Late in 1994, the Company began a broad review of its corporate strategy. During its review, the Company considered a number of alternatives to increase the value of the Company for shareholders. In June of 1996, the Company announced an agreement to sell its individual and small group health insurance business to Pioneer Life Insurance Company. In July of 1996, the Company announced an agreement to sell its large group life and health insurance business to Trustmark Insurance Company (Mutual). As a result of the sales, the operating results of the health businesses are accounted for as discontinued operations and the Company recorded an after-tax loss of $25.1 million. Additionally, $5.0 million of annual corporate overhead and data center expenses previously allocated to the health businesses has been reallocated to the corporate and other segment.
The Company has two business segments. The insurance operations segment consists of universal life and other interest-sensitive life insurance and annuity products marketed to individuals and small businesses by UPI and a block of similar business at WNIC, which no longer sells new business of this type (the closed block), and specialty health insurance products for educators. The second business segment, corporate and other, includes the non-insurance operations of the Company.
Net Investment Income. Net investment income was $165.8 million in 1996, compared to $168.8 in 1995. The amortized cost of the Company's investment portfolio at December 31, 1996, was $2.3 billion, compared to $2.4 billion at December 31, 1995. The portfolio yield (based on amortized cost) declined from 7.6% in 1995 to 7.5% in 1996 primarily due to the reinvestment of proceeds from sales of fixed maturity investments and mortgage loan paydowns in lower yielding fixed maturity investments and short-term investments.
Insurance Benefits Paid or Provided. Insurance benefits paid or provided were $214.3 million in 1996 and 1995. Increased benefits primarily for universal life insurance at UPI and education disability were offset by a decline in benefits in the closed block of life insurance and annuities as this particular business continues to diminish.
Loss from Discontinued Operations, Net of Tax. The Company reported a loss of $25.1 million, net of tax, from the sale of its health insurance business (see "Overview," above). In addition, the 1996 loss from discontinued operations includes $0.9 million relating to the loss on operations from January 1, 1996 through May 31, 1996, the measurement date for the disposal of the health business, compared to income of $7.2 million for the full year of 1995. The loss in 1996 resulted primarily from a benefit ratio (benefits as a percentage of premiums) for the group employee benefits portion of discontinued operations of 87% through the measurement date compared to 79% for all of 1995. The increase in the group benefit ratio was in part due to a higher level of medical claims and in part due to the 1995 release of approximately $2.6 million of policy liabilities on certain disabled policyholders. In addition to an increase in the group benefit ratio, the ratio for individual health insurance increased to 66% through the measurement date compared to 63% in the full year of 1995. The increase was due to higher claims experience in New Jersey.
Operating income for the insurance operations segment increased $6.6 million, or 17.4%, to $44.4 million in 1996 from $37.8 million in 1995, primarily due to a $4.7 million improvement in interest rate spreads
Corporate and Other. The corporate and other segment had pretax operating income of $4.2 million in 1996, compared to $2.2 million in 1995. The improvement was primarily due to a decline in real estate expenses of $2.6 million due to fewer properties combined with lower taxes, offset in part by merger-related expenses of approximately $1 million.
Insurance Premiums and Policy Charges. Insurance premiums and policy charges increased $9.1 million, or 6.7%, from $136.3 million in 1994 to $145.4 million in 1995. The improvement was primarily due to a higher amount of educator disability products and universal life insurance in force and higher policy charges. See "Segment Information," below.
Net Investment Income. Net investment income was $168.8 million in 1995, essentially unchanged from 1994. While the amortized cost of the Company's investment portfolio increased $32.6 million during 1995, the portfolio yield (based on amortized cost) declined from 7.7% in 1994 to 7.6% due to lower market interest rates.
Insurance Benefits Paid or Provided. Insurance benefits paid or provided increased $4.5 million, or 2.2%, from $209.8 million in 1994 to $214.3 million in 1995. The increase was mainly due to higher benefits in the educator disability line and a greater amount of universal life business in force, offset by a decline in the closed block of life insurance and annuities.
insurance claims related to disability. Partially offsetting this improvement to pretax income from discontinued operations was an increase in the benefit ratio for both individual and group major medical health insurance.
