During 1999, Torchmark sold the majority of its investment real estate holdings for total consideration of $123 million. These sold investments included its TMK Income Properties limited partnership and its joint venture investment in Liberty Park, a planned community in Birmingham, Alabama. As of December 31, 1999, Torchmark retained $16 million of investment real estate, which included $8 million of properties that were partially occupied by Torchmark subsidiaries, $7 million of undeveloped land in Liberty Park, and $1 million of undeveloped land in north Texas.
2) Changes in governmental regulations (particularly those impacting taxes and changes to the federal Medicare program that would affect Medicare Supplement insurance);
6) The inability of Torchmark to obtain timely and appropriate premium rate increases;
8) Interest rate changes that adversely affect product sales and/or investment portfolio yield;
11) The inability of Torchmark to achieve the anticipated levels of administrative and operational efficiencies; and
The following discussion should be read in conjunction with the Selected Financial Data and Torchmark's Consolidated Financial Statements and Notes thereto appearing elsewhere in this report.
Sale of Family Service. On June 1, 1998, Torchmark sold Family Service to an unaffiliated insurance carrier. Family Service, which was acquired in 1990, is a preneed funeral insurer but has not issued any new policies since 1995. Consideration for the sale was $140 million in cash. Torchmark recorded a pretax realized loss on the sale of approximately $14 million, but incurred a tax expense on the transaction of $9 million for a total after-tax loss of $23 million. In connection with the sale, Torchmark agreed to continue to service the policies in force of Family Service for five years from the sale date for a fee of $2 million per year plus certain variable processing costs. During 1997, Family Service accounted for $57 million in revenues and $7.7 million in pretax income. Through May, 1998, Family Service contributed $25 million in revenues and $5.8 million in pretax income. Invested assets were $778 million and total assets were $828 million at the date of the sale.
Summary of Operating Results. Torchmark's management computes a classification of income called "net operating income." Net operating income is the measure of income Torchmark's management focuses on to evaluate the performance of the operations of the company. It differs from net income as reported in the financial statements in that it excludes unusual and nonrecurring income or loss items which distort operating trends. It also excludes discontinued operations.
Torchmark reports earnings per share data as basic and diluted. Basic earnings per share are based on average shares outstanding during the period. Diluted earnings per share assume the exercise of Torchmark's employee stock options for which the exercise price was lower than the market price during the year and their impact on shares outstanding. Diluted earnings per share differ from basic earnings per share in that they are influenced by changes in the market price of Torchmark stock and the number of options as well as the number of shares outstanding. Unless otherwise indicated, all references to per share data in this report are on the basis of diluted shares.
Torchmark's revenues were $2.23 billion in 1999, an increase of 3% over 1998 revenues of $2.16 billion. Revenues rose 4% in 1998 over 1997 revenues of $2.07 million. After adjustment for realized investment gains and losses in each year, revenues grew 5% in 1999 from $2.22 billion in 1998 to $2.33 billion. They also rose 5% in 1998 over the prior year. Total premium rose $130 million, or 7%, to $1.88 billion in 1999. Total premium increased 5% in 1998 to $1.75 billion. Life insurance premium rose 6% in 1999 to $1.02 billion, an increase of $59 million. Health premium in 1999 rose 9%, an increase of $65 million to $825 million. Net investment income declined $12 million, or 3%, in 1999 due primarily to the sale of Family Service. Life premium increased 5% to $960 million and health premium grew 3% to $760 million in 1998. Net investment income increased 7% in 1998 to $460 million.
The following table is a summary of Torchmark's continuing net operating income. Insurance underwriting income is defined by Torchmark management as premium income less net policy obligations, commissions, acquisition expenses, and insurance administrative expenses plus other income. Excess investment income is defined as tax-equivalent net investment income reduced by the interest credited to net policy liabilities and financing costs. Financing costs include the interest on Torchmark's debt and the net cost of the Monthly Income Preferred Securities ("MIPS").
Life insurance. Life insurance is Torchmark's largest segment, with life premium representing 54% of total premium and with life underwriting income before other income, administrative expense, and nonrecurring charge, representing 61% of the total. Life insurance products provide higher underwriting margins and a larger asset base resulting from higher reserve levels. A larger asset base provides Torchmark the opportunity to increase investment income.
Family Service was sold on June 1, 1998. Comparisons of 1997 through 1999 in the following discussions of Torchmark's life insurance operations exclude Family Service.
Life insurance products are marketed through a variety of distribution channels. The following table presents life insurance premium by distribution method during each of the three years ended December 31, 1999.
