The Company also leases approximately 10,000 square feet in Cedar Park, Texas, to house the Company’s printing operations and warehouse storage. During 2006, the monthly base rental for the Cedar Park facility was $7,988. The lease term ends on March 31, 2008.
In 2006, the Company sold one of its insurance subsidiaries as described in the accompanying consolidated financial statements in Note 2, “Discontinued Operations - Sale of Family Life Insurance Company.”
In 2004, net income and earnings per share were affected by the cumulative effect of a change in accounting principle of $229,000. This amount represents the cumulative effect of changes in accounting recognition for sales inducements under Statement of Position 03-01, specifically bonus interest. The Company has certain universal life insurance products that are credited with bonus interest after applicable qualifying periods. The adoption of the new accounting principle changed the pattern of recognition of the bonus interest expense.
In 2002, net income and earnings per share were affected by the cumulative effect of a change in accounting principle of $4.1 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. 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.
Following is a discussion and analysis of the consolidated 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 consolidated financial statements beginning on page . See also “Item 1 - Description of Business”.
FIC incurred a net loss of $24.8 million in 2006 compared to net losses of $165,000 and $14.3 million in 2005 and 2004, respectively. The net loss incurred during 2006 primarily includes losses from the discontinued operations of the Company’s wholly-owned subsidiary, Family Life, totaling $25.5 million. This is offset by income from continuing operations of $0.7 million. Compared to results for 2004, the small net loss for 2005 in largely attributable to lower policyholder benefits and operating expenses, along with increases in net realized gains on investments.
At the end of 2006, the equity of FIC’s shareholders totaled $60.7 million, down from $82.1 million at the end of 2005. This $21.4 million decline in shareholders’ equity primarily reflects the Company’s net loss for the year.
On December 29, 2006, Financial Industries Corporation completed the sale of its wholly owned subsidiary, Family Life Insurance Company, to The Manhattan Life Insurance Company for $28.0 million in cash. In accordance with SFAS 144, the consolidated financial statements reflect the assets, liabilities and operating results of Family Life Insurance Company as discontinued operations, adjusted for certain activities as described below.
Prior to the sale, Investors Life assumed certain universal life insurance and annuity contracts written by Family Life under reinsurance treaties between the companies. Effective September 30, 2006, Family Life and Investors Life executed recapture agreements related to these reinsurance treaties effectively terminating these treaties and removing Investors Life from any liability for life insurance and annuity contracts written by Family Life. Accordingly, all of the assets, liabilities, revenues and costs associated with these universal life insurance and annuity contracts are included in discontinued operations.
Also, prior to the closing of the sale, the Family Life Pension Plan, along with its assets and liabilities, was transferred from Family Life to its upstream parent company and all current and future obligations of the Family Life Pension Plan remain the responsibility of the Company. Accordingly, pension liabilities and costs were not included in discontinued operations.
The following sections of this Item 7 reflect Family Life as discontinued operations pursuant to SFAS 144 as described above. Accordingly, unless otherwise noted, amounts and analysis in this Item 7 reflect the continuing operations of FIC and its subsidiaries, exclusive of Family Life. References to income and loss from operations are identified as continuing operations or discontinued operations, while references to net income or net loss reflect the consolidated net results of both continuing and discontinued operations.
During 2006, the equity of the shareholders of the Company (that is, the excess of the Company’s assets over its liabilities) declined by $21.4 million. The change in FIC’s shareholders’ equity is due to the following:
Sale of treasury stock (in conjunction with sale of Family Life) totaling $2.5 million
At the end of 2006, FIC had $687.3 million of assets under its direct management, exclusive of separate account assets and assets of discontinued operations. In broad terms, these funds were invested as follows:
The Company’s life insurance subsidiary has an investment management agreement with Conning. Under this agreement, Conning manages the investment security portfolio in accordance with investment policies set by the Company’s Board of Directors.
Mortgage-backed securities are sensitive to changes in prevailing interest rates, since interest rate levels affect the rate at which the underlying mortgage obligations are repaid. Mortgage-backed pass-through securities, sequential CMOs and support bonds, which comprised approximately 62.8% of the market value of FIC’s mortgage-backed securities at December 31, 2006, are sensitive to prepayment and extension risks. FIC’s insurance subsidiary has reduced the risk of prepayment associated with mortgage-backed securities by investing in planned amortization class (“PAC”), target amortization class (“TAC”) instruments and scheduled bonds. These investments are designed to amortize in a predictable manner by shifting the risk of prepayment of the underlying collateral to other investors in other tranches (“support classes”) of the CMO. At December 31, 2006, PAC and TAC instruments and scheduled bonds represented approximately 21.8% of the market value of FIC’s mortgage-backed securities. Sequential and support classes represented approximately 19.7% of the market value of FIC’s mortgage-backed securities at December 31, 2006.
