Liberty, Globe, and W&R also lease district office space for their agency sales personnel. All of the other Torchmark companies lease their office space in various cities in the U.S.
During 1997, the income producing office buildings owned by TDC, Globe and W&R were contributed into TMK Income Properties, L.P. ("TIP"), a partnership which is wholly-owned by Torchmark subsidiaries. These properties include: 1.) a 300,000 square foot office building at 204 North Robinson, Oklahoma City, of which Globe occupies 56,000 square feet as its home office and the remaining space is either leased or available for lease; 2.) a 330,000 square foot office building complex at 14000 Quail Springs Parkway Plaza Boulevard, Oklahoma City, which is 100% leased; 3.) an 80,000 square foot office building at 120 Robert S. Kerr Avenue, Oklahoma City, which is available for lease; 4.) three office buildings in suburban Kansas City totaling 120,000 square feet which are 99% leased; 5.) five office buildings in Liberty Park in suburban Birmingham, Alabama containing approximately 450,000 square feet which are 90% leased. In addition, TIP has the following development projects underway: 1.) 6329 Glenwood in suburban Kansas City, a 64,542 square foot office building which is 75% pre-leased and scheduled for completion in May, 1998; 2.) River Village, a 46,000 square foot expansion to an existing
- ------------------------------------------------------------------------------- (1) Excludes realized investment gains (losses), the related adjustment to deferred acquisition costs, and discontinued operations. (2) Includes accrued investment income. (3) Computed after deduction of preferred shareholders' equity. (4) Annualized life premium in force includes $144 million, and annualized health premium in force includes $37 million, representing the business acquired in the acquisition of American Income Life Insurance Company in 1994.
Torchmark cautions readers regarding certain forward-looking statements contained in the following discussion and elsewhere in this document, and in any other statements made by, or on behalf of Torchmark whether or not in future filings with the Securities and Exchange Commission ("SEC"). Any statement that is not a historical fact, or that might otherwise be considered an opinion or projection concerning Torchmark or its business, whether express or implied, is meant as and should be considered a forward-looking statement. Such statements represent management's opinions concerning future operations, strategies, financial results or other developments.
Forward-looking statements are based upon estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond Torchmark's control. If these estimates or assumptions prove to be incorrect, the actual results of Torchmark may differ materially from the forward-looking statements made on the basis of such estimates or assumptions. Whether or not actual results differ materially from forward- looking statements may depend on numerous foreseeable and unforeseeable events or developments, which may be national in scope, related to the insurance industry generally, or applicable to Torchmark specifically. Such events or developments could include, but are not necessarily limited to, deteriorating general economic conditions leading to increased lapses and/or decreased sales of Torchmark's policies, changes in governmental regulations (particularly those impacting taxes and mandates for health insurance products), financial markets trends that adversely affect sales of Torchmark's market-sensitive products, interest rate changes that adversely affect product sales and/or investment portfolio yield, increased pricing competition, adverse regulatory developments and adverse litigation results. Readers are also directed to consider other risks and uncertainties described in other documents filed by Torchmark with the SEC.
Per share net operating income for Torchmark was $2.60 for the year 1997, increasing 18% over 1996 per share earnings of $2.21, reflecting solid growth in both Torchmark's insurance and asset management segments. Net operating income is income from continuing operations excluding realized investment gains and losses and the related adjustment to deferred acquisition costs. All per share amounts have been restated for prior periods to reflect the two-for- one stock split paid in the form of a dividend on Torchmark shares in the third quarter of 1997. Net operating income rose 13% in 1996 over 1995 per- share earnings.
Torchmark's net income from continuing operations grew 6% in the 1997 period. On a per-share basis, net income from continuing operations was $2.43 in 1997, compared with $2.24 in 1996 and $1.90 in 1995, rising 8% and 18% in each of the years 1997 and 1996, respectively. Realized investment losses were $37 million in 1997, compared with a gain of $6 million in 1996, resulting primarily from the intentional sale of fixed-maturity investments at a loss to offset current and prior year taxable gains. Realized investment losses for 1995 included a $15 million after-tax, or $.10 per share, writedown of an investment in Southwestern Life Corporation, which filed for Chapter 11 bankruptcy protection in the third quarter of 1995.
Net income in both 1996 and 1995 were negatively affected by Torchmark's decision to dispose of its energy segment and to exit the energy industry in late 1995. In accordance with this decision, the net assets and results attributable to this segment were reflected as discontinued operations in Torchmark's financial statements. Disposition of the energy segment was completed on September 30, 1996, and resulted in an after-tax loss of $7 million or $.05 per share. Additionally, in conjunction with Torchmark's decision to dispose of this segment in 1995, Torchmark wrote down its investment in a coalbed methane gas development to the investment's estimated net realized value because increased production difficulties led to downward revisions to engineering reserve estimates. The writedown amounted to an after-tax charge of $130 million, or $.91 per share in 1995. For more information on the disposition of the energy segment, see "Disposal of Energy Segment" on page 30 of this report.
the exercise used by Torchmark to buy shares. Diluted net income per share was $2.39 in 1997, increasing 10% over 1996 net income per share of $2.17. Diluted net operating income per share was $2.56 in 1997, compared with $2.19 in 1996, an increase of 17%. Per share net operating income on a diluted basis was $1.95 in 1995.
