Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Liberty owns a 487,000 square foot building in Birmingham, Alabama which currently serves as Liberty’s, United Investors’, and Torchmark’s home office. Approximately 160,000 square feet of this building is leased or available for lease to unrelated tenants by Liberty. Liberty also operates from 48 company-owned district offices used for agency sales personnel.
The tables in Note 13-Business Segments reconcile Torchmark’s revenues and expenses by segment to its major income statement line items for each of the years in the three-year period ending December 31, 2005. Additionally, this Note provides a summary of the profitability measures that demonstrates year-to-year comparability and which reconciles to Torchmark’s net income. That summary is reproduced below from the Consolidated Financial Statements to present Torchmark’s overall operations in the manner that management uses to manage the business.
Summary of Operations: Torchmark’s net income increased 6% or $27 million to $495 million in 2005, and 9% or $38 million to $469 million in 2004. The growth in earnings in both periods came primarily from the life insurance segment, although the investment and health segments contributed significantly in 2004. Health margins improved in 2004, but were relatively flat in 2005. Excess investment income declined for the first time in ten years in 2005, compressed by a flattening yield curve in that year.
The life insurance segment added $29 million to the 2005 increase in pretax earnings, and $28 million to the 2004 increase. The 2005 growth in life insurance resulted from margin improvements and 5% premium growth, although there was a decline in sales volume. Growth in 2004 was also a result of increases in premium income and margins. Life insurance segment results are discussed further under the caption Life Insurance.
Torchmark has previously stated that it offers annuities, but does not plan to emphasize annuity products, favoring life insurance instead. See the caption Annuities for further discussion.
Total revenues rose 2% in 2005 to $3.1 billion. In 2004, total revenues increased 5% to $3.07 billion from $2.93 billion in 2003. The life premium increase was the primary contributor to revenue growth in both periods, although net investment income also contributed to the revenue growth in both periods.
In 2005, Torchmark had immaterial after-tax realized investment gains compared with gains of $14 million in 2004 and losses of $2 million in 2003. Under the caption Realized Gains and Losses in this report, Torchmark presents a complete analysis and discussion of its realized gains and losses. Also, as explained in Note 13-Business Segments in the Notes to the Consolidated Financial Statements, Torchmark management does not consider realized gains and losses to be a component of its core insurance operations or its operating segments. However, they can have a material positive or negative impact on net income.
As of January 1, 2004, Torchmark adopted Statement of Position 03-1 (SOP 03-1), an accounting rule concerning guaranteed minimum policy benefits on variable annuities. The adoption of this standard resulted in a one-time after-tax charge of $7.2 million recorded as a change in accounting principle. Also, during 2004, Torchmark received a refund of state income taxes in the amount of $3.0 million, after Federal tax. This refund resulted from the settlement of certain state tax issues concerning a discontinued operation in the mid-1990s. The refund reduced income tax expense in the 2004 Consolidated Statement of Operations.
In 2003, net income was impacted by two nonrecurring items. First, Torchmark sold an airplane and recognized a pretax loss of $.8 million. In the Consolidated Statements of Operations, this item was included as an administrative expense. Secondly, the settlement of a Federal tax issue resulted in interest due Torchmark in the pretax amount of $4.3 million. This item was included in investment income on the Consolidated Statements of Operations. Because the tax issue covered a period of many years, the interest income on the tax refund exceeded the refund itself. After expenses, the effect of the tax refund on earnings was immaterial. Significant gains or losses from non-investment property or significant interest income from non-investment sources are unusual for Torchmark.
Torchmark has in place an ongoing share repurchase program which began in 1986 and was reaffirmed at its July 28, 2005 Board of Director’s meeting. With no specified authorization amount, management determines the amount of repurchases based on the amount of the Company’s excess cash flow, general market conditions, and other alternative uses. The majority of these purchases are made from excess operating cash flow when market prices are favorable. Additionally, when stock options are exercised, proceeds from these exercises and the Company’s tax benefit are used to repurchase additional shares on the open market to minimize dilution as a result of the option exercises. The following chart summarizes share purchase activity for each of the three years ended December 31, 2005.
Throughout the remainder of this discussion, share purchases refer only to those made from excess cash flow.
Life insurance. Life insurance is Torchmark’s largest insurance segment. Its premium is also growing at a greater rate than the other insurance segments. In 2005, life premium represented 59% of total premium, compared with 56% in 2004 and 55% in 2003. Life underwriting income before other income and administrative expense represented 67% of the total in 2005, compared with 65% in both 2004 and 2003. Additionally, investments supporting the reserves for life products result in the majority of excess investment income attributable to the investment segment.
Torchmark management uses four statistical measures as indicators of premium growth and sales over the near term: “annualized premium in force,” “annualized premium issued,” “net sales,” and “first-year collected premium.” Annualized premium in force is defined as the premium income that would be received over the following twelve months at any given date on all active policies if those policies remain in force throughout the twelve-month period. Annualized premium in force is an indicator of growth in
premium revenue. Annualized premium issued (sold) is that amount of annualized premium in force added from new sales in a given period, and is an indicator of the acceleration of premium growth. Net sales is annualized premium issued, net of cancellations in the first thirty days after issue, except in the case of Direct Response where net sales is annualized premium issued at the time the first full premium is paid after any introductory offer period has expired. Management believes that net sales is a superior indicator of the rate of premium growth relative to gross annualized premium issued. First-year collected premium is defined as the premium collected during the reporting period for all policies in their first policy year. First-year collected premium takes lapses into account in the first year when lapses are more likely to occur, and thus is a useful indicator of how much new premium is expected to be added to premium income in the future. Annualized life premium in force was $1.6 billion at December 31, 2005, an increase of 4% over $1.5 billion a year earlier. Annualized life premium in force was $1.4 billion at December 31, 2003.
The following table sets forth net sales information for each of the last three years by distribution method.
expects that sales to the juvenile market and their parents will continue as one of this group’s premier markets. Management believes that the Direct Response Unit is the largest U.S. writer of juvenile direct response life insurance.
While the Direct Response group experienced strong growth in sales in 2003 and 2004, as evidenced by increases in both net sales and first-year collected premium, sales growth was not as strong in 2005. Net sales rose 28% in 2003 to $97 million and 14% in 2004 to $111 million, but increased 1% in 2005 to $112 million. First year collected premium grew 24% in 2003 and 19% in 2004, but rose 3% to $77 million in 2005. It should be noted that the volumes measured by both of these indicators in 2005 exceeded comparable amounts in the two strong-growth prior periods (2003 and 2004). Due to the nature of Torchmark’s Direct Response business, the rate of sales growth can vary from year to year. However, growth in Direct Response life premium has trended upward in a relatively stable manner, and the premium growth rate has averaged an increase of 11% over the past ten years.