Direct Response marketing is conducted through direct mail, co-op mailings, television and consumer magazine advertising, and direct mail solicitations endorsed by groups, unions and associations. It markets a line of life products primarily to juveniles and adults with face amounts of less than $10 thousand on average. The Direct Response operation is characterized by lower acquisition costs than Torchmark's agency-based marketing systems. In each of the three years 1997 through 1999, this distribution center had Torchmark's highest growth in life insurance premium in dollar amount. It accounted for over 24% of Torchmark's life insurance premium during 1999. Direct Response premium was $246 million in 1999, increasing 11% over 1998 premium of $221 million. Direct Response life premium in 1998 grew 13% over 1997 premium of $195 million.
Annualized premium sold by the Direct Response operation was $96 million in 1999, increasing 3% over 1998 sales of $94 million. Sales in 1998 rose 18% over 1997 sales of $79 million. Sales growth declined as compared with previous years due in part to the withdrawal from the under-age 40 adult direct mail market because of unfavorable financial results from that segment. Direct mail sales to ages 40 to 50 were interrupted for part of the year while those products were repriced to improve their financial results. The annualized life premium issued by the Direct Response group represented over 37% of Torchmark's total life sales in 1999. Direct Response annualized life premium in force rose 9% to $283 million at December 31, 1999 from $260 million a year earlier. At December 31, 1999, Direct Response life annualized premium in force was second only to that of the Liberty National Exclusive Agency. Direct Response life insurance annualized premium in force grew 12% in 1998.
In addition to growth in life insurance sales and premium, the Direct Response operation has promoted growth in some of Torchmark's agent-based distribution channels through marketing support. This support includes providing sales leads and assisting in agent recruiting. This assistance has contributed indirectly to the growth in premium in other Torchmark distribution agencies. For example, Direct Response marketing support indirectly contributed to the increase in health sales by the United American Exclusive Agency through its assistance in the agent recruiting process and by providing leads to the agents.
The Liberty National Exclusive Agency distribution system represented Torchmark's largest contribution to life insurance premium income in each of the three years presented, with 1999 premium of $288 million representing 28% of total life premium. The annualized life premium in force of the Liberty Agency was $307 million at year-end 1999, compared with $298 million and $299 million at year-end 1998 and 1997, respectively. Life premium sales, in terms of annualized premium issued, grew 13% during 1999 to $51 million. This $6 million increase in annualized life premium sales by the Liberty National Agency was Torchmark's largest in dollar amount, accounting for 47% of the growth in annualized life premium issued. Life sales in this agency rose 5% in 1998 to $46 million, representing a turnaround in sales growth from a 5% decline in sales in 1997. The turnaround in sales growth in the Liberty Agency was largely attributable to growth in the number of agents. Liberty's agents rose from a count of 1,750 agents at year-end 1997 to 1,829 agents at year-end 1998, an increase of 5%. They further increased 4% to 1,902 at year-end 1999. Improved agent recruitment efforts and training programs which help improve agent retention have been responsible for the new agent growth. Additionally, training programs have been employed to improve the retention of recruited agents. Agency productivity has also increased in 1999, as average sales per agent rose 9% over the prior year. Management believes that the continued recruiting of new agents and the retention of productive agents are critical to the continued growth of sales in controlled agency distribution systems.
The American Income Exclusive Agency is a distribution system that focuses on members of labor unions, credit unions, and other associations for its life insurance sales. It is a high margin business characterized by lower policy obligation ratios. At December 31, 1999, premium from this system accounted for 21% of Torchmark's total life premium. In 1999, American Income's premium increased 6% to $217 million, after having risen 7% in 1998 to $204 million. Annualized life premium in force was $231 million at year-end 1999, an increase of 7% over 1998 premium in force of $216 million. Annualized life premium in force rose 6% in 1998 and 8% in 1997. Sales, in terms of annualized premium issued, were $54 million in 1999, $54 million in 1998, and $55 million in 1997, declining 3% in 1998 but increasing 1% in 1999. Growth in sales of this agency is dependent on the growth in the number of agents. An 8% decline in agent count was experienced in 1998 to 1,222 agents at December 31, 1998, and a further decline in the first half of 1999 resulted in 1,160 agents at June 30, 1999. However, changes in American Income's marketing organization were implemented in 1999 to reverse the decline in the number of agents. As a result, the American Income agency had 1,197 agents at year-end 1999, an increase of 3% in agents over June, 1999. Management continues to make changes to American Income's marketing organization to improve agent recruiting, retention, and productivity in order to increase the size of this agency.