Revenues in 1997 were $2.28 billion, growing 3% over 1996 revenues of $2.21 billion. After adjustment for the above-mentioned realized investment gains and losses in both 1997 and 1996, revenues gained 5% in 1997. Total premium increased $68 million or 4% in 1997, accounting for 57% of the $119 million increase in total revenues excluding realized gains and losses. Life insurance premium increased $55 million, or 6%. Life premium accounted for 46% of the increase in adjusted total revenues. Financial services revenue climbed 12% and net investment income increased 7%. Financial services revenue is derived from the asset management operations and activities of W&R.
The effective tax rate for Torchmark was 35.0% in 1997, compared with 36.5% in 1996 and 36.8% in 1995. The 1997 decline was the result of a recovery of state income taxes from a unitary filing for 1997. Without this one-time recovery, Torchmark's effective tax rate would have been 36.1% in 1997.
The equity in earnings of affiliate represents Torchmark's approximately 27% ownership in Vesta Insurance Group, Inc. ("Vesta"), a property-casualty insurance carrier formerly wholly-owned by Torchmark. Torchmark's earnings from this investment have grown in each of the years presented and in 1997 rose 22%.
- -------- *Tax equivalent basis (Net investment income for insurance operations only, before intercompany eliminations)
In recent years, Torchmark has emphasized the sale of life insurance products relative to health insurance because of higher profit margins associated with life business. Also, the greater asset base from the higher level of reserves required on life business allows Torchmark the opportunity to increase investment income. This emphasis is evidenced by the growth in life underwriting income relative to that of health. In 1997, life underwriting income (before other income and administrative expenses) was 61% of total underwriting income before expenses, compared with 58% in 1996 and 56% in 1995. Health insurance underwriting income declined from 40% in 1995 to 38% in 1996 and 35% in 1997.
Annualized life insurance premium in force was $1.01 billion at December 31, 1997, climbing over the $1 billion milestone for the first time in its history. Annualized premium in force grew 6% in 1997 from $947 million at year-end 1996. Annualized life premium in force rose 9% during 1996 from $869 million. Annualized premium in force and issued data includes amounts collected on certain interest-sensitive life products which are not recorded as premium income but excludes single-premium income and policy account charges.
Life insurance products are marketed through a variety of different distribution channels. The following table presents life insurance premium by distribution method during each of the three years ended December 31, 1997.
Direct response marketing is conducted through direct mail, co-op mailings, television and consumer magazine advertising, and direct mail solicitations endorsed by groups, unions and associations. The direct response operation is a profitable distribution channel for Torchmark characterized by lower acquisition costs than Torchmark's other agency-based marketing systems. This operation has grown rapidly. In 1997, it had Torchmark's highest growth in life insurance premium in both dollar amount and percentage increase, and accounted for over 21% of Torchmark's life insurance premium. Direct response premium was $195 million in 1997, increasing 14% over 1996 premium of $172 million. Direct response life premium in 1996 grew 15% over 1995 premium of $149 million. Direct response annualized premium issued increased 28% in 1997 to $79 million. Annualized premium in force grew 15% in 1997 to $233 million, after having increased 12% in 1996.
The Liberty National Exclusive Agency distribution system accounted for the largest portion of life insurance premium income in each of the three years presented, with 1997 premium of $281 million representing 31% of Torchmark's total life premium. Liberty's annualized life premium in force was $299 million at year-end 1997, compared with $298 million and $297 million at year- ends 1996 and 1995, respectively. Life premium sales, in terms of annualized premium issued, declined 5% during 1997 to $43 million and 6% during 1996 to $45 million. This agency has completed the transition from a debit-style renewal premium collection system to a direct bill or bank-draft collection system. As a result, the transition away from debit-style sales led to a decline in the number of sales agents during the transition period of 1994 through 1996. New agent recruiting programs were implemented late in 1996, resulting in the number of sales agents increasing slightly from year-end 1996 to a total of 1,750 at year-end 1997. The number of first year agents increased from 625 at year-end 1996 to 754 at year-end 1997. During 1997 new training programs were implemented to improve the retention of newly recruited agents beyond their first year anniversaries which should further enhance sales growth. Management believes that continual recruiting of new agents and retention of productive agents are critical to the continued growth of sales in controlled agency distribution systems.
