The following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the "Company") for the years ended December 31, 2014 and 2013. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report.
DAC and Cost of Insurance Acquired - Deferred acquisition costs are commissions, premium taxes and other costs that vary with and are primarily related to the acquisition of new and renewal business and are generally deferred and amortized. The deferred amounts are recorded as an asset and amortized to expense in a systematic manner. Additionally, the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies are also deferred and recorded as deferred acquisition costs as indicated in Note 1 - Summary of Significant Accounting Policies in the Notes to the Consolidated Financial Statements.
Discounted mortgage loans consist of loans that were purchased at a deep discount through an auction process led by the Federal Government. In general, the discounted mortgage loans are non-performing and there is a significant amount of uncertainty surrounding the timing and amount of cash flows to be received by the Company. Accordingly, the Company records its investment in the discounted mortgage loans at its original purchase price adjusted for any principal receipts received.
On a consolidated basis, the Company had net income attributable to common shareholders of $7 million and $3.3 million in 2014 and 2013, respectively. In 2014, income before income taxes was $11.1 million compared to $4.7 million in 2013. Total revenue was $43.6 million in 2014 and $34.4 million in 2013.
Total benefits and other expenses paid in 2014 were $32.5 million compared to $29.7 million in 2013.
Premiums and policy fee revenues, net of reinsurance premiums and policy fees, decreased approximately 7% when comparing 2014 to 2013. The Company writes very little new business. Unless the Company acquires a new company or a block of in-force business, Management expects premium revenue to continue to decline on the existing block of business at a rate consistent with prior experience. The Company's average persistency rate for all policies in-force for 2014 and 2013 was approximately 96.6% and 96.5%, respectively. Persistency is a measure of insurance in-force retained in relation to the previous year.
In recent periods, discounted mortgage loans have become more difficult to purchase as the result of an increase in market competition. Management expects the discounted mortgage loan portfolio to continue to shrink as a result of the market competition and mortgage loan payoffs. While Management believes the discounted loans will continue to have favorable earnings and outcomes as they are worked through, there can be no assurance this will remain true in future periods. Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers' ability to pay or refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices.
Income from the real estate portfolio decreased approximately 13% or $1.2 million when comparing the current and prior year results. Similar to the discounted mortgage loan portfolio, the results of the real estate investment portfolio are mainly driven by one-time events.
The Company's net realized investment gains increased substantially in comparison to the prior year and are mainly the result of gains recognized in the equity and real estate investment portfolios. Gains from the fixed maturities investment portfolio were comparable for 2014 and 2013.
The Company reported net gains of approximately $13.3 million during 2014 from the sale of real estate. During the fourth quarter of 2014, a majority owned subsidiary of UG, HPG Acquisitions, LLC ("HPG"), sold all of the real estate it owned in Midland, Texas and recognized a gain of approximately $10.1 million. The sale of this real estate is the main reason for the fluctuation in the noncontrolling interest balance reported on the Consolidated Statements of Operations. During the third quarter of 2014, the Company recognized a gain of approximately $3.1 million from the sale of real estate held by one of UG's wholly owned subsidiaries. Gains from the sale of real estate are the result of one-time events and are expected to vary from year to year.
During 2014 and 2013, realized gains were offset by other-than-temporary impairments of $162,905 and $1.2 million, respectively. The other-than-temporary impairments were taken as a result of Management's assessment and consideration of the length of time the securities have remained in an unrealized loss position and as a result of management's analysis and determination of value. The investments were written down to better reflect their current expected fair value.
Management made this determination due to the thin profit margin associated with this contract coupled with its labor intensity. The non-renewal of this contract is not expected to have a material financial impact to net income as Management made operating expense reductions close to the lost revenues. The Company has no current plans to terminate any other TPA arrangements and intends to continue to pursue new clients.
In early 2013, the Company began a proactive analysis of its in-force business to try to reconnect with lost customers and verify its customers are not deceased. In some instances, the Company found that the customer was indeed deceased, but no notification or claim was presented to the Company. During 2014 and 2013, the Company paid approximately $1.2 million and $2.9 million, respectively, in death claim benefits as a result of this action. This project was completed during the second quarter of 2014.
