Liberty operates its home office activities out of a 24,000 square foot facility leased in Hoover, Alabama (a Birmingham suburb). Approximately 8,000 square feet of storage space has also been leased near the home office facility. Liberty also operates a company-owned district office used for agency sales personnel. During 2013, Liberty sold a 487,000 square foot building in Birmingham, Alabama, which served as its home office until 2010.
Summary of Operations: Net income was $528 million in 2013, compared with $529 million in 2012. Net income increased 6% in 2012 from $497 million in 2011. On a diluted per share basis, 2013 net income rose 5% to $5.68 after a 19% increase in 2012. Net income per diluted share in 2012 rose to $5.41 from $4.53 in 2011. The per-share results have exceeded the growth in dollar amounts due to our share repurchase program. Also, each year’s per share net income was affected by realized investment gains, which were $.04, $0.25, and $0.15 in 2013, 2012, and 2011, respectively. More information concerning realized investment gains and losses can be found under the caption Realized Gains and Losses in this report where there is a more complete discussion. Also, as explained in Note 14-Business Segments in the Notes to the Consolidated Financial Statements, we do not consider realized gains and losses to be a component of our core insurance operations or operating segments. Additionally, we do not consider non-operating items which are not related to the current ongoing reporting performance of our segments as indicated in the chart above to be part of our segment operating income.
from a new regulation affecting bank hybrid securities, caused us to replace these higher yielding securities with securities at lower yields. The inclusion of Family Heritage’s administrative expenses for a full year for the first time added $8 million of additional administrative expense in 2013. In addition, in both 2013 and 2012, there were increases in stock compensation expense which negatively affected the results during the year. Stock compensation increased $4 million in 2013 and $7 million in 2012. These increases in stock compensation expense resulted primarily from the increase in the value of Torchmark’s stock and not from an increase in the number of grants.
Total revenues rose 5% in 2013 to $3.77 billion, after having risen 6% in 2012 to $3.59 billion. Life premium rose 4% or $77 million in 2013 to $1.89 billion. Life premium increased $82 million in 2012 to $1.81 billion. Net investment income was essentially flat at $694 million in 2012, but rose 2% or $16 million in 2013. Health premium increased 11% to $1.17 billion in 2013 and contributed $119 million to 2013 revenue growth, after having gained 13% to $1.05 billion in 2012. Health premium contributed $117 million to 2012 revenue growth.
We do not currently offer annuities. See the caption Annuities for discussion of the Annuity segment.
Index to Financial Statements The interest required on net policy liabilities is deducted from net investment income, and generally grows in conjunction with the net policy liabilities that are supported by the invested assets. The lower new-money yields resulting from the low-interest-rate environment noted above have compressed excess investment income as required interest has continued to grow at approximately the same rate that net policy liabilities have grown. We have implemented certain strategies to offset this effect, including increasing premium rates on sales of new products as discussed under the caption Investments. Financing costs, which consist of the interest required for debt service on our long and short-term debt, are also deducted from net investment income. Financing costs in 2013 were stable at $80 million, but increased 3% in 2012. The 2012 increase was primarily a result of two new debt offerings issued in the latter half of 2012 as described below.
Torchmark has in place an ongoing share repurchase program which began in 1986. With no specified authorization amount, we determine the amount of repurchases based on the amount of the Company’s excess cash flow, general market conditions, and other alternative uses. The majority of these purchases are made from excess operating cash flow when market prices are favorable. Additionally, when stock options are exercised, proceeds from these exercises and the tax benefit are used to repurchase additional shares on the open market to minimize dilution as a result of the option exercises. The Board of Directors has authorized the Company’s share repurchase program in amounts and with timing that management, in consultation with the Board, determines to be in the best interest of the
Company and its shareholders. The following chart summarizes share purchase activity for each of the three years ended December 31, 2013.
Life Insurance. Life insurance is our largest insurance segment, with 2013 life premium representing 62% of total premium. Life underwriting income before other income and administrative expense represented 70% of the total in 2013. Additionally, investments supporting the reserves for life products produce the majority of excess investment income attributable to the investment segment.
Life insurance premium rose 4% to $1.89 billion in 2013 after having increased 5% in 2012 to $1.81 billion. Life insurance products are marketed through several distribution channels. Premium income by channel for each of the last three years is as follows:
The Direct Response operation accounted for 35% of our life insurance premium during 2013, increasing 5% over 2012 premium. Life premium for this unit rose 6% in 2012 and 5% in 2011. Net sales rose 2% to $144 million in 2013 after a 3% increase in 2012. First-year collected premium was flat at $93 million after an increase of 5% in 2012. The average face amount of policies issued in 2013 was approximately $16 thousand.
