Globe leases 34,000 square feet of office area in the Cotter Tower building located in downtown Oklahoma City, Oklahoma. Globe also leases 11,000 square feet at a nearby facility used for storage. Globe Marketing Services, a subsidiary of Globe, owns a 133,000 square foot facility in Oklahoma City which houses the Globe Life Direct Response operation.
Insurance Product Line Segments. As fully explained in Note 14-Business Segments in the Notes to the Consolidated Financial Statements, the insurance product line segments involve the marketing, underwriting, and the administration of policies. Each product line is further segmented by the various distribution units that market the insurance policies. Each distribution unit operates in a niche market offering insurance products designed for that particular market. Whether analyzing profitability of a segment as a whole, or the individual distribution units within the segment, the measure of profitability used by management is the underwriting margin, which is:
(2) Net operating income from continuing operations is the consolidated total of segment profits after tax and as such is considered a Non-GAAP measure. See Note 14-Business Segments for reconciliation to the most directly comparable GAAP measure and for discussion of the usefulness and purpose of this measure.
(3) Income from discontinued operations (after tax) is included for purposes of reconciling to net income.
Summary of Operations: As shown in the above chart, net income was $550 million in 2016, compared with $527 million in 2015. Net income decreased in 2015 from $543 million in 2014. On a diluted per share basis, 2016 net income rose 8% to $4.49 after a 2% increase in 2015. Net income per diluted share in 2015 rose to $4.16 from $4.09 in 2014. The per share results have exceeded the growth in dollar amounts due to our share repurchase program. Each year’s per share net income was affected by realized investment gains (losses), which were $(0.06), $(0.05), and $0.12, in 2016, 2015 and 2014, respectively. More information concerning realized investment gains and losses can be found under the caption Realized Gains and Losses in this report.
Net operating income from continuing operations rose each year over the prior year from $520 million in 2014 to $523 million in 2015 to $549 million in 2016. Also, as explained in Note 14-Business Segments in the Notes to the Consolidated Financial Statements, we do not consider realized gains and losses to be a component of our core insurance operations or operating segments. Additionally, net income was affected by certain significant and unusual non-operating items in each of the years 2014 through 2016. We do not view these items as components of core operating results because they are not indicative of past performance or future prospects of the insurance operations. Accordingly, as described in Note 14-Business Segments in the Notes to the Consolidated Financial Statements, we remove items such as these that relate to prior periods or are non-operating items when evaluating the results of current operations, and therefore exclude such matters from our segment analysis for current periods.
Effective July 1, 2016, Torchmark sold its Medicare Part D Prescription Drug Plan business to an unaffiliated third party. Torchmark decided to exit its Medicare Part D business due to declining margins, increased risks, higher drug costs, and increased administrative and compliance costs. This sale allows the Company to better focus on its core protection life and health insurance businesses and provides additional capital to invest. The financial results of this business are
The life insurance segment is our strongest segment and is the largest contributor to earnings in each year presented. This segment contributed $4 million in 2016 and $13 million in 2015 to the growth in our underwriting margin. Also contributing to growth in income in both years was our health insurance segment, which provided $6 million of additional margin in 2016 and $5 million in 2015.
Health insurance premium income increased 2% to $948 million in 2016. Health net sales fell 7% to $145 million during 2016, as a result of a 20% decrease in Medicare Supplement sales. The decrease in 2016 Medicare Supplement net sales was expected due to group sales returning to a more normal level after unusually high sales in 2014. Group sales vary significantly from period to period due to the impact of large groups that are sold from time to time. First-year collected health premium fell 11% to $140 million from the prior year total of $157 million as a result of a high level of group sales in the third and fourth quarters of 2014 that positively affected the 2015 first-year collected premium. Health margins were flat at 22%, with underwriting income increasing to $210 million for 2016 due to the growth in premium income. Underwriting income was $204 million for the same period in 2015 compared with $199 million in 2014.
We do not currently market annuities. See the caption Annuities for discussion of the Annuity segment.
low interest rate environment noted above have compressed excess investment income as required interest has continued to grow at approximately the same rate that net policy liabilities have grown. Financing costs, which consist of the interest required for debt service on our long and short-term debt, are also deducted from net investment income. Financing costs in 2016 increased 9% to $83 million from $77 million in 2015. The additional interest expense resulted primarily from the issuance of our new 6.125% Junior Subordinated Debt security seventy days before the maturity and repayment of our 6.375% Senior Notes.
Torchmark’s current investment policy regarding fixed maturities limits new fixed maturity acquisitions to investment-grade securities generally with longer maturities (often exceeding twenty years) that meet our quality and yield objectives. Approximately 96% of our invested assets at fair value are fixed maturities, of which 95% were investment grade at December 31, 2016. The average quality rating of the portfolio was BBB+. The portfolio contains no securities backed by subprime or Alt-A mortgages, no direct investment in residential mortgages, no credit default swaps, or other derivative contracts. See the analysis of excess investment income and investment activities under the caption Investments in this report and Note 4-Investments in the Notes to the Consolidated Financial Statements for a more detailed discussion of this segment.
Throughout the remainder of this discussion, share purchases refer only to those made from excess cash flow at the Parent Company and borrowings.
Life insurance premium rose 6% to $2.2 billion in 2016 after having increased 5% in 2015 to $2.1 billion. Life insurance products are marketed through several distribution channels. Premium income by channel for each of the last three years is as follows:
The Liberty average producing agent count increased 12% to 1,715 for the year ended December 31, 2016 compared with 1,535 for the same period in 2015. We continue to execute our long term plan to grow this agency through expansion from small-town markets in the southeast to more densely populated areas with larger pools of potential agent recruits and customers. Expansion of this agency’s presence into more heavily populated, less-penetrated areas will help create long term agency growth. Additionally, the agency's prospecting training program has helped to improve the ability of agents to develop new work site marketing business.
