Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Torchmark owns and occupies a 300,000 square foot facility in McKinney, Texas. This facility is Torchmark’s corporate headquarters and also houses the operations of a subsidiary, United American, as well as many operations of other subsidiaries. In addition, United American leases 5,000 square feet of space in Omaha, Nebraska and, through a subsidiary, leases 3,230 square feet of office space in Syracuse, New York.
American Income owns and occupies two buildings located in Waco, Texas: 70,000 square foot building for corporate operations and a 43,000 square foot printing facility. American Income also leases 10,800 square feet in a building across the street from the main office building. American Income also leases office space throughout the United States to support its marketing operations.
The tables in Note 14-Business Segments in the Notes to the Consolidated Financial Statements reconcile Torchmark’s revenues and expenses by segment to its major income statement line items for each of the years in the three-year period ended December 31, 2017.
Net investment income increased 5% over the prior year. In addition, excess investment income, a measure used by management as explained below, increased by 7% over the prior year.
During 2017, the Company repurchased 4.1 million shares at a total cost of $325 million for an average share price of $78.67.
The following represents net income and net operating income from continuing operations for the 3 years ended December 31, 2017.
Net income as a ROE and net operating income as a ROE, excluding net unrealized gains on the fixed maturity portfolio in 2016 were 12.0% and 14.6%, respectively and 11.9% and 14.5%, respectively in 2015. Net operating income as a ROE, excluding net unrealized gains on the fixed maturity portfolio is considered a non-GAAP measure. Management utilizes this measure to view the business without the effect of the unrealized gains or losses which are primarily attributable to fluctuation in interest rates on the available-for-sale portfolio.
Summary of Operations: Net income was $1.5 billion in 2017, compared with $550 million in 2016. This sharp increase was due to an $874 million increase to net income, primarily relating to a reduction of deferred income tax liabilities resulting from enactment of the Tax Cuts and Jobs Act of 2017 (Tax Legislation). See further discussion below. Net income also increased in 2016 from $527 million in 2015. On a diluted per common share basis, 2017 net income rose
172% to $12.22 after an 8% increase in 2016, again largely related to implementation of the Tax Legislation. Without the impact of the Tax Legislation, net income per diluted common share would have been $4.88. Net income per diluted common share in 2016 rose to $4.49 from $4.16 in 2015. The per share results have exceeded the growth in dollar amounts due to our share repurchase program. Each year’s per share net income was affected by realized investment gains (losses), which were $0.15, $(0.06), and $(0.05), in 2017, 2016 and 2015, respectively. More information concerning realized investment gains and losses can be found under the caption Realized Gains and Losses in this report.
There will be substantial long-term benefits from the Tax Legislation due to the taxation of future profits at the new 21% tax rate. Looking forward, we are anticipating the effective tax rate on our net operating income before stock compensation expense to decrease and be in the range of 19% to 20%. Despite the lower expected tax rate for financial reporting purposes, in the short and intermediate term, we do not anticipate a significant reduction in our current tax expense, as benefits of the lower tax rate will be virtually offset by several provisions included in the Tax Legislation that increase the Company's current taxable income.
The below table illustrates the impact of the tax reform adjustment on certain balances.
Excess investment income, the measure of profitability of our investment segment, increased 7% to $239 million from the prior year amount of $224 million. In 2016, excess investment income increased 2%. Investment yields continue to be pressured by investing at yields lower than the yield on dispositions and the average yield on the portfolio.
Health insurance premium income increased 3% to $976 million in 2017. Health net sales rose 9% to $158 million during 2017 due to both individual and group sales. Group sales vary significantly from period to period due to the
impact of large groups that are sold from time-to-time. First-year collected health premium fell 3% to $136 million from the prior year total of $140 million as a result of higher net sales in Medicare Supplement in the fourth quarter of 2015 that positively affected the 2016 first-year collected premium. Health margins as a percentage of premium were flat at 22%, with underwriting income increasing to $220 million for 2017 due to the growth in premium income. Underwriting income was $210 million in 2016 compared with $204 million in 2015. The health insurance segment is discussed further in this report under the caption Health Insurance.
Net sales is annualized premium issued (Gross premium that would be received during the policies' first year in force and assuming that none of the policies lapsed or terminated.), net of cancellations in the first thirty days after issue, except in the case of Globe Life Direct Response where net sales is annualized premium issued at the time the first full premium is paid after any introductory offer period has expired. We believe that net sales is a better indicator of the rate of premium growth as compared to annualized premium issued.
Annualized life premium in force was $2.37 billion at December 31, 2017, an increase of 4.9% over $2.26 billion a year earlier. Annualized life premium in force was $2.15 billion at December 31, 2015.
The following table shows net sales information for each of the last three years by distribution channel.
The American Income Exclusive Agency continues to focus on growing and strengthening middle management to support sustainable growth of the agency force. To accomplish this, the agency places an emphasis on agent training programs and financial incentives that appropriately reward agents at all levels for helping develop and train its agents, including more home-office and webinar training programs. These programs are designed to provide each agent, from new recruits to top level managers, coaching and instruction specifically designed for their level of experience and responsibility. We have made considerable investments in information technology in support of the agency, including the launching of a lead mapping and management tool to the agency force. We anticipate this tool will help the Agency enhance agent productivity and agent retention.
channel’s growth has been fueled by constant innovation. In recent years, electronic media production has grown rapidly as management has aggressively increased marketing activities related to internet and mobile technology, and has focused on driving traffic to the inbound call center. We continually introduce new initiatives in this unit in an attempt to increase response rates.
