The Company's primary administrative offices are located in New York, New York; Dallas, Texas; and Raleigh, North Carolina. The Company owns and occupies a home office facility comprising approximately 165,000 rentable square feet, in Raleigh, North Carolina. The Company subleases a portion of its prior Raleigh home office facility which has a lease term expiring in 1999 and requires annual lease payments of approximately $1.1 million.
The Company leases approximately 100 offices throughout its sales territories and has a separate Canadian business office facility that includes office and storage space. Southwestern Financial Services Corporation ("SFSC") leases approximately 125,000 square feet in Dallas, Texas at an annual cost of $1.8 million. American-Amicable owns its home office facility in Waco, Texas. The Company believes that the current makeup of its properties is adequate for its operations and, based on its recent experience, that it will be able to find suitable replacement properties on acceptable terms for properties the Company chooses to replace or for which leases are terminated or not renewed.
This "Management's Discussion and Analysis of Financial Condition and Results of Operations" reviews the consolidated financial condition of the Company as of December 31, 1998 and 1997, the consolidated results of operations for the three years ended December 31, 1998, and where appropriate, factors that may affect future financial performance.
The following discussion should be read in conjunction with the accompanying consolidated financial statements and related notes of this Annual Report on Form 10-K.
Cautionary Statement for purposes of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. All statements, trend analyses and other information contained in this report relative to markets for PennCorp's products and trends in PennCorp's operations or financial results, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," and other similar expressions, constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things: (1) general economic conditions and other factors, including prevailing interest rate levels and stock market performance, which may affect the ability of PennCorp to sell its products, the market value of PennCorp's investments and the lapse rate and profitability of insurance products; (2) PennCorp's ability to achieve anticipated levels of operational efficiencies and cost-saving initiatives and to meet cash requirements based upon projected liquidity sources; (3) customer response to new products, distribution channels and marketing initiatives; (4) mortality, morbidity, and other factors which may affect the profitability of PennCorp's insurance products; (5) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of PennCorp's products; (6) increasing competition in the sale of insurance and annuities; (7) regulatory changes or actions, including those relating to regulation of insurance products and of insurance companies; (8) ratings assigned to PennCorp's insurance subsidiaries by independent rating organizations such as A.M. Best, which the Company believes are particularly important to the sale of annuity and other accumulation products; (9) PennCorp's ability to successfully complete its year 2000 remediation efforts, (10) the ultimate realizable value and sales proceeds to be received from the Businesses Held for Sale and (11) unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect the Company's results of operations.
Planned Dispositions. On February 18, 1998, the Company announced it had engaged investment banking firms Salomon Smith Barney and Fox-Pitt, Kelton Inc. to review strategic alternatives for maximizing shareholder value, including the sale of the Company's Career Sales Division. The Company's decision to dispose of the Career Sales Division, within a period not likely to exceed one year, resulted in the assets and liabilities of the Career Sales Division to be considered "assets and liabilities of Businesses Held for Sale."
On December 31, 1998, the Company entered into an agreement to sell the Career Sales Division and related assets to Universal American. The purchase price of $175.0 million is subject to adjustment based on the capital and surplus of the Career Sales Division at the closing date. The purchase price consists of $136.0 million in cash, subject to adjustment and $39.0 million initial principal amount of subordinated notes of Universal American. The subordinated notes bear interest at a rate of 8.0% per annum and mature ten years from date of issuance. The accreted value of the notes will be subject to offset in the event of adverse development (or subject to increase in the event of positive development) in the disability income reserves of PLIC and may be offset for other indemnification claims under the purchase and sale agreement. In
addition, the Company is required under terms of the purchase and sale agreement to deliver the Career Sales Division and related assets with certain minimum levels of statutory capital and surplus, pay certain ongoing costs and other expenses which the Company anticipates will result in its receiving net cash proceeds of approximately $70.0 to $78.0 million.
On February 21, 1999, the Company signed a definitive agreement to sell the United Life Assets. The purchase price consists of $152.0 million and a dividend payable by United Life at closing, which the Company estimates will be approximately $2.1 million. The purchase consideration may be reduced as a result of the Company's obligation to purchase certain mortgages from United Life at closing. Additionally, a portion of the purchase price may be escrowed at closing to fund the Company's obligation to purchase additional mortgages from United Life after closing. The Company anticipates receiving net cash proceeds from the sale of the Untied Life Assets of approximately $140.0 million.
The Company's decision to dispose of the Career Sales Division, Professional, KIVEX, United Life Assets and Marketing One, within a period not likely to exceed one year resulted in the assets and liabilities of the Career Sales Division, Professional, KIVEX, United Life Assets and Marketing One to be considered "assets and liabilities held for sale," and as such were segregated from those of the Retained Businesses for purposes of presentation of the Company's financial information.
Acquisitions and Other Transactions. On January 2, 1998, following shareholder approval at the Company's 1997 annual meeting of shareholders, the Company consummated the acquisition from KB Fund the SW Financial Controlling Interest for an aggregate purchase price of $73.7 million (not including acquisition expenses).
Restructuring and Other Costs. As a result of the tremendous growth of the Company and the diversification of the underlying business units resulting from acquisitions over time, the Company began a strategic business evaluation during the third quarter of 1996. The review resulted in the Company establishing three divisional platforms, Career Sales Division, Payroll Sales Division and Financial Services Division in 1997.
On January 2, 1998 and January 5, 1998, respectively, the Company acquired the SW Financial Controlling Interest and the Fickes and Stone Knightsbridge Interests. The acquisitions allowed the Company to complete its divisional restructuring which began in 1997. As a result, the Company incurred restructuring costs aggregating approximately $11.8 million for the year ended December 31, 1998, directly and indirectly associated with divisional restructuring.
In addition, the Company recorded in the fourth quarter of 1998, additional restructuring costs aggregating approximately $9.2 million as a result of the decision to consolidate or merge substantially all of its corporate functions into the Company's Dallas location.
On August 30, 1997 the merger agreement between Washington National Corporation ("Washington National") and the Company terminated. The Company incurred legal, accounting and financial advisory fees associated with the merger. In addition, the Company had begun to provide certain resources to Washington National including personnel to perform policy administration and claims processing function on Washington National's behalf. The aggregate advisory and administration costs incurred by the Company during 1997 were approximately $7.6 million.
Impairment Provision Associated with Assets of Businesses Held for Sale. For the year ended December 31, 1998 the Company recorded an impairment provision aggregating $343.0 million. In accordance with SFAS No. 121, the Company recorded the impairment provision in order to reflect the difference in the Company's accounting basis in the Businesses Held for Sale and the fair value of the consideration that the Company would likely receive for such businesses. The fair value of the consideration likely to be received has been primarily based upon the terms of definitive sales agreements. The impaired provisions for the Career Sales Division, Professional and the United Life Assets were $328.6 million, $3.3 million and $11.1 million, respectively.
Many computer and software programs were designed to accommodate only two digit fields to represent a given year (e.g. "98" represents 1998). It is highly likely that such systems will not be able to accurately process data containing date information for the year 2000 and beyond. The Company is highly reliant upon computer systems and software as are many of the businesses with which the Company interacts. The Company's ability to service its policyholders and agents is dependent upon accurate and timely transaction processing. Transaction processing in turn is dependent upon the Company's highly complex interdependent computer hardware, software, telecommunications and desktop applications. The inability of the Company or any of its integral business partners to complete year 2000 remediation efforts associated with these highly
Each of the operating divisions is primarily responsible for its remediation efforts with corporate oversight provided as necessary. The Company believes that the Career Sales Division has substantially completed its year 2000 assessment and remediation efforts, which will be subject to ongoing tests for the remainder of 1999. In addition, the Career Sales Division has committed to a strategy of utilizing third party administrative experts, who have indicated year 2000 compliance, to handle the processing of certain components of its health insurance business, thus eliminating the need for the upgrade or modification of certain existing health administration systems. The Payroll Sales Division has completed the remediation of its largest administrative platforms, except for AA Life, and anticipates successful remediation and testing of the remaining sub-systems and system interfaces during 1999. The Company believes that the Payroll Sales Division, other than AA Life, is 95.0% complete with its compliancy effort for critical business systems. AA Life is in the process of upgrading its policy administration system to a year 2000 compliant version. AA Life is relying on contracted vendor resources in order to complete its upgrade process. Based upon similar internal metrics analysis, AA Life has completed 90.0% of the total effort required for its critical business systems to be year 2000 compliant. The efforts of the Company's Financial Services Division are highly dependent on the utilization of outside resources. The Company believes that the Financial Services Division has contracted with sufficient resources to be able to remediate its essential business systems. Currently, the Company believes that the Financial Services Division is 85.0% complete with remediation efforts associated with its critical business systems. The Company believes that all of its divisions will have completed their remediation efforts by May 1999, but each division will continue to perform testing throughout 1999.