Life insurance is distributed through a nationwide independent agency whose sales force is comprised of former commissioned and non-commissioned military officers who sell exclusively to commissioned and non-commissioned military officers and their families. This business is comprised of whole life products with term insurance riders. The quality of the business produced by this agency is outstanding, and is characterized by extremely low lapse rates. Life premium income from this distribution system grew 12% to $80 million in 1997. Premium in 1996 rose 56% to $71 million, up $26 million from 1995. The 1996 increase resulted primarily from the acquisition from another carrier of a block of business with $21 million of annualized premium in force produced by the military agency. In the past, this agency has produced business through Liberty, but beginning in 1997, additional sales were produced by Globe. Production in the military distribution system almost doubled in 1997, with sales of annualized premium of $16 million, compared with $8 million in 1996. Annualized premium in force was $86 million at year-end 1997, an increase of 16% over 1996 annualized premium of $74 million. Premium in force for 1996 rose 53% from $48 million in 1995, largely a result of the acquired block of business.
The American Income Agency is a distribution system that focuses on members of labor unions, credit unions, and other associations for its life insurance sales. At December 31, 1997, premium from this system accounted for 21% of Torchmark's total life premium. It is a high margin business characterized by lower policy obligation ratios. American Income's premium rose 10% in 1997 to $191 million, after having risen 13% in 1996 to $174 million. Annualized premium was $203 million at year-end 1997, rising 8% in 1997 and 11% in 1996. Sales in terms of annualized premium issued were $55 million in 1997, compared with $54 million in 1996 and $51 million in 1995.
The United Investors exclusive agency is made up of W&R sales representatives, and accounts for approximately 9% of Torchmark's life premium. This agency markets the life insurance products of UILIC, and will continue to do so after the planned spin-off of W&R. (See Initial Public Offering and Planned Spin-off of the Asset Management Segment on page 30 of this report). Premium income rose 6% in both 1997 and 1996, and was $78 million in 1997. Annualized premium in force was $89 million at year-end 1997, growing 5%.
Torchmark's insurance underwriting income as a percentage of premium was approximately 27% in each of the years presented, with 1997 showing a slight improvement over 1996. Stronger persistency has contributed to Torchmark's life insurance profitability and stability in margins. Persistency is beneficial to margins because it lowers the rate of amortization of acquisition costs and increases profits as the premium life is extended. Persistency improvements have resulted over the past few years from a variety of factors, including the previously-mentioned changes in the Liberty National Exclusive Agency marketing system. Another contributing factor to improved persistency in life business is a higher proportion of premium from the military distribution system, which has a very low lapse rate.
Health Insurance. Torchmark markets its health insurance products through several of its distribution channels. The following table indicates health insurance premium income during each of the three years ended December 31, 1997 by distribution method.
Health insurance premium rose 1% in 1997 to $739 million, giving Torchmark its first year-over-year increase in health premium since 1993. Health premium declined 3% in 1996 from $755 million to $733 million. Annualized premium in force for health insurance grew 2% to $762 million at December 31, 1997, over the prior year-end balance of $748 million. Health premium in force declined 1% in 1996. Sales of health premium, in terms of annualized premium issued, were $107 million in 1997, gaining 6% over 1996 sales of $101 million. The 1997 gains in both annualized health premium in force and annualized premium issued were Torchmark's first year-over-year increases in each respective category in five years.
Health products sold by Torchmark insurance companies include Medicare Supplement insurance, cancer insurance, long-term care, and other under-age-65 limited-benefit supplemental medical and hospitalization products. As a percentage of annualized health premium in force at December 31, 1996, Medicare Supplement accounted for 69%, cancer 18%, and other health products 13%. Medicare Supplement's annualized premium in force was $522 million at December 31, 1997. Torchmark's Medicare Supplement sales and premium in force base have stabilized from the declines experienced in the last few years.
In recent years, pressure on Medicare Supplement sales has come from federal mandates implemented in 1992 that substantially reduced allowable first year agents' commissions. As a result, many independent agencies that previously accounted for most of Torchmark's sales of this product left the Medicare Supplement market, adversely affecting sales. Torchmark has implemented certain measures to offset the decline. Medicare Supplement products are now primarily sold by the United American exclusive agency, which is less subject to the financing pressures of independent agencies. Further, very cost- efficient sales leads for this agency are provided by Torchmark's direct response operation. This agency also benefits from the low cost, highly service-oriented back office administration which frees agents to devote full time to sales. In the last few years the primary competition affecting Medicare Supplement sales has come from Medicare health maintenance organizations ("HMOs"), the managed care alternative to traditional fee-for- service Medicare. However, during the last year, growing public dissatisfaction with HMO service, and increased federal regulatory pressures on HMOs, appear to be making Medicare HMOs a less attractive alternative. While 1997 Medicare Supplement sales were down slightly, from $66 million in 1996 to $65 million, sales in the second half of 1997 increased 6% over the first half of the year.