Net Income from Continuing Operations. Net income from continuing operations for 1995 was $26.7 million, an increase of 8.5% as compared to $24.6 million in 1994. The improvement resulted from increased earnings from insurance operations.
Insurance Operations. Revenues for the insurance operations segment for 1995 were $309.1 million, compared to $299.1 million for 1994. The improvement was attributable to higher insurance premiums and policy charges of $9.1 million primarily due to a higher amount of educator disability business in force and an increase in insurance premiums and policy charges at UPI due to an increase in insurance in force. For the educator disability business, the number of insureds increased 3.9% for 1995 over 1994. At UPI, insurance in force increased 4.7% for 1995 over 1994. The increase in insurance premiums and policy charges was offset in part by the expected decline in the closed block of business at WNIC.
At December 31, 1996, the Company had invested assets with a carrying value of $2.4 billion compared to $2.5 billion at December 31, 1995. Certain information about the Company's investment portfolio follows (dollars in millions):
The Company's investment portfolio is managed by an experienced staff of in-house investment professionals, primarily at WNIC, and outside investment advisors, primarily the insurance investment management group at Scudder, Stevens & Clark, Inc. Investments are made pursuant to strategies and guidelines approved by the Finance Committee of the Company's Board of Directors. The Company selects investments that match the needs of the businesses that the assets support in the areas of yield, liquidity, asset quality, and duration. The Company pursues a conservative investment philosophy by balancing a variety of objectives, including high credit quality, liquidity, high current income, preservation of capital, and protection against market interest rate risk. The Company's investment portfolio consists principally of investment grade, publicly-traded fixed maturity investments, and mortgage loans on real estate. All investments made by WNIC and UPI are governed by Illinois and Indiana insurance laws and regulations, respectively.
The Company's fixed maturity investments are carried at fair value. Due to rising interest rates during 1996, the carrying value of the Company's fixed maturity investments compared to amortized cost decreased $75.4 million, resulting in an unrealized gain on fixed maturity investments of $32.0 million at December 31, 1996, compared to $107.4 million at December 31, 1995. The amortized cost of the Company's fixed maturity portfolio decreased $54.2 million during 1996 to $1.9 billion at December 31, 1996. The decrease was largely due to sales of fixed maturity investments to fund the continued run off of the closed life insurance and annuity block and the Company's divestiture of its health business.
The composition of the Company's fixed maturity portfolio at December 31, 1996, based on ratings follows (dollars in millions):
The Company's policy for rating fixed maturity investments is to use the rating determined by Standard & Poor's Company or Moody's Investor Service, Inc. for publicly-traded investments. For privately-traded securities, the ratings of Duff & Phelps Credit Rating Company and Fitch Investors Service, Inc. are also recognized in defining rated securities. If an investment has a split rating (i.e., different ratings from the rating services) the Company categorizes the investment under the lowest rating. For those investments that do not have a rating from these services, the Company categorizes those investments on ratings assigned by the National Association of Insurance Commissioners (NAIC), whose ratings are as follows: NAIC Class 1 is considered equivalent to a AAA/Aaa, AA/Aa, or A rating; NAIC Class 2, BBB/Baa; and NAIC Classes 3-6, BB/Ba and lower. At December 31, 1996, $78.1 million or 4.0% of fixed maturity investments were rated with comparable NAIC ratings, the majority of which is $36.7 million of investments rated BBB and $27.9 million of investments rated BB and lower.
The Company's fixed maturity portfolio at December 31, 1996, includes $578.4 million of mortgage-backed securities, detailed as follows (dollars in millions):
The Company no longer makes new investments in mortgage loans except for purchase money loans and expansion of the Company's properties. The Company will retain its existing mortgage loans.