General. PennCorp ("parent company") is a legal entity, separate and distinct from its subsidiaries and has no material business operations. The parent company needs cash for: (i) principal and interest on debt; (ii) dividends on
preferred and common stock; (iii) holding company administrative expenses; (iv) income taxes and (v) investments in subsidiaries. In September 1998, the Company suspended payment of preferred and common stock dividends. The primary sources of cash to meet these obligations include statutorily permitted payments from life insurance subsidiaries, including: (i) surplus debenture interest and principal payments, (ii) dividend payments; and (iii) tax sharing payments. The parent company may also obtain cash through the sale of subsidiaries or other assets.
For the years ended December 31, 1998, 1997 and 1996, the Company received surplus debenture interest and principal payments from PLAIC of $26.2 million, $16.4 million and $132.0 million, respectively, and received dividends and tax sharing payments of $47.3 million, $18.4 million and $11.3 million, respectively. The Surplus Note Companies received $69.5 million, $32.1 million and $25.8 million in dividends and tax sharing payments from their respective insurance subsidiaries.
Sales of Equity Securities. During 1998 the parent company liquidated its common and preferred stock holdings in ACO Brokerage Holding Corp. ("ACO"), the parent company of Acordia Inc. Total proceeds received from the sale of the preferred and common stock aggregated $30.5 million. The Company had acquired the preferred stock interests in ACO for $20.0 million during 1997 and the common stock interests in January 1998 for $5.0 million as part of the Company's and the KB Capital Fund I investment in ACO. See Note 18 to Notes to Financial Statements for additional information regarding the Company's investment in ACO.
Issuance of Preferred and Common Stock. In August 1996 the Company issued 2,875,000 shares of $3.50 Series II Convertible Preferred Stock ("Series II Convertible Preferred Stock") for net proceeds of $139.2 million. In addition, in February 1996 PennCorp completed the sale of 5,131,000 shares of Common Stock, netting proceeds of $155.5 million ("February 1996 Common Stock Offering"). See Cash Uses below for the use of proceeds from the Series II Convertible Preferred Stock and February 1996 Common Stock Offerings.
Acquisition of Businesses. During 1998, the Company acquired the Controlling Interest in SW Financial for $73.7 million in cash and the Fickes and Stone Knightsbridge Interests for $10.6 million of which $200,000 of the consideration was paid in cash. To fund such acquisitions the Company utilized borrowing under its existing credit facility. For additional information on the acquisition of the Controlling Interest in SW Financial and the Fickes and Stone Knightsbridge Interests, see Note 3 of Notes to Consolidated Financial Statements. During 1996, the Company acquired United Life for $110.1 million and contributed additional capital to United Life of approximately $57.3 million. The Company effectuated the acquisition and capital contribution by providing funds to PLAIC in the form of a surplus note aggregating $155.0 million from proceeds raised under the Series II Convertible Preferred Offering. For additional information on the acquisition of United Life see Note 3 of Notes to Consolidated Financial Statements.
Interest Paid on Indebtedness. During the three year period, the Company utilized varying amounts of leverage in its capital structure. For the years ended December 31, 1998, 1997 and 1996, the average indebtedness outstanding aggregated $452.6 million, $281.6 million and $257.0 million, respectively. The Company's weighted average costs of borrowings increased significantly during 1998 as a result of the Company's increased leverage ratio and projected weakness in future liquidity. The Company anticipates higher interest costs to continue for the year ended 1999. For additional information regarding indebtedness, see Note 9 of Notes to Consolidated Financial Statements and Results of Operations-Interest and Amortization of Deferred Debt Costs.
Operating Expenses Including Restructuring Charges. During 1998 and 1997 the parent company directly and indirectly, through charges from its subsidiaries, incurred significant operating and restructuring charges. Total restructuring charges paid by the parent company during 1998 and 1997 aggregated $9.1 million and $11.5 million, respectively. During 1999, the parent company anticipates funding $5.0 million of restructuring charges. During 1998, the parent company also incurred legal, accounting and investment banking fees associated with asset dispositions aggregating $1.5 million. Operating expenses also include costs aggregating $1.8 million associated with shareholder litigation and the SEC's investigation into the Company's historical accounting practices. The Company anticipates incurring additional amounts of such costs during 1999.
Purchase of SW Financial Note. During 1997, the Company acquired all of the issued and outstanding convertible subordinated indebtedness of SW Financial aggregating $40.0 million. Such indebtedness was previously held by the creditors of ICH Corporation.
Dividends of Preferred and Common Stock. During 1998, 1997 and 1996 the Company paid common and preferred stock dividends aggregating $16.2 million, $23.5 million and $17.5 million, respectively. The increase in amounts paid during 1997 as compared to 1996 was the result of the $3.50 Series II Convertible Preferred Stock being outstanding for the entire year. The drop in dividend payments during 1998 was due to the Company's decision to halt common and preferred stock dividend payments as a result of impending liquidity concerns.
The Company's ability to receive principal and interest payments above $25.2 million under the surplus notes is contingent upon the Company's ability to consummate each of the sales transactions of the Businesses Held for Sale currently under contract. The Company has currently estimated net cash proceeds after required debt reduction under the Company's Bank Credit Facility of $21.1 million. Such liquidity is necessary for the Company to fund interest payments under the Bank Credit Facility and the notes and to fund operating expenses of the Company. Though the Company has the obligation to consummate the sales of the Businesses Held for Sale and to prepay the loans to certain covenanted levels, the Company may not have the requisite ability to effectuate the sale as a result of the restrictive covenants contained in the Amended Bank Credit Facility. The accessibility of the cash proceeds of the Businesses Held for Sale are the subject of regulatory approval. While certain regulatory filings with respect to the sale of the Businesses Held for Sale have been made, not all filings have been so made and the final structure by which such proceeds will be upstreamed to the Company have not yet been finalized. The Amended Credit Agreement provides that the Company and its subsidiaries are limited from entering into certain mergers, consolidations, amalgamations, liquidations, winding up or dissolutions, incurring certain indebtedness and liabilities, making disposition, prepaying certain indebtedness, declaring dividends, or issuing, redeeming, purchasing, retiring, exchanging or converting capital securities, in each case with very limited or scheduled exceptions. While the Company believes it has scheduled or otherwise provided for a great majority of the possible combinations it will take to effectively upstream the cash proceeds of the sales of the Businesses Held for Sale, it is not possible to foresee all combinations. Accordingly, the mechanism to upstream to the Company the necessary cash to pay the covenanted prepayment under the Amended Credit Agreement may be subject to the approval of the majority banks which, if not given, would result in an event of default under the Amended Bank Credit Agreement. Should the sale transactions not close within specified time periods, the Company may face difficulty in meeting its existing and estimated cash obligations and would be in default of certain covenants under the Bank Credit Facility.
As a result of these anticipated actions, management believes the Company will likely have sufficient financial flexibility and projected liquidity sources to meet all cash requirements for 1999. However, there can be no assurances actual liquidity sources will develop as currently projected. In the event of a shortfall of actual liquidity sources, the Company will explore options to generate any necessary liquidity such as: (i) the sale of non-strategic subsidiaries and (ii) obtain regulatory approval for extraordinary dividends from its insurance subsidiaries (which is unlikely at the present time). If the Company is unable to obtain sufficient liquidity to meet its projected cash requirements, such failure could result in a default on one or more obligations and the holders thereof would be entitled to exercise certain remedies, including the acceleration of the maturity of the entire indebtedness and commencing legal proceedings to collect the indebtedness. In such event, the Company will examine and consider the range of available alternatives to the Company at that time.
