SMC leases approximately 31,000 square feet in an office building located at 9100 Keystone Crossing, Indianapolis, Indiana, under the terms of a lease which expires on June 1, 2001. SMC entered into a lease on March 31, 1997, for approximately 16,000 square feet in a warehouse located at 2525 North Shadeland, Indianapolis, Indiana, under the terms of a lease which expires on September 30, 1999.
Standard Management International entered into a lease on November 17, 1997 for approximately 4,500 square feet in an office building located at 13A, rue de Bitbourg, L-1273 Luxembourg, Grand Duchy of Luxembourg, under the terms of a lease which expires on November 16, 2003.
NOTES TO SMC SELECTED HISTORICAL FINANCIAL DATA (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(c)All applicable shares and per share amounts have been adjusted to reflect the adoption of Statement of Financial Accounting Standards ("SFAS") No. 128, "Earning Per Share" on December 31, 1997. Refer to the notes to the consolidated financial statements included in SMC's Audited Consolidated Financial Statements, included elsewhere herein, for a description of earnings per share.
(d)Total capitalization is the sum of SMC's debt (long term debt, notes payable, capital lease obligations and redeemable preferred stock) and shareholders' equity.
(g)Does not reflect preferred stock dividends of $97 ($.01 per share) and $208 ($.04 per share) for 1997 and 1996, respectively, on Class S Preferred Stock.
(h)Excludes the effect of reporting securities available for sale at fair value and recording the unrealized gain or loss on such securities as a component of shareholders' equity, net of tax and other adjustments, which SMC began to do in 1994. Such adjustments are in accordance with SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities", as described in the notes to the consolidated financial statements included in SMC's Consolidated Financial Statements, included elsewhere herein.
The following discussion highlights the principal factors affecting the results of operations and the significant changes in balance sheet items of SMC on a consolidated basis for the periods listed as well as SMC's liquidity and capital resources. This discussion should be read in conjunction with the SMC Consolidated Financial Statements and the Notes thereto appearing elsewhere herein.
SMC acquired Standard Management International on December 15, 1993, Dixie National Life on October 2, 1995, Shelby Life on November 8, 1996 and Savers Life on March 12, 1998. These acquisitions are accounted for using the purchase method of accounting (effective December 31, 1993 for the Standard Management International acquisition, October 2, 1995 for the Dixie National Life acquisition, November 1, 1996 for the Shelby Life acquisition, and March 1, 1998 for the Savers Life acquisition). Therefore, these subsidiaries are included in the SMC Consolidated Financial Statements commencing with their respective acquisition effective dates. SMC disposed of First International on March 18, 1996 (effective March 1, 1996) and terminated the operations of Standard Reinsurance on March 1, 1996.
The activity related to the present value of future profits of the business acquired or recaptured is summarized as follows (in thousands): YEAR ENDED DECEMBER 31,
The percentage of future expected net amortization of the beginning balance of the present value of future profits before the effect of net unrealized gains and losses, based on the present value of future profits at December 31, 1997 and current assumptions as to future events on all policies in force, will be between 6% and 8% in each of the years 1998 through 2002.
VARIANCES BETWEEN ACTUAL AND EXPECTED PROFITS. Actual experience on purchased and produced insurance may vary from projections due to differences in renewal premiums collected, investment spreads, mortality costs, surrender benefits, persistency, administrative costs and other factors. Variances from original projections, whether positive or negative, are included in net income as they occur. To the extent that these variances indicate that future experience will differ from the estimated profits reflected in the capitalization and amortization of the cost of policies purchased or the cost of policies produced, current and future amortization rates may be adjusted.
OPERATING INCOME. The income from operations (before net realized investment gains and gain on disposal of subsidiaries) was $2,384,000 in 1997, or $.48 per share, compared to $1,174,000 for 1996, or $.24 per share. The increase resulted primarily from operations in the United States producing income from operations of $664,000 for 1997 compared to a loss of $44,000 for 1996. The increase is primarily due to an increase in interest spreads on an increasing asset base. The income from international operations also increased to $1,720,000 for 1997 compared to $1,218,000 for 1996. The international operating income resulted primarily from increased fees from an increase in value of assets under separate accounts and deceased operating expenses, primarily due to the strengthening of the U.S. dollar.
