The Company's primary administrative offices are located in Dallas, Texas. Southwestern Financial Services Corporation ("SFSC") leases approximately 125,000 square feet in Dallas, Texas at an annual cost of $1.8 million. The Company believes that the current make up of its properties is adequate for its operations, and based on recent experience, that it will be able to find suitable replacement properties on acceptable terms for properties the Company chooses to replace or to which leases are terminated or not renewed.
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; (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 continued ability to address Year 2000 issues; (10) PennCorp's ability to consummate the Recapitalization Plan; 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.
On March 15, 2000, the Company received a competing bid in the form of a recapitalization plan submitted by Inverness and Vicuna on behalf of the unofficial ad hoc committee of preferred stockholders, and Rapoport and Sharpe. On March 23, 2000 the Company's Board of Directors selected the Recapitalization Plan as the final accepted offer pursuant to the bidding procedures approved as part of the Sales Procedure Order. On March 24, 2000, the Bankruptcy Court approved the Board of Director's selection of the Recapitalization Plan.
The proposed Recapitalization Plan provides that the preferred stockholders will receive one share of common stock of the reorganized company for each share of outstanding preferred stock. In addition, the preferred stockholders will have an opportunity, pursuant to a rights offering, to purchase .3787 shares of common stock of the reorganized company for each share of outstanding preferred stock owned at a purchase price of $12.50 per share. Inverness and Vicuna have issued a stand by commitment letter to the Company, committing $24.5 million to fully underwrite the rights offering. In addition, Rapoport and Sharpe have committed to purchase equity in the recapitalized company amounting to $20.0 million and $3.0 million, respectively. The standby commitment letter and the Rapoport and Sharpe investment, are subject to certain conditions.
Consummation of the recapitalization transaction is subject to certain conditions including regulatory approvals, the consummation of a $95 million credit facility, the consummation of a proposed transaction whereby Southwestern Life and Security Life will reinsure substantially all of their existing deferred annuity blocks of business, an order confirming the Company's plan of reorganization that incorporates the proposed recapitalization transaction shall have been entered by the Bankruptcy Court and such order shall be unstayed and in full force and effect, and the closing of the recapitalization shall occur no later than December 31, 2000. The definitive agreements for the credit facility and the reinsurance transaction will contain conditions to consummation including no material adverse change as defined in the proposed $95 million credit agreement.
The Company has received irrevocable commitments from holders of approximately 71 percent of the Company's two outstanding series of preferred stock indicating that they will vote in favor of the Recapitalization Plan upon solicitation by the Company which, when such shares are voted, will satisfy the voting requirements for confirmation of a plan of reorganization. Inverness, Vicuna, Rapoport and Sharpe have deposited an aggregate of $47.5 million into an escrow account, such that those funds will be used to make their respective committed equity investments in the recapitalized company once the Recapitalization Plan is consummated. A portion of such funds may be forfeited to the Company under certain circumstances.
Historically, the Company, through its three operating divisions, provided accumulation, life, and fixed benefit accident and sickness insurance products throughout the United States and Canada. The Company's products are sold through several distribution channels, including independent general agents, exclusive agents, financial institutions and payroll deduction programs, and are targeted primarily to lower and middle-income individuals in rural and suburban areas. The Company's products are primarily small premium accident and sickness insurance policies with defined fixed benefit amounts, traditional whole life and universal life insurance with low face amounts, and accumulation products such as single premium deferred annuities. During 1999, the Company disposed of its Career Sales Division and certain operating subsidiaries. See "Dispositions and Other Events" below. Each disposition impacted certain distribution channels and related products historically utilized by the Company.
Dispositions and Other Events. On July 30, 1999, the Company consummated the sale of the Career Sales Division to Universal American. The net cash proceeds after transaction costs and fulfillment of contract obligations were $82.0 million. The Company realized a foreign currency translation loss of $25.0 million, which represented previously unrealized translation losses on the Company's Canadian insurance operations, partially offset by a gain of $3.5 million resulting in a net loss of $21.5 million. In addition, as a result of the sale, unrealized gains on securities available for sale and unrealized foreign currency translation losses decreased by $2.3 million and $25.0 million, respectively. On December 29, 1999, as a result of certain settlement and consideration adjustment provisions included in the purchase and sale agreement the Company reduced the consideration received by $2.6 million.
On June 30, 1999, the Company completed the sale of KIVEX to Allegiance for $34.5 million in cash. The net proceeds to the parent company from the sale were $22.2 million after payment of costs and fees associated with the transaction and after repayment of $10.2 million of intercompany borrowings to insurance company affiliates of PennCorp. The Company recorded a gain of $30.9 million from the sale.
On April 30, 1999, the Company consummated the sale of the United Life Assets to ING. The purchase consideration totaled $154.1 million including a dividend of $2.1 million that was paid by United Life at closing. The cash consideration ultimately was reduced as a result of the Company's obligation to purchase certain mortgages and other assets as well as for transaction related costs at closing. The Company received net cash proceeds of $136.5 million. The Company realized a loss from the sale totaling $3.9 million. As a result of the sale, unrealized gains on securities held for sale by United Life decreased $1.7 million. As of December 31, 1999, the Company sold substantially all of the mortgages retained by the Company as a part of the sale of the United Life Assets for aggregate consideration of $8.0 million. The Company may be obligated to repurchase certain of the mortgages sold. The amount of mortgages the Company may be required to repurchase is not expected to exceed approximately $1.6 million. At December 31, 1999, the Company has established a $1.2 million liability related to these contingencies. In addition, the Company has been notified by ING that it disputes certain federal income tax calculations under the provisions in the purchase and sale agreement. Under the provision of the purchase and sale agreement ING is to provide the Company with preliminary tax returns in order for the Company to evaluate any potential differential in tax amounts between closing and the final return preparation. To date ING has not provided such preliminary tax returns and hence the Company has not been able to fully evaluate the merits of ING's claim. At December 31, 1999, the Company has established a liability of $1.2 million related to this contingency.
On March 31, 1999, the Company consummated the sale of Professional to GE Financial for cash proceeds of $47.5 million. The Company realized net cash proceeds of $40.2 million. Professional, which previously was included in the Payroll Sales Division, provided individual fixed benefit and life products utilizing a network of independent agents primarily in the southeastern United States through employer-sponsored payroll deduction programs. The Company realized a gain from the sale totaling $1.1 million. As a result of the sale, unrealized gains on securities available for sale by Professional decreased by $488,000. On September 15, 1999, as a result of certain settlement and consideration adjustment provisions included in the purchase and sale agreement the Company reduced the consideration received by $1.2 million.
The following unaudited selected pro forma financial information has been prepared to illustrate the pro forma effects of the sales of Payroll Sales Division (sold February 4, 2000) (see Notes 3 and 23 of Notes to Consolidated Financial Statements), Career Sales Division (sold July 30, 1999), KIVEX (sold June 30, 1999), the United Life Assets (sold April 30, 1999) and Professional (sold March 31, 1999) . The pro forma statements of operations for the years ended December 31, 1999 and 1998 give effect to such sales as if they had occurred on January 1, 1998. 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, 1998, or results which may occur in the future.
Restructuring and Other Costs. The Company has developed restructuring plans to realign or consolidate certain operations resulting in restructuring costs incurred during 1999, the fourth quarter of 1998, the first quarter of 1998 and 1997.
As a result of the sale of the United Life Assets along with other non-core operations, the Company announced a restructuring plan in June 1999 to significantly reduce its Dallas-based staff and vacate certain office space. The Company incurred restructuring costs aggregating $5.3 million for the year ended December 31, 1999 associated with such restructuring.
The following reflects the impact of activity for the year ended December 31, 1999 on the restructuring accrual balances under the 1999 Plan (in thousands):
In the fourth quarter of 1998, the Company recorded restructuring costs aggregating approximately $9.3 million as a result of the decision to consolidate or merge substantially all of the Company's corporate functions into the Dallas infrastructure.
The following reflects the impact of activity for the years ended December 31, 1998 and 1999 on the restructuring accrual balances under the 4th Quarter 1998 Plan (in thousands):
The fourth quarter 1998 restructuring plan is expected to result in corporate operating expense reductions and cash savings of approximately $4.2 million annually.
The first quarter 1998 restructuring plan provided for vacating certain Dallas office space. In connection with the plan, the Company recorded estimated holding costs of vacated facilities of $2.2 million which represented the net present value of the rent on the office space to be vacated net of the estimated sublease rent to be received. During 1999, the Company charged $350,000 of rent expense on vacated office space against the accrual.
The first quarter 1998 plan also recognized impairment of certain furniture, fixture and data processing equipment totaling $1.1 million which had been utilized in the office space to be vacated. The Company charged $831,000 of such assets against the accrual during 1998.
As a result, the Company began to realign its existing operating companies and incurred restructuring costs aggregating approximately $19.1 million during the year ended December 31, 1997, directly and indirectly associated with the initial divisional restructuring which had no future economic benefit.
The following reflects the impact of activity for the years ended December 31, 1997 and 1998 on the restructuring accrual balances under the 1997 plan (in thousands):
The plan also provided for vacating of certain leased facilities and abandoning certain Company owned real estate. The Company accrued $6.2 million for holding and abandonment costs associated with these facilities. During 1997, the Company charged $1.9 million to such accrued lease costs. During 1998, the Company further charged $841,000 to the accrued costs. As of December 31, 1998, the remaining accrual was no longer necessary as a result of the decision to retain the Waco operating platform.
Restructuring charges in the 1997 plan also included a $6.0 million provision for the write-off of the Company's investment in certain foreign operations, principally Argentina. In 1997, the Company disposed of the foreign operations at a cost of $5.6 million and the balance of $449,000 was adjusted to zero.
The Company did not incur incremental costs during 1999. The Company incurred approximately $6.3 million and $4.7 million of pre-tax period 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 Consolidated Statements of Operations and Comprehensive Income (Loss) as underwriting and other administrative expenses.
