annuity, and other. Managers of the insurance segments are responsible for marketing, underwriting, and administering their respective insurance products. Management’s measure of profitability for the insurance segments is insurance underwriting income before other income and insurance administrative expenses. Insurance underwriting income represents the profit margin on insurance products before administrative expenses, and is calculated by deducting net policy obligations, commissions, and acquisition expenses from premium revenue. The investment segment’s management is responsible for Torchmark’s investments, debt, and cash flow. Management’s measure of profitability for the investment segment is excess investment income, which is the income earned on the investment portfolio less the interest credited to net policy liabilities and financing costs associated with Torchmark’s debt and preferred securities. Other income and the unallocated insurance administrative expenses are classified in a separate “Other Insurance” segment. Torchmark further views its insurance segment operations by the marketing group, either direct response, independent, or captive/career agencies, which distributes the products of that segment. Profitability of these marketing groups is also measured in the same manner as the overall segment is measured. Insurance underwriting income and excess investment income are highly useful to management in evaluating the performance of the segments and the underlying marketing groups within each insurance segment, because each of Torchmark’s distribution units tend to operate in a niche market offering insurance products designed for that niche. These measures enable management to view period-to-period trends, and make informed decisions regarding future courses of action by segment, distribution unit, and niche product.
Summary of Operations: Torchmark’s net income increased $47 million to $430 million in 2003, and net income increased $27 million to $383 million in 2002. The growth in earnings came primarily from the life insurance and investment segments. The life insurance segment added $26 million to the 2003 increase in earnings, and $15 million in 2002 pretax earnings growth. Life insurance growth has been a result of increases in sales volumes, premium and improvements in margins in both 2003 and 2002, and is discussed further under the caption Life Insurance.
The annuity segment profits have been adversely affected by replacement activity of Torchmark’s policies by a former distributor. Torchmark has previously stated that it will offer annuities, but does not plan to emphasize annuity products, favoring life insurance instead. See the caption Annuities for further discussion.
caused by writedowns of fixed maturities due to deterioration in credit quality of certain investments. Realized investment gains and losses are fully discussed under the caption Realized Gains and Losses in this report.
In 2003, net income was impacted by two nonrecurring items. First, Torchmark sold an airplane and recognized a pretax loss of $.8 million. In the Consolidated Statements of Operations, this item was included as an administrative expense. Secondly, the settlement of a tax issue resulted in interest due Torchmark in the pretax amount of $4.3 million. This item was included in investment income on the Consolidated Statements of Operations. Because the tax issue covered a period of many years, the interest income on the tax refund exceeded the refund itself. After costs, the effect of the tax refund on earnings was immaterial. Significant gains or losses from non-investment property or significant interest income from non-investment sources is highly unusual for Torchmark.
The 2001 charge related to previously-discontinued energy operations arose from litigation which was ongoing at the time of Torchmark’s divestiture of energy activities in 1996. This litigation was settled during 2001, resulting in the charge.
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, and 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 in both 2002 and 2003 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 and 2003. In order to compare the performance in 2001 with 2002 and 2003, the effect of goodwill amortization in the amount of $12 million in 2001 must be removed from consideration. See Note 1-Significant Accounting Policies in the Notes to the Consolidated Financial Statements for more information.
Torchmark historically reports its in force, active policies and sales (issued) of insurance policies in terms of “annualized premium,” a statistical measure representing the amount of annual premium prospectively collectible for any policy. In force policies at the end of a reporting period means all the Company’s active policies as of the date regardless of when they were issued. Annualized premium in force means the amount of prospectively collectible annual premium for all active policies. For policies issued during a period, annualized premium issued means the amount of prospectively collectible annual premiums for those policies. Annualized premium is a standard measure used widely in the life insurance industry.
Beginning with this report, Torchmark also presents first year collected premium, which is premium that was collected during the reported period on all policies in their first policy year. Torchmark suggests that this new data is useful primarily as it is more predictive of future annual premium revenue than annualized premium issued because this new measure takes into account lapses on newly issued policies at the time when most lapses occur.
Growth in premium income and annualized premium in force resulted from strong sales of Direct Response products in each period, as evidenced by the increases in first-year collections of 24% in 2003 and 11% in 2002 and annualized premium issued growth of 33% in 2003 and 10% in 2002. The growth in sales is largely attributable to this group’s focus on its juvenile life product. This product was sold for many years as a modified-premium term product. Sales of this product historically resulted in an average face amount of about $7,500 with an average annual premium of $30. In recent years, rising acquisition costs restricted margins and limited marketing expansion. After testing a variety of other replacement products and pricing that would result in more favorable results, Direct Response began marketing in mid-2001 a simple whole-life product with an average face amount of $14,000 and an average annual premium of $80. The higher annual premium has allowed Direct Response to reenter some juvenile markets that had previously become unprofitable with the old product. Not only is the juvenile market an important source of sales, but it also is a vehicle to reach the parents and grandparents of the juvenile insureds. Parents and grandparents are more likely to respond favorably to a solicitation by Direct Response for life coverage on themselves than is the general adult population. Also, both the juveniles and their parents are low-acquisition cost targets for sales of additional coverage over time. Given the success of the change in product offering to the juvenile market and their parents, sales to this demographic group should continue as one of Direct Response’s premier markets.
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 life insurance agency during both 2003 and 2002 in terms of premium income and annualized premium in force. Annualized life premium in force rose 15% to $347 million at year-end 2003, after having increased 14% in 2002, while premium income rose 14% in 2003 and 12% in 2002. Sales for this agency rose 17% in 2003 after having increased 38% in 2002. First-year collected premium grew 19% in 2003 and 35% in 2002. The rapid growth in sales for this agency over the last three years was a result of the growth in the number of its agents. Since year end 2000, the agent count has grown from 1,352 agents to 2,291 agents by year-end 2003, a compounded annual growth rate of 19%. As in the case of all of Torchmark’s agency distribution systems, continued increases in sales are largely dependent on increases in agent count. 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.