Agency advances and other receivables, totaling $929,000 and $2.9 million at December 31, 2006 and 2005, respectively, consist primarily of agent balances, federal income taxes recoverable, receivables for securities, and other receivables. This decrease of $2.0 million is comprised predominately of the following: 1) increase in receivable for securities sold but not settled as of December 31, 2005 of $900,000, and 2) decline in federal income taxes recoverable of $2.7 million during 2006.
For prior year comparative purposes, the changes for in-force from 2004 to 2005 for policies, traditional life insurance, universal life insurance, and annuity funds on deposit were (7.0)%, (16.7)%, (6.3)%, and 0.0%, respectively.
Other liabilities, which totaled $34.0 million at December 31, 2006, compared to $22.1 million at December 31, 2005, consist primarily of accrued expenses, policyholder suspense liabilities, pension plan liabilities, income taxes payable, amounts due on unsettled security transactions, and amounts held as agent or trustee. This increase in other liabilities is primarily due to amounts due for unsettled transactions for purchased securities of $15.2 million.
The entire principal amount of the 2003 Notes and any accrued but unpaid interest may become immediately due and payable upon an event of default, which includes: (1) failure to pay interest within 30 days of any due date; (2) failure to pay principal when due; (3) the bankruptcy or insolvency of FIC; or (4) the merger of FIC or sale of all or substantially all of its assets unless the successor entity to a merger is a United States corporation (or a foreign corporation that agrees to be bound by certain tax provisions). The terms of the 2003 Notes also place certain limitations on the offer or sale of securities of FIC if it would render invalid the exemption of the notes issued in connection with the loan from the registration requirements of the Securities Act of 1933. Other terms and conditions of the $15 million borrowing are described in Note 7 in the accompanying consolidated financial statements. As of December 31, 2006, the Company is in compliance with all provisions of this agreement.
State regulators also use NAIC IRIS ratios to monitor capital adequacy requirements. The NAIC ratios cover 12 categories of financial data with defined “usual” ranges for each such category. The ratios are intended to provide insurance regulators with “early warnings” as to when a given company might warrant special attention. An insurance company may fall outside of the usual range for one or more ratios, and such variances may result from specific transactions that are, by themselves, immaterial or eliminated at the consolidation level. In certain states, insurers with more than three IRIS ratios outside of the NAIC usual ranges may be subject to increased regulatory oversight. For 2005, Investors Life had two ratios which were outside the usual ranges primarily related to investment income and changes in premium. For 2006 Investors Life had four ratios which were outside the usual ranges, which were primarily related to changes in investment income and changes in premium, product mix, and reserving. The ratios were outside the usual ranges primarily due to a recapture of ceded reinsurance by Family Life from Investors Life during 2006. This recapture occurred prior to the sale of Family Life. For statutory accounting purposes, the recapture affected premium income and change in policy reserves which caused ratios to fall outside the usual ranges. Excluding the effects of the reinsurance recapture, Investors Life would have had one ratio outside the usual ranges, which related to investment income. Investors Life continues to maintain capital and surplus positions which significantly exceed risk-based capital (“RBC”) and other regulatory requirements.
During 2004, the Company and its investment manager developed asset-liability (“ALM”) models for the investment portfolio of FIC’s insurance company. These models focus on comparing the respective durations of the assets and liabilities of each company. Since duration is a direct measure of the sensitivity of an asset or liability to a change in interest rates, these ALM models are designed to allow the Company’s management to deploy investment assets in ways expected to moderate the impact of changes in interest rates on the equity of Investors Life.
Net losses for 2006, 2005, and 2004 were $24.8 million, $165,000, and $14.3 million, respectively. However, in analyzing the Company’s results of operations, a separation of results between continuing and discontinued operations provides a more meaningful view. As previously described, the Company sold Family Life resulting in a loss from discontinued operations totaling $25.5 million in 2006, which consists of a $1.1 million loss on operations during the year and a $24.4 million loss on the sale. Losses from discontinued operations were $1.1 million in 2005 and $2.5 million in 2004.
Income from continuing operations totaled $715,000 and $942,000 in 2006 and 2005, respectively. Loss from continuing operations was $12.1 million in 2004. The Company also recorded income resulting from a cumulative effect of change in accounting principle of $229,000 in 2004.
Operating expenses continued to decline in 2006, reflecting reductions of $1.2 million.