The recent declines in premium and sales were due primarily to changes in the structure of the agency that have affected agent counts in recent years. Several years ago, management began a process to convert the agency from a fixed expense, salary-based agency model to a commission-driven variable-cost model. Even though we expected the conversion would result in agent defections, the change was necessary to maintain acceptable underwriting margins on new business and to ensure the long-term survival and growth of this distribution channel. We have implemented these changes gradually in an effort to minimize agency disruption as much as possible.
Index to Financial Statements We also offer life insurance through Other Agencies consisting of the Military Agency, the United American Independent Agency, and other small sales agencies. The Military Agency consists of a nationwide independent agency whose sales force is comprised primarily of former military officers who sell primarily to commissioned and noncommissioned military officers and their families. This business consists of whole-life products with term insurance riders. Military premium represented 10% of life premium at December 31, 2013. The United American Independent Agency represented approximately 1% of Torchmark’s total life premium at that date, as their sales of Torchmark products consist primarily of health insurance.
Index to Financial Statements Health Insurance. Health insurance sold by Torchmark includes primarily Medicare Supplement and Part D prescription drug coverage to enrollees in the federal Medicare program, cancer coverage, accident coverage, and other limited-benefit supplemental health products. All health coverage plans other than Medicare Supplement and Part D are classified here as limited-benefit plans.
The Family Heritage Exclusive Agency was acquired by Torchmark’s acquisition of Family Heritage on November 1, 2012 as discussed in Note 6-Acquisition in the Notes to Consolidated Financial Statements. This agency markets primarily 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. The Family Heritage Agency is our largest agency in terms of health net sales, adding $44 million in net sales in 2013. This agency’s $191 million in health premium income during 2013 represented 22% of Torchmark’s total excluding Part D. The producing agent count was 695 agents at December 31, 2013 compared with 702 agents at December 31, 2012. Management expects to grow this agency going forward through geographic expansion and incorporation of Torchmark’s recruiting programs. Annualized health premium in force at December 31, 2013 was $201 million, compared with $188 million a year earlier.
The American Income Exclusive Agency, predominantly a life insurance distribution channel, was our fourth largest health insurance distributor based on premium income in 2013. Its health plans are comprised of various limited-benefit plans. Approximately 69% of the agency’s 2013 health premium was from accident policies. Sales of the plans by this Agency are generally made in conjunction with a life policy being sold to the same customer.
Index to Financial Statements Direct Response, primarily a life operation, also offers health insurance, which is predominantly Medicare Supplements sold directly to employer or union sponsored groups. In 2013, net health sales were $4 million, compared with $5 million in 2012 and 2011. In 2013, health net sales for this group represented approximately 3% of Direct Response’s total life and health net sales. Direct Response health premium income was $54 million in 2013, a decline of 7% over 2012 premium of $58 million. Health premium rose 2% in 2012.
Medicare Part D. Torchmark, through its subsidiary United American, offers coverage under the government’s Medicare Part D plan. The Medicare Part D plan is a stand-alone prescription drug plan for Medicare beneficiaries. Part D is regulated and partially funded by the Centers for Medicare and Medicaid Services (CMS) for participating private insurers like United American. Under Part D, private carriers are the primary insurers, while CMS provides significant premium subsidies and reinsurance. Our Medicare Part D product is sold through the Direct Response operation and to groups through the UA Independent Agency.
Changes in Part D premium generally result from changes in the number of enrollees, which are heavily influenced by new sales. In 2011 United American had only one Part D product and was not active in the low-income auto-enrollee market. In 2012 the Company added a new lower cost Part D plan which allowed us to pick up a large number of low-income auto-enrollees in 21 regions and to grow our own individual sales. In 2013, due to intensified price competition, we qualified for new auto-enrollees in only 7 regions but were able to keep prior year auto-enrollees in 14 regions and maintain our presence in 21 regions. These variations in the number of new auto-enrollees caused the changes in Part D net sales, premium, and enrollee counts including the large increases in 2012 and the slight decline in premium in 2013. The 2013 decline was also influenced by the loss of several employer group Part D cases at the end of 2012.
