Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Liberty owns a 487,000 square foot building at 2001 Third Avenue South, Birmingham, Alabama which currently serves as Liberty's, UILIC's, and Torchmark's home office. Approximately 160,000 square feet of this building is available for lease to unrelated tenants by Liberty. Liberty also operates from 58 company-owned district office buildings used for agency sales personnel.
American Income owns and is the sole occupant of an office building located at 1200 Wooded Acres Drive, Waco, Texas. The building is a two-story structure containing approximately 72,000 square feet of usable floor space.
- ------------------------------------------------------------------------------- (1) Net income from continuing operations, excluding realized investment gains (losses), the related adjustment to deferred acquisition costs, equity in Vesta earnings for periods prior to 1999, a one-time gain on the sale of equipment, and the nonrecurring charge. (2) Computed after deduction of preferred shareholders' equity. (3) Annualized life premium in force excludes $5.3 million representing the Family Service business sold in 1998.
10) Developments involving Vesta Insurance Group, Inc., ("Vesta") described more fully elsewhere in this document under the caption "Transactions involving Vesta Insurance Group" on page of this report;
Readers are also directed to consider other risks and uncertainties described in other documents filed by Torchmark with the Securities and Exchange Commission.
The following is a discussion of Torchmark's operations for the three years ended December 31, 1999. In the analysis and comparison of Torchmark's operating results with 1998 and 1997, two divestitures that occurred in 1998 should be taken into account:
Divestiture of Waddell & Reed. In March, 1998, Waddell & Reed, Torchmark's asset management subsidiary, completed an initial public offering of approximately 24 million shares of its common stock. The offering represented approximately 36% of Waddell & Reed's shares. Net proceeds from the offering were approximately $516 million after underwriters' fees and expenses. Waddell & Reed used $481 million of the proceeds to repay existing notes owed to Torchmark and other Torchmark subsidiaries and retained the remaining $35 million. Torchmark's $481 million proceeds from the note repayments were invested or used to pay down debt. (See the discussion on Investments on page 28, Liquidity on page 32, and Capital Resources on page 32 of this report.) The initial public offering resulted in a $426 million gain which was added to Torchmark's additional paid-in capital. Torchmark retained the remaining 64% of the Waddell & Reed stock.
Torchmark has accounted for the spin-off of Waddell & Reed as a disposal of a segment. Accordingly, Torchmark's financial statements for 1998 and all prior periods were modified to present the net assets and operating results of Waddell & Reed as discontinued operations of the disposed segment. The $54 million expense of the spin-off is included in discontinued operations under the caption "Loss on Disposal." The distribution of the Waddell & Reed shares resulted in a reduction in Torchmark's shareholders' equity in the approximate amount of $174 million, consisting of the equity in Waddell & Reed, net of the 36% minority interest.
3) Torchmark's pro rata share of the income or losses related to Vesta;
4) The nonrecurring loss from the redemption by Torchmark of its debt in the second quarter of 1998 in the amount of $5 million net of tax;
6) The effect of a change in accounting principle which modified the accounting for an interest rate swap instrument, increasing net income in the after-tax amount of $16.1 million.
Additionally, in 1999, Torchmark entered into a life insurance marketing arrangement with a third party, discussed more fully under the caption Life Insurance on page 20 of this report. This agreement contained certain cash guarantees to the third party which would not be recoverable by Torchmark based on test marketing results. Accordingly, Torchmark recorded a nonrecurring after-tax operating charge of $13 million, or $.10 per diluted share in 1999. Because this was an unusual one-time charge, net operating income has been presented before the charge for comparability.
A reconciliation of net operating income to net income on a per diluted share basis is as follows:
Reconciliation of Per Share Net Operating Income to Reported Net Income*
Realized investment losses in 1999 in the after-tax amount of $72 million included a $41 million after- tax loss from the sale of real estate and a $19 million after-tax loss from the sale of fixed maturities, which are discussed on page 29 of this report under the caption Investments. Realized losses in 1999 also included a $12 million after-tax loss from the reduction in value of Torchmark's interest rate swap relating to its MIPS, as discussed under the caption Capital Resources on page 32 of this report.
Realized investment losses in 1998, which were $51 million net of tax, included a $23 million after-tax loss from the sale of Family Service, a $24 million after-tax loss on the writedown of Torchmark's Vesta holdings, and a $3 million after-tax loss from the sale of a portion of the Vesta holdings. Losses in 1997, in the after-tax amount of $24 million, were primarily a result of intentional sales of fixed-maturity investments at a loss to offset current and prior-year taxable gains.