Liberty’s total agent count at year-end 2003 was essentially flat with the prior year at 2,197. However, the count of renewal agents, those agents that have been with Liberty for more than one year, declined 7% to 856 at year-end 2003. Renewal agents are generally higher producers than first-year agents. In the latter part of 2003, Liberty restructured its bonus system to not only reward production, but also to encourage recruiting and retention of productive agents. Management believes that the continued recruiting of new agents and the retention of productive agents are critical to the continued growth of sales in controlled agency distribution systems.
In addition to life insurance sales, the United Investors distribution system has also engaged in the sale of variable life products. Variable life products are considered deposit-type products under GAAP. Therefore, premium collections on these products are accounted for as deposits and are added to a customer’s account known as a “Separate account liability.” A discussion of the accounting for variable products and how Torchmark manages this business is presented in this report under the caption Annuities because variable life products are very similar to variable annuities. Although variable life collections are not included in premium in force data, they are included in the variable life account balance. Indirectly, they add to premium revenue through charges to the variable life account balance for insurance coverage and administration. The account balance is affected by fluctuations in financial markets, particularly equity markets. Because equity markets were weak in 2002 and 2001, the variable
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 channel for each of the last three years.
The following table presents annualized health premium issued and in force by distribution method for the last three years.
Sales of other limited-benefit health products, in terms of annualized premium issued, rose 52% in 2003 to $137 million over $91 million in 2002. In 2002, sales more than doubled. Annualized premium in force for other health products grew 36% in 2003 to $195 million, after rising 28% in 2002 to $144 million. Both of the United American agencies offer these limited benefit plans. Most of the plans being written are limited-benefit hospital and surgical plans that are lower cost alternatives to individual major medical plans, or that are bought to supplement employer-sponsored group health plans. Increased consumer demand for these plans is the result of the growing unavailability of individual major medical plans and decreased coverage offered by employers. Because of the limits on maximum benefits and other limits, these type plans are less subject to high rate increases that have been experienced in major medical-type plans. From a regulatory standpoint, these plans generally require lower minimum loss ratios and have higher margins than Medicare Supplements, but they do experience slightly higher lapse rates.
Annuities. Annuity products are marketed by Torchmark subsidiaries to service a variety of needs, including retirement income and long-term, tax-deferred growth opportunities. Annuities are sold on both a fixed and variable basis.
Torchmark measures the monetary volume of its inventory of annuity products and annuity sales on the basis of “deposit balance” and “collections,” respectively. Annuity collections are the deposits or annuity premium received from a customer, either as a new sale or as an addition to an existing deposit balance. Collections measure annuity growth through new deposits. Collections are not accounted for as revenue but are added to the deposit balance. The deposit balance is the liability due to customers for Torchmark’s annuities and is a measure of the size of the annuity inventory upon which annuity revenue is based. The variable annuity deposit balance is included in “Separate account liabilities” on Torchmark’s Consolidated Balance Sheet. The fixed annuity balance is a component of Torchmark’s “Future policy benefits.” The deposit balance is increased by collections and interest credits, but is reduced by withdrawals and by the policy charge assessments that are revenue to Torchmark. The variable account balance is additionally increased or decreased by market growth or declines in the investments in the underlying funds.
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 are equal to “Separate account liabilities.”
Revenues on both fixed and variable annuities are derived from charges to the annuity account balances for insurance risk, administration, and surrender, depending on the structure of the contract. Variable accounts are also charged an investment fee and a sales charge. Torchmark benefits to the extent these policy charges exceed actual costs and, on fixed-annuity policies, to the extent actual investment income exceeds the investment income which is credited to the policy.
Prior to the second quarter of 2001, Torchmark’s annuities were sold primarily by the Waddell & Reed sales force, which marketed United Investors’ products under a marketing agreement. Effective April 30, 2001, Torchmark terminated the marketing agreement providing for the sale of Torchmark’s variable annuities by the Waddell & Reed sales force due to a dispute over compensation due and Waddell & Reed’s replacement of United Investors’ variable annuities with those of another carrier. Waddell & Reed was a former subsidiary of Torchmark which was spun off in 1998. In addition to no longer marketing United Investors’ products, Waddell & Reed has continued replacing United Investors’ products with those of another carrier since the termination of the agreement. As a result, Torchmark has experienced declines in annuity sales and deposit balances.
Annuity underwriting margin before other income and administrative expense declined from $26 million in 2001 to $15 million in 2002 to $12 million in 2003. The declines in annuity underwriting income also resulted from the declines in the average annuity account balance in each period. Underwriting income as a percentage of policy charges was 37.7% in 2003, consistent with 37.3% in 2002. The higher ratio in 2001 (42.9%) resulted primarily from the additional surrender charges in that year.
Revenues include realized losses of $3.3 million in 2003, $38.7 million in 2002, and $1.3 million in 2001. Revenues in 2003 also include a nonrecurring interest income benefit of $4.3 million related to a tax settlement. Because realized gains and losses and nonrecurring items bear no relationship to core operations, Torchmark management removes the effect of these items from revenue when evaluating expense ratios.
Excess investment income represents the profit margin attributable to investment operations. It is the measure that management uses to evaluate the performance of the investment segment as described in Note 16-Business Segments in the Notes to the Consolidated Financial Statements. It is defined as net investment income on a tax-equivalent basis reduced by the interest credited to net policy liabilities and
Excess investment income per diluted share is the measure used by management to evaluate the performance of the investment segment. This segment is responsible for the management of capital resources including investments, debt and cash flow. Since 1986, Torchmark has used over $2 billion of cash flow to repurchase Torchmark shares under its ongoing share repurchase program after determining that the repurchases provided a greater return than other investment alternatives. Share repurchases reduce excess investment income because of the foregone earnings on the cash that would otherwise have been invested in interest bearing assets, but they also reduce the number of shares outstanding. In order to put all capital resource uses on a comparable basis, management believes that excess investment income per diluted share is the best measure of the investment segment.
