FIC’s home office is located at River Place Pointe, 6500 River Place Blvd., Building One, Austin, Texas. The Company occupies Building One of River Place Pointe, consisting of approximately 76,143 square feet of space. On June 1, 2005, the Company sold River Place Pointe to a non-affiliated party and entered into a lease with the purchaser with respect to Building One, for a five-year term at a rate of $28.00 per square foot, which is above the market rate in effect in June 2005, but was the prevailing rental rate at the time that FIC and its subsidiaries occupied the building in July 2000. The lease provides the Company with a right of cancellation at March 31, 2008. Upon the sale of Family Life in December, 2006, the Company evaluated its office space requirements. Based on this evaluation, the Company entered into three sublease transactions with unrelated parties in the first quarter of 2007. Cumulatively, these sublease arrangements will reduce the Company’s rent expense by approximately $350,000 through the period ending March 31, 2008.
The following selected consolidated financial data includes the accounts of Financial Industries Corporation and its subsidiaries.
Family Life owned 648,640 shares of FIC common stock prior to the sale. Such shares were reflected as common treasury stock in the Company’s historical consolidated financial statements. Immediately preceding and as a condition of the sale of Family Life, 324,320 of these shares were acquired by the Company and the remaining 324,320 shares remained with Family Life at the time of the sale. Accordingly, the shares that remained with Family Life are now reflected as outstanding common stock shares as of December 31, 2006, and have been reflected as a sale of treasury stock in the accompanying consolidated financial statements.
Net loss for the year of $24.8 million consisting of the following:
Increase in net unrealized losses on fixed maturities available for sale of $1.8 million consisting of the following:
Net appreciation of equity securities of continuing operations totaling $0.5 million included in other comprehensive income
Total managed assets increased during 2006 by $9.3 million, or 1.4%. This overall increase was largely related to the proceeds from the sale of Family Life, partially offset by net run-off of the Company’s annuity and life insurance business in force.
The Company, working with Conning, also revised the investment policies of its insurance subsidiary in recent years. The new policies reiterate compliance with legal requirements of state insurance laws and regulations that are applicable to the Company. They also emphasize sensitivity to the way that FIC’s liabilities are likely to change over time and with changes in general interest rate levels. In practical terms, this means that the Company now focuses almost all of its investment in investment-grade securities, keeping the schedule of anticipated asset maturities in line with its projected cash needs. It also means that the Company attempts to keep the duration of its investment assets (a measure of the sensitivity of their value to changes in interest rates) in line with the duration of the Company’s liabilities. At December 31, 2006, the Company’s holdings of below investment grade securities totaled approximately 3.1% of the fixed maturity securities portfolio.
Since the engagement of Conning as the Company’s investment manager in October 2003, the Company has realigned its portfolio, decreasing its investment in mortgage-backed securities (including asset-backed securities) significantly, from 35.8% in 2004, to 24.1% at December 31, 2005 and to 22.0% at December 31, 2006 as a percentage of its total investment in fixed maturities. With the reduction of this exposure to mortgage and asset-backed securities, the Company increased its holdings in corporate securities from 48.3% in 2004, to 54.3% at December 31, 2005 and to 61.1% at December 31, 2006, substantially all of which are in investment grade securities.
An allocation by security type of the Company’s investments in fixed maturities as of December 31, 2006 and 2005 is detailed below.
FIC’s equity securities consist primarily of its investment in the investment funds underlying the separate accounts business of Investors Life. As of December 31, 2006, FIC’s equity securities totaled $9.8 million, compared to $8.9 million at December 31, 2005. The increase is due to the strong performance of the equity markets during 2006 resulting in appreciation of the investment funds.
The costs related to acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are capitalized and treated as deferred policy acquisition costs (“DAC”) to be amortized over the life of the related policies. The increase in the Company’s DAC from December 31, 2005 to December 31, 2006, reflects that the capitalization of acquisition costs associated with sales of new insurance policies plus adjustments for unrealized losses in the Company’s portfolio exceeded the amortization of such amounts capitalized in prior years. The present value of future profits of acquired business is the capitalized acquisition cost of blocks of insurance business that the Company has acquired from others in the past. This asset is amortized to expense as the profits are realized from the various blocks of acquired business and the policies in force gradually decrease. These two assets are also impacted by the net run-off in business that the Company experienced in 2006, as shown in the following table.
Investors Life had $351.0 million of separate account assets as of December 31, 2006 (not including the value of the Company’s own start-up investment in one of the accounts), as compared to $342.9 million at the end of 2005. These assets include (a) two variable annuity separate accounts that permit contractholders to allocate their contract values among a selection of third-party mutual funds and (b) $325.1 million held in custodian accounts in connection with investment annuity contracts. The investment annuity business was reinsured with Symetra Life Insurance Company (formerly Safeco Life Insurance Company), a third-party reinsurer, on a 90%/10% coinsurance basis, with Investors Life retaining 10% of such business. Investors Life is not marketing new separate account annuity contracts.
