The Company leases approximately 100 offices throughout its sales territories and has a separate Canadian business office facility that includes office and storage space. In addition, Professional leases office space in Jacksonville, Florida, American-Amicable owns its home office facility in Waco, Texas and UC Life leases office space in Baton Rouge, Louisiana. The Company believes that the current makeup of its properties is adequate for its operations and, based on its recent experience, that it will be able to find suitable replacement properties on acceptable terms for any properties the Company chooses to replace or for which leases are terminated or not renewed.
Cautionary Statement for purposes of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. The statements below that relate to future plans, events or performances are forward-looking statements that involve a number of risks or uncertainties. Among those items that could adversely affect the Company's financial condition, results of operations and cash flows are the following: changes in regulations affecting insurance companies, interest rates, the federal income tax code (to the extent the Company's product mix includes tax deferred accumulation products), the ratings assigned to the Company's insurance subsidiaries by independent rating organizations such as A.M. Best (which the Company believes are particularly important to the sale of annuity and other accumulation products) and unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect the Company's results of operations.
Immediately following the consummation of the Washington National and SW Financial transactions, the Company will establish five operating divisions: Career Sales, Individual Sales, Financial Services, Payroll Sales and Other Insurance. The newly reorganized divisions will include the operations of SW Financial and Washington National.
The comparability of the Company's financial position, results of operations and cash flows for each of the periods presented have been affected by these acquisitions. The pro forma effects of the acquisitions of UC Life, Integon Life, and AA Life are described in Note 3 to the Company's Consolidated Financial Statements included elsewhere herein.
Financing Activities. As a part of each of the Company's acquisitions and as part of a long-term plan to maintain an appropriate balance in its capital structure, PennCorp has undertaken various public and private financing transactions. As a result, the Company's historical financial results reflect significant variations in financing costs including preferred stock dividends and extraordinary charges resulting from the early extinguishment of debt.
On February 28, 1996, PennCorp completed the successful sale of 5,131,300 shares of Common Stock, netting proceeds of $155.5 million ("February Common Stock Offering"). Proceeds from this offering were utilized to repay $80.0 million of corporate and $57.0 million of subsidiary indebtedness, and to pay $10.0 million to SW Financial's former owner in lieu of PennCorp's obligation to issue an equivalent number of shares of Common Stock.
In May 1996, the Company entered into a revolving credit agreement with a syndicate of banks (the "bank credit agreement") for up to $175.0 million of funds available at any one time to replace the $100.0 million bridge facility utilized by the Company to make the investment in SW Financial, which was repaid out of the proceeds of the February Common Stock Offering. During the remainder of 1996, the Company borrowed amounts aggregating $92.0 million for (i) the repurchase of $35.4 million in principal amount of the Company's 9 1/4% Senior Subordinated Debenture due 2003 (the "Notes") for $37.7 million, including interest and premium on early redemption of $2.3 million, (ii) the refinancing of $20.0 million of indebtedness under the previously outstanding bridge facility, (iii) the repayment of $16.5 million of amounts owed certain subsidiaries, and (iv) $17.8 million for general corporate purposes including the UC Life acquisition, interest payments and common and preferred stock dividend payments. Total interest and related costs incurred under the bank credit facility were $1.6 million during 1996.
On July 14, 1995, PennCorp issued 2,300,000 shares of the $3.375 Convertible Preferred Stock ("Convertible Preferred Stock") for net proceeds of $110.5 million. On March 16, 1995, PennCorp issued 3,750,000 shares of Common Stock, for net proceeds of approximately $51.2 million. The proceeds from these two offerings were used to (i) consummate the acquisition of Integon Life, which utilized funds totaling $33.4 million (including a capital contribution of $15.0 million), (ii) repay $28.5 million outstanding under, and subsequently cancel, a revolving credit facility, (iii) repurchase, for $34.6 million, all of the Company's Series A Preferred Stock, (iv) repay $11.2 million due to Integon Life's former parent company under a subordinated debenture, (v) pay the $15.4 million cash portion of the purchase price of Occidental Life Insurance Company of North Carolina ("OLIC") (which PennCorp purchased from Pennsylvania Life Insurance Company and its wholly-owned subsidiary, Penncorp Life Insurance Company (collectively referred to herein as "Penn Life") and subsequently contributed to Integon Life), (vi) prepay $20.0 million principal amount of indebtedness under the AAHC credit facility, and (vii) make payments for general corporate purposes, including interest payments and the cancellation of certain interest rate swap agreements. The Company paid or accrued dividends on the Convertible Preferred Stock amounting to $7.8 million and $3.6 million during 1996 and 1995, respectively.