Annuity premium is added to the annuity account balance as a deposit and is not reflected in income. Revenues on both fixed and variable annuities are derived from charges to the annuity account balances for insurance risk, administration, and surrender, depending on the structure of the contract. Variable accounts are also charged an investment fee and a sales charge. Torchmark benefits to the extent these policy charges exceed actual costs and to the extent actual investment income exceeds the investment income which is credited to policyholders.
Insurance operating margins for annuities, as measured by the mean reserve, have shown a modest decline throughout the three years examined. Annuity policy charges have increased in each period. Annuity policy charges rose 27% in 1997 to $29 million, largely as a result of growth in the variable account balance. Policy charges grew 18% in 1996 to $22 million. Growth in policy charges results not only from the increase in size of the annuity account balances, but is also attributable to the increase in the number of annuity contracts in force and the cumulative effect of the growth in sales over the past few years on which the sales charge is based. The investment spread is the investment income earned in excess of policy requirements on fixed annuity contracts. As a percentage of the mean reserve, the interest spread has declined slightly in 1997 and 1996 because of the proportional decrease in size of the fixed account balance relative to the total account balance.
Torchmark's financial services operations include the marketing of 25 mutual funds, including the United Group and the W&R Group of funds through exclusive financial planners. These representatives also market a variety of insurance products of Torchmark subsidiaries. Asset management operations also involve the management of mutual fund portfolios, the management of institutional portfolios, and the servicing of customer accounts. Revenues are derived from commissions from the sale of investment and insurance products, fees for management of investment asset portfolios, and fees for servicing the accounts.
- -------- * Financial services revenue includes $33.0 million in 1997, $33.1 million in 1996, and $27.5 million in 1995 representing revenues from other Torchmark segments which are eliminated in consolidation.
Asset management fees of $120 million in 1997 were the largest component of financial services revenues, representing 49% of 1997 segment revenues. Asset management fees were up 16% in 1997, after having risen 20% to $103 million in 1996. Increases in these fees have occurred due to the growth in mutual fund assets and institutional assets under management, on which asset management fees are based. Average assets under management rose 12% in 1997 and 17% in 1996. Average mutual fund assets under management grew 19% in 1997. Growth in average assets under management in 1997 and 1996 resulted from two factors. First, strength in the financial markets caused increases in the values of fund securities. Secondly, new investment product sales and reinvested dividends in each period contributed to asset growth. Total assets under management were $23.4 billion at December 31, 1997, an increase over the prior year end of 23%. Total assets under management were $19.1 billion at December 31, 1996 and $18.5 billion at December 31, 1995. Mutual fund assets under management rose 20% in 1997 to $20.6 billion at year-end 1997. They rose 14% in 1996 to $17.2 billion at year end. The composition of the portfolios managed has bearing on the relationship of asset management fees to assets under management. Equity-oriented portfolios have higher fee rates than fixed- income portfolios. Therefore, asset management fees grew at a higher rate than assets under management in 1996 primarily because of a change in the type of assets under management. The total increase in assets under management for the 1996 period of $.6 billion was the result of a $2.1 billion increase in mutual fund assets partially offset by a $1.5 billion decrease in institutional assets. The mutual fund assets that were added have a higher management fee rate than the institutional assets that were lost.
Pretax operating income for the asset management segment rose 9% in 1997 to $122 million. Pretax income increased 20% in 1996 from $94 million. Margins for this segment have exceeded 50% in each of the periods considered. Margin improvements have resulted, in large part, from the increase in the proportion of asset management fees, which has a higher margin than other revenue sources.
Torchmark's net investment income increased 7% to $434 million during the year, which follows an increase of 6% in 1996 and an increase of 10% in 1995. When adjusted for the acquisition of American Income in late 1994, however, the 1995 increase was 3%. As in the past several years, the increase in 1997 investment income primarily resulted from the continued accumulation of invested assets, which rose 8% to $6.3 billion at amortized cost by year end. Invested assets increased by 5% in 1996 and 6% in 1995. Mean invested assets at amortized cost, adjusted for the disposition of Torchmark's energy operations, were $6.1 billion in 1997, $5.7 billion in 1996, and $5.4 billion in 1995.
With the quality and liquidity of its fixed-income investments, Torchmark can minimize the level of its short-term investments, which totaled $123 million at year-end 1997 and $85 million at year-end 1996. The following table presents investments by expected maturity.
Fixed income investments continue to represent 90% of invested assets, which causes the percentage holdings of the other types of investments to vary from the latest industry averages. The following table presents Torchmark's components of the investment portfolio compared with industry data.