Globe Life Direct Response’s life premium income rose 4% to $813 million, representing 35% of Torchmark’s total life premium during 2017. Life premium in this channel increased 5% in 2016 to $783 million over the 2015 total of $747 million. Net sales of $136 million for this group decreased 10% from $150 million in 2016, after a 9% decrease in 2016 due to operational changes designed to maximize underwriting margin dollars. We expect sales to decline, consistent with this recent trend, through 2018. First-year collected premium decreased 7% to $92 million in 2017 after having decreased 7% in 2016.
The Liberty average producing agent count increased from 1,715 in 2016 to 2,017 in 2017. We continue to execute our long term plan to grow this agency through expansion from small-town markets in the southeast to more densely populated areas with larger pools of potential agent recruits and customers. Expansion of this agency’s presence into more heavily populated, less-penetrated areas will help create long term agency growth. Additionally, the agency's prospecting training program has helped to improve the ability of agents to develop new work site marketing business.
Health premium increased 3% from $948 million in 2016 to $976 million in 2017. Health underwriting margin increased 4% from $210 million in 2016 to $220 million in 2017. Further discussion is included below by distribution channels.
Premium income by distribution channel for each of the last three years is as follows:
The Family Heritage Exclusive Agency primarily markets limited-benefit supplemental health insurance in non-urban areas. Most of their policies include a cash-back feature, such as a return of premium whereby any excess of premiums over claims paid is returned to the policyholder at the end of a specified period stated within the insurance policy. Management expects to grow this agency through geographic expansion and continuing incorporation of Torchmark’s recruiting systems. The Family Heritage Agency contributed $57 million in net sales in 2017, compared with $51 million in 2016 and $50 million in 2015. Health premium income was $254 million in 2017, representing 26% of Torchmark’s
health premium. This compared with $236 million or 25% of health premium in 2016 and $221 million or 24% in 2015. The average producing agent count was 995 for the year ended December 31, 2017, compared with 923 for the same period in 2016, an increase of 8%.
The Liberty National Exclusive Agency represented 20% of all Torchmark health premium income at $196 million in 2017. The Liberty Agency markets limited-benefit supplemental health products consisting primarily of critical illness insurance. Much of Liberty’s health business is now generated through work site marketing targeting small businesses of 10 to 25 employees. In 2017, health premium income declined 3% after declining 4% during 2016. Liberty’s health premium decline has been due primarily to its declining Medicare Supplement block. Liberty's first-year collected premium increased 2% to $16 million in 2017 compared with an increase of 8% in 2016, reflecting the steady increase in net sales of limited-benefit plans in the agency.
Investments. We manage our capital resources including investments, debt, and cash flow through the investment segment. Excess investment income represents the profit margin attributable to investment operations. It is the measure that we use to evaluate the performance of the investment segment as described in Note 14-Business Segments. It is defined as net investment income less both the required interest attributable to net policy liabilities and the interest cost associated with capital funding or “financing costs.”
The largest component of excess investment income is net investment income, which increased at a compound annual growth rate of 4% during the last three years. Growth in net investment income has been negatively impacted in recent years by the declining interest rate environment during which time we have invested new money and reinvested the
proceeds from bonds that matured or were called or otherwise disposed of at yield rates less than what we earned on these bonds before their maturity or disposition. We currently expect that the average annual turnover rate of fixed maturity assets during the next five years will not exceed 1% to 3% of the portfolio, and will not have a significant negative impact on the growth of net investment income. Presented in the following chart is the growth in net investment income and the growth in mean invested assets.
Should interest rates rise, especially long-term rates, Torchmark's net investment income would benefit due to higher interest rates on new purchases. While such a rise in interest rates could adversely affect the fair value of the fixed maturities portfolio, we could withstand an increase in interest rates of approximately 100 to 105 basis points before the net unrealized gains on our fixed maturity portfolio as of December 31, 2017 would be eliminated. Should interest rates increase further than that, we would not be concerned with potential interest rate driven unrealized losses in our fixed maturity portfolio because we have the intent and, more importantly, the ability, to hold our fixed maturities to maturity.
Required interest on net insurance policy liabilities reduces net investment income as it is the amount of net investment income considered by management necessary to “fund” the required interest included in the insurance segments. As such, it is removed from the investment segment and applied to the insurance segments to offset the effect of the required interest from the insurance segments. As discussed in Note 14-Business Segments, management believes this provides a more meaningful analysis of the investment and insurance segments. Required interest is based on the actuarial interest assumptions used in discounting the benefit reserve liability and the amortization of deferred acquisition costs for our insurance policies in force. The great majority of our life and health insurance policies are fixed interest-rate protection policies, not investment products, and are accounted for under current accounting guidance for long-duration insurance products which mandates that interest rate assumptions for a particular block of business be “locked in” for the life of that block of business. Each calendar year, we set the discount rate to be used to calculate the benefit reserve liability and the amortization of the deferred acquisition cost asset for all insurance policies issued that year. That rate is based on the new money yields that we expect to earn on cash flow received in the future from policies of that issue year, and cannot be changed. The discount rate used for policies issued in the current year has no impact on the in force policies issued in prior years as the rates of all prior issue years are also locked in. As such, the overall discount rate for the entire in force block is a weighted average of the discount rates being used from all issue years. Changes in the overall weighted-average discount rate over time are caused by changes in the mix of the reserves and the deferred acquisition cost asset by issue year on the entire block of in force business. Business issued in the current year has very little impact on the overall weighted-average discount rate due to the size of our in force business.
