Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of FIC's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page.
As described in Note 2 to our accompanying consolidated financial statements included in Item 8 of this Annual Report on Form 10-K and beginning with the discussion on page, we have restated our financial statements for the fiscal years ended December 31, 2001, and 2000. The financial information for all periods included in the following discussion gives effect to the restatement.
In the fourth quarter of 2002, the Company identified uncollectible receivables for which adequate allowance had not been made and policyholder benefits and expenses that were understated due to an interface error between the policy administration system and the general ledger. The Company extended its investigation to determine the years affected and expanded the scope of its review to include other areas, including certain adjustments that were deemed not material in prior years. As a result of this review, the Consolidated Statements of Income for 2001 and 2000 and the Consolidated Balance Sheet for 2001 were restated as follows:
Equity securities, at market value (cost approximates $8,856 at December 31, 2001) $56 $8,279
o A reduction in other revenue in 2001 of $966,000 primarily related to a reclassification of negative goodwill amortization to operating expenses;
o An increase in policyholder benefits and expenses in 2001 of $2.4 million related to certain death benefits and annuity benefits which were not recorded due to an interface error between the Company's policy administration system and its general ledger and a correction of an unreconciled difference between suspense account balances included in the Company's general ledger and those included in its policy administration system.
o Decreases in the equity in net earnings of affiliate of $331,000 in 2001 and $1.5 million in 2000 due to adjustments that decreased ILCO's net income in 2001 and 2000.
The consolidated balance sheet as of December 31, 2001 was restated to reflect the following:
o An increase to assets of $8.2 million in FIC's investments in equity securities to properly reflect the market value of the Company's investment in the separate account;
o A decrease in assets of $3.2 million in deferred policy acquisition costs due to a revision of the factors used to calculate Family Life's deferred policy acquisition costs;
o A decrease in liabilities of $4.7 million related to deferred federal income taxes;
o A decrease in liabilities of $5.4 million related to a reduction in excess of net assets over acquired cost related to ILCO goodwill;
o A decrease in retained earnings of $11.1 million due to the restatements.
In accordance with Generally Accepted Accounting Principles ("GAAP"), universal life insurance premiums and annuity deposits received are reflected on FIC's consolidated balance sheets as increases in liabilities for contract holder deposit funds and not as revenues.
Expenses consist principally of insurance benefits provided to policyholders, interest credited on policyholder account balances, other operating costs and expenses, which include commissions and general business expenses, net of expenses deferred, amortization of present value of future profits of acquired businesses and amortization of deferred policy acquisition costs, and premium and income taxes. Surrender benefits paid relating to universal life insurance policies and annuities are reflected as decreases in liabilities for contract holder deposit funds and not as expenses.
The Company's profitability depends in large part upon: (1) the adequacy of our product pricing, which is primarily a function of competitive conditions, our ability to assess and manage trends in mortality and morbidity experience, our ability to generate investment earnings and our ability to maintain expenses in accordance with pricing assumptions; (2) the amount of assets under management; and (3) the maintenance of our target spreads between the rate of earnings on our investments and credited rates on policyholders' account balances.
On May 18, 2001, pursuant to an Agreement and Plan of Merger, as amended (the "Merger Agreement"), dated as of January 17, 2001, among FIC, InterContinental Life Corporation ("ILCO"), and ILCO Acquisition Company, a Texas corporation and wholly-owned subsidiary of FIC ("Merger Sub"), Merger Sub was merged with and into ILCO (the "Merger"). ILCO was the surviving corporation of the Merger and became a wholly-owned subsidiary of FIC. In accordance with the Merger Agreement, FIC issued 1.1 shares of common stock, par value $0.20 per share ("FIC Common Stock"), for each share of common stock, par value $0.22 per share, of ILCO outstanding at the time of the Merger ("ILCO Common Stock"). In addition, each share of ILCO Common Stock issuable pursuant to outstanding options was assumed by FIC and became an option to acquire FIC Common Stock with the number of shares and exercise price adjusted for the exchange ratio in the Merger. Prior to the merger, FIC owned approximately 48.1% of ILCO's common stock. Since ILCO was a wholly-owned subsidiary of FIC for the period from May 18, 2001 to December 31, 2001 and thereafter, the operations of ILCO are reported on a consolidated basis with FIC in the year end 2001 financial statements as well as for the year end 2002 financial statements. For the period from January 1, 2001 to May 17, 2001, and for the year ended December 31, 2000, FIC's net income includes its equity interest in the net income of ILCO, with such equity interest being based on FIC's percentage ownership of ILCO.