As shown on the following chart, interest credited to the net insurance policy liabilities increased 7% to $206 million in 2003 and 2% to $193 million in 2002.
The 7% increase in interest credited in 2003 was due to a 10% increase in average net liabilities offset by a reduction in the average crediting rate from 5.64% to 5.46%. As discussed under the caption Annuities, the 10% growth in net policy liabilities was primarily due to the annuity production from a new
Financing costs have declined significantly during the past two years, falling 33% in 2002 and an additional 15% in 2003. The decline in short-term interest rates over the past two years has been a significant factor in the decline in financing costs for two reasons. First, it has reduced short-term borrowing costs in each period. Secondly, it has favorably impacted the benefit of Torchmark’s three interest-rate swaps of fixed-rate interest obligations to floating rates. A full description of these swaps is disclosed in Note 13-Debt in the Notes to the Consolidated Financial Statements.
Financing costs have also benefitted from Torchmark’s restructuring of its debt in 2001, redeeming the 9.18% Monthly Income Preferred Securities for lower fixed-rate debt. The issuance and redemption of Torchmark’s debt instruments are disclosed in Note 13-Debt and are further discussed under the caption Capital Resources in this report.
per share. It increased 20% in 2002 and 15% in 2001. The growth in excess investment income in both 2003 and 2002 resulted from the increased investment income due to the growth in the portfolio and the reductions in financing costs caused by the lower interest-rate environment in both years. Additionally, share purchases have caused excess investment income per share to grow faster than excess investment income as the effect of the foregone interest income on funds used for the repurchase was more than offset by the reduced number of diluted shares outstanding. Torchmark acquired 5.9 million shares in 2003 at a cost of $225 million and 4.8 million shares in 2002 at a cost of $182 million.
The chart below presents selected information about Torchmark’s fixed-maturity acquisitions in the years 2001 through 2003. Investment-grade corporate securities include both bonds and trust preferred securities (classified as redeemable preferred stocks) with a diversity of issuers and industry sectors. Both yield and average life calculations on new purchases on noncallable bonds are based on the maturity date. In the case of callable bonds, the average life is based on the call date or maturity date, whichever produces the lowest yield (“yield to worst”).
As rates have declined in recent periods, Torchmark has maintained yield on new investments by lengthening maturities. Management believes that the long-term, fixed-rate characteristics of its policy liabilities do not result in negative asset and liability matching. In years prior to 2003, Torchmark was able to maintain yields in excess of 7.25% on new acquisitions of investment-grade bonds. In 2003, however, yields at this level were unavailable for investment-grade bonds due to the lower-rate environment. As a result, new money was invested at an average effective yield of 6.55% in 2003. While the lower yields available to Torchmark reduce investment income, the impact of the lower rates on excess investment income and total net income is expected to be immaterial in the near term. This is because Torchmark has been able to reduce the crediting rates on the majority of its interest-sensitive and annuity products, offsetting a large portion of the reduction in income. Additionally, the lower interest-rate environment reduces the cost of Torchmark’s commercial paper borrowings and enhances the benefits from its interest-rate swaps, further reducing financing costs and minimizing the impact of lower investment rates on income.
Management believes its strategy to maintain yields has been effective, as evidenced by the increases in excess investment income as a percentage of tax-equivalent investment income even in
periods of very low interest rates. Management also believes that Torchmark will benefit as rates eventually rebound. Funds generated annually from insurance operations as well as those from the investment portfolio exceed the total of floating rate liabilities, and reinvestment at higher rates should result in a positive benefit to excess investment income.
An analysis of Torchmark’s fixed-maturity portfolio by component at December 31, 2003 is as follows.
At the end of 2003, the fixed-maturity portfolio had a gross unrealized gain of $670 million, compared with $482 million at the end of 2002. Gross unrealized losses on fixed maturities were $39 million at December 31, 2003, compared with $177 million a year earlier. The following tables disclose selected information about the gross unrealized losses of Torchmark’s fixed maturities at December 31, 2003.
Based on the information available at December 31, 2003, Torchmark believes that the par value of these securities will be recoverable.
Credit Risk Sensitivity. Credit risk is the level of certainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. In recent periods, the securities of many industry sectors affected by the economic downturn have suffered increased credit risk. As a result, many securities have been downgraded by credit-rating agencies to below-investment grade status. Thus, the likelihood the issuers will honor their securities’ terms has been reduced and the securities’ market values have been impaired. As Torchmark continues to invest in corporate bonds with relatively long maturities, credit risk is a concern. Torchmark mitigates this ongoing risk, in part, by acquiring investment-grade bonds, and by investigating the financial fundamentals of each prospective issuer. At December 31, 2003, approximately 93% of invested assets at fair value were held in fixed-maturity securities. The major rating agencies considered 91% of this portfolio to be investment grade. The average quality rating of the portfolio continues to be BBB+. The table below demonstrates the credit rankings of Torchmark’s fixed-maturity portfolio at fair value as of December 31, 2003.
Torchmark’s current investment policy is to acquire only investment-grade obligations. Thus, increases in below investment-grade issues are a result of ratings downgrades of existing holdings.
Torchmark reduces credit risk by maintaining investments in a wide range of industry sectors. The following table presents the industry sectors that exceeded 2% of the corporate fixed-maturity portfolio at December 31, 2003.
Market Risk Sensitivity. Market risk is the risk that the value of a security will change because of a change in market conditions. Torchmark’s primary exposure to market risk is interest rate risk, which is the risk that a change in a security’s value could occur because of a change in interest rates. This risk is significant to Torchmark’s investment portfolio because its fixed-maturity holdings at amortized cost represent approximately 93% of total investments. The effects of interest rate fluctuations on fixed investments are reflected on an after-tax basis in Torchmark’s shareholders’ equity because these investments are marked to market value under SFAS 115.
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 $4.2 billion and debt was $.9 billion at December 31, 2003, compared with fixed-maturity investments of $7.5 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 61% within ten years.
