WNC's home office building is a five-story, 175,000 square-foot office building located at 300 Tower Parkway, Lincolnshire, Illinois, that was first occupied by WNC in May, 1993. The building is leased for a period of twenty years from a joint venture partnership in which WNIC has a one-third interest. As a result of the merger with PennCorp, the building is expected to be sublet to an unaffiliated company.
WNIC also has a fifty percent interest in a joint venture partnership that owns a 22,000 square-foot data center in Vernon Hills, Illinois, that is leased and occupied solely by WNIC. WNIC first occupied the property in April, 1993, and the building is leased for a period of twenty years.
Washington National Corporation (WNC or the Company) is an insurance holding company that is engaged primarily in marketing and underwriting life insurance, annuities, and specialty health insurance for educators. The major operating subsidiaries of the Company are Washington National Insurance Company (WNIC) and United Presidential Life Insurance Company (UPI).
The Company targets markets that it believes are underserved by other insurance companies. It has a decentralized operating structure and utilizes distinct distribution systems to access each of its targeted markets and to provide timely, individualized service to its customers. The Company emphasizes the sale of market-driven products, a profit-oriented rather than a volume-oriented approach to underwriting, tight expense controls, and a proactive approach to market and regulatory changes. It continually evaluates new products and markets in order to capitalize on potential opportunities and to anticipate and respond effectively to business and regulatory changes.
In November of 1996, after completing its review of its corporate strategy and the insurance industry, the Company announced an agreement to merge with PennCorp Financial Group, Inc. (PennCorp) with PennCorp being the surviving entity. The merger is subject to approval by PennCorp's and the Company's shareholders and certain regulatory agencies and is expected to be completed in the second quarter of 1997.
Insurance Premiums and Policy Charges. Insurance premiums and policy charges increased $12.2 million, or 8.4%, from $145.4 million in 1995 to $157.6 million in 1996. The improvement was primarily due to increases from educator disability products and increased life insurance policy charges at UPI. See "Segment Information," below.
Realized Investment Gains and Losses. Realized investment gains before taxes for 1996 were $0.6 million compared to losses of $1.4 million in 1995. In 1996, total realized investment gains were comprised primarily of gains of $6.1 million on other invested assets, $0.5 million on fixed maturity investments, and $0.4 million on equity securities. These gains were largely offset by realized investment losses of $6.5 million on real estate and joint ventures.
In 1995, realized losses of $0.5 million on fixed maturity investments, $0.2 million on equity securities, and $2.2 million on real estate and mortgage loans were partially offset by gains on other invested assets
of $1.5 million. The Company's income taxes included tax benefits of $0.7 million and $2.1 million in 1996 and 1995, respectively, related to realized investment losses.
Insurance and General Expenses. The Company's expense ratio (expenses as a percentage of premiums and net investment income) was 13.1% in both 1996 and 1995. Increases in insurance operations (primarily in the educator disability line) were partially offset by a decline in corporate and other.
Amortization of Deferred Acquisition Costs. Amortization of deferred acquisition costs was $22.7 million in 1996, down 1.6% from $23.1 million in 1995. The decline was due to a decrease of $2.4 million in amortization for a portion of the closed block where such costs were fully amortized in 1995. Partially offsetting this decline was increased amortization primarily at UPI resulting from improved interest spreads and expense margins in 1996 over 1995.
Income Taxes. Income taxes on operating income from continuing operations increased $3.6 million to $17.6 million in 1996 compared to $14.0 million in 1995 primarily as a result of the improvement in operating income. The effective tax rate on pretax operating income in 1996 was 36.2%, compared to 34.9% in 1995. The increase in the rate was due to certain non-deductible expenses recorded in the fourth quarter related to the Company's pending merger with PennCorp.
Net Income. Net income for 1996 was $6.3 million, compared to $33.9 million in 1995. The decline in net income resulted from the loss on the sale of the health business and the operating loss from discontinued operations in 1996 (compared to income from discontinued operations in 1995), offset in part by improvements in continuing operations.
Insurance Operations. Revenues for the insurance operations segment for 1996 were $318.1 million, compared to $309.1 million for 1995, an increase of $9.0 million, or 2.9%. The improvement was attributable to an increased amount of products in force in the growth portions of this segment. For the educator disability business, the number of insureds increased 15.9% for 1996 over that for 1995. At UPI, insurance in force increased 5.1% for 1996 over 1995. Partially offsetting the increase was a decline in investment income from the closed block attributable to the ongoing shrinkage of the block in 1996. During 1996, annuity account balances for the closed block declined 11.9% and insurance in force declined 7.3%.
