The Company occupies leased office space located at 500 N. Akard, Dallas, Texas 75221. The lease expires in June 2007.
The historical financial information for the five years ended December 31, 2001 and at December 31, 2001, 2000, 1999, 1998 and 1997 has been derived from the audited Consolidated Financial Statements of the Company. The selected consolidated financial data set forth below is qualified in its entirety by reference to and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Company's Consolidated Financial Statements and the Notes thereto included elsewhere in this Form 10-K.
(1) On April 15, 1997, the Company acquired all of the outstanding common stock of Ohio State and Investors Guaranty.
(3) Effective January 1, 2000, the Company disposed of a block of payroll-deduction life insurance business.
The Company's amounts of life insurance and annuities in force have experienced changes over the last two years. These changes can be measured by the changes in the Company's liabilities over this period. The liabilities as of December 31 of the last three years are summarized in the following table (in millions):
The following table summarizes the Company's sales in terms of collected first year premiums over the three-year period ended December 31, 2001.
The Company's reserves for future policy benefits of $811.4 million at December 31, 2001 on term life insurance and whole life insurance policies are calculated using estimates of investment yields, mortality and withdrawals. These estimates are based upon the Company's historical experience and historical experience of the life insurance industry. Policyholder account balances of universal life-type and annuity products of $2,729.9 million at December 31, 2001 represent accumulated contract values, without reduction for potential surrender charges and deferred front-end contract charges that are amortized over the term of the policies. Additions to the reserves for universal life-type policies are required when their balances, in addition to anticipated future net cash flows, including investment income, are insufficient to cover future benefits and expenses.
The costs of new business produced, principally commissions, certain policy issue and underwriting expenses and certain variable agency expenses, are deferred. The Company's deferred policy acquisition cost asset was $242.2 million at December 31, 2001. The cost of business acquired asset of $149.7 million at December 31, 2001 represents the amount of purchase price assigned to the value of the policies at acquisition. For traditional life products, these costs are amortized in proportion to premium revenues over the premium-paying period of related policies using assumptions consistent with those used in computing benefit reserves. For universal life, interest-sensitive and investment products, these costs are amortized in relation to the present value, using the current and projected credited interest rate, of expected gross profits of the policies over the anticipated coverage period. Anticipated investment returns, including realized gains and losses, from the investment of policyholder balances are considered in determining the amortization of deferred policy acquisition costs, the cost of business acquired and unearned policy revenues.
Retrospective adjustment of deferred policy acquisition costs and the cost of business acquired are made annually upon the revision of estimates of current or future gross profits on universal life-type and annuity products. Recoverability of these assets is evaluated annually by comparing the current estimate of future profits to the unamortized asset balances. The Company recorded retrospective adjustments to these asset balances during both 2001 and 2000 as more fully discussed in the "Segment Results" and "Consolidated Year to Year Comparisons" which follow.
Revenues and income before income taxes for the Company's operating segments, as defined by Statement of Financial Accounting Standard ("SFAS") No. 131, "Financial Reporting for Segments of a Business Enterprise", are summarized as follows (in millions):
Life insurance operations. Income before income taxes increased $4.2 million from 2000 to 2001. The profits in both 2001 and 2000 were significantly affected by changes in amortization expense and changes in the Company's policy reserves. Revisions to estimates of future gross profits resulted in a decrease in amortization expense of $21.9 million in 2001 and an increase in amortization expense of $6.6 million in 2000. The most significant revision to estimated gross profits in 2001 occurred as a result of changes in estimated policy revenues and in policy benefits, including revisions made to reflect the anticipated impact of the settlement of litigation in which the Company was the defendant. The increase in reserves in 2001 was $13.0 million higher, primarily associated with the same policies subject to the litigation settlements. Excluding the changes in amortization and the increases in policy reserves discussed above, income before income taxes decreased $11.3 million from 2000 to 2001. This decrease in profits was primarily the result of (i) a $7.0 million increase in death benefits from 2000 to 2001 and (ii) lower profits on the Company's preneed business in 2001 due to adverse lapse experience.