Torchmark profits to the extent that its net investment income exceeds the interest cost attributable to its net insurance policy liabilities and financing costs. The following table presents Torchmark's excess investment income, or tax equivalent net investment income in excess of its net policy reserve requirements and financing costs, as well as the related assets and liabilities.
Excess investment income increased 19% in 1997 and 16% in 1996, as compared to increases in tax equivalent investment income of 7% and 6%, respectively. The higher growth in excess investment income relative to tax equivalent investment income resulted from greater growth in average invested assets than in average net interest-bearing insurance policy liabilities. In addition, financing costs, which consist of interest on debt and dividends on the monthly income preferred securities, were 20% of tax equivalent investment income in 1997, down from 22% in 1996 and 25% in 1995.
Market Risk Sensitivity. Market risk is a risk that the value of a security will change because of a change in market conditions. Torchmark's primary exposure to market risk is interest rate risk which is the risk that a change in a securities' value could occur from a change in interest rates. This risk is significant to Torchmark's investment portfolio because its fixed-income holdings amount to 90% of total investments. The effects of these interest rate fluctuations on fixed investments are reflected on an after-tax basis in Torchmark's shareholders' equity from marking these investments to market as required by SFAS 115.
Market risk is managed in a manner consistent with Torchmark's investment objectives of maintaining a high-quality fixed-maturity portfolio. No derivative instruments are used to manage its exposure to market risk in the investment portfolio. A swap instrument was entered into to allow Torchmark to participate in the downward trend in interest rates in connection with its Monthly Income Preferred Securities as discussed in the Notes to the Consolidated Financial Statement on page 56 of this report and in Capital Resources of page 29 of this report. A cap instrument was also entered into to protect Torchmark from the market risk on an increase in rates associated with the swap on this security. Volatility in the value of Torchmark's fixed-income holdings is reduced by maintaining a relatively short-term portfolio, of which 77% matures within ten years. Also, the portfolio and market conditions are constantly evaluated for appropriate action.
Torchmark's cash and short-term investments were $149 million at December 31, 1997, compared with $103 million at year-end 1996. These liquid assets represented over 1% of total assets at December 31, 1997, approximately the same percentage as at the end of the previous year. In addition to Torchmark's liquid assets, Torchmark has a portfolio of marketable fixed and equity securities which are available for sale should the need arise. These securities had a value of $5.9 billion at December 31, 1997.
Torchmark has in place a line of credit facility with a group of lenders which allows unsecured borrowings up to a specified maximum amount. The maximum amount was increased during 1996 to $600 million and was at this level on December 31, 1997. Interest is charged at variable rates for borrowings. This line of credit is further designated as a backup credit line for a commercial paper program not to exceed $600 million, whereby Torchmark may borrow from either the credit line or issue commercial paper at any time but may not borrow in excess of a total of $600 million on the combined facilities. At December 31, 1997, $139 million in commercial paper was outstanding and there were no borrowings on the line of credit. A fee is charged on the entire $600 million facility. In accordance with the agreements, Torchmark is subject to certain covenants regarding capitalization and earnings. At December 31, 1997, Torchmark was in full compliance with these covenants.
Capital Resources. Torchmark's capital structure consists of its long and short-term debt, its Cumulative Monthly Income Preferred Securities, Series A ("MIPS"), and its shareholders' equity. Torchmark's debt consists primarily of its funded debt and its commercial paper facility. The carrying amount of Torchmark's funded debt was $772 million at year-end 1997, compared with $792 million at year-end 1996. Major debt issues outstanding at December 31, 1997 were as follows:
Short-term debt consists of the current maturity of long-term debt, amounting to $208 million at December 31, 1997, and Torchmark's commercial paper outstanding, which was $139 million at year-end 1997. Short-term debt was $41 million a year earlier, and consisted of commercial paper borrowings. The additional short-term borrowings in 1997 were necessary for a pay down of $20 million in long-term debt and for other corporate purposes. In 1996, Torchmark paid down $148 million of this debt with internal cash flow.
On September 25, 1997, Torchmark executed a stock option exercise and reload program through which over 100 Torchmark directors and employees exercised vested stock options and received replacement options at current market price. This program resulted in the issuance of 4.8 million shares, but over 3 million of the new shares were immediately sold by the directors and employees through the open market to cover the cost of the purchased shares and related taxes. As a result of the reload program, management's ownership interest increased, and Torchmark received a significant current tax benefit from the exercise of the options.
Initial Public Offering and Planned Spin-off of Asset Management Segment: In November 1997, Torchmark announced that W&R, its asset management subsidiary, intended to make an initial public offering of common stock early in 1998, subject to market conditions. It was also announced that Torchmark plans to distribute to its shareholders its remaining W&R shares in a tax-free spin-off late in 1998, subject to market conditions, regulatory approval, and tax-free status. Torchmark believes that the separation of the asset management business from the insurance businesses would allow the financial community to more accurately value each company relative to its industry, thereby enhancing total shareholder value.