For the plan year 2014, Torchmark qualified to receive new Part D auto-enrollees in 15 regions and also qualified to retain prior year auto-enrollees in 8 regions, for a total of 23 regions. Total enrollees in the program were 269 thousand at the beginning of the 2014 plan year. This increase in the number of regions and enrollees should result in an increase in Part D premium to approximately $340 million in 2014.
Total Medicare Part D premium and health premium excludes $2.6 million of risk-sharing premium received in 2013, and $404 thousand in 2012 and $1.0 million in 2011 of risk-sharing premium paid to the CMS consistent with the Medicare Part D contract. This risk-sharing amount is a portion of the excess or deficiency of actual over expected claims, and therefore we view this payment as a component of policyholder benefits in our segment analysis.
Excess investment income declined $18 million or 8% in 2013 from the prior year. Excess investment income declined $22 million or 9% in 2012. Excess investment income has been pressured over the past three years as a result of the impact of lower interest rates on net investment income coupled with the increase in required interest on net policy liabilities discussed later under this caption. On a per diluted share basis, excess investment income declined by 3% to $2.35 in 2013. Excess investment income rose 3% to $2.42 per share in 2012, after having risen 10% in the prior year. The smaller decline in 2013 per-share amounts, as well as the more favorable increases in 2012 and 2011 relative to the changes in dollar amounts for excess investment income are a result of share repurchases.
Excess investment income is reduced by the required interest on net insurance policy liabilities, because we consider these amounts to be components of the profitability of our 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 (formerly SFAS 60, now incorporated into ASC 944-20-05). This guidance mandates that interest rate assumptions be “locked in” for the life of that block of business. Each calendar year, we set the assumed discount rate to be used to calculate the benefit reserve liability and 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 the premiums received in the future from policies of that issue year, and cannot be changed except in the event of a premium deficiency. 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.
Index to Financial Statements The table below presents the components of financing costs and reconciles interest expense per the Consolidated Statements of Operations.
As previously noted, growth rates in our excess investment income decline when growth in income from the portfolio is less than that of the interest required by policy liabilities and financing costs, such as we have experienced in recent periods. In an extended low-interest-rate environment, the portfolio yield will tend to decline as we invest new money at lower long-term rates. We believe, however, the decline would be relatively slow, as, on average, only 2% to 3% of fixed maturities are expected to run off each year over the next five years.
The year 2013 was the third consecutive year that excess investment income declined. However, going forward, we expect this downward trend to reverse. We look for increases in excess investment income and income per share in the near future, as rate declines have moderated, the majority of hybrid calls are behind us, and expected maturities will have lower yields than those in the past.
We prefer to invest primarily in bonds that are not callable (on other than a make-whole basis) prior to maturity, but we periodically invest some funds in callable bonds when the incremental yield available on such bonds warrants doing so. For investments in callable bonds, the actual life of the investment will depend on whether the issuer calls the investment prior to the maturity date. Given our investments in callable bonds, the actual average life of our investments cannot be known at the time of the investment. However, the average life will not be less than the average life to next call and will not exceed the average life to maturity. Data for both of these average life measures is provided in the above chart.
At December 31, 2013, fixed maturities had a fair value of $12.9 billion, compared with $13.5 billion at December 31, 2012. At December 31, 2013, fixed maturities were in a $390 million net unrealized gain position compared with an unrealized gain position of $1.6 billion at December 31, 2012. Approximately 81% of our fixed maturity assets at December 31, 2013 at amortized cost were corporate bonds and 4% were redeemable preferred stocks. This compares with 78% corporate bonds and 6% redeemable preferred stocks at year end 2012. On a combined basis, residential mortgage-backed securities, other asset-backed securities, and collateralized debt obligations (CDOs) were 1% of the assets at amortized cost at December 31, 2013. The $66 million of CDOs at amortized cost made up less than 0.6% of the assets and are backed primarily by trust preferred securities issued by banks and insurance companies. The $8 million of residential mortgage-backed securities are rated AAA. For more information about our fixed-maturity portfolio by component at December 31, 2013 and 2012, including an analysis of unrealized investment losses and a schedule of maturities, see Note 4-Investments in the Notes to Consolidated Financial Statements.