Net amortization of cost of insurance acquired decreased approximately 7% in 2014 compared to 2013. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.
Operating expenses increased approximately 24% in 2014 compared to 2013. The increase in operating expenses was attributable to aircraft repair costs, information technology expenses and charitable contributions. The Company's equipment expenses were up approximately 75% compared to the prior year as a result of aircraft repair costs that were incurred during the second quarter of 2014. Information technology expenses increased approximately 30% compared to the prior year as a result of costs incurred related to the implementation of a new administrative system.
Charitable contributions were approximately $1 million higher in the current year. As mentioned above in the Overview section of the Management Discussion and Analysis, UTG has a strong philanthropic program. The Company generally allocates a portion of its GAAP net income to be used for its philanthropic efforts primarily targeted to Christ-centered organizations or organizations that help the weak or poor. Charitable contributions made by the Company are expected to vary from year to year depending on the earnings of the Company.
Following an extensive analysis of current administrative systems available in the market place, early in 2014 the Company determined it would change its administrative system. Management anticipates it will be year-end 2015 before fully converted to the new system and anticipates additional one time operating costs during 2014 of approximately $500,000 related to training, system modifications or enhancements and other costs related to the transition. Management believes this system change will well position the Company for the future by providing a more modern and flexible operating system while reducing ongoing operating costs.
Cash used in operating activities was approximately $13.6 million and $10.9 million in 2014 and 2013, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years. As such, premium revenues continue to decline. Management anticipates future cash flows from operations to remain similar to historic trends.
Net cash used in financing activities was approximately $(26.5) million during 2014 and the net cash provided by financing activities was approximately $1.3 million during 2013. The Company made principal payments on its outstanding debt of approximately $16.3 million in 2014 compared to approximately $2.8 million in 2013. UTG paid off its line of credit and one of UG's majority owned subsidiaries, HPG Acquisitions, LLC, paid off its outstanding note payable when the entity sold its real estate holdings during the fourth quarter of 2014. As a result of the real estate sale, HPG distributed funds to the minority interest owners of HPG.
The Company had cash and cash equivalents of approximately $14 million and $19.8 million as of December 31, 2014 and 2013, respectively. The Company has a portfolio of marketable fixed and equity securities that are available for sale, if an unexpected event were to occur. These securities had a fair value of approximately $238 million and $215 million at December 31, 2014 and 2013, respectively. However, the strong cash flows from investing activities, investment maturities and the availability of the line of credit facilities make it unlikely that the Company would need to sell securities for liquidity purposes. See Note 2 - Investments in the Notes to the Consolidated Financial Statements for detailed disclosures regarding the Company's investment portfolio.
The Company's capital structure consists of short-term debt, long-term debt and shareholders' equity. A complete analysis and description of the short-term and long-term debt issues outstanding as of December 31, 2014 and 2013 are presented in Note 7 - Credit Arrangements in the Notes to the Consolidated Financial Statements.
Shareholders' equity was approximately $83.6 million and $77.9 million as of December 31, 2014 and 2013, respectively. Total shareholders' equity increased approximately 7% in 2014 compared to 2013. The increase is primarily attributable to the net income reported by the Company during 2014.
We conducted our audits in accordance with the standards of the Public Company
In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of UTG, Inc. and subsidiaries as of December 31, 2014 and 2013, and the consolidated results of their operations and their consolidated cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
This document at times will refer to the Registrant's largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC ("FSF"), a Kentucky corporation, and First Southern Bancorp, Inc. ("FSBI"), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank ("FSNB"). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG's largest shareholder through his ownership control of FSF, FSBI and affiliates. At December 31, 2014, Mr. Correll owns or controls directly and indirectly approximately 57.31 % of UTG's outstanding stock.