Disposal of Energy Segment. On September 30, 1996, Torchmark completed the sale of its energy business segment including its energy asset management subsidiary, Torch Energy Advisors Incorporated ("TEAI"), and its Black Warrior coalbed methane investment. These operations, which were reclassified as discontinued operations in Torchmark's financial statements at December 31, 1995, were sold to a TEAI management group. After the sale, Torchmark had no controlling ownership interest in any energy asset management organization.
In addition to previously transferred securities, warrants, and Section 29 energy-related tax credits, which approximated $112 million at closing, Torchmark received subordinated debt and notes totaling
Litigation. Torchmark and its subsidiaries continue to be named as parties to pending or threatened litigation, most of which involve punitive damage claims based upon allegations of agent misconduct at Liberty in Alabama. Such punitive damage claims are tried in Alabama state courts where any punitive damage litigation has the potential for significant adverse results. It is impossible to predict the extent of punitive damages that may be awarded if liability is found in any given case, since the amount of punitive damages in Alabama is left largely to the discretion of the jury in each case. It is thus difficult to predict with certainty the liability of Torchmark or its subsidiaries in any given case because of the unpredictable nature of this type of litigation.
We have audited the consolidated financial statements of Torchmark Corporation and subsidiaries as listed in Item 8. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in Item 14(a). These consolidated financial statements and financial statement schedules are the responsibility of Torchmark's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three- year period ended December 31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, Torchmark adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, in 1995.
TORCHMARK CORPORATION CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA)
Basis of Presentation: The accompanying financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Principles of Consolidation: The financial statements include the results of Torchmark Corporation ("Torchmark") and its wholly-owned subsidiaries. Subsidiaries which are not majority-owned are reported on the equity method. All significant intercompany accounts and transactions have been eliminated in consolidation.
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 shareholders' equity. 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 shareholders' equity. Policy loans are carried at unpaid principal balances. Mortgage loans are carried at amortized cost. Investments in real estate are reported at cost less allowances for depreciation, which are calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities within three months. Other long-term investments are carried at fair value. If an investment becomes permanently impaired, such impairment is treated as a realized loss and the investment is adjusted to net realizable value.
Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark's net income. Investment income attributable to all other insurance policies and products is included in Torchmark's net investment income. Net investment income for the years ended December 31, 1997, 1996, and 1995 included $308.6 million, $298.4 million, and $279.6 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocable to insurance policyholders' liabilities.
Reclassification: Certain amounts in the financial statements presented have been reclassified from amounts previously reported in order to be comparable between years. These reclassifications have no effect on previously reported shareholders' equity or net income during the periods involved.
Earnings Per Share: Torchmark adopted SFAS 128, "Earnings per share," effective year end 1997. This standard requires the dual presentation of basic and diluted earnings per share ("EPS") on the face of the income statement and a reconciliation of basic EPS to diluted EPS. As required by SFAS 128, all prior-period EPS data has been restated for comparability. Basic EPS is computed by dividing income available to common stockholders by the weighted average common shares outstanding for the period. Weighted average common shares outstanding for each period are as follows: 1997--139,202,354, 1996-- 142,459,783, 1995--143,187,547. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts which could be exercised or converted into common shares. Weighted average diluted shares outstanding for each period are as follows: 1997-- 141,431,156, 1996--143,783,218, 1995--144,228,248.
Torchmark had $30.5 million and $39.2 million in investment real estate at December 31, 1997 and 1996, respectively, which was nonincome producing during the previous twelve months. These properties included primarily construction in process and land. Torchmark had $107 thousand in non-income producing mortgages as of year end 1997. There were no fixed maturity investments, or other long-term investments which were nonincome producing at December 31, 1997.
Derivative investments were immaterial to Torchmark at December 31, 1997. These investments consist of interest-only and principal-only collateralized mortgage obligations and a foreign currency trading account. Torchmark's total carrying value of these investments was $26.4 million and $26.3 million at December 31, 1997 and 1996, respectively. Torchmark has no off-balance sheet exposure in connection with these investments.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $16.6 million, $18.9 million, and $20.0 million, for the years ended December 31, 1997, 1996, and 1995, respectively. The average interest rates used for the years ended December 31, 1997, 1996, and 1995 were 7.19%, 7.26%, and 7.26%, respectively. The estimated amount of the unamortized balance at December 31, 1997 to be amortized during each of the next five years is: 1998, $22.7 million; 1999, $19.9 million; 2000, $17.4 million; 2001, $15.2 million, and 2002, $13.5 million.
In November 1997, Torchmark announced that W&R, its asset management subsidiary, intended to make an initial public offering of common stock early in 1998, subject to market conditions. It was also announced that Torchmark plans to distribute to its shareholders its remaining W&R shares in a tax-free spin-off late in 1998, subject to market conditions, regulatory approval and tax-free status.