Index to Financial Statements Credit Risk Sensitivity. Credit risk relates to the level of uncertainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. Approximately 86% of our fixed-maturity holdings at book value are in corporate securities (including redeemable preferred and asset-backed securities). As we continue to invest in corporate bonds with relatively long maturities, we continually monitor credit risk. We mitigate this ongoing risk, in part, by acquiring only investment-grade bonds and by analyzing the financial fundamentals of each prospective issuer. We continue to monitor the status of issuers on an ongoing basis. We also seek to reduce credit risk by spreading investments over a large number of issuers and a wide range of industry sectors.
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, 2013.
As described in Note 4-Investments under the caption Other-than-temporary impairments in the Notes to Consolidated Financial Statements, we wrote certain securities down to fair value during 2012 and 2011 as a result of other-than-temporary impairment. The impaired securities met our criteria for other-than-temporary impairment as discussed in Note 1-Significant Accounting Policies and in our Critical Accounting Policies in this report. The writedowns resulted in pretax charges of $5.6 million in 2012 ($3.6 million after tax) and $20 thousand in 2011 ($13 thousand after tax). During 2013, we sold investment real estate for an after-tax loss of $1.9 million, of which $1.7 million had been written down due to other-than-temporary impairment earlier in the year. In 2012, we redeemed our 7.1% Trust Originated Preferred Securities, recording a loss on redemption of $4.1 million ($2.7 million after tax).
Index to Financial Statements Our cash and short-term investments were $114 million at year-end 2013 and $157 million at year-end 2012. Additionally, we have a portfolio of marketable fixed and equity securities that are available for sale in the event of an unexpected need. These securities had a fair value of $12.9 billion at December 31, 2013. However, our strong cash flows from operations, investment maturities, and the availability of our credit line make any need to sell securities for liquidity unlikely.
As of December 31, 2013, we had no unconsolidated affiliates and no guarantees of the obligations of third-party entities. All of our guarantees were guarantees of the performance of consolidated subsidiaries, as disclosed in Note 15-Commitments and Contingencies.
Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force at December 31, 2013. These estimated payments were computed using assumptions for future mortality, morbidity and persistency. The actual amount and timing of such payments may differ significantly from the estimated amounts shown. Management believes that the assets supporting the liability of $11.3 billion at December 31, 2013, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
Also noted in Note 11 was our assumption of $20 million of Trust Preferred Securities in connection with our acquisition of Family Heritage. These securities bear interest at a variable rate, the three-month LIBOR plus 330 basis points, which is reset each quarter. While these securities are callable by us at any time, we have no immediate plans to do so.
Torchmark has increased the quarterly dividend on its common shares over the past three years. In the second quarter of 2011, it was raised to $.12 per share from $.1067 per share. In the first quarter of 2012, it was again increased to $.15 per share. Then, in the first quarter of 2013, it was raised to $.17 per share.
Index to Financial Statements 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. Due to the size of our policy liabilities in relation to our shareholders’ equity, this inconsistency in measurement usually has a material impact on the reported value of shareholders’ equity. If these liabilities were revalued in the same manner as the assets, the effect on equity would be largely offset. Fluctuations in interest rates cause undue volatility in the period-to-period presentation of our shareholders’ equity, capital structure, and financial ratios which would be essentially removed if interest-bearing liabilities were valued in the same manner as assets. From time to time, the market value of our fixed maturity portfolio may be depressed as a result of bond market illiquidity which could result in a significant decrease in shareholders’ equity. Because of the long-term nature of our fixed maturities and liabilities and the strong cash flows generated by our insurance subsidiaries, we have the intent and ability to hold our securities to maturity. As such, we do not expect to incur losses due to fluctuations in market value of fixed maturities caused by interest rate changes and temporarily illiquid markets. Accordingly, our management, credit rating agencies, lenders, many industry analysts, and certain other financial statement users prefer to remove the effect of this accounting rule when analyzing our balance sheet, capital structure, and financial ratios.
liabilities and debt, the impact on earnings could be very significant and volatile, causing reported earnings not to be reflective of core results. Therefore, we have not elected this option.
Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 10.5 times in 2013, compared with 10.5 times in 2012 and 10.3 times in 2011. 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.
Approximately 99% of our recorded amounts for deferred acquisition costs at December 31, 2013 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, 2013.