The United American Independent and Exclusive Agencies represented about 6% of total life premium in 1999. On a combined basis, life premium rose 2% to $57 million in 1999 after a 1% increase in 1998. Premium for these agencies increased 12% in 1997 to $55 million. Annualized life premium issued in 1999 was $19 million, increasing 25% over 1998 issues of $15 million.
Health products sold by Torchmark insurance companies include Medicare Supplement, cancer, long-term care, and other under-age-65 limited-benefit supplemental medical and hospitalization products. As a percentage of annualized health premium in force at December 31, 1999, Medicare Supplement accounted for 71%, cancer 17%, and other health products 11%. The table below presents Torchmark's health insurance annualized premium in force by major product category at December 31, 1999 and for the two preceding years.
Medicare Supplement insurance is sold primarily by the United American Exclusive Agency and the United American Independent Agency. Health sales in both agencies have grown significantly in the past three years. The Exclusive Agency sold $103 million in annualized health premium in 1999, a 60% increase over the prior year. Health sales for this agency rose 62% in 1998 to $64 million. This agency accounted for $44 million of the $65 million in health premium growth in 1999. It also was instrumental in health annualized premium growth in both 1999 and 1998, accounting for $58 million of the $87 million growth during 1999 in in-force premium and adding $31 million to annualized health premium in force in 1998. The United American Exclusive Agency represented 26% of Torchmark's annualized health premium in force at December 31, 1999, compared with 22% a year earlier. One factor in the growth in Medicare Supplement sales in the United American Exclusive Agency is the targeted marketing support provided by the Direct Response operation.
Until recently the primary competition for Medicare Supplement sales had come from Medicare health maintenance organizations (HMO's), the managed care alternative to traditional fee-for-service Medicare which eliminated the need for a supplemental policy. However, in the last few years, growing public dissatisfaction with managed care, increased medical cost inflation and increased Federal Government regulatory pressures on Medicare HMO's have caused an increasing number of HMO's to withdraw from the market, reducing that competition. Other regulatory issues continue to affect the Medicare Supplement market. Medical cost inflation and changes to the Medicare program cause the need for annual rate increases, which generally require state insurance department approval. In addition, Congress and the Federal Administration have begun studying ways to restructure the Medicare program in the future as it is anticipated that the program could be insolvent within the next decade. This would occur because of the growth in the number of "baby boomers" becoming eligible for Medicare during that period and increasing medical cost inflation generally due to increased utilization. Therefore, it is likely that changes will be made to the Medicare program at sometime in the future. However, regardless of proposed changes, it appears that there will continue to be an important role for private insurers in helping senior citizens cover their healthcare costs. As a result, Medicare Supplements should continue as a popular product for senior-age consumers.
Cancer insurance premium in force grew 6% in 1999 to $154 million, compared with 5% growth in 1998. Sales of this product rose 4% in 1999 to $11 million from $10 million. Sales in 1997 were also $11 million. Growth in cancer annualized premium in force has been partially attributable to premium rate increases to offset increased health care costs. Cancer insurance products are sold primarily by the Liberty National Exclusive Agency. This agency represented 85% of Torchmark's total cancer annualized premium in force at December 31, 1999.
Annualized premium in force for other health products gained 1% in 1999 to $100 million, after declining 4% in 1998. Other health sales rose 13% in 1999 to $30 million, after having declined 15% in 1998.
Collections of fixed annuity premium were $72 million in 1999, compared with $65 million in 1998, an increase of 11%. Fixed annuity premium collections declined 16% in 1998 from $77 million in 1997. Management believes that the interest-rate environment is a primary factor in the sales of fixed annuities. The low-interest rate environment of 1998 contributed to the lower sales as alternative investments grew more attractive. In 1999, as interest rates increased, fixed annuities became more desirable relative to alternative investments. The fixed annuity deposit balance increased 5% in 1999 to $677 million at year end. It rose 6% in the prior year from $611 million at year- end 1997 to $647 million at the end of 1998.
During 1998, Torchmark sold Family Service, a wholly-owned provider of funeral preneed annuities. While the sale of these preneed annuities had been discontinued in 1995, this block of fixed annuities remained on deposit until Family was sold. At the date of sale, this deposit balance was approximately $396 million.
Variable annuity collections were $393 million in 1999, increasing 31% over the prior year. Variable collections rose 21% to $299 million in 1998. The strength in financial markets has had a positive influence on sales of variable annuities in all of the years 1997 through 1999.
