The Company leases approximately 31,010 square feet of office space in Louisville, Kentucky under a lease agreement (the "Lease") which expires on September 1, 2006, and which is subject to two five-year renewal options. This office space accommodates the executive, marketing, product development, actuarial, accounting, corporate finance and legal functions of the Company. The Company is also negotiating to lease an additional 31,000 square feet in the Louisville office to accommodate the relocation of the Company's main processing center, including information systems, customer service and policy issuance activities, which is currently housed in the Columbus, Ohio vicinity. The Company executed a $1.1 million standby letter of credit with one of its lending institutions to secure the Company's obligations under the Lease.
In addition to its headquarters, the Company and its subsidiaries lease approximately 62,000 square feet of office space in the Columbus, Ohio vicinity and approximately 7,500 square feet of office space in New York, New York. The Columbus office space houses the Company's main processing center which is being relocated and consolidated with the corporate headquarters in Louisville as mentioned above. The operations of the Company's asset management subsidiary, ARM Capital Advisors, and New York insurance subsidiary, National Integrity, are conducted from the New York facility. Additional office space owned in New Ulm, Minnesota supports the distribution operations of SBM Certificate Company.
(3) Total cash and investments, total assets and carrying amount shareholders' equity for the periods ending subsequent to December 31, 1993 reflect a change in accounting principle for the January 1, 1994 adoption of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities."
(5) The methodologies used to estimate fair value are described in the notes to the consolidated financial statements contained herein.
The Company's revenues are derived from its spread-based business and its fee-based business. The products and services comprising the spread-based and fee-based businesses are sold in two principal markets, the retail and institutional markets, through a broad spectrum of distribution channels. In the spread-based line of business the Company earns a spread between what is earned on invested assets and what is credited to customer accounts. In the fee-based line of business the Company receives a fee in exchange for managing customers' deposits, and the customer accepts the investment risk. The Company believes that market forces and population demographics are producing and will continue to generate strong consumer demand for long-term savings and retirement products, including variable and equity-indexed annuity type products. Acquisitions by the Company have provided it with the opportunity to leverage its resources and enter into new markets in order to try to meet this demand. The Company has focused on the development of its fee-based variable annuity business in addition to exploring other alternatives to increase the size of the fee-based business line, which is less capital intensive than the spread-based business and provides the Company with diversified sources of income. Although the Company believes it is desirable to achieve a reasonable business mix between its spread-based and fee-based businesses, the business mix may vary from time to time, due to opportunistic acquisitions.
Although third-party assets managed by ARM Capital Advisors have grown since the KBIMA acquisition, the Company believes that market attitudes towards developing an asset management service for defined benefit pensions plans within a holding company structure consisting predominantly of insurance companies has constrained ARM Capital Advisors' growth. Accordingly, the Company is in the process of selling the operations and assets of ARM Capital Advisors. ARM Capital Advisors' management of defined benefit pension plan accounts generated asset management fees of $4.2 million and $2.2 million during 1996 and 1995, respectively. On December 13, 1996, the Company transferred its contracts to perform management and advisory services for the State Bond Mutual Funds to Federated Investors for $4.5 million. Asset management fee income of $1.6 million and $1.0 million was recorded by the Company during 1996 and 1995, respectively, with respect to management of such funds. Had the sale of ARM Capital Advisors and the sale of the management contracts for the State Bond Mutual Funds occurred on January 1, 1995, they would have had an immaterial effect on the Company's pro forma net income for the years ended December 31, 1996 and 1995.
Average cash and investments $3,227,825 $2,501,125 Average customer deposits 3,213,313 2,488,866
The decrease in investment yields on cash and investments primarily relates to a significant increase in GIC deposits which grew from zero to $143.2 million during 1995 and to $891.9 million at December 31, 1996. The proceeds from GIC sales are invested in securities of shorter duration (which generally have lower investment yields) than the Company's other investment portfolios. The investment yield on cash and investments supporting GIC deposits was 6.53% for 1996. In comparison, the investment yield on cash and investments, excluding assets supporting GIC deposits, was 8.01% for 1996, up from 7.85% for 1995, which reflects the benefits of the ongoing management of the Company's investment portfolios. The average credited rate pattern is dependent upon the general trend of interest rates, frequency of credited rate resets and business mix. The decrease in the average rate of interest credited on customer deposits during 1996 was due primarily to annual or semi-annual crediting rate resets occurring at a time when the overall interest rate environment was generally lower (the last half of 1995 and the first half of 1996 compared to the last half of 1994 and the first half of 1995).