Since actuarial discount rates are locked in for life on essentially all of our business, benefit reserves and deferred acquisition costs are not affected by interest rate fluctuations unless a loss recognition event occurs. Due to the strength of our underwriting margins and the current positive spread between the yield on our investment portfolio and the weighted-average discount rate of our in force block, we do not expect an extended low-interest-rate environment to cause a loss recognition event.
long periods to support the liabilities. Expected yields on these investments are taken into account when setting insurance premium rates and product profitability expectations.
The following table summarizes our tax-effected realized gains (losses) by component for each of the years in the three-year period ended December 31, 2017.
Investment Acquisitions. Torchmark’s investment policy calls for investing in fixed maturities that are investment grade and meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. We believe this strategy is appropriate because our cash flows are generally stable and predictable. If longer-term securities that meet our quality and yield objectives are not available, we do not relax our quality objectives, but instead, consider investing in shorter term or lower yielding securities, taking into consideration the slope of the yield curve and other factors.
From 2015 through 2017, acquisitions consisted of securities spanning a diversified range of issuers, industry sectors, and geographical regions. All of the acquired securities were investment grade. In addition to the fixed maturity acquisitions, Torchmark invested $55 million in other long-term investments in 2017 compared with $20 million in 2016 and $32 million in 2015.
New cash flow available for investment has been primarily provided through our insurance operations and interest received on existing investments. The amount of cash available for investment in 2016 was greater than 2015 due in part to the collection of various receivables from our Medicare Part D business. In some years, a significant amount of new investments can be derived from proceeds from dispositions including issuer calls. While calls increase funds available for investment, as noted earlier in this discussion, they can also have a negative impact on investment income if the proceeds from the calls are reinvested in bonds that have lower yields than those of the bonds that were called. Issuer calls were $371 million in 2017, $182 million in 2016, and $178 million in 2015.
Portfolio Composition. The composition of the investment portfolio at book value on December 31, 2017 and 2016 was as follows:
Approximately 95% of our investments at book value are in a diversified fixed maturity portfolio. Policy loans, which are secured by policy cash values, make up 3% of our investments. We also have insignificant investments in equity securities and other long-term investments. Because fixed maturities represent such a significant portion of our investment portfolio, the remainder of the discussion of portfolio composition will focus on fixed maturities.
Corporate securities, which consist of bonds and redeemable preferred stocks, were the largest component of the fixed maturity portfolio, representing 89% of amortized cost and 90% of fair value. The remainder of the portfolio is
An analysis of the fixed maturity portfolio by a composite rating at December 31, 2017 is shown in the following table. The composite rating for each security, other than private-placement securities managed by third parties, is the average of the security’s ratings as assigned by Moody’s Investor Service, Standard & Poor’s, Fitch Ratings, and Dominion Bond Rating Service, LTD. The ratings assigned by these four nationally recognized statistical rating organizations are evenly weighted when calculating the average. The composite quality rating is created using a methodology developed by Torchmark Corporation using ratings from the various rating agencies noted above. The composite quality rating is not a Standard & Poor's credit rating. Standard & Poor's does not sponsor, endorse or promote the composite quality rating and shall not be liable for any use of the composite quality rating. Included in the chart below are private placement fixed maturity holdings of $591 million at amortized cost ($613 million at fair value) for which the ratings were assigned by the third party managers.
Of the $15.0 billion of fixed maturities at amortized cost as of December 31, 2017, $14.3 billion or 95% were investment grade with an average rating of A-. Below-investment-grade bonds were $702 million with an average rating of B+. Below-investment-grade bonds at amortized cost were 15% of our shareholders’ equity, excluding the effect of unrealized gains and losses on fixed maturities as of December 31, 2017. Overall, the total portfolio had a weighted average quality rating of BBB+ based on amortized cost, the same as at the end of 2016.
The following table illustrates the market risk sensitivity of our interest-rate sensitive fixed maturity portfolio at December 31, 2017 and 2016. This table measures the effect of a parallel shift in interest rates (as represented by the U.S. Treasury curve) on the fair value of the fixed maturity portfolio. The data measures the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
Liquidity. Liquidity provides Torchmark with the ability to meet on demand the cash commitments required by its business operations and financial obligations. Our liquidity is primarily derived from three sources: positive cash flow from operations, a portfolio of marketable securities, and a line of credit facility.
Parent Company Liquidity. Cash flows from the insurance subsidiaries are used to pay interest and principal repayments on Parent Company debt, operating expenses of the Parent, and Parent Company dividends to Torchmark shareholders. In 2017, the Parent received $454 million of cash dividends from its subsidiaries, compared with $438 million in 2016 and $466 million in 2015. Including transfers from other subsidiaries and after paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), the Parent Company had excess cash flow in 2017 of approximately $330 million, compared with $311 million in 2016 and $358 million in 2015.
Short-Term Borrowings. An additional source of parent company liquidity is a line of credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $750 million, which could be extended up to $1 billion. While Torchmark can request the extension, it is not guaranteed. In May 2016, Torchmark amended the facility to extend the maturity date to May 2021. The amendment also allowed for an additional $100 million term loan as discussed under the caption Credit Facility in Note 11-Debt. The facility is further designated as a back-up line of credit for a commercial paper program as well as the stand-by letters of credit as discussed below. As of December 31, 2017, we had available $249 million of additional borrowing capacity under this facility, compared with $310 million a year earlier. There have been no difficulties in accessing the commercial paper market during the three years ended December 31, 2017.
