Liberty owns a 487,000 square foot building in Birmingham, Alabama which until 2010 served as Liberty’s home office. During 2010, Liberty vacated this building and currently operates its home office activities out of a 34,000 square foot facility leased in a Birmingham suburb. Approximately 15,000 square feet of storage space has also been leased near the new home office facility. Liberty also operates from 4 company-owned district offices used for agency sales personnel. Liberty is currently in the process of selling its remaining company-owned office buildings, including its former home office building, opting instead to operate from leased facilities.
(1) Includes Torchmark’s 7.1% Junior Subordinated Debentures reported as “Due to affiliates” on the Consolidated Balance Sheets at year ends 2006 through 2010 in the amount of $123.7 million.
Insurance Product Line Segments. As fully described in Note 14-Business Segments in the Notes to the Consolidated Financial Statements, the product line segments involve the marketing, underwriting, and benefit 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:
The major contributor to the growth in 2010 earnings compared with the previous two years was in realized investment gains and losses, as 2010 had net gains of $24 million compared with net losses of $85 million in 2009 and $70 million in 2008. The losses in 2009 and 2008 included a number of writedowns of fixed-maturity securities that were determined to be other-than-temporarily impaired. In 2009, after-tax realized investment losses reduced per share earnings $1.03, of which $1.13 per share related to other-than-temporary impairments of fixed maturities. In 2008, after-tax losses accounted for $.79 per share, of which $.78 related to fixed maturity other-than-temporary impairments. In 2010, we had realized investment gains which added $.30 to per diluted share earnings, even though there was an other-than-temporary impairment writedown of $.04 per share that offset the net gains for the period. Another important factor in 2010 earnings growth was a $21 million or 8% growth in our excess investment income, the measure of profitability of our investment segment. In 2009, excess investment income declined $28 million or 9%. Poor economic conditions in 2009, especially early in the year, caused us to hold a significant portion in low-yielding cash and short-term investments for increased liquidity. Excess investment income was also negatively affected in 2009 because of our issuance of a $300 million 9 1/4% debt security in June, 2009 (net proceeds of $296 million) and repayment of a $99 million 8 1/4% security which matured in August, 2009. These transactions resulted in a net increase in our financing costs in 2009 and reduced excess investment income. Results in our core life insurance segment rose 7% in 2010 to $455 million and also increased 3% in 2009, largely as a result of premium growth in both years. The life segment is our largest contributor to operating results. Earnings from our health operations stabilized in 2010 after two years of declines. This segment has experienced intense competition in recent periods resulting in significant declines in agent counts, which in turn has resulted in
Total revenues increased 8% in 2010 to $3.37 billion. In 2009, total revenues declined 3% to $3.12 billion from $3.20 billion in 2008. Life premium rose 5% or $72 million in 2010 and $48 million in 2009. Net investment income rose $44 million in 2010, compared with $5 million in 2009. However, growth in revenues in 2009 and 2008 were negatively affected by the aforementioned pretax realized investment losses and declines in health premium, described further under this caption.
We market three primary health insurance products: Medicare Supplement insurance, the Medicare Part D prescription drug benefit, and under-age-65 limited-benefit health insurance. Health premium declined 3% in 2010 to $987 million from $1.02 billion in 2009. Health premium declined 10% in 2009. The decreases in both years were caused by the decline in agent count and poor persistency. Agent turnover has increased as lower premium, lower margin products offered by competitors have provided agents with products that are easier to sell. Turnover has also increased due to the Company’s decision to deemphasize the marketing of certain limited-benefit products. Sales of these de-emphasized products were discontinued altogether after September, 2010. Declines in these agent counts have resulted in lower net sales, which in turn have pressured premium growth. Medicare Supplement remains our largest contributor to total health premium, but increased competition has also dampened sales of this product in recent years, resulting in premium declines in each successive year. Our Medicare Part D premium rose 14% in 2010, after having increased 5% in 2009. However, as most of the country’s Part D enrollees selected a plan provider in 2006, we do not expect significant growth in our Part D business going forward. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
We offer fixed annuities, but we do not emphasize sales of annuity products, favoring life insurance instead. With the sale of United Investors, we disposed of 37% of our annuity deposit balance. See the caption Annuities for further discussion of the Annuity segment.