The American Income Exclusive Agency focuses on members of labor unions, credit unions, and other associations for its life insurance sales. It is a high profit margin business characterized by lower policy obligation ratios. Life premium for this agency rose 9% to $380 million in 2005, after having increased 11% in 2004. Net sales declined 4% in 2005 to $84 million from $88 million in 2004. Net sales were $97 million in 2003, resulting in a decrease of 9% in 2004. First-year collected premium also declined 4% in 2005, after having increased 5% in 2004 and 19% in 2003. As in the case of all of Torchmark’s agency distribution systems, continued increases in product sales are largely dependent on increases in agent count. The American Income agent count was 2,027 at December 31, 2005 compared with 2,090 a year earlier, declining 3%. The agent count declined 9% in 2004 from 2,291 at year end 2003. In its efforts to recruit new agents, Torchmark recently implemented a new incentive program to reward growth in both the recruiting of new agents and in the production of new business. Additionally, the Company continues to utilize its systematic, centralized internet recruiting program to add new agents.
The Liberty National Exclusive Agency distribution system markets its life products to primarily middle-income customers in Southeastern states, but has recently expanded into several other states. Liberty’s life premium declined slightly in both 2005 and 2004 compared with the respective prior year. Annualized life premium in force was $318 million at December 31, 2005, flat with 2004 after having declined 1% in 2004 from 2003. Life premium sales for this agency, in terms of net sales, were $47 million in 2005, representing a decrease of 4% in 2005 after having decreased 8% in 2004. First-year collected premium declined 9% in 2005 to $36 million. First-year collected premium was flat in 2004 with the prior year at $40 million.
Torchmark’s Military Agency consists of a nationwide independent agency whose sales force is comprised 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 and is characterized by low lapse rates. In 2005, life premium was $199 million or 14% of Torchmark’s total life premium. Premium increased 7% in 2005 from $187 million. Premium also rose 12% in both 2004 and 2003. Annualized premium in force rose 3% in 2005 to $205 million after an increase of 11% in 2004 and 13% in 2003. Military net sales declined 37% in 2005 to $18 million. These sales rose 4% in 2004. First-year collected premium declined 20% in 2005 to $22 million after an increase in 2004 of 13%. This agency’s sales have been under pressure as it reorganizes its non-life (non-Torchmark) products. This reorganization included reduced commission rates on non-Torchmark investment products, and resulted in a loss of 30% of this agency’s producing agents appointed with Torchmark in 2005. Margins in the Military group were negatively affected by hostilities in the Middle East in all three periods, resulting in higher than expected benefits paid of $3.9 million in 2005, $4.0 million in 2004, and $1.1 million in 2003.
Torchmark’s Other Agencies consist of the United Investors Agency, the United American Independent and Branch Office Agencies, and other small miscellaneous sales agencies. The United Investors Agency is comprised of several independent agencies that concentrate on annuity business. United Investors represents approximately 5% of Torchmark’s life premium income. The loss of a significant marketing group in 2001 has had a negative impact on production in the United Investors Agency since that time. The United American Independent and Branch Office Agencies combined represented approximately 4% of Torchmark’s total life premium. Life premium income and sales for these two agencies has declined for the past three years because they focus on health insurance, with life sales being incidental.
Torchmark markets its supplemental health insurance products through a number of distribution channels with the two United American agencies being the market leaders. Over the past three years, Torchmark has placed greater emphasis on the sale of limited-benefit health insurance products rather than Medicare Supplement insurance as customer demand for the limited benefit hospital/surgical plans has increased, and price competition and lesser demand for Medicare Supplements has dampened sales of that product. While Medicare Supplement still remains Torchmark’s dominant health product in terms of premium income, the other limited-benefit health products have been growing rapidly in their contribution to health premium. As shown in the chart above, Medicare Supplement premium represented 60% of total health premium in 2005, but has declined steadily as a percentage of total health premium in each successive year. Accordingly, limited-benefit health products have increased as a percentage of total health premium each year during the same period.
The United American Branch Office and Independent Agencies. As discussed above, the two United American Agencies have emphasized sales of individual supplemental limited-benefit health plans known generally as hospital/surgical plans for which demand has increased in recent years. These plans provide a per diem payment for each hospital inpatient day confined, a fixed-amount surgical schedule, some out patient coverage, and other miscellaneous hospital-related charges. They also contain caps on total per-illness benefits. Consumer interest in these products has increased as a result of growing unavailability or lack of affordability of individual major-medical plans and decreased coverage offered by employers. Minimum regulatory loss ratios on these limited-benefit plans are generally lower than those of Medicare Supplement; however, the Medicare Supplement product has higher persistency rates, resulting in both products having approximately the same underwriting margin as a percentage of premium. Both of the United American agencies offer these limited-benefit plans.
The United American Branch Office is an exclusive agency, meaning the agents in its 99 offices nationwide sell only for the Company. In recent years, this agency has been successful in building sales of limited-benefit plans to replace the decline in Medicare Supplement sales. Net sales of limited-benefit plans in 2005 were $78 million, a 26% increase. Net sales in 2004 were $62 million, a 41% increase over 2003. As a result, total health sales at the UA Branch Office were $96 million, a 16% increase over 2004, including the decline in Medicare Supplement sales. Premium from limited-benefit plans at the UA Branch Office increased by 33% to $95 million in 2005 compared with 2004, but total health premium remained
The United American Independent Agency is composed of over 27,000 independent agencies whose size range from very large, multi-state organizations down to one-person offices, all of whom generally sell for a number of insurance companies. In the recent past, most of this agency’s health sales came from one large independent agency. However, in 2005, the UA Independent Agency’s net health sales dropped by 32% to $59 million, reflecting an earlier disruption in that leading agency’s recruiting and training program that resulted in a decline in producing agents. While 2005 limited-benefit premium of $98 million at the UA Independent Agency was up 1% compared with 2004, Medicare Supplement premium of $344 million declined 7%. The UA Independent Agency has the largest in force block of Medicare Supplement policies. Total health premium for 2005 at this agency was $442 million, declining 6% from 2004, while 2004 premium of $468 million was unchanged from 2003.