The Company’s insurance-related liabilities (future policy benefits and contractholder deposit funds) were $570.8 million at December 31, 2006, as compared to $603.5 million at December 31, 2005. The decrease in contractholder deposit funds and future policy benefits reflects the business run-off as previously described above. Contractholder fund withdrawals during 2006 were $56.5 million compared to contractholder fund deposits of $27.7 million, reflecting the primary reason for the decrease in the related liability.
The ILCO pension plan has a projected benefit obligation at year-end 2006 totaling $19.2 million in comparison to the fair value of plan assets of $19.3 million. The difference in these amounts reflects a funded status of approximately $108,000, which is reflected as a pension asset in the accompanying consolidated financial statements. The Family Life pension plan has a projected benefit obligation at year-end 2006 totaling $7.6 million in comparison to the fair value of plan assets of $5.9 million. The difference in these amounts reflects an unfunded status of approximately $1.7 million, which is reflected as a pension liability in the accompanying consolidated financial statements. Amounts included as components of the projected benefit obligation which have not been recognized as an expense are included in accumulated other comprehensive income.
Financial intermediaries such as FIC depend on their capital to absorb short-term fluctuations in asset and liability values in their financial structures. They also count on capital to support the growth of the business. One typical measure of the strength of a financial holding company such as FIC is the simple ratio of its shareholders’ equity to its total assets. For FIC this ratio was 5.8% at December 31, 2006, compared to 7.0% at December 31, 2005. If separate account assets were not included (which management believes is appropriate) this ratio would have been higher by 3.0% and 2.8% at December 31, 2006 and 2005, respectively. The decline in the ratio in 2006 is primarily due to the loss from discontinued operations on the sale of Family Life. Management believes that its current capital is sufficient to meet the Company’s liabilities and to fund growth at currently planned levels.
Investors Life is subject to regulation under state law. Among other requirements, these state laws and regulations impose capital adequacy requirements on insurance companies. Using a calculation that takes into account the quality, liquidity, maturities, and amounts of its assets and liabilities, Investors Life is required to calculate its “risk-based capital” (or “RBC”). Investors Life’s total adjusted capital must exceed 200% of the authorized control level RBC to avoid supervisory activity by the insurance regulators. The RBC solvency margins for Investors Life at December 31, 2006 and 2005 were in excess of NAIC minimum standards. At December 31, 2006 and 2005, the RBC ratios for Investors Life were 584% and 560%, respectively.
In 2006, income from continuing operations was affected by the following items:
Premium revenues increased $0.9 million in 2006 compared to 2005 primarily due to increased sales of mortgage protection term ($0.2 million) and final expense ($0.6 million) insurance products.
Market interest rates have risen, allowing for the investment of cash and short-term investments in fixed maturity securities with higher interest yields, thus allowing for increased investment income during 2006. With the sale of the River Place Pointe property in June 2005, the Company had additional funds to invest in the latter half of 2005 and during 2006. However, as the sale of River Place Pointe occurred in 2005, net realized gains on real estate have declined $8.7 million in 2006 compared to 2005.
Reductions of $3.1 million were noted in policyholder benefits and expenses, as compared to 2005. These were primarily attributable to lower death benefits.
Federal income tax expense was significantly higher reflecting an effective tax rate of 80.3% in 2006. The higher taxes were due primarily to an increase in the Company’s valuation allowance for deferred taxes resulting from the sale of Family Life. The sale of Family Life removed the source of income supporting certain deferred tax assets at the FIC consolidated level.
In 2005, income from continuing operations was affected by the following items:
Significant auditing, actuarial, accounting, consulting, and legal fees were incurred in 2004, much of which was associated with the internal review of the Company’s financial accounts and resulting restatement of prior years’ consolidated financial statements as reported in its 2003 Form 10-K filing. The total for all these expenses and fees, much of which related to the internal review, restatement and litigation matters, was approximately $6.9 million for 2004.
Excess of cost over net assets acquired, or goodwill, totaling $752,000 was written off as an operating expense in 2004 as a result of the Company’s annual impairment analysis of such asset.
Premium revenues reported for traditional life insurance products are recognized when due. Both renewal premiums and first-year premiums declined from 2004 to 2005. However, improvements were shown in both renewal and first-year premiums during 2006, as shown in the following table. The increase in premiums is primarily from sales of mortgage protection term and final expense insurance products, which increased by $0.2 million and $0.6 million respectively.
In accordance with GAAP, deposits received in connection with annuity contracts and premiums received for universal life (“UL”) insurance policies are reflected in the consolidated financial statements as increases in liabilities for contractholder deposit funds and not as revenues. Annual charges made against these deposits are reported as revenue. For the years 2004 through 2006, the table below reflects the amounts of such annuity deposits and UL premiums.