As previously mentioned, the investment segment’s pretax profitability, or excess investment income, increased $21 million in 2010 but declined $28 million in 2009. Profitability in this segment is based on three major components: net investment income, required interest on net policy liabilities (interest applicable to insurance products), and financing costs. In recent years, growth in net investment income has been restricted in relation to the growth in the size of our portfolio. However, in 2010, the growth in net investment income exceeded the growth in the average portfolio (amortized cost) for the first time in many years, primarily as a result of the special constraints on the growth in net investment income in 2009 noted below. One reason that investment income has grown at a lower rate than mean invested assets has grown in recent years is that new investments have been made at yield rates lower than the yield rates earned on securities that matured or were otherwise disposed of. Also, there is sometimes a lag between the time when proceeds from maturities and dispositions are received and when the proceeds are reinvested, in which the funds are held in cash. Growth in total investment income has also been somewhat negatively affected by Torchmark’s share repurchase program (described later under this caption), which has diverted cash that could have otherwise been used to acquire investments. During 2009, due primarily to uncertainty about liquidity in the financial markets, we held significantly more cash and short term investments than we normally would. Additionally, in 2009, we sold a significant portion of higher-yielding but lower-rated fixed maturities and reinvested the proceeds in lower-yielding but higher-rated bonds in 2009 and early 2010 to improve our risk-adjusted return. These factors contributed to reduced 2009 net investment income.
As mentioned earlier, we used a portion of the $296 million proceeds from the offering of our 9 1/4% Senior Notes ($300 million par amount) in 2009 to repay our $99 million 8 1/4% Senior Debentures which also matured in 2009. In addition, we also used $175 million to strengthen the capital position of certain of our insurance subsidiaries in 2009 in the form of capital contributions and surplus notes. The regulatory capital positions of these subsidiaries had been negatively affected by rating-agency downgrades of bonds in their investment portfolios. The subsidiaries in turn invested these funds in investment-grade fixed maturities. More information on these transactions can be found in Note 11-Debt in the Notes to Consolidated Financial Statements and in our discussion of Capital Resources in this report.
Life insurance premium rose 5% to $1.66 billion in 2010 after having increased 3% in 2009 to $1.59 billion. Life insurance products are marketed through several distribution channels. Premium income by channel for each of the last three years is as follows:
We use three statistical measures as indicators of premium growth and sales over the near term: “annualized premium in force,” “net sales,” and “first-year collected premium.” Annualized premium in force is defined as the premium income that would be received over the following twelve months at any given date on all active policies if those policies remain in force throughout the twelve-month period. Annualized premium in force is an indicator of potential growth in premium revenue. Net sales is
Annualized life premium in force was $1.75 billion at December 31, 2010, an increase of 3% over $1.69 billion a year earlier. Annualized life premium in force was $1.63 billion at December 31, 2008.
The following table shows net sales information for each of the last three years by distribution method.
Direct Response consists of two primary components: direct mail and insert media. Direct mail targets primarily young middle-income households with children. The juvenile life insurance policy is a key product. Not only is the juvenile market an important source of sales, but it also is a vehicle to reach the parents and grandparents of the juvenile policyholders. Parents and grandparents of these juvenile policyholders are more likely to respond favorably to a Direct Response solicitation for life coverage on themselves than is the general adult population. Also, both the juvenile policyholders and their parents are low acquisition-cost targets for sales of additional coverage over time. At this time, we believe that the Direct Response unit is the largest U.S. writer of juvenile direct mail life insurance. We expect that sales to this demographic group will continue as one of Direct Response’s premier markets.
The American Income Exclusive Agency focuses primarily on members of labor unions, but also on credit unions and other associations for its life insurance sales. It is Torchmark’s highest profit margin business. Life premium for this agency rose 10% to $560 million in 2010, after having increased 7% in 2009. Net sales increased 8% in 2010 to $138 million from $128 million in 2009, as this agency was Torchmark’s largest contributor to life net sales in 2010. Net sales rose 18% in 2009. First-year collected premium rose 16% in 2010 to $111 million, after having increased 17% in 2009. As in the case of all of Torchmark’s agency distribution systems, continued increases in product sales are largely dependent on increases in agent count. The American Income agent count was 3,912 at December 31, 2010 compared with 4,154 a year earlier, a decline of 6%. However, the agent count rose 35% in 2009 from 3,085 at year end 2008, after having risen 21% in 2008. This agency continues to recruit new agents focusing on an incentive program to reward growth in both the recruiting of new agents and in the production of new business. Additionally, the systematic, centralized internet recruiting program has enhanced the recruiting of new agents.
The Liberty Exclusive Agency agent counts have also decreased due to issues related to its health insurance business. Until recently, the agency’s health insurance marketing efforts had been focused on limited-benefit hospital-surgical plans. These plans were subject to intense competition which ultimately resulted in decreases in agent counts. In addition, these limited-benefit hospital-surgical plans became less marketable due to healthcare reform developments. Sales of these limited-benefit hospital/surgical plans were discontinued after September, 2010. In response, the agency has shifted its marketing focus to a product mix more weighted towards life insurance and supplemental health insurance products (not affected by healthcare reform) that have higher margins and persistency. We believe this will increase the Agency’s profitability and stability in the long run.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 7% in 2010 to $455 million after rising 3% in 2009. As a percentage of life insurance premium, gross margins have been stable each year at 27%. Margin growth in all periods was primarily the result of premium growth.