In summary, Torchmark expects to have readily available funds for 2018 and the foreseeable future to conduct its operations and to maintain target capital ratios in the insurance subsidiaries through internally generated cash flow and the credit facility. In the unlikely event that more liquidity is needed, the Company could generate additional funds through multiple sources including, but not limited to, the issuance of additional debt, additional borrowings on our short-term credit facility, and intercompany borrowing.
Our cash and short-term investments were $246 million at year-end 2017 and $148 million at year-end 2016. Additionally, we have a portfolio of marketable fixed securities that are available for sale in the event of an unexpected need. These
Off-Balance Sheet Arrangements. As a part of its aforementioned credit facility, Torchmark had outstanding $177 million in stand-by letters of credit at December 31, 2017 and 2016. These letters are issued among our subsidiaries, one of which is an offshore captive reinsurer, and have no impact on company obligations as a whole. Any future regulatory changes that restrict the use of off-shore captive reinsurers might require Torchmark to obtain third-party financing, which could cause an insignificant increase in financing costs.
Pension obligations are primarily liabilities in trust funds that are calculated in accordance with the terms of the pension plans. They are offset by invested assets in the trusts, which are funded through periodic contributions by Torchmark in a manner which will provide for the settlement of the obligations as they become due. Therefore, our obligations are offset by those assets when reported on Torchmark’s Consolidated Balance Sheets. At December 31, 2017, these pension obligations were $603 million, but there were also assets of $378 million in the pension entities. The schedule of pension benefit payments covers ten years and is based on the same assumptions used to measure the pension obligations, except there is no interest assumption because the payments are undiscounted. There are also obligations for benefits other than pensions with a liability of $26 million. Please refer to Note 9-Postretirement Benefits for more information on pension obligations.
On November 17, 2017, Torchmark completed the issuance and sale of $125 million in aggregate principal of Torchmark’s 5.275% Junior Subordinated Debentures due 2057. The debentures were sold in a private placement pursuant to exemptions from the registration requirements of the Securities Act of 1933. The initial purchaser of the
Shareholder's Equity: As noted under the caption Analysis of Share Repurchases in this report, we have an ongoing share repurchase program. Under this program, we acquired 4 million shares at a cost of $325 million in 2017, 5 million shares at a cost of $311 million in 2016, and 6 million shares for $359 million in 2015. The majority of purchased shares are retired each year. Please refer to the description of our share repurchase program under the caption Summary of Operations in this report.
We maintain a significant available-for-sale fixed maturity portfolio to support our insurance policyholders’ liabilities. Current accounting guidance requires that we revalue our portfolio to fair market value at the end of each accounting period. The period-to-period changes in fair value, net of their associated impact on deferred acquisition costs and income tax, are reflected directly in shareholders’ equity. Changes in the fair value of the portfolio can result from changes in interest rates and liquidity in financial markets. While invested assets are revalued, accounting rules do not permit interest-bearing insurance policy liabilities to be valued at fair value in a consistent manner as that of assets, with changes in value applied directly to shareholders’ equity.
The following table presents selected data related to our capital resources. Additionally, the table presents the effect of this accounting guidance on relevant line items, so that investors and other financial statement users may determine its impact on Torchmark’s capital structure. Excluding the effect of unrealized gains and losses on the fixed maturity portfolio from shareholders' equity is considered non-GAAP. Below we include the reconciliation to GAAP.
Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 10.8 times in 2017, compared with 10.3 times in 2016 and 11.0 times in 2015 based on continuing operations. This times-interest-earned ratio is computed by dividing interest expense into the sum of pre-tax income from continuing operations and interest expense. A discussion of our interest expense is included in the discussion of financing costs under the caption Investments in this report.
Future Policy Benefits: Due to the long-term nature of insurance contracts, our insurance companies are liable for policy benefit payments that will be made in the future. The liability for future policy benefits is determined by standard actuarial procedures common to the life insurance industry. The accounting policies for determining this liability are disclosed in Note 1-Significant Accounting Policies.
Over 99% of our recorded amounts for deferred acquisition costs at December 31, 2017 were related to traditional products and are being amortized over the premium-paying period in proportion to the present value of actual historic and estimated future gross premiums. The projection assumptions for this business are set at the time of contract issue. These assumptions are “locked-in” at that time and, except where there is a loss recognition issue, are not revised for the lifetime of the contracts. Absent a premium deficiency, variability in amortization after policy issuance is caused only by variability in premium volume. We have not recorded a deferred acquisition cost loss recognition event for assets related to this business for any period in the three years ended December 31, 2017.
Impairment of Investments: We continually monitor our investment portfolio for investments where fair value has declined below carrying value and that have become impaired in value. While the values of the investments in our portfolio constantly fluctuate due to market conditions, an other-than-temporary impairment charge is recorded only when a security has experienced a decline in fair market value which is deemed to be other than temporary. The policies and procedures that we use to evaluate and account for impairments of investments are disclosed in Note 1-Significant Accounting Policies and the discussions under the captions Investments and Realized Gains and Losses in this report. While every effort is made to make the best estimate of status and value with the information available regarding an other-than-temporary impairment, it is difficult to predict the future prospects of a distressed or impaired security.
Defined benefit pension plans: We maintain funded defined benefit plans covering most full-time employees. We also have unfunded nonqualified defined benefit plans covering certain key and other employees. Our obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are offset, at least in part, by the growth in value of the assets in the funded plans. At December 31, 2017, our gross liability under these plans was $603 million, but was offset by assets of $378 million.