In 2002, net income and earnings per share were affected by the cumulative effect of a change in accounting principle of $10.4 million. This amount represents the excess of fair value of net assets acquired over cost as of the beginning of 2002 related to the merger of ILCO with and into a subsidiary of FIC on May 18, 2001. In the Company's filings for the quarters ended March 31, 2002, June 30, 2002 and September 30, 2002, the company reported a cumulative effect of a change in accounting principle of $15.7 million. Due to the restatements, as described below in Item 7, the Company has restated the amount of the excess of fair value of net assets over acquired cost to $10.4 million. The Company recorded this cumulative effect in conjunction with adopting Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations," in the first quarter of 2002, as required by SFAS 141.
For the year ended December 31, 2002, FIC's net income was $5,342,000 (basic and diluted earnings of $0.56 per common share) on revenues of $118,715,000 as compared to net income for the year ended December 31, 2001, which was $9,777,000 (basic earnings of $1.25 per common share or diluted earnings of $1.24 per common share) on revenues of $98,160,000 and net income for the year ended December 31, 2000, which was $7,436,000 (basic earnings of $1.47 per common share or diluted earnings of $1.44 per common share) on revenues of
$44,418,000. The net loss for the year ended December 31, 2002, before the cumulative effect of a change in accounting principle, was $5,087,000 (basic and diluted earnings of ($0.53) per common share).
Premium revenues reported for traditional life insurance products are recognized when due. Premium income, net of reinsurance ceded, for the year 2002, was $35.7 million, as compared to $35.9 million for the year 2001 and $33.1 million for the year 2000. This source of revenues is related to the traditional life insurance book of business of FIC's insurance subsidiaries. For the year ended December 31, 2002, Investors Life contributed approximately $8.7 million and Family Life contributed approximately $27.0 million to premium income. The consolidation of ILCO's operations following the Merger contributed approximately $5 million and Family Life contributed approximately $31 million to premium income for the year ended December 31, 2001. At Family Life (which has been a subsidiary of FIC for all of the year-end periods covered by this report), first year net collected premiums for traditional life insurance products in 2002 were $2.6 million as compared to $3.4 million in 2001. The level of net collected premiums for traditional life insurance products at Family Life for the year 2002 was $23.7 million, as compared to $25.8 million for the year 2001 and $27.7 million for the year 2000. The decrease in renewal premium is attributable to the decrease in the traditional life insurance book of business.
Income from universal life and annuity charges for the year ended December 31, 2002 was $42.0 million, as compared to $27.7 million for the year 2001 and $4.3 million in 2000. The increase from 2001 to 2002 was primarily attributable to the contribution of ILCO's operations for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. The consolidation of ILCO's operations following the Merger contributed approximately $24.0 million to
Real estate income is primarily earned from the leases on the buildings at River Place Pointe, an office complex in Austin, Texas, which is owned and being developed by Investors Life. Net real estate income was $2.6 million for the year ended December 31, 2002, as compared to $1.9 million for the year ended December 31, 2001. Investors Life's real estate income was included in FIC's income statements from May 18, 2001 through December 31, 2001 and for the year ended December 31, 2002. For the year ended December 31, 2000, FIC did not have any real estate income.
Policyholder benefits and expenses were $48.2 million in 2002, as compared to $30.1 million in 2001 and $13.5 million in 2000. The increase of $18.1 million from year ended December 31, 2001 to December 31, 2002 was partly attributable to the inclusion of ILCO's expenses for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. The consolidation of ILCO's operations for the period from May 18, 2001 to December 31, 2001 contributed approximately $19 million to policyholder benefits and expenses for the year ended December 31, 2001. At ILCO's insurance subsidiaries, the level of policyholder benefits and expenses was $32.5 million in the year 2000, $32.4 million in the year 2001 and $37.3 million in the year 2002. The increase from 2001 to 2002 is attributable to increases in death benefit claims. At Family Life, the level of policyholder benefits and expenses decreased from $13.5 million for the year 2000 to $10.1 million for the year 2001 and increased to $10.7 million for the year 2002, which decreases are attributable to decreases in death benefit claims as well as decreases in reserves due to higher than expected lapse rates in Family Life's traditional life business.