On March 5, 1998, W&R sold 23.9 million shares of Class A Common Stock in a public offering. Net proceeds were approximately $516 million after underwriters' fees and expenses. W&R will use $481 million of the net proceeds to repay existing notes owed to Torchmark and other subsidiaries. The remaining $35 million will be used by W&R for general corporate purposes. Torchmark will use the $481 million proceeds to pay down debt, invest in fixed maturity investments, acquire stock, and for other corporate purposes.
W&R contributed $244 million in revenues and $117 million to Torchmark's pretax income in 1997. At December 31, 1997, its assets were $447 million and shareholders' equity was $250 million before giving effect to a $480 million dividend to Torchmark. As a result of the planned spin-off, Torchmark's debt- to-capitalization ratio should be improved and its interest coverage ratio minimally affected. As more fully discussed in Note 10, the spin-off, if and when completed, will constitute the distribution of a portion of the policyholders' surplus account resulting in the recognition of a current tax expense of approximately $50 million.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 7--DISPOSAL OF ENERGY SEGMENT
On September 30, 1996, Torchmark completed the sale of its energy business segment including its energy asset management subsidiary, Torch Energy Advisors Incorporated ("TEAI"), and its Black Warrior coalbed methane investment. These operations, which were reclassified as discontinued operations in Torchmark's financial statements at December 31, 1995, were sold to a TEAI management group. After the sale, Torchmark had no controlling ownership interest in any energy asset management organization.
In the first quarter of 1996, TEAI sold 1.5 million of its shares in Nuevo Energy Company ("Nuevo") common stock for proceeds of $35.6 million. These proceeds were transferred to Torchmark in the form of a dividend prior to the sale of TEAI. Additionally, included in the above mentioned transferred marketable securities were 1.3 million shares of Nuevo common stock which were sold in the fourth quarter of 1996 for proceeds of $57.6 million.
A summary of the assumptions used in determining the liability for future policy benefits at December 31, 1997 is as follows:
1950-54 Select and Ultimate Table 1954-58 Industrial Experience Table 1955-60 Ordinary Experience Table 1965-70 Select and Ultimate Table 1955-60 Inter-Company Table 1970 United States Life Table 1979-81 United States Life Table 1975-80 Select and Ultimate Table X-18 Ultimate Table
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 10--INCOME TAXES
Torchmark and most of its subsidiaries file a life-nonlife consolidated federal income tax return. American Income files its own consolidated federal income tax return and will not be eligible to join Torchmark's consolidated return group until 2000.
In 1997, 1996, and 1995, deferred income tax expense was incurred because of certain differences between net operating income before income taxes as reported on the consolidated statement of operations and taxable income as reported on Torchmark's income tax returns. As explained in Note 1, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
The effective income tax rate differed from the expected 35% rate as shown below:
The reduction in Torchmark's 1997 effective tax rate was a result of a recovery of state income taxes from a unitary filing in 1997. Without this one-time recovery, Torchmark's effective tax rate would have been 36.1% in 1997.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. Contributions are made to the pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Accrued pension expense in excess of amounts contributed has been recorded as a liability in the financial statements and was $8.8 million and $6.2 million at December 31, 1997 and 1996, respectively. The plans covering the majority of employees are organized as trust funds whose assets consist primarily of investments in marketable long-term fixed maturities and equity securities which are valued at market.
The Senior Debentures, remaining principal amount of $99 million, are due August 15, 2009. They bear interest at a rate of 8 1/4%, with interest payable on February 15 and August 15 of each year. The Senior Debentures, which are not redeemable at the option of Torchmark prior to maturity, provided the holder with an option to require Torchmark to repurchase the debentures on August 15, 1996 at principal amount plus accrued interest. Pursuant to this option, $550 thousand debentures were repurchased in 1996. The Senior Debentures have equal priority with other Torchmark unsecured indebtedness.
Torchmark has entered into a revolving credit agreement with a group of lenders under which it may borrow on an unsecured basis up to $600 million. The commitment matures October 22, 2002.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 12--NOTES PAYABLE (CONTINUED) Borrowings are at interest rates selected by Torchmark based on either the corporate base rate or the Eurodollar rate at the time of borrowings. At December 31, 1997 and December 31, 1996 there were no borrowings under the revolving credit agreement. The revolving credit agreement is designed to back up a commercial paper program which began in 1995. The short-term borrowings under the revolving credit agreements and in the commercial paper market averaged $89 million during 1997, and were made at an average yield of 5.61%. At December 31, 1997, commercial paper was outstanding in the face amount of $139 million. Torchmark is subject to certain covenants for the revolving credit agreements regarding capitalization and earnings, for which it was in compliance at December 31, 1997, and pays a facility fee based on size of the line.
