(2) Includes Torchmark’s 7.1% Junior Subordinated Debentures reported as “Due to affiliates” on the Consolidated Balance Sheets at year ends 2008 through 2011 in the amount of $123.7 million.
(3) There is an accounting rule requiring available-for-sale fixed maturities to be revalued at fair value each period. The effect of this rule on diluted equity per share reflects the amount added or (deducted) under this rule to produce GAAP Shareholders’ equity per share. Please see the explanation and discussion under the caption Capital Resources in Management’s Discussion and Analysis in this report concerning the effect this rule has on Torchmark’s equity.
Acquisition: On November 1, 2012, we acquired Family Heritage, a previously privately-held supplemental health insurance carrier. Information about this acquisition can be found in Note 6-Acquisition in the Notes to Consolidated Financial Statements. The results of Family Heritage subsequent to our acquisition are included in this discussion within our health insurance segment.
Insurance Product Line Segments. As fully described in Note 14-Business Segments in the Notes to the Consolidated Financial Statements, the product line segments involve the marketing, underwriting, and the administration of policies. Each product line is further segmented by the various distribution units that market the insurance policies. Each distribution unit operates in a niche market offering insurance products designed for that particular market. Whether analyzing profitability of a segment as a whole, or the individual distribution units within the segment, the measure of profitability used by management is the underwriting margin, which is:
Summary of Operations: Net income rose 6% to $529 million in 2012 from $497 million in 2011. It had declined slightly in 2011 from $499 million in 2010. On a diluted per share basis, 2012 net income rose 19% to $5.41 after a 12% increase in 2011 to $4.53 from net income of $4.05 in 2010. The per-share results have exceeded the growth in dollar amounts due to our share repurchase program. Results in 2010 include a $35 million after-tax loss on the disposal of United Investors, representing $.28 per diluted share. Also, each year’s per share net income was affected by realized investment gains, which were $0.25, $0.15, and $0.20 in 2012, 2011, and 2010, 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 to be part of our segment operating income.
As shown in the above chart, after-tax segment results of operations, before discontinued operations, rose each year over the prior year from $480 million in 2010 to $494 million in 2011 to $507 million in 2012. The primary contributor to the growth in both 2011 and 2012 was the underwriting margin in our life insurance segment, in which margins rose $31 million in 2011 and $49 million in 2012. The life insurance segment is our strongest segment and is the largest contributor to earnings in each year presented. Also contributing to growth in 2012 income was our health insurance segment, which provided $8 million of additional margin after a decline of $10 million in 2011. The 2012 improvement was largely due to the increased volume in our Medicare Part D program while the 2011 decline was a result of the discontinuance of sales of certain limited-benefit health products in late 2010 due to healthcare reform. Both 2012 and 2011 have been impacted negatively by declines in excess investment income, the measure of profitability of our investment segment. These declines in excess investment income have resulted from the continuing low interest rate environment which has pressured investment yields and spreads on policy benefit requirements, discussed more fully under the caption Investments in this report.
In 2012, this pressure on excess investment income was increased as an unusual number of calls, resulting from a new regulation affecting bank hybrid securities, caused us to replace these higher yielding securities with securities at lower yields due to the current low-interest-rate environment. Also in 2012, there was a $7 million increase in stock compensation expense which negatively affected the results during the year. The increase 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.
We primarily market Medicare Supplement insurance, Medicare Part D prescription drug insurance, limited-benefit cancer, and accident health products. Prior to September, 2010, we marketed an under-age-65 limited-benefit hospital-surgical product. Health premium increased $117 million or 13% in 2012, as a result of the addition of a large number of new low-income Medicare Part D auto-enrollees in the 2012 plan year. However, 2011 health premium declined 6% to $930 million as a result of the discontinuance of certain limited-benefit health products because of healthcare reform mentioned above. Medicare Supplement remains our largest contributor to total health premium, and we have experienced growth in net sales in this product in each successive year. Medicare Supplement premium was $432 million in 2012 but has declined slightly in each successive year as lapses have exceeded new sales. Our Medicare Part D premium rose 62% to $318 in 2012 as a result of the previously-noted addition of low-income auto-enrollees in the 2012 plan. Due to increased competition for the 2013 plan year, we expect a slight decrease in 2013 Part D premium. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
As previously mentioned, the investment segment’s pretax profitability, or excess investment income, declined in both 2012 and 2011. Profitability in this segment is based on three major components: net investment income, required interest on net policy liabilities (interest applicable to insurance products), and financing costs. In recent years, growth in net investment income has been restricted in relation to the growth in the size of our portfolio. One reason that investment income has grown at a lower rate than mean invested assets has grown in recent years is that new investments have been made at yield rates lower than the yield rates earned on securities that matured or were otherwise disposed of. Also, there is sometimes a lag between the time when proceeds from maturities and dispositions are received and when the proceeds are reinvested, during which the funds are held in cash. Growth in total investment income has also been somewhat negatively affected by Torchmark’s share repurchase program (described later under this caption), which has diverted cash that could have otherwise been used to acquire investments. In 2012, net investment income rose 1% while the portfolio (at amortized cost) grew 4%, as new money yields available have continued to decline.
Torchmark’s current investment policy limits new investment acquisitions to investment-grade fixed maturities generally with longer maturities (often exceeding twenty years) that meet our quality and yield objectives. Approximately 96% of our invested assets at fair value consist of fixed maturities of which 96% were investment grade at December 31, 2012. The average quality rating of the portfolio was A-. The portfolio contains no securities backed by sub prime or Alt-A mortgages, no direct investment in residential mortgages, no counterparty risks, no credit default swaps, or derivative contracts. See the analysis of excess investment income and investment activities under the caption Investments in this report and Note 4-Investments in the Notes to Consolidated Statements of Operations for a more detailed discussion of this segment.