The Company engaged outside vendors and focused certain employees' full time efforts to help in the full array of its year 2000 initiative. This included systems assessment and monitoring advice, actual code remediation, communication and consultation with critical business partners and additional data center and testing resources. The Company originally projected to incur internal and external costs associated with such expertise ranging from $10.6 million to $14.5 million, which were anticipated to be incurred primarily during 1998 and early 1999. The Company actually incurred internal and external costs of $8.0 million during 1999. The Company estimates it has incurred internal and external costs aggregating $13.4 million and $1.9 million for the years ended December 31, 1998 and 1997, respectively.
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 parent company 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.
Since the February 7, 2000 bankruptcy petition filing, the Company has been managing its assets as a "debtor-in-possession." In anticipation of the filing of the Chapter 11 Case, the Company and the lenders party to the Bank Credit Facility executed a forbearance agreement ("Forbearance Agreement") whereby the lenders agreed to forbear from exercising their remedies under the Bank Credit Facility as a result of the event of default that occurred under the Bank Credit Facility when the Company commenced the Chapter 11 Case.
- -------------- (1) Projected amounts are on pro forma basis which considers the impact of the Recapitalization Plan as if such plan is consummated on June 15, 2000. There can be no assurance that the Recapitalization Plan is consummated in its current form or at all.
The Surplus Note Companies rely upon dividends and tax sharing payments from their respective insurance subsidiaries. Each of the insurance subsidiaries is in turn subject to regulatory restrictions under the Texas Insurance Laws and Regulations with respect to the maximum amount of dividends that can be paid to the Surplus Note Companies within a twelve month period without prior regulatory approval. Such dividend restrictions are generally the greater of 10% of statutory capital and surplus or statutory earnings for the prior calendar year. See Item 1. Business--Regulatory Matters for additional discussions of dividend restrictions.
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 Fund investment in ACO. See Note 18 of Notes to Consolidated Financial Statements for additional information regarding the Company's investment in ACO.
Sales of/Collection on Assets Held. During the year ended December 31, 1999, the Company received mortgage loan principal payments and distribution from a limited partnership totaling $1.4 million. In addition, the Company sold certain mortgage loans and the limited partnership interest held directly by the parent company for proceeds aggregating $10.2 million.
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 borrowings 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.
Operating Expenses Including Restructuring Charges. During 1999, 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 1999, 1998 and 1997 aggregated $1.8 million, $9.1 million and $11.5 million, respectively. During 1999 and 1998, the parent company also incurred legal, accounting and investment banking fees associated with asset dispositions aggregating $2.4 million and $1.5 million, respectively. Operating expenses incurred during 1999 and 1998 also include costs aggregating $1.6 and $1.6 million, respectively, associated with shareholder litigation and the SEC's investigation into the Company's historical accounting practices.
Reduction of Notes Payable. During the year ended December 31, 1999, the Company made repayments under the Bank Credit Facility aggregating $267.0 million upon the consummation of sales of Professional, the United Life Assets, KIVEX and the Career Sales Division. An additional $2.0 million was repaid as a result of liquidity at the parent company level above amounts prescribed in the Bank Credit Facility, as amended.
Capital Contributions to Subsidiaries. For the years ended December 31, 1999, 1998 and 1997, the Company made capital contributions to subsidiaries totaling $27.7 million, $7.9 million and $14.9 million, respectively. During 1999, $3.3 million was contributed to PLAIC to make a subsequent capital contribution to PLIC and $3.1 million was contributed to a non-life insurance subsidiary. In addition, $21.3 million was contributed to subsidiaries to meet certain target capital and surplus requirements as required by the purchase and sale agreement for the Career Sales Division. The Company utilized funds from proceeds from the Businesses Held for Sale to fund these contributions. During 1998 and 1997, contributions were primarily made to certain non-life insurance subsidiaries, principally KIVEX, to fund expansion and for other corporate purposes.
Dividends of Preferred and Common Stock. During 1998 and 1997 the Company paid common and preferred stock dividends aggregating $16.2 million and $23.5 million, respectively. The decrease 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.
For the period from January 1, 2000 to February 7, 2000, the Company paid $10.0 million in employment contract obligations and $280,000 in transaction bonuses ($8.3 million had been accrued and expensed prior to December 31, 1999) under executive employment agreements with certain senior executives of the Company and its subsidiaries (see Notes 15 and 23 of Notes to Consolidated Financial Statements.) In addition, the Company paid $2.0 million for insurance coverage, principally to cover possible indemnification claims arising from a breach of the representations and warranties contained in each of the subsidiary and asset sale agreements, $1.9 million in retainers to professional services firms and $3.5 million for other professional and legal services. Interest totaling $3.1 million was paid during the period in order to bring the Bank Credit Facility current.
Cash Sources and Uses for the Period February 8, 2000 to December 31, 2000
The pro forma schedule of cash sources and uses of the parent company for the period from February 8, 2000 to December 31, 2000, assumes the consummation of the Recapitalization Plan in June of 2000. As part of this plan, additional equity of $47.5 million would be contributed and the Company would enter into a new $95.0 million credit facility of which $90.0 million is anticipated to be drawn during 2000. Existing senior and subordinated debt with a principal balance of $180.0 million would be repaid. The parent company would receive approximately $55.0 million from PLAIC as principal repayment on the existing surplus debenture. The $55.0 million would be made available to PLAIC from proceeds received as the result of an extraordinary dividend from Southwestern Life and Security Life, subject to final approval from the Texas Department of Insurance. Such approval is contingent in part, upon the consummation of a reinsurance transaction whereby Southwestern Life and Security Life would reinsure substantially all of their existing deferred annuity blocks of business to a non-affiliated reinsurer. Projected cash sources also include $9.8 million in dividends and principal and interest payments on the surplus debenture. Closing costs associated with the Recapitalization Plan are estimated to aggregate $13.5 million.
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 Operating Activities. Cash flow from operating activities, excluding the parent company, were $54.9 million, $34.2 million and $74.6 million, respectively, for the years ended December 31, 1999, 1998 and 1997. The increasing trend in cash flow from operating activities for the year ended December 31, 1999 principally resulted from decreasing costs associated with (i) year 2000 remediation at all of the insurance subsidiaries, (ii) reduced costs as a result of strategic business evaluations and associated restructuring of the Company and (iii) sale of KIVEX, which used cash from operating activities due to its rapid growth. The decreasing trend in cash flow from operating activities for the year ended December 31, 1998, is primarily attributable to the Company assuming 100% of the economic interest of KB Management during 1998. Prior to the acquisition, the Company maintained a 45% economic interest in KB Management. At the time of the acquisition, KB Management's operating and administrative expenses were in excess of current fee income resulting in a cash strain to the Company. Other factors impacting the decreasing trend in cash flow from operating activities for 1998 were increasing costs associated with: (i) Year 2000 remediation at all of the insurance subsidiaries, (ii) the strategic business evaluations and associated restructuring of the Company and (iii) the accelerating expansion and transition of KIVEX from a regional to a national internet service provider.
The Company has prepared such information as it believes that: (i) the acquisition of the SW Financial Controlling Interest, (ii) the intended disposition of the Businesses Held for Sale and (iii) the restructuring costs are material enough to make historical comparative results not meaningful. In addition, the Company believes that the pro forma financial information will facilitate the subsequent discussion parallel with how management views and evaluates the operations of the Company.
Year ended December 31, ------------------------------ 1999 1998 1997 --------- --------- --------- ($ in thousands) Revenues: Policy revenues............................ $ 133,930 $ 129,241 $ 138,006 Net investment income...................... 161,841 179,433 201,483 Other income............................... 11,395 3,678 1,052 --------- --------- --------- 307,166 312,352 340,541 --------- --------- --------- Benefits and expenses: Total policyholder benefits................ 213,407 215,415 195,131 Insurance related expenses................. 28,653 29,591 32,893 Other operating expenses................... 38,893 48,328 36,927 --------- --------- --------- 280,953 293,334 264,951 --------- --------- --------- Pre-tax operating income.................. $ 26,213 $ 19,018 $ 75,590 ========= ========= =========
Policy revenues increased 3.6% during 1999 to $133.9 million compared with 1998. Policy revenues in 1998 decreased 6.4% to $129.2 million compared with 1997. Life premiums collected, net of reinsurance, were $116.8 million in 1999 compared with $150.3 million in 1998 and $145.9 million in 1997. First year universal life premiums decreased 15.0% in 1999 to $9.5 million and first year traditional life decreased 24.5% to $9.6 million. The decline in 1999 is attributable to lower sales at Security Life. New sales at Security Life declined significantly in 1999 reflecting the impact of ratings downgrades and management changes in Security Life's marketing management. The Company announced in the third quarter of 1999 it was discontinuing new life sales at Security Life in order to reduce costs and concentrate its marketing efforts at Southwestern Life. Partially offsetting the decline in first year premiums for Security Life was an increase in first year universal life premium at Southwestern Life which increased 21.1% to $7.3 million during 1999 compared with 1998. Most of the increase in production during 1998 compared with 1997 was attributable to Southwestern Life. The A.M. Best downgrades, which occurred during the third quarter of 1998 continue to have a negative impact on new business production levels.
Annuity premiums have declined 46.4% to $8.7 million in 1999 compared to 1998 after declining $13.1 million or 44.8% 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 financial strength 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 improve.
Net Investment Income. Net investment income decreased 9.8% to $161.8 million in 1999 due to a decrease in invested assets and reduced yields on investments. Average invested assets declined approximately $177.6 million in 1999 compared with 1998 and decreased $110.3 million from 1998 compared to 1997. Most of this decrease resulted from the need to liquidate invested assets to provide cash to fund surrenders of annuities and interest sensitive life contracts, which totaled $265.1 million and $179.0 million in 1999 and 1998. Most of the surrendered policies had reached the end of their surrender fee period. A continued decline in the invested asset base and related investment income is anticipated as surrenders are expected to remain high over the next few years as more policies in force reach the end of the surrender fee periods. The decrease in invested assets due to surrenders was partially offset by premiums on new and existing life policies and investment income collected, less commissions and operating expenses. Weighted average yields on invested assets have decreased to 6.8% in 1999 compared to 7.1% in 1998 and 7.4% in 1997. The decline reflects a decrease in higher yielding but less liquid asset classes such as mortgages, real estate and collateral loans. Also impacting investments yields were lower new money rates available to the Company to invest as a result of extensive maturities and calls of higher yielding investments and slightly higher investment expenses as a result of the decision in 1997 to utilize outside investment managers.