The actuarial assumptions used in determining our obligations for pensions include employee mortality and turnover, retirement age, the expected return on plan assets, projected salary increases, and the discount rate at which future obligations could be settled. These assumptions have an important effect on the pension obligation. A decrease in the discount rate or rate of return on plan assets will cause an increase in the pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. Small changes in assumptions may cause significant differences in reported results for these plans. For example, a sensitivity analysis is presented below for the impact of change in the discount rate and the long-term rate of return on assets assumed on our defined benefit pension plans expense for the year 2017 and projected benefit obligation as of December 31, 2017.
The discount rate was 4.27% for 2017 expense and 3.75% for the projected benefit obligation at December 31, 2017.
The Company determines mortality assumptions through the use of published mortality tables that reflect broad-based studies of mortality and published longevity improvement scales.
Changes in lapse rates and/or sales of our insurance policies as well as levels of mortality, morbidity, and utilization of healthcare services that differ from our assumptions;
Federal and state legislative and regulatory developments, particularly those impacting taxes and changes to the federal Medicare program that would affect Medicare Supplement;
Reported amounts in the financial statements which are based on our estimates and judgments which may differ from the actual amounts ultimately realized.
Income tax effects of certain items were reclassified from accumulated other comprehensive income to retained earnings to remove stranded tax effects as a result of early adoption of ASU 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. See further discussion in Note 1-Significant Accounting Policies.
Business: Torchmark Corporation (Torchmark or alternatively, the Company) through its wholly-owned subsidiaries provides a variety of life and supplemental health insurance products and annuities to a broad base of customers. Torchmark is organized into four reportable segments: life insurance, health insurance, annuity, and investment.
The great majority of Torchmark's fixed maturities are not actively traded and direct quotes are not generally available. Management therefore determines the fair values of these securities after consideration of data provided by third-party pricing services, independent broker/dealers, and other resources. At December 31, 2017, Torchmark's investments in fixed maturities were primarily composed of the following significant security types: Corporate securities, state and municipal securities, redeemable preferred stocks, and U.S. government securities. The remaining security types represented less than 1% of the total in the aggregate.
Over 95% of the fair value reported at December 31, 2017 was determined using data provided by third-party pricing services. Prices provided by these services are not binding offers, but are estimated exit values. Third-party pricing services use proprietary pricing models to determine security values by discounting cash flows using a market-adjusted spread to a benchmark yield.
Torchmark invests in a portfolio of private placement bonds which are not actively traded. This portfolio is managed by third parties. The portfolio managers provide valuations for the bonds based on a pricing matrix utilizing observable inputs, such as the benchmark treasury rate and published sector indices, and unobservable inputs such as an internally-developed credit rating. If they cannot be corroborated, the fair values are classified as Level 3.
Impairment of Investments: Torchmark’s portfolio of fixed maturities fluctuates in value due to changes in interest rates in the financial markets as well as other factors. Fluctuations caused by market interest rate changes have little bearing on whether or not the investment will be ultimately recoverable. Therefore, Torchmark considers these declines in value resulting from changes in market interest rates to be temporary. In certain circumstances, however, Torchmark determines that the decline in the value of a security is other-than-temporary and writes the book value of the security down to its fair value, realizing an investment loss. The evaluation of Torchmark’s securities for other-than-temporary impairments is a process that is undertaken at least quarterly and is overseen by a team of investment and accounting professionals. Each security, which is impaired because the fair value is less than the cost or amortized cost, is identified
The financial condition of the issuer and the prospects for recovery in fair value of the security
Cash: Cash consists of balances on hand and on deposit in banks and financial institutions.
Other Receivables: Other receivables consist mostly of agent debit balances, which primarily represent commissions advanced to insurance agents. These balances are repaid to the Company over time as the premiums associated with the advanced commissions are collected by the Company and the agents' commissions on such premiums are retained. The balances were $378 million and $353 million at December 31, 2017 and 2016, respectively. Management believes these balances are recoverable as they are less than the estimated present value of future commissions.
Goodwill: The excess cost of a business acquired over the fair value of net assets acquired is reported as goodwill. Goodwill is subject to impairment testing in accordance with GAAP on an annual basis, or whenever potential impairment triggers occur. The Company may perform a qualitative analysis under certain circumstances, or perform a two-step quantitative analysis. In the qualitative analysis, the Company determines if it is more likely than not that the fair value of a reporting unit is less than its carrying amount by assessing current events and circumstances. If there are factors present indicating potential impairment, the Company would proceed to the two-step quantitative analysis.
on businesses with similar assets to determine a fair value. In both cases, the fair value of each reporting unit is then measured against that reporting unit’s corresponding carrying value. In the event the fair value is less than the carrying value, further testing is required under the accounting guidance to determine the amount of impairment, if any. If there is an impairment in the goodwill of any reporting unit, it is written down and charged to earnings in the period of the test.
Future Policy Benefits: The liability for future policy benefits for annuity and universal life-type products is represented by policy account value. The liability for future policy benefits for all other life and health products, approximately 87% of total future policy benefits, is determined on the net level premium method. This method provides for the present value of expected future benefit payments less the present value of expected future net premiums, based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were considered appropriate at the time the policies were issued. For limited-payment contracts, a deferred profit liability is also recorded which causes profits to emerge over the life of the contract in proportion to policies in force.
On December 22, 2017, the Tax Cuts and Jobs Act (Tax Legislation) was enacted into law which changed existing tax law, including a reduction of the corporate income tax rate from 35% to 21% effective January 1, 2018. The Company recorded $877 million of tax benefits in net income in 2017 as a result of re-measuring its deferred assets and liabilities using the lower corporate tax rate as of the date of enactment. Based on the analysis of the Tax Legislation, the Company was able to determine that this amount is a reasonable estimate of the impact of the Tax Legislation in accordance with SEC Staff Accounting Bulletin (SAB) No. 118. However, the Company will continue to analyze relevant information to complete the accounting for income taxes which may result in an adjustment to tax expense in 2018. The accounting is expected to be complete when the 2017 U.S. corporate income tax returns are filed later in 2018. More information concerning income taxes is provided in Note 8-Income Taxes.