As noted earlier, we issued two new debt offerings during 2012: our $300 million principal amount 3.8% Senior Notes due 2022 and our $125 million principal amount 5.875% Junior Subordinated Debentures due 2052, both issued in September. Proceeds from the Senior Notes were $297 million, but $150 million were purchased by our insurance subsidiaries and were eliminated in consolidation. Proceeds from this offering provided funding for the retirement of our 7 3/8% Senior Notes due in August, 2013 and for the acquisition of Family Heritage in November, 2012. The $121 million net proceeds from the Subordinated Debentures were used to fund the call of our $120 million principal amount 7.1% Trust Originated Preferred Securities in October, 2012. More information on these transactions can be found in Note 6-Acquisition and Note 11-Debt in the Notes to Consolidated Financial Statements and in our discussion of Capital Resources in this report.
The Direct Response Unit reaches the market through a variety of direct-to-consumer marketing approaches which include direct mailings, insert media, internet, and inbound telephone calls. These different approaches support and complement one another in our efforts to reach the consumer. Direct
The Liberty National Agency’s net sales declined 11% to $32 million in 2012, after having declined 19% a year earlier. As is the case with all of our agencies, sales are driven by the size of the agent force. The Liberty agency had 1,419 producing agents at December 31, 2012, compared with 1,345 a year earlier, an increase of 6%. The producing agent count declined 33% during 2011.
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, 2012. 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.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 11% in 2012 and 7% in 2011. The margin increased to $509 million in 2012 after rising to $461 million in 2011. Margin growth in all periods was primarily the result of premium growth. As a percentage of life insurance premium, the margins have risen steadily each year, largely due to improved persistency.
Health insurance, excluding Medicare Part D. Health premium other than Part D has declined in each successive year presented, falling 1% in 2012 to $730 million and declining 6% in 2011. The declines in premium resulted primarily from the previously-mentioned run-off of a block of discontinued hospital-surgical plans. Net sales increased 22% in 2012 to $78 million, due in part to the acquisition of Family Heritage, which contributed 12% of the increase. Net sales declined 1% in 2011 and declined 33% in 2010. First-year collected premium increased 17% in 2012 after a 22% decline in 2011. Family Heritage accounted for 10% of the 2012 increase.
Medicare Supplement provides the greatest amount of health premium, partially because Medicare Supplement products are generally more persistent than the limited-benefit products, but also because of improved sales in recent periods. Medicare Supplement premium represented 59% of non-Part D health premium in 2012, compared with 60% in 2011 and 58% in 2010.
The Family Heritage 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 feature whereby any excess of premiums over claims paid is returned to the policyholder at the end of a specified period stated within the insurance policy. Management expects to grow this agency through geographic expansion and incorporation of Torchmark’s recruiting programs. This agency contributed $30 million in health premium income during the two-month period of 2012. Annualized health premium in force at December 31, 2012 was $188 million.
Health premium at this agency was flat in 2012 at $80 million, after rising 1% in 2011. However, net health sales declined 9% to $9 million in 2012, after a 27% decline in 2011. Because this agency focuses on life products, net health sales comprised only 5% of the American Income Agency’s total net sales in 2012.
Index to Financial Statements 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. Part D net sales were $114 million in 2012, compared with $115 million in 2011 and $39 million in 2010. We count only sales to new first-time enrollees in net sales, and the majority of premium income was from previous enrollees. Total Medicare Part D premium was $318 million in 2012, compared with $197 million in 2011, an increase of 62%. Part D premium declined 6% in 2011.
Index to Financial Statements As presented in the following table, Torchmark’s health insurance underwriting margin before other income and administrative expense increased 4% to $197 million in 2012, but declined 5% in 2011 to $189 million. As a percentage of premium income, margins were 20% in both 2011 and 2010 as compared with 19% in 2012. The 2012 percentage reflects the greater proportion of Medicare Part D business which has a much higher benefit ratio.
Our fixed annuity balances at the end of 2012, 2011, and 2010 were $1.35 billion, $1.29 billion, and $1.24 billion, respectively. Underwriting income was $3.5 million, $2.3 million, $1.3 million in each of the years 2012, 2011, and 2010, respectively.
While the fixed annuity account balance has increased modestly each year over the prior year and underwriting income has increased each year as well, policy charges have actually declined slightly in each successive year. The majority of policy charges consist of surrender charges which are not based on account size. These charges have remained somewhat level in recent periods. A considerable portion of fixed annuity profitability is derived from the spread of investment income exceeding contractual interest requirements, which can result in negative net policy obligations. In each of the years presented, the spreads for fixed annuities increased over the prior year as a result of credited rate reductions on the inforce annuities accounting for the growth in underwriting margin. The amortization of deferred acquisition costs also rose as these costs are amortized in relation to gross profits.
Administrative expenses. Operating expenses are included in the Other and Corporate Segments and are classified into two categories: insurance administrative expenses and expenses of the parent company. The following table is an analysis of operating expenses for the three years ended December 31, 2012.