The Vesta transactions are discussed on page 35 and the redemption of Torchmark debt is discussed under the caption Capital Resources on page 32 of this report. The change in accounting principle is discussed in Note 15-- Change in Accounting Principle to the Consolidated Financial Statements on page 64 of this report.
Earnings and Earnings Per Share (Dollar amounts in thousands, except for per share data)
On a per share basis, Torchmark's net operating income before nonrecurring charge grew 11% in 1999 and 18% in 1998. Excluding the proceeds from the public offering of Waddell & Reed, the increase for 1998 would have been 10%.
In total dollars, Torchmark's net operating income before nonrecurring charge rose 5% in 1999 after an 18% increase in 1998. Contributing to the growth in net operating income were gains in insurance underwriting income and excess investment income. Excluding Family Service, insurance underwriting income rose 5% in 1999 to $333 million and 5% in 1998 to $317 million. Excess investment income also rose in both 1998 and 1999 as a result of lower policy requirements in 1999, increased investment income in 1998, and lower financing costs in both years. Torchmark's core operations are segmented into insurance underwriting operations and investment operations. Insurance underwriting activities are further segmented into life insurance, health insurance, and annuity product groups. A detailed discussion of each of Torchmark's segments follows.
Another of Torchmark's distribution channels for life insurance is a nationwide independent agency whose sales force is comprised of former commissioned and noncommissioned military officers who sell exclusively to commissioned and noncommissioned military officers and their families. This business consists of whole life products with term insurance riders and is characterized by extremely low lapse rates. Life premium income from this distribution system grew 13% to $105 million in 1999. Premium for this agency rose 16% to $92 million in 1998. These premium increases represented the largest percentage growth in life premium of any Torchmark distribution channel in 1999 or 1998. Annualized life premium in force for the Military distribution system grew 13% in 1999 to $111 million, after having increased 15% to $99 million in 1998. In both years this distribution system produced the greatest amount of growth in annualized life premium in force on a percentage basis. A major factor in this growth of in-force premium relates to the very high persistency associated with this business. Annualized premium sold during 1999 by this agency was $17 million, flat with 1998 sales of $17 million. Sales in 1998 gained 7% over sales of $16 million in 1997.
Life insurance gross margins have been presented in the above table to remove the effect of Family Service underwriting income and the nonrecurring charge, which distort comparisons. Excluding these items, gross margins, as indicated by insurance underwriting income before other income and administrative expense, increased 4% in 1999 to $263 million after having risen 5% in 1998 to $253 million. As a percentage of life insurance premium, life insurance gross margins were 26% in both 1999 and 1998, as compared with 27% in 1997. Slight increases in mortality have been experienced in both 1999 and 1998 over the prior year, resulting in increased obligation ratios. Fluctuations in mortality are normal in the life insurance industry and are not indicative of a trend.
Premium for the health insurance segment increased 9% to $825 million in 1999 over 1998 premium of $760 million. In 1998, health premium rose 3%. Annualized health premium in force grew 11% to $884 million at December 31, 1999 over the previous year-end balance of $797 million. Health premium in force rose 5% during 1998. Sales of health insurance, in terms of annualized premium issued, were $193 million in 1999, increasing 39% over 1998 sales of $139 million. Sales in 1998 grew 30% over the prior year. Sales of health insurance have accelerated greatly in the past three years due to increases in sales of Medicare Supplement policies. Prior to 1997, Torchmark had not experienced year-over-year sales growth in health insurance for five years.
The United American Independent Agency continues to represent the largest amount of Torchmark's health premium in force. The agency's $444 million of annualized health premium in force at December 31, 1999, of which $418 million was Medicare Supplement premium in force, was 50% of Torchmark's total health premium in force. This agency increased annualized health premium in force over the previous year for the first time at year-end 1999 since 1992. Health sales by the United American Independent Agency, in terms of annualized premium issued, were $68 million in 1999, a 35% increase over 1998. Sales rose 18% to $51 million in 1998.
Medicare Supplement policies are highly regulated at both the federal and state levels with standardized benefit plans, limits on first year agent compensation, and mandated minimum loss ratios. However, they remain a popular supplemental health policy with the country's large and growing group of Medicare beneficiaries. About 85% of all Medicare beneficiaries have Medicare Supplements to cover at least some of the deductibles and coinsurance for which the federal Medicare program does not pay. During the last few years, Torchmark has focused on developing its United American Exclusive Agency to serve this market. Using the Direct Response operation, targeted marketing support and increased agent recruiting have led to increased sales. Because of loss ratio regulation, underwriting margins on Medicare Supplements are less than on Torchmark's life business. However, due to United American's low cost, service-oriented customer service and claims administration, as well as its economies of scale, it is a profitable line of business.