As part of the financing of the AA Life acquisition, PennCorp issued 450,000 shares of Series A Preferred Stock with a stated dividend rate of approximately 6.0% for the first five years and approximately 8.0% thereafter, until redemption in 2009. During 1994, and prior to its full repurchase on August 25, 1995, PennCorp incurred dividends of $1.2 million and $1.7 million, respectively, related to the Series A Preferred Stock.
The Notes, the bank credit agreement and the Series C Preferred Stock impose certain covenants on the Company, including covenants restricting the amount of additional indebtedness the Company may incur, its ability to engage in future acquisitions and certain other business transactions, and the amount of dividends the Company may declare and pay, and requires the Company to maintain specified financial ratios and meet specified financial tests, all of which may impose limitations on the Company's future liquidity.
The Surplus Note Companies rely upon dividends and tax sharing payments from their respective insurance subsidiaries. Each of the insurance subsidiaries is in turn subject to regulatory restrictions with respect to the maximum amount of dividends that can be paid to the Surplus Note Companies without prior regulatory approval. Such dividend restrictions are primarily in the form of (i) the greater of 10% of statutory capital and surplus or statutory earnings, or (ii) the lesser of 10% of statutory capital and surplus or statutory earnings, depending upon applicable state laws. The Company believes that such restrictions will not significantly impact the Company's liquidity for the foreseeable future.
The Company continuously evaluates its investment portfolio and the conditions under which it might sell securities, including changes in interest rates, changes in prepayment risk, liquidity needs, asset liability matching, tax planning strategies and other economic factors. Those securities that the Company believes would be subject to sale prior to the specified maturity date are included in "securities available for sale," which amounted to $2,993.9 million and $1,487.0 million at December 31, 1996 and 1995, respectively. Of those securities available for sale, 92.1% and 92.7% were rated Baa or above by Moody's Investors Services, Inc. at December 31, 1996 and 1995, respectively.
The Washington National Merger and the acquisition of the Controlling Interest in SW Financial will expand the Company's individual and payroll sales division operations with similar products, distribution channels and asset mixes.
Should the Company obtain shareholder approval for the above transactions, the Company's reported financial information would change significantly.
In anticipation of the Washington National Merger and the acquisition of the Controlling Interest in SW Financial, the Company recently consummated a five-year, $450 million revolving credit facility ("revolver") with a syndicate of banks and terminated the Bank Credit Agreement. The revolver provides the Company with sufficient capacity, (i) to pay the cash portion of the Washington National Merger consideration, (ii) to pay the consideration due to the controlling shareholders of SW Financial, (iii) to provide amounts needed to refinance existing indebtedness at SW Financial, and (iv) to provide liquidity for other general corporate purposes.
Borrowings under the revolver will carry variable rates of interest plus a margin which varies with the Company's implied senior unsecured indebtedness rating. Based upon PennCorp's current ratings, the revolver would reduce the Company's current borrowing rates under the formerly outstanding bank facility by approximately 35 basis points and would reduce the cost of indebtedness outstanding at SW Financial by nearly 300 basis points.
Operating Ratios. Pretax operating margin improved modestly to 21.7% of revenues during 1996 from 21.5% and 20.9% in 1995 and 1994, respectively. The slight improvement was primarily due to declines in all operating ratios except for policy benefits, which nearly offset the other improvements. As the mix of insurance products shifts toward life and accumulation products versus fixed benefit products, management believes the 1996 ratios will be indicative of future ratios.