No derivative instruments are used to manage Torchmark’s exposure to market risk in the investment portfolio. Interest-rate swap instruments have been entered into by Torchmark in connection with its preferred stock and certain debt issues as discussed in Note 13-Debt in the Notes to the Consolidated Financial Statements and under the caption Capital Resources in this report.
Realized Gains and Losses. Torchmark’s core business of providing insurance coverage requires it to maintain an investment portfolio to support its insurance liabilities. These insurance liabilities are often very long-term in nature, with the realization of profits from core insurance operations emerging over many years. The investments that support these liabilities consist primarily of fixed maturities, with yields expected to provide for the cost of carrying these insurance liabilities. These expected yields are taken into account when setting insurance premium rates and product profitability expectations. As a result, fixed maturities are generally held for long periods to support the liabilities, even though they are available for sale at any time.
Because Torchmark holds a large and diverse investment portfolio, investments are sold or called from time to time, resulting in a realized gain or loss. These gains and losses occur only incidentally, and are usually the result of sales for tax reasons, deterioration in investment quality of issuers, or calls by the issuers. Torchmark does not engage in trading investments for profit. Therefore, gains or losses which occur in protecting the portfolio or its yield are only secondary to Torchmark’s core insurance operation of providing insurance coverage to policyholders.
Realized gains and losses can be significant in relation to the earnings from core insurance operations, and as a result, have a material positive or negative impact on net income. They are not considered in determining premium rates or product profitability of Torchmark’s insurance products, nor are they considered to be part of ongoing investment income. Therefore, they have no bearing on core insurance operations or segment results as management views its operations because such results might not be indicative of the past or future performance of core operations. For these reasons, Torchmark management removes the effects of realized gains and losses when evaluating its overall insurance operating results.
In each year, 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 Note 3-Investments in the Consolidated Financial Statements and in its Critical Accounting Policies in this report. Pretax charges for these impairments were $10 million in 2003, $89 million in 2002, and $9 million in 2001. Of the seventeen issuers written down in 2001 through 2003, the bonds of five issuers were still held at December 31, 2003 at a fair value of $43 million and a book value of $19 million.
Accounting rules require Torchmark to revalue its interest-rate swaps at their fair value at the end of each accounting period. The fair values of these instruments fluctuate with interest rates in financial markets and diminish with the passage of time so that their value is zero when they expire. Torchmark intends to hold its swaps until they expire. Therefore, while period-to-period fluctuations can be
substantial, the value of the swaps and the cumulative unrealized gains and losses from marking the swaps to market value from inception will be zero when the swap agreements expire. Temporary unrealized changes in swap values are included as a component of “Realized investment losses” on the Consolidated Statements of Operations. This fair value adjustment for all swaps on a pretax basis was a negative $16 million in 2003, a positive $18 million in 2002, and a positive $5 million in 2001.
In September, 2003, the Securities and Exchange Commission informally interpreted SFAS 133, the GAAP rules concerning the reporting of nonhedged derivatives. Their interpretation concluded that all income and expenses related to a non hedged derivative must be recorded in the same line item on the income statement that the adjustment to fair value is recorded. This interpretation was effective immediately with prior periods reclassified accordingly for comparability. This interpretation requires cash settlements in interest cost to be combined with the noncash unrealized fair value adjustment as a component of realized investment gains and losses. Torchmark’s pretax interest cost reduction from its swap derivatives that was included in realized investment gains was a positive $26 million in 2003, a positive $23 million in 2002, and a positive $8 million in 2001. Torchmark continues to reduce interest cost for this benefit in its segment analysis as permitted because Torchmark views the benefit from lower interest rates as a reduction in its financing costs.
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 2003, Torchmark held $35 million at fair value of asset-backed securities subject to the provisions of EITF 99-20. Under the provisions of this standard, these investments were not considered impaired. For more information on the effects of this accounting rule, see Note 11-Change in Accounting Principle in the Notes to the Consolidated Financial Statements.
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 is split into two parts: a $325 million 364-day tranche maturing November 24, 2004, and a $300 million five-year tranche maturing November 30, 2006. The company has the ability to request up to $200 million in letters of credit to be issued against the $300 million five-year tranche. Under either tranche, interest is charged at floating rates. The line of credit is further designated as a back-up credit line for a commercial paper program not to exceed $600 million, whereby Torchmark may borrow from either the credit line or issue commercial paper at any time. Commercial paper borrowings and letters of credit on a combined basis may not exceed $625 million. At December 31, 2003, $182 million carrying amount of commercial paper was outstanding, $159 million letters of credit were issued, and there were no borrowings under the line of credit. Although the commercial paper borrowing balance fluctuates based on Torchmark’s needs, a facility fee is charged on the entire $625 million facility. The facility does not contain any ratings-based acceleration triggers which would require early repayment. In accordance with the agreements, Torchmark is subject to certain covenants regarding capitalization and earnings. At December 31, 2003, Torchmark was in full compliance with these covenants. Borrowings on this facility are reported as short-term debt.
Liquidity of the parent company is affected by the ability of the subsidiaries to pay dividends. The parent receives dividends from subsidiaries in order to meet dividend payments on common and preferred stock, interest and principal repayment requirements on parent-company debt, and operating expenses of the parent company. Dividends from insurance subsidiaries of Torchmark are limited to the greater of statutory net gain from operations, excluding capital gains and losses, on an annual noncumulative basis, or 10% of surplus, in the absence of special approval. Distributions are not permitted in excess of statutory net worth. Subsidiaries are also subject to certain minimum capital requirements. Although these restrictions exist, dividend availability from subsidiaries historically has
substantially exceeded the cash flow needs for parent company operations. In 2003, subsidiaries of Torchmark paid $314 million in dividends to the parent company. During the year 2004, a maximum amount of $341 million is expected to be available to Torchmark from insurance subsidiaries without regulatory approval.
Off-Balance Sheet Arrangements. As of December 31, 2003, Torchmark had no off-balance sheet arrangements, no significant unconsolidated affiliates, no variable interest entities, and no guarantees of the obligations of third-party entities. All of Torchmark’s guarantees, as disclosed in Note 17-Commitments and Contingencies, were guarantees of the performance of consolidated subsidiaries. All of Torchmark’s derivative instruments were recorded at fair value on the balance sheet.