Liberty National Exclusive Agency, predominately a life insurance distribution channel, is the third largest writer of Torchmark health business based on premium collected. Cancer supplemental plans are the limited-benefit health products primarily produced by this agency and Liberty is the only Torchmark distribution channel for which cancer insurance is its primary health product. Approximately one half of the cancer block consists of a closed block of business which arose from a class-action settlement in the mid-1990s. Prior to 2005, significant rate increases to offset deteriorating margins on the closed block were a continuing factor causing growth in health premium, but increasing claims continued to reduce underwriting margins. Early in 2005, Liberty settled a class-action lawsuit that arose over the timing and size of the rate increases on the closed block. The settlement provides for claims incurred after the effective date of the settlement in early March 2005 to be paid on an actual incurred basis, rather than a billed basis, which management estimates will reduce benefits paid going forward. It also provides for a grandfathered period for certain claimants that will allow them to be paid at billed rates for one year. The settlement further requires Liberty to reduce premiums and to maintain an 85% claims loss ratio over the remaining life of the business. As a result, premiums are estimated to decline from about $70 million per year prior to the settlement to about $50 million in force when the settlement is fully phased in, assuming no lapsed policies. Prior to the settlement, Liberty has had a claims loss ratio above 100% on this block.
Health premium at Liberty declined 9% to $149 million in 2005 compared with 2004 because of the reduced premiums on the closed block of cancer business, as described above. 2004 health premium of $164 million remained unchanged from 2003. Net health sales for 2005 increased 5% to $14 million compared with 2004 net health sales of $13 million, which were up 12% compared with 2003.
Health premium for 2005 increased 7% over 2004 to $64 million, while 2004 premium of $60 million increased 7% over 2003. Net health sales of $11 million in 2005 declined 6% compared with 2004, but net sales of $12 million increased 1% over 2003. Net health sales comprised only 12% of American Income Agency’s total net sales in 2005.
New health product offering-Medicare Part D. In 2005, United American contracted with Centers for Medicare and Medicaid Services (CMS) to be an insurer under the government’s new prescription drug plan for Medicare beneficiaries. Unlike the traditional Medicare program for hospital and doctor services, where CMS is the primary insurer and private Medicare Supplement insurers like United American are secondary insurers, insurers participating in Part D are the primary insurers for plans regulated by CMS. CMS will pay approximately two thirds of the premium with the insured Medicare beneficiary paying one third of the premium. For 2006, United American will collect monthly premiums averaging $65.00 from CMS and $34.50 from each insured who joins UA’s plan. Sales solicitations were allowed to begin in October 2005 with the coverage becoming effective January 1, 2006. By January 31, 2006, United American had enrolled 121 thousand insureds into its Part D plan. Enrollment for 2006 coverage can continue until May 15, 2006. Details of the United American Part D plan can be viewed at www.unitedamericanpartd.com.
For all three periods shown in the chart above, account balances declined, which resulted in reductions in policy fees and charges. Policy obligations also declined in each period. In all three periods, investment income earned exceeded required interest credited to fixed accounts resulting in negative net required interest on reserves. As a result, insurance underwriting margin for annuities (before other income and administrative expenses) increased 18% from $11.8 million in 2003 to $14.0 million in 2004, but declined 10% to $12.6 million in 2005. Margins were benefited by a decline in guaranteed minimum policy benefits in 2004 to $2.8 million from $5.0 million in 2003, as a result of an increase in equity markets. Equity markets were more stable in 2005.
Consider the following information for the three years ended December 31, 2005.
The investment segment is responsible for the management of capital resources including investments, debt and cash flow. Excess investment income represents the profit margin attributable to investment operations. It is the measure that management uses to evaluate the performance of the investment segment as described in Note 13-Business Segments in the Notes to the Consolidated Financial Statements. It is defined as net investment income less both the interest credited to net policy liabilities and the interest cost associated with capital funding or “financing costs.” Management also views 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 its share repurchase program in 1986, Torchmark has used over $2.8 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, management believes that excess investment income per diluted share is an appropriate measure of the investment segment.
Excess investment income declined 2% in 2005 to $324 million from $331 million in 2004. It increased 4% in 2004 and 9% in 2003. However, on a per diluted share basis, 2005 excess investment income rose 4% to $3.07. Per share excess investment income increased 7% in 2004 and 14% in 2003. Growth in excess investment income is impacted by increases in investment income due to the growth in the portfolio and changes in rates available in financial markets. It is also affected by crediting rates on policy liabilities and changes in Torchmark’s borrowing costs. Additionally, share purchases in recent periods have caused excess investment income per share to grow faster than excess investment income.
The lower growth in income is reflective of new investments made each year at long-term yields lower than the portfolio’s average yield, resulting from the lower rates available in financial markets in recent years. Also contributing to the lower growth in yields in recent years were calls on fixed maturity securities in the portfolio, as the yield on the reinvestment of the proceeds was below that of the called securities. Given the sizeable annual cash flow from Torchmark’s operations, management expects mean invested assets to continue to grow, but as long as the current low-interest rate environment continues, the rate of growth of investment income will be under pressure. More detailed information about investment acquisitions follows under this caption.
Excess investment income is reduced by interest credited to net insurance policy liabilities and the interest paid on corporate debt. Information about interest credited to policy liabilities is shown in the following table.
Excess investment income was positively affected by reduced crediting rates on certain policy liabilities in 2003 and 2004. In those years, the growth in interest credited to policy liabilities was not as great as the growth in the liabilities, as the Company was able to respond to the low-interest environment with reduced crediting rates on fixed annuities and certain life products. While annuity crediting rates were reduced in 2005, the Company was not able to further reduce life and health crediting rates. For more information on life and health crediting rates, please refer to Note 5-Future Policy Benefit Reserves in the Notes to Consolidated Financial Statements.
(2) Included in the Consolidated Statements of Operations as a realized investment gain under the caption “Realized investment gains (losses)”. See Derivatives in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements.
In the event of an increase in long-term rates, excess investment income will benefit as new acquisitions can be made at higher yields. While higher short-term rates will increase floating-rate financing costs, higher long-term rates would be to Torchmark’s advantage because the amount of cash invested annually significantly exceeds the amount of floating rate debt, and would result in greater investment income net of financing costs under most yield curve scenarios. At any rate, excess investment income has grown significantly in each of the four years prior to 2005 and has exceeded fifty percent of net investment income in every year since 2000.
Acquisitions. The chart below presents selected information about Torchmark’s fixed-maturity acquisitions in the years 2003 through 2005. Investment-grade corporate securities include both bonds and trust-preferred securities (classified as redeemable preferred stocks) with a diversity of issuers and industry sectors. Both yield and average life calculations on new purchases on noncallable bonds are based on the maturity date. In the case of callable bonds, the average life is based on the call date or maturity date, whichever produces the lowest yield (“yield to worst”).