UTG's life insurance subsidiary has several wholly-owned and majority-owned subsidiaries. The subsidiaries were formed to hold certain real estate and other investments. The investments were placed into the limited liability companies and partnerships to provide additional protection to the policyholders and to UG.
Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement book values and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. More information concerning income taxes is provided in Note 6 - Income Taxes.
Securities designated as trading securities are reported at fair value, with gains or losses resulting from changes in fair value recognized in net investment income on the Consolidated Statements of Operations. Trading securities include exchange traded equities and exchange traded options. Trading securities carried as liabilities are securities sold short. A gain, limited to the price at which the security was sold short, or a loss, potentially unlimited in size, will be recognized upon the termination of the short sale. The fair value of derivatives included in trading security assets and trading security liabilities as of December 31, 2014 was $6,250 and $(23,853), respectively. The fair value of derivatives included in trading security assets and trading security liabilities as of December 31, 2013 was $194,000 and $(353,907), respectively. The derivatives held by the Company are for income generation purposes only.
During 2014 and 2013, the Company acquired $2,348,890 and $16,761,525 in mortgage loans, respectively, including both regular participation mortgage loans as well as discounted mortgage loans. FSNB services the majority of the Company's mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.
During 2014 and 2013, the maximum and minimum lending rates for mortgage loans were:
The Company had investments with a fair value of $10,635,716 and $10,824,094 on deposit with various state insurance departments as of December 31, 2014 and 2013, respectively.
The Company's investments in fixed maturity securities available for sale, equity securities available for sale and trading securities assets and liabilities are carried at fair value. The following are the Company's methodologies and valuation techniques for assets and liabilities measured at fair value.
The carrying amount of short term investments in the financial statements approximates fair value. The inputs used to measure the fair value of our short term investments are classified as Level 3 within the fair value hierarchy.
As is customary in the insurance industry, the insurance subsidiary cedes insurance to, and assumes insurance from, other insurance companies under reinsurance agreements. Reinsurance agreements are intended to limit a life insurer's maximum loss on a large or unusually hazardous risk or to obtain a greater diversification of risk. The ceding insurance company remains primarily liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. However, it is the practice of insurers to reduce their exposure to loss to the extent that they have been reinsured with other insurance companies. The Company sets a limit on the amount of insurance retained on the life of any one person. The Company will not retain more than $125,000, including accidental death benefits, on any one life. At December 31, 2014, the Company had gross insurance in-force of $1.4 billion of which approximately $287 million was ceded to reinsurers. At December 31, 2013, the Company had gross insurance in-force of $1.5 billion of which approximately $313 million was ceded to reinsurers.
UG entered into a coinsurance agreement with Park Avenue Life Insurance Company ("PALIC") effective September 30, 1996. Under the terms of the agreement, UG ceded to PALIC substantially all of its then in-force paid-up life insurance policies. Paid-up life insurance generally refers to non-premium paying life insurance policies. Under the terms of the agreement, UG sold 100% of the future results of this block of business to PALIC through a coinsurance agreement. UG continues to administer the business for PALIC and receives a servicing fee through a commission allowance based on the remaining in-force policies each month. PALIC has the right to assumption reinsure the business, at its option, and transfer the administration. The Company is not aware of any such plans. PALIC and its ultimate parent, The Guardian Life Insurance Company of America ("Guardian"), currently hold an "A" (Excellent) and "A++" (Superior) rating, respectively, from A.M. Best. The PALIC agreement accounts for approximately 63% and 62% of UG's reinsurance reserve credit, as of December 31, 2014 and 2013, respectively.
At December 31, 1992, UG (formerly American Capitol) entered into a reinsurance agreement with Canada Life Assurance Company ("the Canada Life agreement") that fully reinsured virtually all of its traditional life insurance policies. The reinsurer's obligations under the Canada Life agreement were secured by assets withheld by UG representing policy loans and deferred and uncollected premiums related to the reinsured policies. UG continues to administer the reinsured policies. At December 31, 2013, the Canada Life agreement had insurance in-force of approximately $6,815,000, with no reserve credit being taken on that amount. The Canada Life agreement was fully repaid in August 2012. With the reinsurance recaptured by the Company, a 15% profit share will continue to be paid to the reinsurer going forward relative to the block of business. Effective July 1, 2014, the Company acquired the 15% profit share on this block of business from Canada Life for $300,000. This payment effectively settled any future obligations of the Company to the reinsurer under this agreement.