PREMIUM INCOME. GAAP premium income for 1997 was $7,100,000, a decrease of $3,368,000 or 32% from 10,468,000 for 1996. This decrease is attributable to the recapture of premiums ceded of $4,234,000 in 1996 due to the termination and recapture of a reinsurance agreement with National Mutual which offset the increase in premium income for the inclusion of Shelby Life in the results of operations for periods after November 1, 1996. The Shelby Life block of business recorded net premium income of $1,685,000 in 1997.
The pretax net unrealized gain on the Company's fixed maturity portfolio was $5,201,000 at December 31, 1997, compared to a pretax net unrealized (loss) of $(1,837,000) at December 31, 1996. In the absence of continued decreases in interest rates the Company may be unable to realize gains on its investment portfolio at the levels of prior years or could recognize losses from sales of securities prior to maturity. The Company's future earnings could be adversely affected to the extent it is unable to realize gains on its investment portfolio.
GAIN ON DISPOSAL OF SUBSIDIARIES. On March 18, 1996, SMC completed the sale of a duplicate charter associated with First International to GIAC. SMC received sale proceeds of $10,393,000, including $1,500,000 for the charter and licenses associated with First International. Standard Life realized a net pre-tax gain of $1,042,000 on this sale. In addition, First International, Standard Life and GIAC have entered into a series of agreements that include provisions for Standard Life to retain the economic interest in certain First International policies and administer First International policies in force at the date of such sale.
In an unrelated matter, SMC decided in February 1996 to terminate the reinsurance agreement between Standard Reinsurance and Salamandra, and not to renew the Barbados license of Standard Reinsurance. This resulted in a 1996 write-off of SMC's investment in Standard Reinsurance and certain intangible assets of Standard Reinsurance amounting to $156,000.
POLICY CHARGES. Policy charges, which represent the amounts assessed against policyholder account balances for the cost of insurance, policy administration and surrenders, increased $2,961,000 or 116% to $5,512,000 for 1997 compared to $2,551,000 for 1996. The increase in policy charges resulted from an increase in policy charges for Standard Life's universal life insurance products of $1,790,000 due to the inclusion of Shelby Life in the results of operations for periods after November 1, 1996, and an increase in policy surrender charges on FPDAs of $693,000. The increase in annuity policy withdrawals and surrender charges on flexible premium deferred annuities generally corresponds to the aging and growth of SMC's annuity business in force.
FEES FROM SEPARATE ACCOUNTS. Fees from separate accounts increased $215,000 or 14% to $1,779,000 for 1997 from $1,564,000 for 1996. This increase is due primarily to an increase in the value of assets held in separate accounts from $122,705,000 at December 31, 1995 to $148,064,000 at December 31, 1997. Net deposits from sales of unit-linked products by Standard Management International were $21,954,000 and $16,902,000 for 1997 and 1996, respectively. Such income fluctuates in relationship to total separate account assets and the return earned on such assets.
SALARIES AND WAGES. Salaries and wages were $5,608,000 for 1997, an increase of $555,000 or 11% from $5,053,000 for 1996. This increase was caused primarily by an increase in the average wages per employee in 1997 and an increase in the number of employees from 84 at January 1, 1996 to 92 at December 31, 1997.
AMORTIZATION. Amortization expense increased $656,000 or 25% to $3,248,000 for 1997 from $2,592,000 for 1996. The increase in current year amortization expense resulted primarily from the amortization of present value of future profits of $555,000 in 1997 for the acquisition of Shelby Life.
INTEREST EXPENSE AND FINANCING COSTS. Interest expense and financing costs increased $1,576,000 or 196% to $2,381,000 for 1997 from $805,000 for 1996. The increase in interest expense and financing costs during 1997 resulted primarily from increased borrowing of $10,100,000 in November 1996 on the Amended Credit Agreement and borrowings of $4,000,000 from an unaffiliated insurance company in connection with the acquisition of Shelby Life and additional borrowings of $5,600,000 in connection with funding capital contributions to an insurance subsidiary and redemption of Class S Preferred Stock in 1997.