Other Income. Other income increased $7.7 million in 1999 compared to 1998 and increased $2.6 million in 1998 compared to 1997. Included in 1999 was income of $5.7 million from the distribution of assets of a joint venture investment resulting from the sale of most of the operations and assets of the joint venture. During 1998, the Company received approximately $1.0 million resulting from a settlement associated with securities owned in the past. Most of the remaining differences between the years reflect changes in consideration received on supplemental contracts. Supplemental contract revenue is derived from annuity contracts which have reached the annuitization period. Consideration from supplemental contracts recognized as other income is offset by policyholder benefits, resulting in no net effect on the Company's results of operations.
Other Operating Expenses. Other operating expenses (including general operating, overhead and policy maintenance) decreased $9.4 million in 1999 from $48.3 million in 1998, and increased $11.4 million in 1998 from $36.9 million in 1997. The decrease in 1999 is attributable to ongoing reductions in costs associated with the restructuring of the Dallas operations, a reduction in non-deferrable expenses associated with year 2000 remediation efforts and systems conversions for Security Life. The decrease was also impacted by a charge of $2.3 million during 1998 for uncollectible agents' debit balances at Security Life. In addition, the liabilities held at Southwestern Life and Security Life to reflect expected assessments to life and health guaranty associations of states in which it is licensed to do business was reduced by approximately $3.4 million as a result of completing these companies' evaluation of third party guaranty fund assessment data on a corporate-wide basis, including the impact of the disposition of the Businesses Held for Sale. The 1998 increase is attributable to several factors including: (i) Security Life established an allowance for uncollectible agents' debit balances aggregating approximately $2.3 million, (ii) approximately $4.9 million of remediation costs associated with Year 2000 systems conversions and upgrades and (iii) additional non-deferrable expenses such as consulting fees, appraisal costs and other costs associated with the divisional realignment which are not considered restructuring costs.
Net Investment Income. Net investment income decreased 3.9% in 1999 from 1998 to $36.8 million and increased 0.2% in 1998 from 1997 to $38.3 million. The decrease in net investment income is primarily a result of a decrease in weighted average yields on invested assets which decreased to 7.0% in 1999 from 7.2% in 1998 and a decrease in average invested assets of $1.5 million in 1999. The increase in net investment income in 1998 was primarily the result of an increase in the average invested assets which increased approximately $14.9 million in 1998 compared to 1997. The increases in invested assets is primarily attributed to modest increases in business in force at AA Life.
Other Income. Other income was $2.1 million in 1999 compared to a loss of $1.7 million in 1998. Other income in 1998 decreased $6.1 million from 1997 and resulted in a loss of $1.7 million in 1998 compared to income of $4.5 million in 1997. Supplemental contracts represent most of the other income in 1999 which can fluctuate significantly from period to period but have little impact on results of operations as proceeds are offset by change in reserves. 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.
Insurance Related Expenses. Insurance related expenses (including non-deferrable commissions, amortization of deferred policy acquisition costs and amortization of present value of insurance in force) decreased $6.9 million in 1999 compared to 1998 and increased $12.8 million in 1998 compared to 1997. The decrease in 1999 results principally from a decline in amortization of deferred policy acquisition costs at OLIC of $10.2 million. During 1998, OLIC accelerated amortization of deferred acquisition costs by $8.6 million primarily as a result of refinements in persistency assumptions and unlocking of the estimates of future profits. In addition, there was a small increase in 1999 in the amortization of present value of insurance in force at OLIC. This was partially offset by amortization of deferred policy acquisition costs at AA Life which increased $2.4 million in 1999 when compared with 1998 primarily reflecting the growing block of policies in force as a result of new business sales subsequent to the Company's acquisition of AA Life. Amortization of present value of insurance in force increased $280,000 in 1999. The increase in 1998 compared to 1997 primarily reflects the $8.6 million of accelerated amortization of deferred policy acquisition costs at OLIC. In addition, amortization of deferred policy acquisition costs at AA Life increased $2.7 million in 1998 compared to 1997 primarily reflecting the growing block of in force policies sold since the Company's acquisition of AA Life.
Businesses Held for Sale include the operations of the Career Sales Division (sold July 30, 1999), KIVEX (sold June 30, 1999), Professional (sold March 31, 1999) and the United Life Assets (sold April 30, 1999). As a result, all of the Businesses Held for Sale were disposed of by July 30, 1999. The Career Sales Division, which included the operations of Penn Life, marketed and underwrote fixed benefit accident and sickness products and, to a lesser extent, life products through a sales force exclusive to the Company throughout the United States and Canada. With the January 2, 1998, consummation of the acquisition of the SW Financial Controlling Interest, the Company integrated Union Bankers, Marquette and Constitution with the Career Sales Division. KIVEX was an internet service provider. Professional provided individual fixed benefit and life products utilizing a network of independent agents primarily in the southeastern United States through employer-sponsored payroll deduction programs. United Life principally markets fixed and variable annuities through financial institutions and independent general agents, primarily in the southern and western United States.
Other Income. Other income decreased $8.0 million (38.0%) in 1999 compared to 1998 and increased $846,000 (4.2%) to $21.0 million in 1998 compared to 1997. The decrease in 1999 from 1998 is attributable to the sale of KIVEX on June 30, 1999. The increase in other income in 1998 compared to 1997 is attributable to increases in revenue from KIVEX and increased fee income for United Life. These increases in 1998 are partially offset by a decline in the amortization of Union Bankers' deferred gain associated with a third party Medicare reinsurance contract. The decrease in amortization is attributable to a decline in the underlying premium in force subject to the reinsurance arrangement, over time, which results in lower amortization of the gain.
The lag factor method (an actuarial method to estimate aggregate claims reserves which utilize the ratio of actual claims paid to what is ultimately paid as a function of time since the date incurred based upon historical experience) is one method which utilized Penn Life's experience considering its products and market. The Company believes that available industry data for establishing claim reserves was not appropriate for Penn Life's products and market. The utilization of a case reserve method (which estimates aggregate claims reserves based on the total estimates of all cases outstanding) for Penn Life required experience, in addition to that utilized by the lag factor method, to create case reserves based on Penn Life's experience. This experience was not sufficient until 1998. With system upgrades, Penn Life was able to obtain better benefit data distinguishing disability benefits from other benefits which may be payable under the same policy form. With the systems upgrades and more robust experience the Company was able to consider a more refined claims methodology such as seriatim case reserves (which estimates aggregate claims reserves based upon the sum of estimates for each individual unsettled case). During 1998, Penn Life implemented a method which substituted case reserves for most disability claims. The new method utilizes more detailed information by policy and by line of business resulting in a more refined estimate. As a result, the accident and health claim reserve for Penn Life increased by $25.7 million during 1998. The effect of the change in methodology is inseparable from the effect of the change in accounting estimate and is accordingly reflected in operations for the year ended December 31, 1998. 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 in Union Bankers policyholder benefits, reflecting less business in force as a result of the decision to cease sales of major medical and life business, the cession of the remaining 20% of the Medicare business and the runoff of existing business.
Interest and Amortization of Deferred Debt Issuance Costs. Interest and amortization of deferred debt issuance costs decreased $2.7 million in 1999 compared to 1998 and increased $4.3 million in 1998 compared to 1997. The decrease in 1999 compared to 1998 is principally a result of principal repayments under the bank credit facility. The Company repaid the outstanding bank credit facility aggregating $267.0 million upon consummation of the sales of Professional ($40.0 million), the United Life Assets ($127.0 million), KIVEX ($22.0 million) and the Career Sales Division ($78.0 million). In addition, the Company repaid $2.0 million on September 23, 1999 as a result of liquidity at the parent company above amounts prescribed in the bank credit facility, as amended. The decrease during 1999 of the weighted average amount of principal outstanding was partially offset by the higher borrowing costs, additional costs associated with credit facility fees and costs incurred to amend the credit agreement as a direct result of the Company's financial position. In addition, during 1999, the Company accelerated amortization of certain deferred loan costs in the amount of $2.1 million in accordance with Emerging Issue Task Force ("EITF") Issue No. 98-14, "Debtor's Accounting for Changes in Line-of-Credit or Revolving-Debt-Arrangements," as a result of the amendment to the bank credit facility. EITF Issue No. 98-14 requires the unamortized deferred loan costs to be amortized in proportion to the impact of periodic changes in a credit facility as compared with its original terms. The increase in 1998 compared to 1997 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.
Corporate Expenses. Corporate expenses, eliminations and other costs were $37.2 million, $36.9 million, and $25.3 million for the years ended December 31, 1999, 1998 and 1997, respectively. The increase in 1999 compared to 1998, despite the cost savings realized by the decision to close the Company's New York and Bethesda offices and eliminate personnel located in such offices, is principally attributable to additional amortization of costs in excess of net assets acquired of approximately $7.6 million in 1999 associated with KB Management. The accelerated amortization reflects the Board of Directors' decision to terminate KB Fund, for which KB Management and KB Investment act as administrator and general partner, respectively. The Company also incurred (i) additional costs associated with efforts to develop recapitalization and restructuring alternatives aggregating $2.2 million; (ii) additional consulting and legal fees of $1.8 million associated with the negotiation and implementation of, and compliance with, the amended Bank Credit Facility, pending class action securityholder litigation and the SEC investigation; (iii) additional deferred compensation of $3.2 million associated with the two year employment agreements of the Company's senior executives which were entered into in May 1998; and (iv) provisions of $2.3 million to settle shareholder and other litigation.
The increase in 1998 compared to 1997 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. During the years ended December 31, 1997, the Company maintained a 45% economic interest in KB Management. As of January 2, 1998, the Company purchased the remaining interest in KB Management (see Note 3 of Notes to Consolidated Financial Statements). From the formation of KB Management in 1995, KB Management provided certain management and acquisition services to the Company. From its formation through the year ended December 31, 1996, the transaction and management fees derived by KB Management were sufficient to offset the majority of the administrative costs which in turn minimized the costs associated with the Company's 45% economic interest in KB Management. During 1997, KB Management operating and administrative expenses grew disproportionately to the ability of KB Management to engage and consummate acquisitions and other business transactions which would generate fee income and the Company recognized a net loss related to its 45% economic interest. With acquisition of the remaining interest in KB Management on January 2, 1998, the Company recognized 100% of the economic net loss derived by KB Management for the year ended December 31, 1998.