As a result of the acquisition of Family Heritage in late 2012 as described in Note 6-Acquisition in the Notes to Consolidated Financial Statements, we incurred expenses related to the transaction of $2.9 million. Additionally, as mentioned in Note 1-Significant Accounting Policies, we incurred two settlement expense issues in 2011 that related to events occurring many years ago: the settlement of a state administrative issue of $7 million and a litigation issue in the estimated amount of $12 million. The latter item was settled in that amount in 2012. In addition to these two 2011 items, we sold aviation equipment in 2011 at a loss of $979 thousand. While all of these nonrecurring expenses were included in “Operating expenses” for the respective year in the Consolidated Statements of Operations in accordance with accounting guidance, they are considered as non-operating expenses by management.
Investments. We manage our capital resources including investments, debt, and cash flow through the investment segment. Excess investment income represents the profit margin attributable to investment operations. It is the measure that we use to evaluate the performance of the investment segment as described in Note 14-Business Segments in the Notes to the Consolidated Financial Statements. It is defined as net investment income less both the required interest attributable to net policy liabilities and the interest cost associated with capital funding or “financing costs.” We also view excess investment income per diluted share as an important and useful measure to evaluate the performance of the investment segment. It is defined as excess investment income divided by the total diluted weighted average shares outstanding, representing the contribution by the investment segment to the consolidated earnings per share of the Company. Since implementing our share repurchase program in 1986, we have used over $5.4 billion of cash flow to repurchase Torchmark shares after determining that the repurchases provided a greater return than other investment alternatives. Share repurchases reduce excess investment income because of the foregone earnings on the cash that would otherwise have been invested in interest-bearing assets, but they also reduce the number of shares outstanding. In order to put all capital resource uses on a comparable basis, we believe that excess investment income per diluted share is an appropriate measure of the investment segment.
The largest component of excess investment income is net investment income, as adjusted for the segment analysis, which rose 1% to $716 million in 2012. It increased 3% to $707 million in 2011 from $685 million in 2010. Presented in the following chart is the growth in net investment income compared with the growth in mean invested assets.
Growth in net investment income has generally been slower than growth in mean invested assets in recent years due to the declining interest rate environment. In a declining interest rate environment, the overall portfolio yield will decrease as new money is invested at lower yields, especially when the new investments are replacing higher-yielding investments that mature or are otherwise disposed of. Approximately 50% of the invested assets added in 2010 through 2012 replaced higher-yielding assets that matured or were disposed of during that period. This level of replacement activity was higher than normal.
The combined average interest discount rate has risen in each of the last three years due to the changes in the mix of the in force business discussed above.
However, 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.
Investment Acquisitions. Torchmark’s current investment policy calls for investing almost exclusively in investment-grade fixed maturities generally with long maturities (maturity date more than 20 years after acquisition date) that meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. Further, we believe this strategy is appropriate because our strong positive cash flows are generally stable and predictable. If such longer-term securities do not meet our quality and yield objectives, we consider investing in short-term securities, taking into consideration the slope of the yield curve and other factors at the time. During calendar years 2010 through 2012, Torchmark invested almost exclusively in fixed-maturity securities, primarily with longer-term maturities as presented in the chart below.
During the three years 2010 through 2012, we have invested primarily in investment-grade corporate bonds. Purchases in 2012 and 2011 consisted almost entirely of these corporates. During 2010, we acquired a significant amount of taxable municipal bonds, primarily Build America Bonds authorized by the American Recovery and Retirement Act of 2009. The investments in these municipal bonds consisted almost exclusively of general obligation bonds and revenue bonds for essential services. In assessing the creditworthiness of these bonds, we took into account a number of factors, including the geographic location of the municipalities.
Portfolio Analysis. Because Torchmark has recently invested almost exclusively in fixed-maturity securities, the relative percentage of our assets invested in various types of investments varies from industry norms. The following table presents a comparison of Torchmark’s components of invested assets at amortized cost as of December 31, 2012 with the latest industry data.
At December 31, 2012, approximately 96% of our investments at book value (or amortized cost) were in a diversified fixed-maturity portfolio. Policy loans, which are secured by policy cash values, made up an additional 3%. The remaining balance was comprised of other investments including equity securities, mortgage loans, and other long-term and short-term investments.
At December 31, 2012, fixed maturities had a fair value of $13.5 billion, compared with $11.9 billion at December 31, 2011. At December 31, 2012, fixed maturities were in a $1,578 million net unrealized gain position compared with an unrealized gain position of $964 million at December 31, 2011. Approximately 78% of our fixed maturity assets at December 31, 2012 at amortized cost were corporate bonds and 6% were redeemable preferred stocks. This compares with 77% corporate bonds and 11% redeemable preferred stocks at year end 2011. On a combined basis, residential mortgage-backed securities, other asset-backed securities, and collateralized debt obligations (CDOs) were less than 1% of the assets at amortized cost at December 31, 2012. The $65 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 $13 million of residential mortgage-backed securities are rated AAA. For more information about our fixed-maturity portfolio by component at December 31, 2012 and 2011, including an analysis of unrealized investment losses and a schedule of maturities, see Note 4-Investments in the Notes to Consolidated Financial Statements.
The following table presents the relative percentage of our fixed maturities by industry sector at December 31, 2012.
At December 31, 2012, approximately 27% of the fixed maturity assets at amortized cost (26% at fair value) were in the financial sector, including 15% in life and health or property casualty insurance companies and 7% in banks at amortized cost. Financial guarantors, mortgage insurers, and insurance brokers comprised approximately 5% of the portfolio at amortized cost. After financials, the next largest sector was utilities, which comprised 17% of the portfolio at amortized cost. The balance of the portfolio is spread among 410 issuers in a wide variety of sectors. As previously noted, gross unrealized losses were $89 million at December 31, 2012, declining from $239 million a year earlier. The portfolio was in a net unrealized gain position of $1,578 million at December 31, 2012.