Cash Flows. During 1996, the Company's operating activities generated cash of $15.9 million compared to $89.4 million in 1995. The decrease in cash provided by operations resulted primarily from the discharge of certain policy and claim liabilities related to the divested health insurance businesses, an increase in the benefits ratio on the discontinued operations, and certain cash expenditures related to the divestiture. As a result of the health sales, the Company expects that it will require additional cash of approximately $86 million in 1997 to discharge certain policyholder benefit liabilities and to pay expenses related to the sales. The Company has anticipated this need by the build-up of short-term investments (see "Liquidity," below).
Cash provided from investing activities was $77.3 million in 1996, compared to cash used of $34.7 million in 1995. The increase in cash provided from investing activities resulted primarily from a reduction in fixed maturity investment purchases and from increased mortgage loan paydowns in 1996.
Liquidity. The fair value of the Company's investment portfolio, primarily fixed maturity investments, is affected by changing interest rates. When interest rates rise, the fair value of the Company's fixed maturity investments declines, while in periods of declining interest rates, the fair value of the Company's fixed maturity investments increases. The Company estimates that a one percentage point change in market interest rates would have an inverse effect on the fair value of its fixed maturity investments of approximately 5%. In addition, rising interest rates could result in increased surrenders of life insurance policies and annuities (as current policy and contract holders seek higher returns elsewhere) causing the Company to sell fixed maturity investments below cost.
In order to minimize the need to sell fixed maturity investments below cost, the Company seeks to maintain sufficient levels of cash and short-term investments. The Company held cash and short- term investments of $106.4 million at December 31, 1996, compared to $56.9 million at December 31, 1995. Management believes the Company has adequate liquidity to meet its ongoing cash requirements as well as the requirements relating to the sale of its health insurance businesses.
A. M. Best's 15 categories of rating for insurance companies currently range from "A++ (Superior)" to "F (In Liquidation)." According to A. M. Best, an "A" or "A-" rating is assigned to companies which, in A. M. Best's opinion, have achieved excellent overall performance when compared to the standards of the
life insurance industry and generally have demonstrated a strong ability to meet their obligations to policyholders over a long period of time. Many of the Company's competitors have A.M. Best ratings of "A-" or lower, and the Company believes the insurance subsidiaries' A.M. Best ratings are adequate to enable them to compete successfully. A.M. Best ratings are based upon factors of concern to policyholders, agents, and intermediaries and are directed toward the protection of policyholders, not investors.
Inflation and changing prices are anticipated by the Company in the pricing of its insurance products. The Company monitors market interest rates to determine the rates it will credit on its interest-sensitive life insurance and annuity products in order to achieve adequate interest rate spreads. The effect of inflation on operating expense has not been significant.
We have audited the accompanying consolidated balance sheet of Washington National Corporation as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Washington National Corporation at December 31, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note C, the Company changed its method of accounting for certain investments in debt and equity securities in 1994.
The markets for WNC's life insurance and annuity products include individuals and small businesses seeking universal life insurance and other interest-sensitive life insurance and annuity products. The markets for the Company's specialty health insurance products for educators consist primarily of school district employees.
In November 1996, WNC signed a definitive agreement to merge with PennCorp Financial Group, Inc. (PennCorp). The transaction, which is subject to approval by WNC and PennCorp shareholders and certain regulatory agencies, is expected to be completed in the second quarter of 1997. Under the terms of the merger, the separate corporate existence of WNC will cease and PennCorp will continue as the surviving entity.
The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) and include the accounts and operations of the Company. Significant intercompany transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ from these estimates. Certain amounts applicable to prior years' financial statements have been reclassified to conform to the 1996 presentation.
Fixed Maturities. Fixed maturities include bonds, redeemable preferred stocks, and mortgage-backed securities with contractual maturities greater than one year. All of the Company's fixed maturities are classified as "available for sale" and are carried at fair value. The carrying value of the Company's fixed maturity portfolio is inversely impacted by increases and decreases in market interest rates which may change significantly in short time periods.