Asset accumulation operations. Income before income taxes decreased $12.0 million from 2000 to 2001. The profits in both 2001 and 2000 were significantly affected by changes in amortization expense. Revisions to estimates of future gross profits resulted in an increase in amortization expense of $3.1 million in 2001 and a decrease in amortization expense of $5.5 million in 2000. The most significant revision to estimated gross profits in 2001 occurred as a result of changes in estimated policy benefits, including revisions made pursuant to the anticipated impact of the settlement of litigation in which the Company was the defendant. Excluding the changes in amortization expense discussed above, income before income taxes decreased $3.4 million from 2000 to 2001. This decrease in profits was primarily the result of (i) lower surrender charge income in 2001 and (ii) an additional $1.4 million of expense accrued for commission bonus plans in 2001.
Income before income taxes increased $10.0 million from 1999 to 2000. The primary reasons for the increase were (i) a $3.5 million reduction in amortization of deferred policy acquisition costs resulting from revisions made to the Company's estimate of future gross profits from its interest-sensitive life and annuity products in both 2000 and 1999, (ii) a $2.7 million increase in surrender charge revenue resulting from higher levels of surrenders in 2000, and (iii) an increase in interest margins due to higher fund values on annuity business in 2000.
Similar reconciling items had the effect of decreasing income before income taxes by $3.1 million from 1999 to 2000. The primary reasons for the decrease were (i) a $10.8 million increase in net realized investment losses not allocated to segments, offset by (ii) a $3.9 million decrease in operating expenses due to cost controls implemented in 2000, (iii) a $1.9 million increase in net investment income related to a reduction in the unrecovered ceding commission due to the Reinsurer, and (iv) a $1.6 million decrease in interest expense due to lower average outstanding notes payable in 2000 compared to 1999.
Income before income taxes and cumulative effect of a change in accounting principle in 2001 was $17.0 million compared to $22.4 million in 2000. Excluding the effects of net realized investment gains and losses, income before income taxes decreased $11.0 million for this same period from $29.0 million to $18.0 million. The primary reasons for the decrease in profits in 2001 compared to 2000 were (i) a $8.4 million increase in death benefits, net of reserves released on traditional death benefits, (ii) a $7.0 million decrease in surrender charge income on closed blocks of universal life and annuity business, and (iii) a $9.9 million restructuring loss in 2001 related to the Company's decision to terminate certain operations and relocate other operations. These decreases in profits were partially offset by (i) lower amortization expense in 2001 resulting from the revisions of estimates of the future gross profits on certain of its universal life-type and annuity products and (ii) a decrease in amortization expense resulting from lower surrender charge income in 2001.
Premiums and policy revenues. Premiums and policy revenues totaled $206.9 million in 2001 compared to $220.7 million in 2000. Premiums from traditional life insurance and preneed policies decreased $4.9 million during 2001 compared to 2000. A $12.4 million decrease in premiums from the Company's inforce traditional life insurance business was partially offset by a $7.5 million increase in preneed premiums. Policy revenues from interest-sensitive life and annuity products decreased $8.0 million from 2000 to 2001. This decrease was primarily due to a $7.0 million reduction in surrender charge revenue in 2001 as a result of lower surrenders in closed blocks of annuities and the asset accumulation business.
Policyholder benefits. Policyholder benefits totaled $257.4 million for 2001 compared to $261.2 million for 2000. As discussed above, included in policyholder benefits in 2001 is a $22.2 million reduction related to the decline in value of the issued options embedded in the Company's equity-indexed annuity liabilities. Excluding the decrease in the value of the issued options, policyholder benefits increased $18.4 million from 2000 to 2001. Death benefits, net of reserves released on traditional death benefits, during 2001 were $8.6 million higher than 2000. The remaining increase in policyholder benefits from 2000 to 2001 was attributable to higher increases in reserves for future policy benefits in 2001.
Commissions. Commission expense totaled $8.7 million for 2001 compared to $4.3 million in 2000. The increase in commission expense in 2001 included an additional $1.4 million of expense accrued for commission bonus plans. The receipt of approximately $1.5 million of nonrecurring reimbursements had reduced commission expense in 2000. These reimbursements were offset by higher ceded premiums on the same reinsurance agreement in 2000.