Earned insurance charges totaled $31.7 million, $32.8 million, and $34.0 million for the years ended December 31, 2006, 2005, and 2004, respectively. These revenues primarily consist of UL cost of insurance charges, but also include policy surrender charges, and policy administration charges. The decline in earned insurance charges is primarily due to reduced UL cost of insurance charges resulting from the net run-off of business.
The Company’s holdings of fixed maturities, policy loans, and short-term investments (including cash equivalents) are its primary interest bearing securities. Components of net investment income by investment type are detailed below:
Real estate revenue was primarily earned from the leases on the buildings at the Company’s River Place Pointe office complex in Austin, Texas. Net real estate income (revenues from leases less associated operating expenses and depreciation) totaled $0.6 million and $1.8 million for the years ended December 31, 2005 and 2004, respectively. The decrease in real estate income from 2004 to 2005 was primarily due to the sale of the River Place Point office complex in June, 2005. The Company’s remaining real estate properties held for sale totaling $130,000 at December 31, 2005 were sold in January 2006. Accordingly, the Company no longer had real estate income in 2006.
Interest expense on contractholder deposit funds represents interest paid or credited to contractholders on cash values accumulated in their universal life insurance and annuity accounts. Interest expense totaled $18.0 million in 2006, $18.4 million in 2005, and $19.4 million in 2004. The decreases in interest expense noted during the preceding two years were primarily due to the decline in the number of universal life insurance and annuity policies in-force. As previously described, UL premiums and annuity deposits have declined and contractholder fund withdrawals have been exceeding contractholder deposits in 2006, 2005 and 2004, reflecting the net run-off of business. Consequently, the decrease in interest expense in 2006 and 2005 is primarily attributable to the overall reduction in the level of contractholder deposit funds. Liabilities for contractholder deposit funds have declined from $511.4 million in 2004 to $483.1 million and $453.0 million in 2005 and 2006, respectively.
The level of market interest rates can effect the interest spread which is the difference in the Company’s investment portfolio rate and the interest rates credited on policyholder contracts for universal life insurance and annuities. The Company responded to lower market rates in 2004 and 2005 by lowering many of the credited rates on its policies in these periods. However, universal life insurance and annuity policies have contractual minimum guaranteed rates and credited rates cannot be lower than such minimums. Because many of the Company’s policies have minimum guaranteed rates of 4.0%, the market interest rate environment in prior periods put pressure on the Company’s interest spread. Market rate increases in 2005 and 2006 have improved the Company’s interest spread.
Amortization of deferred policy acquisition costs (“DAC”) totaled $1.2 million, $1.6 million, and $978,000 for the years ended December 31, 2006, 2005, and 2004, respectively. These expenses represent the amortization of the costs of producing new business, which consist primarily of agents’ commissions and certain policy issuance and underwriting costs. DAC is amortized over the premium-paying period of the policies in proportion to estimated annual premium revenue for traditional life insurance business. For interest sensitive products, these costs are amortized in relation to the estimated annual gross profits of the policies. The level of policy lapses and surrenders can also have a significant impact on the amount of amortization. Lower policy lapses and surrenders for certain blocks of traditional life business resulted in the reduced amortization for 2006.
Present value of future profits on acquired businesses (“PVFP”) is amortized in a similar manner as DAC, as previously described, for traditional and interest sensitive business. Amortization of PVFP totaled $902,000, $1.1 million, and $1.1 million for the years ended December 31, 2006, 2005, and 2004, respectively. The amortization is consistent with the run-off of the acquired blocks of business.
As discussed in Item 1 - Description of the Business, the Company filed its Form 10-K and Forms 10-Q on October 30, 2006 and filed its 2005 Form 10-K and Forms 10-Q on January 12, 2007. These efforts required significant additional audit, actuarial, and consulting services, especially considering that, following the filing of the 2003 Form 10-K, the Company engaged Deloitte & Touche LLP as its new independent registered public accounting firm and engaged Allen Bailey & Associates, Inc. as its new actuarial consulting firm. Both firms were also engaged to work on the 2004 and 2005 statutory financial statements for the Company’s insurance subsidiaries, as well as the 2004 and 2005 consolidated financial statements. This change in auditors and actuaries, the first by the Company in many years, required additional work by both internal and external accounting and actuarial personnel. Effectively, costs and fees related to two years of audits were substantially incurred in one year during 2006. During 2007, substantially all the costs and fees related to the 2006 audits and Form 10-K and Forms 10-Q for 2006 will be incurred, along with a significant portion of the costs for the 2007 audits related to interim audit work throughout the year.