The strategic business evaluation and associated restructuring of the Company that began in the early part of 1997 (see Note 21 of Notes to Consolidated Financial Statements) was primarily funded by the Company on behalf of the subsidiaries. As a result, a significant portion of the associated period costs were funded by the Company. Period costs recognized by the Company increased to $5.7 million for the year ended December 31, 1998, from $1.8 million for the year ended December 31, 1997. Included in expenses for the year ended December 31, 1998 were $6.8 million associated with severance and other employment agreements. In addition, the Company paid or expensed approximately $3.0 million associated with the shut down of a small marketing entity in anticipation of the sale of Professional.
Internal auditors monitor and assess the effectiveness of the internal control system and report their findings to management and the Board of Directors throughout the year. The Company's independent auditors are engaged to express an opinion on the financial statements and with the coordinated support of the internal auditors, review the financial records and related data and test the internal control system over financial reporting.
We have audited the accompanying consolidated balance sheets of PennCorp Financial Group, Inc. and subsidiaries as of December 31, 1999 and 1998, and the related consolidated statements of operations and comprehensive income (loss), changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1999. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
As discussed in Note 8, the Company changed its method of recording claim reserves associated with disability income products of the Career Sales Division during the year ended December 31, 1998. The effect of the change in methodology is inseparable from the effect of the change in accounting estimates and is accordingly reflected in operations as a change in accounting estimate for the year ended December 31, 1998.
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 and the United Life Assets (the United Life Assets is comprised of the operations of United Life, UC, Cyberlink and certain assets of Marketing One), within a period not likely to exceed one year (see Notes 3 and 16), the assets and liabilities of the Career Sales Division, KIVEX, Professional and the United Life Assets, (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. As of July 30, 1999, sales of all the Businesses Held for Sale had been completed.
Fixed maturities and equity securities classified as available for sale are recorded at fair value, as they may be sold in response to changes in interest rates, prepayment risk, liquidity needs, the need or desire to increase income, capital or other economic factors. Fair values are determined based on quoted market prices, where available. For fixed maturities and equity securities not actively traded, fair values are estimated using values obtained from independent pricing services or are estimated based on expected future cash flows using a current market rate applicable to the yield, credit quality and maturity of the investments. Changes in unrealized gains and losses related to securities available for sale are recorded as accumulated other comprehensive income, a separate component of shareholders' equity, net of applicable income taxes and amount attributable to deferred policy acquisition costs and present value of insurance in force related to universal life and accumulation products. Securities classified as trading securities are reported at fair value with realized gains and losses and changes in unrealized gains and losses included in the determination of net income as a component of other income. During 1997, the Company carried its investment in SW Financial and its wholly-owned subsidiaries on the equity basis of accounting as a result of its percentage ownership and lack of voting control. Mortgage-backed fixed maturity securities held for investment or available for sale are amortized using the interest method including anticipated prepayments at the date of purchase. Significant changes in estimated cash flows from original assumptions are reflected in the period of such change. Mortgage loans on real estate are recorded at cost, adjusted for amortization of premium or discount and provision for loan loss, if necessary. Policy loans and short-term investments are recorded at cost. Other invested assets include investments in limited partnerships stated at cost and adjusted for contributions, distributions and undistributed income and other miscellaneous investments carried at cost.
The Company regularly evaluates the carrying value of its investments based on current economic conditions, past credit loss experience and other circumstances. A decline in net realizable value that is other than temporary is recognized as a realized investment loss and a reduction in the cost basis of the investment. The Company discounts expected cash flows in the computation of net realizable value of its investments, other than certain mortgage-backed securities. In those circumstances where the expected cash flows of residual interest and interest only mortgage-backed securities, discounted at a risk-free rate of return, result in an amount less than the carrying value, a realized loss is reflected in an amount sufficient to adjust the carrying value of a given security to its estimated fair value.
Cash and cash equivalents include cash on hand and investments with original maturities of three months or less.
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 1999, 1998 and 1997, the Company wrote off receivables totaling $1,541, $1,960 and $6,605, respectively.
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 upon the policy liability or contract rate, over the years that such profits are anticipated to be received in proportion to the estimated gross profits. Accumulated amortization was $119,313 and $96,273 as of December 31, 1999 and 1998, respectively.
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 $32,921 and $31,024 as of December 31, 1999 and 1998, respectively. In 1999, unamortized costs in excess of net assets acquired in the amount of $19,287 was impaired due to the evaluation of recoverability of intangible assets of the Payroll Sales Division as a result of its sale on February 4, 2000 (see Notes 3 and 23). During 1999, costs in excess of net assets acquired of a non-insurance subsidiary in the amount of $7,635 was written off as the result of the decision to cease operations. During 1998, unamortized costs in excess of net assets acquired in the amount of $22,792 were transferred to assets of Businesses Held for Sale and $114,514 was written off in connection with the impairment provision associated with assets of Businesses Held for Sale.
Shares purchased are recorded at cost as a reduction of shareholders' equity. Shares abandoned by the associated shareholders are recorded at no cost. The cost basis of shares reissued from treasury are determined on the basis of specific identification.
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 was originally effective for all fiscal quarters of all years beginning after June 15, 1999. In June 1999, the FASB deferred the effective date until fiscal years beginning after June 15, 2000. The Company will adopt SFAS No. 133 on January 1, 2001. The Company is currently evaluating SFAS No.133 but does not expect its adoption to have a material effect on the consolidated financial statements.
On January 2, 1998, following shareholder approval at the Company's 1997 annual meeting of shareholders, the Company consummated the acquisition, from KB Investment Fund I, LP (formerly Knightsbridge Capital Fund I, LP) (the "KB Fund") and Messrs. Steven W. Fickes and David J. Stone, former executive officers and directors of the Company, of their respective holdings of common stock and, in the case of the KB Fund, common stock warrants of SW Financial (collectively, the "SW Financial Controlling Interest") for an aggregate purchase price of $73,658 (not including acquisition expenses). The fair value of net assets acquired amounted to $45,520 resulting in $28,138 of costs in excess of net assets acquired which will be amortized over 30 years. As part of the acquisition of the SW Financial Controlling Interest on January 2, 1998, SW Financial Subordinated Notes in the amount of $40,000 previously purchased by the Company were reclassified to purchase consideration for SW Financial. The acquisition of the SW Financial Controlling Interest has been accounted for as a step purchase transaction in accordance with generally accepted accounting principles, and accordingly, fair values of assets and liabilities acquired have been determined as of January 2, 1998.
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). Under the transaction terms, Mr. Fickes is to receive consideration in the form of estimated annual interest payments, ranging from $301 to $330, on April 15 each year through 2001 and is to 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.
On March 31, 1999, the Company consummated the sale of Professional to GE Financial Assurance Holdings, Inc. ("GE Financial"). The operating results of Professional are included in the consolidated operating results through March 31, 1999. The Company realized a gain from the sale totaling $1,054. As a result of the sale, unrealized gains on securities available for sale by Professional decreased by $488. On September 15, 1999, as a result of certain settlement and consideration adjustment provisions included in the purchase and sale agreement the Company reduced the consideration received by $1,237.
On June 30, 1999, the Company completed the sale of KIVEX to Allegiance Telecom, Inc. The operating results of KIVEX are included in the consolidated operating results through June 30, 1999. The Company recorded a gain of $30,881 on the sale.
On July 30, 1999, the Company consummated the sale of the Career Sales Division to Universal American Financial Corp. ("Universal American"). During 1999 and prior to the consummation of the sale, the Company incurred an additional impairment provision of $58,486 related to the Career Sales Division. This resulted from the decrease in the nominal purchase consideration of $38,000 partially offset by an estimated discount to the stated value of the note to be received. In addition, impairment provision included the impact of the true-up of statutory capital and surplus of the Career Sales Division companies to levels specified in the sale agreement which aggregated approximately $24,218. Other factors modestly impacting the impairment provision included additional transaction costs, changes in unrealized gains and losses of securities, foreign currency translation and net income not considered in the determination of sale consideration. The operating results of the Career Sales Division are included in the consolidated operating results through July 30, 1999. The Company realized a foreign currency transaction loss on the sale of the Career Sales Division totaling $24,978, which represented previously unrealized translation losses on the Company's Canadian insurance operations, partially offset by a gain of $3,522 on the disposition resulting in a net loss of $21,456. In addition, as a result of the sale, unrealized gains on securities available for sale and unrealized foreign currency translation losses decreased by $2,268 and $24,978, respectively. On December 29, 1999, as a result of certain settlement and consideration adjustment provisions, included in the purchase and sale agreement the Company reduced the consideration received by $2,550.
In January 2000, the Company announced it had agreed to sell the Payroll Sales Division to a company formed by Thoma Cressey Equity Partners for approximately $102,000, subject to adjustment. The sale was consummated on February 4, 2000 (see Note 23). The operating results of the Payroll Sales Division are included in the consolidated operating results through December 31, 1999. The Company recorded impairment provision totaling $95,522 to reflect the difference in the Company's accounting basis in the Payroll Sales Division and the consideration the Company is to receive for such businesses. The Company fully impaired the costs in excess of net assets acquired aggregating $19,287. In addition, the Company fully impaired the present value of insurance in force and partially impaired deferred policy acquisition costs resulting in charges of $67,617 and $49,668 respectively, net of related deferred taxes of $41,050.
The Company's Chief Executive Officer evaluates performance of each segment based on profit or loss from operations excluding (i) restructuring costs, (ii) net gains on the sale of investments, (iii) net gains from sales of subsidiaries, (iv) impairment valuation associated with Businesses Held for Sale, (v) interest expense, (vi) income taxes and (vii) equity in earnings of unconsolidated subsidiaries. The accounting policies of segments are the same as those described in the summary of significant accounting policies (see Note 2). Segment data for 1998 and 1997 have been restated to conform to the 1999 presentation.