Policy Claims and Other Benefits Payable. This liability consists of known benefits currently payable and an estimate of claims that have been incurred but not yet reported to us. The estimate of unreported claims is based on prior experience and is made after careful evaluation of all information available to us. However, the factors upon which these estimates are based can be subject to change from historical patterns. Factors involved include the litigation environment, regulatory mandates, and the introduction of policy types for which claim patterns are not well established, and medical trend rates and medical cost inflation as they affect our health claims. Changes in these estimates, if any, are reflected in the earnings of the period in which the adjustment is made. We believe that the estimates used to produce the liability for claims and other benefits, including the estimate of unsubmitted claims, are the most appropriate
Valuation of Fixed Maturities. We hold a substantial investment in high-quality fixed maturities to provide for the funding of our future policy contractual obligations over long periods of time. While these securities are generally expected to be held to maturity, they are classified as available for sale and are sold from time to time, primarily to manage risk. We report this portfolio at fair value. Fair value is the price that we would expect to receive upon sale of the asset in an orderly transaction. The fair value of the fixed-maturity portfolio is primarily affected by changes in interest rates in financial markets, having a greater impact on longer-term maturities. Because of the size of our fixed-maturity portfolio, small changes in rates can have a significant effect on the portfolio and the reported financial position of the Company. This impact is disclosed in 100 basis point increments under the caption Market Risk Sensitivity in this report. However, as discussed under the caption Financial Condition in this report, we believe these unrealized fluctuations in value have no meaningful impact on our actual financial condition and, as such, we remove them from consideration when viewing our financial position and financial ratios.
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 2013 and projected benefit obligation as of December 31, 2013.
Discount rate is 4.18% for 2013 expense and 5.12% for the projected benefit obligation at December 31, 2013
Index to Financial Statements REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries (Torchmark) as of December 31, 2013 and 2012, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2013. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
Torchmark accounts for its variable interest entities (VIE’s) under accounting guidance which clarifies the definition of a variable interest and the instructions for consolidating VIE’s. Only primary beneficiaries are required or allowed to consolidate VIE’s. Therefore, a company may have voting control of a VIE, but if it is not the primary beneficiary of the VIE, it is not permitted to consolidate the VIE. The trust that was liable for Torchmark’s Trust Preferred Securities met the definition of a VIE. However, Torchmark was not the primary beneficiary of this entity because its interest was not variable. Therefore, Torchmark was not permitted to consolidate its interest, even though it owned 100% of the voting equity of the trust and guaranteed its performance. For this reason, Torchmark reported its 7.1% Junior Subordinated Debentures due to the trust as “Due to affiliates” each period at its carrying value. However, Torchmark viewed the Trust Preferred Securities as it does any other debt offering and consolidated the trust in its segment analysis because GAAP requires that the segment analysis be reported as management views its operations and financial condition. These Securities were redeemed in October, 2012, as disclosed in Note 11-Debt.
Investments: Torchmark classifies all of its fixed-maturity investments, which include bonds and redeemable preferred stocks, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Policy loans are carried at unpaid principal balances. Mortgage loans, included in “Other long-term investments,” are carried at amortized cost. Investments in real estate, included in “Other long-term investments,” are reported at cost less allowances for depreciation. Depreciation is calculated on the straight-line method. Short-term investments include investments in interest-bearing time deposits with original maturities of twelve months or less.
When third-party vendor prices are not available, the Company attempts to obtain at least three quotes from broker/dealers for each security. When at least three quotes are obtained, and the standard deviation of such quotes is less than 3%, (suggesting that the independent quotes were likely derived using similar observable inputs), the Company uses the median quote and classifies the measurement as Level 2. At December 31, 2013 and 2012, there were no assets valued as Level 2 in this manner with broker quotes.
When the standard deviation is 3% or greater, or the Company cannot obtain three quotes, then additional information and management judgment are required to establish the fair value. Further review is performed on the available quotes to determine if they can be corroborated within reasonable tolerance to any other observable evidence. If one of the quotes or the median of the available quotes can be corroborated with other observable evidence, then the value is reported as Level 2. Otherwise, the value is classified as Level 3. The Company uses information and valuation techniques deemed appropriate for determining the point within the range of reasonable fair value estimates that is most representative of fair value under current market conditions. As of December 31, 2013 and 2012, fair value measurements classified as Level 3 represented 2.8% and 2.1%, respectively, of total fixed maturities and equity securities. Transfers between levels are recognized as of the end of the period of transfer.
Beginning in 2012, Torchmark began investing in a portfolio of private placement bonds which are not actively traded. This portfolio is managed by a third party and was $313 million at amortized cost on December 31, 2013, compared with $184 million a year earlier. The portfolio manager provides 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 the unobservable inputs can be closely corroborated with publicly available information, the fair values are classified as Level 2. If they cannot be corroborated, the fair values are classified as Level 3. As of December 31, 2013 and 2012, all private placements were classified as Level 3.