The Other Agencies distribution channels offering life insurance include the Military Agency, the UA Independent Agency (which predominantly writes health insurance), and various smaller distribution channels. The Other Agencies contributed $223 million of life premium income, or 10% of Torchmark’s total in 2016, but contributed only 3% of net sales for the year.
Life insurance underwriting income before insurance administrative expense was $574 million in 2016 compared with $569 million in 2015 and $556 million in 2014. As a percentage of premium, underwriting margins declined to 26% in 2016 from 27% in 2015. The decrease in underwriting margin as a percentage of premium in 2016 and 2015 was due to higher Globe Life Direct Response net policy obligations. The higher than anticipated net policy obligations in the Globe Life Direct Response Unit primarily relate to policies issued in calendar years 2011 through 2015. The increase is primarily attributed to a spike in claims in certain blocks of policies as well as policies where additional prescription drug information was used in the underwriting process with an expectation of improved mortality. To date, improvements in actual mortality have been less than expected, causing higher than expected net policy obligations.
Health premium accounted for 30% of our total premium in 2016, while the health underwriting margin accounted for 26% of total underwriting margin, reflective of the lower underwriting margin as a percent of premium for health compared with life insurance. As noted under the caption Life Insurance, we have emphasized life insurance sales relative to health, due to life’s superior profitability and its greater contribution to excess investment income.
Health premium increased 2% to $948 million in 2016 compared with $926 million in 2015 after an increase of 6% in 2015 over the 2014 total of $869 million. Medicare Supplement premium increased 1% to $472 million in 2016 compared with $466 million in 2015. Medicare Supplement premium totaled $423 million in 2014. Other limited-benefit health premium increased 4% to $475 million over the prior year total of $459 million. Other limited-benefit premium totaled $446 million in 2014.
Health net sales declined 7% to $145 million in 2016 from $156 million in 2015. Health net sales in 2014 totaled $181 million. Medicare Supplement net sales decreased 20% to $61 million in 2016, after declining 29% to $76 million in 2015. Limited-benefit net sales increased 4% to $84 million in 2016 compared with an increase of 8% in 2015 to $81 million.
Health first-year collected premium fell 11% to $140 million. Health first-year collected premium rose 32% during 2015. First year Medicare Supplement premium was down 23% in 2016 to $69 million from the prior year total of $91 million compared with an increase of $32 million or 53% in 2015 over 2014 total of $59 million. First year limited-benefit premium increased 7% to $71 million in 2016 compared with an increase of 11% in 2015 over the 2014 total of $60 million.
The Family Heritage Exclusive Agency primarily markets limited-benefit supplemental health insurance in non-urban areas. Most of their policies include a cash-back feature, such as a return of premium whereby any excess of premiums over claims paid is returned to the policyholder at the end of a specified period stated within the insurance policy. Management expects to grow this agency through geographic expansion and continuing incorporation of Torchmark’s recruiting programs. The Family Heritage Agency contributed $51 million in net sales in 2016, compared with $50 million in 2015 and $47 million in 2014. Health premium income was $236 million in 2016, representing 25% of Torchmark’s health premium. This compared with $221 million or 24% of health premium in 2015 and $205 million or 24% in 2014. The average producing agent count was 923 for the year ended December 31, 2016, compared with 882 for the same period in 2015, an increase of 5%.
The Liberty National Exclusive Agency represented 21% of all Torchmark health premium income at $202 million in 2016. The Liberty Agency markets limited-benefit supplemental health products consisting primarily of critical illness insurance. Much of Liberty’s health business is now generated through work site marketing targeting small businesses of 10 to 25 employees. In 2016, health premium income in the Agency declined 4% from prior year premium of $209 million after declining 6% during 2015. Liberty’s health premium decline has been due primarily to its declining Medicare Supplement block. Liberty's first-year collected premium increased 8% to $16 million in 2016 compared with an increase of 11% to $15 million in 2015, reflecting the steady increase in net sales of limited-benefit plans in the agency.
Administrative expenses. Operating expenses are included in the Other and Corporate Segments and are classified into two categories: insurance administrative expenses and expenses of the parent company. The following table is an analysis of operating expenses for the three years ended December 31, 2016.
Net of deferred acquisition costs, excluding the associated unrealized gains and losses thereon.
Excess investment income increased $5 million or 2% in 2016 over the prior year. Excess investment income decreased $5 million or 2% in 2015. On a per diluted share basis, excess investment income increased 6% to $1.83 in 2016. Excess investment income increased 2% to $1.73 per share in 2015, after having increased 8% in the prior year. The higher percentage increase in the excess investment income per diluted share amount over the percentage increase in the dollar amount of excess investment income for those same periods is a result of our share repurchase program.
The largest component of excess investment income is net investment income, which rose 4% to $807 million in 2016. It increased 2% to $774 million in 2015 from $758 million in 2014. In 2016, fixed maturity yields averaged 5.78% on a tax-equivalent and effective-yield basis, compared with 5.84% in 2015 and 5.91% in 2014.Growth in net investment income has been slower than the growth in mean invested assets in recent years as a result of the decline in the average yields. The decrease in the overall portfolio yield from 2014 to 2016 was due primarily to reinvesting proceeds from calls and maturities at yield rates lower than the bonds earned before it was called or matured.
Net investment income has also been negatively affected in the calendar years 2014 through 2016 by the CMS requirement for us to pay certain Medicare Part D claims costs during the current period that are ultimately the responsibility of the government, but are not reimbursed until the following year. Because of the overall design of the program and higher Part D claims due to higher overall drug costs, we have incurred extensive upfront costs that are not reimbursed by CMS until late in the following respective year. We also experience delays from the time certain claims are paid until related drug rebates are received from various pharmaceutical companies. These delays in reimbursements cause a lag in the timing of investable cash flows that result in lower investment income than would have been earned absent the delays. We estimate the delays resulted in a loss of approximately $5 million, $8 million and $9 million of pre-tax net investment income in 2014, 2015 and 2016, respectively. As we have exited this business, the negative impact is expected to be approximately $2 million to $3 million in 2017 and negligible in 2018.