The amortized cost and fair value of investments in fixed maturities available for sale were as follows as of December 31:
Due in one year or less ....................... $ 72,287 $ 72,405 Due after 1 through 5 years ................... 409,061 399,277 Due after 5 through 10 years .................. 567,644 542,233 Due after 10 years ............................ 464,579 418,112 Mortgage-backed securities, principally obligations of U.S. Government agencies ...... 972,425 931,663 ---------- ---------- $2,485,996 $2,363,690 ========== ==========
Included in fixed maturities available for sale as of December 31, 1999 and 1998, are below investment-grade securities with an amortized cost of $161,785 and $177,263 and a fair value of $139,521 and $163,252, respectively. Included in fixed maturities available for sale as of December 31, 1999, are unrated securities with an amortized cost of $33,041 and a fair value of $21,115. Included in fixed maturities available for sale as of December 31, 1998 are unrated securities with an amortized cost of $18,211 and a fair value of $18,239. Investments in a single entity, other than obligations of the U.S. government or agencies thereof, totaling in excess of 10% of the Company's equity at December 31, 1999 consisted of an investment in Episode IV Loan Trust with carrying value and fair value of $25,000.
The Company's commercial and residential mortgage portfolios had net carrying values $20,032 and $36,882, respectively, and, fair values of $20,285 and $38,865, respectively, as of December 31, 1999 and 1998.
As of December 31, 1999, commercial and residential mortgage loan investments were concentrated in the following states:
Texas............................... $10,070 50.3% Kansas.............................. 1,946 9.7 Illinois............................ 1,787 8.9 Nevada.............................. 1,719 8.6 Alabama............................. 1,673 8.4 Louisiana........................... 1,187 5.9 All other (less than 4% individually) 1,650 8.2 ------- ----- $20,032 100.0% ======= =====
The Company had non-income producing investments at December 31, 1999 with an amortized cost and fair value as follows:
On January 2, 1998, the Company acquired the SW Financial Controlling Interest (see Note 3).
The Company accounted for its investment in SW Financial utilizing the equity method for the year ended December 31, 1997. The consolidated condensed results of operations for the years ended December 31, 1997 are provided below:
Revenues: Policy revenues ......................................... $ 145,818 Net investment income ................................... 126,427 Other income ............................................ 16,039 Net gains from the sale of investments .................. 1,841 --------- Total revenues ..................................... 290,125 --------- Benefits and expenses:
Information related to the present value of insurance in force is as follows:
For traditional life products, the liability for future policy benefits is based primarily upon Commissioners' Standard Ordinary Tables with interest rates ranging from 2.5 to 6.0 percent. Fixed benefit products establish a liability for future policy benefits equal to the excess of the present value of future benefits to or on behalf of the policyholder over the future net premium discounted at interest rates ranging primarily from 4.5 to 8.0 percent. Traditional life products and fixed benefit products future policy benefits may also be determined using Company experience as to mortality, morbidity and lapses with a provision for adverse deviation. The Company may vary assumptions by year of policy issue.
Total future policy benefits consist of the following as of December 31, 1999 and 1998:
The Company closely monitored the development of its claim reserve experience associated with the Career Sales Division. The historical method of establishing claims reserves principally utilized claims lag factors. Based on results of independent calculations of the claim lag factors, performed annually, this methodology indicated a deterioration in the adequacy of claim reserves associated with Penn Life's disability income products underwritten prior to PennCorp's ownership of Penn Life. Disability claim adequacy analysis included statutory claim information, independent third-party review of claim lag method and factors and other claim tests. Previous results indicated no reason to consider a new methodology as results appeared consistent between periods and claim reserves appeared adequate. Once results of such analysis began to vary outside an acceptable tolerance, the Company reviewed its methods to determine the reasons for the variances.
The outstanding principal amounts of the notes payable consist of the following as of December 31:
Covenants and Liquidity. The Notes and the bank credit agreement (the "Bank Credit Facility") impose certain covenants on the Company, including covenants restricting the amount of additional indebtedness the Company may incur, limit its ability to engage in future acquisitions and certain other business transactions, and the amount of dividends the Company may declare and pay (see Note 12), and requires the Company to maintain specified financial ratios and meet specified financial tests.
On March 31, April 30, May 14, June 25 and June 30, 1999, the Company entered into amendments (the "amendments") to its existing Bank Credit Facility. The amendments included additional covenants and revised certain financial covenants to the Bank Credit Facility. In addition, the amendments changed, among other things, the maturity date of the Bank Credit Facility to May 2000, extensions of dates for cash sweeps, principal payments and certain available commitments.
Upon sale of Professional $ 40,000 Upon sale of United Life Assets 127,000 Upon sale of KIVEX 22,000 Upon sale of Career Sales Division 78,000
In anticipation of the filing of the Chapter 11 case, the Company and the lenders party to the Bank Credit Facility executed a forbearance agreement ("Forbearance Agreement") whereby the lenders agreed to forbear from exercising their remedies under the Bank Credit Facility as a result of the event of default that occurred under the Bank Credit Facility when the Company commenced the Chapter 11 case. In connection with the commencement of the Chapter 11 Case, the Bank Credit Facility was superseded by a Cash Collateral Agreement dated as of February 8, 2000 (as amended, the "Cash Collateral Agreement"), by and among the Company, the lenders from time to time party thereto and The Bank of New York, as administrative agent. The Cash Collateral Agreement provides a mechanism for the Company to repay its currently outstanding borrowings and establishes certain covenants with which the Company must comply until all of the Company's outstanding loans (plus interest thereon) are repaid. Certain covenants strictly define the Company's ability to utilize any and all cash that is maintained in the cash collateral account held by the agent lender. As a result, the Company may utilize cash from the cash collateral account for only predetermined types of expenses and in specified amounts. On February 10, 2000, the Company, the lenders party thereto and The Bank of New York, as administrative agent, executed Amendment No. 1 to Cash Collateral Agreement ("Amendment No. 1"), in order to provide for the establishment of a custody account to provide for the investment of the Company's funds which are in the possession of The Bank of New York (and over which it has a lien) through a custody account maintained at The Bank of New York, all as required by the Bankruptcy Court.
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. 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, 1999.
As of December 31, 1999, a valuation allowance has not been established for the deferred tax asset relating to the unrealized loss on investment securities. Management believes that the recognition of these unrealized losses can be managed through a tax planning strategy of holding the investment securities to maturity or until market conditions improve.
The Company's recording of impairment provisions associated with the sale of the Payroll Sales Division results in a reduction in deferred tax liabilities of $41,050 during 1999 related to such assets. The Company's recording of impairment provisions associated with the Businesses Held for Sale results in a reduction in deferred tax liabilities of $95,137 during 1998 related to such assets.
As of December 31, 1999, the Company has life consolidated net operating loss carryforwards of approximately $55,681 for tax return purposes which, if not utilized, will begin to expire in 2004. The Company has life consolidated capital loss carryforwards of approximately $13,545 which, if not utilized, will begin to expire in 2000. In addition, Pioneer Security has acquired net operating loss carryforwards of approximately $8,693. The utilization of acquired net operating loss carryforwards is limited in any one year to the lesser of (i) the Pioneer Security life insurance group's consolidated taxable income or (ii) OLIC's taxable income computed on a separate return basis. The acquired net operating loss carryforwards will begin to expire in 2003.
Under provisions of the Life Insurance Company Tax Act of 1959, certain special deductions were allowed to life insurance companies for federal income tax purposes. These special deductions were repealed by the Tax Reform Act of 1984, and the untaxed balances were frozen at their December 31, 1983 levels. These balances aggregate approximately $42,301 for the Company's life insurance subsidiaries and are subject to taxation if certain levels of premium income or life insurance reserves are not maintained, or if the life insurance companies make excess distributions to shareholders. In addition, on February 7, 2000, the Clinton administration released its Fiscal Year 2001 Budget which included a revenue raising provision that would require life insurance companies to include the balance of these special deductions in income over a five 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.
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 during 1998.
Associated with the restructuring and the consolidation of all corporate functions into the Company's Dallas location, certain employees were severed. For the year ended December 31, 1998, notes receivable secured by 7,500 shares of common stock were discharged and 9,051 and 88,280 shares of common stock were abandoned as a result of the severance during 1999 and 1998, respectively. The result was to increase treasury stock, and decrease notes receivable secured by common stock, $261. During 1999, the Company reversed previously accrued interest on notes receivable secured by common stock totaling $146.
The Company suspended the payment of cash dividends during the third quarter of 1998 on its outstanding $3.375 Convertible Preferred Stock, $3.50 Series II Convertible Preferred Stock and Common Stock. Under the amended terms of the Company's Bank Credit Facility the Company may not pay dividends on its Common Stock or Preferred Stock issues. Under the terms of the two series of convertible preferred stock, if dividends are in arrears for six or more quarterly dividend periods (whether or not consecutive), the holders of the convertible preferred stock, voting as a single class, will have the right to elect two directors of the Company. In addition, for as long as there are dividend arrearages on the convertible preferred stock, the Company will be prohibited from paying dividends on the Common Stock or purchasing, redeeming or otherwise acquiring Common Stock.
The Company has also established a senior management warrant award plan ("Warrant Plan"). The Warrant Plan allows for grants to senior executive officers of PennCorp and Directors of PennCorp who are not executive officers of the Company. Grant prices are determined based on the average price of the shares traded on the date of grant. Warrants granted under the Warrant Plan are determined by the Compensation Committee and are exercisable at such times and in such amounts as the Compensation Committee shall determine, but no warrant granted under the Warrant Plan will be exercisable more than ten years after the date of grant. Upon change of control (as defined) of PennCorp, all outstanding warrants become immediately vested and exercisable, and any warrants that remain unexercised shall be canceled and replacement warrants shall be issued by the surviving entity.