(the difference between interest credited to policyholders and the interest earned on investments) and a decrease of $2.4 million in amortization of deferred insurance costs for a portion of the closed block where such costs were fully amortized in 1995.
Realized Investment Losses. Realized investment losses before taxes for 1995 were $1.4 million compared to $1.6 million in 1994. In 1995, realized losses of $0.5 million on fixed maturity investments, $0.2 million on equity securities, and $2.2 million on real estate and mortgage loans were partially offset by gains on other invested assets of $1.5 million. In 1994, realized losses of $1.7 million on fixed maturity investments and $2.0 million on real estate and mortgage loans were partially offset by gains on equity securities and other invested assets of $2.1 million. The Company's income taxes included tax benefits of $2.1 million and $2.8 million in 1995 and 1994, respectively, related to realized investment losses.
Insurance and General Expenses. The Company's expense ratio (expenses as a percentage of premiums and net investment income) was 13.1% in 1995, unchanged from 1994. The stable expense ratio was due, in part, to cost containment efforts at the Company.
Amortization of Deferred Acquisition Costs. Amortization of deferred acquisition costs increased $2.2 million, or 10.4%, from $20.9 million in 1994 to $23.1 million in 1995. The change was primarily due to improved sales in 1994 and 1995.
Income Taxes. Income taxes on continuing operations increased $0.9 million to $14.0 million in 1995 compared to $13.1 million in 1994 primarily as a result of the improvement in operating income.
Income from Discontinued Operations, Net of Tax. Income from discontinued operations, net of tax, was $7.2 million in 1995, compared to $6.7 million in 1994, a 7.0% increase. The increase was primarily due to improved revenue, resulting from average rate increases of approximately 7% and 5% on the direct individual and group employee benefits businesses, respectively. Additionally, revenues improved as sales of individual health insurance policies increased from 28,100 in 1994 to 67,200 in 1995 due to a more competitive product and in increase in agents selling these products. In addition to the increase in revenue, 1995 income from discontinued operations included approximately $2.6 million, before taxes, resulting from the elimination of group life insurance policy liabilities on certain disabled insureds. The elimination of these liabilities resulted from a program completed in 1995 to more effectively manage life
The individual health benefit ratio increase was primarily due to higher claims experience in New Jersey, where that state implemented certain adverse restrictions on health insurers. To offset this experience, the Company implemented rate increases to significantly reduce future losses.
Pretax operating income for the insurance operations segment increased $3.4 million to $37.8 million in 1995 primarily due to a 17% increase at UPI, the growth portion of the life insurance and annuity business. UPI's improved operating income was primarily due to increased policy charges and greater investment income yield of $1.3 million each. This increase was partially offset by a decline in earnings of $2.5 million in WNIC's closed block due to a 4.8% decrease in its size and $3.5 million due to narrower 1995 interest rate spreads.
Corporate and Other. For both 1995 and 1994, the corporate and other segment had pretax operating income of $2.2 million. In 1995, revenues increased primarily due to higher investment income of $1.8 million on the Company's surplus funds. This improvement was mostly offset by an increase in expenses of $1.6 million primarily due to a change in the allocation of certain expenses to the other segments.
To mitigate prepayment risk, the Company primarily invests in CMO classes that have, at time of investment, the most stable prepayment structure. Such CMO classes are termed "planned amortization class" (PAC) which comprised 82.3% of the Company's CMO portfolio at December 31, 1996. The next most stable class of CMOs is "target amortization class" (TAC) which comprised 3.6% of the Company's CMO portfolio at December 31, 1996. PACs and TACs are designed to protect against prepayment risk and may therefore have more predictable cash flows than pass-through mortgage- backed securities.
The Company had investments in mortgage loans of $257.6 million (net of allowances of $6.7 million) at December 31, 1996 compared to $317.2 million at December 31, 1995. Investments in mortgage loans declined primarily due to prepayments and amortization. Of the outstanding loans at December 31, 1996, loans with a carrying value of $6.2 million, or approximately 2.4%, were delinquent 60 days or more as to interest or principal.