While net investment income in recent years has been negatively impacted by the factors discussed above, we would expect to see only modest declines in the average portfolio yield rate over the next few years. We anticipate that approximately 2% of fixed maturities on average are expected to run off each year over the next five years. Accordingly, we believe it is unlikely that dispositions will have a significant negative impact on net investment income and the growth rate of net investment income in the next few years.
Should interest rates rise, especially long-term rates, Torchmark's net investment income would benefit due to higher interest rates on new purchases. We could withstand an increase in interest rates of approximately 60 to 65 basis points before the net unrealized gains on our fixed maturity portfolio as of December 31, 2016 would be eliminated (assuming there were no credit related valuation declines). Should interest rates increase further than that, we would not be concerned with potential interest rate driven unrealized losses in our fixed maturity portfolio because we have the intent and, more importantly, the ability to hold our fixed maturities to maturity.
Excess investment income is also impacted by financing costs. Financing costs for the investment segment primarily consist of interest on our various debt instruments and are deducted from excess investment income. The table below presents the components of financing costs and reconciles interest expense per the Consolidated Statements of Operations.
Excess investment income benefits from increases in long-term rates available on new investments and decreases in short-term borrowing rates. Of these two factors, higher investment rates have the greater impact because the amount
New cash flow available for investment has been primarily provided through our insurance operations and interest received on existing investments. In some years, a significant amount of new investments can be derived from proceeds from dispositions including issuer calls. Issuer calls, as a result of the low-interest environment experienced during the past three years, were an important factor. Calls increase funds available for investment, but as noted earlier in this discussion, they can have a negative impact on investment income if the proceeds from the calls are reinvested in
bonds that have lower yields than those of the bonds that were called. Issuer calls were $182 million in 2016, $178 million in 2015, and $160 million in 2014.
Corporate securities, which consist of bonds and redeemable preferred stocks, were the largest component of the fixed maturity portfolio, representing 88% at both amortized cost and fair value. The remainder of the portfolio is invested primarily in securities issued by the U.S. government and U.S. municipalities. The Company holds insignificant amounts in foreign government bonds, collateralized debt obligations, asset-backed securities, and agency mortgage-backed securities. Corporate securities are diversified over a variety of industry sectors and issuers. As shown in the chart above, financial, utility, and energy sectors represented approximately 50% of the portfolio. Corporate securities are diversified over a variety of industry sectors and issuers. At December 31, 2016, the total fixed maturity portfolio consists of 588 issuers, with 208 issuers within the financial, utility, and energy sectors.
For more information about our fixed maturity portfolio by component at December 31, 2016 and 2015, including a discussion of other-than-temporary impairments, an analysis of unrealized investment losses and a schedule of maturities, see Note 4-Investments in the Notes to the Consolidated Financial Statements.
An analysis of the fixed maturity portfolio by a composite rating at December 31, 2016 is shown in the following table. The composite rating for each security, other than private-placement securities managed by third parties, is the average of the security’s ratings as assigned by Moody’s Investor Service, Standard & Poor’s, Fitch Ratings, and Dominion Bond Rating Service, LTD. The ratings assigned by these four nationally recognized statistical rating organizations are evenly weighted when calculating the average. The composite quality rating is created using a methodology developed by Torchmark Corporation using ratings from the various rating agencies noted above. The composite quality rating is not a Standard & Poor's credit rating. Standard & Poor's does not sponsor, endorse or promote the composite quality rating and shall not be liable for any use of the composite quality rating. Included in the chart below are private placement fixed maturity holdings of $565 million at amortized cost ($574 million at fair value) for which the ratings were assigned by the third party managers.
unrealized gains and losses on fixed maturities as of December 31, 2016. Overall, the total portfolio had a weighted average quality rating of BBB+ based on amortized cost, a decline from A- at the end of 2015.
Market Risk Sensitivity. Torchmark’s investment securities are exposed to interest rate risk, meaning the effect of changes in financial market interest rates on the current fair value of the company’s investment portfolio. Since 96% of the book value of our investments is attributable to fixed maturity investments (and virtually all of these investments are fixed-rate investments), the portfolio is highly subject to market risk. Declines in market interest rates generally result in the fair value of the investment portfolio rising and increases in interest rates cause the fair value to decline. Under normal market conditions, we do not expect to realize these unrealized gains and losses because we have the ability and the intent to hold these investments to maturity. The long-term nature of our insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase or decrease in the fair value of insurance liabilities and debt due to increases or decreases in market interest rates largely offsets the impact of rates on the investment portfolio. However, as is permitted by GAAP, these liabilities are not recorded at fair value.
In summary, Torchmark expects to have readily available funds for 2017 and the foreseeable future to conduct its operations and to maintain target capital ratios in the insurance subsidiaries through internally generated cash flow and the credit facility. In the unlikely event that more liquidity is needed, the Company could generate additional funds through multiple sources including, but not limited to, the issuance of additional debt, additional borrowings on our short-term credit facility, and intercompany borrowing.
Our cash and short-term investments were $148 million at year-end 2016 and $116 million at year-end 2015. Additionally, we have a portfolio of marketable fixed securities that are available for sale in the event of an unexpected need. These securities had a fair value of $15.2 billion at December 31, 2016. However, our strong cash flows from operations, investment maturities, and the availability of our credit line make any need to sell securities for liquidity unlikely.