The following table summarizes information concerning outstanding and exercisable options and warrants as of December 31, 1999:
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:
The fair value of each option and warrant grant used to determine the pro forma amounts indicated in the previous table is estimated on the date of grant using the following weighted average assumptions for 1999, 1998 and 1997:
Weighted average risk-free interest rate..... -- % 6.06% 6.34% Weighted average dividend yields............. -- % -- % -- % Volatility factors........................... -- 0.83 .61 Weighted average expected life (years)....... -- 1.90 4.50 Weighted average fair value per share........ $ -- $ 15.02 $ 15.67
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options having no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. As employee stock options and warrants have characteristics significantly different from those of traded options, and because changes in subjective assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not provide a reliable single measure of the fair value of employee stock options and warrants. As SFAS No. 123 is effective only for awards granted after January 1, 1995, the pro forma disclosures provided above may not be representative of the effects on reported net income for future years.
Statutes in Texas, the domiciliary state of the Company's insurance subsidiaries owned at December 31, 1999, restrict the payment of dividends by insurance companies to the available surplus funds derived from their net profits. The maximum amount of cash dividends that may be declared without regulatory approval in any twelve-month period is the greater of ten percent (10%) of the insurer's statutory surplus, as shown by its last annual statement on file with the Texas Department of Insurance, or one hundred percent (100%) of statutory net gain from operations for the preceding year. In addition, dividends may only be paid from earned surplus. After considering the extraordinary dividends of $21,897 paid on January 31, 2000, Southwestern Life and Security Life, the Company's principal insurance subsidiaries (excluding the Payroll Sales Division which was sold on February 4, 2000), will be able to pay $2,244 in dividends in 2000 to PLAIC, without prior regulatory approval.
Statutory capital and surplus of the Company's life insurance subsidiaries as reported to regulatory authorities at December 31, 1999 and 1998, totaled $253,435 and $399,766, respectively. Statutory net income (loss) of the Company's life insurance subsidiaries as reported to regulatory authorities totaled $116,134, ($44,563) and $18,776 for the years ended December 31, 1999, 1998 and 1997, respectively. The 1999 statutory net income included gains on sales of subsidiaries totaling $127,435. Surplus note interest expense of $34,599, $40,531 and $34,758 for the years ended December 31, 1999, 1998 and 1997, respectively, is included in statutory net income (loss).
The Company's insurance subsidiaries are required, at least annually, to perform cash flow and "Asset Adequacy Analysis" under differing interest rate scenarios. At December 31, 1999 and 1998, Southwestern Life failed certain of those cash flow testing scenarios. As a result, Southwestern Life performed a series of expanded tests. Based upon the results of these expanded tests, Southwestern Life has determined that additional statutory reserves were not needed at December 31, 1999 or 1998. Factors that may require Southwestern Life to establish additional statutory reserves in future periods include changes in interest rates, timing of the emergence of insurance profits, persistency of the insurance in force, sales or reinsurance of blocks of insurance in force and mortality experience. Management actions that may mitigate the need for these additional reserves may include but are not limited to, new profitable business being added to the insurance in force, reinsurance or actions that impact persistency, mortality experience, interest spreads and costs to administer the insurance in force. Southwestern Life monitors these factors to determine if additional statutory reserves will be required.
Calculations using the NAIC formula and the life insurance subsidiaries' statutory financial statements as of December 31, 1999, indicate that each of the insurance subsidiaries' capital exceeded Company Action Level RBC requirements.
The Company has an established bonus plan for insurance subsidiary officers. The amount available to pay awards for any year is determined by a committee of senior executives of the Company and is subject to the review and recommendation of the Compensation Committee and approval of the Board of Directors of the Company. Awards are based primarily on the achievement of specified operating objectives and the performance of eligible participants. The Company recognized expense of $1,875, $3,390 and $1,417 under this plan during the years ended December 31, 1999, 1998 and 1997, respectively.
In May 1998, the three senior executives of the Company entered into two year employment agreements with the Company which have various annual bonus, deferred payment and termination provisions. As of December 31, 1999, the Company had accrued liabilities aggregating $1,800 for the annual 1999 bonus and $8,252 for deferred compensation provisions, respectively associated with these employment agreements. The deferred compensation provisions are payable upon the earliest of: expiration of the employment agreement; termination of the executive by the Company without cause; or termination by the executive for "good reason" as defined in the employment agreements (see Note 23).
The Company and certain of its subsidiaries 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, 1999 and 1998:
1999 1998 ------ ------ Benefit obligation at beginning of year...... $26,602 $10,380 Service cost................................. 283 184 Interest cost................................ 1,384 1,533 Plan participants' contributions............. 238 364 Actuarial (gain) loss........................ (2,826) 1,975 Acquisition/sale............................. (4,717) 14,827 Benefit paid................................. (2,342) (2,661) ------- ------- Benefit obligation at end of year........... $18,622 $26,602 ======= =======
The liability for accrued benefit obligation includes the following at December 31, 1999 and 1998:
Components of net periodic benefit cost include the following for the year ended December 31, 1999 and 1998:
1999 1998 ------ ------ Service cost................................. $ 229 $ 130 Interest cost................................ 1,407 1,533 Amortization of transition obligation........ 158 657 Recognized net actuarial loss................ (125) (108) ------- ------- Net periodic benefit cost................... $ 1,669 $ 2,212 ======= =======
For measurement purposes, an annual rate increase ranging from 5.5% to 7% in the health care cost trend rate was assumed for 1999; the rate was assumed to decrease gradually to 4% by year 2015 and remain at that level thereafter. The weighted average discount rates used in determining the accumulated postretirement benefit obligation ranged from 6.5% to 7.5%. The health care cost trend rate assumption has a significant effect on the amounts reported. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
Effect on total of service and interest cost components.. $ 160 $ (142) Effect on postretirement benefit obligation.............. 1,014 (917)
During 1999 and 1998 the Company recorded impairment provisions aggregating $58,486 and $342,960, respectively, associated with Businesses Held for Sale. 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 was based primarily upon the terms of definitive sales agreements. The impairment provisions recorded in 1999 for the Career Sales Division resulted from a renegotiation of the purchase and sell agreement which included a decrease in the nominal purchase consideration of $38,000 which was partially offset by an estimated discount to the stated value of the note to be received. In addition, impairment provision included the impact of the true-up of statutory capital and surplus of the Career Sales Division companies to levels specified in the sale agreement which aggregated approximately $24,218. Other factors modestly impacting the impairment provision included additional transaction costs, changes in unrealized gains and losses of securities, foreign currency translation and net income not considered in the determination of sale consideration. The Company realized a foreign currency transaction loss on the sale of the Career Sales Division totaling $24,978, which represented previously unrealized translation losses on the Company's Canadian insurance operations, partially offset by a gain of $3,126 on the disposition resulting in a net loss of $21,852.
The Company impaired costs in excess of net assets acquired for the Career Sales Division, Professional and the United Life Assets in 1998 by $100,138, $3,263 and $11,113, respectively. To the extent that the impairment provision exceeded the balance of costs in excess of net assets acquired associated with each company to be disposed, additional impairment was necessary, as was the case for the Career Sales Division, the Company reduced other intangible assets in accordance with APB No. 17. As a result, the Company fully impaired the present value of insurance in force and deferred policy acquisition costs resulting in charges of $98,164 and $191,595, respectively, net of related deferred taxes of $95,137. Additionally, the Company established a liability aggregating $33,824 for the remaining impairment as a result of all monetary assets of the Career Sales Division being recorded at fair value.
(Unaudited) --------- As Reported Pro Forma 1999 1999 ----------- --------- (In thousands, except per share amounts)
Total revenues................................. $ 636,640 $ 318,467 Loss before extraordinary charge............... (200,712) (72,144) Loss before extraordinary charge applicable to common stock............................. (218,537) (89,969) Per share information: Net loss before extraordinary charge applicable to common stock-basic........... $ (7.44) $ (3.06) Net loss before extraordinary charge applicable to common stock-diluted......... (7.44) (3.06)
(Unaudited) --------- As Reported Pro Forma 1998 1998 ----------- --------- (In thousands, except per share amounts)
For the year ended December 31, 1997 (prior to the purchase of the Fickes and Stone Knightsbridge Interests in January 1998), PennCorp paid or accrued $2,385 in transaction fees and expenses to KM related to the Washington National, United Life and SW Financial transactions, respectively. During 1997, certain of the Company's affiliates and subsidiaries paid management fees to KM amounting to $5,325. SW Financial and United Life incurred KM investment advisory fees totaling $4,358 during 1997.
The Company and its subsidiaries are obligated under operating leases, primarily for office space. Rent expense, net of sublease income, was $2,769, $5,299 and $ 5,178 in 1999, 1998 and 1997, respectively.
Minimum lease commitments for the Businesses Owned at December 31, 1999 are:
2000......................................... $ 2,724 2001......................................... 2,576 2002......................................... 2,568 2003......................................... 2,376 2004......................................... 2,242 2005 and thereafter.......................... 6,118 ------- Total minimum payments required........... $18,604 =======
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.
During a conference on March 19, 1999, defendants sought and were granted permission to file, and subsequently filed, a motion to dismiss the Complaint. Although there are no assurances that the motion to dismiss will be granted, management believes that there are meritorious defenses to the action that were raised in connection with the motion, including whether the Complaint adequately pleads scienter (i.e., intent to defraud) as required under the Private Securities Litigation Reform Act of 1995.
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: (i) all expenses and (ii) any losses in excess of a $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. As explained below, the primary insurer has agreed in principle to contribute to a settlement of the litigation.
Following settlement discussions with the Plaintiffs' counsel and representatives of the primary insurance carrier and their counsel, the parties to the Complaint entered into a Memorandum of Understanding dated November 11, 1999 (the "Memo") containing the essential terms of a settlement.