New cash flow available to Torchmark for investment has been greatly affected by issuer calls as a result of the low-interest environment experienced during the past few years. Issuers are more likely to call bonds when rates are low because they can refinance them at a lower cost. Calls increase funds available for investment, but they negatively affect portfolio yield, as they cause Torchmark to replace higher-yielding bonds with those available at lower prevailing yields. Calls increased during 2003 and 2004 but declined somewhat in 2005. Issuer calls were $226 million in 2005, $352 million in 2004, and $457 million in 2003. As long as the yields on new fixed maturity acquisitions remain below the overall portfolio yield, the portfolio yield will slowly decline as will investment income and excess investment income. As discussed above, however, because of the sizeable annual cash flow generated from operations, management believes the Company will be well positioned when investment interest rates eventually rebound.
A measure of the price sensitivity of a fixed-income security to a particular change in interest rates.
At the end of 2005 and 2004, the fixed-maturity portfolio had a gross unrealized gain of $486 million and $670 million, respectively. Gross unrealized losses on fixed maturities were $61 million at December 31, 2005, compared with $21 million a year earlier. Please see Note 3-Investments in the Notes to Consolidated Financial Statements for an analysis of unrealized investment losses.
Credit Risk Sensitivity. Credit risk is the level of certainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. In weak economic periods, the securities of industry sectors affected by the economic downturn suffer increased credit risk. As a result, securities in these weakened sectors could be downgraded by credit-rating agencies to below-investment grade status. Thus, the likelihood the issuers will honor their securities’ terms is reduced and the securities’ market values can be negatively impacted. As Torchmark continues to invest in corporate bonds with relatively long maturities, credit risk is a concern. Torchmark mitigates this ongoing risk, in part, by acquiring investment-grade bonds, and by investigating the financial fundamentals of each prospective issuer. Torchmark continues to monitor the status of issuers on an ongoing basis. At December 31, 2005, approximately 94% of invested assets at fair value were held in fixed-maturity securities. The major rating agencies considered 92% of this portfolio to be investment grade. The average quality rating of the portfolio continues to be BBB+. The table below demonstrates the credit rankings of Torchmark’s fixed-maturity portfolio at fair value as of December 31, 2005.
Market Risk Sensitivity. The primary market risk to which Torchmark’s financial securities are exposed is 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 Torchmark’s portfolio is comprised 94% of fixed-maturity investments, it is highly subject to market risk. Declines in market interest rates in recent years have generally resulted in the fair value of the investment portfolio exceeding the book value of the
portfolio. However, Torchmark does not expect to realize these unrealized gains because it is generally the Company’s investment strategy to hold these investments to maturity. The Company’s strategy would be the same should markets reverse and market rates increase placing the fixed-income portfolio in an unrealized loss position. The long-term nature of Torchmark’s insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase in the fair value of insurance liabilities and debt due to declines in market interest rates largely offset the impact of rates on the investment portfolio. However, in accordance with GAAP, these liabilities are not marked to market.
Realized gains and losses can be significant in relation to the earnings from core insurance operations, however, and as a result, have a material positive or negative impact on net income. The significant fluctuations caused by gains and losses can cause period-to-period trends of net income to not be indicative of historical core operating results nor predictive of the future trends of core operations. Accordingly, they have no bearing on core insurance operations or segment results as management
The Securities and Exchange Commission’s accounting guidance currently requires that all income and expenses related to a nonhedged derivative be recorded in the same line item on the income statement that the adjustment to fair value is recorded. Therefore, Torchmark combines the cash settlements on nonhedged swaps with the noncash unrealized fair value adjustment as a component of realized investment gains and losses. Additionally, Torchmark includes the cash settlements on its hedged swap derivatives in realized investment gains and losses for consistency. Torchmark’s pretax interest cost reduction from these cash settlements included in realized investment gains was a positive $7 million in 2005, a positive $23 million in 2004, and a positive $26 million in 2003. Torchmark continues to reduce interest cost for this benefit in its segment analysis, because the segment analysis is required by GAAP to be as management evaluates the performance of the segment. Torchmark views the benefit from lower interest rates as a reduction in its financing costs in its investment segment.
Torchmark’s insurance operations have historically generated positive cash flows in excess of its immediate needs. Sources of cash flows from operations include primarily premium and investment income. Cash outflows from operations include policy benefit payments, commissions, administrative expenses, and taxes.
Torchmark’s cash and short-term investments were $138 million at year-end 2005 and $99 million at year-end 2004. Additionally, Torchmark has 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 $8.9 billion at December 31, 2005. However, Torchmark’s strong cash flows from operations, investment maturities, and credit line availability make any need to sell securities for liquidity unlikely.
Off-Balance Sheet Arrangements. As fully described and discussed in Note 10-Debt in the Notes to the Consolidated Financial Statements and under the subcaption Funded Debt, Torchmark has outstanding $150 million (par amount) 7 3/4% Trust Preferred Securities. The Capital Trusts which are liable for these securities are the legal entities which are responsible for the securities and facilitate the payment of dividends to shareholders. They are off-balance sheet arrangements which Torchmark is required to deconsolidate in accordance with GAAP rules. Deconsolidation is required by accounting rules because they are considered to be variable interest entities in which Torchmark has no variable interest. Therefore Torchmark is not the primary beneficiary of the entity, even though it owns all of the entity’s voting equity. While these liabilities are not on Torchmark’s balance sheet, they are represented by Torchmark’s 7 3/4% Junior Subordinated Debentures due to the trusts. These Junior Subordinated Debentures are a Torchmark liability of $155 million par and book value at both December 31, 2005 and
(1) Interest on debt is based on Torchmark’s fixed contractual obligations. As certain debt instruments have related swaps which exchange fixed obligations to those based on floating rates, Torchmark’s actual interest cost may be greater or lesser than presented. At December 31, 2005, Torchmark had in place swaps with a notional amount of $330 million on its $692 million of long-term debt at par value. More information about Torchmark’s swaps is found in Note 10-Debt in the Notes to Consolidated Financial Statements.
The carrying value of the funded debt was $688 million at December 31, 2005, compared with $695 million a year earlier. In connection with these instruments, Torchmark had in place two interest-rate swap agreements at December 31, 2005, but also had two swap agreements that were sold in September, 2005 and another swap agreement which expired in September, 2004. All of these agreements were entered into to exchange Torchmark’s fixed-rate obligations on the debt instruments to floating rates. Information about these swaps is also found in Note 10.
The following tables present selected data related to Torchmark’s capital resources. Additionally, the tables present the effect of SFAS 115 on relevant line items, so that investors and other financial statement users may determine its impact on Torchmark’s capital structure.