Net investment income declined 3% in 1999 to $447 million after rising 7% to $460 million in 1998 and 7% to $429 million in 1997. On a tax-equivalent basis, in which the yield on tax-exempt securities is adjusted to produce a yield equivalent to the pretax yield on taxable securities, investment income declined 3% in 1999 after rising 7% in both 1998 and 1997. The 1999 decline in investment income was a result of the sale of Family Service in the second quarter of 1998 and repurchases of Torchmark Stock since late 1998. The Family Service sale resulted in the investment of approximately $140 million proceeds, producing an additional $10 million of investment income in 1999, compared with incremental investment income of $6 million in 1998. However, the 1998 tax-equivalent net investment income also included $22 million earned on Family Service assets which were not includable in 1999. The Family Service sale also negatively impacted 1998 net investment income as 1997 tax- equivalent net investment income included $54 million on Family Service assets held for the entire year.
Mean invested assets, computed based on book values, were flat in 1999, compared with the year 1998. The growth in 1999 invested assets from reinvested cash flows were essentially offset by the loss of Family Service's $778 million in invested assets when compared with the prior year. In spite of the loss of Family Service's invested assets in 1998, mean invested assets increased 5% during 1998 over the prior year. This increase was largely due to the receipt of $481 million in proceeds from the Waddell & Reed stock offering in early 1998, offset to some extent by the sale of investments to repay debt and to acquire Torchmark stock.
Excess investment income increased 5% in 1999 and 44% in 1998 because the increases in excess investment income were greater than the growth in net investment income. While the 1998 sale of Family Service caused a reduction in 1998 and 1999 investment income, it had little effect on excess investment income comparisons in either 1999 or 1998. The reduction in required interest on Family Service's policy liabilities offset the loss in investment income. The 1999 increase in excess investment income resulted primarily from decreased financing costs. The $63 million increase in 1998 excess investment income resulted primarily from the proceeds of the Waddell & Reed offering which provided Torchmark with additional funds to invest or to apply to outstanding debt. Additionally, there was $7 million of interest income on an internal financing with Waddell & Reed included in 1998 income. Also in 1998, Torchmark essentially refinanced $380 million principal amount of its long- term debt with either short-term debt or with sales of lower-yielding investments, saving an average of 350 basis points in 1998 financing costs.
During 1999, the yield curve "flattened" with short-term yields approaching long-term yields. In fact, the yield curve "inverted" in early 2000, with short-term yields exceeding long-term yields. This flattening allowed the purchase of new investments at higher yields with shorter maturities as compared with 1998. The average life of acquired securities was 14.9 years in 1999, compared with 20.7 years in 1998 and 13.3 years in 1997. In the fourth quarter of 1999, the average life of acquired securities was 8.8 years.
Emphasis continues to be on marketable, high and medium quality investments. Approximately 92% of invested assets are fixed-maturity securities, and 94% of these holdings are rated investment grade by Standard & Poor's. The NAIC considers 95% of the portfolio investment grade. While the portfolio is highly marketable, its value fluctuates with changes in interest rates. The portfolio's unrealized loss of $275 million at year-end 1999 compares with unrealized gains of $249 million and $213 million at year ends 1998 and 1997, respectively. A considerable portion of the portfolio is expected to repay or mature within the next several years, as indicated by the following table.
The actual interest rate risk to Torchmark is reduced because the effect that changes in rates have on assets is offset by the effect they have on insurance liabilities and on debt. Interest assumptions are used to compute the majority of Torchmark's insurance liabilities. These liabilities, net of deferred acquisition costs, were $3.4 billion at December 31, 1999, compared with fixed-income investments of $6.0 billion at amortized cost at the same date. Because of the long-term nature of insurance liabilities, temporary changes in value caused by rate fluctuations have little bearing on ultimate obligations. These liabilities are not marked to market.
The liability for Torchmark's insurance policy obligations is computed using interest assumptions, some of which are contractually guaranteed. A reduction in market interest rates of a permanent nature could cause investment return to fall below amounts guaranteed. Torchmark's insurance companies participate in the cash flow testing procedures imposed by statutory insurance regulations, the purpose of which is to insure that such liabilities are adequate to meet the company's obligations under a variety of interest rate scenarios. Those procedures indicate that Torchmark's insurance policy liabilities, when considered in light of the assets held with respect to such liabilities and the investment income expected to be received on such assets, are adequate to meet the obligations and expenses of Torchmark's insurance activities in all but the most extreme circumstances.
Torchmark's cash and short-term investments were $115 million at December 31, 1999, compared with $81 million at year-end 1998. In addition to these highly liquid assets, Torchmark has a portfolio of marketable fixed and equity securities, which are available for sale should the need arise. These securities had a value of $5.7 billion at December 31, 1999.