Index to Financial Statements An analysis of the fixed-maturity portfolio by a composite rating at December 31, 2012 is shown in the table below. The composite rating for each security is the average of the security’s ratings as assigned by Moody’s Investor Service, Standard & Poor’s, Fitch Ratings, and Dominion Bond Rating Service, LTD. The ratings assigned by these four nationally recognized statistical rating organizations are evenly weighted when calculating the average.
The portfolio has a weighted average quality rating of A- based on amortized cost. Approximately 95% of the portfolio at amortized cost was considered investment grade. Our investment portfolio contains no securities backed by sub-prime or Alt-A mortgages (loans for which some of the typical documentation was not provided by the borrower). We have no direct investments in residential mortgages, nor do we have any counterparty risks as we are not a party to any credit default swaps or other derivative contracts. We do not participate in securities lending. There are no off-balance sheet investments, as all investments are reported on our Consolidated Balance Sheets. Other than $11 million of German government bonds at amortized cost and fair value, we have no direct exposure to European sovereign debt.
An analysis of changes in below-investment grade fixed maturities at amortized cost is as follows.
Index to Financial Statements Market Risk Sensitivity. Torchmark’s financial securities are exposed to interest rate risk, meaning the effect of changes in financial market interest rates on the current fair value of the company’s investment portfolio. Since 96% of the book value of our investments is attributable to fixed-maturity investments (and virtually all of these investments are fixed-rate investments), the portfolio is highly subject to market risk. Declines in market interest rates generally result in the fair value of the investment portfolio exceeding the book value of the portfolio and increases in interest rates cause the fair value to decline below the book value. Under normal market conditions, we do not expect to realize these unrealized gains and losses because we have the ability and generally the intent to hold these investments to maturity. The long-term nature of our insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase or decrease in the fair value of insurance liabilities and debt due to increases or decreases in market interest rates largely offsets the impact of rates on the investment portfolio. However, in accordance with GAAP, these liabilities are not marked to market.
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, 2012.
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 each year 2010 through 2012 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), $20 thousand in 2011 ($13 thousand after tax), and $5 million in 2010 ($3.2 million after tax). In 2010, we acquired $7.3 million book value of our 9 1/4% Senior Notes at a cost of $8.9 million, resulting in an after-tax loss on debt redemption of $1.1 million. 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).
Parent Company Liquidity. Cash flows from the insurance subsidiaries are used to pay interest and principal repayments on Parent Company debt, operating expenses of the Parent, and Parent Company dividends to Torchmark shareholders. In 2012, the Parent received $493 million of dividends and transfers from its insurance subsidiaries, as compared with $790 million in 2011 and $401 million in 2010. The 2011 dividend included $305 million of additional dividends available as a result of the sale of United Investors. Including transfers from other subsidiaries and after paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), Torchmark Parent had excess operating cash flow in 2012 of approximately $371 million, compared with $672 million in 2011 including the $305 million from the sale of United Investors. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2013, it is expected that the Parent Company will receive approximately $506 million in dividends and transfers from subsidiaries, and that approximately $365 million will be available as excess cash flow. Certain restrictions exist on the payment of these dividends. For more information on the restrictions on the payment of dividends by subsidiaries, see the restrictions section of Note 12-Shareholders’ Equity in the Notes to Consolidated Financial Statements. Although these restrictions exist, dividend availability from subsidiaries historically has been sufficient for the cash flow needs of the Parent Company. As additional liquidity, the Parent held $2 million of cash and short-term investments at December 31, 2012, compared with $27 million a year earlier. The Parent also had available a $144 million receivable from subsidiaries at December 31, 2012.
Short-Term Borrowings. An additional source of parent company liquidity is a line of credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $600 million. As of December 31, 2012, we had available $177 million of additional borrowing capacity under this facility, as we also had a year earlier. There have been no difficulties in accessing the commercial paper market under this facility during the three years ended December 31, 2012. For detailed information about this line of credit facility, see the Commercial Paper section of Note 11-Debt.
Index to Financial Statements Our cash and short-term investments were $157 million at year-end 2012 and $105 million at year-end 2011. 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 $13.6 billion at December 31, 2012. 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.
Off-Balance Sheet Arrangements. As described in Note 11-Debt in the Notes to Consolidated Financial Statements and under the subcaption Funded Debt, Torchmark had outstanding $120 million (par amount) 7.1% Trust Preferred Securities at December 31, 2011, but these securities were redeemed during 2012. The capital trust liable for these securities was the legal entity responsible for the securities and facilitated the payment of dividends to shareholders. The trust was an off-balance sheet arrangement which we were required to deconsolidate in accordance with GAAP rules, because the capital trust was considered to be a variable interest entity in which we had no variable interest. While these liabilities were not on our Consolidated Balance Sheets, they were represented by Torchmark’s 7.1% Junior Subordinated Debentures due to the trust in the amount of $124 million which was on our balance sheet at December 31, 2011 under the caption “Due to affiliates”.
As a part of its above-mentioned credit facility, Torchmark had outstanding $198 million in stand-by letters of credit at December 31, 2012. However, these letters are issued among our subsidiaries and have no impact on company obligations as a whole.
The following table presents information about future payments under our contractual obligations for the selected periods as of December 31, 2012.
Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force at December 31, 2012. 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 $10.7 billion at December 31, 2012, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
The carrying value of the long-term funded debt was $990 million at December 31, 2012, compared with $914 million a year earlier. As fully explained in Note 11-Debt, we issued $300 million principal amount of 3.8% Senior Notes due in 2022 in September, 2012 for proceeds of $297 million in a public offering. However, $150 million of the offering was acquired by Torchmark insurance subsidiaries and was eliminated in consolidation, resulting in net proceeds after issue expenses to the consolidated group of $147 million. The majority of the $297 million proceeds received by the Parent were used to acquire Family Heritage as described in Note 6-Acquisition. The balance was invested to be used for the redemption of our 7 3/8% Senior Notes that mature in August, 2013, or at an earlier time if opportunities to repurchase these notes become available, and for other corporate purposes.
Shareholders’ equity was $4.4 billion at December 31, 2012, compared with $3.9 billion at December 31, 2011. During the twelve months since December 31, 2011, shareholders’ equity was reduced by the $360 million in share purchases under the repurchase program and another $210 million to offset the dilution from stock option exercises, but has been increased by the $529 million of net income, $204 million from option exercises, and by after-tax unrealized gains of $404 million in the fixed maturity portfolio as conditions in financial markets have improved.
Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 10.5 times in 2012, compared with 10.3 times in 2011 and 10.9 times in 2010. 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.
The financial strength of our major insurance subsidiaries is rated by Standard & Poor’s and A. M. Best. The following chart presents these ratings for our four largest insurance subsidiaries at December 31, 2012.
Future Policy Benefits. Because of the long-term nature of insurance contracts, our insurance companies are liable for policy benefit payments that will be made in the future. The liability for future policy benefits is determined by standard actuarial procedures common to the life insurance industry. The accounting policies for determining this liability are disclosed in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements.
Deferred Acquisition Costs. Certain costs of acquiring new business are deferred and recorded as an asset. Deferred acquisition costs eligible for deferral consist primarily of sales commissions and other underwriting costs related to the successful issuance of a new insurance contract as indicated in Note 1-Significant Accounting Policies under the caption Deferred Acquisition Costs in the Notes to Consolidated Financial Statements. Additionally, the cost of acquiring blocks of insurance business or insurance business through the purchase of other companies, known as the value of insurance purchased, is included in deferred acquisition costs. Our policies for accounting for deferred acquisition costs and the associated amortization are reported under the same caption in Note 1.
Torchmark accounts for its variable interest entities under accounting guidance which clarifies the definition of a variable interest and the instructions for consolidating variable interest entities (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.
When a component of Torchmark’s business is sold or expected to be sold during the ensuing year, Torchmark reports the assets and liabilities of the component as assets and liabilities of subsidiaries held for sale. Assets or liabilities of subsidiaries held for sale are segregated and are recorded in the Consolidated Balance Sheets at the lower of the carrying amount or estimated fair value less cost to sell. If the carrying amount of the business exceeds its estimated fair value, a loss is recognized. Torchmark reports the results of operations of a business as discontinued operations when the component is sold or expected to be sold, the operations and cash flows of the business have been or will be eliminated from
The great majority of the Company’s fixed maturities are not actively traded and direct quotes are not generally available. Management therefore determines the fair values of these securities after consideration of data provided by third-party pricing services and independent broker/dealers. Over 99% of the fair value reported at December 31, 2012 was determined using data provided by third-party pricing services. Prices provided by third-party pricing services are not binding offers but are estimated exit values. They are based on observable market data inputs which can vary by security type. Such inputs include benchmark yields, available trades, broker/dealer quotes, issuer spreads, benchmark securities,
bids, offers, and other market data. As part of the Company’s controls over pricing, management reviews and analyzes all prices obtained to insure the reasonableness of the values, taking all available information into account. One very important control is the corroboration of prices obtained from third-party sources against other independent sources. When corroborated prices produce small variations, the close correlation indicates observable inputs, and the median value is used. When corroborated prices present greater variations, additional analysis is required to determine which value is the most appropriate. When only one price is available, management evaluates observable inputs and performs additional analysis to confirm that the price is appropriate. All fair value measurements based on prices determined with observable market data are reported as Level 1 or Level 2 measurements.
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, 2012 and 2011, 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 reported as Level 3. The measurement is then 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, 2012 and 2011, fair value measurements classified as Level 3 represented 2.1% and 0.4%, 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 small portfolio of private placement bonds which are not actively traded. This portfolio is managed by a third party and was $184 million at amortized cost on December 31, 2012. The portfolio manager provides valuations for the bonds based on a 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, 2012, all private placements were classified as Level 3.
Impairment of Investments: Torchmark’s portfolio of fixed maturities fluctuates in value due to changes in interest rates in the financial markets as well as other factors. Fluctuations caused by market interest rate changes have little bearing on whether or not the investment will be ultimately recoverable. Therefore, Torchmark considers these declines in value resulting from changes in market interest rates to be temporary. In certain circumstances, however, Torchmark determines that the decline in the value of a security is other-than-temporary and writes the book value of the security down to its fair value, realizing an investment loss. The evaluation of Torchmark’s securities for other-than-temporary impairments is a process that is undertaken at least quarterly and is overseen by a team of Company investment and accounting professionals. Each security which is impaired because the fair value is less than the cost or amortized cost is identified and evaluated. The determination that an impairment is other-than-temporary is highly subjective and involves the careful consideration of many factors. Among the factors considered are:
difference between the security’s amortized cost and the present value of expected future cash flows discounted at the security’s original effective yield rate. The temporary portion is the difference between this present value of expected future cash flows and fair value (as discounted by a market yield). The expected cash flows are determined using judgment and the best information available to the Company. Inputs used to derive expected cash flows include expected default rates, current levels of subordination, and loan-to-collateral value ratios. Management believes that the present value of future cash flows at the original effective yield is a better measure of valuation, because fair value is based on limited observable market data, and the market for these securities is neither active nor orderly.