Off-Balance Sheet Arrangements. As a part of its aforementioned credit facility, Torchmark had outstanding $177 million in stand-by letters of credit at December 31, 2016 and 2015. These letters are issued among our subsidiaries, one of which is an offshore captive reinsurer, and have no impact on company obligations as a whole. Any future regulatory changes that restrict the use of off-shore captive reinsurers might require Torchmark to obtain third-party financing, which could cause an immaterial increase in financing costs.
Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force at December 31, 2016. These estimated payments were computed using assumptions for future mortality, morbidity and persistency. The actual amount and timing of such payments may differ significantly from the estimated amounts shown. Management believes that the assets supporting the liability of $12.8 billion at December 31, 2016, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
Subsidiary Capital: Our insurance subsidiaries target a capital ratio of approximately 325% of Company action level regulatory capital under Risk-Based Capital (RBC), a formula designed by insurance regulatory authorities to monitor the adequacy of capital. The 325% target is considered sufficient for the subsidiaries because of their strong reliable cash flows, the relatively low risk of their product mix, and because that ratio is in line with rating agency expectations for Torchmark. At December 31, 2016, our insurance subsidiaries had an aggregate RBC ratio of approximately 324%. Should we experience impairments and/or ratings downgrades within our fixed maturity portfolio in the future, the ratio could fall below targeted levels. In such a case, management believes more than sufficient liquidity exists at the Parent Company to make additional contributions as necessary to maintain the targeted ratio.
Shareholder's Equity: As noted under the caption Summary of Operations in this report, we have an ongoing share repurchase program. Under this program, we acquired 5 million shares at a cost of $311 million in 2016, 6 million shares at a cost of $359 million in 2015, and 7 million shares for $375 million in 2014. The majority of purchased shares are retired each year. Please refer to the description of our share repurchase program under the caption Summary of Operations in this report.
Torchmark has continually increased the quarterly dividend on its common shares over the past three years. In the first quarter of 2014, it was increased to $0.1267 per share from $0.1133 per share. In the first quarter of 2015, it was raised to $0.135 per share. Finally, in the first quarter of 2016, dividends were raised to $0.14 per share.
Amount added to (deducted from) comprehensive income to produce the stated GAAP item.
Due to the adoption of ASU 2016-09 as described in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements under "Accounting Pronouncements Adopted in Current Year", certain current year balances related to excess tax benefits from stock compensation were adjusted prospectively.
Torchmark’s ratio of earnings before interest and taxes to interest requirements (times interest earned) was 10.3 times in 2016, compared with 11.0 times in 2015 and 11.3 times in 2014 based on continuing operations. This times-interest-earned ratio is computed by dividing interest expense into the sum of pre-tax income from continuing operations and interest expense. A discussion of our interest expense is included in the discussion of financing costs under the caption Investments in this report.
Financial Strength Ratings. The financial strength of our major insurance subsidiaries is rated by Standard & Poor’s and A. M. Best. The following chart presents these ratings for our five largest insurance subsidiaries at December 31, 2016.
Future Policy Benefits: Due to the long-term nature of insurance contracts, our insurance companies are liable for policy benefit payments that will be made in the future. The liability for future policy benefits is determined by standard actuarial procedures common to the life insurance industry. The accounting policies for determining this liability are disclosed in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements.
Policy Claims and Other Benefits Payable: This liability consists of known benefits currently payable and an estimate of claims that have been incurred but not yet reported to us. The estimate of unreported claims is based on prior experience and is made after careful evaluation of all information available to us. However, the factors upon which these estimates are based can be subject to change from historical patterns. Factors involved include the litigation environment, regulatory mandates, and the introduction of policy types for which claim patterns are not well established, and medical trend rates and medical cost inflation as they affect our health claims. Changes in these estimates, if any, are reflected in the earnings of the period in which the adjustment is made. We believe that the estimates used to produce the liability for claims and other benefits, including the estimate of unsubmitted claims, are the most appropriate under the circumstances. However, there is no certainty that the resulting stated liability will be our ultimate obligation. At this time, we do not expect any change in this estimate to have a material impact on earnings or financial position consistent with our historical experience.
At times, the values of our fixed maturities can also be affected by illiquidity in the financial markets. Illiquidity would contribute to a spread widening, and accordingly unrealized losses, on many securities that we would expect to be fully recoverable. Even though our fixed maturity portfolio is available for sale, we have the ability and intent to hold the securities until maturity as a result of our strong and stable cash flows generated from our insurance products. Considerable information concerning the policies, procedures, classification levels, and other relevant data concerning the valuation of our fixed maturity investments is presented in Note 1-Significant Accounting Policies and in Note 4-Investments in the Notes to Consolidated Financial Statements under the captions Fair Value Measurements in both notes.
Impairment of Investments: We continually monitor our investment portfolio for investments where fair value has declined below carrying value and that have become impaired in value. While the values of the investments in our portfolio constantly fluctuate due to market conditions, an other-than-temporary impairment charge is recorded only when a security has experienced a decline in fair market value which is deemed to be other than temporary. The policies and procedures that we use to evaluate and account for impairments of investments are disclosed in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements and the discussions under the captions Investments and Realized Gains and Losses in this report. While every effort is made to make the best estimate of status and value with the information available regarding an other-than-temporary impairment, it is difficult to predict the future prospects of a distressed or impaired security.
The actuarial assumptions used in determining our obligations for pensions include employee mortality and turnover, retirement age, the expected return on plan assets, projected salary increases, and the discount rate at which future obligations could be settled. These assumptions have an important effect on the pension obligation. A decrease in the discount rate or rate of return on plan assets will cause an increase in the pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. Small changes in assumptions may cause significant differences in reported results for these plans. For example, a sensitivity analysis is presented below for the impact of change in the discount rate and the long-term rate of return on assets assumed on our defined benefit pension plans expense for the year 2016 and projected benefit obligation as of December 31, 2016.