Through its insurance subsidiaries, Torchmark has reacquired a portion of its funded debt in the open market. In 1999, $7.5 million principal amount of its 7 7/8% Notes due 2023 were acquired at a cost of $7.9 million. Also in 1999, $4.0 million principal amount of its 7 3/8% Notes due 2013 were purchased for $4.1 million. In 1998, Torchmark bought $10.8 million of its 7 7/8% Notes at a price of $10.6 million. Insurance company holdings in the funded debt reduce consolidated debt outstanding.
During 1997, Torchmark repaid $20 million principal amount on its Sinking Fund Debentures due in 2017, of which $8 million was a mandatory redemption and $12 million was an optional repayment under the terms of the agreement.
Effective January 1, 1999, Torchmark changed its method of accounting for the swap agreement to recognize changes in its fair value, net of tax, as realized investment gains or losses. This method of accounting for such instruments was believed to be preferable under the guidance established by Statement of Financial Accounting Standards No. 80, Accounting for Futures Contracts ("SFAS 80") and the Securities and Exchange Commission. Previously, Torchmark accounted for the swap using hedge accounting under SFAS 80. The after-tax cumulative effect of the change at January 1, 1999 was $16.1 million (net of income taxes of $8.7 million). The effect of the change on the twelve months ended December 31, 1999 was to increase realized losses by $11.7 million ($.09 per diluted share), excluding the cumulative effect of the change in accounting principal. Market value of the swap at December 31, 1999 was $6.7 million.
Total debt as a percentage of total capitalization was 25% at December 31, 1999. In the computation of this ratio, the MIPS are counted as equity and the effect of fluctuations in security values based on changes in interest rates in financial markets are excluded. This debt-to-capitalization ratio was 24% at year-end 1998 and 31% at year-end 1997. The increase in the debt-to- capitalization ratio at year-end 1999 was caused by the increase in short-term borrowings. The 1998 decline in this ratio resulted primarily from the funded debt paydowns, net of the increase in short-term debt. The debt-to- capitalization ratio was also favorably impacted by the net increase in Torchmark's shareholders' equity resulting from the Waddell & Reed offering and spin-off. Torchmark's ratio of earnings before interest, taxes and discontinued operations to interest requirements was 8.7 in 1999, compared with 8.9 in 1998 and 6.5 in 1997. Torchmark's interest expense declined 7% to $52 million in 1999, largely as a result of lower average debt than in 1998. There was also a larger proportion of short-term debt in 1999 compared with the prior year, resulting in lower borrowing costs. In 1998, interest expense declined 22% to $56 million primarily because of the funded debt paydowns.
Torchmark resumed its share buyback program in November, 1998 after completion of the Waddell & Reed spin-off. Torchmark purchased 6.7 million shares on the open market at a cost of $222 million in 1999. Purchases of 3.4 million shares were made in late 1998 at a cost of $126 million. During 1997, Torchmark acquired 5.2 million shares at a cost of $183 million. Torchmark will continue to make share purchases under its share repurchase program on the open market when prices are attractive. Share purchases could have a favorable impact on earnings per share and return on equity, but negatively affect book value per share.
On November 15, 1999, Torchmark executed a stock option exercise and restoration program through which 80 Torchmark directors and employees exercised vested stock options and received a reduced number of replacement options at the current market price. This program resulted in the issuance of 1.8 million shares, but over 1.3 million of the new shares were immediately sold by the directors and employees through the open market to cover the cost of the purchased shares and the related taxes. As a result of the restoration program, management's ownership interest increased, and Torchmark received a significant current tax benefit from the exercise of the options.
Accounting for Derivative Instruments and Hedging Activities (FASB Statement No. 133), as amended by FASB Statement No. 137, is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000, with earlier application of all of the provisions of this statement encouraged. Early adoption of selective provisions is prohibited. Prior periods may not be restated for comparability.
Recognition of Premium Revenue and Related Expenses: Premiums for insurance contracts which are not defined as universal life-type according to Statement of Financial Accounting Standards ("SFAS") No. 97 are recognized as revenue over the premium-paying period of the policy. Profits for limited-payment life insurance contracts as defined by SFAS 97 are recognized over the contract period. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Variable annuity products are also assessed an investment management fee and a sales charge. Life premium includes policy charges of $71.9 million, $71.7 million, and $72.3 million for the years ended December 31, 1999, 1998, and 1997,
Income Taxes: Income taxes are accounted for under the asset and liability method in accordance with SFAS 109. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement book values and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Litigation: Torchmark and its subsidiaries continue to be named as parties to legal proceedings. Because much of Torchmark's litigation is brought in Alabama, a jurisdiction known for large punitive damage verdicts bearing little or no relationship to actual damages, the ultimate outcome of any particular action cannot be predicted. It is reasonably possible that changes in the expected outcome of these matters could occur in the near term, but such changes should not be material to Torchmark's reported results or financial condition.