Gains were recognized on the sales of River Place Pointe and other real estate totaling $9.2 million. Lease income, which is included in net real estate income, declined approximately $1.2 million in 2005, as compared to 2004, as a result of these sales.
Significant auditing, actuarial, accounting, consulting, and legal fees continued to be incurred in 2005, although reduced from the level of 2004, as a result of the audit of the Company’s financial accounts and resulting restatement of prior years’ consolidated financial statements included in its 2004 Form 10-K filing, along with various litigation matters continuing into 2005. These fees totaled $5.6 million in 2005, reflecting a $1.3 million decrease from 2004.
Reductions of $5.8 million were noted in policyholder benefits and expenses, as compared to 2004. These were primarily attributable to lower death benefits and policy surrenders.
Interest expense on contractholder deposit funds continues to decline totaling $18.4 million in 2005 compared to $19.4 million in 2004.
A valuation allowance related to the realization of net operating loss deferred tax assets reduced the income tax benefit from continuing operations by $3.3 million.
The above described items need to be taken into consideration in drawing comparisons between the results from continuing operations in 2006 and other periods.
The declines in UL premiums and annuity deposits in 2006 and 2005, shown in the above table, reflect the net run-off of business from the Company’s existing book of business, and declining sales of new UL policies. Although the Company is focusing on reversing these trends on an overall basis, management has de-emphasized the sale of annuity and UL products since 2004 due primarily to the interest-rate environment and certain design features of FIC’s current annuity products. Most of the Company’s marketing efforts are now focused on the sale of traditional life insurance products, such as mortgage protection term insurance and final expense whole life insurance. Liabilities for contractholder deposit funds have declined from $511.4 million in 2004 to $483.1 million and $453.7 million in 2005 and 2006, respectively.
Net investment income for the year ended December 31, 2006, was $29.3 million as compared to $25.8 million for the year ended December 31, 2005, and $25.1 million for the year ended December 31, 2004. The increase in net investment income from 2005 to 2006 of $3.5 million and from 2004 to 2005 of $0.8 million was primarily attributable to the reinvestment of cash and short-term investments and real estate sales proceeds into higher-yielding fixed maturity investments during the latter part of 2005 and 2006 consistent with the revised investment policies of the Company. The Company sold its investment in the River Place Pointe office complex in June 2005 for $103 million in cash. These proceeds were initially invested in short-term investments and subsequently reinvested into longer term fixed maturity securities resulting in increased net investment income versus real estate income. The increase in market interest rates has also had a positive impact on investment yields.
For the year ended December 31, 2006, FIC had $11,000 net realized losses on fixed maturities and other investments, compared to net realized losses of $631,000 in 2005 and net realized gains of $1.1 million in 2004. In the third quarter of 2005, a bond was classified as temporarily impaired, resulting in a writedown of $1 million. This bond was called in the fourth quarter of 2005. Various other bonds were called or sold by the Company throughout 2005 for net gains that largely offset the previously described write-down.
Other revenues totaled $4.9 million, $2.7 million and $2.2 million for the years ended December 31, 2006, 2005 and 2004, respectively. The significant increase in other revenues in 2006 is primarily related to fees earned related to the Company’s separate accounts. As previously described, effective June 1, 2006, Investors Life recaptured the previously reinsured investment annuity business with Symetra Life resulting in the retention of 100% of this business. The recapture of this previously reinsured separate accounts business increased other revenues in 2006 by approximately $1.3 million as compared with 2005. Additionally, other revenues in 2006 included approximately $0.6 million in interest income received from the IRS on tax refunds related to prior years’ amended returns.
Operating expenses for 2006 were $20.6 million, as compared to $21.8 million in 2005 and $26.1 million in 2004. The Company implemented cost reduction measures in and 2005, as well as in 2006, and this continues to be a critical focus for the Company. However, audit, actuarial, accounting and other consulting, and legal fees continue to represent a significant component of operating expenses, as the Company completes its delinquent SEC filings with a target of becoming current on all filings at the end of the second quarter of 2007. During 2006, the expenditures in these cost components continued to significantly offset overall reductions in the Company’s overhead cost structure. As indicated in the table below, these fees totaled approximately $6.6 million, $5.6 million, and $6.9 million for 2006, 2005, and 2004, respectively.
During 2004, the Company took significant steps to reduce the level of general operating expenses. Subsequent to the changes in the Board and management in late 2003 and early 2004 as previously described, a comprehensive review of the Company’s staffing and operational structure was performed. This review identified numerous opportunities in these areas for reductions in the Company’s cost structure, given the levels of sales and business in force. Accordingly, significant reductions in staffing levels have been achieved since 2003. The Company also closed its Seattle branch office and records storage facility, upgraded various operating and accounting systems, and restructured employee benefit programs.