Interest expense on contract holders deposit funds was $29.7 million for the year 2002, as compared to $19.9 million for the year 2001 and $2.2 million for the year 2000. The increase from 2001 to 2002 was due to the inclusion of ILCO's expenses for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. The increase from 2000 to 2001 is primarily attributable to $17.5 million of interest expense on contract holders deposit funds resulting from the consolidation of ILCO's operations following the Merger. This expense is related to payment of interest to policyholders for cash values accumulated in their accounts.
Results of Operations - Three Months Ended December 31, 2002 as compared to the Three Months Ended December 31, 2001
For the three-month period ended December 31, 2002, FIC's net income before the cummulative effect of change in accounting principle was (5.8) million (basic and diluted earnings of (6.0 per common share) on revenues of $26.0 million as compared to the restated net income of $2.4 million (basic and diluted earnings of $0.25 per common share) on restated total revenues of $31.9 million in the last three months of 2001. The decrease in net income and total revenues from the three-month period ended December 31, 2001 to the same period in 2002 is attributable to (i) a decrease in investment income; (ii) a net realized loss on investments relating to impairments; (iii) an increase in death benefits; (iv) an increase in operating expenses.
Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. FIC is an insurance holding company whose principal assets consist of the outstanding capital stock of its insurance subsidiaries - Family Life Insurance Company ("Family Life"), Investors Life Insurance Company of North America ("Investors Life"), and prior to February 19, 2002, Investors Life Insurance Company of Indiana ("Investors-IN"). Prior to the merger of FIC and ILCO on May 18, 2001, the principal assets of FIC consisted of the common stock of its insurance subsidiary, Family Life, and its equity ownership in ILCO. As a holding company, FIC's ability to meet its cash requirements, pay interest on any debt, pay expenses related to its affairs and pay dividends on its common stock substantially depends upon dividends from its subsidiaries.
Prior to June 2001, the principal source of liquidity for FIC and its wholly-owned subsidiary, Family Life Corporation, consisted of the periodic payment of principal and interest by Family Life pursuant to the terms of the surplus debenture issued in connection with the Family Life acquisition from Merrill Lynch. The surplus debenture was completely paid off as of June 30, 2001. For periods subsequent to June 30, 2001, FIC's available source of liquidity will be dividends paid to it from its subsidiaries. Applicable state insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of prescribed limitations without prior approval.
FIC's cash and cash equivalents at December 31, 2002 was $25.0 million as compared to $7.1 million at December 31, 2001 and $2.7 million at December 31, 2000. The increase in cash and cash equivalents was primarily due to maturities and early redemptions of fixed income investments that occurred during December, 2002, resulting in an increased cash position pending reinvestment. The $4.4 million increase in cash and cash equivalents at December 31, 2001 from 2000 was due primarily to the Merger and the cash acquired in the purchase.
Net cash flow provided by investing activities was $20.6 million in 2002, as compared to $15.4 million in 2001 and $9.1 million in 2000. The increase in cash provided by investing activities from 2001 to 2002 was primarily attributable to the increase in cash due to proceeds from the sales and maturities of fixed maturities. The increase in cash provided by investing activities from 2001 to 2000 was due to the purchase of ILCO, which provided $9.1 million, and a $14.8 million increase in proceeds from short-term investments. These amounts were offset by a ($18.1) million investment in real estate.
Net cash flow used in financing activities was ($10.3) million in 2002, as compared to ($13.8) million in 2001 and ($7.3) million in 2000. Payment of cash dividends to stockholders attributed to $2.2 million of cash used in financing for 2002, as compared to $6.0 million in 2001 and $0.9 million in 2000; however, repayment of subordinated notes payable decreased from ($6.1) million in 2000 to ($1.5) million in 2001 and $0 in 2002 due to the Merger. In 2002, contractholder fund withdrawals exceeded deposits by $8.7 million, while in 2001 withdrawals exceeded deposits by $4.4 million.
A primary liquidity consideration with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawal. Deposit fund liabilities for universal life and annuity products as of December 31, 2002 were $557.5 million, as compared to $556.1 million at December 31, 2001. Individual life insurance policies are less susceptible to withdrawal than are annuity contracts because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. At December 31, 2002, the bulk of the liabilities for contractholder deposit funds on FIC's balance sheet, $419.1 million, were related to insurance products, as compared to only $138.4 million of annuity product liabilities.