Stock Split: On August 1, 1997, Torchmark distributed one share for every one share owned by shareholders of record as of July 1, 1997 in the form of a stock dividend. The dividend was accounted for as a stock split.
Earnings Per Share: Torchmark presents basic and diluted earnings per share ("EPS") on the face of the income statement and a reconciliation of basic EPS to diluted EPS. Basic EPS is computed by dividing income available to common stockholders by the weighted average common shares outstanding for the period. Weighted average common shares outstanding for each period are as follows: 1999--133,197,023, 1998--139,998,671, 1997--139,202,354. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts which could be exercised or converted into common shares. Weighted average diluted shares outstanding for each period are as follows: 1999--133,985,943, 1998--141,351,912, 1997-- 141,431,156.
Insurance subsidiaries of Torchmark are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from GAAP. Consolidated net income and shareholders' equity on a statutory basis for the insurance subsidiaries were as follows:
Proceeds from sales of fixed maturities available for sale were $1.24 billion in 1999, $758 million in 1998, and $745 million in 1997. Gross gains realized on those sales were $4.3 million in 1999, $6.1 million in 1998, and $1.3 million in 1997. Gross losses were $36.5 million in 1999, $20.1 million in 1998, and $32.2 million in 1997.
Torchmark had $7.0 million and $24.7 million in investment real estate at December 31, 1999 and 1998, respectively, which was nonincome producing during the previous twelve months. These properties included primarily construction in process and land. Torchmark had $118 thousand in nonincome producing mortgages as of year end 1999. There were no fixed maturity investments, or other long-term investments which were nonincome producing at December 31, 1999.
- -------- (1) Represents amounts pertaining to investments relating to universal life- type products.
Divestiture of Waddell & Reed. Waddell & Reed, Torchmark's asset management subsidiary, completed an initial public offering in March, 1998 of approximately 24 million shares of its common stock. The offering represented approximately 36% of Waddell & Reed's shares. Net proceeds from the offering were approximately $516 million after underwriters' fees and expenses. Waddell & Reed used $481 million of the proceeds to repay existing notes owed to Torchmark and other Torchmark subsidiaries and retained the remaining $35 million. Torchmark's $481 million proceeds from the note repayments were invested or used to pay down debt. The initial public offering resulted in a $426 million gain which was added to Torchmark's additional paid-in capital in accordance with Staff Accounting Bulletin 51. Torchmark retained the remaining 64% of the Waddell & Reed stock.
Note 6--Initial Public Offering and Divestiture of Asset Management Segment (continued)
On June 1, 1998, Torchmark sold Family Service to an unaffiliated insurance carrier. Family Service, which was acquired in 1990, is a preneed funeral insurer but has not issued any new policies since 1995. Consideration for the sale was $140 million in cash. Torchmark recorded a pretax realized loss on the sale of approximately $14 million, but incurred a tax expense on the transaction of $9 million. In connection with the sale, Torchmark will continue to service the policies in force of Family Service for the next five years for a fee of $2 million per year plus certain variable processing costs. During 1997, Family Service accounted for $57 million in revenues and $7.7 million in pretax income. Through May, 1998, Family Service contributed $25 million in revenues and $5.8 million in pretax income. Invested assets were $778 million and total assets were $828 million at the date of the sale.
A summary of the assumptions used in determining the liability for future policy benefits at December 31, 1999 is as follows:
The overall average interest assumption for determining the liability for future life and health insurance benefits in 1999 was 6.1%.
In 1999, 1998, and 1997, deferred income tax expense was incurred because of certain differences between net operating income before income taxes as reported on the consolidated statement of operations and taxable income as reported on Torchmark's income tax returns. As explained in Note 1, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
Torchmark has not recognized a deferred tax liability for the undistributed earnings of its wholly-owned subsidiaries because such earnings are remitted to Torchmark on a tax-free basis. A deferred tax liability will be recognized in the future if the remittance of such earnings becomes taxable to Torchmark. In addition, Torchmark has not recognized a deferred tax liability of approximately $10 million that arose prior to 1984 on temporary differences related to the policyholders' surplus accounts in the life insurance subsidiaries. A current tax expense will be recognized in the future if and when these amounts are distributed.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. Contributions are made to the pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Accrued pension expense in excess of amounts contributed has been recorded as a liability in the financial statements and was $7.5 million and $7.2 million at December 31, 1999 and 1998, respectively. The plans covering the majority of employees are organized as trust funds whose assets consist primarily of investments in marketable long-term fixed maturities and equity securities which are valued at market.