Short-term Investments. Short-term investments include commercial paper, variable demand notes, and money market funds and are carried at amortized cost.
Net Investment Income. Net investment income consists primarily of interest and dividends less expenses. Interest on fixed maturities and performing mortgage loans, adjusted for any amortization of discount or premium, is recorded as income when earned and includes adjustments resulting from prepayments or expected changes in prepayments on mortgage-backed securities. Income on impaired loans and real estate is recorded principally on a cash basis. Income on investments accounted for under the equity method is recognized as it becomes earned. Investment expenses are accrued as incurred.
Realized Investment Gains and Losses. Realized investment gains and losses are recognized using the specific identification method and include write-downs on investments having an other- than-temporary decline in value.
Insurance premiums and policy charges include reinsurance premiums assumed and are net of reinsurance ceded. Health insurance premiums are earned on a pro rata basis over the policy period. Premiums for traditional life insurance products are recognized as revenues when due. Revenues for certain interest- sensitive products consist of charges earned and assessed against policy account balances during the period for the cost of insurance, policy initiation fees, policy administration expenses, and surrender charges.
The unamortized cost of purchased insurance in force is included in DAC and amortized in proportion to the present value of estimated gross profits over an estimated twenty year remaining life with interest rates ranging from 7.5% to 8.5%.
The estimated percentage of the December 31, 1996 balance before the effect of unrealized investment gains and losses to be amortized over the next five years follows:
Liabilities for future policy benefits for traditional life insurance products are provided on the net level premium method. The Company bases reserve calculations on the present value of future net premiums, benefits, and expenses, using estimates of future investment yields, mortality, and withdrawal rates, adjusted to provide for possible adverse deviation. Interest rate assumptions are graded and ranged from 4.5% to 7.5% at December 31, 1996. Withdrawal assumptions are based principally on Company experience and vary by issue age, type of coverage, and duration.
Liabilities for future policy benefits of certain interest- sensitive products are based on policy account balances prior to applicable surrender charges, deferred policy initiation fees that are recognized as income over the term of the policies, and, for certain policies, a provision for the return of cost of insurance charges. Policy benefits and claims that are charged to expense include benefit claims in excess of related policy accounts incurred in the period, interest credited to policy balances, and a provision for the return of the cost of insurance charges. Credited interest rates for these products ranged from 4.0% to 6.75% at December 31, 1996.
The amount paid to acquire a company over the fair value of its net assets is reported as goodwill and is being amortized on a straight-line basis, over a thirty-five year period. The value of goodwill is considered appropriate based on the long-term nature of the insurance policies sold. Accumulated amortization of goodwill was $7,450,000 and $6,744,000 at December 31, 1996 and 1995, respectively.
In the normal course of business, the Company minimizes its exposure to loss by reinsuring a portion of its life insurance, annuity, and health insurance risks with other insurance companies. The Company's policy on claim exposure for life insurance and annuity products is to retain a maximum of $300,000 of life insurance exposure on any one individual. The Company retains 100% of all long-term disability and a maximum of 50% of all long-term care claims.
For continuing operations, the Company cedes reinsurance to entities with A. M. Best ratings of "A-" or better or to entities required to maintain assets in an independent trust fund whose fair value is sufficient to discharge the obligations of the reinsurer. Reinsurance contracts do not discharge the Company from its obligations to the policyholders.
Accounting Standard Adopted in Prior Years. Effective January 1, 1994, the Company adopted SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities." The effect of the adoption resulted in an increase to shareholders' equity of $41,644,000.
In May, 1996, the Company's Board of Directors approved a plan to dispose of the Company's health insurance business. The Company ceased the writing of this type of business effective November 1, 1996. The sale of the individual and small group health insurance to Pioneer Life Insurance Company (PLIC) closed on August 2, 1996 and provided that PLIC would purchase the Company's individual and small group health business, through a reinsurance transaction, for a purchase price of $19,000,000.
