The principal operations of the insurance subsidiaries are conducted from Kansas City, Missouri and Dallas, Texas. The Company's locations include the following leased office space:
The following discussion analyzes significant items affecting the results of operations and the financial condition of the Company. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers against relying on forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the "SEC"). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Statements using words such as "may," "will," "should," "estimate," "predict," "intend," "plan," "anticipate," "believe," "expect" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements that represent the Company's beliefs concerning future levels of sales and surrenders of the Company's products, investment spreads and yields or the earnings and profitability of the Company's activities.
The following discussion should be read together with Item 6, "Selected Consolidated Financial Data" and the Company's consolidated financial statements and the accompanying notes appearing elsewhere in this Form 10-K.
o premiums on its life insurance and annuity products; o net investment income earned on its investments; and o realized capital gains and losses recognized on its investments.
o death benefits, contract payments and other cash values paid to policyholders; o expenses incurred in selling and issuing policies, including commission expenses; o expenses incurred in servicing its products and customers; and o interest expense on the Company's long-term debt.
o its ability to charge premiums on its term life and whole life products and to assess charges on its interest-sensitive life products sufficient to cover the ultimate cost of death benefits paid on those policies, which is a function of proper product design and prudent underwriting procedures; o its ability to retain existing policyholders over an extended period of time, since higher retention rates and higher continuing premiums generally improve profitability; o its ability to manage its investment portfolio to generate acceptable investment returns and control risks such as interest rate changes or defaults or impairments of invested assets; and o its ability to manage operating expenses.
The Company's discussion and analysis of its financial condition and results of operations are based on its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make certain judgments and estimates that affect the amounts reported in the financial statements and in the notes thereto. These judgments and estimates are based on the best information available to the Company at the time and are often based on the historical experience of the Company. However, actual results will often differ from these estimates. The revision of estimates can have a significant impact on the reported results of operations for a period.
The deferred policy acquisition costs and cost of business acquired related to traditional life products are amortized in proportion to premium revenues over the premium-paying period of related policies using assumptions consistent with those used in computing policy liability reserves.
The deferred policy acquisition costs and cost of business acquired related to universal life-type policies and annuities are amortized in relation to the present value of expected gross profits from projected investment, mortality and expense margins and surrender charges of the policies over the anticipated coverage period. Both historical and anticipated investment returns, including realized and unrealized gains and losses, from the investment of policyholder funds are considered in determining the amortization of deferred policy acquisition costs and the cost of business acquired.
Front-end contract charges on universal life-type policies and annuities are deferred as unearned policy revenues and amortized into policy revenues over the term of the policies. The amortization of the unearned policy revenue liability is determined in the same manner as the amortization of deferred policy acquisition costs on the same policies.
The Company's other significant accounting policies do not involve the same level of estimation and management judgment as those described above. These accounting policies are described in note 1 to the Company's consolidated financial statements included in this Form 10-K.
The table below sets forth the Company's liabilities as of December 31 of each of the last three years (in millions):
The following table summarizes the Company's sales in terms of collected first year premiums over the three-year period ended December 31, 2002 (in millions):
The adoption of SFAS No. 133 during 2001 had a significant impact on the comparability of 2001 income statement components versus 2000. The impact on individual income statement components is addressed in the discussion of the results for the year ended December 31, 2001 below.