Credit Ratings. The credit quality of Torchmark’s debt instruments and capital securities are rated by various rating agencies. During 2003, Standard and Poor’s upgraded Torchmark’s funded debt rating from A to A+ and its preferred securities rating from BBB+ to A-. The chart below presents Torchmark’s credit ratings as of December 31, 2005.
The AA rating is assigned by Standard & Poor’s Corporation to those insurers which have very strong financial security characteristics, differing only slightly from those rated higher. The A+ rating is assigned to an insurer with strong financial security characteristics, somewhat more likely to be affected by adverse business conditions than insurers with higher ratings. The “+” indicates that United Investors is among the strongest insurers within the A category.
Litigation. Torchmark and its subsidiaries continue to be named as parties to pending or threatened litigation, much of which involves 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 may have the potential for significant adverse results since punitive damages in Alabama are based upon the compensatory damages (including mental anguish) awarded and the discretion of the jury in awarding compensatory damages is not precisely defined. Additionally, it should be noted that Torchmark subsidiaries actively market insurance in the State of Mississippi, a jurisdiction which is nationally recognized for large punitive damage verdicts. Bespeaking caution is the fact that it is impossible to predict the likelihood or extent of punitive damages that may be awarded if liability is found in any given 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. Based upon information
presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, contingent liabilities arising from threatened and pending litigation are not presently considered by management to be material. For more information concerning litigation, please refer to Note 14-Commitments and Contingencies in the Notes to the Consolidated Financial Statements.
Stock Option Expensing: Stock options have been granted to executives, employees, consultants, and directors as a form of compensation to provide motivation and to align the interests of these groups with the same interests of shareholders. Because they are generally granted at the fair value of Torchmark stock at the date of grant, the value of these options increases as the value of Torchmark stock increases. The cost of these options to the Company is in the dilution caused by the assumed exercise of the options, as the grantees’ ownership of the Company grows in relation to that of existing shareholders. This dilution cost has historically been reflected in per share earnings in the financial statements under the “intrinsic value” method currently permitted by GAAP and used by Torchmark. Under this method, a value is assigned to an option only if the exercise price is less than the fair value of the stock at the date of grant. Because Torchmark’s options are generally granted at an exercise price equal to the fair value of Torchmark stock, Torchmark has historically incurred no option expense.
GAAP rules currently require Torchmark to disclose in Note 1-Significant Accounting Policies the impact on earnings on a pro forma basis as if the “fair value” method were in effect. Please refer to Note 1 for more details on the impact of adoption of this revised statement. As explained in Note 1, the Company does not expect the adoption of this Statement to materially alter its methodology of computing option expense or that future results will vary significantly from the pro forma results disclosed for prior periods. At the present time, Torchmark does not plan to change its policies of stock option compensation because of the adoption of this revised statement.
The “fair value” assigned to option grants is derived from complex option pricing models using subjective assumptions such as price volatility and expected term. Considerable judgment is sometimes involved in the determination of these assumptions, which must be made at the time of option grant. Variations in actual experience versus the assumptions can cause material differences in an option’s actual value when it is ultimately exercised versus its expense recorded in the financial statements. However, while a variety of pricing models are acceptable under the Statement, Torchmark plans to use the Black-Scholes pricing model used for the pro forma disclosures, with assumptions most reflective of Torchmark’s experience. Statement 123R does not permit the recorded expense to be adjusted to reflect actual experience.
Deferred Acquisition Costs and Value of Insurance Purchased. The costs of acquiring new business are generally deferred and recorded as an asset. Deferred acquisition costs consist primarily of sales commissions and other underwriting costs of new insurance sales. Additionally, the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies are also deferred and recorded as assets under the caption “Value of Insurance Purchased.” Torchmark’s policies for accounting for deferred acquisition costs and the associated amortization are reported in Note 1-Significant Accounting Policies in the Notes to the Consolidated Financial Statements. Different assumptions with regard to deferred acquisition costs could produce materially different amounts of amortization. For more information about accounting for deferred acquisition costs see Note 4-Deferred Acquisition Costs and Value of Insurance Purchased in the Notes to the Consolidated Financial Statements.
Revenue Recognition. Premium income for Torchmark’s subsidiaries’ insurance contracts is generally recognized as the premium is collected. However, in accordance with GAAP, revenue on limited-payment contracts and universal life-type contracts (deposit balance products) are recognized differently. Revenues on limited-payment contracts are recognized over the contract period. Premium for
deposit balance products, such as Torchmark’s annuity and interest-sensitive life policies, is added to the policy account value. The policy account value (or deposit balance) is a Torchmark liability. This deposit balance is then charged a fee for the cost of insurance, administration, surrender, and certain other charges which are recognized as revenue in the period the fees are charged to the policyholder. In each case, benefits and expenses are matched with revenues in a manner by which they are incurred as the revenues are earned.
Impairment of Investments. Torchmark continually monitors its investment portfolio for investments that have become impaired in value. While the values of the investments in Torchmark’s portfolio constantly fluctuate due to market conditions, an investment is considered to be impaired only when it has experienced a decline in fair market value which is deemed other than temporary. The policies and procedures that Torchmark uses to evaluate and account for impairments of investments are disclosed in Note 1-Significant Accounting Policies and Note 3-Investments in the Notes to the Consolidated Financial Statements and the discussions under the captions Investments and Realized Gains and Losses in this report.
The actuarial assumptions used in determining Torchmark’s obligations for pensions include employee mortality and turnover, retirement age, the expected return on plan assets, projected salary increases, and the discount rate at which future obligations could be settled. These assumptions have an important effect on the pension obligation. A decrease in the discount rate or rate of return on plan assets will cause an increase in Torchmark’s pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. These assumptions are subjective in many cases and small changes in certain assumptions may cause material differences in reported results. While management has used its best efforts to determine the most reliable assumptions, given the information available from company experience, economic data, independent consultants and other sources, no assurance can be given that actual results will be the same as expected. The assumptions are reviewed annually and revised, if necessary, based on more current information available to the Company. Torchmark’s discount rate, rate of return on assets, and projected salary increase assumptions are disclosed in Note 9-Postretirement Benefits in the Notes to Consolidated Financial Statements. This note also contains information about pension plan assets, investment policies, funded status, and other related data.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Torchmark’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of Torchmark’s internal control over financial reporting and an unqualified opinion on the effectiveness of Torchmark’s internal control over financial reporting.
Investments: Torchmark classifies all of its fixed-maturity investments, which include bonds and redeemable preferred stocks, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Policy loans are carried at unpaid principal balances. Mortgage loans, included in “Other long-term investments,” are carried at amortized cost. Investments in real estate, included in “Other long-term investments,” are reported at cost less allowances for depreciation. Depreciation is calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities within twelve months.