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 charging 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 for non-smoking policyholders 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 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 charge 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. In June 1999, the North Carolina Department of Insurance ("NCDOI") asked Security Life about the status of its current practice of not charging cost of insurance charges after the eighth contract year for non-smokers on these same insurance products and requested to be informed if Security Life changes its current practice. Security Life has responded to the NCDOI's inquiry by verifying that no decision has been made to date to change such current practice and such practice has not changed; and affirming that the NCDOI would be notified in the event this current practice changes. The Company has initiated an exchange program which enables policyholders of such life insurance products to terminate their policies and, in exchange for the termination of the original policy and a release, obtain either (i) the refund of all premiums paid and other consideration or (ii) another Security Life product. On November 5, 1999, Security Life was served with an Original Petition filed in state court in Dallas County, Texas, asserting a class action concerning such policies. The petition alleges that Security Life has waived the right to charge cost of insurance charges after the eighth year on such non-smoker policies and to increase cost of insurance charges on such smoker policies. The petition alleges Security Life made these waivers through its marketing pieces and signed statements by its officers. The petition also alleges that not all of the facts were outlined in the Company's communication to its policyholders outlining the exchange program and therefore alleges Security Life's exchange program is deceptive. The petition asks for declaratory judgment concerning the rights of the Plaintiffs, and the class of policyholders of such policies and for attorney's fees. It, among other things, asks for an injunction to prevent Security Life from charging cost of insurance charges for such non-smoker policies or increasing cost of insurance charges on such smoker policies after the eighth contract year. It also asks the Court to rule the releases signed by such policyholders under the exchange program be declared null and void and those policyholders who signed the releases be given the option of reinstating the prior policies. Security Life denies the allegations in the petition and intends to vigorously defend this lawsuit. The trial court in which this case is pending has granted class certification in at least one other lawsuit involving similar types of claims. There can be no assurances that the exchange program will be successful or that the Company will resolve these matters on such life insurance products 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.
On July 30, 1998, the SEC notified the Company that it had 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 six 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.
Many computer and software programs were designed to accommodate only two digit fields to represent a given year (e.g. "98" represents 1998). It was highly likely that such systems could not have been 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 complex and interdependent systems could have led to a significant business interruption. Such an interruption could have resulted in a decline in current and long-term profitability and business franchise value.
The Company's overall year 2000 compliance initiatives, included the following components: (i) assessment of all business critical systems (business critical systems includes computer and other systems), processes and external interfaces and dependancies; (ii) remediation or upgrading of business critical systems; (iii) testing of both modified and updated systems as well as integrated systems testing; (iv) implementation of modified and updated systems; and (v) contingency planning. As a part of the process, the Company has written letters and corresponded with its outside vendors and critical business partners concerning year 2000 compliance efforts and has followed up periodically.
Each of the definitive purchase and sale agreements the Company has consummated for Professional, the United Life Assets, KIVEX, the Career Sales Division and the Payroll Sales Division, contain indemnification provisions
which survive the closing of each sales transaction for varying periods of time. The indemnification provisions would be invoked by the purchasers should the Company be found in breach of certain representation and warranty provisions or upon the occurrence of specified events contained in the purchase and sale agreements. The Company has purchased representations and warranty insurance to cover potential indemnification claims arising under each of the definitive purchase and sale agreements in an aggregate amount of $20,000 for all indemnification claims.
At December 31, 1999, the Company's insurance subsidiaries had outstanding commitments to invest up to $10,185 in various limited partnership funds and other investments.
In addition, the Company has been notified by ING that it disputes certain federal income tax calculations under the provisions of the related purchase and sale agreement. Under the provisions of the purchase and sale agreement ING is to provide the Company with preliminary tax returns in order for the Company to evaluate any potential differential in tax amounts between closing and the final return preparation. To date ING has not provided such preliminary tax returns and hence the Company has not been able to fully evaluate the merits of ING's claim. At December 31, 1999, the Company has established a liability of $1,151 related to this contingency.
In the normal course of business, the Company reinsures portions of certain policies that it underwrites to limit disproportionate risks. The Company retains varying amounts of individual insurance up to a maximum retention of $500 on any life. Amounts not retained are ceded to other insurance enterprises or reinsurers on an automatic or facultative basis. The Company cedes varying amounts of certain accident and sickness policies up to a maximum cession of $800, as well as varying portions of certain disability income policies on a facultative basis.
1999 1998 1997 ------- ------- ------- Direct policy revenues and amounts assessed against policyholders...................... $423,030 $586,317 $375,538 Reinsurance assumed.......................... 2,492 6,018 2,527 Reinsurance ceded............................ (86,648) (133,177) (32,499) -------- -------- ------- Net premiums and amounts earned............ $338,874 $459,158 $345,566 ======== ======== ========
The Company has developed restructuring plans to realign or consolidate certain operations resulting in restructuring costs incurred during 1999, the fourth quarter of 1998, the first quarter of 1998 and 1997.
The 1999 plan provided for the termination of 50 employees consisting of divisional management and staff in Dallas over a nine month period. As of December 31, 1999, the Company had paid and charged $663 against the accrual for severance and related benefits for 32 terminated employees. Substantially all of the remaining terminations will occur by March 31, 2000.
The 1999 plan also provided for vacating additional floors of the Company's Dallas leased offices. The restructuring provision of $2,122 represented the estimated net present value of the rent on the office space to be vacated net of the estimated sublease rental income to be received by the Company.
In the fourth quarter of 1998, the Company recorded restructuring costs aggregating approximately $9,274 as a result of the decision to consolidate or merge substantially all of the Company's corporate functions into the Dallas infrastructure.
The fourth quarter 1998 plan recognized abandoned leasehold improvement costs in connection with the Company's plan to sublease or vacate the New York offices. The Company expensed $2,954 principally as a result of abandoning the New York leased property.
On January 2, 1998, and January 5, 1998, respectively, the Company acquired the SW Financial Controlling Interest and the Fickes and Stone Knightsbridge Interest. The acquisition allowed the Company to complete its divisional restructuring which began in 1997. As a result, the Company incurred restructuring costs aggregating approximately $11,767 for the year ended December 31, 1998, associated with the divisional restructuring.
The first quarter 1998 restructuring plan provided for vacating certain Dallas office space. In connection with the plan, the Company recorded estimated holding costs of vacated facilities of $2,205 which represented the net present value of the rent on the office space to be vacated net of the estimated sublease rent to be received. During 1999, the Company charged $350 of rent expense on vacated office space against the accrual.
As part of the first quarter 1998 restructuring plan, the Company terminated an information technology outsourcing agreement. The original contract termination fee was $4,600. As a result of an amendment to the termination agreement, the Company exited the agreement for a payment of $3,247 and the remaining accrual was adjusted during 1998.
The Company has experienced significant changes in the past three years. As a result of integration of acquired businesses and material changes to the Company's operating platform, the Company began a strategic business evaluation in 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.
The 1997 plan provided for the termination of approximately 269 employees in the Company's Raleigh offices and certain foreign operations and substantially all of the employees of the Company's Waco operations, totaling 114. The 1997 plan anticipated a significant consolidation of operations into an affiliate's Dallas offices over a twelve month period. As of December 31, 1997, the Company had charged $2,411 against the accrual for severance and related benefits. The Company adjusted the remaining severance accrual by $1,008 during 1997 due to natural attrition thus reducing the level of severance required coupled with the decision to retain certain employees indefinitely. As of December 31, 1997, the severance accrual was $1,936 which was adjusted during 1998 as a result of the decision not to merge the Company's Waco operations into Dallas.
The plan also provided for vacating of certain leased facilities and abandoning certain Company owned real estate. The Company accrued $6,166 for holding and abandonment costs associated with these facilities. During 1997, the Company charged $1,916 to such accrued lease costs. During 1998, the Company further charged $841 to the accrued costs. As of December 31, 1998, the remaining accrual was no longer necessary as a result of the decision to retain the Waco operating platform.
Restructuring charges in the 1997 plan also included a $6,000 provision for the write-off of the Company's investment in certain foreign operations, principally Argentina. In 1997, the Company disposed of the foreign operations at a costs of $5,555 and the balance of $445 was adjusted to zero.
The Company did not incur incremental costs during 1999. The Company incurred approximately $6,296 and $4,652 of pre-tax period 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 Consolidated Statements of Operations and Comprehensive Income (Loss) as underwriting and other administrative expenses.
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 began 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 administrative costs incurred by the Company during 1997 were $7,646.
The following is a summary of the carrying value and fair value of the Company's financial instruments at December 31, 1999 and 1998:
Notes Payable: The carrying value for outstanding notes payable 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.
On January 10, 2000, the Company announced that it had agreed to sell its Payroll Sales Division to a company formed by Thoma Cressey Equity Partners for approximately $102,000 subject to certain adjustments. On February 4, 2000, the Company consummated the sale of the Payroll Sales Division for cash proceeds of approximately $103,000. The Company used $100,000 of the proceeds to repay the Bank Credit Facility. As a result of the sale, the Company recognized an impairment loss of $95,522 which was recognized in the financial statements for the year ended December 31, 1999.
Also on January 10, 2000, the Company announced that it had agreed to sell its Financial Services Division to Reassure America Life Insurance Company ("Reassure America"), a subsidiary of Swiss Reinsurance Company of Zurich ("Swiss Re"), for $260,000 subject to certain adjustments, and accomplish such transaction through the filing of a voluntary petition for relief under Chapter 11 ("Chapter 11") of title 11 of the United States Bankruptcy Code (the "Bankruptcy Code").
On February 7, 2000 (the "Petition Date"), PennCorp filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). Since the Petition Date, PennCorp has continued to operate and manage its assets and business as a debtor in possession as authorized by provisions of the Bankruptcy Code.
On March 15, 2000, the Company received a competing bid in the form of a recapitalization plan submitted by Inverness/Phoenix Capital LLC ("Inverness") and Vicuna Advisors, LLC ("Vicuna") on behalf of the unofficial ad hoc committee of preferred stockholders, and Mr. Bernard Rapoport ("Rapoport") and Mr. John Sharpe ("Sharpe") ("Recapitalization Plan"). On March 23, 2000 the Company's Board of Directors selected the Recapitalization Plan as the final accepted offer pursuant to the bidding procedures approved as part of the Sales Procedure Order. On March 24, 2000, the Bankruptcy Court approved the Board of Director's selection of the Recapitalization Plan.
The Company's fourth quarter 1998 reported loss primarily resulted from an additional impairment provision associated with assets of Businesses Held for Sale totaling $57,475. The Company unlocked actuarial assumptions of future interest rates, lapses, expenses and mortality on interest sensitive blocks of business (principally interest sensitive and deferred annuity products) resulting in additional amortization of deferred policy acquisition costs and present value of insurance in force amounting to approximately $16,250. Such unlocking was necessary principally as a result of deteriorating persistency associated with certain blocks of business in the Payroll Sales Division which aggregated approximately $8,575. The remaining amortization resulted from the application of current period assumptions (unlocking) for expenses and persistency for the Financial Services Division. In addition, the Company incurred restructuring costs of $7,228.