Changes in lapse rates and/or sales of our insurance policies as well as levels of mortality, morbidity and utilization of healthcare services that differ from our assumptions;
Interest rate changes that affect product sales and/or investment portfolio yield;
Levels of administrative and operational efficiencies that differ from our assumptions;
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2016
Consolidated Statements of Comprehensive Income for each of the three years in the period ended December 31, 2016
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries (Torchmark) as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Torchmark’s internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 27, 2017 expressed an unqualified opinion on Torchmark’s internal control over financial reporting.
Business: Torchmark Corporation (Torchmark or alternatively, the Company) through its wholly-owned subsidiaries provides a variety of life and health insurance products and annuities to a broad base of customers. Torchmark is organized into four reportable segments: life insurance, health insurance, annuity, and investment.
Principles of Consolidation: The consolidated financial statements include the results of Torchmark and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. When Torchmark acquires a subsidiary or a block of business, the assets acquired and the liabilities assumed are measured at fair value at the acquisition date. Any excess of acquisition cost over the fair value of net assets is recorded as goodwill. Expenses incurred to effect the acquisition are charged to earnings as of the acquisition date. Upon acquisition, the accounts and results of operations are consolidated as of and subsequent to the acquisition date.
Fair Value Measurements, Investments in Securities: Torchmark measures the fair value of its fixed maturities based on a hierarchy consisting of three levels which indicate the quality of the fair value measurements as described below:
Level 1-fair values are based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access as of the measurement date.
cost is identified and evaluated. The determination that an impairment is other-than-temporary is highly subjective and involves the careful consideration of many factors. Among the factors considered are:
The nature and amount of recent and expected future sources and uses of cash
While all available information is taken into account, it is difficult to predict the ultimate recoverable amount of a distressed or impaired security. If a security is determined to be other-than-temporarily impaired, the cost basis of the security is written down to fair value and is treated as a realized loss in the period the determination is made. The written-down security will be amortized and revenue recognized in accordance with estimated future cash flows.
Advertising Costs: Costs related to advertising are generally charged to expense as incurred. However, certain Globe Life Direct Response advertising costs are capitalized when there is a reliable and demonstrated relationship between total costs and future benefits that is a direct result of incurring these costs. Globe Life Direct Response advertising costs consist primarily of the production and distribution costs of direct mail advertising materials, and when capitalized are included as a component of deferred acquisition costs. They are amortized in the same manner as other deferred acquisition costs. Globe Life Direct Response advertising costs charged to earnings and included in other operating expense were $9 million, $10 million, and $8 million in 2016, 2015, and 2014, respectively. Capitalized advertising costs included within deferred acquisition costs were $1.25 billion at December 31, 2016 and $1.21 billion at December 31, 2015.
In the two-step quantitative analysis, the Company utilizes two approaches, income and market, to determine the fair value of each reporting unit. In the income approach, judgment and assumptions are used in developing the projected cash flows for the reporting units, and such estimates are subject to change. The Company also exercises judgment in the determination of the discount rate as management believes this to be appropriate for the risk associated with the cash flow expectations. In the market approach, the Company utilizes the share price and a control premium based on businesses with similar assets to determine a fair value. In both cases, the fair value of each reporting unit is then measured against that reporting unit’s corresponding carrying value. In the event the fair value is less than the carrying value, further testing is required under the accounting guidance to determine the amount of impairment, if any. If there is an impairment in the goodwill of any reporting unit, it is written down and charged to earnings in the period of the test.
Future Policy Benefits: The liability for future policy benefits for annuity and universal life-type products is represented by policy account value. The liability for future policy benefits for all other life and health products, approximately 86% of total future policy benefits, is determined on the net level premium method. This method provides for the present value of expected future benefit payments less the present value of expected future net premiums, based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were considered appropriate at the time the policies were issued. For limited-payment contracts, a deferred profit liability is also recorded which causes profits to emerge over the life of the contract in proportion to policies in force. Assumptions used for traditional life and health insurance products are based primarily on Company experience. Assumptions for interest rates range from 2.5% to 7.0% for Torchmark’s insurance companies with an overall weighted average assumed rate of 5.7%. Mortality tables used for individual life insurance include various statutory tables and modifications of a variety of generally accepted actuarial tables. Morbidity assumptions for individual health are based on Company experience and industry data. Withdrawal and termination assumptions are based on Torchmark’s experience. Once established, assumptions for these products are generally not changed. An additional provision is made on most products to allow for possible adverse deviation from the assumptions. These estimates are reviewed annually and compared with actual experience. If it is determined that existing contract liabilities, together with the present value of future gross premiums, will not be sufficient to cover the present value of future benefits and to recover unamortized deferred acquisition costs, then a premium deficiency exists. Such a deficiency would be recognized immediately by a charge to earnings and either a
Policy Claims and Other Benefits Payable: Torchmark establishes a liability for known policy benefits payable and an estimate of claims that have been incurred but not yet reported to the Company. Torchmark makes an estimate of unreported claims after careful evaluation of all information available to the Company. This estimate is based on prior experience and is reviewed quarterly. However, there is no certainty the stated liability for claims and other benefits, including the estimate of unsubmitted claims, will be Torchmark’s ultimate obligation.