Derivatives: Torchmark accounts for derivative instruments in accordance with Statement of Financial Accounting Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging Activities, as amended. All of Torchmark’s derivatives, which consist of interest-rate swaps, are carried at fair market value in the consolidated financial statements. Fluctuations in these values adjust realized investment gains and losses. If a derivative qualifies as a fair value hedge under SFAS 133, gains and losses in the derivative are substantially offset by changes in the underlying hedged instrument.
During 2003, the Securities and Exchange Commission made known interpretative guidance concerning SFAS 133. They have concluded that all income and expenses related to a nonhedged derivative must be recorded in the same line item that the adjustment to fair value is recorded. In order to comply with this interpretation, Torchmark no longer reduces its interest expense on the Statements of Operations for the reduction in interest cost for swapping its fixed rate for a variable rate on nonhedged derivatives. Instead, this benefit from cash settlements is reported as a component of realized investment gains (losses), the same line where the required fair value adjustment for nonhedged derivatives is reported. Torchmark has also reported the interest cost benefit on hedged derivatives as a component of realized gains (losses), in order to report these items on a consistent basis. In its segment disclosure, however, Torchmark continues to report the interest cost benefit from the swaps as a reduction in interest expense, as GAAP requires this disclosure to be presented as management views its business.
Policy Claims and Other Benefits Payable: Torchmark establishes a liability for known policy benefits payable and an estimate of claims that have been incurred but not yet reported to the Company. The estimate of unreported claims is based on prior experience. Torchmark makes an estimate after careful evaluation of all information available to the company. However, there is no certainty the stated liability for claims and other benefits, including the estimate of unsubmitted claims, will be Torchmark’s ultimate obligation.
In 2003, the American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1), which was adopted by Torchmark on January 1, 2004. This Statement covers various aspects of accounting for nontraditional product features in order to increase uniformity in practice. The primary issue in the Statement affecting Torchmark is the accounting for liabilities for certain guaranteed minimum policy benefits on Torchmark’s variable annuities. Upon adoption, Torchmark established a liability for these guaranteed minimum policy benefits in the amount of $8.2 million and wrote down deferred acquisition costs in the amount of $2.8 million. As a result, Torchmark recorded a charge in the amount of $11.0 million before tax ($7.1 million after tax) to reflect the guaranteed benefits. This charge was reported as a cumulative effect of a change in accounting principle in 2004.
Goodwill: The excess cost of businesses acquired over the fair value of their net assets is reported as goodwill. In accordance with SFAS 142, Goodwill and Other Intangible Assets, goodwill is subject to annual impairment testing based on the procedures outlined in the Statement. Amortization of goodwill is not permitted. Torchmark tested its goodwill annually in each of the years 2003 through 2005. As a result of the tests, Torchmark’s goodwill was not impaired in any of the periods. Therefore, Torchmark continues to carry its goodwill at the January 1, 2003 balance of $378 million.
Litigation Settlements: In 2005, Torchmark settled three significant legal matters. These cases involved Torchmark’s race-distinct mortality/dual-pricing litigation, its class-action cancer case, and its Waddell & Reed litigation. All of these cases related to litigation arising many years ago. The Waddell & Reed litigation was settled with Torchmark recording the $13.5 million proceeds net of costs as “Other income.” The other two settlements resulted in a $15 million pre-tax charge to “Other operating expenses.”
Torchmark has elected to account for its stock options under the intrinsic value method as outlined in APB 25, and has therefore computed the required pro forma earnings disclosures utilizing the fair value method. The fair value method requires the use of an option valuation model to value employee stock options. Torchmark uses the Black-Scholes valuation model to value its options, and pro forma compensation expense is based on these values. The pro forma expense is then charged to pro forma earnings over the option vesting period. Under the intrinsic value method, compensation expense for Torchmark’s option grants is only recognized if the exercise price of the employee stock option is less than the market price of the underlying stock on the date of grant.
if an option fully vests upon an optionee’s retirement, the expense is accelerated to the earlier retirement date rather than the option’s normal vesting date as previously recorded.
if the deferred tax benefits recorded in connection with option expense exceeds the actual tax benefit realized upon exercise and the cumulative pool of such actual tax benefits allowed by the Statement, there would be an additional charge for such excess taxes.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2005 and 2004 is as follows:
Proceeds from sales of fixed maturities available for sale were $78.0 million in 2005, $46.0 million in 2004, and $91.7 million in 2003. Gross gains realized on those sales were $7.6 million in 2005, $3.1 million in 2004, and $3.7 million in 2003. Gross losses were $13.7 million in 2005, $2.9 million in 2004, and $13.5 million in 2003. Proceeds from sales of equity securities were zero in 2005, $32.5 million in 2004, and $5.3 million in 2003. Gross gains realized on those sales were $4.7 million in 2004 and $1.5 million in 2003. Gross losses realized on those sales were $19 thousand in 2004 and zero in 2003.
Torchmark’s portfolio of fixed maturities fluctuates in value based on interest rates in financial markets and other economic factors. These fluctuations caused by market rate changes have little bearing on whether or not the investment will be ultimately recoverable. Therefore, Torchmark considers
these declines in value as temporary even in periods exceeding one year. In certain circumstances, however, it may become apparent that the principal of an investment may not be recoverable, generally due to factors specific to an individual issuer and not market interest rates. In this event, Torchmark classifies such investments as other-than-temporarily impaired and writes the investment down to fair value, realizing an investment loss. The determination that a security is other-than-temporarily impaired is highly subjective and involves the careful consideration of many factors. These factors include:
The following tables disclose unrealized investment losses by class of investment at December 31, 2005 and December 31, 2004. Torchmark considers these investments to be only temporarily impaired.
The estimated fair value of mortgage loans was $31.0 million at December 31, 2005 and $32.5 million at December 31, 2004. Accumulated depreciation on investment real estate was $21.1 million and $21.4 million at December 31, 2005 and 2004, respectively.
During 2003, Torchmark recorded a reserve against its mortgage loans on real estate as a result of impairments. The reserve resulted in a pretax loss of $5 million, or $3.3 million after tax.
(1) In 2003, $10.9 million in disputed commissions paid in prior years to Waddell & Reed were returned in settlement. This amount reduced deferred commissions.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $4.1 million, $4.8 million, and $5.5 million for the years ended December 31, 2005, 2004, and 2003, respectively. The average interest rates used for the years ended December 31, 2005, 2004, and 2003 were 5.6%, 5.7%, and 5.7%, respectively. The estimated amortization, net of interest accrued, on the unamortized balance at December 31, 2005 during each of the next five years is: 2006, $6.1 million; 2007, $5.5 million; 2008, $5.0 million; 2009, $4.5 million; and 2010, $4.0 million.