CONSOLIDATED STATEMENT OF INCOME for the Year Ended December 31, 1997 (In thousands)
Revenues: Premiums ...................................................... $ 103,138 Interest sensitive policy product charges ..................... 42,680 Net investment income ......................................... 126,427 Net gains from sale of investments ............................ 1,841 Other income .................................................. 16,039 --------- Total revenues ............................................... 290,125 ---------
Amortization of present value of insurance in force and deferred policy acquisition costs ............... 21,589 Amortization of costs in excess of net assets acquired ........ 4,130 Underwriting and other administrative expenses ................ 40,600 Interest and amortization of deferred debt issuance costs ..... 13,773 --------- Total benefits and expenses .................................. 246,374 ---------
Income before income taxes ...................................... 43,751 Income taxes ................................................. 16,416 --------- Net income ...................................................... 27,335 Preferred stock dividend requirements ........................ 3,012 --------- Net income available to common shareholders ..................... $ 24,323 =========
SOUTHWESTERN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1997 (In thousands)
The Company regularly evaluates the carrying value of their investments based on current economic conditions, past credit loss experience and other circumstances. A decline in net realizable value that is other than temporary is recognized as a realized investment loss and a reduction in the cost basis of the investment. The Company discounts expected cash flows in the computation of net realizable value of its investments, other than certain mortgage-backed securities. In those circumstances where the expected cash flows of residual interest and interest-only mortgage-backed securities, discounted at a risk-free rate of return, result in an amount less than the carrying value, a realized loss is reflected in an amount sufficient to adjust the carrying value of a given security to its fair value.
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.
Costs in excess of the fair value of net assets acquired are amortized on a straight-line basis over 30 years. Accumulated amortization totaled $8,260.
The amortized cost and fair value of investments in fixed maturities available for sale at December 31, 1997 by categories of securities are as follows:
Fixed maturities ........................ $ 487 $ 66 Equity securities ....................... 688 1,079 Other investments ....................... 5,778 5,791 ---------- ---------- $ 6,953 $ 6,936 ========== ==========
At December 31, 1997 net unrealized appreciation of equity securities of $391 consisted of gross unrealized gains of $415, less unrealized losses of $24.
Following is an analysis of net gains (losses) from sale of investments for the year ended December 31, 1997:
Fixed maturities....................... $ 553 Other investments...................... 1,146 Real estate............................ 134 Short-term investments................. 8 --------- $ 1,841 =========
Major categories of net investment income for the year ended December 31, 1997 consist of the following:
Fixed maturities...................................... $ 98,906 Mortgage loans........................................ 5,490 Policy loans.......................................... 7,621 Short-term investments................................ 4,442 Collateral loans...................................... 2,218 Real estate........................................... 441 Investments held in trust under reinsurance treaty(a). 9,617 Other investments..................................... 1,250 Investment expenses................................... (3,558) --------- $ 126,427 =========
-------------------- (a)Investments held in trust by a reinsurer with carrying values of $121,016 as of December 31, 1996, are included in amounts due from reinsurers. This contract was recaptured during 1997 (see Note 10).
At December 31, 1997 the Company held mortgage loans principally involving commercial real estate with carrying value of $51,070, net of an allowance for losses of $680. Estimated fair values of mortgage loans totaled $51,816 at December 31, 1997. The average outstanding loan balance was approximately $1,027. At December 31, 1997 mortgage loan investments were concentrated in the following states:
Total policy liabilities and accruals consist of the following as of December 31, 1997:
Policy and contract claims at January 1 .................... $ 55,011 Less reinsurance recoverables .............................. 153 -------- Net balance at January 1 ................................. 54,858 --------
Policy and contract claims at December 31 .................. $ 57,517 ========
As a result of changes in estimates of insured events in prior years, the liability for policy and contract claims decreased, net of reinsurance, by $6,012 in 1997.
The outstanding principal amounts of notes payable at December 31, 1997 consist of the following:
Interest costs under the bank term debt totaled $2,229 for the year ended December 31, 1997. The interest rate of the term debt is based on, at the Company's option, either a floating rate (based on the base rate of the First National Bank of Chicago) plus a margin of 2.25% or a Eurodollar rate (based on LIBOR) plus a margin of 3.25%. At December 31, 1997, the effective rate of the term loans was approximately 9.63%. The bank term debt was repaid on January 2, 1998.
On December 14, 1995, the Company issued 210,000 shares of Series A preferred stock with a liquidation value of $21,000 to PennCorp and one of its subsidiaries. The Series A preferred stock accrues dividends at a rate of 10.0% per annum, compounded quarterly and is mandatorily redeemable at December 31, 2005. Dividends on the Series A preferred stock are payable in cash, or at SWF's option, are payable in kind. The Series A preferred stock is not redeemable at the option of the Company but at maturity will be required to be redeemed for approximately $56 million in cash assuming no cash dividend distributions. If the Company fails to satisfy its mandatory redemption obligation, the holders of the Series A preferred stock will be entitled to elect 49.0% of the members of the Board of SWF and, upon receipt of regulatory approval, a majority of the directors of SWF. The Series A preferred stock is senior preferred stock. The holders of the Series A preferred stock are entitled to class voting rights under certain circumstances, including in connection with a merger of SWF or a sale of all or substantially all its assets or the authorization or issuance of senior or pari passu preferred stock, and as otherwise provided by law. For the year ended December 31, 1997, 24,180 additional shares were issued with a redemption value of $2,418 in lieu of cash to satisfy dividend requirements.
Tax expense computed at statutory rate ..................... $ 15,313 Amortization of costs in excess of net assets acquired ..... 1,445 Change in deferred tax asset valuation allowance ........... 364 Other ...................................................... (706) -------- $ 16,416 ========
Temporary differences, including $1,956 in 1997 of deferred tax assets transferred in association with a reinsurance contract with an affiliate, between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to the deferred tax assets (liabilities) at December 31, 1997 relate to the following:
Deferred tax liabilities: Present value of insurance in force ...................... (20,498) Other assets and liabilities ............................. (20,123) Net unrealized gain ...................................... (11,776) --------- (52,397)
In assessing the realizability of deferred tax assets, 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 believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowance at December 31, 1997.
Balance at beginning of year ................................. $ 71,333 Accretion of interest ........................................ 3,806 Amortization ................................................. (16,303) Transferred on assumed reinsurance contract with affiliate ... 2,291 Unrealized investment (gain) loss adjustment ................. (2,562) -------- Balance at end of year ..................................... $ 58,565 ========
8. Deferred Policy Acquisition Costs and Present Value of Insurance in Force (Continued)
The Company's cash flow is derived principally from dividends and principal and interest payments owed on the surplus debenture by Constitution. The principal source of repayment of the surplus debenture is dividends from Constitution's subsidiaries, Southwestern Life and Union Bankers. Generally, the net assets of the insurance subsidiaries available for transfer to the Company are limited to the greater of the subsidiary net gain from operations during the preceding year or 10% of the subsidiary net statutory surplus as of the end of the preceding year as determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities. Payment of dividends in excess of such amounts would generally require approval by the regulatory authorities. Based upon Constitution's earned surplus at December 31, 1997, no dividends can be paid to its parent without prior regulatory approval.
Statutory capital and surplus of the Company's life insurance subsidiaries as reported to regulatory authorities at December 31, 1997 totaled approximately $174,715. Statutory net loss of the Company's life insurance subsidiaries as reported to regulatory authorities totaled $2,521 for the year ended December 31, 1997.
Direct policy revenues and amounts assessed against policyholders .................................... $ 252,656 Reinsurance assumed ........................................ 1,182 Reinsurance ceded .......................................... (108,020) --------- Net premiums and amounts earned ............................ $ 145,818 =========
Service cost ................................ 269 Interest cost................................ 930 --------- Net periodic postretirement benefit cost..... 1,199 Benefit payments.............................. (1,290) --------- Net change.................................... (91) --------- Accrued postretirement benefits, end of year.. $ 12,595 =========
The liability for accrued postretirement benefits includes the following at December 31, 1997:
Accumulated postretirement benefit obligation: Retirees..................................... $ 11,167 Active eligible.............................. 1,076 Active ineligible............................ 944 --------- 13,187
Unrecognized actuarial loss................... (592) --------- Accrued postretirement benefits............... $ 12,595 =========
The Company and its subsidiaries have management and services agreements with entities affiliated with Knightsbridge, a shareholder. In connection with an Advisory and Management Services Agreement with Knightsbridge Management, L.L.C., the Company pays an annual fee of $1,500 plus expenses. Each insurance subsidiary has an Investment Management Agreement with Knightsbridge Consultants, L.L.C. For the year ended December 31, 1997, fees incurred totaled $1,871.
1998...................................... $ 2,381 1999...................................... 2,685 2000...................................... 2,666 2001...................................... 2,652 2002...................................... 2,497 2003 and thereafter....................... 10,704 ------- Total minimum payments required......... $23,585 =======
The following is a summary of the carrying value and fair value of the Company's financial instruments at December 31, 1997:
Cash and Short-term Investments, Agent and Premium Receivables: The carrying value of short-term investments and amounts receivable approximate their fair value due to the short-term maturity of these instruments.
On January 2, 1998, PennCorp acquired all of the outstanding common stock held by Knightsbridge and certain other parties for aggregate cash consideration ranging from $73,777 to $77,444 (excluding anticipated acquisition expenses) depending upon the outcome of certain contingencies. As a result, SWF became a wholly-owned subsidiary of PennCorp. After the acquisition of the common stock, PennCorp repaid SWF's bank revolving debt in the amount of $90,250 and its bank term debt in the amount of $24,500. Consequently, the Company will realize an extraordinary charge in 1998 for the write-off of deferred costs of $2,571 associated with these loans. In addition, PennCorp canceled the $40,000 SWF note it acquired from ICH.
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, excess of liabilities over assets, total revenues and net loss of the SW Financial Businesses Held for Sale aggregated $530,866, $49,697, $109,387 and $5,201, respectively.