Health Insurance. Health insurance sold by Torchmark includes primarily Medicare Supplement and Part D prescription drug coverage to enrollees in the federal Medicare program, cancer coverage, and accident coverage. All health coverage plans other than Medicare Supplement and Part D are classified here as limited-benefit plans. For several years, our primary health insurance product had been hospital/surgical plans. However, as previously mentioned, these plans became subject to intense competition which resulted in decreasing agent counts. In addition, these plans became less marketable due to healthcare reform developments. These factors contributed to the Company’s decisions to de-emphasize and discontinue the marketing of these products. In 2010, Medicare Supplement sales exceeded those of the limited-benefit products for the first time since 2001, and represented 56% of health net sales exclusive of Medicare Part D. Medicare Supplement sales have been stronger than limited-benefit sales due in part to changes in agent counts in our health distribution groups discussed below.
Total Medicare Part D premium and health premium exclude $.5 million in 2010 and $2.5 million in 2009 of risk-sharing premium paid to the Centers for Medicare and Medicaid Services consistent with the Medicare Part D contract. In 2008, $122 thousand of risk-sharing premium was received, increasing premium. This risk-sharing amount is a portion of the excess or deficiency of actual over expected claims, and therefore we view this payment as a component of policyholder benefits in our segment analysis.
Index to Financial Statements We market supplemental health insurance products through a number of distribution channels with the United American Independent Agency being our market leader. The following table presents net sales by distribution method for the last three years.
Index to Financial Statements Medicare Supplement provides the greatest amount of health premium, partially because Medicare Supplement products are generally more persistent than the limited-benefit products, but also because of more stable sales in recent periods. Medicare Supplement premium represented 58% of non-Part D health premium in 2010, compared with 55% in 2009 and 51% in 2008.
The Liberty National Exclusive Agency is Torchmark’s largest in terms of health premium income. In 2010, this Agency represented 43% of all Torchmark non-Part D income health premium at $331 million. The Liberty Agency markets Medicare Supplements and limited-benefit health products including cancer insurance. In 2010, health premium income in this Agency declined 15% from prior year premium of $389 million. Premium also fell 18% in 2009 from $476 million. First-year collected premium declined 52% to $16 million in 2010, after declining 62% a year earlier. As noted earlier, increased competition in the health insurance market and our de-emphasis of certain health products has caused declines in agent counts. Marketing of the de-emphasized products was discontinued altogether after September, 2010. The decline in agent counts has resulted in decreased new sales, translating into declines in premium. Net sales for 2010 declined 52% from $30 million in 2009 to $14 million. In 2009, this Agency’s net sales fell 64%. Also discussed under the Life Insurance caption are efforts designed to strengthen this Agency.
The UA Independent Agency is composed of independent agencies appointed with Torchmark whose size range from very large, multi-state organizations down to one-person offices. All of these agents generally sell for a number of insurance companies. Torchmark had 1,406 active producing agents at December 31, 2010. This agency is our largest distributor of non-Part D health insurance in terms of health net sales, representing 50% in 2010. This agency is also our largest carrier of Medicare Supplement insurance, with $267 million or 59% of our Medicare Supplement premium income in 2010. Net sales for this Agency dropped 25% to $32 million in 2010, after having gained 14% to $43 million in 2009. Medicare Supplement net sales of $27 million declined 10% from $30 million a year earlier. Medicare Supplement net sales had more than doubled in 2009 over net sales of $15 million in 2008. The increases in 2009 were due to increases in group Medicare Supplement sales. Group Medicare Supplement sales fluctuate greatly from period to period and do not indicate a trend. Total health premium income for the UA Independent Agency was $315 million in 2010, a 4% decline from 2009 premium of $326 million. Premium income also declined 9% in 2009 from 2008. These declines in premium have resulted as new sales have not compensated for lapses.
The American Income Exclusive Agency, predominantly a life insurance distribution channel, is our third largest health insurance distributor based on 2010 premium collected. Its health plans are comprised of various limited-benefit plans. Approximately 70% of the agency’s 2010 health premium was from accident policies. Sales of the plans by this agency are generally made in conjunction with a life policy being sold to the same customer.
Health premium at this agency rose 5% in 2010 to $79 million, after having increased 2% to $75 million in 2009. Net health sales were $13 million in both 2010 and 2009, compared with $12 million in 2008. Net health sales comprised 9% of the American Income Agency’s total net sales in 2010.
Direct Response, primarily a life operation, also offers health insurance, which is predominantly Medicare Supplements sold directly to employer or union sponsored groups. In 2010, net health sales were $5 million, comprising approximately 4% of Direct Response’s total life and health net sales. Direct Response health premium income has risen each year over the prior year. Health premium rose 17% in 2010 to $54 million and 3% in 2009.