The ratio of total policy benefits to revenues increased during 1996 to 47.1% from 38.4% and 34.7% in 1995 and 1994, respectively. The increase in total policy benefits to revenues during 1996 was primarily attributable to the continued increase in life products, relative to fixed benefit products, since benefits for life insurance products are typically greater, as a percentage of premium, than benefits for fixed benefit products. Additionally, accumulation products, such as deferred annuities, are priced to allow for the vast majority of interest earned on assets backing policy reserves to be credited to the policyholder account balance resulting in a faster growth in policy benefits than policy benefits for fixed benefit products. Also, during 1996, the Company experienced higher than expected mortality and morbidity costs for Penn Life and OLIC, which collectively resulted in an approximately 2.0% increase in the claims incurred ratio for the Company as a whole. The increase in total policy benefits during 1995, as compared to 1994 was the result of the shift in product mix, from fixed benefit accident and sickness insurance, to accumulation and life insurance products as claims incurred ratios remained consistent between periods.
Other operating expenses declined as a percentage of revenues to 12.5% during 1996, from 16.3% and 17.5% during 1995 and 1994, respectively. This downward trend was due to the acquisitions of UC Life and Integon Life, which are administered by the Company at overhead expense rates less than the business in force prior to their respective acquisitions. Despite the growing revenue base, the Company's total underlying expense infrastructure has increased only moderately. In addition, expense costs have shifted from overhead and maintenance expenses to those more closely related to the production of new business.
Policy Revenues. Policy revenues increased to $348.1 million in 1996 from $301.9 and $244.4 million in 1995 and 1994, respectively. Fixed benefit policy revenues decreased by 3.1% and 1.2% to $169.3 million and $174.7 million during 1996 and 1995, respectively, after increasing by 15.9% during 1994 to $176.9 million. Increases in fixed benefit policy revenues during 1994 resulted primarily from the acquisition of Professional. During 1996 and 1995, the Company's operating focus was concentrated primarily on increasing life policy revenues to achieve a balance of life policy revenues with those of fixed benefit products. In addition, during 1996 the Company effectively ceased marketing its "instant issue" fixed benefit products and as a result of higher than anticipated loss ratios which resulted in a $4.9 million decline in fixed benefit policy revenues.
Life policy revenues increased 43.9%, 75.0% and 37.2% to $170.0 million, $118.1 million and $67.5 million for the years ended 1996, 1995 and 1994, respectively. The acquisition of UCLife in July 1996, and Integon Life in July 1995, added $72.4 million and $22.2 million of life policy revenues during 1996 and 1995, respectively. The inclusion of AA Life for the full year 1995 increased life policy revenue by $29.1 million while AA Life provided an additional $13.7 million of life policy revenues during 1994. Partially offsetting some of these increases were declines in Penn Life's policy revenues from closed blocks of business of $1.1 million, $750,000 and $1.0 million during 1996, 1995 and 1994, respectively.
Insurance Related Expenses. Insurance related expenses (including commissions, amortization of deferred policy acquisition costs and amortization of the present value of insurance in force) increased 9.7%, 29.2% and 4.3% to $87.4 million, $79.7 million and $61.7 million during 1996, 1995 and 1994, respectively. During each of the periods the amortization of the present value of insurance in force increased slightly as a result of acquisitions. During 1996, and 1995, the Company utilized deferral methods comparable to those utilized in 1994 and thus the increase in amortization of deferred policy acquisition costs was the result of the growth of the blocks of new business issued since the acquisition of each subsidiary and related deferred costs. The increased insurance related expenses were also the result of somewhat higher commissions which totaled $34.7 million, $31.9 million and $30.7 million during 1996, 1995 and 1994, respectively.
Other Operating Expenses. Other operating expenses (including general operating, overhead and policy maintenance expenses) increased during 1996 to $71.2 million compared to $67.9 million during 1995 and $51.9 million during 1994. Excluding the impact of the UCLife acquisition in 1996 and the inclusion of Integon Life and AA Life for the full year period 1996 and 1995, respectively, and a non-recurring restructuring charge of $3.9 million in 1995, primarily related to the relocation of the Company's operating facility, other operating expenses decreased by $7.2 million or 14.8% during 1996 to $41.3 million for the Company's other insurance subsidiaries compared to $48.5 and $46.0 million during 1995 and 1994, respectively.