Revenues and income before income taxes for each of the three years in the period ended December 31, 2002 for the Company's operating segments, as defined by SFAS No. 131, "Financial Reporting for Segments of a Business Enterprise," are summarized as follows (in millions):
Income before income taxes in the Company's life insurance operations segment increased $4.2 million, or 9.0%, to $51.0 million for the year ended December 31, 2001 from $46.8 million for the year ended December 31, 2000. The primary reason for the increase in profits in 2001 was a decrease in amortization expense from 2000 to 2001. Revisions to estimates of future gross profits resulted in adjustments to the Company's deferred policy acquisition costs and the cost of business acquired that decreased amortization expense by $21.9 million in 2001 and increased amortization expense by $6.6 million in 2000. The most significant revision to estimated gross profits in 2001 occurred as a result of changes in estimated policy revenues and policy benefits to reflect the impact of the settlement of litigation in which the Company was a defendant. Partially offsetting the decrease in amortization expense in 2001 was a larger increase in policy reserves in 2001, a $7.0 million increase in death benefits, net of reserves released on traditional death benefits, from 2000 to 2001 and lower profits on the Company's preneed business in 2001 that resulted from adverse lapse experience. The increase in policy reserves was $13.0 million higher in 2001 compared to 2000, primarily associated with the same policies subject to the litigation settlements discussed above.
o interest expense, o a portion of net investment income, o a portion of operating expenses, and o net realized investment gains and losses.
The net loss from reconciling items decreased $2.4 million, or 6.9%, to $32.6 million for the year ended December 31, 2001 from $35.0 million for the year ended December 31, 2000. The improvement from 2000 to 2001 resulted from net realized investment gains of $1.9 million in 2001 compared to net realized investment losses of $4.7 million in 2000, continued improvement in the reduction of operating expenses from 2000 to 2001, partially offset by $9.9 million of restructuring expenses related to the Company's decision in 2001 to exit the administration business described above and to relocate the Company's Austin operations to its Kansas City and Dallas locations.
Premiums and policy revenues. Premiums and policy revenues increased $13.2 million, or 6.4%, to $220.1 million for the year ended December 31, 2002 from $206.9 million for the year ended December 31, 2001. The primary reasons for this increase in premium and policy revenues were increases in policy revenues from interest-sensitive life and annuity products of $11.1 million and an increase in premiums from the Company's preneed and final expense policies of $2.1 million. During 2001, the Company revised its estimate of future gross profits on certain interest-sensitive life insurance policies, which had the effect of increasing its unearned policy revenue liability at December 31, 2001. Consequently, revenue arising from amortization of this larger unearned policy revenue liability increased in 2002. Also during 2002, the Company recorded $2.2 million of additional policy revenue from amortization of the unearned policy revenue liability resulting from realized gains on bonds.
The Company's decision in early 2003 to discontinue selling its preneed whole life insurance products will have the effect of reducing premium revenue in 2003 as compared to 2002. However, policyholder benefits associated with these same products will experience a comparable decline. As a result, the decision to discontinue these sales should not have a material impact on the Company's results of operations.
Income from fixed maturities investments increased $4.4 million in 2002 as compared to 2001 due primarily to the Company's larger investment balances in 2002 as compared to 2001. The Company's investment balances increased in 2002 as a result of the overall growth in the Company's business. Partially offsetting the increase in investment income from fixed maturity securities was a $3.6 million decrease in 2002 in investment income earned on reinsurance funds held by reinsurer, due to a decrease in the amount of funds held by reinsurer. The decrease in reinsurance funds held by reinsurer was consistent with the decrease in liabilities related to these reinsurance funds.
Other income. Other income increased $1.3 million, or 18.3%, to $8.4 million for the year ended December 31, 2002 from $7.1 million for the year ended December 31, 2001. The reason for this increase was a $1.3 million gain on the repurchase of notes payable by the Company. The Company repurchased notes payable with an unpaid principal balance of $8.7 million and a carrying value of $6.4 million for a cash payment of $5.1 million.
Policyholder benefits. Policyholder benefits decreased $8.3 million, or 3.2%, to $249.1 million for the year ended December 31, 2002 from $257.4 million for the year ended December 31, 2001. The primary reasons for the decrease in policyholder benefits in 2002 were a decrease in death benefits of $3.1 million and lower increases in reserves for future policy benefits. These decreases in policyholder benefits were partially offset by a $3.5 million increase in interest credited on policyholder funds due to the overall growth of the Company's universal life-type policies and annuities, and by decreases in the fair values of the embedded derivative component of the Company's equity-indexed annuity liabilities. As discussed above, a decrease in the fair value of the embedded derivative component is recorded as a reduction to policyholder benefits. The fair value of the embedded derivative component decreased $19.4 million in 2002 and $22.2 million in 2001.