The insurance subsidiaries' principal sources of cash are premiums and investment income. The insurance subsidiaries' primary uses of cash are policy claims, commissions, operating expenses, income taxes and payments to the
Company for principal and interest due under surplus debentures, tax sharing payments and dividends. Both sources and uses of cash are reasonably predictable.
Cash Flow from Investing Activities. The Company's investment portfolio is managed with the objectives of maintaining high credited quality and liquidity, maximizing current income within acceptable levels of risk, minimizing market and credit risk, and matching the anticipated maturities of investments to the Company's liabilities. The Company believes a conservative investment strategy fits the nature of its insurance products which have little or no inflation risk and limited build-up of cash accumulation values in earlier years.
As a result of the Company's decision to exit the private placement bond sector, the Company transferred all of its remaining assets in the fixed maturities held for investment portfolio to its fixed maturities available for sale portfolio as of April 1, 1997. During 1996, the Company sold one security in its held for investment portfolio aggregating $4.9 million as a result of a dramatic deterioration in its credit rating.
Mortgage loans on real estate amounted to 1.2%, 7.2% and 7.2% of total invested assets as of December 31, 1998, 1997 and 1996, respectively. United Life is the Company's only subsidiary which actively originates new mortgage loans. United Life invests in first mortgage loans and provides a mortgage loan warehousing facility for its former parent as a means of obtaining higher invested asset yields necessary to support competitively priced annuity products.
The unaudited selected pro forma financial information for the years ended December 31, 1997 and 1996, gives effect to the acquisition of the SW Financial Controlling Interest and the Fickes and Stone Knightsbridge Interests as though each had occurred on January 1, 1996.
The following unaudited selected pro forma financial information has been prepared for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisitions been made as of January 1, 1996, or the results which may occur in the future.
Policy revenues decreased 6.4% during 1998 to $129.2 million compared with 1997. Policy revenues in 1997 decreased less than 1% compared with 1996. Life premiums collected, net of reinsurance, were $144.3 million in 1998 compared with $144.9 million in 1997 and $146.0 million in 1996. First year universal life premiums increased 56.4% in 1998 to $18.5 million and first year traditional life increased 80.5% to $7.8 million. Most of the increase in production was attributable to Southwestern Life. The Company expects the A.M. Best downgrades, which occurred during the third quarter of 1998 to negatively impact 1999 new business production levels relative to 1998. New life sales were also strong at Security Life in the first half, of 1998 but declined in the third and fourth quarters reflecting the impact of ratings downgrades and management changes in Security Life's marketing management. The increase in first year life premiums was mostly offset by decreases in life renewal premiums, which declined 8.3% in 1998 from 1997 compared to a decrease of 2.1% in 1997 compared with 1996. This reflects ratings downgrades and the impact of certain management actions instituted by Southwestern Life in the third quarter of 1997. Additional management actions are planned or are being considered with respect to certain interest sensitive life insurance contracts. Such plans, if implemented, would likely result in reduced renewal premiums in 1999 and subsequent years. See Managements' Discussion and Analysis of Financial Condition and Results of Operations-Total Policyholder Benefits, included herein. Annuity premiums have declined 59.4% to $11,152 in 1998 compared to 1997. The sales decline is attributable to a shift in the overall annuity market to sales of variable products (which the Financial Services Division does not offer) from fixed products due to historically low interest rates and consumer interest in equities. Annuity sales are also typically more sensitive to Company ratings than other insurance products. Annuity sales are likely to continue to decline unless market conditions for fixed annuities become more favorable and ratings of Southwestern Life and Security Life improve.
In January 1999, Security Life initiated management action in the form of a new exchange program for certain policyholders of Security Life. The program is being offered to all policyholders who had certain policy forms in force as of January 1, 1998. The program allows the policyholder the following options in exchange for terminating his or her policy and executing a release: (i) refund of 115% of all premiums paid for the policy prior to January 1, 1999 and 100% of premiums paid thereafter; (ii) exchange the policy, without proof of insurability, for the same face amount in a universal life policy, or a new term universal life policy. The policyholder also has the choice of not accepting the exchange program and keeping the current policy in force.
The exchange program is not expected to have a material effect on the Company's financial position or results of operations. However, statutory surplus of Security Life could be reduced by approximately $12.5 million on a pre-tax basis if every eligible policyholder elects the exchange option.
Other Income. Other income decreased $6.4 million from 1997 and resulted in a loss of $2.0 million in 1998 compared to income of $4.5 million in 1997. Included in other income in 1998 is a loss on the sale of OLIC's Guam book of business totaling $2.6 million. In 1997, OLIC recorded a gain of $4.4 million on the sale of its Panamanian business.
Total Policyholder Benefits. The following table shows the components of total policyholder benefits for the year ended December 31, 1998, 1997 and 1996:
Policyholder benefits totaled $64.5 million in 1998, which was little changed compared to 1997 or 1996.
Other Operating Expenses. Other operating expenses (including general operating, overhead and policy maintenance) increased $8.9 million from 1997 after remaining flat from 1996 to 1997. The increase is attributable to several factors, including: (i) approximately $3.6 million of remediation costs associated with Year 2000 systems conversions and upgrades, (ii) approximately $2.0 million of acquisition costs at OLIC which were expensed in 1998 as unrecoverable from future profits and (iii) additional non-deferrable expenses such as consulting fees, appraisals and other costs associated with divisional realignment which are not considered restructuring costs.
Policy Revenues. Policy revenues declined 9.0% or $23.8 million to $239.9 million in 1998 compared to 1997. This followed a 19.5% or $63.8 million decline in 1997 compared to 1996. The decline in 1998 of $21.4 million is primarily attributable to Union Bankers which discontinued sales of major medical health products and its life insurance products and increased its utilization of reinsurance. Union Bankers also accounts for nearly all of the $52.0 million of the decrease in policy revenues in 1997 compared to 1996. The remainder of the decrease is attributable to Penn Life which experienced decreases in policy revenues of $3.8 million (2.6%) in 1998 compared to 1997 and a decrease of $6.4 million (4.3%) in 1997 compared to 1996 principally as a result of lower first year sales.
Net Investment Income. Net investment income decreased $6.9 million (4.5%) in 1998 compared to 1997 and decreased $6.7 million (4.2%) in 1997 compared to 1996. The decrease is primarily attributable to United Life, where net investment income decreased $11.4 million in 1998 compared to 1997 and decreased $5.3 million in 1997 compared to 1996. United Life has experienced high surrenders of fixed annuities in 1998 and 1997 reflecting low reinvestment rates available as annuities reached the end of their surrender fee period. Surrenders at United Life totaled $253.2 million in 1998 and $255.6 million in 1997. Such surrenders resulted in a liquidation of approximately $168.9 million and $104.0 million of invested assets during 1998 and 1997, respectively, which caused the declines in investment income. Partially offsetting the decline at United Life are small increases for other companies, the largest of which related to investment income earned by Marquette during 1998 from an assumed reinsurance contract. This contract was terminated as of September 30, 1998.
Total Policyholder Benefits. Policyholder benefits increased $30.8 million (13.4%) in 1998 compared to 1997. The policyholder benefits of Penn life increased $43.0 million in 1998 compared to 1997. The increase was primarily the result of specific increases in reserve estimates associated with long term care products and certain claims reserves held by Penn Life. Policy reserves and claims reserves increases associated with the changes in estimates aggregated approximately $32.6 million. The Company had been closely monitoring the development of claims reserve experience associated with its Career Sales Division. The Company has experienced, what appears to be, a deterioration of the adequacy of its claims reserves associated with disability income products sold prior to the Company's ownership of Penn Life. As a result of such possible trends, the Company increased claims reserves estimates for the Career Sales Division by approximately $25.0 million, which is included above in the additional policy benefit reserves. See Notes 2 and 8 of Notes to Consolidated Financial Statements. In determining the amount of the necessary increase in policy reserve estimates associated with its long term care products, Penn Life allocated approximately $11.2 million of previously identified redundant policy reserves to long term care reserves, and additionally increased policy reserves by approximately $7.6 million. This was partially offset by decreases of $16.9 million
Interest and Amortization of Deferred Debt Issuance Costs. Interest and amortization of deferred debt issuance costs increased $4.3 million in 1998 compared to 1997. This is the result of higher weighted average borrowing costs and additional costs associated with credit facility fees and costs incurred to amend the credit agreement. These are a direct result of the Company's current financial position.