During 2014, the Company disposed of a block of business through an assumption reinsurance agreement, whereby the Company transferred cash of $3,000,000 and extinguished reserves of $3,600,000 and reduced cost of insurance acquired by $600,000.
At December 31, 2014 and 2013, the Company had the following outstanding debt:
The HPG Acquisitions promissory note issued on December 27, 2012 was secured by real estate owned by HPG. The promissory note carried interest at a fixed rate of 4% and was payable monthly. Principal was payable monthly beginning in the third year of the note. This note was fully repaid in November of 2014 when the assets of HPG were sold.
The UTG Avalon line of credit issued on March 28, 2013 carried interest at a rate of 4.00 % with interest payable monthly. The interest rate was a variable rate that was 0.50% above the lowest of the U.S. Prime Rates as published in the money section of the Wall Street Journal. The interest rate was subject to change monthly and changes in the interest rate were effective on the first day of the month following the rate change. This line of credit was repaid in December of 2014 and replaced by the promissory note described above.
During 2012, the Company committed to invest in MM-Marcellus HBP1, LP, which purchases land for leasing opportunities to those looking to harvest natural resources. MM-Marcellus HPB1, LP makes capital calls to investors as funds are needed for continued land purchases.
During 2012, the Company committed to invest in Sovereign's Capital, LP ("Sovereign's"), which invests in companies in emerging markets.
Stock Repurchase Program - The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. During December of 2014, the Board of Directors approved a resolution to increase the repurchase amount by $1 million for a total repurchase of $7 million. Repurchased shares are available for future issuance for general corporate purposes. This program can be terminated at any time. Open market purchases are made based on the last available market price and are generally limited to a maximum per share price of the most recent reported per share GAAP equity book value of the Company. During 2014, the Company repurchased 74,172 shares through the stock repurchase program for $996,851. Through December 31, 2014, UTG has spent $6.1 million in the acquisition of 662,698 shares under this program.
The computation of diluted earnings per share is the same as basic earnings per share for the years ending December 31, 2014 and 2013, as there were no outstanding securities, options or other offers that give the right to receive or acquire common shares of UTG.
Statutory Restrictions - Restrictions exist on the flow of funds to UTG from its insurance subsidiary. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. UG is required to maintain minimum statutory surplus of $2,500,000. At December 31, 2014, substantially all of the consolidated shareholders' equity represents net assets of UTG's subsidiaries.
The following table reflects UG's statutory basis net income and capital and surplus (shareholders' equity) as of December 31:
On February 20, 2003, UG purchased $4,000,000 of a trust preferred security offering issued by First Southern Bancorp, Inc. ("FSBI"). The security has a mandatory redemption after 30 years with a call provision after 5 years. The security pays a quarterly dividend at a fixed rate of 6.515 %. The Company received dividends of $264,219 during 2014 and 2013. On March 30, 2009, UG purchased $1,000,000 of FSBI common stock. The sale and transfer of this security is restricted by the provisions of a stock restriction and buy-sell agreement.
The Company from time to time acquires mortgage loans through participation agreements with FSNB. FSNB services the Company's mortgage loans including those covered by the participation agreements. The Company pays a 0.25% servicing fee on these loans and a one-time fee at loan origination of 0.50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan. The Company paid $33,894 and $93,285 in servicing fees and $0 and $1,250 in origination fees to FSNB during 2014 and 2013, respectively.
Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of December 31, 2014, approximately 54% of the Company's total direct premium was collected from Illinois, Ohio, Texas and West Virginia. As of December 31, 2013, approximately 54% of the Company's total direct premium was collected from Illinois, Ohio, Texas and West Virginia. Thus, results of operations are heavily dependent upon the strength of these economies.