Future Policy Benefits: The liability for future policy benefits for universal life-type products is represented by policy account value. The liability for future policy benefits for all other life and health products, approximately 82% of total future policy benefits, is determined on the net level premium method. This method provides for the present value of expected future benefit payments less the present value of expected future net premiums, based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were considered appropriate at the time the policies were issued. Assumptions used for these traditional life and health insurance products are based on Torchmark’s previous experience with similar products. Assumptions for interest rates range from 2.5% to 7.0% for Torchmark’s insurance companies with an overall weighted average assumed rate of 5.9%. Mortality tables used for individual life insurance include various statutory tables and modifications of a variety of generally accepted actuarial tables. Morbidity assumptions for individual health are based on either Company experience or the assumptions used in determining statutory reserves. Withdrawal and termination assumptions are based on Torchmark’s experience. Once established, assumptions for these products are generally not changed. An additional provision is made on most products to allow for possible adverse deviation from the assumptions. These estimates are periodically reviewed and compared with actual experience. If it is determined that existing contract liabilities, together with the present value of future gross premiums, will not be sufficient to cover the present value of future benefits and to recover unamortized acquisition costs, then a premium deficiency exists. Such a deficiency would be recognized immediately by a charge to earnings and either a reduction of unamortized acquisition costs or an increase in the liability for future policy benefits. From that point forward, the liability for future policy benefits would be based on the revised assumptions.
Deferred Acquisition Costs: Certain costs of acquiring new insurance business are deferred and recorded as an asset. These costs are essential to the acquisition of new insurance business and are directly related to the successful issuance of an insurance contract including sales commissions, policy issue costs, and underwriting costs for policies that are successfully issued. Additionally, deferred acquisition costs include the value of insurance purchased, which are the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies. These costs represent the difference between the fair value of the contractual insurance assets acquired and liabilities assumed and the assets and liabilities for insurance contracts that the Company issues or holds measured in accordance with GAAP. Deferred acquisition costs and the value of insurance purchased are amortized in a systematic manner which matches these costs with the associated revenues. Policies other than universal life-type policies are amortized with interest over the estimated premium-paying period of the policies in a manner which charges each year’s operations in proportion to the receipt of premium income. Limited-payment contracts are amortized over the contract period. Universal life-type policies are amortized with interest in proportion to estimated gross profits. The assumptions used to amortize acquisition costs with regard to interest, mortality, morbidity, and persistency are consistent with those used to estimate the liability for future policy benefits. For interest-sensitive and deposit-balance type products, these assumptions are reviewed on a regular basis and are revised if actual experience differs significantly from original expectations. For all other products, amortization assumptions are generally not revised once established. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing to determine if there is a premium deficiency. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost asset. These cash flows consist primarily of premium income, less benefits and expenses taking inflation into account. The present value of these cash flows, less the benefit reserve, is then compared with the unamortized deferred acquisition cost balance. In the event the estimated present value of net cash flows is less, the deficiency would be recognized by a charge to earnings and either a reduction of unamortized acquisition costs or an increase in the liability for future benefits, as described under the caption Future Policy Benefits.
Advertising Costs: Costs related to advertising are generally charged to expense as incurred. However, certain direct response advertising costs are capitalized when there is a reliable and demonstrated relationship between total costs and future benefits that is a direct result of incurring these costs. Torchmark’s Direct Response advertising costs consist primarily of the production and distribution costs of direct mail advertising materials, and when capitalized are included as a component of deferred acquisition costs. They are amortized in the same manner as other deferred acquisition costs. Direct response advertising costs charged to earnings and included in other operating expense were $16 million, $16 million, and $12 million in 2012, 2011, and 2010, respectively. Capitalized advertising costs were $1.04 billion at December 31, 2012 and $1.00 billion at December 31, 2011.
Low-Income Housing Tax Credit Interests: As of December 31, 2012, Torchmark had $285 million invested in limited partnerships that provide low-income housing tax credits and other related Federal income tax and state premium tax benefits to Torchmark. The carrying value of Torchmark’s investment in these entities was $293 million at December 31, 2011. As of December 31, 2012, Torchmark was obligated under future commitments of $67 million, which amount is included in the above carrying value. Interests for which the return has been guaranteed by unrelated third-parties are accounted for using the effective-yield method. The remaining interests are accounted for using the amortized-cost method.
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, 2012, $275 million associated with the Federal interests was included in “Other assets” with the remaining $10 million state-related interests included in “Other invested assets.” At December 31, 2011, the comparable amounts were $281 million and $12 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.