Corporate Expenses. Corporate expenses, eliminations and other costs were $40.1 million, $23.9 million, and $0.3 million for the years ended December 31, 1998, 1997 and 1996, respectively. The increase is directly attributable to two factors as follows: (i) the economics of KB Management, and (ii) strategic business evaluation and associated restructuring of the Company.
Income Taxes. The effective tax rates (benefit) for the years ended December 31, 1998, 1997 and 1996, were (0.8)%, 39.5% and 37.0%, respectively. The significant change in the effective tax rate between 1998 and 1997 is substantially due to the non-deductibility of the reduction in carrying value of the assets associated with Businesses Held for Sale and an increase in the tax valuation allowance, primarily representing unrecoverable net operating loss carryforwards at certain non- life companies. The 1997 and 1996 effective rates are higher than the statutory rate of 35% primarily due to non-deductible amortization of costs in excess of net assets acquired and foreign taxes in excess of foreign taxes utilized.
PENNCORP FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts)
PENNCORP FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) For the years ended December 31,
PENNCORP FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) For the years ended December 31,
As a result of the Company's announcement of its decision to sell the Career Sales Division (the Career Sales Division is comprised of the operations of Penn Life, Peninsular, Union Bankers, Constitution and Marquette), KIVEX, Professional, United Life, UC, Cyberlink and Marketing One within a period not likely to exceed one year (see Note 3 and 16 of Notes to Consolidated Financial Statements), the assets and liabilities of the Career Sales Division, KIVEX, Professional, United Life, UC, Cyberlink and Marketing One (collectively the "Businesses Held for Sale") were reported as "Assets of Businesses Held for Sale" and "Liabilities of Businesses Held for Sale" at December 31, 1998.
The Retained Businesses includes the Payroll Sales Division (the Payroll Sales Division is comprised of AA Life and OLIC) and the Financial Services Division (the Financial Services Division is comprised of Southwestern Life and Security Life).
As a result of the Company's decision to exit the private placement bond sector, the Company transferred all of its remaining assets in the fixed maturities held for investment portfolio aggregating $49,384 to its fixed maturities available for sale portfolio as of April 1, 1997. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, the Company marked all assets subject to the transfer to fair value resulting in a net increase in shareholders' equity, net of applicable income taxes, of $1,800.
Accounts and notes receivable consist primarily of agents' balances and premiums receivable from agents and policyholders. Agents' balances are partially secured by commissions due to agents in the future and premiums receivable are secured by policy liabilities. An allowance for doubtful accounts is established, based upon specific identification and general provision, for amounts which the Company estimates will not ultimately be collected. During 1998 and 1997, the Company wrote off receivables totaling $1,960 and $6,605, respectively.
During 1996, the Company implemented Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and Assets to be Disposed of." This accounting standard modified the methodology companies utilize to evaluate the carrying value of certain assets by requiring, among other things, companies evaluate assets at the lowest level at which identifiable cash flows can be determined.
Costs in excess of the fair value of net assets acquired are primarily amortized on a straight-line basis ranging from 5 to 30 years. Accumulated amortization was $31,024 and $44,606 as of December 31, 1998 and 1997, respectively. Unamortized costs in excess of net assets acquired in the amount of $22,792 were transferred to assets of Businesses Held for Sale in 1998 and $114,514 was written off in connection with the impairment provision.
Net income (loss) per common share is computed in accordance with SFAS No. 128, "Earnings Per Share." Basic earnings (loss) per share excludes dilution and is computed by dividing income (loss) applicable to common shareholders by weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share represents the potential dilution that could occur if all convertible securities, warrants and stock options were exercised and converted into common stock, if the effect of doing so is dilutive. The diluted earnings per share calculation assumes that the proceeds received upon the conversion of all dilutive options and warrants are used to repurchase the Company's common shares at the average market price of such shares during the period.
The Company adopted the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation," in 1996. This statement provides a choice for the accounting of employee stock compensation plans. A company may elect to use a new fair-value methodology, under which compensation cost is measured and recognized in results of operations, or continue to account for these plans under Accounting Principles Board ("APB") No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Note 13 of the Notes to Consolidated Financial
Statements contains a summary of the pro forma effects to reported net income applicable to common stock and earnings per share for 1998, 1997 and 1996, as if the Company had elected to account for employee stock compensation plans utilizing the fair value methodology prescribed by SFAS No. 123.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 defines derivative instruments and provides comprehensive accounting and reporting standards for the recognition and measurement of derivative and hedging activities (including certain instruments embedded in other contracts). It requires derivatives to be recorded in the Consolidated Balance Sheet at fair value and establishes criteria for hedges of changes in the fair value of assets, liabilities or firm commitments, hedges of variable cash flows of forecasted transactions, and hedges of foreign currency exposures of net investments in foreign operations. Changes in the fair value of derivatives not meeting specific hedge accounting criteria would be recognized in the Consolidated Statement of Operations. SFAS No. 133 is effective for all fiscal quarters of all years beginning after June 15, 1999. The Company is currently evaluating SFAS No.133 and has not determined its effect on the consolidated financial statements.
In March 1998, the AICPA issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This SOP provides guidance for determining whether costs of software developed or obtained for internal use should be capitalized or expensed as incurred. In the past, the Company has expensed such costs as they were incurred. This SOP is also effective for fiscal years beginning after December 15, 1998. The Company is currently completing its evaluation of the financial impact as well as the changes to its related disclosures.
On January 5, 1998, following shareholder approval at the 1997 annual meeting of shareholders, the Company consummated the acquisition of the interests of Messrs. Fickes and Stone in KB Management, KB Fund and KB Consultants LLC (formerly known as Knightsbridge Consultants LLC) (collectively, the "Fickes and Stone Knightsbridge Interests") for total consideration estimated to be $10,564 (not including acquisition expenses). Mr. Fickes will receive consideration in the form of estimated annual interest payments, ranging from $301 to $330, on April 15 each year through 2001 and will be issued 173,160 shares of the Company's Common Stock on April 15, 2001. Mr. Stone was issued his 173,160 shares in July 1998 which he pledged to financial institutions in connection with his appeal of a judgment awarded against him and his spouse. The fair value of net assets acquired amounted to ($1,701) resulting in $12,294 of costs in excess of net assets acquired which will be amortized over seven years. The acquisition of the Fickes and Stone Knightsbridge Interests has been accounted for as a purchase transaction in accordance with generally accepted accounting principles, and accordingly, preliminary fair values of assets and liabilities acquired were recorded as of the acquisition date which became the new accounting basis.
The Career Sales Division is comprised in part of the operations of Penn Life. With the acquisition in January 1998 of SW Financial, the Company has integrated Union Bankers, Constitution and Marquette into the Career Sales Division.
to $78,000. For additional information concerning the disability insurance reserves of PLIC, see Note 8 of Notes to Consolidated Financial Statements.
Also on December 31, 1998, the Company signed a definitive agreement to sell Professional. Professional, which previously was included in the Payroll Sales Division, provides individual fixed benefit and life products utilizing a network of independent agents primarily in the southeastern United States through employer-sponsored payroll deduction programs. Pursuant to the purchase and sale agreement, Professional will be sold to GE Financial Assurance Holdings, Inc. ("GEFAH") for $47,500 in cash. The purchase price is subject to adjustment based on Professional's capital and surplus at the closing date. In addition, GEFAH will pay interest on the purchase price from December 31, 1998 to the date of settlement. The Company currently estimates receiving net cash proceeds for the Professional sale of approximately $40,000 to $41,500.