Recognition of Premium Revenue and Related Expenses: Premium income for traditional long-duration life and health insurance products is recognized evenly over the contract period and when due from the policyholder. Premiums for short-duration health contracts are recognized as revenue over the contract period in proportion to the insurance protection provided. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Life premium includes policy charges of $17 million, $18 million, and $19 million for the years ended December 31, 2017, 2016, and 2015, respectively. Other premium consists of annuity policy charges in each year. For most insurance products, the related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of DAC in a manner which recognizes profits as they are earned over the revenue recognition period. For limited-payment life insurance products, the profits are recognized over the contract period.
The fair value method requires the use of an option valuation model to value employee stock options. Torchmark has elected to use the Black-Scholes valuation model for option expensing. A summary of assumptions for options granted in each of the three years 2015 through 2017 is as follows:
The expected term is generally derived from Company experience. However, expected terms are determined based on the simplified method as permitted under the ASC 718 Stock Compensation topic when Company experience is insufficient. The Torchmark Corporation 2011 Incentive Plan replaced all previous plans and allows for option grants for employees with a ten-year contractual term which vest over five years in addition to seven-year grants which vest over three years as permitted by the previous plans. Director grants vest over six months. The Company has sufficient experience with seven-year grants that vest in three years, but insufficient historical experience with five-year vesting. Therefore, Torchmark has used the simplified method to determine the expected term for the ten-year grants with five-year vesting and will do so until adequate experience is developed. Volatility and risk-free interest rates are assumed over a period of time consistent with the expected term of the option. Volatility is measured on a historical basis. Monthly data points are utilized to derive volatility for periods greater than three years. Expected dividend yield is based on current dividend yield held constant over the expected term. Once the fair value of an option has been determined, it is amortized on a straight-line basis over the employee’s service period for that grant (from the grant date to the date the grant is fully vested). Expenses for restricted stock and restricted stock units are based on the grant date fair value allocated on a straight-line basis over the service period. Performance share expense is recognized based on management’s estimate of the probability of meeting the metrics identified in the performance share award agreement, assigned to each service period as these estimates develop.
Earnings Per Share: Torchmark presents basic and diluted earnings per common share (EPS) on the face of the Consolidated Statements of Operations for income from continuing operations and income from discontinued operations. Basic EPS is computed by dividing income available to common shareholders by the weighted average common shares outstanding for the period. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts, such as stock options, which could be exercised or converted into common shares. For more information on earnings per share, see Note 12-Shareholders’ Equity.
ASU 2016-01: In January 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, which primarily revises the classification and measurement of certain equity investments such that they will be measured at fair value through net income. Additionally, it eliminates the cost method for partnerships and joint ventures and requires these types of investments to be accounted for under the fair value through net income method or equity method. Lastly, the guidance will require certain disclosures associated with fair value of financial instruments. This standard became effective for the Company on January 1, 2018. The adoption will result in a $6 million positive adjustment to the opening balance of retained earnings as we have minimal ownership interests in equity investments and partnerships.
ASU 2016-16: In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other Than Inventory. This guidance was issued to improve the accounting for income tax consequences of intra-entity transfers of assets other than inventory by allowing the immediate recognition of the current and deferred income tax effects. Current guidance prohibits the recognition of current and deferred income taxes for an intra-entity transfer until the asset has been sold to an outside party. This new guidance should be applied on a modified retrospective approach and became effective on January 1, 2018. This adoption will not have a significant impact on the financial statements.
ASU 2017-04: In January 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. This guidance was issued to simplify the subsequent measurement of goodwill through the elimination of Step 2 from the goodwill impairment test which required a hypothetical purchase price allocation. It will become effective on January 1, 2020 and should be applied on a prospective basis. This adoption will not have an impact to the financial statements.
ASU 2017-07: In March 2017, the FASB issued ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. This guidance was issued to simplify the reporting of pension costs by disaggregating the service-cost component from the other components of net benefit costs and reporting it separately on the income statement. The service-cost component is the only component of net benefit cost that will be eligible for capitalization. The guidance became effective on January 1, 2018 with a retrospective transition method for separation of net benefit costs and a prospective transition method for the capitalization of service costs. The Company expects the adoption to add an additional $3 to $5 million in expense to the 2018 Consolidated Statements of Operations due to the elimination of the ability to capitalize a portion of the benefit costs.
ASU 2017-09: In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting. This guidance was issued to provide clarity and guidance regarding changes to the terms or conditions of a share-based payment award that requires an entity to apply modification accounting. It became effective on January 1, 2018 with early adoption permitted, including adoption in any interim periods. The adoption will have a minimal impact on the financial statements as modifications to stock compensation are infrequent.
Income tax effects of certain items were reclassified from accumulated other comprehensive income to retained earnings to remove stranded tax effects as a result of early adoption of ASU No. 2018-02, Income Statement-Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. See further discussion in Note 1-Significant Accounting Policies.
Reclassification adjustments out of Accumulated Other Comprehensive Income are presented below for each of the years 2015 through 2017.
Includes unsettled sales of $17.9 million at December 31, 2016. There were no unsettled sales in 2017 or 2015.