As described under the caption New Accounting Rules, the Financial Accounting Standards Board (FASB) has issued a revised interpretation of rules concerning consolidation of variable interests (FIN46R). This interpretation will result in the trusts which are liable for Torchmark’s Trust Preferred Securities being deconsolidated as of January 1, 2004 and reflected as “off-balance sheet arrangements,” even though Torchmark is the sole owner and has total voting control of these trusts.
The following table presents Torchmark’s scheduled contractual obligations for the selected periods as of December 31, 2003.
The carrying value of Torchmark’s 6 1/4% Senior Notes is adjusted each period to reflect the change in fair value of a swap instrument which hedges the value of the note. This instrument increased the value of long-term debt by $12.0 million and $15.1 million at December 31, 2003 and December 31, 2002, respectively.
During 2001, Torchmark redeemed its Monthly Income Preferred Securities, redemption amount $200 million, and issued its $150 million 7 3/4% Trust Preferred Securities and $180 million 6 1/4% Senior Notes. Information about the issuance and redemption of these instruments, including the terms and the uses of proceeds, are disclosed in Note 13-Debt in the Notes to the Consolidated Financial Statements. In connection with these instruments, Torchmark has in place three interest-rate swap agreements in which Torchmark has exchanged its fixed-rate obligations on the debt instruments to floating rates. Information about these swaps is also found in this note.
On July 24, 2003, Torchmark’s Board reaffirmed its continued authorization of the Company’s stock repurchase program in amounts and timing that management, in consultation with the Board, determined to be in the best interest of the Company. Torchmark has repurchased its common stock every year since 1986, except for 1995, the year following the acquisition of American Income. Since 1998, Torchmark has repurchased 34.8 million shares at a total cost of $1.2 billion, and has acquired no fewer than 3.4 million shares in any one year. Management believes that Torchmark share purchases at favorable prices add incrementally to per share earnings, return on equity, and are an excellent way to increase total shareholder value. In 2003, Torchmark acquired 5.9 million shares at a cost of $225 million. If the $225 million free cash flow used for the repurchase of Torchmark common stock had alternatively been invested in corporate bonds, an estimated $5.7 million of additional investment income, after tax, would have resulted and net income per diluted share would have increased 15% to $3.67. Because share purchases were made, actual net income per share was $3.73, an increase of 17%. Torchmark intends to continue the repurchase of its common shares when financial markets are favorable. In 2002, Torchmark acquired 4.8 million shares at a cost of $182 million and purchased 7.8 million shares at a cost of $303 million in 2001.
Credit Ratings. The credit quality of Torchmark’s debt instruments and capital securities are rated by various rating agencies. During 2003, Standard and Poor’s upgraded Torchmark’s funded debt rating from A to A+ and its preferred securities rating from BBB+ to A-. The chart below presents Torchmark’s credit ratings as of December 31, 2003.
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 17-Commitments and Contingencies in the Notes to the Consolidated Financial Statements.
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 2003 was $1.6 million, in 2002 was $780 thousand, and in 2001 was $108 thousand. At December 31, 2003, the face amount of life insurance ceded was $241 million and annualized ceded premium was $2.0 million.
The collateral loan agreement was originally entered into in 1998 with an initial loan of $7 million and an additional $15 million loaned in 2001. The loan bears interest at a rate of 7%. 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. It is collateralized by a group of mutual funds and real estate in which the loan balance can never exceed 90% of the mutual funds pledged plus 75% of the appraised value of the real estate. Because First Command made a significant payment in 2003, the outstanding loan balance at December 31, 2003 was $12.7 million, compared with $22.0 million at December 31, 2002. The market value of the mutual funds pledged was $12.6 million at December 31, 2003. The real estate was appraised by an independent firm in 2002 for $17.6 million.
In the fourth quarter of 2003, a reserve in the pretax amount of $5 million was established on certain mortgages that met Torchmark’s criteria for impairment. These mortgages were originated and serviced by MidFirst.
Baxley. William J. Baxley is a partner in the law firm of Baxley, Dillard, Dauphin, McKnight & Barclift 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, 2003 and 2002, the outstanding balance of this loan was $689 thousand and $743 thousand, respectively.
In future periods, Torchmark does not believe that the provision for guaranteed minimum policy benefits will have a material impact on its operations. However, the liability for guaranteed minimum policy benefits is highly dependent on the performance of financial markets, whereby poor market performance in the future could increase Torchmark’s obligations.
Deconsolidation. In January 2003, the FASB issued FASB Interpretation 46 (FIN 46), Consolidation of Variable Interest Entities, which Torchmark adopted in 2003 with no impact to the consolidated financial statements. In December, 2003, the FASB revised FIN 46 (FIN46R) and deferred its adoption for variable interest entities (VIEs) that meet certain criteria until the first quarter of 2004. FIN46R clarified the definition of a variable interest such that only the holder of a variable interest can ever be the VIE’s primary beneficiary. Only primary beneficiaries are permitted to consolidate VIEs. Therefore, FIN46R does not permit consolidation of VIEs in which a company has voting control but is not the primary beneficiary. The trusts that are liable for Torchmark’s Trust Preferred Securities meet the definition of VIEs. Under FIN46R, Torchmark does not have a variable interest in the trusts and therefore cannot be the entity’s primary beneficiary. For this reason, Torchmark may no longer consolidate the trusts, even though Torchmark is the sole owner of the voting equity of these entities.
Upon adoption, effective January 1, 2004, prior periods will be restated for comparability. The effect of adoption will be to increase Torchmark’s long-term debt by approximately $5 million with a corresponding increase in an asset of equal amount. In addition, investment income and interest expense will be increased by approximately $350 thousand per year.