Health insurance underwriting income before other income and administrative expense rose 4% in 1999 to $145 million, after having declined 1% in 1998. As a percentage of premium, underwriting income before other income and administrative expense declined 1% in both of the years 1999 and 1998 from the prior year, respectively. Margins have lagged premium growth because of higher obligation costs. Medicare Supplement margins are restrained by the federally mandated minimum loss ratio of 65% and by competition. Cancer obligation ratios have increased in each year because of healthcare inflationary pressures. To the extent management is able to obtain timely and adequate premium rate increases from regulatory authorities to offset these cost increases, margins may be stabilized on cancer business. Torchmark continues to seek such rate increases.
Annuities. Annuity products are marketed by Torchmark to service a variety of needs, including retirement income and long-term, tax-deferred growth opportunities. Torchmark's annuities are sold almost entirely by the United Investors Agency. This Agency consists of the Waddell & Reed sales force which markets United Investors annuities and other products under a marketing agreement. In 1999, this Agency collected $403 million of Torchmark's total $464 million in annuity collections, or 87%. The United Investors Agency accounted for almost 99% of total annuity policy charges in 1999. Annuities are also marketed by the United American Independent Agency, which collected $56 million in annuity deposits in 1999.
Annuities are sold on both a fixed and variable basis. Fixed annuity deposits are held and invested by Torchmark and are obligations of the company. Variable annuity deposits are invested at the policyholder's direction into his choice among a variety of mutual funds managed by Waddell & Reed, which vary in degree of investment risk and return. A fixed annuity investment account is also available as a variable annuity investment option. Investments pertaining to variable annuity deposits are reported as "Separate Account Assets" and the corresponding deposit balances for variable annuities are reported as "Separate Account Liabilities."
The variable annuity account balance continues to experience rapid growth. The variable account balance rose 40% in 1999 from $2.3 billion at December 31, 1998 to $3.3 billion at year-end 1999. This balance had previously increased 29% in 1998 and 32% in 1997. Strong financial markets in all of these periods contributed greatly to the growth. Variable accounts are valued based on the market values of the underlying securities. The additional collections in each year also added to the balances.
Annuity underwriting income excluding Family Service and before other income and administrative expense has grown steadily throughout each of the years 1997 through 1999, increasing 15% to $27 million in 1999 and 23% to $23 million in 1998 over the respective prior year. Policy charges have also grown in each period, rising 22% in both 1999 and 1998. Growth in policy charges is primarily related to the growth in the size of the account balance, but is also attributable to the increase in the number of annuity contracts in force and the cumulative effect of the growth in sales over the past few years upon which the sales charge is based.
Excess investment income represents the profit margin attributable to investment operations and cash flow management. It is defined as tax- equivalent investment income reduced by the interest cost credited to net policy liabilities and the interest cost associated with capital funding or "financing costs." Excess investment income is increased in a number of ways: an increase in investment yields over the rates credited to policyholders' liabilities or in relationship to the rates applicable to Torchmark debt, growth in invested assets in relation to policy liabilities and debt, and the efficient use of capital resources and cash flow.
During 1999, Torchmark entered into two transactions to dispose of the majority of its investment real estate. The first transaction closed in July, 1999 and the other closed in October, 1999. Total consideration for the combined transactions was $123 million of which $111 million was cash. The real estate dispositions resulted in an after-tax loss of $41 million. After the sales, Torchmark retained $16 million in investment real estate, of which $8 million was represented by properties partially occupied by Torchmark subsidiaries.
With the steady increase in interest rates during 1999, new investments of corporate bonds afforded higher returns each successive quarter, and the 1999 average yield on fixed maturity purchases was the highest it had been since 1992. Acquisitions in fixed maturity securities totaled $2.1 billion in 1999 and $1.8 billion in 1998. The 1999 acquisitions were made at an effective compounded yield of 7.54%, compared with an effective compounded yield of 7.26% for the prior year. The yields equate to nominal yields on acquisitions of 7.38% and 7.13% for 1999 and 1998, respectively.