EXTRAORDINARY GAIN ON EARLY REDEMPTION OF REDEEMABLE PREFERRED STOCK. Extraordinary gains were recorded on the early redemption of the Class S Preferred Stock for the amounts by which the repurchase price for the Class S Preferred Stock was below its book value plus accrued and unpaid dividends. SMC recorded no extraordinary gain for 1997 compared to a $502,000 gain for 1996. Effective August 1, 1997, SMC redeemed all of its issued and outstanding Class S Preferred Stock at redemption value of $10.00 per share plus accumulated and unpaid dividends.
DISCUSSION OF CHANGES IN THE CONSOLIDATED STATEMENT OF OPERATIONS FROM YEAR ENDED DECEMBER 31, 1996 TO YEAR ENDED DECEMBER 31, 1995
SMC also decreased the quota-share portion of business ceded pursuant to a reinsurance agreement from 70% to 50% at September 1, 1995, which was further decreased to 25% effective April 1, 1995. Premium deposits ceded pursuant to this reinsurance agreement reduced net premium deposits by $8,907,000 in 1996 compared to $20,090,000 in 1995.
NET INVESTMENT INCOME. Net investment income increased $2,354,000 or 13% to $20,871,000 for 1996 from $18,517,000 for 1995. The increase primarily resulted from an increase in total invested assets (amortized cost) of approximately 32% from 1995 to 1996, most of which occurred in the fourth quarter due to the acquisition of Shelby Life. The weighted average net yield on SMC's invested assets was 7.32% for both 1996 and 1995. The continued growth in SMC's total invested assets reflects increased sales of FPDAs and the inclusion of the invested assets of Dixie National Life of approximately $26,400,000 and Shelby Life of approximately $100,000,000 in the consolidated balance sheet effective October 2, 1995 and November 1, 1996, respectively, which was offset by the invested assets ceded in the GIAC reinsurance transaction of approximately $18,000,000.
NET REALIZED INVESTMENT GAINS. Net realized investment gains increased $614,000 or 89% to $1,302,000 from $688,000 for 1996 and 1995, respectively. The increase primarily resulted from active portfolio management by SMC. Net realized investment gains fluctuate from period to period and arise when securities are sold in response to changes in the investment environment which provide opportunities to maximize return on the investment portfolio without adversely affecting the quality and overall yield of the investment portfolio.
POLICY CHARGES. Policy charges increased $84,000 or 3% to $2,551,000 for 1996 compared to $2,467,000 for 1995. The increase in policy charges resulted from an increase in policy surrender charges on FPDAs of $254,000 and the inclusion of Dixie National Life and Shelby Life in operating results for periods after October 2, 1995 and November 1, 1996, respectively, for an increase of $1,359,000 which offset a decrease of $1,502,000 for the absence of policy charges from SMC's closed blocks of universal life business which were sold to GIAC through a reinsurance contract effective January 1, 1995.
OTHER INCOME. Other income increased $897,000 or 236% to $1,277,000 for 1996 compared to $380,000 for 1995. The increase resulted primarily from administration fees of $316,000 and the reserve and experience refund adjustments in connection with the agreements with GIAC and increased commissions received by Standard Marketing from the sale of unaffiliated products.
SALARIES AND WAGES. Salaries and wages were $5,053,000 for 1996, an increase of $352,000 or 7% from $4,701,000 for 1995. This increase was caused primarily by an increase in incentive compensation expense of $315,000.
AMORTIZATION. Amortization expense increased $548,000 or 27% to $2,592,000 for 1996 from $2,044,000 for 1995. The increase in current year amortization expense resulted primarily from increased amortization of deferred acquisition costs as gross profits from business sold in recent years began to emerge and increased surrenders and their corresponding increase in the amortization of deferred acquisition costs, and from an increase of $602,000 for the amortization of present value of future profits for the acquisitions of Dixie National Life, Shelby Life and National Mutual. These items more than offset reduced amortization of excess of cost over net assets acquired of $46,000 and present value of future profits of $120,000 due to the sale of First International.
OTHER OPERATING EXPENSES. Other operating expenses increased $1,292,000 or 21% to $7,311,000 for 1996 from $6,019,000 for 1995. The increase in other operating expenses resulted primarily from the expenses of Dixie National Life and Shelby Life included in the results for the periods after October 2, 1995 and November 1, 1996, respectively and the increased expenses related to potential acquisitions and advisory fees.