Commissions. Commission expense decreased $3.2 million, or 36.8%, to $5.5 million for the year ended December 31, 2002 from $8.7 million for the year ended December 31, 2001. The decrease in commission expense from 2001 to 2002 is due to higher amounts of nondeferrable commissions incurred in 2001. Additionally, the Company recorded an additional $1.4 million of expense accrual for commission bonus plans in 2001.
During both 2002 and 2001, the Company revised its estimates of the future gross profits on certain of its universal life-type and annuity products. The revisions in 2001 primarily consisted of changes in estimated policy revenues and benefits paid to policyholder account balances, some of which resulted from the anticipated impact of settling litigation in which the Company was a defendant. As a result of these changes in estimates, the Company recorded retrospective adjustments to deferred policy acquisition costs and the cost of business acquired that reduced amortization expense in 2002 by $6.5 million and reduced amortization expense in 2001 by $18.4 million.
Other operating expenses. Other operating expenses decreased $6.3 million, or 8.0%, to $72.2 million for the year ended December 31, 2002 from $78.5 million for the year ended December 31, 2001. The Company realized significant cost savings in 2002 as a result of the Company's decision to cease operations in the third quarter of 2001 of a subsidiary that provided administration for retirement and cafeteria plans to school districts and other clients. Partially offsetting the decreases in operating expenses in 2002 were approximately $0.8 million of expenses associated with the transition of the Company's Austin, Texas operations to its Kansas City, Missouri offices (see discussion of restructuring expenses below). These transition expenses were not eligible for inclusion in the exit costs recorded by the Company in 2001.
Premiums and policy revenues. Premiums and policy revenues decreased $13.8 million, or 6.3%, to $206.9 million for the year ended December 31, 2001 from $220.7 million for the year ended December 31, 2000. The primary reasons for the decrease in premiums and policy revenues in 2001 were a $12.4 million decrease in premiums related to a decrease in the Company's in force traditional life insurance business and a $7.0 million reduction in surrender charge revenue. The decrease in surrender charge revenue in 2001 was a result of lower annuity surrenders in 2001. These decreases in premiums and policy revenues were partially offset by a $7.5 million increase in premiums on the Company's preneed policies in 2001.
Net investment income. Net investment income decreased $15.5 million, or 6.9%, to $208.1 million for the year ended December 31, 2001 from $223.6 million for the year ended December 31, 2000. Net investment income for the years ended December 31, 2001 and 2000 was comprised of the following (in millions):
The reduction in net investment income in 2001 was primarily due to a $18.4 million decrease in the fair value of call options and futures contracts owned by the Company. The decrease in the fair value of these call options and futures contracts in 2001 was partially offset by the decline in the fair value of the embedded derivative component of the Company's equity-indexed annuity liabilities, which is recorded as a reduction to policyholder benefits. Also contributing to the decrease in net investment income in 2001 was a $6.0 million decrease in investment income earned on reinsurance funds held by reinsurer, due to a decrease in the amount of funds held by the reinsurer in 2001. The decrease in reinsurance funds held by reinsurer in 2001 was consistent with the decrease in the liabilities related to these reinsurance funds. Partially offsetting these decreases was a $10.0 million increase in investment income on fixed maturity securities in 2001, primarily due to the increased amount of fixed maturity securities owned by the Company in 2001 as compared to 2000.
Policyholder benefits. Policyholder benefits decreased $3.8 million, or 1.5%, to $257.4 million for the year ended December 31, 2001 from $261.2 million for the year ended December 31, 2000. The primary reason for the decrease in policyholder benefits in 2001 was a $22.2 million decrease in the fair value of the embedded derivative component in the Company's equity-indexed annuity liabilities. As discussed above, a decrease in the fair value of the embedded derivative component is recorded as a reduction to policyholder benefits. This decrease was partially offset by a $8.3 million increase in death benefits, net of reserves released on traditional death benefits, in 2001. Also partially offsetting the decrease in policyholder benefits in 2001 were higher increases in reserves for future policy benefits, primarily associated with the same policies subject to the litigation settlement discussed above.