A summary of the assumptions used in determining the liability for future policy benefits at December 31, 2005 is as follows:
The overall average interest assumption for determining the liability for future life and health insurance benefits in 2005 was 6.0%.
Torchmark’s Federal income tax returns are routinely audited by the Internal Revenue Service (IRS). In the fourth quarter of 2005, the Appeals division of the IRS and Torchmark agreed to settle all issues with respect to the Company’s 1996 and 1997 tax years. As a result, Torchmark recorded a $15.9 million tax benefit in 2005 to reflect the impact of this settlement on the tax years covered by the examination as well as all other tax years prior to 2005 to which these issues apply. The benefit relates primarily to Torchmark’s computation of the dividends received deduction on its separate account and the amount of life insurance reserves for income tax purposes. The IRS has completed its examinations of Torchmark’s 1998-2002 income tax returns, with most of the proposed adjustments being referred to Appeals. The Federal income tax returns for 2003 and 2004 are not currently under examination. Management believes that adequate provision has been made in the financial statements for any potential assessments that may result from the completed examinations, future tax examinations, and other tax-related matters for all open tax years.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. All plan measurements for the defined benefit plans are as of December 31 of the respective year. The defined benefit pension plans covering the majority of employees are funded. Contributions are made to the pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Defined benefit plan contributions were $12.0 million in 2005, $10.7 million in 2004, and $10.4 million in 2003. Torchmark estimates as of December 31, 2005 that it will contribute an amount not to exceed $20 million to these plans in 2006. The actual amount of contribution may be different from this estimate.
The accumulated benefit obligations (ABO) for Torchmark’s funded defined benefit pension plans were $183.1 million and $155.3 million at December 31, 2005 and 2004, respectively. Plan assets exceeded the ABO in all of Torchmark’s funded pension plans at both December 31, 2005 and 2004. In the unfunded plans, the ABO was $11.3 million at December 31, 2005 and $9.9 million at December 31, 2004.
Torchmark has estimated its expected pension benefits to be paid over the next ten years as of December 31, 2005. These amounts will be substantially funded by plan assets and not corporate assets. These estimates use the same assumptions that measure the benefit obligation at December 31, 2005, taking estimated future employee service into account. Those estimated benefits are as follows:
For retired employees over age sixty-five, Torchmark does not provide postretirement benefits other than pensions and the life insurance benefits described above. Torchmark does provide a portion of the cost for health insurance benefits for certain employees who retired before February 1, 1993 and for certain employees that retired before age sixty-five, covering them until they reach age sixty-five. Eligibility for this benefit was generally achieved at age fifty-five with at least fifteen years of service. This subsidy is minimal to retired employees who did not retire before February 1, 1993.
The following table presents a reconciliation of the benefit obligation and plan assets from the beginning to the end of the year and a reconciliation of the funded status to the accrued benefit liability:
For measurement purposes of the healthcare benefits, a range of 7-10% annual rate of increase in per capita cost of covered healthcare benefits was assumed for the years 2003 through 2005. Torchmark has assumed that the health care cost trend rate will remain stable at the 7-10% range in future periods. This trend rate assumption could have a significant effect on the amounts reported. However, because participants substantially pay the cost of this benefit, a 1% increase or decrease in the health care cost trend rate is not expected to have a significant effect in the service and interest cost components, nor is the effect on the plan’s benefit obligation expected to exceed $1 thousand.
Effective January 1, 2004, Torchmark has accounted for its Trust Preferred Securities under FASB Interpretation 46, Consolidation of Variable Interest Entities as revised (FIN46R). FIN46R clarified the definition of a variable interest entity (VIE) and the determination of which holder is the VIE’s primary beneficiary. Only primary beneficiaries are permitted to consolidate VIE’s. Therefore, FIN46R does not permit consolidation of VIE’s in which a company has voting control but is not the primary beneficiary. The trusts that are liable for Torchmark’s trust preferreds meet the definition of VIE’s. Under FIN46R, Torchmark has no variable interest in these trusts and can therefore not be the entity’s primary beneficiary. For this reason, Torchmark does not consolidate the trusts, even though Torchmark is the sole owner of the voting equity of these entities and guarantees their performance. Therefore, Torchmark does not report the trust preferreds as long-term debt but instead reports its 7 3/4% Junior Subordinated Debentures due 2041 to the trust entities as “Due to Affiliates.” The amount of this debt was $154.6 million at December 31, 2004 and 2005, $4.6 million greater than the par value of the trust preferreds. Deconsolidation of the trusts results in reporting $4.6 million of additional debt which is due to the trust entities and is offset by an asset, included in “Other Receivables,” of a like amount representing Torchmark’s equity interest in the trusts. Also, the unamortized issue expenses of the trust preferreds of $5.5 million still remain as a reduction of long-term debt. The additional interest expense on this debt exceeds the trust preferred distributions by $360 thousand in each of the years ended December 31, 2005, 2004, and 2003, which is offset by investment income to Torchmark in like amount representing dividends from the trusts.
(2) Junior Subordinated Debentures are classified as “Due to affiliate” and are junior to other securities in priority of payment.
Retirement of Treasury Stock: Torchmark retired 4 million shares of treasury stock in December, 2005. In 2004 and 2003, Torchmark also retired 5 million and 13 million treasury shares, respectively.
Restrictions: Restrictions exist on the flow of funds to Torchmark from its insurance subsidiaries. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. Dividends from insurance subsidiaries of Torchmark are limited to the greater of statutory net gain from operations, excluding capital gains and losses, on an annual noncumulative basis, or 10% of surplus, in the absence of special regulatory approval. Additionally, insurance company distributions are generally not permitted in excess of statutory surplus. Subsidiaries are also subject to certain minimum capital requirements. In 2005, subsidiaries of Torchmark paid $365 million in dividends to the parent company. During the year 2006, a maximum amount of $437 million is expected to be available to Torchmark from subsidiaries without regulatory approval.
Certain employees, directors, and consultants have been granted options to buy shares of Torchmark stock, generally at the market value of the stock on the date of grant, under the provisions of the various Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring according to the terms of the grant. Options generally expire the earlier of employee termination or option contract term, which ranges from seven to eleven years. Employee and consultant stock options generally vest one-half in two years and one-half in three years. Formula-based director grants generally vest in six months. Stock options awarded in connection with compensation deferrals by certain directors and executives generally vest over a range of six to ten years. All options vest immediately upon the attainment of age 65, subject to a minimum vesting period of one year for employees or six months for directors. Torchmark generally issues shares for the exercise of stock options from treasury stock.