On February 21, 1999, the Company signed a definitive agreement to sell United Life and its wholly-owned subsidiary, United Variable Services, Inc., to ING America Insurance Holdings, Inc. ("ING"). United Life, which previously was included in the Financial Services Division, principally markets fixed and variable annuities through financial institutions and independent general agents, primarily in the southern and western United States. The sale of United Life to ING also includes the sale of UC, Cyberlink and certain assets of Marketing One. The aggregate purchase price consists of $152,000 and a dividend payable by United Life at closing, which the Company estimates will be approximately $2,100. The purchase consideration may be reduced as a result of the Company's obligation to purchase certain mortgages from United Life at closing. Additionally, a portion of the purchase price may be escrowed at closing to fund the Company's obligation to purchase additional mortgages from United Life after closing. United Life, including its subsidiary United Variable Services, Inc., UC, Cyberlink and certain assets of Marketing One are referred to herein collectively as the "United Life Assets." The Company anticipates receiving net cash proceeds from the sale of the United Life Assets of approximately $140,000.
The amortized cost and fair value of fixed maturities available for sale as of December 31, 1998, by contractual maturity, are shown below:
As of December 31, 1998, commercial and residential mortgage loan investments were concentrated in the following states:
Investments with a carrying value of $146,385 and $68,219 were on deposit with certain regulatory authorities as of December 31, 1998 and 1997, respectively.
Realized, and changes in unrealized gains and losses on investments were as follows for the years ended December 31:
The Retained Businesses had non-income producing investments at December 31, 1998 with an amortized cost and fair value as follows:
On December 14, 1995, SW Financial (see Notes 18 and 19 of the Notes to Consolidated Financial Statements) purchased SW Life, Union Bankers and certain other related assets from I.C.H. Corporation for $260,000.
Through its initial direct investment of $120,000 in SW Financial (the "Southwestern Life Investment"), the Company beneficially owned, at December 31, 1997 and 1996, 74.8% of SW Financial's outstanding common stock, including 100% of SW Financial's non-voting common stock, 14.3% of SW Financial's voting common stock, and 100% of SW Financial preferred stock. PennCorp is also a 16.3% limited partner in KB Fund. As a result, the Company had an economic interest in SW Financial aggregating 78.0 percent. Retained earnings of the Company included undistributed earnings of SW Financial aggregating $40,919 and $21,947 as of December 31, 1997 and 1996, respectively.
(7) DEFERRED POLICY ACQUISITION COSTS AND PRESENT VALUE OF INSURANCE IN FORCE
The Company is continually evaluating actuarial assumptions associated with interest sensitive life insurance contracts in which the determination of policy reserves is highly sensitive to assumptions such as withdrawal rates, investment earnings rates, mortality rates, and premium persistency. Currently reflected in the Company's financial statements are policy reserves and account values associated with such contracts, which aggregated approximately $525,445 and $504,562 as of December 31, 1998 and 1997, respectively. If developing trends were to continue, the Company would be required to record additional reserves or reduce intangible assets, which could have a material impact on the Company's financial position and results of operations. Management is also assessing the potential impact of future management actions, which might mitigate the financial impact of these trends. Type of management actions would likely include, but not limited to, the redetermination of non-guaranteed charges and/or benefits under the contracts, asset segmentation, and reinsurance. There are risks associated with management action including potential sales disruption and the treat of litigation. The Company is continuing to refine its actuarial estimates, likely management action plans and associated sensitivity testing of such interdependencies on policy reserves associated with these contracts which could result in changes in such estimates in the future.
Total future policy benefits consist of the following as of December 31, 1998 and 1997:
The Company has been closely monitoring the development of claims reserve experience associated with its Career Sales Division. The methodology previously utilized has experienced, what appears to be, a deterioration of the adequacy of its claims reserves associated with disability income products sold prior to the Company's ownership. During 1998, the Company changed its methodology in recording these reserves. As a result of the trends and change in methodology the Company increased claims reserves estimates for the Career Sales Division by $25,000. The effect of the change in methodology is inseparable from the effect of the change in accounting estimate and is accordingly reflected in operations as a change in accounting estimate for the year ended December 31, 1998.
The aggregate maturities of notes payable during each of the five years after December 31, 1998, are as follows: 1999, $726; 2000, $728; 2001, $434,666; 2002, $157; and 2003, $114,646.
Credit Facility. Total annualized interest and associated costs with the Bank Credit Facility are expected to exceed LIBOR based borrowing rates by approximately 400 basis points.
As a result of these anticipated actions, management believes the Company will likely have sufficient financial flexibility and projected liquidity sources to meet all cash requirements for 1999. However, there can be no assurances actual liquidity sources will develop as currently projected. In the event of a shortfall of actual liquidity sources, the Company will explore options to generate any necessary liquidity such as: (i) the sale of non-strategic subsidiaries, (ii) obtain regulatory approval for extraordinary dividends from its insurance subsidiaries (which is unlikely at the present time) and (iii) borrowing on a secured basis. If the Company is unable to obtain sufficient liquidity to meet its projected cash requirements, such failure could result in a default on one or more obligations and the holders thereof would be entitled to exercise certain remedies, including the acceleration of the maturity of the entire indebtedness and commencing legal proceedings to collect
the indebtedness. In such event, the Company will examine and consider the range of available alternatives to the Company at that time.
The Company and a number of its non-insurance subsidiaries file a consolidated federal income tax return. Marketing One and its subsidiaries file a consolidated federal income tax return. The life insurance subsidiaries file federal income tax returns with either PLAIC, or Pioneer Security, or Constitution as the parent of the particular consolidated life insurance company tax group.
In assessing the realization of deferred taxes, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon those considerations, management has established a valuation allowance for all net deferred tax assets associated with the non-life insurance members of its group. Management believes it is more likely than not that the Company will realize the remaining benefits of these deductible differences, net of the existing valuation allowance as of December 31, 1998.
The Company's recording of an impairment provision associated with the Businesses Held for Sale results in a reduction in deferred tax liabilities of $95,137 related to such assets.
As of December 31, 1998, the Company has non-life consolidated net operating loss carryforwards of approximately $60,860 for tax purposes which, if not utilized, will begin to expire in 2012.
over a ten year period as of the beginning of the first taxable year starting after the date of enactment. At this time, it is uncertain whether this provision will be included in any legislation proposed by Congress, and if included, whether such provision would be enacted into law. As it is not currently considered likely that a tax would become due on any such balances, no deferred income taxes have been provided. However, if such tax were to become payable, it would amount to approximately $14,805.
At December 31, 1998 the Company had 100,000,000 shares of $.01 par value common stock authorized and 30,072,344 shares issued and outstanding. The common stock has no preemptive or other subscription rights and there are no conversion rights, redemption or sinking fund provisions with respect to such shares.
A portion of the consideration for the acquisition of the Fickes and Stone Knightsbridge Interests included 173,160 shares of the Company's Common Stock due each of Messrs. Fickes and Stone on April 15, 2001. As a result of the acquisition, common stock and additional paid in capital increased $3 and $8,497, respectively, for the year ended December 31, 1998. Common shares due Mr. Stone were issued as of December 31, 1998.
During the year ended December 31, 1998, certain employees exercised stock options and warrants resulting in the issuance of 616,572 shares of the Company's Common Stock. The result of such exercises was to increase common stock and additional paid in capital by $2 and $2,014, respectively.
As of December 31, 1998 and 1997, accrued and unpaid dividends on the $3.375 Convertible Preferred Stock amounted to $3,558 and $1,617, respectively. As of December 31, 1998 and 1997, accrued and unpaid dividends on the $3.50 Convertible Preferred Stock amounted to $4,193 and $1,677, respectively.
The Company has established a U.S. Sales Manager incentive stock option plan in which the senior sales manager of one of the Company's insurance subsidiaries may earn stock options in the amount of 275,000 shares over a five-year period, subject to achieving certain performance goals, in addition to an initial grant of 100,000 options. Such options are vested immediately as earned, except for the initial 100,000 which vest in September 1999, and option prices range from $15 per share, for the initial 100,000 options, to the fair value of the common stock of the Company on the date of grant for those shares subject to performance goals and as such no compensation expense is recorded.