The provision for federal income taxes on income (loss) from continuing operations, before cumulative effect of change in accounting principle, reflects tax expense (benefit) totaling $2.9 million, $0.6 million and $(0.9) million for the years 2006, 2005 and 2004, respectively. These tax amounts equate to effective tax expense (benefit) rates of 80.3%, 39.7%, and (7.0%) for the years ended December 31, 2006, 2005, and 2004, respectively. The primary reason for the significant deviation from the expected statutory tax rate of 34% for the Company for the year 2006 is due to an increase in the Company’s valuation allowance for deferred taxes resulting from the sale of Family Life. The sale of Family Life removed the source of income supporting certain deferred tax assets at the FIC consolidated level. The primary reason for the significant deviation from the expected statutory tax rate of 34% for the Company for the year 2005 is due to increases to the valuation allowance for deferred tax assets and the tax benefit for dividends received deduction. The primary reason for the significant deviation from the expected statutory tax rate of 34% for the Company for the year 2004 is due to increases to the valuation allowance for deferred tax assets. Under SFAS No. 109, the Company has established a valuation allowance when, based on the weight of the available evidence, it is more likely than not that some portion of its deferred tax assets will not be realized. Realization of deferred tax assets is dependent upon the Company’s generation of sufficient taxable income in the future to recover tax benefits that cannot be recovered from taxes paid in prior periods. The Company’s deferred tax assets are primarily comprised of net operating losses of FIC and its non-life insurance wholly owned subsidiaries and unrealized losses and policy reserves of its life insurance subsidiary. These non-life net operating loss carry forwards totaled approximately $33.0 million at year-end 2006 and begin to expire in 2008 through 2025. The valuation allowance totaled $12.3 million at December 31, 2006. Additions to the allowance totaled $2.1 million, $0.4 million and $3.0 million in 2006, 2005 and 2004, respectively. The additions in 2006 include $2.0 million related to continuing operations, $0.5 million related to discontinued operations, and $(0.4) million related to other comprehensive income. The additions in 2005 include $0.1 million related to continuing operations and $0.3 million related to other comprehensive income. The additions in 2004 include $3.3 million related to continuing operations and a reduction of $(0.3) million related to other comprehensive income.
Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of its business operations. FIC is an insurance holding company whose principal assets at and for the year ended December 31, 2006, consisted of its ownership interests in its insurance subsidiary, Investors Life. As a holding company, FIC’s ability to pay interest and principal on its debt, pay its expenses and pay dividends on its common stock depend substantially on its receipt of dividends or other cash flow from Investors Life.
At the holding company level, FIC’s principal current ongoing liquidity demands relate to debt service on the $15 million of 2003 Notes that it issued in May 2003. (See “Financial Condition - Liabilities” earlier in this Item 7.) These notes require quarterly interest payments at a variable interest rate of the three-month LIBOR rate plus 4.2% (which yielded an average rate of approximately 9.4% for 2006). The principal amount of the 2003 Notes must be repaid in a single payment in 2033.
Since FIC is not current in its filing of financial information with the SEC, it does not have access to the public capital markets. Although FIC does not believe that it will need additional capital to fund its obligations through 2006, the unavailability of access to the public capital markets may adversely affect our ability to grow our business through acquisitions.
A primary liquidity consideration with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawals. Deposit fund liabilities for universal life and annuity products as of December 31, 2006, were $453.7 million, compared to $483.1 million at December 31, 2005. Individual life insurance policies are less susceptible to withdrawal than are annuity contracts because life insurance policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. At December 31, 2006, the bulk of the liabilities for contractholder deposit funds on FIC’s balance sheet, $340.0 million, represented insurance products, as compared to only $113.7 million of annuity product liabilities.
Since Investors Life holds a large portfolio of highly liquid publicly traded debt securities, raising cash through asset sales is available should other sources of liquidity fail to provide cash as needed. In this regard, however, Investors Life must be concerned about such sales at inopportune times, when adverse movements in interest rates may have depressed the market price of securities so that sales would result in the realization of significant losses. To guard against such an outcome, FIC’s management monitors benefits paid and surrenders of insurance products to provide projections of future cash requirements. Also as part of this monitoring process, FIC performs cash flow testing of assets and liabilities at each year-end to evaluate the match between the planned maturities of the insurance company assets and the likely liquidity needs of Investors Life over time. Such cash-flow testing, prescribed by insurance laws and regulations, models the likely performance of assets and liabilities over time, using a wide variety of future interest rate scenarios.