Other operating expenses. Other operating expenses totaled $78.5 million for 2001 compared to $84.4 million for 2000. Included in other operating expenses for 2001 was a $3.5 million increase in the allowance for receivables from agents which the Company has estimated to be uncollectible, $1.5 million of litigation costs and $0.8 million related to the costs of mailing notices to policyholders to comply with recently-issued federal privacy regulations. The majority of the agent receivables deemed uncollectible were older balances on which related litigation was settled during 2001. Other operating expenses for the year ended December 31, 2000 included $3.1 million of costs associated with the settlement of lawsuits. The remaining net reduction in other operating expenses from 2000 to 2001 reflects the Company's continued efforts to reduce expenses and improve the efficiency of its operations.
In May 2000, the Company entered into an agreement to permanently reinsure a block of payroll-deduction life insurance business to an unaffiliated company on an indemnity coinsurance basis using an effective date of January 1, 2000. The policy liabilities remain as direct liabilities to the Company in the accompanying consolidated financial statements. As of the effective date, liabilities associated with these policies totaled $138.5 million. Under the reinsurance agreement, the Company transferred cash assets totaling $100.0 million and miscellaneous assets totaling $17.1 million to the unaffiliated reinsurer. In addition, the Company removed deferred policy acquisition costs totaling $20.3 million from its consolidated financial statements in conjunction with this disposition. In order to fund the cash transfer, the Company sold fixed maturity held to maturity investments with an amortized cost of $54.6 million and realized net investment losses of $0.3 million on those sales. The Company will continue to service these policies for a fee paid by the reinsurer for a period of time defined in the related servicing agreement. This transaction has no significant effect on the Company's consolidated financial position or results of operations.
The following table summarizes the effects of this business on components of the Company's income statement during 1999 (in millions):
The increase related to the Company's remaining bond portfolio is primarily due to an increase in assets supporting the asset accumulation business from sales in the Company's Americo Financial Services sales division.
Interest credited on fund balances increased $12.4 million due to increased fund values related to the asset accumulation business. This increase was partially offset by a $4.5 million decrease in interest credited on a closed block of annuity business resulting from lower aggregate fund values. Other policyholder benefits increased primarily due to an increase in surrender benefits on closed blocks of traditional life business. The reserve reduction decrease in 2000 was due to increased traditional life premiums in the preneed market offset by increased reserves released on higher surrender benefits in 2000 on closed blocks of traditional life insurance business.
Liquidity. Americo has no operations of its own and relies on its subsidiaries for funds. Americo's cash requirements consist of debt service requirements on notes payable, amounts due to FHC under advisory and data processing agreements and its own operating expenses. These cash requirements are met by dividends from United Fidelity and by payments of principal and interest on surplus debentures that Americo holds which were issued to it by United Fidelity. Americo also receives payments under investment advisory and data processing agreements with its insurance subsidiaries which permit Americo to recover a portion of the amounts paid by it under similar agreements with FHC. On a stand-alone basis, at December 31, 2001, Americo had a total of $28.8 million of cash, marketable equity securities and fixed maturity securities available for debt service and other corporate requirements. During 1999, Americo repaid the $21.0 million then outstanding under a credit facility, using available cash and $12.3 million of dividends received from its life insurance subsidiaries. This credit facility was terminated during 1999.
At December 31, 2001, Americo held four United Fidelity surplus debentures with an aggregate unpaid balance of $120.0 million. The terms of the surplus debentures have been established to provide for the payment of principal and interest to Americo in amounts sufficient to make timely payments on Americo's external debt obligations in accordance with their payment schedules. The surplus debentures and their payment schedules have been approved by the Texas Department of Insurance; therefore, no scheduled payment will require the further approval of the Texas Department of Insurance.