Although 1999 acquisitions were made at a higher average yield than in the past six years, the new investment yield was slightly below the average yield of the portfolio, resulting in a 3 basis point decline in the nominal portfolio yield at year-end 1999. At December 31, 1999, the fixed-maturity portfolio had an estimated nominal yield of 7.39%, compared with 7.42% in 1998 and 7.49% in 1997. The average life of the portfolio was 12.7 years at year- end 1999, increasing from 8.8 years at year-end 1998 and 8.0 years at the year-end 1997. Duration also rose at 1999 year end to 6.2 years from the 5.7 year level at the end of 1998 and 5.1 year level at the end of 1997. The increase in average life and duration was impacted primarily by the purchase of securities with longer maturities than the prior year average maturity.
Because Torchmark emphasizes fixed-maturity investments, the percentage holdings of Torchmark's investments by type vary considerably from industry averages. The following table presents Torchmark's components of invested assets compared with the latest industry data:
Market Risk Sensitivity. Market risk is a 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- income holdings amount to 92% of total investments. The effects of these 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.
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. A significant change in the level of interest rates, changes in credit quality of individual securities, or changes in the relative values of a security or asset sector are the primary factors that influence such sales. Occasionally, the need to raise cash for various operating commitments may also necessitate the sale of a security. Volatility in the value of Torchmark's fixed-income holdings is reduced by maintaining a relatively short-term portfolio, of which 18% matures within five years and 58% matures within ten years. Also, the portfolio and market conditions are constantly evaluated for appropriate action.
No derivative instruments are used to manage Torchmark's exposure to market risk in the investment portfolio. An interest-rate swap instrument was entered into to allow Torchmark to participate in the downward trend in interest rates in connection with its MIPS as discussed in the Notes to the Consolidated Financial Statements on page 64 of this report and in Capital Resources on page 33 of this report. A cap instrument was also entered into to protect Torchmark from the market risk on an increase in rates associated with the swap on this security. This cap expired during 1999.
The following table illustrates the market risk sensitivity of Torchmark's interest-rate sensitive fixed-maturity portfolio at December 31, 1999 and December 31, 1998. This table measures the effect of a change in interest rates (as represented by the U.S. Treasury curve) on the fair value of Torchmark's fixed-maturity portfolio. The data is prepared through a model that measures the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points. It takes into account the effect that special option features such as call options, put options, and unscheduled repayments would have on the portfolio, given the changes in rates. The valuation of these option features is dependent upon assumptions about future interest rate volatility that are based on past performance.
Liquidity. Torchmark's liquidity relates to its ability to meet on demand the cash commitments required by its business operations and financial obligations. Torchmark's liquidity is very strong, as evidenced by its three sources of liquidity: its positive cash flow from operations, its portfolio of marketable securities, and its line of credit facility.
Torchmark's insurance operations generate positive cash flows in excess of its immediate needs. Cash flows provided from operations were $512 million in 1999, compared with $389 million in 1998 and $410 million in 1997. In addition to operating cash flows, Torchmark received $413 million in investment maturities and repayments during 1999, adding to available cash flows. Such repayments were $474 million in 1998 and $513 million in 1997. Cash flows in excess of immediate requirements are used to build an investment base to fund future requirements.
Torchmark has a line of credit facility with a group of lenders which allows unsecured borrowings up to a specified maximum amount. The maximum amount on this facility was $600 million at December 31, 1999. Interest is charged at variable rates for borrowings. This line of credit is further designated as a backup 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 but may not borrow in excess of a total of $600 million on the combined facilities. At December 31, 1999, $420 million in face amount of commercial paper was outstanding and there were no borrowings on the line of credit. A fee is charged on the entire $600 million facility. In accordance with the agreements, Torchmark is subject to certain covenants regarding capitalization and earnings. At December 31, 1999, Torchmark was in full compliance with these covenants.
Liquidity of the parent company is affected by the ability of the subsidiaries to pay dividends. Dividends are paid by subsidiaries to the parent in order to meet its dividend payments on common and preferred stock, interest and principal repayment requirements on parent-company debt, and operating expenses of the parent company. These requirements have declined in both 1999 and 1998 from the respective prior year. 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 has been and is expected to be more than adequate for parent company operations. During the year 2000, a maximum amount of $192 million will be available to Torchmark from insurance subsidiaries without regulatory approval.
Capital Resources. Torchmark's capital structure consists of long and short- term debt, MIPS, and shareholders' equity. Torchmark's debt consists primarily of its funded debt and its commercial paper facility. An analysis of Torchmark's funded debt outstanding at year-ends 1999 and 1998 on the basis of par value was as follows:
The carrying value of the funded debt was $372 million at December 31, 1999, compared with $383 million a year earlier.