In 2002, management reviewed the Company's liquidity to determine whether the cash, cash equivalents and short term investments of the Company were sufficient to meet the Company's needs for cash for operations, capital requirements and commitments. Based on such review, management determined that it would be in the Company's best interest to reduce the amount of dividends paid to shareholders (see "Item 5 - C. Dividends"), to discontinue donations to the Mitte Foundation and to streamline certain operations of the Company. Based on this review and the subsequent initiatives set forth by management, management believes that the cash, cash equivalents and short term investments of FIC and its subsidiaries are sufficient to meet the needs of its business and to satisfy debt service. There are no trends, commitments or capital asset requirements that are expected to have an adverse effect on the liquidity of FIC.
The assets of FIC's life insurance subsidiaries must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the emphasis is to obtain targeted profit margins, while minimizing the exposure to changing interest rates. This objective is implemented by selecting primarily short- to medium-term, investment grade fixed income securities. In making such portfolio selections, the Company generally does not select new investments which are commonly referred to as "high yield" or "non-investment grade." The general investment objective of the Company emphasizes the selection of short to medium term high quality fixed income securities, rated Baa-3 (investment grade) or better by Moody's Investors Service, Inc. We determine the allocation of our assets primarily on the basis of cash flow and return requirements of our products and secondarily by the level of investment risk.
The following table summarizes invested assets by asset category, excluding separate account assets, as of December 31, 2002 and 2001: (in thousands)
The Company's fixed maturity securities portfolio is predominately comprised of low risk, investment grade, available for sale publicly traded corporate securities, mortgage-backed securities and United States Government bonds. As of December 31, 2002, the market value of the fixed maturities available for sale segment was $493.8 million as compared to an amortized cost of $479.4 million or an unrealized gain of $14.4 million. The increase reflects unrealized gains on such investments related to changes in interest rates subsequent to the purchase of such investments. At December 31, 2001, the market value of the fixed
The securities valuation office (SVO) of the National Association of Insurance Commissioners evaluates all public and private bonds purchased as investments by insurance companies. The SVO assigns one of six investment categories to each security it reviews. Category 1 is the highest quality rating, and Category 6 is the lowest. As of December 31, 2002, the majority of our bonds are investment grade (Category 1 and 2). The Company's fixed maturities portfolio (including short-term investments), included only a non-material amount of debt securities which, in the annual statements of the companies as filed with state insurance departments, were designated by the SVO as "3" (medium quality) or below.
As of December 31, 2002, Investors Life had invested $93.7 million in the construction of River Place Pointe, of which $19.7 million is recorded on FIC's balance sheet as real estate occupied by the Company. Investors Life paid $13.5 million during 2002 for the construction of the project. FIC and its insurance subsidiaries occupy all of Building One at River Place Pointe, consisting of approximately 76,143 square feet of space, and additionally occupies approximately 5,000 square feet of Building Four of River Place Pointe. As of December 31, 2002, 222,007 rentable square feet of office space was leased to third party tenants and 281,682 rentable square feet was available for lease. According to the Federal Deposit Insurance Corporation's ("FDIC") National Edition of Regional Outlook, Fourth Quarter, 2002 "the vacancy rate in Austin has risen almost fivefold in three years, the most dramatic increase in the country the Austin suburban (office) market reported an office vacancy rate of 27.2 percent as of September 30, 2002, the highest in the nation, with about 10 percent attributable to sublease space."
Policy loans totaled $46.6 million at December 31, 2002, as compared to $49.8 million at December 31, 2001.
The Company's investments primarily consist of fixed maturity securities, which include bonds, notes and redeemable preferred stocks. Fair values of investments in fixed securities are based on quoted market prices or dealer quotes. Fixed maturities are classified as "available for sale" and are reported at fair value, with unrealized investment gains and losses, net of income taxes, credited or charged directly to shareholder's equity. Generally accepted accounting principles require that investments be written down to fair value when declines in value are considered other than temporary. When such impairments occur, the decrease in value is reported in net income as a realized investment loss and a new cost basis is established.
Present value of future profits of acquired business ("PVFP") are the costs associated with acquiring blocks of insurance from other companies or through the acquisition of other companies. PVFP is capitalized and amortized in a manner that matches these costs against the associated revenues.