Medicare Part D. Torchmark, through its subsidiary United American, offers coverage under the government’s Medicare Part D plan. The Medicare Part D plan is a stand-alone prescription drug plan for Medicare beneficiaries. Part D is regulated and partially funded by the Centers for Medicare and Medicaid Services (CMS) for participating private insurers like United American, unlike the traditional Medicare program for hospital and doctor services, where CMS is the primary insurer and private Medicare Supplement insurers are secondary insurers. The program generally calls for CMS to pay approximately two thirds of the premium with the insured Medicare beneficiary paying one third of the premium. Total Medicare Part D premium was $209 million in 2010, compared with $184 million in 2009, an increase of 14%. Part D premium rose 5% in 2009. Changes in Part D premium generally result from changes in the
Annuities. As described in Note 3-Discontinued Operations, we sold our subsidiary United Investors. United Investors was our carrier of variable annuities and a primary carrier of fixed annuities. As a result of the sale, we disposed of approximately 37% of our annuity deposit balance as of December 31, 2010, including all variable annuities. These balances have been reported as “Held for Sale” on the Consolidated Balance Sheets of prior periods. Accordingly, we do not expect that annuities will be a significant portion of our business or marketing strategy going forward.
Index to Financial Statements As mentioned in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements, we settled litigation for $2.5 million in 2008 relating to issues occurring many years ago. As previously noted, we do not consider the costs of settling litigation applicable to prior periods to be related to current insurance operations. Stock compensation expense declined in 2009, primarily as a result of the lower stock price caused by the severe market decline in 2009 and the effect it had on values at the time of our annual stock and stock option grants for 2009. Expense related to the new 2009 grants replaced the expense for costlier older grants that became fully vested. Stock compensation expense rose in 2010 as market conditions improved, resulting in higher values for stock and option grants in 2010. Management believes that stock compensation expense will increase slightly in 2011. As stated in Note 14-Business Segments in the Notes to Consolidated Financial Statements, management views stock compensation expense as a corporate expense, and therefore treats it as a Parent Company expense. As described in Note 4-Investments under the caption Other-than-temporary impairments, we wrote down certain Company-occupied real estate because it met our criteria as described in that note for other-than-temporary impairment. As a result, we incurred a pretax charge of $2.1 million in 2008 and $355 thousand in 2009 which are included in Operating expenses in the Consolidated Statements of Operations in the respective year.
Excess investment income increased $21 million or 8% in 2010 over the prior year. Excess investment income declined $28 million or 9% in 2009. On a per diluted share basis, excess investment income rose 9% to $3.62 per share in 2010, after having declined 3% in the prior year. Share purchases caused the 2010 increase in per share excess investment income to be greater than the dollar amount of increase. Likewise, those purchases also caused the decline in per share excess investment income in 2009 to be less than the decline in the dollar amount.
The largest component of excess investment income is net investment income, which rose 8% to $685 million in 2010. It increased 1% to $632 million in 2009 from $627 million in 2008. Presented in the following chart is the growth in net investment income compared with the growth in mean invested assets.
In 2010, the growth in net investment income exceeded the growth in mean invested assets (at amortized cost) for the first time in many years. One of the primary reasons that investment income has grown at a lower rate than mean invested assets has grown in recent years is that new investments have been made at yield rates lower than the yield rates earned on securities that matured or were otherwise disposed of. Another factor that has contributed to the relatively slower growth rate of investment income is the time lag between the date proceeds from maturities and dispositions are received and the date such proceeds are reinvested. During these lags, we have held cash at lower yields. One of the most important factors contributing to the low growth rate in investment income during 2009 is the fact that, due primarily to uncertainty about liquidity in the financial markets, we held significantly more cash and short term investments during 2009 than we did during 2010 and 2008. Had we not done so, and if short term investment rates had not been much lower during 2009 than in 2008, the growth rate in investment income during 2009 would have been approximately the same as the growth rate in mean assets.
Index to Financial Statements The table below presents the components of financing costs.
Financing costs increased $6 million or 8% in 2010. They rose $7 million or 11% in 2009. The increases in financing costs in both years reflect the issuance in June 2009 of $300 million principal amount 9 ¼% Senior Notes due in 2019. In 2010, we incurred a full year of interest on this issue. The increase in 2009 was partially offset by the maturity in August 2009 of $99 million principal amount 8 ¼% Senior Debentures. Short-term interest expense has trended downward over the past three years, decreasing $3 million in 2010 after having declined $4 million in 2009. These declines have resulted from significantly lower interest rates when compared with the respective prior year. The 2010 decrease was also impacted by a 22% decline in the average balance of commercial paper outstanding compared with 2009.
Investment Acquisitions. Torchmark’s current investment policy calls for investing almost exclusively in investment-grade fixed maturities generally with long maturities (maturity date more than 20 years after acquisition date) that meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. We believe this strategy is appropriate because our strong positive cash flows are generally stable and predictable. If such longer-term securities do not meet our quality and yield objectives, we consider investing in short-term securities, taking into consideration the slope of the yield curve and other factors at the time. During calendar years 2008 through 2010, Torchmark invested almost exclusively in fixed-maturity securities.