Restructured loans, where modifications of the terms of the mortgage loan have occurred and which are considered current investments, had a carrying value of $11.6 million at December 31, 1996, a decrease of $3.5 million from December 31, 1995, resulting primarily from impairments recognized. Impaired loans, where compliance with the terms of the mortgage is in doubt, total $9.4 million, a decrease of $1.0 million from December 31, 1995.
Cash used for financing activities was $98.4 million in 1996, compared to $53.7 million in 1995. The increase was primarily due to increased annuity policyholder withdrawals. In 1996, UPI's deposits exceeded withdrawals by $43.9 million, compared to $58.8 million in 1995. For the WNIC closed block, withdrawals exceeded deposits by $128.0 million and $102.3 million in 1996 and 1995, respectively.
Dividends. The Company's primary sources of funds to pay dividends to shareholders are investments held at the parent and dividends from WNIC. These dividends are subject to restrictions set forth by the Illinois Insurance Department. Illinois regulations limit the amount that can be withdrawn from WNIC without the approval of the Illinois Insurance Department to the greater of the previous year's statutory earnings or 10% of statutory capital and surplus.
The ability of an insurance company to compete successfully depends, in part, on its financial strength, operating performance, and claims-paying ability as rated by A.M. Best and other rating agencies. A. M. Best uses a variety of qualitative and quantitative measures in determining a company's rating and surplus adequacy. The Company's insurance subsidiaries are each currently rated "A- (Excellent)" by A.M. Best, based on their 1995 statutory financial results and operating performance.
Washington National Corporation (WNC or the Company) and its subsidiaries are engaged primarily in marketing and underwriting life insurance and annuities for individuals and specialty health insurance for educators. Based on assets and income, the life insurance and annuity products account for more than eighty percent of WNC's business. The Company's surplus and specialty health insurance products for educators account for the remainder.
In 1995, the Company transferred its $84,146,000 of "held to maturity" fixed maturities to "available for sale" resulting in a $5,337,000 increase to unrealized investment gains. The Company no longer holds any fixed maturities as "held to maturity."
Real Estate and Joint Ventures. In general, real estate investments are considered available for sale and carried at the lower of book or fair value less estimated costs to sell. Joint ventures are accounted for using the equity method.
Policy Loans. Loans to policyholders are carried at the unpaid principal balance.
Other Long-term Investments. Other long-term investments consist of investments in equity securities reported at fair value, and venture capital investments that are accounted for under the equity method.
Unrealized Investment Gains and Losses. Unrealized investment gains and losses on investments carried at fair value, net of deferred taxes and adjustments for certain deferred acquisition costs, are recorded directly in shareholders' equity.
Depreciation for real estate investments and property and equipment is based on the estimated useful life of the asset primarily using the straight-line method. Information on depreciation related to continuing operations follows:
Certain costs associated with acquiring new business are deferred and amortized to income over time. Amortization of costs for traditional life insurance and health products is over the premium paying period and is based on assumptions consistent with those used in determining policy benefit reserves. Actual results may differ significantly from these assumptions. For certain interest-sensitive products, costs are amortized over the estimated life of those products in proportion to the present value of estimated gross profits from surrender charges and investment, mortality, and expense margins. Changes in the amount or timing of estimated gross profits will result in adjustments in the cumulative amortization of these costs.
To the extent that unrealized investment gains or losses on fixed maturities would result in an adjustment of DAC had those investment gains or losses been realized, the related unamortized DAC is adjusted and included in shareholders' equity.
Liabilities for policy and contract claims are determined using statistical analyses and case-basis evaluations and represent estimates of the expected cost of incurred claims. Revisions to these estimates are recognized in the consolidated statement of income in the period when the revisions are made.
Separate Account assets and liabilities are principally carried at fair value and represent funds that are separately administered for annuity contracts for which the contract holders bear the investment risk. The assets are legally segregated from the Company's assets and are not subject to any claims that arise from any other business of WNC. Investment income and realized investment gains and losses accrue directly to the contract holders and are excluded from the accompanying consolidated statement of income.
The Company files a consolidated life/nonlife federal income tax return. The Company establishes deferred tax provisions for temporary differences between the financial reporting basis and the tax basis of assets and liabilities at the enacted tax rate expected to be in effect when the temporary differences reverse. A valuation allowance for deferred tax assets is provided for the portion of the asset not expected to be realized.
Benefit amounts paid directly by the Company for insurance claims covered under ceded reinsurance agreements are recorded as reinsurance recoverables to the extent not already reimbursed. The cost of reinsurance is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies.