Fair Value Measurements, Other Financial Instruments: Fair values for cash, short-term investments, short-term debt, receivables and payables approximate carrying value. The fair values of Torchmark’s long-term debt issues are based on the same methodology as investments in fixed maturities. Because observable inputs were available for these debt securities at December 31, 2013, they were classified as Level 2 in the valuation hierarchy. The fair value for each debt instrument as of December 31, 2013 is disclosed in Note 11-Debt. Mortgage loans are valued using discounted cash flows and are considered to be Level 3 in the valuation hierarchy. The fair values for these loans are presented in Note 4-Investments under the caption Other investment information. As described in Note 9-Postretirement Benefits, Torchmark maintains an unqualified supplemental retirement plan. Because this plan is unfunded, the assets which support the liability for this plan are considered general assets of the Company. These assets consist of the cash value of corporate-owned life insurance policies and exchange traded funds (ETF’s). The fair value of the insurance cash values approximates carrying value. Fair values for the ETF’s are derived from direct quotes and are considered Level 1 in the valuation hierarchy.
Current accounting guidance is such that if an entity intends to sell or if it is more likely than not that it will be required to sell an impaired security prior to recovery of its cost basis, the security is to be considered other-than-temporarily impaired and the full amount of impairment must be charged to earnings. Otherwise, losses on fixed maturities which are other-than-temporarily impaired are separated into two categories, the portion of loss which is considered credit loss and the portion of loss which is due to other factors. The credit loss portion is charged to earnings while the loss due to other factors is
The Federal income benefits accrued during each of the years presented, net of the amortization associated with guaranteed interests, were recorded in “Income taxes.” Amortization associated with non-guaranteed interests and interests providing for state premium tax benefits was reflected as a component of “Net investment income.” All state premium tax benefits, net of the related amortization, were recorded in “Net investment income.” At December 31, 2013, $283 million associated with the Federal interests was included in “Other assets” with the remaining $7 million state-related interests included in “Other invested assets.” At December 31, 2012, the comparable amounts were $275 million and $10 million, respectively. Any unpaid commitments to invest are recorded in “Other liabilities.” In the segment analysis, the amortization associated with the non-guaranteed interests is reflected as a component of “Income tax expenses,” and not “Net investment income,” consistent with the treatment of the guaranteed interests. Management views this presentation as a more accurate matching of costs with the associated revenues with respect to the low-income housing interests.
Goodwill: The excess cost of business acquired over the fair value of net assets acquired is reported as goodwill. Goodwill is subject to annual impairment testing based on certain procedures outlined by GAAP. These procedures include a qualitative assessment as to whether it is more likely than not that goodwill is impaired, and they also require consideration of a change in relevant events or circumstances that could possibly affect the valuation of a goodwill reporting unit. If it is determined that an impairment is likely, the procedures then involve measuring the carrying value of each reporting unit of Torchmark’s segments, including the goodwill of that unit, against the estimated fair value of the corresponding unit. If the carrying value of a unit including goodwill exceeds its estimated fair value, then the goodwill in that unit could potentially be impaired. In that event, 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 test.
Settlements and Assessments: During 2011, Torchmark settled a state administrative matter involving issues arising over a period of many years. The settlement resulted in a pre-tax charge of $6.9 million ($4.5 million after tax). Additionally in 2011, the Company accrued a liability for settlement of an insurance litigation matter which was settled in 2012. The liability for this litigation, which arose many years ago, was $12.0 million pretax ($7.8 million after tax). During 2013, Torchmark incurred three non-operating charges: (1) a state guaranty fund assessment in the amount of $1.2 million ($751 thousand after tax), resulting from events in years prior to 2012, (2) a legal settlement related to a non-insurance matter in the amount of $500 thousand ($325 thousand after tax), and (3) the settlement of a litigation matter related to prior years in the amount of $8.6 million ($5.6 million after tax). Management removes items that are related to prior periods when evaluating the operating results of current periods. Management also removes items unrelated to its core insurance activities when evaluating those results. Therefore, these items are excluded in its presentation of segment results as disclosed in Note 14-Business Segments, because accounting guidance requires that operating segment results be presented as management views its business.