Shareholders' equity declined 12% to $1.99 billion at December 31, 1999. Shareholders' equity rose 17% in 1998, from $1.93 billion at year-end 1997 to $2.26 billion at year-end 1998. The 1999 decrease was impacted by the decrease in the value of the fixed-maturity portfolio due to increases in interest rates in the financial markets. The 1998 growth in shareholders' equity was greatly impacted by the Waddell & Reed offering and spin-off in that year. Proceeds from the March, 1998 offering added $516 million to Torchmark's shareholders' equity, but equity was reduced by $90 million of minority interest at the time of the offering representing the 36% of Waddell & Reed that Torchmark no longer owned. Additionally, the November, 1998 spin-off caused a reduction in Torchmark's equity of $174 million, representing its carrying value of Waddell & Reed at the time of the spin. Book value per share was $15.10 at 1999 year end, compared with $16.51 at year-end 1998. After adjusting for the impact on shareholders' equity for security value fluctuations due to changes in interest rates in financial markets, shareholders' equity rose from $2.11 billion at year-end 1998 to $2.15 billion at year-end 1999. Book value per share was $16.32 at year-end 1999, an increase of 6% over $15.43 at year-end 1998. Return on common shareholders' equity was 16.2% in 1999, compared with 15.1% in 1998. The return-on-equity ratios exclude the mark up or down of shareholders' equity for changes in security values caused by fluctuations in market interest rates. They are also computed on a basis of net operating income before nonrecurring charge, as defined on page 16 through 17 of this report.
Transactions Regarding Vesta Insurance Group. Since 1993, Torchmark has held a passive investment in Vesta, a property insurance carrier. Torchmark held 5.1 million shares of Vesta stock, or approximately 28% of the outstanding shares of Vesta, until December, 1998. Torchmark carried its investment in Vesta during this period on the equity method of accounting. In June, 1998, Vesta announced that (a) an investigation of accounting irregularities that occurred during the fourth quarter of 1997 and the first quarter of 1998 would result in an aggregate $14 million net after-tax reduction in previously reported net income, and, in addition, that (b) it would restate its historical financial statements for the period of 1993 through the first quarter of 1998, reflecting reductions in reported net after-tax earnings of $49 million for the period of 1993 through 1997 and $10 million for the first quarter of 1998. To reflect its pro rata share of Vesta's cumulative reported financial corrections, Torchmark recorded a pre-tax charge of $20 million ($13 million after tax) or $.09 per diluted share in the second quarter of 1998. As a result of the announcements relating to Vesta and the decline in value of Vesta stock, Vesta is currently subject to numerous class action lawsuits in state and Federal courts filed subsequent to such announcements.
Litigation. Torchmark and its subsidiaries continue to be named as parties to pending or threatened litigation, most of which involves punitive damage claims based upon allegations of agent misconduct at Liberty National 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. It is impossible to predict the extent of punitive damages that may be awarded if liability is found in any given case, 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. 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.
Management believes that Statement 133 will have an immaterial impact on Torchmark's financial statements. Other than the interest rate swap on its MIPs, which is carried at fair market value, Torchmark's use of derivatives is limited.
We have audited the accompanying consolidated balance sheet of Torchmark Corporation and subsidiaries as of December 31, 1999, and the related consolidated statements of operations, comprehensive income, shareholders' equity, and cash flow for the year then ended. Our audit also included the financial statement schedules listed in the Index at Item 14 as of and for the year ended December 31, 1999. These financial statements and financial statement schedules are the responsibility of Torchmark's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audit.
In our opinion, such 1999 consolidated financial statements present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries as of December 31, 1999, and the results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, such 1999 financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We have audited the consolidated financial statements of Torchmark Corporation and subsidiaries as listed in Item 8 as of and for the years ended December 31, 1998 and December 31, 1997. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in Item 14(a) as of and for the years ended December 31, 1998 and December 31, 1997. These consolidated financial statements and financial statement schedules are the responsibility of Torchmark's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the years in the two-year period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
TORCHMARK CORPORATION CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Amounts in thousands except per share data)
Investments: Torchmark classifies all of its fixed maturity investments, which include bonds and redeemable preferred stocks, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in other comprehensive income. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in other comprehensive income. Policy loans are carried at unpaid principal balances. Mortgage loans are carried at amortized cost. Investments in real estate are reported at cost less allowances for depreciation, which are calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities within three months. If an investment becomes permanently impaired, such impairment is treated as a realized loss and the investment is adjusted to net realizable value.
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, 1999, 1998, and 1997, included $287.6 million, $296.7 million, and $308.6 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocable to insurance policyholders' liabilities.