Accounting Standard Adopted in 1996. For year-end 1996, the Company adopted the disclosure requirements of Statement of Financial Accounting Standards (SFAS) 123, "Accounting for Stock- Based Compensation," which establishes accounting and reporting requirements for stock-based compensation arrangements. As permitted, the Company has elected to continue under the current accounting standards of Accounting Principles Board Opinion No. 25 and, accordingly, no compensation expense has been recognized for options granted. The pro forma impact on net income and earnings per share can be found in Note J. The fair value of stock options is reported in Note I.
The transactions resulted in the Company recording an estimated net loss of $25,080,000, net of a tax credit of $12,500,000. The loss consists principally of the future operating losses of this business for which the Company remains responsible after the measurement date, employee severance costs, the cost to terminate one of the Company's defined benefit pension plans, related net asset write-offs, and other related disposal costs net of the anticipated proceeds. The loss is an estimate due to the nature of the transactions and may change in future periods.
Activity in the liability for short duration unpaid claims and short duration claim adjustment expense reported in continuing operations (included in policy and contract claims and a component of general expenses and other liabilities) follows:
The amortized cost and fair value of fixed maturities at December 31, 1996, by contractual maturity, follow. Expected maturities differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without penalties. In addition, corporate requirements may result in sales before maturity.
Information on mortgage loan impairment for the years ended December 31 follows:
Details of realized investment gains (losses) for the years ended December 31 follow:
Major sources of net investment income from continuing operations for the years ended December 31 follow:
At December 31, 1996, the carrying value of investments that produced no income for the previous twelve month period was $4,286,000 or less than 1% of invested assets.
Plan assets are invested principally in mutual funds, stocks, and venture capital funds. The WNIC Plan held 415,564 shares of WNC Common and 17,108 shares of WNC Preferred Stock at both December 31, 1996 and 1995 with a fair market value of $12,322,000 and $12,408,000, respectively. Dividends of $492,000 were received on the WNC Common and Preferred Stock in both 1996 and 1995. No WNC shares were purchased or sold during 1996 or 1995. The Company will repurchase the shares from the WNIC Plan in 1997 in connection with the distribution of plan assets to participants.
The actuarial assumptions used to measure the projected benefit obligations include:
The UPI Plan and the WNIC Plan (prior to the WNIC's Plan termination) transition asset is being amortized over a fourteen- year period. Actuarial gains and losses are deferred and then amortized over a fourteen-year period when the cumulative deferred amounts exceeded certain limits.
In 1993, the Company established a Voluntary Employees' Beneficiary Association (VEBA) trust under section 501(c)(9) of the IRC for the purpose of paying out postretirement benefits to plan participants. The VEBA is funded annually, based on the difference between the net periodic postretirement benefit expense as measured by statutory accounting rules and the retiree medical claims incurred during the respective periods, subject to certain IRC limitations. Assets of the VEBA trust were invested in a short-term government money market fund and corporate demand notes at December 31, 1996.
The actuarial assumptions used to measure the postretirement benefit obligation include:
WNC sponsors a Stock Benefit Plan (the Plan) which is administered by the Compensation Committee (the Committee) of WNC's Board of Directors. The Plan allows for awards of non- qualified and incentive stock options and stock appreciation rights to key managerial employees. Employees are eligible for awards of restricted stock that may be granted or sold in tandem with the grants of a stock option. The Plan also provides for grants of non-qualified stock options to non-employee directors. There were no incentive stock options or stock appreciation rights outstanding in 1994, 1995, or 1996.
Non-qualified stock options issued to key employees and non- employee directors prior to March 12, 1993 were originally exercisable up to 20 years from the date of grant. Non-qualified stock options issued on or after March 12, 1993 to key employees were originally exercisable up to 10 years from the date of grant. Non-qualified stock options issued to non-employee directors on or after March 12, 1993 were originally exercisable at anytime from six months to 10 years after the date of grant.
Information about stock options outstanding at December 31, 1996, is summarized as follows:
The weighted average fair value per share of options granted was $2.15 and $2.28 in 1996 and 1995, respectively. The weighted average fair value per share of awards of restricted stock issued in 1995 and 1996 was $29.50.