Index to Financial Statements Sales transactions. As disclosed in Note 4-Investments, the Company sold $703 million of fixed maturities at amortized cost in the third quarter of 2009, including $293 million of below- investment-grade securities. The market value for some of these securities increased significantly during the period to a level where, even though the sales price was less than amortized cost, management determined that better risk-adjusted returns could be achieved by selling rather than continuing to hold the securities. Other securities were sold at prices that produced gains to offset these losses for tax purposes. Due in large part to selling below-investment-grade securities and reinvesting the proceeds in investment-grade securities, below-investment-grade securities as a percentage of total fixed maturities at amortized cost declined from 15% at June 30, 2009 to 9% at December 31, 2009. The reduction in below-investment-grade securities had a positive impact on the risk-based capital position of our insurance subsidiaries.
Index to Financial Statements Because fixed maturities represent such a significant portion of our investment portfolio, the remainder of the discussion of portfolio composition will focus on fixed maturities. An analysis of our fixed-maturity portfolio by component at December 31, 2010 and December 31, 2009 is as follows:
Index to Financial Statements At December 31, 2010, fixed maturities had a fair value of $10.5 billion, compared with $9.1 billion at December 31, 2009. At December 31, 2010, fixed maturities were in a $108 million net unrealized gain position compared with an unrealized loss position of $455 million at December 31, 2009. Approximately 74% of our fixed maturity assets at December 31, 2010 at amortized cost were corporate bonds and 13% were redeemable preferred stocks. This compares with 73% corporate bonds and 14% redeemable preferred stocks at year end 2009. At December 31, 2010, less than 2% of the assets at amortized cost were residential mortgage-backed securities, other asset-backed securities, and collateralized debt obligations (CDOs). The $57 million of CDOs at amortized cost made up less than 1% of the assets and are backed primarily by trust preferred securities issued by banks and insurance companies. The $16 million of mortgage-backed securities are rated AAA. For more information about our fixed-maturity portfolio by component at December 31, 2010 and 2009, including an analysis of unrealized investment losses and a schedule of maturities, see Note 4-Investments in the Notes to Consolidated Financial Statements.
As shown in the table above, the ratio of gross unrealized losses to book value was greater than 45% for our investments in CDOs and the financial guarantor sector. We evaluated each of the impaired securities in these and all other sectors to determine whether or not any of the impairments were other-than-temporary. Certain information about our evaluation of the impaired securities in the CDO and monoline insurer sectors is provided in the following paragraphs.
Index to Financial Statements At December 31, 2010, we held investments in five different CDOs. In our opinion, our investments in four of these CDOs were other-than-temporarily impaired. Three of these CDOs have been written down to a carrying value of zero. The fourth is carried at a value of $34 million, less than the present value of discounted future cash flows at original purchase yield but greater than its fair value of $17 million. The fifth CDO ($22 million amortized cost and $6 million fair value) we believe was not other-than-temporarily impaired. At December 31, 2009, the four CDOs that were other-than-temporarily impaired had an amortized cost of $34 million ($13 million fair value). The CDO that was not other-than-temporarily impaired had an amortized cost of $21 million ($5 million fair value). In reaching these conclusions concerning other-than-temporary impairment, we reviewed and discussed with the collateral managers of each of these CDOs the current status of the collateral underlying our investments, the credit events (defaults and deferrals in underlying collateral) experienced to date, and the possibility of future credit events. We calculated expected future cash flows using assumptions for expected future credit events that reflect actual historical experience and expected future experience. We reviewed the actual versus expected cash flows received to date and the impact that potential future credit events would have on our expected future cash flows. We calculated the magnitude of future credit events that could be experienced without negatively impacting the recovery of our investment and our expected yield rate. While there is a possibility that future credit events will exceed our current expectations, we believe there is ample evidence to support our conclusions.
Also at December 31, 2009, we held investments issued by five different monoline insurers. In our opinion, our investments in three of these monoline insurers ($9 million amortized cost and $10 million fair value) were other-than-temporarily impaired. These securities were sold in 2010 for $12 million for a realized gain of $3 million. Our investments in the other two monoline insurers ($83 million amortized cost and $37 million fair value at December 31, 2009) were not believed to be other-than-temporarily impaired. At December 31, 2010, these two investments were carried at an amortized cost of $84 million (fair value $56 million). We collected and analyzed a significant amount of information to form opinions about the reasons for the severity of our impairments, including the illiquidity of some of our holdings (and its impact on fair values), the expected future experience in the mortgage market, and the reasonable expectation of the receipt of all future contractual interest and principal payments for these investments. We reviewed news and information about the economy and the mortgage market in general and about the issuers of our investments. We reviewed and analyzed financial statements and had discussions with sell-side and independent credit analysts who follow this sector, certain regulators, and members of the management teams of some of the issuers of our investments. While there is a possibility that future experience in the mortgage markets will differ from our current expectations, we believe there is ample evidence to support our conclusions.