Fair value measurements: The following tables represent the fair value of fixed maturities measured on a recurring basis at December 31, 2017 and 2016:
The private placement fixed maturities and asset-backed securities reported as Level 3 are managed by third party investment managers. These securities are valued based on the contractual cash flows discounted by a yield determined as a treasury benchmark adjusted for a credit spread. The credit spread is developed from observable indices for similar public fixed maturities and unobservable indices for private fixed maturities for corresponding credit ratings. However, the credit ratings for the securities are considered unobservable inputs, as they are assigned by the third party investment manager based on a quantitative and qualitative assessment of the credit underwritten. A higher (lower) credit rating would result in a higher (lower) valuation.
The following table presents transfers in and out of each of the valuation levels of fair values.
Other-than-temporary impairments (OTTI): Based on the Company's evaluation of its fixed maturities available for sale in an unrealized loss position in accordance with the OTTI policy as described in Note 1-Significant Accounting Policies, the Company concluded that there was an other-than-temporary impairment of $245 thousand ($159 thousand, net of tax) during the year ended December 31, 2017. For the two years ended December 31, 2016, there were no other-than-temporary impairments.
At December 31, 2015, Torchmark met the criteria to account for its Medicare Part D Prescription Drug Plan business as a discontinued operation. Historically, the business was a reportable segment. Effective July 1, 2016, Torchmark sold its Medicare Part D Prescription Drug Plan business to an unaffiliated third party.
The net assets related to discontinued operations at December 31, 2017 and 2016 were as follows:
At December 31, 2017, the balance included $37.3 million due to CMS. At December 31, 2016, the balance includes $3.6 million contingent sale price reserve.
Income from discontinued operations for the three years ended December 31, 2017 is as follows:
Although Torchmark primarily sells long-duration contracts for both life and health, the Company also has a limited amount of group health products that qualify as short-duration contracts in accordance with the applicable guidance.
The incurred claims and cumulative number of reported claims for all years prior to 2017 are unaudited.
Valuations: Torchmark has net operating loss carryforwards of approximately $22.7 million at December 31, 2017 which will begin to expire in 2033 if not otherwise used to offset future taxable income. A valuation allowance is to be provided when it is more likely than not that deferred tax assets will not be realized by the Company. No valuation allowance has been recorded relating to Torchmark’s deferred tax assets as management believes Torchmark will more likely than not have sufficient taxable income in future periods to fully realize its existing deferred tax assets.
Tax penalties: Torchmark’s continuing practice is to recognize interest and penalties related to income tax matters in income tax expense. The Company recognized interest income of $5 thousand, $9 thousand, and $11 thousand, net of federal income tax expense, in its Consolidated Statements of Operations for 2017, 2016, and 2015, respectively. The Company had no accrued interest or penalties at December 31, 2017 or 2016.
Plan assets in the funded plans consist primarily of investments in marketable fixed maturities and equity securities and are valued at fair value. Torchmark measures the fair value of its financial assets, including the assets in its benefit plans, in accordance with accounting guidance which establishes a hierarchy for asset values and provides a methodology for the measurement of value. Please refer to Note 1-Significant Accounting Policies under the caption Fair Value Measurements, Investments in Securities for a complete discussion of valuation procedures. The following table presents the assets of Torchmark’s defined benefit pension plans for the years ended December 31, 2017 and 2016.
Allowed investments are limited to equities, fixed maturities, and short-term investments (invested cash). The assets are to be invested in a mix of equity and fixed income investments that best serve the objectives of the pension plan. Factors to be considered in determining the asset mix include funded status, annual pension expense, annual pension contributions, and balance sheet liability. Equities can include common and preferred stocks, securities convertible into equities, mutual funds and exchange traded funds that invest in equities, equity interests in limited partnerships, and other equity-related investments. Primarily, equities are listed on major exchanges and adequate market liquidity is required. Fixed maturities primarily consist of marketable debt securities rated investment grade at purchase by a major rating agency. Short-term investments include fixed maturities with maturities less than one year and invested cash. Short-term investments in commercial paper must be rated at least A-2 by Standard & Poor’s with the issuer rated investment grade. Invested cash is limited to banks rated A or higher. Investments outside of the aforementioned list are not permitted, except by prior approval of the Plan’s Trustees.
The discount rate is determined based on the expected duration of plan liabilities. A yield is then derived based on the current market yield of a hypothetical portfolio of higher-quality corporate bonds which match the liability duration. The rate of compensation increase is projected based on Company experience, modified as appropriate for future expectations. The expected long-term rate of return on plan assets is management’s best estimate of the average rate of earnings expected to be received on the assets invested in the plan over the benefit period. In determining this assumption, consideration is given to the historical rate of return earned on the assets, the projected returns over future periods, and the discount rate used to compute benefit obligations.
The accumulated benefit obligation (ABO) for Torchmark’s funded defined benefit pension plans was $466 million and $411 million at December 31, 2017 and 2016, respectively. In the nonqualified plans, the ABO was $75 million at December 31, 2017 and $69 million at 2016.
All securities, other than the term loan, commercial paper and Junior Subordinated Debentures have equal priority with one another.
Retirement of Treasury Stock: Torchmark retired 3.0 million shares of treasury stock in 2017, 3.0 million in 2016, and 4.0 million in 2015.
Options: The following table summarizes information about stock options outstanding at December 31, 2017.
stock and restricted stock units are generally granted on the first work day of the year. Performance shares are granted to a limited number of senior executives. Performance shares have a three year contract life and are not settled in shares until the termination of the three-year contract period. While the grant specifies a stated target number of shares, the determination of the actual settlement in shares will be based on the achievement of certain performance objectives of Torchmark over the respective three-year contract periods. Certain executive restricted stock and performance share grants contain terms related to age that could accelerate vesting.