On December 31, 2001, the Company issued 1,350,000 shares of cumulative Series A Preferred Stock to FHC in exchange for an equal number of shares of FHC cumulative preferred stock. The Company authorized a total of 2,000,000 shares of Series A Preferred Stock, which ranks senior to the Company's common stock as to dividends and liquidation rights. The Company's preferred stock and the FHC preferred stock each have a par value of $1.00 per share and a total stated value of $135.0 million. Cumulative annual dividends on the Company's preferred stock of 3.38% plus the LIBOR rate are payable quarterly, either in cash or in additional shares of preferred stock. The Company will receive a quarterly dividend on the FHC preferred stock of 3.11% plus the LIBOR rate per annum, either in cash or in additional shares of FHC preferred stock. The Company is required to redeem any outstanding shares of the Series A Preferred Stock on December 31, 2016 for $100 per share plus any unpaid dividends.
On December 31, 2001, Americo Retirement Services, Inc. (ARS), a wholly-owned subsidiary of Americo Life, Inc., established a grantor trust (the Trust) for the purpose of paying certain amounts due under a litigation settlement agreement. The Trust was funded with a contribution of the FHC preferred stock received by Americo in exchange for Americo's own preferred stock. In order to fund its obligations, the Trust is authorized to sell shares of the FHC preferred stock as necessary. FHC has a right of first refusal on any shares the Trust offers for sale. The Trust will exist until all such obligations for which it has been made responsible have been paid or expired. At such time, any assets remaining in the Trust will revert back to ARS. The accounts of the Trust are included in the consolidated financial statements of the Company. The Company's December 31, 2001 consolidated financial statements reflect the Company's best estimate of its liability under the settlement.
Investment Portfolio. The Company has what it believes to be a conservative investment philosophy. The credit quality of its portfolio is high with limited amounts of securities below investment grade. The Company's policy is to have a substantial portion of its investment portfolio in fixed income securities with call protection.
The following table sets forth the composition of the Company's fixed maturity securities according to NAIC designations and S&P and Moody's ratings at December 31, 2001:
(2) Carrying amount is amortized cost. The market value of held to maturity securities at December 31, 2001 was $712.3 million.
The primary risk associated with the MBS portfolio is that a changing interest rate environment might cause prepayment of the underlying mortgages at prepayment rates different than anticipated at the time of their purchase. The degree to which a security is at risk to either increases or reductions in yield is influenced by (i) the difference between its carrying value and par value, (ii) the relative sensitivity of the underlying mortgages to prepayment in a changing interest rate environment and (iii) the repayment priority of the securities in each securitization structure.
The Company manages the yield and cash flow variability of its MBS portfolio by (i) purchasing securities backed by collateral with lower prepayment sensitivity (such as mortgages priced at a discount to par value), (ii) avoiding the purchase of securities whose values are heavily influenced by changes in prepayments (such as interest-only and principal-only securities) and (iii) purchasing securities with prepayment protected structures (such as planned amortization class CMO's). See Note 4 to the Company's Consolidated Financial Statements included elsewhere in this Form 10-K for a summary of the Company's investments in CMO's.
Real estate investments made up 1.0% of the carrying value of the Company's cash and invested assets at December 31, 2001.
Management is aware that prevailing interest rates may shift significantly and has strategies in place to manage either an increase or decrease in interest rates. In a rising interest rate environment, the Company's cost of funds would increase over time as it prices its new and existing interest-sensitive and investment products to maintain generally competitive market rates. Management would seek to invest new and renewal premiums in investments which are high yielding and generally correspond to the duration of its liabilities. Management believes that liquidity to fund withdrawals would be available through a combination of incoming cash flow, the sale of short-term or floating-rate instruments and maturing short-duration assets and that therefore the Company could avoid the sale of significant amounts of longer duration fixed-rate assets in an unfavorable bond market. In a declining rate environment, the Company's cost of funds would decrease over time, reflecting lower interest crediting rates on its interest-sensitive liabilities. The Company's interest-sensitive liabilities carry minimum interest guarantees, which may cause the reduction in the Company's cost of funds to be less than the overall decrease in market interest rates. In addition, redemptions of callable fixed-rate investments would likely increase in a declining rate environment, causing the Company to reinvest funds at lower yields. In order to mitigate this risk, the Company has reduced its investment in callable securities. Should increased liquidity be required for withdrawals, management believes that a significant portion of its investments could be sold without adverse consequences in light of the general strengthening which would be expected in the bond market.