Index to Financial Statements An analysis of the fixed-maturity portfolio by a composite rating at December 31, 2010 is shown in the table below.
The portfolio has a weighted average quality rating of BBB+ based on amortized cost. Approximately 92% of the portfolio at amortized cost was considered investment grade. Our investment portfolio contains no securities backed by sub-prime or Alt-A mortgages (loans for which some of the typical documentation was not provided by the borrower). We have no direct investments in residential mortgages, nor do we have any counterparty risks as we are not a party to any credit default swaps or other derivative contracts. We do not participate in securities lending. There are no off-balance sheet investments, as all investments are reported on our Consolidated Balance Sheets. At December 31, 2010, we had $22 million at fair value ($57 million book value) invested in CDOs, for which the composite rating at that date was C+. The collateral underlying these CDOs is primarily trust preferred securities issued by banks and insurance companies, and no sub-prime or Alt-A mortgages are included in the collateral.
Realized Gains and Losses. Our life and health insurance companies collect premium income from policyholders for the eventual payment of policyholder benefits, sometimes paid many years or even decades in the future. In addition to the payment of these benefits, we also incur acquisition costs, administrative expenses, and taxes as a part of insurance operations. Because benefits are expected to be paid in future periods, premium receipts in excess of current expenses are invested to provide for these obligations. For this reason, we hold a significant investment portfolio as a part of our core insurance operations. This portfolio consists primarily of high-quality fixed maturities containing an adequate yield to provide for the cost of carrying these long-term insurance product obligations. As a result, fixed maturities are generally held for long periods to support the liabilities. Expected yields on these investments are taken into account when setting insurance premium rates and product profitability expectations.
As described in Note 4-Investments under the caption Other-than temporary impairments in the Notes to Consolidated Financial Statements, we wrote certain securities down to fair value during each year 2008 through 2010 as a result of other-than-temporary impairment. The impaired securities met our criteria for other-than-temporary impairment as discussed in Note 4 and in our Critical Accounting Policies in this report. The writedowns resulted in pretax charges of $5 million in 2010 ($3 million after tax), $143 million in 2009 ($94 million after tax), and $106 million in 2008 ($69 million after tax). The 2009 charge included $83 million on CDOs ($55 million after tax) and $24 million on monoline financial guarantors and mortgage insurers ($16 million after tax). The remaining writedowns in 2009 were from losses on a variety of corporate bonds. In 2008, the significant bonds written down were Lehman Brothers bonds of $74 million pretax ($48 million after tax) and Washington Mutual bonds of $19 million pretax ($12 million after tax). Other writedowns in 2008 included perpetual preferred stocks of Federal National Mortgage Association and certain non-financial securities.
Parent Company Liquidity. Cash flows from the insurance subsidiaries are used to pay Parent Company dividends on common and preferred stock, interest and principal repayments on Parent Company debt, and operating expenses of the Parent. In 2010, the Parent received $401 million of dividends and transfers from its insurance subsidiaries, as compared with $392 million in 2009 and $437 million in 2008. After paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), Torchmark Parent had excess operating cash flow in 2010 of approximately $269 million. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2011, it is expected that the Parent Company will receive $742 million in dividends from subsidiaries, including approximately $305 million of the proceeds from the sale of United Investors, and that approximately $655 million will be available as excess cash flow. Certain restrictions exist on the payment of these dividends. For more information on the restrictions on the payment of dividends by subsidiaries, see the restrictions section of Note 12-Shareholders’ Equity in the Notes to Consolidated Financial Statements. Although these restrictions exist, dividend availability from subsidiaries historically has been sufficient for the cash flow needs of the Parent Company. As additional liquidity, the Parent held $63 million of cash and short-term investments at December 31, 2010, compared with $155 million a year earlier. The Parent also had available a $138 million receivable from subsidiaries at December 31, 2010.
Short-Term Borrowings. An additional source of parent company liquidity is a line of credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $600 million. As described in the Commercial Paper section of Note 11-Debt in the Notes to Consolidated Financial Statements, this facility was entered into on December 10, 2010 and replaced an earlier $600 million facility which would have expired in August, 2011. As of December 31, 2010, we had available $203 million under this facility. For detailed information about this new line of credit facility, see the Commercial Paper section of Note 11-Debt.
There have been no difficulties in accessing the commercial paper market under this facility during the years ending December 31, 2010 and 2009.
In summary, Torchmark expects to have readily available funds for 2011 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, a short-term credit facility, and intercompany borrowing.