Also included in other operating expense is the amortization of costs in excess of net assets acquired which aggregated $8.0 million, $6.6 million and $5.2 million for 1996, 1995 and 1994, respectively.
We have audited the accompanying consolidated balance sheets of PennCorp Financial Group, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1996. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. All dollar amounts presented hereafter, except share information, are stated in thousands.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Accounts that the Company deems to be acutely sensitive to changes in estimates include deferred policy acquisition costs, future policy benefits, policy and contract claims and present value of insurance in force. In addition, the Company must determine requirements for disclosure of contingent assets and liabilities as of the date of the financial statements based upon estimates. In all instances, actual results could differ from estimates.
Fixed maturities classified as held for investment are recorded at cost, adjusted for amortization of premium or discount, as the Company has the intent and ability to hold them to maturity. Fixed maturities and equity securities classified as available for sale are recorded at fair value, as they may be sold in response to changes in interest rates, prepayment risk, liquidity needs, the need or desire to increase income or capital and other economic factors. Changes in unrealized gains and losses related to securities available for sale are recorded as a separate component of shareholders' equity, net of applicable income taxes. Securities classified as trading securities are reported at fair value with realized gains and losses and changes in unrealized gains and losses included in the determination of net income as a component of other income. The classification of securities as held for investment, available for sale or trading is generally determined at the date of purchase. The Company carries certain equity investments in affiliates on the equity basis of accounting as a result of its percentage ownership and lack of voting control. Mortgage-backed securities held for investment or available for sale are amortized using the interest method including anticipated prepayments at the date of purchase. Significant changes in estimated cash flows from original assumptions are reflected in the period of such change. Mortgage loans on real estate are recorded at cost, adjusted for amortization of premium or discount and provision for loan loss, if necessary. Policy loans, short-term investments, and other investments are recorded at cost, which approximates market.
Liabilities for future policy benefits generally have been computed on the net level premium method, based on estimated future investment yield, mortality, morbidity and withdrawals. Estimates used are based on experience adjusted to provide for possible adverse deviation. These estimates are periodically reviewed and compared with actual experience. Future policy benefits for interest sensitive products include the balance that accrues to the benefit of the policyholders and amounts that have been assessed to compensate the life insurance subsidiaries for services to be provided in the future.
Estimated costs of acquiring new business which vary with, and are primarily related to, the production of new business, have been deferred to the extent that such costs are deemed recoverable from future revenues. Such estimated costs include commissions, certain costs of policy issuance, underwriting and certain variable agency expenses. Costs deferred on accident and sickness and traditional life policies are amortized, with interest, over the anticipated premium-paying period of the related policies in proportion to the ratio of annual premium revenue to expected total premium revenue to be received over the life of the policies. Expected premium revenue is estimated by using the same mortality, morbidity and withdrawal assumptions used in computing liabilities for future policy benefits. For interest sensitive products and limited pay life products, policy acquisition costs are amortized in relation to the emergence of anticipated gross profits over the life of the policies.
The present value of insurance in force represents the anticipated gross profits to be realized from future revenues on insurance in force at the date such insurance was purchased, discounted to provide an appropriate rate of return and amortized, with interest based upon the policy liability or contract rate, over the years that such profits are anticipated to be received in proportion to the estimated gross profits. Accumulated amortization was $151,173 and $122,851 as of December 31, 1996 and 1995, respectively.
Net income per common share is determined after recognition of preferred stock dividends and accretion of discount on preferred stock and is based on the weighted average number of common shares outstanding during the year after giving consideration to the dilutive effect of stock options and stock warrants. Fully diluted net income per share assumes the conversion of convertible preferred stock.
The Company adopted the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation", in 1996. This statement provides a choice for the accounting of employee stock compensation plans. A company may elect to use a new fair-value methodology, under which compensation cost is measured and recognized in results of operations, or continue to account for these plans under Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. Note 12 of the Consolidated Financial Statements contains a summary of the pro forma effects to reported net income applicable to common stock and earnings per share for 1996 and 1995, if the Company had elected to account for employee stock compensation plans utilizing the fair value methodology prescribed by SFAS No. 123.
Costs in excess of the fair value of net assets acquired are amortized on a straight-line basis primarily over 20 years. Accumulated amortization was $32,434 and $26,484 as of December 31, 1996 and 1995, respectively.