The Rights would have become exercisable only if a person or group acquired 20% or more of WNC's Common Stock or announced a tender offer following which it would hold 30% or more of such Common Stock. If the Rights had become exercisable, a holder would have been entitled to buy from WNC one share of WNC Common Stock at a price of $100 per share. If, after the Rights had become exercisable, WNC was acquired in a merger or other business combination or more than 50% of WNC's assets or earning power were sold, each Right would have entitled its holder to buy that number of shares of Common Stock of the acquiring company having a fair value of twice the exercise price of the Right. Alternatively, if a 20% WNC shareholder acquired WNC by means of a merger in which WNC and its Common Stock survive or that shareholder engages in self-dealing transactions with WNC, each Right not owned by the 20% holder would have become exercisable for that number of shares of WNC Common Stock which have a fair value of twice the exercise price of the Right. One additional Right was distributed with each share of WNC Common Stock issued in the future. The Rights were redeemable by WNC at $.01 per Right prior to the time that 20% or more of WNC's Common Stock has been accumulated by a person or group or within ten days thereafter under certain circumstances.
The pro forma impact on net income and earnings per share of computing compensation cost for the Company's stock options and restricted stock based on the fair value at the date of grant follows:
Components of WNC's deferred tax liabilities and assets at December 31 follow:
Prior to 1984, WNC's life insurance subsidiaries were required to accumulate certain untaxed amounts in a memorandum "policyholders' surplus account." Under the Tax Reform Act of 1984, the "policyholders' surplus account" balances were capped at December 31, 1983 and taxed only to the extent distributed to shareholders or when they exceed certain prescribed limits. WNC's life insurance subsidiaries do not intend to make any taxable distributions or to exceed the prescribed limits in the foreseeable future; therefore, no income tax provision has been made for those purposes. However, if such taxes were assessed, the amount of tax payable would be approximately $19,922,000. At December 31, 1996, the combined "policyholders' surplus account" of WNC's life insurance subsidiaries approximates $57,000,000.
Deferred income taxes (benefits) of $(11,526,000), $45,045,000, and $(24,451,000) have been provided in 1996, 1995, and 1994, respectively, which are recorded as a direct charge to shareholders' equity rather than net income. These taxes primarily relate to the change in net unrealized investment gains and losses.
WNC has noncancelable operating leases primarily for office space and office equipment, the most significant of which is a twenty- year lease of the Company's home office building with a related party as lessor. Future minimum lease payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year at December 31, 1996 follow:
The amount of dividends available for distribution without prior regulatory approval is limited by regulatory restrictions. This amount is the greater of: a) 10% of the insurance subsidiaries' statutory capital and surplus as of the preceding year end; or b) the insurance subsidiaries' statutory net income from operations for the preceding year. WNC's insurance companies are permitted a maximum of $23,950,000 in dividend distributions to WNC in 1997 without the prior approval of regulatory authorities. WNC received dividends of $11,200,000 from WNIC in 1996. In connection with the pending merger, the Illinois Insurance Department has approved WNIC's request to pay an extraordinary dividend of $75,000,000 in 1997.
WNC has two business segments: insurance operations and corporate and other. The corporate and other segment includes realized investment gains and losses and operations that do not specifically support the insurance operations. Assets not individually identifiable by segment are allocated, generally, based on the amount of segment liabilities. Depreciation expense and capital expenditures are not material. Revenues, pretax income from continuing operations, and assets by segment for the years ended and at December 31 follow:
Actuarial estimates are used in determining certain policy liabilities and deferred acquisition costs which in turn effect the reported profitability of the insurance operations segment. Actual results can differ materially from these actuarial estimates. In addition, changes in these estimates, where required, may have a significant effect on reported net income, especially in the year of the change.
The profits of the insurance operations segment are highly dependent on interest rate spreads, which is the difference between the amount earned on investments and the amount credited to policyholders. Increases in market interest rates could result in the need to credit higher rates to policyholders without a comparable increase in the rate earned on the Company's invested assets; they could also result in customers surrendering their policies to obtain higher rates from other insurance companies or alternative products. Decreases in market interest rates could result in inadequate spreads due to the inability to lower credited rates below certain minimum guarantees as to such rates.
The profitability of most of the Company's products depends on the ability to attract and retain customers at a price level sufficient to cover the various expenses incurred by the Company. The nature of these products is such that customers can in most cases easily transfer to other insurance carriers offering more attractive coverage. The profitability of the products may change over time depending on the degree of competition in the markets for such products.