Future Policy Benefits. Because of the long-term nature of insurance contracts, Torchmark’s insurance companies are liable for policy benefit payments that will be made in the future. The liability for future policy benefits is determined by standard actuarial procedures common to the life insurance industry. The accounting policies for determining this liability are disclosed in Note 1-Significant Accounting Policies in the Notes to the Consolidated Financial Statements. While management and company actuaries have used their best judgment in determining the assumptions and in calculating the liability for future policy benefits, there is no assurance that the estimate of the liabilities reflected in the financial statements represents Torchmark’s ultimate obligation. Additionally, because of the size of this liability, significantly different assumptions could result in materially different reported amounts. A complete list of the assumptions used to calculate the liability for future policy benefits is reported in Note 6-Future Policy Benefits Reserves in the Notes to the Consolidated Financial Statements.
Deferred Acquisition Costs and Value of Insurance Purchased. The costs of acquiring new business are generally deferred and recorded as an asset. 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.” Torchmark’s policies for accounting for deferred acquisition costs and the associated amortization are reported in Note 1-Significant Accounting Policies in the Notes to the Consolidated Financial Statements. 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 5-Deferred Acquisition Costs and Value of Insurance Purchased in the Notes to the Consolidated Financial Statements.
Impairment of Investments. Torchmark continually monitors its investment portfolio for investments that have become impaired in value. While the values of the investments in Torchmark’s portfolio constantly fluctuate due to market conditions, an investment is considered to be impaired only when it has
experienced a decline in fair market value which is deemed other than temporary. The policies and procedures that Torchmark uses to evaluate and account for impairments of investments are disclosed in Note 1-Significant Accounting Policies and Note 3-Investments in the Notes to the Consolidated Financial Statements and the discussions under the captions Investments and Realized Gains and Losses in this report.
Defined benefit pension plans. Torchmark maintains funded defined benefit plans covering most full-time employees. It also has unfunded nonqualified defined benefit plans covering certain key and other employees. Torchmark’s obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are offset by the growth in value of the assets in the funded plans.
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2003
As discussed in Note 13 to the consolidated financial statements, Torchmark Corporation and subsidiaries changed their classification of the trust preferred securities in 2003, in accordance with Statement of Financial Accounting Standards No. 150, Accounting for Certain Financial Instruments With Characteristics of Both Liabilities and Equity. In addition, as discussed in Note 1 to the consolidated financial statements, Torchmark Corporation and subsidiaries changed their method of accounting for goodwill in 2002, in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.
Gains and losses realized on the disposition of investments are determined on a specific identification basis. Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark’s net income. Investment income attributable to all other insurance policies and products is included in Torchmark’s net investment income. Net investment income for the years ended December 31, 2003, 2002, and 2001, included $351 million, $332 million, and $321 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocated to insurance policyholders’ liabilities.
Derivatives: Torchmark accounts for derivative instruments in accordance with Statement of Financial Accounting Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging Activities, as amended. At December 31, 2003 and 2002, 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 133, gains and losses in the derivative are substantially offset by changes in the underlying hedged instrument.
During 2003, the Securities and Exchange Commission made known interpretative guidance concerning SFAS 133. They have concluded that all income and expenses related to a nonhedged derivative must be recorded in the same line item that the adjustment to fair value is recorded. This interpretation also requires prior periods to be reclassified accordingly for comparability. In order to comply with this interpretation, Torchmark no longer reduces its interest expense on the Statement of Operations for the reduction in interest cost for swapping its fixed rate for a variable rate on nonhedged derivatives. Instead, this benefit is reported as a component of realized investment gains (losses), the same line where the required fair value adjustment for nonhedged derivatives is reported. Torchmark has also reported the interest cost benefit on hedged derivatives as a component of realized gains (losses), in order to report these items on a consistent basis.
Determination of Fair Values of Financial Instruments: Fair value for cash, short-term investments, short-term debt, receivables and payables approximates carrying value. Fair values for investment securities are based on quoted market prices, where available. Otherwise, fair values are based on quoted market prices of comparable instruments. Mortgages are valued using discounted cash flows. Substantially all of Torchmark’s long-term debt, along with the trust preferred securities, is valued based on quoted market prices. Interest-rate swaps are valued using discounted anticipated cash flows.
Deferred Acquisition Costs and Value of Insurance Purchased: The costs of acquiring new business are generally deferred and recorded as an asset. 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 and the value of insurance purchased are amortized in a systematic manner which matches these costs with the associated revenues. 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. Limited-payment contracts are amortized over the contract period. Universal life-type policies are amortized with interest in proportion to estimated gross profits. 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
Goodwill: The excess cost of businesses acquired over the fair value of their net assets is reported as goodwill. Effective January 1, 2002, Torchmark adopted SFAS 142, Goodwill and Other Intangible Assets. SFAS 142 changed the accounting for goodwill from an amortization method to an impairment method. SFAS 142 calls for goodwill to be subject to impairment testing upon implementation and annually thereafter based on the procedures outlined in the Statement. Amortization of goodwill is not permitted after adoption. Restatement of prior year results to exclude the amortization of goodwill for comparability is prohibited.
The pro forma effect of the adoption of SFAS 142 on reported earnings are as follows:
In 2001, $29.4 million was related to a restoration grant as discussed in Note 15 - Employee Stock Options.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2003 and 2002 is as follows:
A schedule of fixed maturities by contractual maturity at December 31, 2003 is shown below on an amortized cost basis and on a fair value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions.
Proceeds from sales of fixed maturities available for sale were $92 million in 2003, $424 million in 2002, and $926 million in 2001. Gross gains realized on those sales were $3.7 million in 2003, $25.4 million in 2002, and $20.6 million in 2001. Gross losses were $13.5 million in 2003, $14.7 million in 2002, and $21.4 million in 2001. Proceeds from sales of equity securities were $5.3 million in 2003. Gross gains realized on those sales were $1.5 million and there were no gross realized losses. There were no sales of equity securities during 2002 or 2001.