Asset-liability management is utilized by the Company to reduce the risks to the Company for interest rate fluctuations and disintermediation. The Company believes that its fixed-rate liabilities should be backed by a portfolio principally composed of fixed-rate investments that generate reasonably predictable yields in a variety of interest rate environments. The Company does not have a specific target rate of return. Instead, its rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, and general economic conditions. The Company's portfolio strategy is constructed with a view to achieving adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability management, liquidity and safety. The Company has structured its investment portfolio to reduce changes in the value of the assets under various rate environments. In that regard, the percentage of the Company's fixed-rate investment portfolio which is non-callable has increased from 44% in 1995 to 73% in 2001. In addition, the portfolio's concentration in mortgage-backed securities and asset-backed securities, which are subject to cash flow variability in changing interest rate environments, has decreased from 38% in 1995 to 29% in 2001. See "Investment Portfolio" section included elsewhere in "Management's Discussion and Analysis of Financial Condition and Results of Operations" for additional information related to the Company's investments.
In order to reduce the probability of unexpected increases in policy or contract surrenders, which would create a need for increased liquidity, the Company has structured its interest-sensitive life insurance and annuity products to include substantial surrender charges. At December 31, 2001, approximately 60% and 92% of the reserves for interest-sensitive life insurance and annuity products, respectively, were for policies with surrender charges or otherwise not subject to discretionary withdrawal by the policyholder. Similarly, at December 31, 2001, the aggregate cash surrender values of the Company's interest-sensitive life insurance and annuity products were approximately 88% and 90%, respectively, of the aggregate policyholder fund value.
The Company's equity-indexed annuity (EIA) products credit interest to the policyholder's account balance based on a percentage (the "participation rate") of the change in external indices over a two year period (the "index period"). At the end of each index period, a new index period begins using the then-current account balance and external index value. The Company has the discretion to change the participation rate at the beginning of each index period, subject to contractually-guaranteed minimums. SFAS No. 133 requires that each premium deposit be bifurcated between the embedded derivative component and the host contract component. The embedded derivative component of the Company's EIA products includes the options issued to the policyholder for the current index period and for forward-starting periods. The Company records the changes in the values of the embedded derivatives in current earnings as a component of policyholder benefits. The host contract accretes interest to a maturity value over a projected term. The interest accretion of the host contract is included in interest credited on policyholder funds on the consolidated statement of income.
The Company also uses computer-generated simulations to evaluate how effectively it has managed the risk associated with these derivatives. The Company periodically generates 500 different interest rate and equity return scenarios to measure the present value of its equity-indexed annuity block of business. Over 95% of these scenarios returned a positive present value using a 9% discount rate. The standard deviation of the resulting present values was approximately $11.0 million.
In July 2001, the Financial Accounting Standards Board issued SFAS No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible Assets." SFAS No. 141 supersedes previously issued guidance on accounting for business combinations. SFAS No. 141 eliminates the pooling-of-interests method of accounting for business combinations initiated after July 1, 2001 and also changes the criteria used to recognize intangible assets apart from goodwill.
SFAS No. 144 provides guidance on the accounting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" and amends Accounting Principles Board Opinion No. 30 ("APB No. 30") Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business." SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, entities are no longer required to include under "discontinued operations" operating losses that have not yet occurred. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The Company does not expect that adoption of SFAS No. 144 will have a significant effect on its consolidated financial position or results of operations.
The AICPA also recently issued Statement of Position No. 01-06 ("SOP 01-06") "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others." The guidance in SOP 01-06 relating to financing and lending activities is explicitly applicable to insurance companies. SOP 01-06 reconciles and conforms the accounting and financial reporting guidance presently contained in other accounting guidance. SOP 01-06 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The Company's accounting practices for its lending activities are already consistent with the guidance contained in SOP 01-06. Therefore, adoption of SOP 01-06 will not have a significant effect on the Company's financial statements.
The Company's audited consolidated financial statements for the three years ended December 31, 2001 and the related report of independent accountants thereon are set forth at pages to hereof and are incorporated herein by reference. Reference is made to the Index to Financial Statements on page herein.