The financial statement accounts of the Canadian operations, which are denominated in Canadian dollars, are translated into U.S. dollars as follows: (i) Canadian currency assets and liabilities are translated at the rates of exchange as of the balance sheet dates and the related unrealized translation adjustments are included as a separate component of shareholders' equity, and (ii) revenues, expenses and cash flows, expressed in Canadian dollars, are translated using a weighted average of exchange rates for each of the periods presented.
Financial reinsurance that does not transfer significant insurance risk is accounted for as deposits. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies. Balances due to, or from, reinsurers have been reflected as assets and liabilities rather than being netted against the related account balances.
Certain prior year amounts have been reclassified to conform to the current year presentation.
The UC Life acquisition has been accounted for as a purchase transaction in accordance with generally accepted accounting principles, and accordingly, all assets and liabilities acquired were recorded at fair value as of the acquisition date which became the new cost basis.
The acquisition of Integon Life was initiated on January 20, 1995, when the Company and its subsidiaries entered into a series of related agreements to acquire all of the issued and outstanding capital stock of Salem Holdings Corporation (formerly Integon Life Corporation), including the purchase for $15,000 in cash, of a 49% limited partnership interest in the ultimate limited partner that controlled Integon Life. Prior to the consummation of the acquisition, the Company's 49% equity interest in the net income of Integon Life, which aggregated $3,808, was reported on the equity method of accounting as undistributed earnings in unconsolidated affiliates for the period from January 20, 1995, to July 25, 1995.
On August 31, 1994, the Company consummated the acquisition of AA Life for a total cash purchase price of $103,392 including acquisition expenses of $1,865. The fair value of net assets acquired was $86,880 resulting in $16,512 of costs in excess of net assets acquired.
The AA Life acquisition has been accounted for as a purchase transaction in accordance with generally accepted accounting principles, and accordingly, all assets and liabilities acquired were recorded at fair value as of the acquisition date which became the new cost basis. .
The following unaudited pro forma data represents the Company's consolidated results of operations as if (i) the Integon Life and AA Life acquisition occurred as of January 1, 1994, and (ii) the UC Life acquisition occurred as of January 1, 1995. This unaudited pro forma data has been prepared for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisitions been made as of January 1, 1995 and 1994, or results which may occur in the future.
The components of operations for the years ended December 31 were as follows:
The amortized cost and fair value of fixed maturities available for sale as of December 31, 1996, by contractual maturity, are shown below:
Included in fixed maturities held for investment as of December 31, 1996 and 1995, are below investment-grade securities with an amortized cost and fair value of $34,624 and $39,281, respectively. Included in fixed maturities held for investment as of December 31, 1996, are unrated securities with an amortized cost of $46,413 and a fair value of $48,831.
As of December 31, 1996, commercial and residential mortgage loan investments were concentrated in the following states:
Realized, and changes in unrealized gains and losses, on investments for the years ended December 31 were as follows:
On December 14, 1995, Southwestern Financial Corporation ("SW Financial"), a newly organized corporation formed by the Company and Knightsbridge Capital Fund I, L.P. ("Knightsbridge", see Notes 15 and 16) purchased Southwestern Life Insurance Company, Union Bankers Insurance Company and certain other related assets from I.C.H. Corporation for $260,000.
Through its direct investment of $120,000 in SW Financial (the "Southwestern Life Investment"), the Company beneficially owns 67.2% of SW Financial's outstanding common stock, including 100% of SW Financial's non-voting common stock, 15.1% of SW Financial's voting common stock, and preferred stock of SW Financial and its subsidiary. PennCorp is also a 16.3% limited partner in Knightsbridge.
The consolidated condensed results of operations and financial position of SW Financial are provided below:
The methods used by the Company to value the fixed benefit, life, and accumulation products purchased are consistent with the valuation methods used most commonly to value blocks of insurance business. It is also consistent with the basic methodology generally used to value insurance assets. The method used by the Company includes identifying the future cash flows from the acquired business, the risks inherent in realizing those cash flows, the rate of return the Company believes it must earn in order to accept the risks inherent in realizing the cash flows, and determining the value of the insurance asset by discounting the expected future cash flows by the discount rate the Company requires.