The increase in spread-based deposits was attributable to sales of GICs to institutional customers. The increase in the fee-based line of business was primarily attributable to variable annuity sales. The Company continues to focus on its fee-based variable annuity business to diversify its spread-based and fee-based products and their associated channels of distribution.
Sales by market and type of business for 1996 and 1995 were as follows:
The increase in retail sales was primarily attributable to an increase in sales of fee-based investment portfolio options of variable annuity contracts due, in part, to the continuing strong stock market returns during 1996 and an increased emphasis on marketing efforts of both spread-based and fee-based products during the fourth quarter, principally through stockbrokers and independent agents. The Company's institutional spread-based products (i.e., GICs) are issued primarily through a marketing partnership with another insurance company. Expanded distribution of GIC products through bank trust departments, mutual fund companies, investment managers, insurance companies and investment consultants contributed to the increase in sales of such products. The decrease in institutional fee-based sales was attributable to the Company's marketing partnership arrangement with General American which was converted from a fee-based to primarily a spread-based arrangement in late 1995. The Company's sales strategy is to broaden its mix of products, services and distribution channels to enable it to achieve its target sales within different interest rate environments.
Net surrenders of annuity products issued by the Company's insurance subsidiaries were $326.2 million and $319.8 million in 1996 and 1995, respectively. Of these amounts, $106.9 million and $62.8 million, respectively, can be attributed to fixed annuity business acquired from SBM. Surrender charge income increased to $5.0 million in 1996 from $3.3 million in 1995, due to higher average surrender charges associated with SBM products compared to other products of the Company's insurance subsidiaries and to the overall increase in the volume of surrenders. Policies issued by the Company's insurance subsidiaries generally include lapse protection provisions that provide a deterrent to surrenders when interest rates rise. These provisions can include surrender charges and market value adjustments on annuity withdrawals. During the period that surrender charges are assessable, generally the first five to seven years after a policy is issued, surrenders are
relatively low. The surrender and withdrawal activity during 1995 and 1996 was generally expected by the Company due to the level of customer deposits written several years ago that were subject to declining or expiring surrender charges and the Company's strategy of maintaining investment spreads. The Company has programs designed to reduce surrender activity and improve persistency. During 1996 and 1995, through one such program, $21.0 million and $42.0 million, respectively, of new annuity contracts were issued to customers that had initiated a withdrawal request. The Company excludes this activity from its net surrenders and sales disclosures because such amounts have no impact on net cash flow. Other programs involve direct contact with customers and are designed to inform customers of the financial strength of the Company and its insurance subsidiaries and to describe other product offerings available.
Amortization of deferred policy acquisition costs related to operations was $6.8 million and $2.9 million during 1996 and 1995, respectively. This increase was the result of growth in the deferred policy acquisition cost asset due to additional sales of fixed and variable annuity products. Variable costs of selling and issuing the Company's insurance subsidiaries' products (primarily first-year commissions) are deferred and then amortized over the expected life of the contract.
The Company recorded a $5.0 million non-recurring charge in 1996 including $3.2 million related to the move of operations facilities from Columbus, Ohio to Louisville, Kentucky; costs of
Federal income tax expense was $5.2 million and $7.0 million in 1996 and 1995, respectively, reflecting effective tax rates of 18.1% and 37.1%. The lower effective tax rate in 1996 resulted primarily from the recognition of benefits associated with certain deferred tax assets established in connection with the Company's acquisition of the Integrity Companies on November 26, 1993 for which a full valuation allowance was originally provided. These deferred tax benefits are being recognized based on the taxable income generated by the Integrity Companies in the post-acquisition period and projections of future taxable income.
Spread-based operating earnings were 0.90% and 0.81% of average spread-based assets under management of $2.47 billion and $2.00 billion during 1995 and 1994, respectively. This increase in spread-based margins was primarily attributable to ongoing asset/liability management, which generated higher net investment spreads. Fee-based operating earnings were 0.19% and 0.51% of average fee-based assets under management of $1.84 billion and $421.7 million during 1995 and 1994, respectively. The decrease in fee-based margins was primarily attributable to the growth in off-balance sheet fee-based assets managed by ARM Capital Advisors for institutional clients, which generate lower margins than the Company's other fee-based products, specifically variable annuities. For example, margins on the Company's variable annuities were 0.64% and 0.66% during 1995 and 1994, respectively.
The increase in investment yield was primarily attributable to benefits from ongoing management of the Company's investment portfolios, the rising interest rate environment during 1994 and lower amortization of invested asset write-ups resulting from purchase accounting adjustments.