Below is the final determination of the performance share grants in 2013 to 2015:
The measure of profitability for the Investment segment is excess investment income, which represents the income earned on the investment portfolio in excess of net policy requirements and financing costs associated with Torchmark’s debt. Other than the above-mentioned interest allocations and an intersegment commission, there are no other intersegment revenues or expenses. Expenses directly attributable to corporate operations are included in the “Corporate & Other” category. Stock-based compensation expense is considered a corporate expense by Torchmark management and is included in this category. All other unallocated revenues and expenses on a pretax basis, including insurance administrative expense, are also included in the “Corporate & Other” segment category.
Management removes items that are related to prior periods when evaluating the operating results of current periods. Management also removes non-operating items unrelated to its core insurance activities when evaluating those results. Therefore, these items are excluded in its presentation of segment results, because accounting guidance requires that operating segment results be presented as management views its business. With the exception of the administrative settlements noted in the paragraphs above, all of these items are included in “Other operating expense” in the Consolidated Statements of Operations for the appropriate year.
In 2017, Torchmark recorded $8.7 million in administrative settlements ($5.6 million after tax) where claims were not properly filed or information to support the validity of the claim had not been properly submitted. These administrative settlements were included in "Policyholder benefits" in the Consolidated Statements of Operations in 2017.
As further discussed in Note 15-Commitments and Contingencies, the Company received an assessment from various state guaranty fund associations for the liquidation of Penn Treaty and its affiliate. The total estimated assessment for Torchmark's subsidiaries is approximately $9.6 million of which $1.8 million is estimated to be unrecoverable. We are anticipating the remaining amount of the assessments to be recovered through premium tax credits. The assessment expenses were considered a non-operational event and therefore were excluded from the core underwriting operations of the Company.
As a result of the Tax Legislation, which is discussed in Note 1-Significant Accounting Policies, we recorded a one-time increase in stock-based compensation expense of 3.4 million ($2.2 million after tax) due to the impact the Tax Legislation had on certain performance based equity awards.
In 2015, Torchmark recorded $1.4 million in administrative settlements ($906 thousand after tax) related to a post- closing adjustment on the sale of a former subsidiary. These administrative settlements were included in "Commissions, premium taxes, and non-deferred acquisition costs" in the Consolidated Statements of Operations in 2015.
Assets for each segment are reported based on a specific identification basis. The insurance segments’ assets contain DAC. The investment segment includes the investment portfolio, cash, and accrued investment income. Goodwill is assigned to the insurance segments at the time of purchase. All other assets are included in the Other category. The table below reconciles segment assets to total assets as reported in the consolidated financial statements.
Liabilities for each segment are reported also on a specific identification basis similar to the assets. The insurance segments' liabilities contain future policy benefits, unearned and advance premiums, and policy claims and other benefits payable. Other policyholders' funds are included in Other as well as current and deferred income taxes payable. Debt represents both short and long-term.
Reinsurance: Insurance affiliates of Torchmark reinsure that portion of insurance risk which is in excess of their retention limits. Retention limits for ordinary life insurance range up to $2 million per life. Life insurance ceded represented 0.4% of total life insurance in force at December 31, 2017. Insurance ceded on life and accident and health products represented 0.2% of premium income for 2017. Torchmark would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.
Leases: Torchmark leases office space, office equipment, and aviation equipment under a variety of operating lease arrangements. The Company does not have any capital leases.
Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2017 were as follows:
Investments: As of December 31, 2017, Torchmark is committed to purchase $210 million of commercial mortgage loan participations from a third party.
Guarantees: At December 31, 2017, Torchmark had in place four guarantee agreements, of which were either Parent Company guarantees of subsidiary obligations to a third party, or Parent Company guarantees of obligations between wholly-owned subsidiaries. As of December 31, 2017, Torchmark had no liability with respect to these guarantees.
Letters of Credit: Torchmark has guaranteed letters of credit in connection with its credit facility with a group of banks as disclosed in Note 11-Debt. The letters of credit were issued by TMK Re, Ltd., a wholly-owned subsidiary, to secure TMK Re, Ltd.’s obligation for claims on certain policies reinsured by TMK Re, Ltd. that were sold by other Torchmark insurance companies. These letters of credit facilitate TMK Re, Ltd.’s ability to reinsure the business of Torchmark’s insurance carriers. The agreement expires in 2021. The maximum amount of letters of credit available is $250 million. The Torchmark Parent Company would be liable to the extent that TMK Re, Ltd. does not pay the reinsured party. Letters of credit outstanding were $177 million at December 31, 2017 and 2016.
Guaranty Fund Assessment: In 2017, the Commonwealth Court of Pennsylvania issued orders placing Penn Treaty Network America Insurance Company (Penn Treaty) and affiliate American Network Insurance Company (ANIC) in liquidation due to financial difficulties. In such instances, the various state guaranty fund associations employ funding mechanisms, through assessments to their member companies, to cover the obligations of the insolvent entities. Consequently, the Company continues to receive guaranty fund assessments from the state associations related to these companies. The Company has projected its share of the ultimate assessments from these insolvencies based on assumptions about future events and its market share of premiums by state. The total estimated assessment for Torchmark's subsidiaries is approximately $9.6 million of which $7.8 million is estimated to be recoverable through state premium tax credit offsets. We anticipate the remaining $1.8 million will be unrecoverable.