Expected future cash flows used in determining such values are based on actuarial determinations of future premium collection, mortality, morbidity, surrenders, operating expenses and yields on assets held to back policy liabilities as well as other factors. Variances from original projections, whether positive or negative, are included in income as they occur and will affect the present value of insurance in force interest rates for products subject to SFAS No. 97. To the extent that these variances indicate that future cash flows will differ from those included in the original scheduled amortization of the present value of the insurance in force, future amortization may be adjusted. Recoverability of the present value of insurance in force is evaluated annually and appropriate adjustments are then determined and reflected in the financial statements for the applicable period.
Expected gross amortization, based upon current assumptions and accretion of interest at a policy liability or contract rate ranging from 3.5% to 14.5%, for the next five years of the present value of insurance in force is as follows:
The liability for future policy benefits consists of reserves for fixed benefit, life and accumulation products. For interest sensitive life products and annuity products, the liability for future policy benefits is equal to the accumulated fund value. Fund values are equal to the excess premium received and interest credited to the fund value less deductions for mortality costs and expense charges. Current declared interest rates credited range from 4.0% to 6.75 percent. Mortality costs and expense charges are established by the Company based upon its experience and cost structure.
For traditional life products, the liability for future policy benefits is based primarily upon Commissioners' Standard Ordinary Tables with interest rates ranging from 2.5% to 6.0 percent. Fixed products establish a liability for future policy benefits equal to the excess of the present value of future benefits to or on behalf of the policyholder over the future net premium discounted at interest rates ranging primarily from 4.5% to 8.0 percent. Traditional life products' and fixed benefit products' future policy benefits are determined using Company experience as to mortality, morbidity and lapses with a provision for adverse deviation. The Company may vary assumptions by year of policy issue.
The following table presents information on changes in the liability for accident and sickness claims for the years ended December 31:
* Included in the balance sheet captions "future policy benefits" and "policy and contract claims".
(a) Interest costs under the Notes totaled $13,545, $14,463 and $15,206 during 1996, 1995 and 1994, respectively. At December 31, 1996, the effective rate for the Notes was approximately 9.6 percent.
(b) Interest costs under the $100,000 credit facility totaled $1,701 and $362 in 1996 and 1995, respectively. The effective rate of interest charged on amounts outstanding during 1996 was 7.2 percent.
(d) Interest costs under the $175,000 revolving credit facility totaled $1,558 in 1996. The effective rate of interest charged was 6.0% during 1996 on a weighted average outstanding balance of $25,861.
The fair value of amounts outstanding as notes payable for the years ended December 31, 1996 and 1995, amounted to $215,341 and $311,771, respectively. All recorded amounts other than the Senior Subordinated Notes approximate market as they carry variable rates of interest which adjust at least every 90 days. The fair value of the Senior Subordinated Notes is determined based upon quotes from market makers.
The aggregate maturities of notes payable during each of the five years after December 31, 1996, are as follows: 1997, $570; 1998, $617; 1999, $668; 2000, $724; 2001, $92,951.
All of the Company's debt obligations contain financial and operating covenants. The Company and its subsidiaries were in compliance with all applicable covenants as of December 31, 1996.
The Company and a number of its non-insurance subsidiaries file a consolidated federal income tax return with a July 31 year end, which differs from its financial year end. Marketing One and its subsidiaries file a consolidated federal income tax return with a December 31 year end. The AA Life, PLAIC, and Salem Life groups each file a consolidated federal life insurance company income tax return on a calendar year basis with their life insurance subsidiaries.
The valuation allowance for deferred tax assets as of January 1, 1996 and 1995 was $15,892 and $17,157, respectively. The net change in the total valuation allowance for the years ended December 31, 1996 and 1995, was a decrease of $1,265 and of $104, respectively. If recognized as a tax benefit, a portion of the valuation allowance totaling $7,349 would be allocated to reduce costs in excess of net assets acquired.