In addition, amortization expense decreased $5.6 million in 2001 as compared to 2000, primarily resulting from significantly lower levels of withdrawals in the Company's closed blocks of universal life and annuity policies during 2001 as compared to 2000. The decrease in amortization expense related to these blocks was partially offset by lower surrender charge revenue during 2001, as discussed above in "Premiums and Policy Revenues."
Restructuring expenses. During 2001, the Company made certain changes to its administrative and sales operations involved in the sale of insurance products to the tax-qualified market. Among other matters, the Company decided to relocate operations located in Austin to existing operations located elsewhere. Additionally, the Company decided to cease operations of PCA, a subsidiary that provided administration for retirement and cafeteria plans to school districts and other clients. Among the factors leading to these decisions was the settlement of litigation in which the Company had been a defendant. The relocation of the remaining Austin operations was completed in May 2002. In connection with these business decisions, the Company recorded a restructuring loss of $9.9 million in 2001 that consisted of several components. The Company determined that a portion of the goodwill related to these entities had become impaired. Based upon the Company's best estimate of the future results of operations of these entities, the goodwill asset was reduced by $4.7 million. The restructuring loss also includes $1.5 million representing the unamortized cost of software developed for use by these entities and exit costs of $0.9 million for expected severance payments to employees and for lease payments on the Austin office space beyond the date of the relocation. The remaining portion of the loss consisted of the operating expenses of PCA.
Liquidity. Americo has no operations of its own and relies on its subsidiaries for funds. Americo's cash requirements consist of debt service requirements on notes payable, amounts due to FHC under advisory and data processing agreements, its own operating expenses and cash dividends paid to FHC. These cash requirements are met by dividends from United Fidelity and by payments of principal and interest on surplus debentures that Americo holds, which were issued to it by United Fidelity. Americo also receives payments under investment advisory and data processing agreements with its insurance subsidiaries that permit Americo to recover substantially all of the amounts paid by it under similar agreements with FHC. On a stand-alone basis, at December 31, 2002, Americo had a total of $21.9 million of cash, marketable equity securities and fixed maturity securities available for debt service, current payables and other corporate requirements.
Americo has outstanding $100.0 million aggregate principal amount of senior subordinated notes that it issued in 1993. These senior subordinated notes bear interest at 9.25% and mature in May 2005. They became redeemable at the option of Americo beginning in 1998 and are currently redeemable at par. Several of Americo's insurance subsidiaries owned a total of $8.5 million of the outstanding notes at December 31, 2002. On January 31, 2003, Americo Retirement Services, Inc., a subsidiary of Americo, purchased an additional $7.0 million of the outstanding notes.
During 2002, the Company paid dividends on its preferred stock of $7.2 million, consisting of 61,500 shares of newly issued preferred stock and $1.1 million of cash. During 2002, the Company received dividends on FHC preferred stock of $6.9 million, consisting of 61,500 shares of newly issued preferred stock and $0.7 million of cash.
At December 31, 2002, Americo held four United Fidelity surplus debentures with an aggregate unpaid balance of $119.3 million. The terms of the surplus debentures have been established to provide for the payment of principal and interest to Americo in amounts sufficient to make timely payments on Americo's external debt obligations in accordance with their payment schedules. The maturity dates of the surplus debentures are as follows (in millions):
In connection with the Notzon litigation referred to under Item 3, "Legal Proceedings," on December 31, 2001, Americo Retirement Services, Inc. ("ARS"), a wholly-owned subsidiary of Americo, established a grantor trust (the "Trust") for the purpose of paying potential distributions to claimants arising from the Notzon litigation. The Trust was funded with FHC preferred stock contributed to ARS by Americo. If the dividends that the Trust receives on the FHC preferred stock are not sufficient to fund the Trust's obligations, the Trust is authorized to sell shares of the FHC preferred stock as necessary. FHC has a right of first refusal on any shares the Trust offers for sale. The Trust will exist until all such obligations for which it has been made responsible have been paid or expired. At such time, any assets remaining in the Trust will revert to ARS. The accounts of the Trust are included in the consolidated financial statements of the Company.