Cash: Cash consists of balances on hand and on deposit in banks and financial institutions. Overdrafts arising from the overnight investment of funds offset cash balances on hand and on deposit.
Note 1--Significant Accounting Policies (continued) respectively. Other premium includes annuity policy charges for the years ended December 31, 1999, 1998 and 1997, of $40.5 million, $33.5 million, and $28.2 million, respectively. Profits are also earned to the extent that investment income exceeds policy requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period.
Treasury Stock: Torchmark accounts for purchases of treasury stock on the cost method. Issuance of treasury stock is accounted for using the weighted- average cost method.
Comprehensive Income: Torchmark adopted SFAS 130, Reporting Comprehensive Income, effective January 1, 1998. This standard defines comprehensive income as the change in equity of a business enterprise during a period from transactions from all nonowner sources. It requires the company to display comprehensive income for the period, consisting of net income and other comprehensive income. In compliance with SFAS 130, a Consolidated Statement of Comprehensive Income is included as an integral part of the financial statements.
During 1998, Liberty National Life Insurance Company paid an extraordinary dividend to Torchmark in the amount of $213 million. In 1999, Liberty paid $61 million and Globe Life And Accident Insurance Company paid $34.5 million in extraordinary dividends.
A schedule of fixed maturities by contractual maturity at December 31, 1999 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.
During 1999, Torchmark determined to dispose of most of its investment real estate. In the second quarter of 1999, efforts to dispose of these properties revealed that the carrying value of the real estate exceeded its estimated realizable value. For this reason Torchmark wrote down its investment real estate portfolio to its estimated realizable value as of June 30, 1999. This write down resulted in a pretax loss of $64 million, or $41 million after tax. The majority of the investment real estate was sold in two transactions in the latter half of 1999 for total consideration of $123 million, of which $111 million was in cash and the remainder in a ten-year collaterized note. After the sales, Torchmark retained $16 million in investment real estate, of which $8 million was included with properties partially occupied by Torchmark subsidiaries.
Depreciation expense on property used in the business was $5.6 million, $4.2 million, and $4.6 million in each of the years 1999, 1998, and 1997, respectively.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $10.5 million, $13.2 million, and $16.6 million, for the years ended December 31, 1999, 1998, and 1997, respectively. The average interest rates used for the years ended December 31, 1999, 1998, and 1997 were 6.5%, 6.8%, and 7.19%, respectively. The estimated amortization, net of interest accrued, on the unamortized balance at December 31, 1999 during each of the next five years is: 2000, $16.7 million; 2001, $14.1 million; 2002, $12.5 million; 2003, $11.0 million; and 2004, $9.7 million.
On November 6, 1998, Torchmark distributed the remaining 64% investment in Waddell & Reed through a tax-free spin-off to Torchmark shareholders. Each Torchmark shareholder of record on October 23, 1998 received a total of .3018 Waddell & Reed shares per Torchmark share. After the spin-off, Torchmark retained no further ownership interest in Waddell & Reed. As a result of the transaction, Torchmark incurred $54 million in expense related to the spin- off, the majority of which was $50 million of corporate Federal income tax resulting from the distribution of a portion of the policyholder surplus account of a Torchmark life subsidiary.
Torchmark adopted FASB Statement No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits, effective for year-end 1998 with comparative periods restated. In accordance with this Standard, the following table presents a reconciliation from the beginning to the end of the year of the benefit obligation and plan assets. This table also presents a reconciliation of the plans' funded status with the amounts recognized on Torchmark's balance sheet.
For measurement purposes, an 8.0% annual rate of increase in per capita cost of covered healthcare benefits was assumed for 1999. These rates grade to ranges of 4.5% to 5.5% by the year 2010. The health care cost trend rate assumption has a significant effect on the amounts reported, as illustrated in the following table which presents the effect of a one percentage point increase and decrease on the service and interest cost components and the benefit obligation:
The Notes, due August 1, 2013, were issued in July, 1993 in the principal amount of $100 million for net proceeds of $98 million. Interest is payable on February 1 and August 1 of each year at a rate of 7 3/8%. In March, 1999, $4.0 million principal amount were purchased in the open market at a cost of $4.1 million. These notes are not redeemable prior to maturity and have equal priority with other Torchmark unsecured indebtedness.