Torchmark’s portfolio of fixed maturities fluctuates in value based on interest rates in financial markets and other economic factors. These fluctuations caused by market rate changes have little bearing on whether or not the investment will be ultimately recoverable. Therefore, Torchmark considers these declines in value as temporary even in periods exceeding one year. In certain circumstances,
however, it may become apparent that the principal of an investment may not be recoverable, generally due to factors specific to an individual issuer and not market interest rates. In this event, Torchmark classifies such investments as other-than-temporarily impaired and writes the investment down to fair value, realizing an investment loss. The determination that a security is other-than-temporarily impaired is highly subjective and involves the careful consideration of many factors. These factors include:
Torchmark maintains a “watchlist” of all securities upon which are reported those investments that have a fair value less than 80% of book value, have a NAIC designation of 5 or 6, or were previously impaired and written down. Securities on this list are reviewed and tested for impairment at least quarterly. At December 31, 2003, securities of twelve issuers were on this list with a fair value of $96 million and a book value of $77 million. Securities of 4 issuers with a fair value of $20 million and a book value of $25 million were in this position for more than a year. As of December 31, 2003, Torchmark has no information available to cause it to believe that any of these investments are other-than-temporarily impaired.
Torchmark had $7.5 million in investment real estate at December 31, 2003, which was nonincome producing during the previous twelve months. These properties consisted primarily of undeveloped land. Torchmark had $9.2 million in nonincome producing mortgages as of December 31, 2003. Torchmark had $2.7 million in nonincome producing fixed maturities during the twelve months ended December 31, 2003. There were no other long-term investments which were nonincome producing at December 31, 2003.
During 2003, Torchmark recorded a reserve against its mortgage loans on real estate portfolio as a result of impairments. The reserve resulted in a pretax loss of $5 million, or $3.3 million after tax. At December 31, 2003, Torchmark owned $115.4 million in mortgage real estate.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $5.5 million, $6.6 million, and $7.7 million, for the years ended December 31, 2003, 2002, and 2001, respectively. The average interest rates used for the years ended December 31, 2003, 2002, and 2001, were 5.7%, 6.1%, and 6.2%, respectively. The estimated amortization, net of interest accrued, on the unamortized balance at December 31, 2003 during each of the next five years is: 2004, $10.6 million; 2005, $9.2 million; 2006, $7.8 million; 2007, $6.8 million; and 2008, $5.8 million.
A summary of the assumptions used in determining the liability for future policy benefits at December 31, 2003 is as follows:
The overall average interest assumption for determining the liability for future life and health insurance benefits in 2003 was 5.9%.
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 which were subject to impairment writedowns 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.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. All plan measurements for the defined benefit plans are as of December 31 of the respective year. The defined benefit pension plans covering the majority of employees are funded. Contributions are made to the pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Defined benefit plan contributions were $10.4 million in 2003, $7.2 million in 2002, and $1.0 million in 2001. Torchmark estimates as of December 31, 2003 that it will contribute an amount not to exceed $20 million to these plans in 2004. The actual amount of contribution cannot reasonably be determined as of December 31, 2003.
Plan assets in the funded plans consist primarily of investments in marketable long-term fixed maturities and equity securities and are valued at fair market value. The following table presents the assets of Torchmark’s defined benefit pension plans by component for the years ended December 31, 2003 and 2002.
Portfolio risk is managed through quality standards, diversification, and continuous monitoring. Equities must be listed on major exchanges and adequate market liquidity is required. Fixed maturities must be rated investment grade at purchase by a major rating agency. Short-term investments in commercial paper must be rated at least A-2 by Standard & Poor’s with the issuer rated investment grade. Invested cash is limited to banks rated A or higher. Investments outside of the aforementioned list are not permitted, except by prior approval of the Plans’ Trustees. At December 31, 2003, there were no restricted investments contained in the portfolio.
The expected long-term rate of return on plan assets is management’s best estimate of the average rate of earnings expected to be received on the assets invested in the plan over the benefit period. In determining this assumption, consideration is given to the historical rate of return earned on the assets, the projected returns over future periods, and the spread between the long-term rate of return on plan assets and the discount rate used to compute benefit obligations.
Torchmark has estimated its expected pension benefits to be paid over the next ten years as of December 31, 2003. These estimates use the same assumptions that measure the benefit obligation at December 31, 2003, taking estimated future employee service into account. Those estimated benefits are as follows:
For retired employees over age sixty-five, Torchmark does not provide postretirement benefits other than pensions. Torchmark does provide a portion of the cost for health insurance benefits for certain employees who retired before February 1, 1993 and for certain employees that retired before age sixty-five, covering them until they reach age sixty-five. Eligibility for this benefit was generally achieved at age fifty-five with at least fifteen years of service. This subsidy is minimal to retired employees who did not retire before February 1, 1993. Because Torchmark does not offer postretirement health benefits to retired employees over age sixty-five, passage of the Medicare Prescription Drug Improvement and Modernization Act of 2003 has no effect on its benefit obligations.
The amount of debt that becomes due during each of the next five years is: 2004-$182,448, 2005-$0, 2006-$180,000, 2007-$0, 2008-$0, and thereafter-$512,412.
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%. These notes are not callable prior to maturity and have equal priority with other Torchmark unsecured indebtedness.
Interest rate swaps: All swaps are carried at fair value and are classified as “Other long-term investments” on the Consolidated Balance Sheet. The swap related to the Senior Notes qualifies as a hedge under accounting rules. Changes in the fair value of this swap adjust the carrying value of the Senior Notes in like amount each period. The following tables summarize selected information about interest rate swaps.
$200 million of Monthly Income Preferred Securities were redeemed in full in 2001, but the related swap was retained.
Commercial Paper: 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 24, 2004 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, 2003, Torchmark had $183 million face amount of commercial paper outstanding, $159 million of letters of credit issued, and no borrowings under the line of credit. During 2003, the short term borrowings under the combined facilities averaged approximately $175 million, and were made at an average yield of 1.2%. 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 2003, 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, 2003.