Operating expenses in 2004 also include a write off of excess of cost over net assets acquired, or goodwill, totaling $752,000 resulting from the Company’s annual impairment analysis of such asset. The goodwill was originally recognized by ILCO in connection with its acquisitions, including Investors Life. The impairment of the entire goodwill asset was triggered by the significant decline in the Company’s stock price from December 31, 2003 to December 31, 2004. The Company’s stock price is a significant component in the valuation calculation as required in the impairment analysis.
The ability of Investors Life to pay dividends to FIC and meet these holding-company liquidity demands is subject to restrictions set forth in the insurance laws and regulations of Texas, its domiciliary state. Texas limits how and when Investors Life can pay such dividends by (a) including the “greater of” standard for payment of dividends to shareholders and (b) requiring that prior notification of a proposed dividend be given to the Texas Department of Insurance. Under the “greater of” standard, an insurer may pay a dividend in an amount equal to the greater of: (i) 10% of the policyholder surplus or (ii) the insurer’s statutory net gain from operations for the previous year.
In June 2004, FIC, with the approval of the Texas Department of Insurance, created FIC Insurance Services, L.P., a service company subsidiary, and transferred to it many of the administrative functions of the insurance companies. The new service company charges Investors Life a monthly service fee that is calculated using a formula based on policies under management, new policies issued, managed assets, and other factors. Profits earned by the service company are paid as dividends to the holding company, providing an additional source of liquidity at the holding company level. Profits earned by the service company are expected to decrease in 2007, as fees will decline due to the sale of Family Life on December 29, 2006. This agreement with the service company was terminated by Family Life upon the sale of Family Life to The Manhattan Life Insurance Company.
It is not Company practice to enter into off-balance sheet arrangements nor is it Company policy to issue guarantees to third parties, other than in the normal course of issuing insurance contracts. Accordingly, the Company currently does not have any off-balance sheet arrangements. Commitments related to insurance products sold are reflected as policy liabilities and contractholder deposit funds using reserving methodologies described in Note 1 in the accompanying consolidated financial statements. Insurance contracts guarantee certain performances by the Company.
The increase of $18.7 million in cash and cash equivalents during 2006 was primarily due to cash provided by operating activities and by investing activities from the proceeds due to the sale of Family Life. The increase of $12.0 million in cash and cash equivalents during 2005 was primarily due to proceeds from the sales and maturities of invested assets, net of reinvestment of a portion of these proceeds. The decrease of $22.0 million in cash and cash equivalents during 2004 was primarily due to purchase of investments and cash used in financing activities to fund net cash outflows from contractholder deposits.
Net cash used in financing activities totaled $26.4 million, $32.7 million and $29.8 million in 2006, 2005 and 2004, respectively. The most significant components of the Company’s financing activities are contractholder fund deposits and withdrawals for annuity and universal life insurance policies. For 2006, 2005, and 2004, contractholder fund withdrawals exceeded deposits by $28.9 million, $32.7 million and, $29.8 million, respectively. The change in net withdrawals in 2006 was due to a decline in deposits in 2006 from 2005 of $2.2 million and a decline in withdrawals of $6.1 million for the same period. The change in net withdrawals in 2005 was due to a decline in deposits in 2005 from 2004 of $10.7 million and a decline in withdrawals of $7.9 million for the same period.
FIC’s liability for future policy benefits accounted for 12.0% of its total liabilities at December 31, 2006, or 18.7% after excluding liabilities associated with separate accounts. These liabilities for future policy benefits, referred to as reserves, are estimated using actuarial methods based on assumptions about future receipts of premiums, interest yields, investment returns, expenses, mortality, morbidity, and persistency. These assumptions consider Company experience and industry standards. The assumptions vary by plan, age at issue, year of issue, and duration. They include estimates, shaped by judgment and experience, and have a substantial impact on the reported financial condition of the Company. Differences between actual experience and assumptions used in the pricing of these policies and in the establishment of liabilities may result in variability of net income in amounts which may be material.
In September, 2005, the AICPA issued SOP 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for DAC on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. It is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. Adoption of SOP 05-1 did not have a material impact on the Company’s consolidated financial statements.
In March, 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140” (“SFAS 156”). Among other requirements, SFAS 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations. SFAS 156 will be applied prospectively and is effective for fiscal years beginning after September 15, 2006. Adoption of SFAS 156 did not have a material impact on the Company’s consolidated financial statements.
In February, 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits all entities the option to measure most financial instruments and certain other items at fair value at specified election dates and to report related unrealized gains and losses in earnings. The fair value option will generally be applied on an instrument-by-instrument basis and is generally an irrevocable election. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is evaluating which eligible financial instruments, if any, it will elect to account for at fair value under SFAS 159 and the related impact on the Company’s consolidated financial statements.
Consolidated Statements of Operations for the years ended December 31, 2006, 2005, and 2004.
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2006, 2005, and 2004.