The following table summarizes information concerning outstanding and exercisable options and warrants as of December 31, 1998:
As allowed under the provisions of SFAS No. 123, the Company utilizes APB Opinion No. 25 and related Interpretations in accounting for its stock option and warrant plans and, accordingly, does not recognize compensation cost based on fair value as a component of net income applicable to common stock. If the Company had elected to recognize compensation cost based on the fair value of the options and warrants as of the grant date, estimated utilizing the Black- Scholes multiple options approach prescribed by SFAS No. 123, the Company's net income (loss) applicable to common stock as well as earnings (loss) per share would have been reduced by the pro forma amounts indicated in the following table:
Cash generated by the Company's insurance subsidiaries is made available to PennCorp principally through periodic payments of principal and interest on surplus debentures issued by PLAIC, Constitution and Pioneer Security (collectively, the "Surplus Note Companies"). The amounts outstanding under the surplus debentures totaled $453,118 and $358,346 as of December 31, 1998 and 1997, respectively. These surplus debentures generally require (subject to availability of statutory capital and surplus and in some instances, regulatory approval) principal and interest payments to be made quarterly.
Dividend payments by the Company's insurance subsidiaries are limited by, or subject to the approval of the insurance regulatory authority of each subsidiary's state of domicile. Such dividend requirements and approval processes vary significantly from state to state. In 1999, the Company's retained insurance subsidiaries, subject to availability of cash, statutory capital and surplus and regulatory approval, will be able to pay a maximum of $25,848 in dividends to the Surplus Note Companies (including SW Financial).
Statutory capital and surplus of the Company's life insurance subsidiaries as reported to regulatory authorities at December 31, 1998 and 1997, totaled $399,766 and $299,062, respectively. Statutory net income (loss) of the Company's life insurance subsidiaries as reported to regulatory authorities totaled ($44,563), $18,776 and ($28,600) for the years ended December 31, 1998, 1997 and 1996, respectively. Surplus note interest expense of $40,531, $34,758 and $51,254 for the years ended December 31, 1998, 1997 and 1996, respectively, is included in statutory net income (loss).
In December 1992, the NAIC adopted the RBC for Life and/or Health Insurers Model Act (the "Model Act"). The main purpose of the Model Act is to provide a tool for insurance regulators to evaluate the capital of insurers with respect to the risks assumed by them and determine whether there is a need for possible corrective action with respect to them. To date, either the Model Act or similar legislation or regulation has been adopted in all the domiciliary states of the Company's insurance subsidiaries.
Calculations using the NAIC formula and the life insurance subsidiaries' statutory financial statements as of December 31, 1998, indicate that each of the insurance subsidiaries' capital exceeded RBC requirements, except for PLIC (see Note 20 of Notes to Consolidated Financial Statements).
On October 1, 1990, the Company established the PennCorp Financial, Inc. Retirement and Savings Plan, a defined contribution retirement plan, for eligible employees. This plan and the Marketing One Incorporated 401(k) Profit Sharing Plan merged with the Southwestern Financial Services Corporation Savings Investment Plan effective January 1, 1998 and the name of the plan was changed to the PennCorp Financial Group, Inc. Retirement and Savings Plan ("the PennCorp Plan"). Employees are eligible to participate in the plan after six months of employment in which they are credited with 500 hours of service. Participants may contribute from 1 to 15% of pre-tax compensation and/or from 1 to 10% of after tax compensation. Each employer participating in the plan matches each pay-period, 50% of pre-tax contributions up to 6% of compensation. If approved by the Board of Directors, each employer may make a discretionary profit sharing contribution annually on behalf of employees eligible to participate in the plan based on their compensation for the prior plan year. Employee contributions are fully vested at all times. The employer matching contributions made for employees who participated in the PennCorp Plan prior to January 1, 1998 vest at the rate of 50% per calendar year of service. The employer matching contributions made for all other participants and the employer discretionary contribution vests at the rate of 20% per year of service. All participants are fully vested at death, disability or attainment of age 65. The assets of each account are invested at the direction of the participant. Eleven funds with various investment objectives are available to the participants. Distributions are normally made in a lump sum. Participants of the PennCorp Plan prior to January 1, 1998 may elect to receive an annuity in various forms of payment. Expenses related to this plan for years ended December 31, 1998, 1997 and 1996 amounted to $3,341, $1,483 and $1,520.
The Company and, through its wholly-owned subsidiary, SW Financial (as a result of the acquisition of the SW Financial Controlling Interest, see Note 3 of Notes to Consolidated Financial Statements), provide certain postretirement benefits to eligible retirees. The plans provide certain health care and life insurance benefits for retired employees. Employees meeting certain age and length of service requirements become eligible for these benefits. The Company's obligation for accrued postretirement benefits is unfunded. Following is an analysis of the accumulated benefit obligation and the liability for accrued postretirement benefits for the year ended December 31, 1998 and 1997:
The liability for accrued benefit obligation includes the following at December 31, 1998 and 1997:
At December 31, 1998, the accumulated benefit obligation and the liability for accrued postretirement benefits included $4,717 and $933, respectively, related to Businesses Held for Sale.
As a result of the Company's announcement of its decision to sell the Career Sales Division, KIVEX, Professional, United Life, UC, Cyberlink and Marketing One within a period not likely to exceed one year, the assets and liabilities of the Career Sales Division, KIVEX, Professional, United Life, UC, Cyberlink and Marketing One were reported as "Assets of Businesses Held for Sale" and "Liabilities of Businesses Held for Sale" at December 31, 1998 in the accompanying consolidated balance sheet (see Note 3 of Notes to Consolidated Financial Statements). The assets and liabilities of Businesses Held for Sale at December 31, 1998 were as follows:
Invested assets................................................... $ 1,974,280 Insurance assets.................................................. 329,950 Other assets...................................................... 117,574 ----------- Total assets.................................................... $ 2,421,804 ===========
Insurance liabilities............................................. $ 1,853,163 Other liabilities................................................. 213,391 ----------- Total liabilities............................................... $ 2,066,554 ===========
For the year ended December 31, 1998 the Company recorded the impairment provision aggregating $342,960. In accordance with SFAS No. 121, the Company recorded an impairment provision in order to reflect the difference in the Company's accounting basis in the Businesses Held for Sale and the fair value of the consideration that the Company would be likely to receive for such businesses. The fair value of the consideration likely to be received is based primarily upon the terms of definitive sales agreements. The impairment provisions for the Career Sales Division, Professional and the United Life Assets were $328,584, $3,263 and $11,113, respectively. The Company will continue to evaluate the terms and conditions of the definitive agreements relative to its accounting basis in the Businesses Held for Sale and, as a result, may need to reflect additional impairment provisions prior to ultimate disposition of the Businesses Held for Sale.
The following unaudited selected pro forma financial information has been prepared to illustrate the pro forma effects of the purchase of the SW Financial Controlling Interest as well as the Fickes and Stone Knightsbridge Interests and the sales of Career Sales Division, KIVEX, Professional, United Life, UC, Cyberlink and Marketing One. The pro forma statements of operations for the years ended December 31, 1998 and 1997 give effect to such purchases and sales as if they had occurred on January 1, 1997. The unaudited selected pro forma financial information has been prepared for comparative purposes only and does not purport to be indicative of what would have occurred had such purchases and sales been made as of January 1, 1997, or results which may occur in the future.
During 1998 the Company liquidated its common and preferred stock holdings in ACO. Total proceeds received from the sale of the preferred and common stock aggregated $30,500. The Company- had acquired the common stock interest in January 1998 for $5,000 as part of the Company's and the KB Capital Fund I investment in ACO.
The Company owns 66,555 shares of redeemable preferred stock of Portsmouth Financial Group, Inc. ("Portsmouth") with a carrying value of $6,656. Southwestern Life may, subject to regulatory approvals, make up to a $10,000 preferred equity investment in Portsmouth. The preferred stock pays dividends of 18.0% of which 12% is in cash with the remainder in the form of additional preferred stock. The shares are mandatorily redeemable in June 30, 2002. Portsmouth underwrites, acquires and holds to receipts of benefits, life insurance contacts covering individuals facing terminal illnesses. Portsmouth is owned by KB Fund and its affiliates.