INTEREST EXPENSE AND FINANCING COSTS. Interest expense and financing costs increased $687,000 or 582% to $805,000 for 1996 from $118,000 for 1995. The increase in interest expense and financing costs during 1996 resulted primarily from the borrowing on the Amended Credit Agreement. The borrowing under the Amended Credit Agreement and the original credit agreement primarily occurred after December 31, 1995 in connection with the acquisition of Shelby Life and the repurchase of Common Stock and Class S Preferred Stock.
SMC reported on a consolidated GAAP basis net cash provided by operations of $7,764,000 and $1,726,000 for 1997 and 1996, respectively. Although deposits received on SMC's interest-sensitive annuities and other financial products are not included in cash flow from operations under GAAP, such funds are available for use by SMC. Cash provided by operations plus net deposits received, less net account balances returned to policyholders on interest sensitive annuities and other financial products, resulted in positive cash flow of $19,649,000 and $26,717,000 for 1997 and 1996, respectively. Cash generated on a consolidated basis is available to Standard Management only to the extent that it is generated at Standard Management level or is available to Standard Management through dividends, interest, management fees or other payments from subsidiaries.
In April 1993, Standard Management instituted a program to repurchase SMC Common Stock from time to time. The purpose of the stock repurchase program is to enhance shareholder value. Standard Management had repurchased 1,134,356 shares of SMC Common Stock for $5,826,000 as of January 1, 1998. Of the repurchases, 419,026 shares were paid for through additional borrowings under the Amended Credit Agreement, 39,016 shares from the proceeds of the additional borrowings of the subordinated convertible notes, and the remainder were paid from working capital. At January 1, 1998, Standard Management was authorized to purchase an additional 365,644 shares under this program.
Pursuant to the management services agreement with Standard Management, Standard Life paid Standard Management a monthly fee of $166,667 (annual fee of $2,000,000) during 1997 for certain management services related to the production of business, investment of assets and evaluation of acquisitions. Pursuant to the management service agreements with Standard Life, Dixie National Life paid monthly payments of $83,333 (annual fee of $1,000,000) to Standard Life in 1997. Both of these agreements provide that they may be modified or terminated by the Indiana and Mississippi departments of insurance in the event of financial hardship of Standard Life or Dixie National Life.
A management services agreement between SMC and Savers Life was approved by the North Carolina Department of Insurance on March 11, 1998. The management services agreement calls for the payment of $83,333 per month by Savers Life to SMC for financial and regulatory reporting, investment of assets and the production of business. SMC has agreed to receive no fee, nor shall Savers life have an obligation to pay, unless the capital and surplus of Savers Life is $7,000,000 after the acquisition of Savers Life. The amount of capital and surplus of Savers Life at December 31, 1997 was $7,134,00.
At April 1, 1995, Standard Management sold its property and equipment to an unaffiliated leasing/financing company for $1,396,000 and subsequently entered into a capital lease obligation whereby Standard Management pays a monthly rental amount of $45,000. Standard Management charges a monthly equipment rental fee to its subsidiaries for this equipment and additional equipment purchased after April 1, 1995. The amount of the rental fee income received from Standard Management's subsidiaries was $1,145,000 and $853,000 for 1997 and 1996, respectively.
The Amended Credit Agreement permits Standard Management to borrow up to $20,000,000 in the form of a seven-year reducing revolving loan arrangement. Standard Management has agreed to pay a non-use fee of .50% per annum on the unused portion of the commitment. In connection with the original and Amended Credit Agreement, Standard Management issued warrants to the bank to purchase 77,500 shares of SMC Common Stock. Borrowing under the Amended Credit Agreement may be used for contributions to surplus of insurance subsidiaries, acquisition financing, and repurchases of Class S Preferred and SMC Common Stock. The debt is secured by a Pledge Agreement of all of the issued and outstanding shares of common stock of Standard Life and Standard Marketing. Interest on the borrowing under the Amended Credit Agreement is determined, at the option of Standard Management, to be: (i) a fluctuating rate of interest based on corporate base rate announced by the bank from time to time plus 1% per annum, or (ii) a rate at LIBOR plus 3.25%. Annual principal repayments of $3,333,000 begin in March 2000 and conclude in March 2005. Indebtedness incurred under the Amended Credit Agreement is subject to certain restrictions and covenants including, among other things, certain minimum financial ratios, minimum statutory surplus requirements for the insurance subsidiaries, minimum consolidated equity requirements for Standard Management and certain investment and indebtedness limitations. At December 31, 1997, Standard Management had borrowed $16,000,000 under the Amended Credit Agreement at a weighted average interest rate of 9.062%.