Assets under management by type of product and service as of December 31, 1995 and 1994 were as follows:
Sales by market and type of business during 1995 and 1994 were as follows:
The decrease in retail sales was primarily attributable to greater industry-wide competition from banks and other financial services institutions for savings products. However, the Company believes yield curve flattening benefited sales of institutional spread-based products (i.e., GICs), resulting in total overall sales growth of spread-based products. The increase in sales of institutional fee-based products and services is primarily attributable to the increase in GIC deposits from the Company's arrangement with General American.
Net surrenders of annuity products issued by the Company's insurance subsidiaries were $319.8 million (including $62.8 million attributable to business acquired from SBM) in 1995, compared to $221.8 million in 1994. This resulted in an increase in surrender charge income to $3.3 million in 1995 from $2.4 million in 1994. The surrender and withdrawal activity during 1994 and 1995 was generally expected by the Company due to the level of customer deposits written several years ago that were subject to declining or expiring surrender charges during 1994 and 1995, and the Company's strategy of maintaining investment spreads. During the third quarter of 1994 and continuing to date, the Company began implementing programs designed to reduce surrender activity and improve persistency. During 1995, through one such program, $42.0 million of new annuity contracts were issued to customers that had initiated a withdrawal request.
annuities acquired in connection with the SBM acquisition. Commissions, net of deferrals for the corresponding period in 1994 were $2.6 million which included $2.5 million of commissions on variable life insurance contracts. The majority of the variable life block of business was sold in December 1994.
Amortization of deferred policy acquisition costs related to operations was $2.9 million and $1.3 million during 1995 and 1994, respectively. The increase in amortization was related to growth in the deferred policy acquisition cost asset.
Amortization of value of insurance in force related to operations increased to $7.1 million in 1995 from $3.8 million in 1994 reflecting amortization of the value of insurance in force established as an asset by the Company on May 31, 1995 in connection with the acquisition of SBM's insurance subsidiary.
Realized investment gains were $4.0 million in 1995, compared to realized investment losses of $36.7 million in 1994. Such realized investment gains and losses were primarily interest-rate related and attributable to the ongoing management of the Company's fixed maturity securities classified as available-for-sale. The 1994 realized investment losses were a result of the market interest rate environment at November 26, 1993 when the acquisition of the Integrity Companies occurred. This acquisition was accounted for under the purchase method which required that the Integrity Companies' investment portfolio be marked-to-market on November 26, 1993, at which time the yield on ten-year U.S. Treasury Notes was 5.74%. The yield on such notes increased steadily during 1994 and at year-end was 7.83%. As a result of the acquisition and mark-to-market occurring in a low interest rate environment and ongoing portfolio management during the rising interest-rate environment of 1994, realized investment losses of $36.7 million were generated.
ARM CAPITAL ADVISORS Through its acquisition of the U.S. fixed income unit of KBIMA in January 1995, the Company obtained a recognized fixed income management service which became part of the then newly-formed ARM Capital Advisors. In addition to providing asset management services to institutional clients, ARM Capital Advisors manages the investment portfolios of the Company's subsidiaries. Assets managed by ARM Capital Advisors under contracts with institutional clients acquired from KBIMA and new contracts with other institutional clients increased from $0.8 billion as of January 5, 1995 to $2.7 billion as of December 31, 1996. Although third-party assets managed by ARM Capital Advisors have grown since the acquisition, the Company believes that market attitudes towards developing an asset management service for defined benefit pension plans within a holding company structure consisting predominantly of insurance companies has constrained ARM Capital Advisors' growth. Accordingly, the Company is in the process of selling the operations and assets of ARM Capital Advisors (see "Business-History").
The Company's cash and investments as of December 31, 1996 are detailed as follows:
At December 31, 1996 the ratings assigned by the NAIC and comparable S&P ratings on the Company's fixed maturity portfolio, and the percentage of total fixed maturity investments classified in each category were as follows:
The higher interest rate environment at December 31, 1996 compared to December 31, 1995 resulted in unrealized gains on available-for-sale securities which totaled $3.7 million (net of $1.3 million of related amortization of deferred policy acquisition costs and value of insurance in force and $2.0 million of deferred income taxes) at December 31, 1996, compared to unrealized gains of $28.5 million (net of $14.2 million of related amortization of deferred policy acquisition costs and value of insurance in force and $15.4 million of deferred income taxes) at December 31, 1995. This change in net unrealized gains on available-for-sale securities for the year ended December 31, 1996 decreased reported shareholders' equity by $24.9 million as compared to an increase of $133.5 million for the year ended December 31, 1995. This volatility in reported shareholders' equity occurs as a result of SFAS No. 115, which requires that available-for-sale securities be carried at fair value while other assets and all liabilities are carried at historical values. At December 31, 1996 and 1995, shareholders' equity excluding the effects of SFAS No. 115 was $178.3 million and $159.5 million, respectively.