As of December 31, 1998, the Company invested a total of $12,641 in transactions sponsored by Wand Partners L.L.C. ("Wand Partners") in which a director of the Company is a managing member. The Company has committed to invest up to an additional $11,393 in future transactions sponsored by Wand Partners.
Certain individuals, who are shareholders and directors of PennCorp, and affiliates of these individuals, provide services to the Company. During 1997 and 1996, payments aggregating $250 and $250, respectively, were made to these individuals and their affiliates for services provided in connection with the Company's acquisition activity.
The Amended Proposed Settlement was subject to approval by the Chancery Court after notice to PennCorp stockholders. As discussed above, Messrs. Stone and Fickes agreed that, if the Amended Proposed Settlement was approved by the Chancery Court, they would cancel their SW Financial common stock warrants and they would not participate in the increased consideration (other than the possible price protection right) for the SW Financial Controlling Interest to the extent it relates to their $7,000 personal investment in SW Financial, which together would reduce the price to be paid by PennCorp for the SW Financial Controlling Interest by approximately $3,667. Because the Knightsbridge restructuring would have the effect of substantially eliminating potential future conflicts of interest between Messrs. Stone and Fickes and PennCorp, and because the Amended Proposed Settlement would have the effect of reducing the price paid for the SW Financial Controlling Interest and would obviate the need to expend considerable management and director time to litigate the actions, the PennCorp Board determined that the Amended Proposed Settlement was in the best interests of PennCorp and its shareholders and conferred a substantial economic benefit on PennCorp. Accordingly, the PennCorp Board authorized the payment to plaintiffs' counsel of legal fees of $785 and documented expenses not to exceed $50 in connection with the lawsuits and the related settlement negotiations.
The Amended Proposed Settlement was approved by the Chancery Court on May 12, 1998. The time period for filing an appeal had expired and the Company paid $835 to plaintiffs counsel representing fees of $785 and documented expenses of $50.
The Complaint alleges that defendants violated the Securities Exchange Act of 1934. Among other things, plaintiffs' claim that defendants issued a series of materially false and misleading statements and omitted material facts regarding the Company's financial condition, including the value of certain of its assets, and failed to timely disclose that it was under investigation by the Securities and Exchange Commission (the "SEC").
Plaintiffs seek to recover damages in unspecified amounts on behalf of themselves and all other purchasers of the Company's common stock and purchasers of the Company's subordinated notes during the period of February 8, 1996 through November 16, 1998.
The Company has notified its primary and excess carriers of directors and officers liability insurance of the existence of the claims set forth in the Complaint, and the total potential insurance available is $15,000 of primary and $10,000 of excess coverage, respectively, for securities claims. The primary insurance coverage requires the Company to bear 25% of all expenses and any losses in excess of the $1,000 retention amount. The primary and excess carriers have reserved their rights under the policies with respect to coverage of the claims set forth in the Complaint.
On July 30, 1998, the SEC notified the Company that it has commenced a formal investigation into possible violations of the federal securities laws including matters relating to the Company's restatement of its financial statements for the first nine months of 1997, and for the years ended December 31, 1994, 1995 and 1996. The Company and its management are fully cooperating with the SEC in its investigation.
In May 1998, the North Carolina Attorney General's Office (the "NCAG") initiated an inquiry concerning certain life insurance products historically sold by Security Life and representations allegedly made by Security Life's agents and officers with respect to not changing insurance charges after the eighth policy year for non-smoker insureds. The NCAG indicated that Security Life may be estopped to change its current practice of not charging the cost of the insurance because of certain representations made by agents and officers of Security Life. Although Security Life has not charged the cost of insurance charges for non-smoker policyholders who recently reached their ninth policy year, this practice is not guaranteed under the life insurance contracts. The contracts specifically allow Security Life the right to change the cost of insurance rates in accordance with the parameters set forth in the insurance contracts. Security Life has responded to the NCAG's inquiry by denying that it is estopped from changing the cost of insurance rates based on the alleged representations, and continuing to reserve its contractual rights to change the cost of insurance rates in accordance with the parameters set forth in the insurance contracts. In June 1998, the NCAG informed Security Life that it could not adjudicate this matter and left it mutually unresolved. No further communications from the NCAG have been received to date. The Company has initiated an exchange program which enables policyholders of such life insurance products to terminate their policies and obtain either (i) the refund of all premiums paid and other consideration or (ii) another Security Life product. See Item 1. Business -- Regulatory Matters. There can be no assurances that the exchange program will be successful or that the Company will resolve these matters on such life insurance product on a satisfactory basis, or at all, or that any such resolution would not have a material adverse effect on the Company's financial condition, results of operations or cash flows.
In connection with a potential leveraged buyout of the Career Sales Division, the sales force of Penn Life agreed to a reduction in the commission rates over the life of the policy contract on new sales on and after January 1, 1998, in exchange for the opportunity to participate in the equity in a newly-formed leveraged entity. Discussions have also been held relating to equity incentive programs based on sales production and persistency measures. Additionally, the Company has held discussions with a marketing organization, which it has contracted with for the development and marketing of products focused on the senior marketplace, concerning the issuance of equity in the newly-formed leveraged entity based on a percentage of profits contributed by such marketing organization. In connection with the Company's definitive agreement to sell the Career Sales Division and related assets to Universal American, the sales force of Penn Life and the marketing organization will receive equity in Universal American and will participate in certain equity incentive programs of Universal
American. A portion of the proceeds to be received by the Company from Universal American for the sale of the Career Sales Division will be used to fund the equity of Universal American to be issued to the sales force of Penn Life and to make certain other payments to the sales force in exchange for a release relating to the potential leveraged buyout. If the Company does not consummate its transaction with Universal American, then it will pursue alternatives with the Penn Life sales force in light of the modifications to commissions associated with new business production after January 1, 1998 and with the marketing organization in light of the marketing contract.
On September 30, 1998, PLIC entered into a financial reinsurance agreement with an unaffiliated reinsurer to coinsure certain in force individual life and health business written or acquired by PLIC prior to January 1, 1998. Such
Fees incurred for financial reinsurance were approximately, $675 in 1998, $145 in 1997, and $265 in 1996.
In addition, the Company recorded in the fourth quarter of 1998 additional restructuring costs aggregating approximately $9,274 as a result of the Company's decision to consolidate or merge substantially all of its corporate functions into the Company's Dallas location.
The restructuring costs recognized the following for the year ended December 31, 1998 and 1997:
During the years ended December 31, 1998 and 1997, the Company re-evaluated the restructuring costs and reduced the remaining accruals by approximately $6,164 and $2,300, respectively, as a result of the final determination of certain obligations.
The Company incurred approximately $6,296 and $4,652 of pre-tax incremental costs ("period costs") associated with the corporate restructuring for the years ended December 31, 1998 and 1997, respectively. Such costs are included in the Company's Results of Operations as underwriting and other administrative expenses.
Other Investments: Other investments consist primarily of limited partnerships and joint ventures. These are evaluated periodically. Carrying value represents the underlying equity of the limited partnerships or joint ventures of their cost which approximates fair value.
Notes Payable: The carrying value for outstanding notes receivable other than the senior subordinated notes approximates the fair value as they carry variable interest rates of interest which adjust at least every 90 days. The fair value of the senior subordinated notes is determined based upon quotes from market makers.
The following is a summary of the quarterly results of operations for the years ended December 31, 1998 and 1997:
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Southwestern Financial Corporation and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles.