In December 2002, the Company received an unsolicited indication of interest from the Pillar Foundation Group ("Pillar"). As previously publicly disclosed by the Company, the Company believes that the letters sent to FIC by Pillar did not constitute an offer. Rather, the letter stated that it was as an indication of interest to enter into a letter of intent at an undefined future time with respect to the acquisition of all or part of the outstanding common shares of FIC at a tentative valuation of $13 to $18 per share. Pillar did not indicate the source of funds for any such transaction, nor the structure or timing of any possible transaction. Furthermore, Pillar stated in the letter that any transaction would be subject to numerous due diligence and other identified and unnamed conditions, such as determination of a final price, regulatory and board approvals, and execution by sellers of a satisfactory stock purchase agreement. In fact, the letter did not state clearly whether Pillar intended to acquire shares from FIC or from other shareholders. In addition, Pillar did not have an established reputation in the insurance industry for consummating transactions of this magnitude and there was no evidence that it had the financial ability to do so. Because the valuation indicated by Pillar was below book value and because of the depressed state of the U.S. capital markets and poor general economic conditions, the Board of Directors concluded that it would not be in the best interest of the Company's shareholders to negotiate toward selling the Company for a depressed price in the existing economic conditions.
Nevertheless, in the exercise of its fiduciary duties, on December 13, 2002, the Board of Directors unanimously approved the appointment of a Special Committee to review unsolicited indications of interest in the acquisition of the Company. On January 6, 2003, the Board of Directors unanimously approved a realignment of the Special Committee to include only independent directors and it authorized the Special Committee to select an investment banking firm to perform a valuation analysis of FIC and to explore strategic alternatives to improve shareholder value, including a sale of FIC. The Special Committee interviewed four firms and selected Salomon Smith Barney.
On January 20, 2003, attorneys representing the Mitte Foundation sent a demand that the Company hold a special shareholders meeting for the purpose of removing all members of the board of directors and electing unidentified directors that would be proposed by the Mitte Foundation, Roy Mitte, Mr. Mitte's wife, Joann Cole Mitte, and Mr. Mitte's son, Scott Mitte (collectively, the "Mitte Family"). These attorneys informed the Company that they were prepared to pursue litigation if their demands were not met. The Mitte Foundation's demand, if granted by the Company or ordered by a court, would have required holding a shareholders' meeting without proxy materials of the Company or the dissemination to shareholders of all appropriate financial and other information concerning the Company's performance in 2002. Specifically, the federal securities laws require that each proxy statement furnished to shareholders by the Company must be accompanied or preceded by an annual report to shareholders which includes audited financial statements for the prior fiscal year. The Mitte Foundation demanded that the Company hold a special shareholders' meeting on February 4, 2003, only fifteen days after the date of the demand letter. The Company could not have prepared audited financial statements for fiscal year 2002 so soon after the fiscal year, nor was it otherwise required to file such financial statements by such time under the federal securities laws, which allow 90 days following the end of the fiscal year to prepare such information. As a result, the Company could not have disseminated proxy materials to its shareholders in compliance with the federal securities laws. Accordingly, in light of the Mitte Foundation's demand for a special meeting, the Company commenced litigation against Mr. Mitte, the Mitte Foundation, and Joann Cole Mitte which sought to delay the meeting, alleging, among other things, Mr. Mitte's violation of certain provisions of the securities laws as described below.
o In January 2002, Roy Mitte caused the transfer of $1,000,000 from FIC to the Mitte Foundation, in contravention of a promise made by Mr. Mitte to the Compensation Committee of the Board of Directors that no such transfers would be sought or made in 2002; and
o A preliminary injunction preventing, among other things, the Mitte Foundation from demanding that the Company notice a special shareholders' meeting;
o A monetary judgment against the Mitte Foundation in the amount of $1,000,000 and for all sums which FIC has improperly paid or borne on behalf of the Mitte Foundation;
o A monetary judgment against Mr. Mitte in the amount of $1,000,000, in the event that the Mitte Foundation fails to repay this amount; and
On March 19, 2003, Mr. Mitte filed a counterclaim against the Company alleging breach of contract with respect to the Company's failure to pay Mr. Mitte severance benefits and compensation that Mr. Mitte claims he is entitled to receive under his employment agreement with the Company. Mr. Mitte seeks actual damages, interest and attorney's fees and costs.
1. Report of PricewaterhouseCoopers LLP, Independent Accountants, dated April 17, 2003.
2. Consolidated Balance Sheet as of December 31, 2002 and Restated Consolidated Balance Sheet as of December 31, 2001.
4. Consolidated Statement of Changes in Shareholders' Equity for the year ended December 31, 2002, and Restated Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2001 and 2000.