Mortgage loans on real estate represented 1% and 2% of total cash and investments at December 31, 1996 and 1995, respectively. Pursuant to the terms of the acquisition of certain of the Company's insurance operations, National Mutual has indemnified the Company with respect to principal (up to 100% of the investments' year-end 1992 statutory book value) and interest with respect to approximately 99% of these loans at December 31, 1996. In support of its indemnification obligations, National Mutual placed $23.0 million into escrow in favor of the Company's insurance subsidiaries, which will remain available until the subject commercial and agricultural loans have been paid in full.
Assets held in separate accounts at December 31, 1996 totaled $1.1 billion, compared to $0.8 billion at December 31, 1995. The increase is primarily attributable to the receipt of variable annuity deposits and from a market-driven increase in the value of existing variable annuity deposits invested in mutual funds.
The Company's principal need for liquidity has historically consisted of debt service obligations under its bank financing agreement, dividend payments on its preferred stock, operating expenses not absorbed by management fees charged to its subsidiaries and corporate development
expenditures. The Company is dependent on dividends from Integrity and management and service fee income from the Company's subsidiaries to meet ongoing cash needs, including amounts required to pay dividends on its preferred stock.
The ability of the Company's insurance subsidiaries to pay dividends and enter into agreements with affiliates is limited by state insurance laws. During 1996, the Company received dividends of $16.0 million from Integrity. The maximum dividend payments that may be made by Integrity to the Company during 1997 without the prior approval of the Ohio Insurance Director are $26.0 million, of which $7.0 million was paid in the first quarter of 1997. The Company had cash and investments at the holding company level of $6.8 million at December 31, 1996. In addition, $20.0 million was available on unused bank lines of credit at December 31, 1996.
The primary sources of liquidity of the Company's insurance subsidiaries are investment income and proceeds from maturities and redemptions of investments. The principal uses of such funds are benefits, withdrawals and loans associated with customer deposits, commissions, operating expenses and the purchase of new investments.
The Company develops cash flow projections under a variety of interest rate scenarios generated by the Company. The Company attempts to structure asset portfolios so that the interest and principal payments, along with other fee income, are more than sufficient to cover the cash outflows for benefits, withdrawals and expenses under the expected scenarios developed by the Company. In addition, the Company maintains other liquid assets and aims to meet unexpected cash requirements without exposure to material realized losses during a higher interest rate environment. These other liquid assets include cash and cash equivalents and high-grade floating-rate securities held by both the Company and its insurance subsidiaries. The Company also has $20 million available on unused bank lines of credit as mentioned above.
cash flows resulted principally from investment income, less commissions and operating expenses. Proceeds from sales, maturities and redemptions of investments generated $2,214.4 million, $1,463.3 million and $761.1 million in cash flows during 1996, 1995 and 1994, respectively, which were offset by purchases of investments of $2,772.0 million, $1,506.5 million and $854.4 million, respectively. An increase in investment purchases and sales activity during 1996 compared to 1995 reflects the Company's ongoing management of its fixed maturity portfolio which has increased in size due to sales of spread-based products and the SBM acquisition.
The Company has only limited involvement with derivative financial instruments and does not use them for trading purposes. They are used to manage well defined interest rate risks and, with respect to the Company's equity-indexed annuity deposits, equity market risks.
The Company believes that inflation will not have a material adverse effect on results of operations. The Company manages its investment portfolios in part to reduce its exposure to interest rate fluctuations. In general, the fair value of the Company's fixed maturities portfolio increases or decreases inversely with fluctuations in interest rates, and the Company's investment income increases or decreases directly with interest rate changes. For example, if interest rates decline, the Company's fixed maturity investments generally will increase in fair value, while investment income will decrease as fixed income investments are sold or mature and proceeds are reinvested at declining rates. The converse will be true if interest rates rise.
The Company has made a number of forward-looking statements in this document that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations and those preceded by, followed by or that include the words "believes," "expects," "anticipates" or similar expressions. Such forward-looking statements are based on the Company's beliefs as to its competitive position in its industry and the factors affecting its business. In particular, the statements of the Company's belief as to the stimulation of future demand for long-term savings and retirement products, including variable and equity-indexed annuity type products, under the heading "General" are forward-looking statements.