In October, 1994, Torchmark, through its wholly-owned finance subsidiary, Torchmark Capital L.L.C., completed a public offering of eight million shares of 9.18% MIPS at a face amount of $200 million. The securities are subject to a mandatory redemption in full at September 30, 2024, although Torchmark may elect to extend the MIPS for up to an additional 20 years if certain conditions are met. They are redeemable at Torchmark's option after September 30, 1999. Torchmark subsequently entered into a ten-year swap agreement with an unaffiliated party whereby Torchmark agreed to pay a variable rate on the $200 million face amount in exchange for payment of the fixed dividend. In a related transaction, Torchmark purchased a five-year cap on the swap agreement that insures that the variable rate cannot exceed 10.39% through September 30, 1999. The interest rate was 7.36% at December 31, 1997 and 6.95% at December 31, 1996. Torchmark pays a yearly fee of $860 thousand for the cap agreement. The market value of the swap agreement was a benefit of $18.7 million December 31, 1997 and $14.7 million at December 31, 1996. The market value of the cap agreement, net of the present value of future annual payments, was an obligation of $.8 million at December 31, 1997 and $1.3 million at December 31, 1996. Except as otherwise described in "Note 3--Investments" on page 43 of this report, Torchmark is a party to no other derivative instruments as defined by SFAS 119.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 14--SHAREHOLDERS' EQUITY
Grant of Restricted Stock: A grant of 120,000 Torchmark shares was made on May 1, 1991 to a Torchmark senior officer. The shares are restricted as to resale, vesting 12,000 shares per year for 10 years on the anniversary date of the grant. The market value of Torchmark stock was $17.46 per share on the grant date. On January 1, 1998, 117,500 shares were granted to four executive officers of Torchmark or its subsidiaries. These shares vest over eight years in accordance with the following schedule: 16% on the first anniversary, with the vesting percentage declining one percent each year thereafter until the eighth anniversary. The market value of Torchmark stock was $42.1875 per share on the grant date.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 15--EMPLOYEE STOCK OPTIONS (CONTINUED)
On September 25, 1997, Torchmark executed a stock option exercise and "reload" program through which over 100 Torchmark directors and employees exercised vested stock options and received replacement options at current market price. This program resulted in the issuance of 4.8 million shares, of which over 3 million shares were immediately sold by the directors and employees through the open market to cover the cost of the purchased shares and related taxes. As a result of the "reload" program, management's ownership interest increased, and Torchmark received a significant current tax benefit from the exercise of the options.
The weighted average fair value of options granted during the years ended December 31, 1997, 1996 and 1995 were $8.43, $5.08, and $3.95, respectively.
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 $2.5 million per life. Life insurance ceded represents less than 1.0% of total life insurance in force at December 31, 1997. Insurance ceded on life and accident and health products represents .8% of premium income for 1997. 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 represents 2.8% of life insurance in force at December 31, 1997 and reinsurance assumed on life and accident and health products represents 1.8% of premium income for 1997.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) NOTE 16--COMMITMENTS AND CONTINGENCIES (CONTINUED)
It has been previously reported that Liberty was a party to 53 individual cases filed in Chambers County, Alabama involving allegations that an interest-sensitive life insurance policy would become paid-up or self- sustaining after a specified number of years. Only four of these cases remain pending with all others having been settled and dismissed by the Chambers County Circuit Court.
Prior filings have reported that the Mobile County, Alabama Circuit Court had ordered a reduction to $37,500 of the $5.0 million judgment against Liberty in Strickland v. Liberty National Life Insurance Company, Case No. CV- 95-1399. This order was appealed by the plaintiffs to the Alabama Supreme Court, which affirmed the lower court's decision on February 13, 1998.
As previously reported, Liberty is a party to two lawsuits alleging that a class of persons were insured under Liberty cancer policies when Liberty knew that such persons were not entitled to retain any benefits under these policies, one of which was filed in 1996 in the Circuit Court of Jefferson County, Alabama (Harris v. Liberty National Life Insurance Company, Case No. CV-96-01836) and the other in the Circuit Court of St. Clair County, Alabama (Gentry v. Liberty National Life Insurance Company, Case No. CV-97-61). The St. Clair County Circuit Court conditionally certified a class in Gentry while the Jefferson County Circuit Court stayed the Harris case pending resolution of the Gentry case and did not certify a class in Harris. Plaintiffs in Harris then filed a petition for a writ of mandamus with the Alabama Supreme Court in Gentry seeking to preserve the class claims in their action in the Jefferson County Circuit Court. On January 30, 1998, the Alabama Supreme Court issued the writ of mandamus to the St. Clair County
Circuit Court in the Gentry case. On February 20, 1998, Liberty filed a motion to dismiss the class claims in the Gentry case with the St. Clair County Circuit Court.