Our cash and short-term investments were $582 million at year-end 2010 and $529 million at year-end 2009. Included in cash at December 31, 2010 was the $343 million of proceeds received from the sale of United Investors on that date. Additionally, we have a portfolio of marketable fixed and equity securities that are available for sale in the event of an unexpected need. These securities had a fair value of $10.5 billion at December 31, 2010. 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 fully described and discussed in Note 11-Debt in the Notes to the Consolidated Financial Statements and under the subcaption Funded Debt, Torchmark had outstanding $120 million (par amount) 7.1% Trust Preferred Securities at both December 31, 2010 and 2009. The capital trust liable for these securities is the legal entity which is responsible for the securities and facilitates the payment of dividends to shareholders. The trust is an off-balance sheet arrangement which we are required to deconsolidate in accordance with GAAP rules. Deconsolidation is required because the capital trust is considered to be a variable interest entity in which we have no variable interest. Therefore Torchmark is not the primary beneficiary of the entity, even though we own all of the entity’s voting equity and have guaranteed the entity’s performance. While these liabilities are not on our Consolidated Balance Sheets, they are represented by Torchmark’s 7.1% Junior Subordinated Debentures due to the trust. These Junior Subordinated Debentures were a Torchmark liability of $124 million par and book value at both December 31, 2010 and 2009. These securities are indicated as a capital resource to us under the caption Capital Resources in this report. The 7.1% preferred dividends due to the preferred shareholders are funded by our 7.1% interest payment on our debt to the trusts. As described in Note 15-Commitments and Contingencies in the Notes to Consolidated Financial Statements, we have guaranteed the performance of the capital trust to meet its financial obligations to the Trust Preferred shareholders.
Index to Financial Statements As a part of its above-mentioned credit facility, Torchmark has outstanding $198 million in stand-by letters of credit. However, these letters are issued among our subsidiaries and have no impact on company obligations as a whole.
As of December 31, 2010, we had no other significant unconsolidated affiliates and no guarantees of the obligations of third-party entities other than as described above. All of our guarantees, other than the Trust Preferred guarantee, were guarantees of the performance of consolidated subsidiaries, as disclosed in Note 15-Commitments and Contingencies.
The following table presents information about future payments under our contractual obligations for the selected periods as of December 31, 2010.
(2) Interest on debt is based on our fixed contractual obligations.
(5) Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force at December 31, 2010. 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 $9.2 billion at December 31, 2010, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
Index to Financial Statements Capital Resources. Torchmark’s capital structure consists of short-term debt (the commercial paper facility described in Note 11-Debt in the Notes to Consolidated Financial Statements), long-term funded debt, Junior Subordinated Debentures supporting its Trust Preferred Securities, and shareholders’ equity. The Junior Subordinated Debentures are payable to Torchmark’s Capital Trust III which is liable for its Trust Preferred Securities. In accordance with GAAP, these instruments are included in “Due to affiliates” on the Consolidated Balance Sheets. A complete analysis and description of long-term debt issues outstanding is presented in Note 11-Debt in the Notes to Consolidated Financial Statements.
The carrying value of the funded debt was $913 million at December 31, 2010, compared with $920 million a year earlier. As fully explained in Note 11-Debt, we issued $300 million principal amount of 9¼% Senior Notes due in 2019 in June of 2009 for proceeds of $296 million. A portion of these proceeds were used to repay the $99 million due upon the August, 2009 maturity of our 8¼% Senior Debentures. Of the $197 million balance of the proceeds, $175 million was contributed as capital to our insurance subsidiaries in 2009. The subsidiaries then in turn invested these funds in investment-grade corporate bonds and municipal bonds. The capital contributions were made as a result of our desire to maintain subsidiary regulatory capital at levels adequate to meet the requirements of rating agencies.
Poor economic conditions experienced during 2009 caused the ratings of many bonds in our insurance subsidiaries’ portfolios to be downgraded and also resulted in increased other-than-temporary impairments taken. This large volume of ratings downgrades and impairments in 2009 had a significant negative effect on the subsidiaries’ regulatory capital. Our insurance subsidiaries generally target a capital ratio of at least 325% of required 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. RBC was favorably impacted in 2009 by these capital contributions and the sales of below-investment-grade securities discussed under the caption Investments-Sales Transactions in this report. Improvements in financial markets in 2010 which resulted in rating upgrades in the bond portfolios further strengthened the capital position of our insurance subsidiaries in 2010. At both December 31, 2010 and 2009, our insurance subsidiaries in the aggregate had RBC ratios in excess of 350%. Should we experience additional impairments and ratings downgrades in the future and the ratio falls below 325%, management has available cash on hand and a credit line at the Parent Company to make additional contributions as necessary to maintain the ratios at or above 325%.
As noted under the caption Highlights in this report, we reactivated our share repurchase program during the first quarter of 2010. We previously had suspended the program indefinitely in March, 2009 due to general economic conditions at that time. Under this program, we acquired 4 million shares at a cost of $204 million in 2010 (average of $53.51 million per share), 2 million shares for $47 million in 2009, and 8 million shares for $427 million in 2008. The majority of purchased shares are retired each year. Please refer to the description of our share repurchase program under the caption Highlights in this report.