Torchmark has tested its goodwill annually in each of the years 2010 through 2012. These tests, performed in the third quarter each year, involved assigning carrying value by allocating the Company’s net assets to each of the reporting units of Torchmark’s segments, including the portion of goodwill
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 2010 through 2012 is as follows:
The expected term is generally derived from Company experience. However, expected terms of grants made under the Torchmark Corporation 2005 Incentive Plan (2005 Plan) and the 2007 Long-Term Compensation Plan (2007 Plan), involving grants made in the years 2005 through 2010, were determined based on the simplified method as permitted by Staff Accounting Bulletins 107 and 110. This method was
used because the 2005 and 2007 Plans limited grants to a maximum contract term of seven years, and Torchmark had no previous experience with seven-year contract terms. Prior to 2005, substantially all grants contained ten-year terms. Because a large portion of these grants vest over a three-year period, the Company did not have sufficient exercise history during 2010 or previous years to determine an appropriate expected term on these grants. Beginning in 2011, all grants with seven-year terms are based on Company experience. The Torchmark Corporation 2011 Incentive Plan replaced the previous plans and allows for option grants with a ten-year contractual term which vest over five years in addition to seven-year grants which vest over three years as permitted by the previous plans. The Company has no historical experience with five-year vesting, and will therefore use the simplified method to determine the expected term for these grants until such experience is developed. Volatility and risk-free interest rates are assumed over a period of time consistent with the expected term of the option. Volatility is measured on a historical basis. Monthly data points are utilized to derive volatility for periods greater than three years. Expected dividend yield is based on current dividend yield held constant over the expected term. Once the fair value of an option has been determined, it is amortized on a straight-line basis over the employee’s service period for that grant (from the grant date to the date the grant is fully vested).
Segment revenues differ from discontinued revenues by the amount of realized investment gains/losses, which Torchmark excludes from its consideration of ongoing operations.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2012 and 2011 is as follows:
Proceeds from sales including discontinued operations were $326 million in 2010.
Transfers into Level 2 from Level 3 result from the availability of observable market data when a security is valued at the end of a period. Transfers into Level 3 occur when there is a lack of observable market information. Transfers into Level 1 from Level 2 occur when direct quotes are available; transfers from Level 1 into Level 2 result when only observable market data and no direct quotes are available.
Other-than-temporary impairments: Torchmark has determined that certain of its holdings in fixed maturity investments were other-than-temporarily impaired during the three years ended December 31, 2012. The following table presents the writedowns recorded due to these impairments in accordance with accounting guidance and whether the writedown was charged to earnings or other comprehensive income.
As of year end 2012, previously written down securities remaining in the portfolio were carried at a fair value of $48 million. Otherwise, as of December 31, 2012, 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.
Unrealized gain/loss analysis. As conditions in financial markets have improved since 2009, unrealized gains in the portfolio have occurred and losses have declined. Net unrealized losses on fixed maturities of $455 million at December 31, 2009 became net unrealized gains of $108 million at December 31, 2010. During 2011, net unrealized gains rose to $964 million at December 31, 2011 and to $1.6 billion at December 31, 2012. At December 31, 2012, investments in securities in the financial sector were in a $339 million unrealized gain position compared with an unrealized gain position of $14 million at December 31, 2011. Investments in securities in the other sectors had net unrealized gains of $1.2 billion in 2012 and $950 million in 2011. The following tables disclose gross unrealized investment losses by class of investment at December 31, 2012 and December 31, 2011. Torchmark considers these investments to be only temporarily impaired.
The fair value for mortgages was approximately $0.5 million at December 31, 2012 and $0.6 million at December 31, 2011. The fair value for collateral loans was approximately $7 million at December 31, 2011. Accumulated depreciation on investment real estate was $2.1 million at December 31, 2012 and $1.8 million at December 31, 2011.
Torchmark had $125 thousand in fixed maturities at book value ($150 thousand at fair value) that were non-income producing during the twelve months ended December 31, 2012. Torchmark had $2.6 million in investment real estate at December 31, 2012 which was non-income producing during the previous twelve months. Torchmark did not have any other invested assets that were non-income producing during the twelve months ended December 31, 2012.
Family Heritage was founded in 1989 and is headquartered in Cleveland, Ohio. It is a specialty insurer focused primarily on selling protection-oriented individual supplemental health insurance products through a captive agency force. Torchmark believes that Family Heritage is an excellent fit with Torchmark’s existing insurance business, given that Family Heritage’s operations are consistent with Torchmark’s strategy of selling basic protection products in relatively non-competitive markets through controlled distribution channels. Acquisition expenses in connection with the transaction charged to Torchmark’s earnings in 2012 were $2.9 million ($1.9 million after tax). These costs were included as “Other operating expense” in the Consolidated Statement of Operations for 2012.
The acquisition was accounted for under the purchase method of accounting as required by accounting guidance. This guidance requires that the total purchase price be allocated to the assets acquired and liabilities assumed based on their fair values at the acquisition date. The results of operations since the acquisition date have been consolidated. A summary of the net assets acquired is as follows:
Claims paid in each of the years 2010 through 2012 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 2010 through 2012, 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 2010 through 2012, 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 has a Supplemental Executive Retirement Plan (SERP), which provides to a limited number of executives an additional supplemental defined pension benefit. The supplemental benefit is based on the participant’s qualified plan benefit without consideration to the regulatory limits on compensation and benefit payments applicable to qualified plans, except that eligible compensation is capped at $1 million. The SERP is unfunded. However, life insurance policies on the lives of plan participants have been established for this plan with an unaffiliated insurance carrier. The premiums for this coverage paid in 2012 were $1.7 million and in 2011 were $3.9 million. The cash value of these policies at December 31, 2012 was $18 million and was $16 million a year earlier. Additionally, a Rabbi Trust was established for this plan in 2010 in the amount of $21 million to support the liability for this plan. Additional deposits of $5 million in 2012 and $5 million in 2011 were added to this trust as an investment account was established in 2011. Investments consist of exchange traded funds. As of December 31, 2012, the combined value of the insurance policies and the trust investments was $54 million, compared with $43 million a year earlier. Because this plan is unqualified, the Rabbi Trust and the policyholder value of these policies are not included as defined benefit plan assets but as assets of the Company. They are included with “Other Assets” in the Consolidated Balance Sheets. The liability for this SERP at December 31, 2012 was $59 million and was $47 million a year earlier.