The excess benefit pension plan provides the benefits that an employee would have otherwise received from a defined benefit pension plan in the absence of the Internal Revenue Code's limitation on benefits payable under a qualified plan. Although this plan is unfunded, pension cost is determined in a similar manner as for the funded plans. Liability for the excess benefit plan was $4.7 million at both December 31, 1999 and 1998.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.15% in 1999 and 7.38% in 1998.
The amount of debt that becomes due during each of the next five years is: 2000, $418,394, and 2001-2004, $0.
The Notes, due May 15, 2023, were issued in May, 1993 in the principal amount of $200 million. Proceeds of the issue, net of issue costs, were $196 million. Interest is payable on May 15 and November 15 of each year at a rate of 7 7/8%. In 1998 and 1999, $10.8 million and $7.5 million principal amount were purchased in the open market at a cost of $10.6 million and $7.9 million respectively. These notes are not redeemable prior to maturity and have equal priority with other Torchmark unsecured indebtedness.
Torchmark has entered into a revolving credit agreement with a group of lenders under which it may borrow on an unsecured basis up to $600 million. The commitment matures October 22, 2002. Borrowings are at interest rates selected by Torchmark based on either the corporate base rate or the Eurodollar rate at the time of borrowing. At December 31, 1999 and December 31, 1998 there were no borrowings under the revolving credit agreement. The revolving credit agreement is also designed to back up a commercial paper program. The short-term borrowings under the revolving credit agreements and in the commercial paper market averaged $411 million during 1999, and were made at an average yield of 5.43%. At December 31, 1999, commercial paper was outstanding in the face amount of $420 million. Torchmark is subject to certain covenants for the revolving credit agreements regarding capitalization and earnings, for which it was in compliance at December 31, 1999, and pays a facility fee based on size of the line. Including fees, the average borrowing cost during 1999 was 5.61%.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Dollar amounts in thousands except per share data)
Interest in the amount of $284 thousand, $2.4 million, and $1.7 million was capitalized during 1999, 1998, and 1997, respectively.
In October, 1994, Torchmark, through its wholly-owned finance subsidiary, Torchmark Capital L.L.C., completed a public offering of eight million shares of 9.18% MIPS at a face amount of $200 million. The securities are subject to a mandatory redemption in full at September 30, 2024, although Torchmark may elect to extend the MIPS for up to an additional 20 years if certain conditions are met. They have been redeemable at Torchmark's option since September 30, 1999. Torchmark subsequently entered into a ten-year swap agreement with an unaffiliated party whereby Torchmark agreed to pay a variable rate on the $200 million face amount in exchange for payment of the fixed dividend. In a related transaction, Torchmark purchased a five-year cap on the swap agreement that expired on September 30, 1999. The interest rate was 7.00% at December 31, 1999 and 6.44% at December 31, 1998. The market value of the swap agreement was a benefit of $6.7 million at December 31, 1999 and $24.7 million at December 31, 1998. Torchmark changed its method of accounting for this swap agreement during 1999. Refer to Note 15--Change in Accounting Principle below for more information on this change in accounting principle.
Acquisition of Common Shares: Torchmark shares are acquired from time to time through open market purchases under the Torchmark stock repurchase program when it is believed to be the best use of Torchmark's funds and for future employee stock option exercises. Share repurchases under this program were 6.7 million shares at a cost of $222 million in 1999, 3.4 million shares at a cost of $126 million in 1998, and 5.2 million shares at a cost of $183 million in 1997.
Restrictions: Restrictions exist on the flow of funds to Torchmark from its insurance subsidiaries. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. These restrictions generally limit the payment of dividends by insurance subsidiaries to statutory net gain from operations before realized capital gains or losses on an annual noncumulative basis in the absence of special approval. Additionally, insurance companies are not permitted to distribute the excess of shareholders' equity as determined on a GAAP basis over that determined on a statutory basis. In 2000, 192 million will be available to Torchmark for dividends from insurance subsidiaries in compliance with statutory regulations without prior regulatory approval.
Certain employees, directors, and consultants have been granted options to buy shares of Torchmark stock generally at the market value of the stock on the date of grant under the provisions of the various Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring ten years and two days or eleven years after grant. Employee and consultant stock options generally vest one-half in two years and one-half in three years. Formula-based director grants generally vest in six months. Grants in September, 1997 and November, 1999 vested immediately. Stock options awarded in connection with compensation deferrals by certain directors and executives vest over ten years. Torchmark generally issues shares for the exercise of stock options out of treasury stock.