The $19,000,000 was received at the close of the transaction. PLIC has assumed the risks incurred related to this business after August 1, 1996 except for a small run-off block of New Jersey guaranteed issue business. The Company believes it has made adequate provisions in the accrual for the loss on the sale for the claims incurred prior to August 1, 1996 and the risks not assumed by PLIC.
The sale of the remaining health insurance business, the large group business, to Trustmark Insurance Company (Mutual) closed on October 30, 1996, through a reinsurance transaction, that provides that the Company will receive future consideration based on persistency. The future consideration to be received is .5% of premiums and premium equivalents, during the first three years on groups that renew with Trustmark. The Company has estimated this amount to be approximately $1,300,000 based on past persistency and premium levels. The Company has retained responsibility for the profit or loss on this business through the next renewal date of each group. As a result, the Company has recorded a provision for future losses on this business in the accrual for the loss on sale.
The operating results of the sold business have been reported in the consolidated statement of income as discontinued operations. As permitted, the consolidated balance sheet has not been segregated between continuing and discontinued operations. At December 31, 1996, the business had remaining assets of approximately $220,444,000 consisting primarily of invested assets and a $72,840,000 reinsurance receivable, and liabilities of approximately $220,444,000 consisting primarily of policy liabilities.
Fixed Maturities A comparison of amortized cost to fair value of fixed maturity investments by category at December 31 follows:
During 1995, the Company sold one "held to maturity" investment with an amortized cost of $2,000,000. The sale, which resulted in a realized investment loss of $50,000, was made as a result of significant deterioration of the bond issuer's creditworthiness.
The following table details the net unrealized investment gains and losses included in shareholders' equity:
The change in gross unrealized net gains and losses for fixed maturity investments was $(75,397,000), $226,872,000, and $(201,808,000) in 1996, 1995, and 1994, respectively.
During 1996, 1995, and 1994, non-cash investing activities totaled $8,461,000, $10,707,000, and $4,009,000, respectively, and consisted of real estate acquired through foreclosure of fixed maturities and mortgage loans on real estate, purchase money mortgages, and venture capital distributions of common stock.
The Company has a non-qualified supplemental retirement plan under which benefits are paid to certain employees equal to the amounts by which the qualified plan benefits are reduced due to provisions of the Internal Revenue Code (IRC). At both December 31, 1996 and 1995, the unfunded liability for the supplemental retirement plan was not material. This Plan will be terminated at the completion of the merger with PennCorp and the benefits distributed to the participants.
The Company has two defined benefit retirement plans, the Washington National Retirement Plan ("WNIC Plan") and the United Presidential Corporation Employees' Retirement Plan ("UPI Plan") both of which cover certain grandfathered employees and agents. Benefits are based principally on years of service and compensation. In connection with the Company's disposal of the health business, the WNIC Plan was terminated on October 1, 1996. The Company is committed to fund amounts sufficient to meet all benefit obligations under the WNIC Plan which are not covered by plan assets. The distribution of plan assets to participants will occur through the first half of 1997. The UPI Plan has been amended to
The components of net periodic pension income reported in income from continuing operations for the defined benefit plans for the years ended December 31 follow:
In addition, WNC's Consolidated Balance Sheet includes an accrual of $3,500,000 for the estimated funding for the termination of the WNIC Plan.
The components of net periodic postretirement benefit expense for continuing operations for the years ended December 31 follow:
The funded status of the plan and the amount recognized in WNC's Consolidated Balance Sheet as part of other liabilities at December 31 follow:
Reinsurance benefits ceded from continuing operations were $19,837,000, $19,619,000, and $19,134,000, in 1996, 1995, and 1994, respectively.
At December 31, 1996, approximately 66% of WNC's total reinsurance recoverables related to the Company's discontinued operations. Of the 66%, 85% was from PLIC as a result of the sale of the individual and small group business and 12% was due from UNUM Life Insurance Company. Of WNC's total reinsurance recoverables, 21% were due from Combined Insurance Company of America.