In the first quarter of 1998, Torchmark repaid $20 million principal amount of its 8 5/8% Sinking Fund Debentures due March 1, 2017, through a sinking fund payment of which $8 million was mandatory and $12 million was elective under the terms of the issue. An identical payment was made in the third quarter of 1997. The remaining $160 million principal amount was called on April 1, 1998, at a prevailing call price of 103.76, or $166 million. An after-tax loss on the redemption of debt of $5 million was recorded in the second quarter of 1998. These payments were made from additional commercial paper borrowings.
Share Data: A summary of preferred and common share activity which has been restated to give effect for the two-for-one stock split in the form of a dividend is as follows:
- -------- (1) This stock grant was made from the 1987 Stock Incentive Plan. The retirement of an employee during 1999 resulted in the lapse of unvested grants. (2) The 1987 Stock Incentive Plan, the 1998 Directors' Stock Option Plan, and the 1998 Executive Deferred Compensation Stock Option Plan were closed in 1998.
The fair value for Torchmark's employee stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 1999, 1998, and 1997:
On September 25, 1997, Torchmark executed a stock option exercise and restoration program through which over 100 Torchmark directors and employees exercised vested stock options and received a reduced number of replacement options at current market price. This program resulted in the issuance of 4.8 million shares, of which over 3 million shares were immediately sold by the directors and employees through the open market to cover the cost of the purchased shares and related taxes. Another restoration program was effected on November 15, 1999. The 1999 program involved 80 directors and employees who exercised vested options for 1.8 million shares, resulting in the net issuance to employees of 523 thousand shares and 1.2 million replacement options for the shares sold by the employee to pay the exercise price and minimum withholding taxes. As a result of these restoration programs, management's ownership interest increased, and Torchmark received a significant current tax benefit from the exercise of the options.
The weighted average fair value of options granted during the years ended December 31, 1999, 1998, and 1997 were $9.29, $8.88, and $8.43, respectively.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. These leases contain various renewal options, purchase options, and escalation clauses. Rental expense for operating leases was $3.4 million in 1999 and $3.2 million in 1998 and 1997. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 1999 are as follows: 2000, $2.0 million; 2001, $1.2 million; 2002, $845 thousand; 2003, $438 thousand; 2004, $189 thousand and in the aggregate, $4.9 million.
Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. Most of the investments in foreign government securities are in Canadian government obligations. Corporate debt and equity investments are made in a wide range of industries. At December 31, 1999, 4% or more of the portfolio was invested in the following industries:
Guarantees: In the fourth quarter of 1999, Torchmark issued a full financial guaranty of all obligations, receivables, and recovery of capital on behalf of its subsidiaries American Income and AILIC Receivable Corporation up to $100 million. The guarantee was made to an unaffiliated third party as agent for the purchasers of certain agent receivables of American Income.
Litigation: Torchmark and its subsidiaries continue to be named as parties to pending or threatened legal proceedings. These lawsuits involve 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. Many of these lawsuits involve claims for punitive damages in state courts of Alabama, a jurisdiction particularly recognized for its large punitive damage verdicts. A number of such actions involving Liberty also name Torchmark as a defendant. In 1999, Alabama enacted legislation limiting punitive damages in non-physical injury cases to the greater of $500,000 or three times compensatory damages. Since this legislation has not undergone scrutiny by appellate courts regarding its constitutionality and a jury's discretion regarding the amount of compensatory damages (including mental anguish) awarded in any given case is not precisely defined, the effect of this legislation on Torchmark's litigation remains unclear. Thus, the likelihood or extent of a punitive damage award in any given case is currently impossible to predict. As of December 31, 1999, Liberty was a party to approximately 135 active lawsuits (including 17 employment related cases and excluding interpleaders and stayed cases), 126 of which were Alabama proceedings in which punitive damages were sought. Liberty faces trial settings in these cases on an on-going basis.
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. It should be noted, however, that large punitive damage awards bearing little or no relation to actual damages awarded by juries in jurisdictions in which Torchmark has substantial business, particularly in Alabama, continue to occur, creating the potential for unpredictable material adverse judgments in any given punitive damage suit.