The fair value method requires the use of an option valuation model to value employee stock options. Torchmark has elected to use the Black-Scholes valuation model for option expensing. A summary of assumptions for options granted in each of the three years 2014 through 2016 is as follows:
The expected term is generally derived from Company experience. However, expected terms are determined based on the simplified method as permitted under the ASC 718 Stock Compensation topic when company experience is insufficient. The Torchmark Corporation 2011 Incentive Plan replaced all previous plans and allows for option grants for employees with a ten-year contractual term which vest over five years in addition to seven-year grants which vest over three years as permitted by the previous plans. Director grants vest over six months. The Company has sufficient experience with seven-year grants that vest in three years, but insufficient historical experience with five-year vesting. Therefore, Torchmark has used the simplified method to determine the expected term for the ten-year grants with five-year vesting and will do so until adequate experience is developed. Volatility and risk-free interest rates are assumed over a period of time consistent with the expected term of the option. Volatility is measured on a historical basis. Monthly data points are utilized to derive volatility for periods greater than three years. Expected dividend yield is based on current dividend yield held constant over the expected term. Once the fair value of an option has been determined, it is amortized on a straight-line basis over the employee’s service period for that grant (from the grant date to the date the grant is fully vested). Expenses for restricted stock and restricted stock units are based on the grant date fair value allocated on a straight-line basis over the service period. Performance share expense is recognized based on management’s estimate of the probability of meeting the metrics identified in the performance share award agreement, assigned to each service period as these estimates develop.
Earnings Per Share: Torchmark presents basic and diluted earnings per share (EPS) on the face of the Consolidated Statements of Operations for income from continuing operations and income from discontinued operations. Basic EPS is computed by dividing income available to common shareholders by the weighted average common shares outstanding for the period. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts, such as stock options, which could be exercised or converted into common shares. Due to the prospective adoption of ASU 2016-09, as further discussed below, an adjustment was made to the weighted average diluted shares outstanding in 2016 to exclude excess tax benefits from the assumed proceeds in the diluted shares calculation. For more information on earnings per share, see Note 12-Shareholders’ Equity.
Going Concern: In August 2014, the FASB issued Accounting Standards Update No. 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40). This accounting standard requires management to perform interim and annual assessments of the entity's ability to continue its business operations within one year of the date of issuance of its financial statements. The Company must then provide certain disclosure if there is substantial doubt about its ability to continue as a going concern. As of January 1, 2016, the Company adopted this standard with no impact to the financial statements.
Short-Duration Contracts: The FASB issued Accounting Standards Update No. 2015-09 Financial Services-Insurance: Disclosures about Short-Duration Contracts (ASU 2015-09), requiring companies to disclose additional information with regards to its short-duration insurance contracts. These new disclosures provide additional insight into an insurance entity’s ability to underwrite claims. Torchmark's disclosures under ASU 2015-09 are effective for the 2016 annual consolidated financial statements. The guidance consists only of new disclosures and did not impact the accounting for short-duration contracts. See Note 7-Liability for Unpaid Claims.
Weighted average diluted shares: The weighted average diluted shares outstanding were adjusted to exclude excess tax benefits from the assumed proceeds in the diluted shares calculation. This change resulted in diluted weighted average shares outstanding of 122.4 million for 2016, as compared with 121.5 million previous guidance.
Earnings per share: The adoption resulted in a $0.13 increase in earnings per share for the year ended December 31, 2016.
Consolidated statement of cash flows: The excess tax benefits related to share-based payments of $20 million were presented as a component of operating activities in the same manner as other cash flows related to income taxes. In 2015 and 2014, the excess tax benefits of $18 million and $19 million, respectively, were presented within financing activities.
Leases: In February 2016, the FASB issued Accounting Standards Update No. 2016-02, Leases (Topic 842), which requires all lessees to report a right-of-use asset and a lease liability for most leases. For lessors, the standard modifies the classification criteria and the accounting for sales-type and direct financing leases. The standard will become effective for the Company beginning January 1, 2019 and will require recognizing and measuring leases at the beginning of the earliest period presented using a modified retrospective approach. Early adoption is permitted. The Company does not expect the adoption to have a significant impact on the financial statements. Refer to Note 15-Commitments and Contingencies for consideration of five year operating lease commitments.
Investment Impairment: In June 2016, the FASB issued Accounting Standards Update No. 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments as well as to change the loss impairment methodology for available-for-sale debt securities. This standard will become effective on January 1, 2020. The applicable section of the standard related to debt securities requires a prospective transition. The Company does not expect the adoption to have a significant impact on the financial statements.
Cash Flows: In August 2016, the FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments. This guidance was issued to provide uniformity in the classification of cash receipts and payments recorded in the statement of cash flows, including debt prepayment or extinguishment costs, settlements of zero-coupon bonds, and proceeds from the settlement of insurance claims. This standard will become effective on January 1, 2018. The Company is currently evaluating the standard to determine its impact.
Goodwill: In January 2017, the FASB issued Accounting Standards Update No. 2017-04, Intangibles-Goodwill and Other: Simplifying the Test for Goodwill Impairment. This guidance was issued to simplify the subsequent measurement of goodwill through the elimination of Step 2 from the goodwill impairment test. It will become effective on January 1, 2020 and should be applied on a prospective basis. The Company does not expect the adoption to have a significant impact on the financial statements.
Reclassifications out of Accumulated Other Comprehensive Income are presented below for each of the years 2014 through 2016.
Securities held on deposits with various state and federal regulatory authorities had a carrying value of $600 million and $555 million at December 31, 2016 and 2015, respectively.
Fair value measurements: The following tables represent the fair value of fixed maturities measured on a recurring basis at December 31, 2016 and 2015:
Acquisitions of Level 3 investments in each of the years 2014 through 2016 are comprised of private-placement fixed maturities managed by an unaffiliated third-party. See Note 1-Significant Accounting Policies for more information on private placements.
Gross unrealized losses decreased from $564 million at year end 2015 to $216 million at year end 2016, a decrease of $348 million. The decrease in the gross unrealized losses from prior year was primarily attributable to the improved conditions during 2016 in the energy and metals and mining sectors.
Torchmark’s entire fixed maturity portfolio consisted of 1,565 issues at December 31, 2016 and 2015. The weighted-average quality rating of all unrealized loss positions at amortized cost was BBB+ for both 2016 and 2015.