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 2011 through 2013 is as follows:
The expected term is generally derived from Company experience. However, expected terms are determined based on the simplified method as permitted by Staff Accounting Bulletins 107 and 110 when company experience is insufficient.
Reclassifications out of Accumulated Other Comprehensive Income are presented below for the twelve months ended December 31, 2013.
A schedule of fixed maturities by contractual maturity at December 31, 2013 is shown below on an amortized cost basis and on a fair value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions.
Acquisitions of Level 3 investments in 2013 and 2012 are comprised of private-placement fixed maturities managed by an unaffiliated third-party.
As of year end 2013, previously written down securities remaining in the portfolio were carried at a fair value of $42 million. Otherwise, as of December 31, 2013, Torchmark has no information available to cause it to believe that any of its investments are other-than-temporarily impaired. Torchmark has the ability and intent to hold these investments to recovery, and does not intend to sell nor expects to be required to sell its other impaired securities.
Claims paid in each of the years 2011 through 2013 were settled for amounts less than anticipated when estimated at the previous year end. The most significant components of these favorable variances were in Torchmark’s UA Independent, Liberty National Branch, and Medicare Part D distribution channels. The Company’s estimates at each point have reflected the emerging data and trends. In the Medicare Part D channel, the Company is required to estimate claim discounts that will be received from drug manufacturers. In each of the years 2011 through 2013, the discounts from the drug manufacturers received in the current year but related to prior year claims were higher than anticipated when the claim liability was determined.
In each of the years 2011 through 2013, deferred income tax expense was incurred because of certain differences between net income before income taxes as reported on the Consolidated Statements of Operations and taxable income as reported on Torchmark’s income tax returns. As explained in Note 1-Significant Accounting Policies, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
Torchmark and its subsidiaries, excluding Family Heritage, file a life-nonlife consolidated Federal income tax return. Family Heritage files its Federal income tax return on a separate company basis. Torchmark’s consolidated Federal income tax returns are routinely audited by the Internal Revenue Service (IRS). The IRS is currently examining Torchmark’s 2008-2011 consolidated income tax returns. The statutes of limitations for the assessment of additional tax are closed for all tax years prior to 2008 with respect to Torchmark’s consolidated Federal income tax returns and are closed for all tax years prior to 2010 with respect to Family Heritage’s Federal income tax returns. Management believes that adequate provision has been made in the consolidated financial statements for any potential assessments that may result from current or future tax examinations and other tax-related matters for all open years.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. All plan measurements for the defined benefit plans are as of December 31 of the respective year. The defined benefit pension plans covering the majority of employees are funded. Contributions are made to funded pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Defined benefit plan contributions were $10.3 million in 2013, $8.2 million in 2012, and $8.6 million in 2011. Torchmark estimates as of December 31, 2013 that it will contribute an amount not to exceed $20 million to these plans in 2014. The actual amount of contribution may be different from this estimate.
The portion of other comprehensive income that is expected to be reflected in pension expense in 2014 is as follows:
Torchmark has estimated its expected pension benefits to be paid over the next ten years as of December 31, 2013. These estimates use the same assumptions that measure the benefit obligation at December 31, 2013, taking estimated future employee service into account. Those estimated benefits are as follows:
(4) Quarterly payments on the 15th of March, June, Sept., and Dec.
Funded debt: On September 24, 2012, Torchmark issued $300 million principal amount of 3.80% Senior Notes due 2022. Interest on the Senior Notes will be payable semi-annually and will commence on March 15, 2013. As part of the offering, two of Torchmark’s insurance subsidiaries acquired a combined amount of $150 million par value of the Senior Notes. Proceeds from the issuance of this debt, net of underwriters’ discount and expenses, were $147 million with total proceeds to the Parent Company of approximately $297 million. The Senior Notes are redeemable by Torchmark in whole or in part at any time subject to a “make-whole” premium, whereby the Company would be required to pay the greater of the full principal amount of the notes or otherwise the present value of the remaining payment schedule of the notes discounted at a rate of interest equivalent to the rate of a United States Treasury security of comparable term plus a spread of 30 basis points. Torchmark used a portion of the net proceeds from the new Senior Note offering to fund the acquisition of Family Heritage as described in Note 6 - Acquisition. The Parent Company used the remaining proceeds to repay its $94 million principal amount 7 3/8% Notes that matured on August 1, 2013.