As previously stated in Note 1-Significant Accounting Policies, Torchmark accounts for its employee stock options in accordance with SFAS 123, Accounting for Stock-Based Compensation as amended by SFAS 148, and has elected to account for its stock options under the intrinsic value method as outlined in
The weighted average fair value of options as determined by the option pricing model granted during the years ended December 31, 2005, 2004, and 2003 were $9.31, $11.83, and $10.52, respectively.
A summary of Torchmark’s stock option activity and related information for the years ended December 31, 2005, 2004, and 2003 follows:
(1) Reclassification of interest amount due to FIN46R (accounting rule requiring deconsolidation of Trust Preferred Securities).
swaps in Realized investment gains and losses in the Consolidated Statements of Operations, as this is the line item that contains the fair value adjustment each period.
Assets for each segment are reported based on a specific identification basis. The insurance segments’ assets contain deferred acquisition costs, value of insurance purchased, and separate account assets. The investment segment includes the investment portfolio, cash, and accrued investment income. Goodwill is assigned to the insurance segments based on SFAS 142. All other assets, representing less than 2% of total assets, are included in the other category. The table below reconciles segment assets to total assets as reported in the consolidated financial statements.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represents 1.6% of life insurance in force at December 31, 2005 and reinsurance assumed on life and accident and health products represents .9% of premium income for 2005.
Otherwise, no individual industry represented 2% or more of Torchmark’s investments. At year-end 2005, 7% of invested assets was represented by fixed maturities rated below investment grade (BB or lower as rated by the Bloomberg Composite or the equivalent NAIC designation). Par value of these investments was $670 million, amortized cost was $671 million, and fair value was $676 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value.
Personal loans: Torchmark subsidiary American Income is a party to an agreement to guarantee certain personal loans of American Income employees and agents with First Command Bank. First Command Bank is a subsidiary of First Command Services, Inc. (First Command) of which Lamar C. Smith is chairman and CEO. Mr. Smith is also a director of Torchmark. At December 31, 2005, the balance subject to this guarantee was $182 thousand. These guarantees are secured by vested commissions due the employees and agents. See Note 15-Related Party Transactions for more information on Mr. Smith and First Command.
Litigation: Torchmark and its subsidiaries, in common with the insurance industry in general, are subject to litigation, including claims involving tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark’s subsidiaries, employment discrimination, and miscellaneous other causes of action. A number of such actions involving Torchmark’s subsidiary Liberty also name Torchmark as a defendant. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, management does not believe that such litigation will have a material adverse effect on Torchmark’s financial condition, future operating results or liquidity; however, assessing the eventual outcome of litigation necessarily involves forward-looking speculation as to judgments to be made by judges, juries and appellate courts in the future. This bespeaks caution, particularly in states with reputations for high punitive damage verdicts such as Alabama and Mississippi.
As previously reported in Forms 10-K and Forms 10-Q, Liberty National Life Insurance Company is a party to a number of lawsuits (both a large number of lawsuits brought by individual plaintiffs and class action litigation with extremely broad class periods and relief sought) involving allegations of racially discriminatory pricing in the sale of insurance to African Americans prior to 1966. The litigation began with the December 8, 1999 filing of Moore v. Liberty National Life Insurance Company, Case No. CV-99-BU-3262-S in the U.S. District Court for the Northern District of Alabama. Over 29 race-distinct mortality cases with approximately 2,000 named plaintiffs have been consolidated with the Moore case (Master Case No. 2:02-CV-02741-UWC) and are pending in the U.S. District Court for the Northern District of Alabama, with one pending Alabama Circuit Court case (Baldwin v. Liberty National Life Insurance Company, Case No. CV-00-684) stayed pending a disposition of the Moore case.
As previously reported in Form 10-Q, United American Insurance Company has been named as a defendant in purported class action litigation filed on September 16, 2004, in the Circuit Court of Saline County, Arkansas on behalf of the Arkansas purchasers of association group health insurance policies or certificates issued by United American through Heartland Alliance of America Association and Farm & Ranch Healthcare, Inc. (Smith and Ivie v. Collingsworth, et al., CV2004-742-2). The plaintiffs assert claims for fraudulent concealment, breach of contract, common law liability for non-disclosure, breach of fiduciary duties, civil conspiracy, unjust enrichment, violation of the Arkansas Deceptive Trade Practices Act, and violation of Arkansas law and the rules and regulations of the Arkansas Insurance Department. Declaratory, injunctive and equitable relief, as well as actual and punitive damages are sought by the plaintiffs. United American removed the case from the Saline County Circuit Court to the U.S. District Court for the Eastern District of Arkansas, but the District Court ordered the case back to the Circuit Court on December 21, 2005. The U.S. Circuit Court of Appeals for the Eighth Circuit denied United American’s petition for permission to appeal the District Court’s decision on January 25, 2006.
First Command. Lamar C. Smith, a director of Torchmark, is an officer and director of First Command Financial Services, Inc. (First Command), a corporation 100% owned by the First Command Employee Stock Ownership Plan (First Command ESOP). Mr. Smith is a beneficiary of the First Command ESOP although he has no ability to vote the stock of First Command that is held by the First Command ESOP. First Command receives commissions as the Military Agency distribution system for selling certain life insurance products offered by Torchmark’s insurance subsidiaries. These commissions were $60.9 million in 2005, $67.0 million in 2004, and $59.4 million in 2003. Torchmark held balances due from these agents of $9.4 million at year-end 2005 and $17.0 million at year-end 2004.
Torchmark annually pays premiums on three life insurance policies for Mr. Richey, in the amount of $61 thousand in each of the years 2003 through 2005.
In the fourth quarter of 2003, a reserve in the pretax amount of $5 million was established on certain mortgages that met Torchmark’s criteria for impairment. These mortgages were originated and serviced by MidFirst. In the fourth quarter of 2004, Torchmark’s subsidiary Liberty sold its participation interests in certain mortgages back to MidFirst Bank in two transactions. The first transaction was completed in October, 2004 for proceeds of $57.3 million with a carrying value of $56.2 million, and the second was effected in December, 2004 for $17.1 million proceeds and a carrying value of $19.5 million. Because of Mr. Records’ relationship, the Board of Directors of Torchmark, with Mr. Records recusing himself, reviewed and approved the first transaction. Both of the transactions were also reviewed and approved by the Liberty National Board of Directors on which Mr. Records did not serve. Torchmark obtained opinions from an independent third party valuation firm experienced in valuing commercial loans that the purchase price on each transaction was within a reasonable and acceptable range.