Concentrations of Credit Risk: Torchmark maintains a diversified investment portfolio with limited concentration in any given issuer. At December 31, 2016, the investment portfolio, at fair value, consisted of the following:
Corporate debt securities and redeemable preferred stocks represent 84% of Torchmark's investment portfolio. These investments are spread across a wide range of industries. Below are the ten largest industry concentrations held in the corporate portfolio of corporate debt securities and redeemable preferred stocks at December 31, 2016, based on fair value:
At December 31, 2015, Torchmark met the criteria to account for its Medicare Part D Prescription Drug Plan business as a discontinued operation. Historically, the business was a reportable segment. Effective July 1, 2016, Torchmark sold its Medicare Part D Prescription Drug Plan business to an unaffiliated third party. Management believes this sale allows the Company to better focus on its core protection life and health insurance businesses, as well as provides additional capital to invest.
Torchmark retained certain assets and liabilities related to the Medicare Part D business including all corresponding profits or losses for the 2016 plan year. The buyer assumed the rights and obligations related to the business for all subsequent plan years. To facilitate a seamless transition, Torchmark administered the plans for the duration of 2016. The remaining assets and liabilities reflected on the Torchmark balance sheet related to discontinued operations are receivables and payables primarily associated with 2016 plan year that are expected to be settled in the ordinary course of business during 2017 and 2018.
The net assets related to discontinued operations at December 31, 2016 and 2015 were as follows:
At December 31, 2016, other receivables included $50 million from CMS and $69 million from drug manufacturer rebates. At December 31, 2015, the comparable amounts were $193 million and $95 million, respectively.
Balance includes $3.6 million contingent sale price reserve for the year ended December 31, 2016.
Income from discontinued operations for the three years ended December 31, 2016 is as follows:
Income taxes paid related to discontinued operations for the three years ended December 31, 2016 were as follows:
At the end of each period, the liability for unpaid health claims includes an estimate of claims incurred but not yet reported to the Company. Such estimates are updated regularly based upon the Company’s most recent claims data
with recognition of emerging experience trends. Because of the nature of the Company’s health business, the payment lags are relatively short and most claims are fully paid within a year from the time incurred. Fluctuations in claims experience can lead to either over or under estimation of the liability for any given year. The difference between the estimate made at the end of the prior period and the actual experience during the period is reflected above under the caption “Incurred related to: Prior years.”
The liability for unpaid health claims is included with “Policy claims and other benefits payable” in the Consolidated Balance Sheets.
The incurred claims and cumulative number of reported claims for all years prior to 2016 are unaudited.
Torchmark and its subsidiaries, excluding Family Heritage Life Insurance Company (Family Heritage), file a life-nonlife consolidated federal income tax return. Family Heritage files its federal income tax return on a separate company basis. Torchmark’s consolidated federal income tax returns are routinely audited by the Internal Revenue Service (IRS). The IRS completed its examination of Torchmark’s 2008-2011 consolidated income tax returns during 2014 resulting in no impact on the Company’s effective tax rate. The statutes of limitations for the assessment of additional tax are closed for all tax years prior to 2013 with respect to Torchmark’s consolidated and Family Heritage’s federal income tax returns. Management believes that adequate provision has been made in the consolidated financial statements for any potential assessments that may result from current or future tax examinations and other tax-related matters for all open years.
Torchmark’s tax liability is adjusted to include a provision for uncertain tax positions taken or expected to be taken in a tax return. However, during the years 2014 through 2016, Torchmark did not have any uncertain tax positions which resulted in unrecognized tax benefits.
Pension Plans: Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. All plan measurements for the defined benefit plans are as of December 31 of the respective year. The defined benefit pension plans covering the majority of employees are qualified and funded. Contributions are made to funded pension plans subject to minimums required by regulation and maximums allowed for tax purposes. Defined benefit plan contributions were $15.8 million in 2016, $15.5 million in 2015, and $14.6 million in 2014. Torchmark estimates as of December 31, 2016 that it will contribute an amount not to exceed $20 million to these plans in 2017. The actual amount of contribution may be different from this estimate.
Plan assets in the funded plans consist primarily of investments in marketable fixed maturities and equity securities and are valued at fair value. Torchmark measures the fair value of its financial assets, including the assets in its benefit plans, in accordance with accounting guidance which establishes a hierarchy for asset values and provides a methodology for the measurement of value. Please refer to Note 1-Significant Accounting Policies under the caption Fair Value Measurements, Investments in Securities for a complete discussion of valuation procedures. The following table presents the assets of Torchmark’s defined benefit pension plans for the years ended December 31, 2016 and 2015.
A fund including marketable securities that mirror the S&P 500 index.
Torchmark’s investment objectives for its plan assets include preservation of capital, preservation of purchasing power, and long-term growth. Torchmark seeks to preserve capital through investments made in high quality securities with adequate diversification by issuer and industry sector to minimize risk. The portfolio is monitored continuously for changes in quality and diversification mix. The preservation of purchasing power is intended to be accomplished through asset growth, exclusive of contributions and withdrawals, in excess of the rate of inflation. Torchmark intends to maintain investments that when combined with future plan contributions will produce adequate long-term growth to provide for all plan obligations. It is also Torchmark’s objective that the portfolio’s investment return will meet or exceed the return of a balanced market index.
Includes amortization of postretirement benefits other than pensions of $33 thousand in 2016, $120 thousand in 2015, and $2 thousand in 2014.
Torchmark has estimated its expected pension benefits to be paid over the next ten years as of December 31, 2016. These estimates use the same assumptions that measure the benefit obligation at December 31, 2015, taking estimated future employee service into account. Those estimated benefits are as follows:
The table below presents the assumptions used to determine the liabilities and costs of Torchmark’s postretirement benefit plans other than pensions.
All Junior Subordinated Debentures have equal priority, but are subordinate to all other issues.
Interest paid at 3 Month LIBOR plus 330 basis points, resets each quarter.
Interest paid at 1 Month LIBOR plus 125 basis points, resets each month.