SOUTHWESTERN FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY for the Years Ended December 31, 1997 and 1996 (In thousands)
SOUTHWESTERN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1997 and 1996 (In thousands)
On December 14, 1995 (the acquisition date), Southwestern Financial Corporation (SWF or the Company), a newly organized corporation, was formed by PennCorp Financial Group, Inc. (PennCorp) and Knightsbridge Capital Fund I, L.P. (Knightsbridge). A wholly-owned subsidiary of SWF acquired from I.C.H. Corporation (ICH), Southwestern Life Insurance Company (Southwestern Life) and its wholly-owned subsidiary, Constitution Life Insurance Company (Constitution) and its 83% owned subsidiary, ICH Funding Corp. (ICH Funding), and Union Bankers Insurance Company (Union Bankers) and its wholly-owned subsidiary, Marquette National Life Insurance Company (Marquette). In addition, a wholly-owned subsidiary of SWF acquired from ICH substantially all of the assets and liabilities of Facilities Management Installation, Inc. (FMI), which had provided management services to ICH's insurance companies. The acquisition was accounted for as a purchase in accordance with generally accepted accounting principles (GAAP) and, accordingly, the purchase price was allocated to assets and liabilities acquired based on estimates of their fair value as of the acquisition date, which became the new cost basis. Subsequently, the insurance companies were reorganized such that Constitution became the parent of Southwestern Life and Union Bankers. Effective January 2, 1998, PennCorp acquired Knightsbridge's interest in SWF and SWF became a wholly-owned subsidiary of PennCorp. (See Note 16).
Revenues for interest sensitive products such as universal life and annuity contracts represent charges assessed against the policyholders' account balance for the cost of insurance, surrenders and policy administration. Benefits charged to expenses include benefit claims incurred during the period in excess of policy account balances and interest credited to policy account balances.
Accounts and notes receivable consist primarily of agents' balances and premium receivable from agents and policyholders. Agents' balances are partially secured by commissions due to agents in the future and premiums
receivable are secured by policy liabilities. An allowance for doubtful accounts is established, based upon specific identification and general provision, for amounts which the Company estimates will not ultimately be collected.
The present value of insurance in force represents the anticipated gross profits to be realized from future revenues on insurance in force at the date such insurance was purchased, discounted to provide an appropriate rate of return and amortized, with interest, based on credited rate, over the years that such profits are anticipated to be received in proportion to the estimated gross profits. Accumulated amortization was $35,386 and $22,889 as of December 31, 1997 and 1996, respectively.
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to (i) temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and (ii) operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the temporary differences are expected to be recovered or settled. The effect
Financial reinsurance that does not transfer significant insurance risk is accounted for as a deposit and is reflected as a component of due from reinsurers. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsurance policies. Balances due to, or from, reinsurers have been reflected as assets and liabilities rather than reducing the related account balances.
Investments with a fair value of $119,695 and $121,617 were on deposit with certain regulatory authorities at December 31, 1997 and 1996, respectively.
At December 31, 1997 and 1996, the accounts of GSSW are consolidated into the accompanying consolidated balance sheet.
The outstanding principal amounts of notes payable at December 31, 1997 and 1996 consist of the following:
As part of the consideration for the acquisition of Southwestern Life, Union Bankers, Constitution and Marquette from ICH, the Company issued to ICH a $40,000 aggregate principal amount of SWF's 7.0% Convertible Subordinated Notes due 2005. The notes are convertible into an aggregate 3,200,000 shares of common stock of SWF, of which 800,000 will be Class B non-voting common stock. In the aggregate the shares upon conversion represent approximately 21.2% of SWF's fully diluted shares at closing before giving effect to certain warrants outstanding. During 1997, PennCorp acquired the notes from the liquidating trust for the creditors of ICH for $40,000 plus accrued interest. The Convertible Notes are unsecured obligations and are subordinate in right of payment to SWF's bank debt and all of the indebtedness of SWF. Interest costs under the Convertible Notes totaled $2,800 for the years ended December 31, 1997 and 1996. The Company agreed to maintain sufficient cash and cash equivalents to fund the interest payments on the Convertible Notes for the first three years. At December 31, 1997 and December 31, 1996, restricted cash and short-term investments totaled $3,339 and $5,959, respectively.
8. Deferred Policy Acquisition Costs and Present Value of Insurance in Force
The methods used by the Company to value the health, life and annuity products purchased are consistent with the valuation methods used most commonly to value blocks of insurance business. It is also consistent with the basic methodology generally used to value insurance assets. The method used by the Company includes identifying the future cash flows from the acquired business, the risks inherent in realizing those cash flows, the rate of return the Company believes it must earn in order to accept the risks inherent in realizing the cash flows, and determining the value of the insurance asset by discounting the expected future cash flows by the discount rate the Company requires.
The discount rate used to determine such values is the rate of return required in order to invest in the business being acquired. In selecting the rate of return, the Company considered the magnitude of the risks associated with actuarial factors described in the following paragraph, cost of capital available to the Company to fund the acquisition, compatibility with other Company activities that may favorably affect future profits, and the complexity of the acquired company.
Expected future cash flows used in determining such values are based on actuarial determinations of future premium collection, mortality, morbidity, surrenders, operating expenses and yields on assets held to back policy liabilities as well as other factors. Variances from original projections, whether positive or negative, are included in income as they occur. To the extent that these variances indicate that future cash flows will differ from those included in the original scheduled amortization of the value of the insurance in force, current and future amortization may be adjusted. Recoverability of the value of insurance in force is evaluated annually and appropriate adjustments are then determined and reflected in the financial statements for the applicable period.
Expected amortization, based upon current assumptions and accretion of interest at a policy liability or contract rate ranging from 5.5% to 6.6% for the next five years of the present value of insurance in force is as follows:
The insurance subsidiaries prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their respective state insurance departments. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are approved by insurance regulatory authorities; such practices differ from state to state, and may differ from company to company within a state, and may change in the future. Furthermore, the NAIC has a project to codify statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. Accordingly, that project, will likely change to some extent prescribed statutory accounting practices, and may result in changes to the accounting practices that insurance enterprises use to prepare their statutory financial statements.
Southwestern Life previously ceded a block of annuities under a reinsurance agreement with Employees Reassurance Corporation (ERC). Such reinsurance, accounted for as a financing arrangement, is not reflected in the accompanying financial statements except for the risk fees paid to ERC. The reinsurance agreement was terminated as of November 30, 1997.Statutory surplus provided by this treaty totaled $8,714 at December 31, 1996. Risk fees paid to the reinsurer were 2% of the net amount of surplus provided, but not less than a minimum fee of $40 per quarter, and totaled $110 and $222 for the years ended December 31, 1997 and 1996, respectively. Amounts due from reinsurers included amounts due from ERC of $121,016 at December 31, 1996. The underlying assets held by ERC had carrying values of $121,016 and fair values of $122,639 at December 31, 1996.
The Company provides services for a wholly-owned subsidiary of PennCorp. The Company charges the subsidiary for its direct costs and a share of overhead costs based upon time and utilization studies. These costs totaled approximately $5,178 during 1997.
The life insurance companies are required to be members of various state insurance guaranty associations in order to conduct business in those states. These associations have the authority to assess member companies in the event that an insurance company conducting business in that state is unable to meet its policyholder obligations. In some states, these assessments can be partially recovered through a reduction in future premium taxes. The insurance subsidiaries paid assessments of $980 in 1997 and $1,357 in 1996. Based on information currently available, the insurance subsidiaries have accrued $3,194 at December 31, 1997 for future assessments, net of future premium tax reductions.
The following is a summary of the carrying value and fair value of the Company's financial instruments at December 31, 1997 and 1996:
Interest rate cap: The fair value of the interest rate cap is $0 as the current interest rate is below the cap rate.
Notes Payable: Fair values of the Company's bank obligations approximate carrying values due to the variable interest structure. The fair value of the Company's convertible note payable is not valued at December 31, 1997 as it was owned by PennCorp and canceled in February 1998.
Universal Life and Investment Contract Liabilities: The carrying value and fair values for the Company's liabilities under universal life and investment-type insurance contracts are the same as the interest rates credited to these products are periodically adjusted by the Company to reflect market conditions. The fair values of liabilities under all insurance contracts are taken into consideration in the overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts.
On February 18, 1998, PennCorp announced that it had engaged investment banking firms to review strategic alternatives for maximizing shareholder value, including the sale of certain divisions, which include Union Bankers, Constitution, Marquette and affiliated service providing companies ("SW Financial businesses held for sale"). As of and for the year ended December 31, 1997, the total assets, net liabilities, total revenues and net loss of the SW Financial businesses held for sale aggregated $530,866, $49,697, $109,387 and $5,201, respectively.