In connection with the acquisition of Shelby Life, Standard Management borrowed $4,000,000 from an insurance company pursuant to a subordinated convertible debt agreement which is due in December, 2003. At June 30, 1997, this subordinated convertible debt agreement was amended to the principal amount of $4,372,000 which is due July 2004 unless previously converted, and requires interest payments in cash on January 1 and July 1 of each year at 10% per annum. At June 30, 1997, SMC borrowed an additional $5,628,000 from an insurance company pursuant to another subordinated convertible debt agreement (collectively, the "Notes") which is due July 2004 unless previously converted, and requires interest payments in cash on January 1 and July 1 of each year at 10% per annum. Proceeds from the additional borrowings were used for contributions to surplus of insurance subsidiaries of $2,400,000, redemption of Class S Preferred Stock of approximately $1,840,000 and other general corporate purposes. The Notes are convertible at any time at the option of the noteholders into Common Stock at the rate of $5.747 per share. The Notes may be prepaid in whole or in part at the option of SMC commencing on July 1, 2000 at redemption prices equal to 105% of the principal amount (plus accrued interest) and declining to 102% of the principal amount (plus accrued interest). The Notes may be prepaid prior to July 1, 2000 at a redemption price equal to 101% of the principal amount plus accrued interest under certain limited circumstances. The subordinated convertible debt agreements contains terms and financial covenants substantially similar to those in the Amended Credit Agreement.
Assuming the current level of debt under the Amended Credit Agreement and current interest rates at December 31, 1997 (weighted average rate of 9.062%), annual debt service in 1998 would be approximately $2,800,000 in interest paid. In addition, Standard Management has 1998 obligations under a capital lease of $151,000.
From the funds borrowed by Standard Management pursuant to the Amended Credit Agreement and the subordinated convertible debt agreement, $13,000,000 was loaned to Standard Life pursuant to an Unsecured Surplus Debenture Agreement ("Surplus Debenture") which requires Standard Life to make quarterly interest payments to Standard Management at a variable corporate base rate plus 2% per annum, and annual principal payments of $1,000,000 per year beginning in 2007 and concluding in 2019. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life's capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance. Standard Management currently anticipates these quarterly approvals will be granted. Assuming the approvals are granted and the December 31, 1997 interest rate of 10.50% continues in 1998, Standard Management will receive interest income of $1,365,000 from the Surplus Debenture for 1998.
Dividends from Standard Life to Standard Management are limited by laws applicable to insurance companies. As an Indiana domiciled insurance company, Standard Life may pay a dividend or distribution from its surplus profits, without the prior approval of the Commissioner of the Indiana Department of Insurance, if the dividend or distribution, together with all other dividends and distributions paid within the preceding twelve months, does not exceed the greater of (i) net gain from operations or (ii) 10% of surplus, in each case as shown in its preceding annual statutory financial statements. Also, regulatory approval is required when dividends to be paid exceed unassigned statutory surplus. For the year ended December 31, 1997, Standard Life reported statutory net gain from operations before realized capital losses of $2,374,000 and statutory surplus of $25,923,000 which includes unassigned surplus of $1,693,000. During 1998, Standard Life can pay dividends of approximately $2,500,000 without regulatory approval.
Standard Management has a note receivable of $2,858,000 from an affiliate and a note payable of $2,858,000 to a different affiliate. This note receivable and note payable are eliminated in the consolidated financial statements.