Funded debt: On April 5, 2016, Torchmark completed the issuance and sale of $300 million in aggregate principal of Torchmark’s 6.125% Junior Subordinated Debentures due 2056. The debentures were sold pursuant to Torchmark’s shelf registration statement on Form S-3, filed September 25, 2015. The net proceeds from the sale of the debentures were $290 million, after giving effect to the underwriting discount and expenses of the offering of the debentures. Torchmark used the net proceeds from the offering of the debentures to repay the $250 million outstanding principal, plus accrued interest of $8 million, on the 6.375% Senior Notes that were due June 15, 2016. The remaining proceeds were used for general corporate purposes.
Credit Facility: On May 17, 2016, Torchmark amended its credit facility to include, as a part of the facility, the issuance of a $100 million term loan and to extend the maturity date of the entire credit facility to May 2021. The facility is further designated as a back-up credit line for a commercial paper program under which the Company may either borrow from the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed the facility maximum of $750 million, less any letters of credit issued. Interest is charged at variable rates. The term loan will be repaid on a redemption schedule which provides for quarterly installments beginning June 30, 2017 that escalate each annual period with a balloon payment of $75 million due in May 2021. Interest on the term loan is computed and paid monthly at 125 basis points plus 1 Month LIBOR. In accordance with the agreement, Torchmark is subject to certain covenants regarding capitalization. As of December 31, 2016, the Company was in full compliance with these covenants.
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. Dividends from insurance subsidiaries of Torchmark are restricted based on regulations by their state of domicile. Additionally, insurance company distributions are generally not permitted in excess of statutory surplus. Subsidiaries are also subject to certain minimum
capital requirements. Subsidiaries of Torchmark paid cash dividends to the Parent Company in the amount of $438 million in 2016, $466 million in 2015, and $479 million in 2014. As of December 31, 2016, dividends and transfers from insurance subsidiaries to parent available to be paid in 2017 are limited to the amount of $262 million without regulatory approval, such that $1.1 billion was considered restricted net assets of the subsidiaries. Dividends exceeding these limitations may be available during the year pending regulatory approval. While there are no legal restrictions on the payment of dividends to shareholders from Torchmark’s retained earnings, retained earnings as of December 31, 2016 were restricted by lenders’ covenants which require the Company to maintain and not distribute $2.6 billion from its total consolidated retained earnings of $3.9 billion.
During 2014, shareholders approved an amendment to the 2011 Incentive Plan allowing for an additional 6.3 million shares available for grant.
No equity awards were cash settled during the three years ended December 31, 2016.
Selected stock option activity for the three years ended December 31, 2016 is presented below:
Restricted stock units outstanding at each of the year ends 2016, 2015, and 2014 were 112,591, 105,679, and 98,039, respectively. All restricted stock units were fully vested at the end of each year of grant.
Time-vested restricted stock holders, both employees and directors, are entitled to dividend payments on the unvested stock. Restricted stock unit holders are entitled to dividend equivalents. These equivalents are granted in the form of additional restricted stock units and vest immediately upon grant. Dividend equivalents are applicable only to restricted stock units. Performance shareholders are not entitled to dividend equivalents and are not entitled to dividend payments until the shares are vested and settled.
An analysis of the weighted-average grant-date fair values per share of unvested restricted stock is as follows for the year 2016:
The measure of profitability established by the chief operating decision makers for insurance segments is underwriting margin before other income and administrative expenses, in accordance with the manner the segments are managed. It essentially represents gross profit margin on insurance products before insurance administrative expenses and consists of premium, less net policy obligations, acquisition expenses, and commissions. Interest credited to net policy liabilities (reserves less deferred acquisition costs) is reflected as a component of the Investment segment in order to match this cost to the investment earnings from the assets supporting the net policy liabilities.
Rental expense for operating leases for each of the three years ended December 31, 2016 is as follows:
Investments: As of December 31, 2016, Torchmark had committed to purchase $8.4 million of private placement fixed maturities managed by a third party in early 2017.
Letters of Credit: Torchmark has guaranteed letters of credit in connection with its credit facility with a group of banks as disclosed in Note 11-Debt. The letters of credit were issued by TMK Re, Ltd., a wholly-owned subsidiary, to secure TMK Re, Ltd.’s obligation for claims on certain policies reinsured by TMK Re, Ltd. that were sold by other Torchmark insurance companies. These letters of credit facilitate TMK Re, Ltd.’s ability to reinsure the business of Torchmark’s insurance carriers. The agreement expires in 2021. The maximum amount of letters of credit available is $250 million. The Torchmark parent company would be liable to the extent that TMK Re, Ltd. does not pay the reinsured party. Letters of credit outstanding were $177 million at December 31, 2016 and 2015.
Unclaimed Property Audits: Torchmark subsidiaries are currently the subject of audits regarding the identification, reporting and escheatment of unclaimed property arising from life insurance policies and a limited number of annuity contracts. These audits are being conducted by private entities that have contracted with forty-seven states through their respective Departments of Revenue, and have not resulted in any financial assessment from any state nor indicated any liability. The audits are wide-ranging and seek large amounts of data regarding claims handling, procedures, and payments of contract benefits arising from unreported death claims. No estimate of range can be made at this time for loss contingencies related to possible administrative penalties or amounts that could be payable to the states for the escheatment of abandoned property.
With respect to its current litigation, at this time management believes that the possibility of a material judgment adverse to Torchmark is remote, and no estimate of range can be made for loss contingencies that are at least reasonably possible but not accrued.
The following is an unaudited summary of quarterly results for the two years ended December 31, 2016. The information includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.
Due to the adoption in 2016 of ASU 2016-09, certain current year balances related to excess tax benefits from stock compensation were adjusted prospectively as described in Note 1-Significant Accounting Policies under "Stock Compensation."