The Company uses yearly renewable term reinsurance at an insurance subsidiary to maintain statutory profitability and other statutory financial requirements while sustaining growth. The cumulative contribution to statutory basis capital and surplus from this reinsurance was $8,018,000 and $8,202,000 at December 31, 1996 and 1995, respectively. These transactions do not materially impact the Company's GAAP financial statements.
The Committee passed an amendment to the Plan during the fourth quarter of 1996 which deemed that all of the outstanding stock options and restricted stock will be 100% vested as of the date of the merger with PennCorp and will be exchanged for cash at that time.
The pretax compensation expense relating to restricted stock which was recognized in the financial statements was $84,000 and $262,000 in 1996 and 1995, respectively.
The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used for both 1996 and 1995 grants: dividend yield of 3.91 percent and an expected stock price volatility of 19.5 percent. A risk free interest rate of 5.80 percent and 6.68 percent was used for 1996 and 1995 grants, respectively. The assumption for the expected life of an option was .96 years and 1.95 years for 1996 and 1995, respectively, due to the pending merger.
WNC has 10,000,000 authorized shares of $5 par value Preferred Stock with 143,000 shares outstanding that are designated as $2.50 Convertible Preferred Stock. Each share is entitled to a cumulative annual dividend of $2.50 and a preference of $50 in the event of involuntary liquidation of WNC and $55 in the event of voluntary liquidation. Further, each share is convertible at any time into 1.875 shares of Common Stock at the option of the holder and is redeemable at $55 at the option of WNC. Each holder is entitled to one vote for each share held. The $2.50 Convertible Preferred Stock and the Common Stock vote together as one class. All outstanding shares will be redeemed in connection with the merger with PennCorp.
At December 31, 1996 and 1995, WNC had one outstanding Common Stock Purchase Right for each outstanding share of Common Stock. All of the Rights expired in January 1997.
WNC has 60,000,000 authorized shares of $5 par value Common Stock including treasury shares. At December 31, 1996, 13,820,000 shares of WNC's Common Stock were reserved for future issuance: 12,358,000 shares for future exercises of Purchase Rights that expired in January 1997; 267,000 shares for conversion of outstanding Convertible Preferred Stock; 1,161,000 shares for exercise of options to purchase Common Stock and for use in connection with the restricted stock grants; and 34,000 shares for issuance of Common Stock in connection with the dividend reinvestment plan. The annual dividend paid on WNC Common Stock in 1996, 1995, and 1994 was $1.08 per share.
The pro forma effects on income and earnings per share are not likely to be representative of the effects on reported net income in future years as 1995 and 1996 pro forma amounts include only the 1995 and 1996 grants, and reflects these grants fully vesting in 1996 instead of over five years.
Other than capital gain or loss items, the nature of WNC's deferred tax assets and liabilities is such that the general reversal pattern for these temporary differences is expected to result in a full realization of WNC's deferred tax assets.
At December 31, 1996, WNC had capital loss carryforwards for tax return purposes of $110,000, which will expire in 2000. For financial reporting purposes, a valuation allowance has been recognized to offset the deferred tax assets related to those carryforwards, investment loss reserves, and other capital loss- related deferred tax assets not expected to be realized. The valuation allowance increased by $2,685,000 in 1996 and decreased by $10,510,000 in 1995.
Under current and prior law, income of WNC's life insurance subsidiaries taxed on a current basis is accumulated in a shareholders' surplus account and can be distributed without tax to WNC. At December 31, 1996, this shareholders' surplus was $279,711,000.
The following reconciles the difference between actual tax expense and the amounts obtained by applying the statutory federal income tax rate of 35%:
Income taxes paid by WNC were $10,759,000, $12,969,000, and $8,120,000 in 1996, 1995, and 1994, respectively.
The fair values of certain financial instruments along with their corresponding carrying values at December 31, 1996, and 1995 follow. As the fair value of all WNC's assets and liabilities is not presented, this information in the aggregate does not represent the underlying value of WNC. WNC does not have any financial instruments held or issued for trading purposes.