The other supplemental benefit pension plan is limited to a very select group of employees and was closed as of December 31, 1994. It provides the full benefits that an employee would have otherwise received from a defined benefit plan in the absence of the limitation on benefits payable under a qualified plan. This plan is unfunded. Liability for this closed plan was $3 million at both December 31, 2012 and 2011. Pension cost for both supplemental defined benefit plans is determined in the same manner as for the qualified defined benefit plans.
The accumulated benefit obligation (ABO) for Torchmark’s funded defined benefit pension plans was $321 million and $263 million at December 31, 2012 and 2011, respectively. In the unfunded plans, the ABO was $52 million and $39 million at December 31, 2012 and 2011, respectively.
The following table presents a reconciliation of the benefit obligation and plan assets from the beginning to the end of the year. As these plans are unfunded, funded status is equivalent to the accrued benefit liability.
(11) Interest paid at 3 month LIBOR plus 330 basis points, resets each quarter.
The amount of debt that becomes due during each of the next five years is: 2013-$319 million; 2014-$0; 2015-$0; 2016-$250; 2017-$0 and thereafter-$753 million.
Commercial Paper: In December, 2010, Torchmark entered into a credit facility with a group of lenders allowing unsecured borrowings and stand-by letters of credit up to $600 million. The facility includes a provision which allows Torchmark to increase the facility limit by $200 million if certain conditions are met. The Company also has the ability to request up to $250 million in letters of credit to be issued against the facility. The agreement is set to terminate on January 7, 2015. The credit facility is further designated as a back-up credit line for a commercial paper program, where Torchmark may borrow from either the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed the facility limit less any letters of credit issued. Interest is charged at variable rates. The facility does not have a ratings-based acceleration trigger which would require early payment. A facility fee is charged for the entire facility. There is also an issuance fee for letters of credit issued. Torchmark is subject to certain covenants for the agreements regarding capitalization and earnings, with which it was in compliance at December 31, 2012 and throughout the three-year period ended December 31, 2012. Borrowings on the credit facilities are reported as short-term debt on the Consolidated Balance Sheets. A table presenting selected information concerning Torchmark’s short-term borrowings is presented below.
shareholders from Torchmark’s retained earnings, retained earnings as of December 31, 2012 were restricted by lenders’ covenants which require the Company to maintain and not distribute $3.23 billion from its total consolidated retained earnings of $3.40 billion.
Ten year grants - vest one fourth in two years, and one fourth in each of the next three years.
Employees - vest one half in two years, and one half in three years.
Restricted stock units outstanding at each of the year ends 2012, 2011, and 2010 were 53,272, 42,938, and 29,872, respectively. Restricted stock units are only available to directors, and are not converted to shares until the director’s retirement, death, or disability. There were no unvested director restricted shares outstanding at the end of any of the years 2010 through 2012. Director restricted stock and restricted stock units are generally granted on the first working day of the year and vest in six months. Dividend equivalents are earned on restricted stock units only. They are granted in the form of additional restricted stock units and vest immediately upon grant.
The following table summarizes information about stock options outstanding at December 31, 2012.
Reclassification of interest amount due to accounting rule requiring deconsolidation of Trust Preferred Securities.
Low-Income Housing Tax Credit Interests: As described in Note 1, Torchmark had $285 million invested in entities which provide certain tax benefits at December 31, 2012. As of December 31, 2012, Torchmark remained obligated under these commitments for $67 million, of which $47 million is due in 2013, $16 million in 2014, $1 million in 2015, and $3 million thereafter.
As of December 31, 2012, securities of state and municipal governments represented 10% of invested assets at fair value. Such investments are made throughout the U.S. At year-end 2012, 5% or more of the state and municipal bond portfolio at fair value was invested in securities issued within the following states: Texas (31%), Ohio (8%), Washington (7%), Illinois (5%), and Alabama (5%). Otherwise, there was no significant concentration within any given state.
Corporate debt and equity investments are made in a wide range of industries. Below are the ten largest industry concentrations held in the corporate portfolio at December 31, 2012, based on fair value:
reputations for high punitive damage verdicts such as Alabama and Mississippi. 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, particularly Alabama and Mississippi, creating the potential for unpredictable material adverse judgments in any given punitive damage suit.
As previously reported in Securities and Exchange Commission (SEC) filings on March 15, 2011, purported class action litigation was filed against American Income and Torchmark in the District Court for the Northern District of Ohio (Fitzhugh v. American Income Life Insurance Company and Torchmark Corporation, Case No. 1:11-cv-00533). The plaintiff, a formerly independently contracted American Income agent, alleged that American Income intentionally misclassified its agents as independent contractors rather than as employees in order to escape minimum wage and overtime requirements of the Fair Labor Standards Act, as well as to avoid payroll taxes, workers compensation premiums and other benefits required to be provided by employers. Monetary damages in the amount of unpaid compensation plus liquidated damages and/or prejudgment interest as well as injunctive and/or declaratory relief were sought by the plaintiff on behalf of the purported class. On November 3, 2011, the Court granted American Income’s motion to compel arbitration and dismissed the case. Plaintiffs appealed this decision. In May 2012, the parties negotiated a settlement of this matter and filed a joint motion for its approval by the Court. On December 4, 2012, the Court entered an order approving the settlement and dismissing the case with prejudice.
With respect to its current litigation, at this time management believes that the possibility of a material judgment adverse to Torchmark is remote and no estimate of range can be made for loss contingencies that are at least reasonably possible but not accrued.