During 2002, Americo paid quarterly cash dividends of $500,000 to FHC. The Company expects that comparable cash dividends will continue to be paid in the future.
The purchase obligation represents amounts payable under FHC's data processing contract with CSC. The contract contains variable pricing terms dependent on the number of policies administered by CSC's data processing system. The amounts shown in the table are based on the Company's best estimate of projected policy counts through the term of the contract.
Investment Portfolio. The amortized cost of investments in fixed maturities, the cost of equity securities and the estimated market values of such investments by category of securities, are as follows:
The Company believes it has a conservative investment philosophy. The credit quality of its portfolio is high with limited amounts of securities below investment grade.
(2) Carrying amount is amortized cost. The market value of held to maturity securities at December 31, 2002 was $621.1 million.
The Company regularly reviews its investment securities to determine if declines in market value below cost are other than temporary. See "Critical Accounting Policies and Estimates" section included elsewhere in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" for more information regarding other than temporary impairments. Included in 2002 net realized investment losses were write-downs for other than temporary impairments on fixed maturity securities and equity securities totaling $12.9 million. Write- downs on fixed maturities totaled $9.3 million, consisting of impairments in the communication and technology sector of $7.0 million, the energy sector of $1.0 million and asset-backed retail franchise lending securities of $1.3 million. Impairment losses on equities in 2002 included $2.5 million on communication and technology sector common stocks and $1.1 million on energy sector common stocks.
At December 31, 2002, $464.0 million, or 14.7%, of the Company's invested assets and cash were invested in mortgage-backed securities ("MBS"). Approximately 75% of the MBS portfolio consists of securities or pools of securities either guaranteed by the U.S. government, including those issued by Government National Mortgage Association, or those issued by a government-sponsored agency such as the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The remaining 25% of the MBS portfolio was invested in securities collateralized by whole loans, either "pass-through" obligations or collateralized mortgage obligations ("CMOs").
The following table sets forth the amortized cost and estimated market value of the Company's MBS portfolio at December 31, 2002 (in thousands):
o purchasing securities backed by collateral with lower prepayment sensitivity (such as mortgages priced at a discount to par value), o avoiding the purchase of securities whose values are heavily influenced by changes in prepayments (such as interest-only and principal-only securities), and o purchasing securities with prepayment protected structures.
At December 31, 2002, the Company's MBS portfolio included $131.3 million of single property agency pass-through securities and CMOs with prepayment protection, which economically protects the Company in the event of prepayments. See note 4 to the Company's consolidated financial statements included in this Form 10-K for a summary of the Company's investments in CMOs.
At December 31, 2002, 1.4% of the Company's mortgage loan portfolio consisted of loans with balloon payments that mature before January 1, 2004. At December 31, 2002, only one mortgage loan, representing 0.03% of the portfolio, was delinquent by more than 90 days. There were no loans foreclosed upon and transferred to real estate owned in the Company's consolidated balance sheet at December 31, 2002. The Company's favorable default experience is principally attributable to the Company's selectivity in the mortgage loans acquired in connection with the Company's acquisitions of its life insurance subsidiaries and in its origination of new mortgage loans. In light of the current interest rate environment, the Company may experience prepayments on its mortgage loan portfolio, thus reducing its yield on such portfolio. However, approximately 85% of the Company's mortgage loan portfolio has call protection in the form of U.S. Treasury make-whole yield maintenance features, which also benefit from a minimum prepayment premium of 1% in the absence of a true make-whole gap. Of that portion of the Company's mortgage loan portfolio without call protection, a portion, or 6% of the total portfolio, consists of floating rate loans that feature a fixed-rate conversion option that, when exercised, converts to a make-whole yield maintenance prepayment option. The remaining 9% of the portfolio without call protection consists of fixed-rate loans that are currently open to prepayment at par. The Company plans to continue applying its historical underwriting standards to future investments in mortgage loans.