Retirement of Treasury Stock: In 2003, Torchmark retired 13 million shares of its treasury stock. The retirement of these shares resulted in a decrease in common stock of $13 million, a decrease in additional paid-in capital of $56 million, a decrease in retained earnings of $426 million, and a decrease in treasury stock of $495 million in 2003. In 2001, Torchmark retired 21 million shares of its treasury stock. This retirement resulted in a decrease in common stock of $21 million, a decrease in additional paid-in capital of $89 million, a decrease in retained earnings of $527 million, and a decrease in treasury stock of $637 million.
Stock options to purchase 3,252,445, 5,551,271, and 3,305,025 as of December 31, 2003, 2002, and 2001, 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.
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. As a result of this restoration program, management’s ownership interest increased, and Torchmark received a significant current tax benefit from the exercise of the options.
A summary of Torchmark’s stock option activity and related information for the years ended December 31, 2003, 2002, and 2001 follows:
The weighted average fair value of options as determined by the option pricing model granted during the years ended December 31, 2003, 2002, and 2001 were $10.52, $10.33, and $13.00, respectively.
The following table summarizes information about stock options outstanding at December 31, 2003.
Torchmark markets its insurance products through a number of distribution channels, each of which sells the products of one or more of Torchmark’s insurance segments. The tables below present segment premium revenue by each of Torchmark’s marketing groups.
Because of the nature of the insurance industry, Torchmark has no individual or group which would be considered a major customer. Substantially all of Torchmark’s business is conducted in the United States, primarily in the Southeastern and Southwestern regions.
The measure of profitability for the investment segment is excess investment income, which represents the income earned on the investment portfolio in excess of net policy requirements and financing costs associated with Torchmark’s debt. The investment segment is measured on a tax-equivalent basis, equating the return on tax-exempt investments to the pretax return on taxable investments. Other than the above-mentioned interest allocations, there are no other intersegment revenues or expenses. Expenses directly attributable to corporate operations are included in the “Corporate” category. All other unallocated revenues and expenses on a pretax basis, including insurance administrative expense, are included in the “Other” segment category. The following tables set forth a reconciliation of Torchmark’s revenues and operations by segment to its major income statement line items.
Investment segment includes preferred distributions, net of swap benefit, on a pretax basis
Investment segment includes preferred distributions, net of swap benefit, on pretax basis.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. Rental expense for operating leases was $4.7 million in 2003, $3.4 million in 2002, and $3.2 million in 2001. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2003 are as follows: 2004, $3.3 million; 2005, $2.7 million; 2006, $2.3 million; 2007, $1.9 million; 2008, $1.6 million and in the aggregate, $17.4 million.
Otherwise, no individual industry represented 2% or more of Torchmark’s investments. At year-end 2003, 9% of invested assets was represented by fixed maturities rated below investment grade (BB or lower as rated by the Bloomberg Composite or the equivalent NAIC designation). Par value of these investments was $736 million, amortized cost was $713 million, and fair value was $752 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value.
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 Life Insurance Company. 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, 2003, the present value of future commissions substantially exceeded the purchased balance.
Litigation: Torchmark and its subsidiaries, in common with the insurance industry in general, are subject to litigation, including claims involving tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark’s subsidiaries, employment discrimination, and miscellaneous other causes of action. A number of such actions involving Torchmark’s subsidiary Liberty also name Torchmark as a defendant. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, management does not believe that such litigation will have a material adverse effect on Torchmark’s financial condition, future operating results or liquidity, however, assessing the eventual outcome of litigation necessarily involves forward-looking speculation as to judgments to be made by judges, juries and appellate courts in the future. This bespeaks caution, particularly in states with reputations for high punitive damage verdicts such as Alabama and Mississippi.
On December 23, 2003, an order of dismissal was entered by the U.S. District Court for the Northern District of Mississippi in Cates v. Liberty National Life Insurance Company, Civil Action No. 4:03CV35-P-B, one of the three above-mentioned Mississippi cases. In another of the Mississippi cases, Billingsley v. Liberty National Life Insurance Company, (Civil Action No. 2002-532), the U.S. District Court entered an order of partial dismissal on January 30, 2004, reducing the remaining number of plaintiffs to nine persons with claims involving 14 policies.
defendants in litigation filed in the U.S. District Court for the District of Kansas by Waddell & Reed Financial, Inc. (Waddell & Reed) (Waddell & Reed Financial, Inc. v. Torchmark Corporation, Civil Action No. 01-2372-KHV). Torchmark and UILIC are also plaintiffs in litigation in Circuit Court in Jefferson County, Alabama against Waddell & Reed and Waddell & Reed, Inc. (W&R) (United Investors Life Insurance Company v. Waddell & Reed Financial, Inc., Case No. CV 00-2720). On November 2, 2003, the Jefferson County Alabama Circuit Court denied Waddell & Reed’s motion for summary judgment filed in October 2003. UILIC continues to pursue its remaining claims against Waddell & Reed in this case which is pending in the Alabama Circuit Court. Additional information regarding the Kansas District Court litigation and the Alabama Circuit Court litigation can be found in the Company’s prior Forms 10-K and Forms 10-Q.
The collateral loan agreement was originally entered into in 1998 with an initial loan of $7 million and an additional $15 million loaned in 2001. The loan bears interest at a rate of 7%. 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. It is collateralized by a group of mutual funds and real estate in which the loan balance can never exceed 90% of the mutual funds pledged plus 75% of the appraised value of the real estate. Because First Command made a significant payment in 2003, the outstanding loan balance at December 31, 2003 was $12.7 million compared with $22.0 million at December 31, 2002. The market value of the mutual funds pledged was $12.6 million at December 31, 2003. The real estate was appraised by an independent firm in 2002 for $17.6 million.
the outstanding balance of the collateralized note with Elgin Development Company was $10.1 million. In 2003, Elgin Development defaulted on the note. As a result, Torchmark foreclosed on the collateral which consisted of real estate with a value of $5.7 million. Torchmark recognized a realized loss on the transaction of $2.6 million after tax.
The following is a summary of quarterly results for the two years ended December 31, 2003. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.