There can be no assurance that future experience regarding benefits and surrenders will be similar to the historic experience on which such cash-flow testing is based, since withdrawal and surrender levels are influenced by such factors as the interest-rate environment and general economic conditions as well as the claims-paying and financial strength ratings of Investors Life.
The following table summarizes information regarding FIC’s contractual obligations, including principal and interest where applicable, as of December 31, 2006. The amounts in the table are different than those reported in our consolidated balance sheet as of December 31, 2006 due to the consideration of interest on debt obligations. Some of the amounts included in this table are based on management’s estimates and assumptions about these obligations, including those related to duration, future mortality, and persistency. Because these estimates and assumptions are necessarily subjective, the amounts actually paid by the Company in the future may vary significantly due to the uncertainty of the timing of cash flows based on insurable events or policyholder surrenders.
For the year ended December 31, 2006 net cash provided by operating activities was $24.9 million compared to net cash used in operating activities of $3.3 million, and net cash provided by operating activities of $17.1 million for the years ended December 31, 2005, and 2004, respectively. The primary changes noted between 2006 and 2005 were increases in other liabilities and deferred income taxes, and decreases in reinsurance receivables. The increase in other liabilities is the most significant change which is primarily related to amounts due for unsettled transactions for purchased securities of $15.2 million. The decrease in cash from operating activities in 2005 compared to 2004 was primarily the result of increases in agency advances and other receivables and decreases in policy liabilities and accruals and other liabilities.
Net cash provided by investing activities in 2006 and 2005 was $20.2 million and $48.0 million, respectively. Net cash used in investing activities in 2004 was $9.3 million. Net cash provided in 2006 is primarily related to the proceeds received upon the sale of Family Life, which due to the timing of the transaction, had not been reinvested into long-term securities as of December 31, 2006. Proceeds from the sales and maturities of fixed maturities and sales of investment real estate in 2005, combined with proceeds from short-term investments, provided substantially all of the cash from investing activities. As market interest rates began to rise subsequent to 2004, the majority of the proceeds obtained were invested in longer-term fixed maturity securities during 2005 and 2006.
The significant decrease in contractholder fund deposits in 2006, 2005 and 2004 was largely due to the Company’s decision in 2004 to temporarily discontinue the sale of fixed annuity products, as previously described. Certain design features of the Company’s annuity products, coupled with competition in the annuity market and a low interest rate market environment led to this decision. Additionally, most of the Company’s marketing efforts are now focused on the sale of traditional insurance products, such as mortgage protection term and final expense products, as opposed to universal life insurance products. Total contractholder fund deposits, which include UL premiums and annuity deposits, for 2006, 2005, and 2004 were $27.7 million, $29.9 million, and $40.6 million, respectively.
Total contractholder fund withdrawals for 2006, 2005, and 2004, totaled $56.5 million, $62.6 million, and $70.5 million, respectively. Contractholder fund withdrawals are a normal part of the run-off of any company’s existing book of business. The higher withdrawals in 2004 could be impacted by the low market interest rate environment and the Company’s lowering of credited interest rates on certain annuity and universal life insurance products in response to lower investment rates.
Also included in 2006 financing activities is $2.5 million in cash provided from the sale of treasury stock. Immediately prior to the sale of Family Life to Manhattan Life, Family Life owned 324,320 shares of FIC common stock, which were reflected as treasury stock for consolidated financial statement purposes. Upon the sale of Family Life, these shares were recorded as a sale of treasury stock and are now reflected as outstanding FIC common stock shares in the accompanying consolidated financial statements as December 31, 2006. The $2.5 million received for the sale of these shares is an allocated portion of the total $28.0 million purchase price for Family Life.
Deferred Policy Acquisition Costs and Present Value of Future Profits of Acquired Business
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes − an Interpretation of FASB Statement No. 109” ("FIN 48"), which clarifies the accounting for uncertainty in tax positions. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheets; and provides transition and interim period guidance, among other provisions. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. FIN 48 is to be applied prospectively and will be effective for fiscal years beginning after December 15, 2006. The Company will implement FIN 48 in the first quarter of 2007. Based upon the Company’s evaluation work completed to date, the Company expects to recognize a reduction to the January 1, 2007 balance of retained earnings of between $1.0 million and $1.5 million.
In September 2006, the SEC staff issued Staff Accounting Bulletin 108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused and a balance sheet focused assessment. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. SAB 108 did not have a material effect on the Company’s consolidated financial position or results of operations.
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005, and 2004.