At December 31, 1996, the Company has life consolidated net operating loss carryforwards of approximately $100,009 for tax return purposes. In addition, OLIC and Peninsular have available, on a separate return basis, acquired net operating loss
carryforwards of approximately $10,153. The utilization of acquired net operating loss carryforwards is limited in any one year to the lesser of (i) the life insurance group's consolidated taxable income or (ii) the subsidiary's taxable income computed on a separate return basis.
The Company issued 2,875,000 shares of $50 redemption value $3.50 Series II Convertible Preferred Stock (the "Series II Convertible Preferred Stock") on August 2, 1996. The Series II Convertible Preferred Stock is convertible at the option of the holder, unless previously redeemed, into 1.4327 shares of common stock for each share, subject to adjustment in certain events. Dividends accrued and unpaid as of December 31, 1996, were $1,677. The carrying value of the Series II Convertible Preferred Stock approximates market due to the short-term nature of the instrument.
In conjunction with the acquisition of AA Life in August 1994, the Company issued 450,000 shares of nonvoting Series A Preferred Stock, $0.01 per share par value and $100 per share redemption value. The Series A Preferred Stock was redeemed on August 25, 1995, from the proceeds received from the issuance of the Convertible Preferred Stock. During 1995, and 1994, the Company paid or accrued dividends amounting to $1,725 and $1,151, respectively.
date of grant and are exercisable during a one-year period immediately following the fourth anniversary of the date of grant. The 1996 Stock Option Plan allows for awards of stock or options subject to such terms, conditions, and restrictions, and/or limitations, if any, as the Stock Option Committee of the Board of Directors deems appropriate.
As part of an employment agreement effective August 1990, the Company issued to a former officer of the Company, warrants to purchase up to 570,760 shares of the common stock of the Company at any time up to 10 years from the date of the agreement. The warrants are exercisable at a price of $4.00 per share which was fair value on the date of grant.
The Company has established a U.S. Sales Manager incentive stock option plan in which the senior sales manager of one of the Company's insurance subsidiaries may earn stock options in the amount of 275,000 shares over a five-year period, subject to achieving certain performance goals, in addition to an initial grant of 100,000 options. Such options are vested immediately as earned, except for the initial 100,000 which vest in September 1999, and option prices range from $15 per share, for the initial 100,000 options, to the fair value of the common stock of the Company on the date of grant for those shares subject to performance goals.
The following table summarizes information concerning outstanding and exercisable options and warrants as of December 31, 1996:
In accordance with the provisions of SFAS No. 123, the Company applies APB Opinion 25 and related Interpretations in accounting for its stock option and warrant plans and, accordingly, does not recognize compensation cost. If the Company had elected to recognize compensation cost based on the fair value of the options and warrants as of the grant date as prescribed by SFAS No. 123, the reduction in net income applicable to common stock and earnings per share would have been immaterial.
Cash generated by the Company's insurance subsidiaries is made available to PennCorp principally through periodic payments of principal and interest on surplus debentures issued by PLAIC, Salem Life and Pioneer Security, (collectively, the "Surplus Note Companies"). The amounts outstanding under the surplus debentures totalled $367.9 million and $315.8 million as of December 31, 1996 and 1995, respectively. Surplus debentures generally require (subject to availability of statutory capital and surplus and in some instances, regulatory approval) principal and interest payments to be made periodically in amounts sufficient to allow PennCorp to meet its cash requirements.
If the Company meets established performance goals, the Company's two most senior officers are eligible to receive annual cash bonuses based primarily on annual growth rates in fully diluted earning per share. Bonus awards range from 0% to 200% of a predetermined target annually. During 1996, the Company did not accrue for such bonuses as the employment arrangements containing the bonus plan are contingent upon the purchase by the Company of the Fickes and Stone Knightsbridge Interests (see Notes 15 and 16 below).
Postretirement benefits are accrued (but not funded) for eligible retirees. The components of the accumulated postretirement benefit obligation as of December 31 were as follows:
For the year ended December 31, 1996, the postretirement benefit liability was calculated assuming an annual trend rate in health care inflation of 8% in 1997 grading down to 5.5% in 2000 and after. If the health care cost trend rate assumption increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1996, would increase $198 or 3.8%.