On August 25, 1995, a purported class action was filed against Torchmark, Globe, United American and certain officers of these companies in the United States District Court for the Western District of Missouri on behalf of all former agents of Globe (Smith v. Torchmark Corporation, Case No. :95-3304-CV- S-4). This action alleges that the defendants breached independent agent contracts with the plaintiffs by treating them as captive agents and engaged in a pattern of racketeering activity wrongfully denying income and renewal commissions to the agents, restricting insurance sales, mandating the purchase of worthless leads, terminating agents without cause and inducing the execution of independent agent contracts based on misrepresentations of fact. Monetary damages in an unspecified amount are sought. A plaintiff class was certified by the District Court on February 26, 1996, although the certification did not go to the merit of the allegations in the complaint. On December 31, 1996, the plaintiffs filed an amended complaint in Smith to allege violations of various provisions of the Employment Retirement Income Security Act of 1974. Extensive discovery was then conducted. In October 1998, defendants filed a motion to decertify the presently defined class in Smith. On March 23, 1999, the District Court granted defendants' motion to decertify the Smith class in part and decertified all but the ERISA claims of a more narrowly defined Smith class. In May 1999, the defendants filed motions to dismiss the claims certified by the Court's March 23, 1999 order. On December 14, 1999, the District Court granted defendants' motion for summary judgment. That Court denied a motion for reconsideration on January 21, 2000.
It has been previously reported that Torchmark, its subsidiaries United American and Globe and certain individual corporate officers are parties to purported class action litigation filed in April, 1996 in
Defendants' motion for summary judgment on all remaining issues in Crichlow was granted by the District Court on February 4, 1999. The Crichlow plaintiffs have appealed and Crichlow defendants have cross-appealed various orders of the District Court to the United States Court of Appeals for the Eleventh Circuit.
In 1978, the United States District Court for the Northern District of Alabama entered a final judgment in Battle v. Liberty National Life Insurance Company, et al (Case No. CV-70-H-752-S), class action litigation involving Liberty, a class composed of all owners of funeral homes in Alabama and a class composed of all insureds (Alabama residents only) under burial or vault policies issued, assumed or reinsured by Liberty. The final judgment fixed the rights and obligations of Liberty and the funeral directors authorized to handle Liberty burial and vault policies as well as reforming the benefits available to the policyholders under the policies. Although class actions are inherently subject to subsequent collateral attack by absent class members, the Battle decree remains in effect to date. A motion filed in February 1990 to challenge the final judgment under Federal Rule of Civil Procedure 60(b) was rejected by both the District Court in 1991 and the Eleventh Circuit Court of Appeals in 1992 and a Writ of Certiorari was denied by the U.S. Supreme Court in 1993.
Note 18--Commitments and Contingencies (continued) District Court requesting that it order certain contract funeral directors to comply with their obligations under the Final Judgment in Battle and their funeral service contracts. A petition was filed on April 8, 1996 on behalf of a group of funeral directors seeking to modify the 1978 decree in Battle in light of changed economic circumstances. All parties made extensive submissions to the District Court and a hearing on the opposing petitions was held by the District Court on February 9, 1999. On March 8, 1999, the District Court entered an order granting Liberty's petition to enforce the obligations of contract funeral directors under their funeral service contracts and denying the funeral directors' petition for review of the Battle Final Judgment and alternative relief. On July 29, 1999, the funeral director class filed an appeal with the U.S. Court of Appeals of the Eleventh Circuit seeking to have the March 8, 1999 order vacated on the merits. Liberty filed a joint motion in the Eleventh Circuit Court seeking remand to the District Court for purposes of appointment of class counsel for burial policyholders, who are currently not formally represented in these proceedings. The Circuit Court issued an order denying Liberty's joint motion on September 15, 1999 and the funeral director class' appeal remains pending. On January 24, 2000, Liberty and the funeral director class filed a joint motion for remand in order to allow the District Court to evaluate a proposed settlement of the funeral directors' appeal.
The measure of profitability established by management for insurance segments is underwriting income before other income and administrative expenses, in accordance with the manner the segments are managed. It essentially represents gross profit margin on insurance products before insurance administrative expenses and consists of premium, less net policy obligations, acquisition expenses, and commissions. It differs from GAAP pretax operating income before other income and administrative expense for two primary reasons. First, there is a reduction to policy obligations for interest credited by
- -------- * Investment segment includes MIPS dividend on a pretax basis. ** Insurance segments exclude Family Service.
- ------- * Investment segment includes MIPS dividend on a pretax basis. ** Insurance segments exclude Family Service.
Transactions with Directors and Officers: Lamar C. Smith, elected a director of Torchmark in October 1999, is an officer, director and 15% owner of Independent Research Agency for Life Insurance, Inc. (IRA), which receives commissions as the Military Agency distribution system for selling certain life insurance products offered by Torchmark's insurance subsidiaries.
On October 1, 1999, Torchmark sold the majority of its investment real estate in two transactions. One transaction involved sales to Elgin Development Company and other investors for total consideration of $97.4 million. The Chairman of the Executive Committee of Torchmark is a one- third investor in Elgin Development Company. His investment in Elgin Development was approximately $1.5 million.