Real estate investments made up 0.8% of the carrying value of the Company's cash and invested assets at December 31, 2002.
Asset-liability management is utilized by the Company to reduce the risks to the Company from interest rate fluctuations and disintermediation. The Company believes that its fixed-rate liabilities should be backed by a portfolio principally composed of fixed-rate investments that generate reasonably predictable yields in a variety of interest rate environments. The Company's portfolio strategy is constructed with a view to achieving adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability management, liquidity and safety. The Company has structured its investment portfolio to reduce changes in the value of the assets under various interest rate environments. In this regard, the percentage of the Company's fixed-rate investment portfolio that is non-callable has increased from 44% in 1995 to 74% in 2002. In addition, the portfolio's concentration in mortgage-backed securities and asset-backed securities, which are subject to cash flow variability in changing interest rate environments, has decreased from 38% in 1995 to 26% in 2002. See "Investment Portfolio" section included elsewhere in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" for additional information related to the Company's investments.
As part of its asset-liability management process, the Company conducts detailed computer simulations that model its fixed-rate assets and liabilities under various interest rate scenarios. With the results of these computer-generated simulations, the Company can measure the potential gain or loss in the fair value of its interest-rate sensitive assets and liabilities and seek to protect its economic value. Effective duration is a common measure for price sensitivity to changes in interest rates. It measures the approximate percentage change in the market value of a portfolio when interest rates change by 100 basis points. This measure includes the impact of estimated changes in portfolio cash flows from features such as bond calls and prepayments. When the effective durations of assets and liabilities are similar, exposure to interest rate risk is reduced because a change in the value of assets should be largely offset by a change in the value of liabilities. At December 31, 2002, the Company's assets had an effective duration of 5.3 and its liabilities had an effective duration of 5.5. If interest rates were to decrease 10% from December 31, 2002 levels, the increase in the value of the Company's assets would exceed the increase in the value of the Company's liabilities by approximately $1.3 million.
The Company uses computer-generated simulations to evaluate how effectively it has managed the risk associated with these derivatives. The Company regularly generates hundreds of different interest rate and equity return scenarios to measure the effectiveness of its hedging program.
The American Institute of Certified Public Accountants ("AICPA") issued Statement of Position No. 01-05 ("SOP 01-05") "Amendments to Specific AICPA Pronouncements for Changes Related to the NAIC Codification" in December 2001. SOP 01-05 amends SOP 94-5 "Disclosures of Certain Matters in the Financial Statements of Insurance Enterprises" in response to the completion of the codification of statutory accounting principles for insurance companies. SOP 01-05 requires the disclosure of prescribed or permitted statutory accounting practice and the related effect on statutory surplus of using an accounting practice that differs from either state prescribed statutory accounting practices or NAIC codified statutory accounting principles. These disclosures are required beginning with financial statements issued for fiscal years ending after December 15, 2001. The Company adopted the disclosure requirements of SOP 01-05 in its December 31, 2001 consolidated financial statements.
The AICPA issued Statement of Position No. 01-06 ("SOP 01-06") "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others" in December 2001. The guidance in SOP 01-06 relating to financing and lending activities is explicitly applicable to insurance companies. SOP 01-06 reconciles and conforms the accounting and financial reporting guidance presently contained in other accounting guidance. SOP 01-06 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The Company's accounting practices for its lending activities were already consistent with the guidance contained in SOP 01-06. Therefore, adoption of SOP 01-06 did not have a significant effect on the Company's financial statements.