A summary of Torchmark's stock option activity and related information for the years ended December 31, 1999, 1998, and 1997 follows:
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represents 2.3% of life insurance in force at December 31, 1999 and reinsurance assumed on life and accident and health products represents 1.9% of premium income for 1999.
Concentrations of Credit Risk: Torchmark maintains a highly diversified investment portfolio with limited concentration in any given region, industry, or economic characteristic. At December 31, 1999, the investment portfolio consisted of the following:
Otherwise, no individual industry represented 4% or more of Torchmark's investments. At year-end 1999, 5% of the carrying value of fixed maturities was rated below investment grade (BB or lower as rated by Standard & Poor's or the equivalent NAIC designation). Par value of these investments was $313
Note 18--Commitments and Contingencies (continued) million, amortized cost was $314 million, and market value was $295 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value.
As previously reported, Liberty has been a party to two lawsuits alleging that a class of persons were insured under Liberty policies when Liberty knew that such persons were not entitled to retain any benefits under these policies, one of which was filed in 1996 in the Circuit Court of Jefferson County, Alabama (Harris v. Liberty National Life Insurance Company, Case No. CV-96-01836) and the other in the Circuit Court of St. Clair County, Alabama (Gentry v. Liberty National Life Insurance Company, Case No. CV-97-61). The Gentry case was dismissed by the St. Clair County Circuit Court on June 16, 1998 and subsequently the Harris case was amended to add former plaintiff Gentry as an additional class representative in that case. On December 28, 1999, the Jefferson County Circuit Court entered an order in Harris granting summary judgment for Liberty on all plaintiffs' claims except unjust enrichment. The only remaining claim in the Harris plaintiffs' motion for class certification, one of unjust enrichment, was denied by the Circuit Court in an order denying the motion for class certification entered February 10, 2000.
In November 1993, an attorney (purporting to represent the funeral director class) filed a petition in the District Court seeking "alternative relief" under the final judgment. This petition was voluntarily withdrawn on November 8, 1995 by petitioners. On February 23, 1996, Liberty filed a petition with the
Torchmark's segments are based on the insurance product lines it markets and administers, life insurance, health insurance, and annuities. These major product lines are set out as segments because of the common characteristics of products within these categories, comparability of margins, and the similarity in regulatory environment and management techniques. There is also an investment segment which manages the investment portfolio, debt, and cash flow for the insurance segments and the corporate function. Torchmark's management evaluates the overall performance of the operations of the company in accordance with these segments.
contract to policyholders because this interest is earned and credited by the investment segment. Second, interest is also added to acquisition expense which represents the implied interest cost of deferred acquisition costs, which is funded by and is attributed to the investment segment.
Transactions Regarding Vesta: Since 1993, Torchmark has held a passive investment in Vesta, a property insurance carrier. Torchmark held 5.1 million shares of Vesta stock, or approximately 28% of the outstanding shares of Vesta, until December, 1998. Torchmark carried its investment in Vesta during this period on the equity method of accounting. In June, 1998, Vesta announced that (a) an investigation of accounting irregularities that occurred during the fourth quarter of 1997 and the first quarter of 1998 would result in an aggregate $14 million net after-tax reduction in previously reported net income, and, in addition, that (b) it would restate its historical financial statements for the period of 1993 through the first quarter of 1998, reflecting reductions in reported net after-tax earnings of $49 million for the period of 1993 through 1997 and $10 million for the first quarter of 1998. To reflect its pro rata share of Vesta's cumulative reported financial corrections, Torchmark recorded a pre-tax charge of $20 million ($13 million after tax) or $.09 per diluted share in the second quarter of 1998. As a result of the announcements relating to Vesta and the decline in value of Vesta stock, Vesta is currently subject to numerous class action lawsuits in state and Federal courts filed subsequent to such announcements.
In the fourth quarter of 1998, Torchmark announced its intention to dispose of its holdings in Vesta and to sell Vesta shares under satisfactory terms. In December, 1998, Torchmark sold 680 thousand Vesta shares at a price of $4.75 per share, recording a loss of $3 million after tax. In 1999, Vesta filed a registration statement with the Securities and Exchange Commission for the public offering of its shares held by Torchmark. To facilitate the registration of Vesta shares, Torchmark reacquired the previously sold 680 thousand shares at a price of $5 per share. On November 5, 1999, the registration statement was filed by Vesta to offer all of Torchmark's holdings in Vesta.
The following is a summary of quarterly results for the two years ended December 31, 1999. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.