On October 24, 2012, Torchmark’s 7.1% Trust Originated Preferred Securities were redeemed in the amount of $120 million plus accrued dividends at a total cost of $121 million. These securities were originally issued in 2006 as preferred securities of Torchmark’s Capital Trust III, a deconsolidated variable interest entity. Upon redemption of these securities, Capital Trust III as well as the 7.1% Junior Subordinated Debentures due to that Trust in the amount of $124 million were liquidated. An after-tax loss of $2.7 million was recorded on this redemption in the fourth quarter of 2012 within “Realized investment gains (losses),” representing the write-off of the unamortized issue expenses.
Torchmark’s stock-based compensation consists of stock options, restricted stock, restricted stock units, and performance shares. Certain employees, directors, and consultants have been granted fixed equity options to buy shares of Torchmark stock at the market value of the stock on the date of grant, under the provisions of the Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring according to the terms of the grant. Options generally expire the earlier of employee termination or option contract term, which ranges from seven to ten years. Options generally vest in accordance with the following schedule:
A summary of restricted stock and restricted stock units granted during each of the years in the three year period ended December 31, 2013 is presented in the table below. Restricted stock holders are entitled to dividends on the stock and holders of restricted stock units are entitled to dividend equivalents. Executive grants vest over five years and director grants vest over six months.
Additional information about Torchmark’s stock-based compensation as of December 31, 2013 and 2012 is as follows:
The following table summarizes information about stock options outstanding at December 31, 2013.
No equity awards were cash settled during the three years ended December 31, 2013.
Life insurance products include traditional and interest-sensitive whole life insurance as well as term life insurance. Health products are generally guaranteed-renewable and include Medicare Supplement, Medicare Part D, cancer, accident, long-term care, and limited-benefit hospital and surgical coverages. Annuities include fixed-benefit contracts.
Assets for each segment are reported based on a specific identification basis. The insurance segments’ assets contain deferred acquisition costs (including the value of insurance purchased). The investment segment includes the investment portfolio, cash, and accrued investment income. Goodwill is assigned to the insurance segments at the time of purchase based on the excess of cost over the fair value of assets acquired for the benefit of that segment. All other assets, representing approximately 4% of total assets, are included in the other category. The table below reconciles segment assets to total assets as reported in the consolidated financial statements.
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 $2.0 million per life. Life insurance ceded represented .5% of total life insurance in force at December 31, 2013. Insurance ceded on life and accident and health products represented .3% of premium income for 2013. 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.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represented 2.5% of life insurance in force at December 31, 2013 and reinsurance assumed on life and accident and health products represented .9% of premium income for 2013.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. Rental expense for operating leases was $4.1 million in 2013, $3.6 million in 2012, and $4.8 million in 2011. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2013 were as follows: 2014, $3.4 million; 2015, $3.3 million; 2016, $1.9 million; 2017, $1.1 million; 2018, $1.0 million and in the aggregate, $11.4 million.
Low-Income Housing Tax Credit Interests: As described in Note 1, Torchmark had $290 million invested in entities which provide certain tax benefits at December 31, 2013. As of December 31, 2013, Torchmark remained obligated under these commitments for $58 million, of which $41 million is due in 2014, $8 million in 2015, $0 million in 2016, and $9 million thereafter.
Investment Commitment: As of December 31, 2013, Torchmark had committed to purchase $33.8 million of private placement investments.
Letters of Credit: Torchmark has guaranteed letters of credit in connection with its credit facility with a group of banks. 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 2015. The maximum amount of letters of credit available is $250 million. Torchmark (parent company) would be liable to the extent that TMK Re, Ltd. does not pay the reinsured party. At December 31, 2013, $198 million of letters of credit were outstanding.
Litigation: Torchmark and its subsidiaries, in common with the insurance industry in general, are subject to litigation, including claims involving tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark’s subsidiaries, employment discrimination, and miscellaneous other causes of action. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, management does not believe that such litigation will have a material adverse effect on Torchmark’s financial condition, future operating results or liquidity; however, assessing the eventual outcome of litigation necessarily involves forward-looking speculation as to judgments to be made by judges, juries and appellate courts in the future. This bespeaks caution, particularly in states with reputations for high punitive damage verdicts. Torchmark’s management recognizes that large punitive damage awards bearing little or no relation to actual damages continue to be awarded by juries in jurisdictions in which Torchmark and its subsidiaries have substantial business, creating the potential for unpredictable material adverse judgments in any given punitive damage suit.
The following is a summary of quarterly results for the two years ended December 31, 2013. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.