For the years ended December 31, 1996 and 1995, PennCorp paid or accrued $2,548 and $3,900 in transaction fees to KM related to the UC Life and SW Financial transactions, respectively. During 1996, certain of the Company's affiliates and subsidiaries paid management fees to KM amounting to $2,190 which have been contingently expensed in the accompanying financial statements pending the shareholder vote on the acquisition of the Fickes and Stone Knightsbridge Interests. SW Financial and UC Life paid KM investment advisory fees totalling $1,813 and $- during 1996 and 1995, respectively. In addition, PennCorp received a $1,000 stand-by commitment fee from SW Financial for contingent financing on a real estate transaction. SW Financial did not draw upon the commitment.
Certain individuals, who are shareholders, directors and officers of PennCorp, and affiliates of these individuals, provide services to the Company. During 1996 and 1995, payments aggregating $250 and $210, respectively, were made to these individuals and their affiliates for services provided in connection with the Company's acquisition activity. During 1994, fees amounting to $813 were paid in connection with the establishment of PennCorp's Canadian subsidiary, the acquisition of AA Life, and certain reinsurance transactions.
On January 22, 1997, the Company filed with the Securities and Exchange Commission ("SEC"), a preliminary PennCorp Financial Group, Inc. and Washington National Corporation Joint Proxy Statement and Prospectus ("Joint Proxy Statement") in which the Company, pending final review by the SEC, will be soliciting shareholder approval for the following transactions: (i) the Washington National Merger, (ii) the acquisition of the Controlling Interest in SW Financial, (iii) the acquisition of the Fickes and Stone Knightsbridge Interests, and (iv) other items.
PennCorp will receive its right to acquire the Controlling Interest in SW Financial through the assignment by Fickes and Stone and Knightsbridge ("the Controlling Parties") of certain rights including common stock and common stock equivalents of SW Financial. The Controlling Parties will receive aggregate cash consideration ranging from $67,500 to $69,600 (not including expenses) depending upon the outcome of certain contingencies.
The Company and its subsidiaries are obligated under operating leases, primarily for office space. Rent expense, net of sublease income, was $8,416, $8,489 and $7,172 in 1996, 1995 and 1994, respectively.
* Total minimum lease payments have not been reduced by minimum sublease rentals of $947 due in the future under noncancelable subleases.
The defendants in the Tozour Case have filed a motion seeking its dismissal on the ground that the plaintiff failed to comply with the requirements of Delaware law before instituting a derivative suit and intend to defend the lawsuit vigorously. Because the Company has not been served with the Miller Complaint, no action has been taken in that case, although the Company would also defend it vigorously. The defendants believe, however, that it would not be in the best interests of PennCorp and its shareholders to expend considerable management and director time and to incur substantial expenses to litigate the actions. Consequently, PennCorp's legal advisors have met or spoken by telephone with the plaintiff's counsel on several occasions to discuss the terms of a potential settlement.
Certain other lawsuits have been brought against the Company's life insurance and non-life subsidiaries in the normal course of business involving the settlement of various matters seeking compensatory and in some cases punitive damages. Management believes that the ultimate settlement of all such litigation will not have a materially adverse effect on the Company's consolidated financial position or results of operations.
Effective January 1, 1996, the Company outsourced the vast majority of its data center operations and administrative systems programming to a third party vendor. The processing agreement extends through December 2002 and requires the Company or its insurance subsidiaries to make payments ranging from approximately $8,399 to $9,248 during each of the contract years. The contract has standard provisions for early cancellation, including breakage fees. As part of the outsourcing agreement, the Company has agreed to provide a line of credit which may be drawn upon during the first two years, with repayment in nearly equal monthly installments over the remainder of the contract.
The Company has guaranteed approximately $12,800 in mortgage loans sold to third parties.
In the normal course of business, the Company reinsures portions of certain policies that it underwrites to limit disproportionate risks. The Company retains varying amounts of individual insurance up to a maximum retention of $300 on any life. Amounts not retained are ceded to other insurance enterprises or reinsurers on an automatic or facultative basis.
The Company cedes varying amounts of certain accident and sickness policies up to a maximum cession of $240, as well as varying portions of certain disability income policies on a facultative basis.
Fees incurred for financial reinsurance were approximately, $265 in 1996, $339 in 1995, and $515 in 1994.