Commencing January 1, 1995, Standard Life began to reinsure a portion of its annuity business. This reinsurance agreement has allowed SMC to write volumes of business that it would not otherwise have been able to write due to regulatory restrictions based on its ratio of surplus to liabilities as determined by regulatory authorities in the State of Florida. By reinsuring a portion of the annuity business, the liability growth is slowed, thereby avoiding the erosion of surplus that occurs in periods of increasing sales. If SMC's ratio of surplus to liabilities falls below 4%, the State of Florida could prohibit SMC from writing new business in Florida. Standard Life's largest annuity reinsurer at December 31, 1997, Winterthur, is rated "A" ("Excellent") by A.M. Best. From January 1, 1995 to August 31, 1995 approximately 70% of certain of Standard Life's annuity business produced was ceded. Standard Life decreased the quota-share portion of business ceded to 50% at September 1, 1995 and further reduced it to 25% effective April 1, 1996 to reflect the reduced need for additional capital and increase current earnings potential. This reduction was possible since the surplus strain experienced by Standard Life was not as great as originally anticipated as a result of lower than expected sales in 1995 and the increase in surplus resulting from the sale of First International. In addition, Standard Life's ability to retain business was further increased by contributions to surplus of insurance subsidiaries of $2,400,000 in 1997. Winterthur limits dividends and other transfers by Standard Life to Standard Management or affiliated companies in certain circumstances.
Management believes that operational cash flow of Standard Life will be sufficient to meet its anticipated needs for 1998. As of December 31, 1997, Standard Life had statutory capital and surplus for regulatory purposes of $25,923,000 compared to $22,970,000 at December 31, 1996. The increase is primarily due to the capital contribution of $2,400,000 from Standard Management in 1997. As the life insurance and annuity business produced by Standard Life and Dixie National Life increases, Standard Life expects to continue to satisfy statutory capital and surplus requirements through statutory profits, through the continued reinsurance of a portion of its new business, and through additional capital contributions by Standard Management. Net cash flow from operations on a statutory basis of Standard Life, after payment of benefits and operating expenses, was $19,588,000 and $17,921,000 for 1997 and 1996, respectively. If the need arises for cash which is not readily available, additional liquidity could be obtained from the sale of invested assets.
Standard Management International dividends are limited to its accumulated earnings without regulatory approval. Standard Management International and Premier Life (Luxembourg) were not permitted to pay dividends in 1997 and 1996 due to accumulated losses. Premier Life (Bermuda) did not pay dividends in 1997 and 1996. SMC does not anticipate any dividends from these companies in 1998.
Due to the nature of unit-linked products issued by Standard Management International, which represent over 90% of the Standard Management International portfolio, the investment risk rests with the policyholder. Investment risk for Standard Management International exists where Standard Management International makes investment decisions with respect to the remaining traditional business and for the assets backing certain actuarial and regulatory reserves. The investments underlying these liabilities mostly represent short-term investments and fixed maturity securities. These short term investments and fixed maturity securities are normally bought and/or disposed of only on the advice of independent consulting actuaries who perform an annual analysis comparing anticipated cash flows on the insurance portfolio with the cash flows from the fixed maturity securities. Any resulting material mismatches are then covered by adjusting the securities in the investment portfolio as appropriate.
FINANCIAL SERVICES DEREGULATION. The United States Congress is currently considering a number of legislative proposals intended to reduce or eliminate restrictions on affiliations among financial services organizations. Proposals are extant which would allow banks to own or affiliate with insurers and securities firms. An increased presence of banks in the life insurance and annuity businesses may increase competition in these markets. The Company cannot predict the impact of these proposals on the earnings of the Company.
IMPACT OF YEAR 2000. Some of the Company's older computer programs were written using two digits rather than four to define the applicable year. As a result, those computer programs have time-sensitive software that recognize a date using "00" as the year 1900 rather than the year 2000. This could cause a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send billing notices, or engage in similar normal business activities.
The Company has completed an assessment and will have minimal expenditures to modify or replace portions of its software so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. Modifications and or replacements are estimated to be completed not later than December 31, 1998, which is prior to any anticipated impact on its operating systems. The Company believes that with modifications to existing software and conversions to new software, the Year 2000 Issue will not pose significant operational problems for its computer systems. Additionally, management has concluded that the Year 2000 Issue will not materially affect future financial results, or cause reported financial information not to be indicative of future operating results or future financial condition.