Torchmark has recently increased the dividend on its common shares. In the first quarter of 2010, the dividend was increased from $.14 per share to $.15 per share and in the fourth quarter of 2010, it was further increased to $.16 per share.
We plan to use excess cash as efficiently as possible in the future but we will be cautious in doing so. Excess cash flow could be used for share repurchases, acquisitions, increases in shareholder dividends, investment in fixed maturities, or repayment of short-term debt. We will determine the best use of excess cash after ensuring that desired capital levels are maintained in our companies.
** Includes Torchmark’s 7.1% Junior Subordinated Debentures in 2010 and 2009 in the amount of $124 million.
During the three year period ended December 31, 2010, each of the rating agencies revised the outlook for Torchmark from stable to negative and then back to stable. Reasons cited for the negative outlook included increased risk in our investment portfolio, tighter liquidity, and reduced financial flexibility. Reasons cited for the revision back to a stable outlook included improved financial flexibility, increased capital levels at the insurance subsidiaries, the decrease in unrealized losses, and strong operating performance.
The credit quality of Torchmark’s debt instruments and capital securities are rated by various rating agencies. During 2009, A. M. Best downgraded our preferred stock from bbb+ to bbb. Also in 2009, Fitch downgraded our Senior Debt from A to BBB+ (two notches), our preferred stock from A- to BBB (two notches), and our commercial paper from to (one notch). Fitch stated that the downgrades were a result of the weakness in the statutory capital position of Torchmark’s insurance subsidiaries brought on by the ratings downgrades of fixed maturity securities held in the subsidiaries’ investment portfolios. They also expressed concern with the level of intercompany financing by the Parent Company from the subsidiaries, the ongoing exposure to financial market turmoil, and the expectation of continued investment deterioration going forward. In January, 2010, Fitch further downgraded our preferred stock one notch to BBB-. At that time, Fitch downgraded over 200 hybrid securities issued by insurance industry entities, as their assessments of these securities in our industry changed.
The financial strength of our major insurance subsidiaries is also rated by Standard & Poor’s and A. M. Best. The following chart presents these ratings for our four largest insurance subsidiaries at December 31, 2010.
A.M. Best states that it assigns an A+ (Superior) rating to those companies which, in its opinion, have demonstrated superior overall performance when compared to the norms of the life/health insurance industry. A+ (Superior) companies have a superior ability to meet their obligations to policyholders over a long period of time. The A.M. Best A (Excellent) rating is assigned to those companies which, in its opinion, have demonstrated excellent overall performance when compared to the norms of the life/health insurance industry. A (Excellent) companies have an excellent ability to meet their obligations to policyholders over a long period of time.
Index to Financial Statements The AA financial strength rating category is assigned by Standard & Poor’s Corporation to those insurers which have very strong financial security characteristics, differing only slightly from those rated higher. The minus sign (-) shows the relative standing within the major rating category. The A rating is assigned to an insurer with strong financial security characteristics, somewhat more likely to be affected by adverse business conditions than insurers with higher ratings.
Litigation. Torchmark and its subsidiaries are subject to being named as parties to pending or threatened litigation, much of which involves punitive damage claims based upon allegations of agent misconduct at the insurance subsidiaries. Such punitive damage claims that are tried in Alabama state courts may have the potential for significant adverse results since punitive damages in Alabama are based upon the compensatory damages (including mental anguish) awarded and the discretion of the jury in awarding compensatory damages is not precisely defined. Additionally, it should be noted that our subsidiaries actively market insurance in the State of Mississippi, a jurisdiction which is nationally recognized for large punitive damage verdicts. This bespeaks caution since it is impossible to predict the likelihood or extent of punitive damages that may be awarded if liability is found in any given case. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, contingent liabilities arising from threatened and pending litigation are not presently considered by us to be material. For more information concerning litigation, please refer to Note 15-Commitments and Contingencies in the Notes to the Consolidated Financial Statements.
Policy Acquisition Costs: This new accounting guidance amends the accounting for costs associated with acquiring or renewing insurance contracts in order to address the diversity in practice surrounding the capitalization and deferral of these costs. This guidance will be effective for Torchmark beginning January 1, 2012, with early adoption permitted. Prospective or retrospective application is permitted. We are currently evaluating the new guidance. At this time we expect its adoption to reduce our shareholders’ equity approximately 8% at the time of adoption. We intend to adopt this guidance retrospectively. Because both the deferral and amortization of acquisition costs will be lower in future periods, and those effects are largely offsetting, we do not expect that there will be a material impact on operating results going forward.
Deferred Acquisition Costs and Value of Insurance Purchased. The costs of acquiring new business are generally deferred and recorded as an asset. Deferred acquisition costs consist primarily of sales commissions and other underwriting costs of new insurance sales. Additionally, the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies are also deferred and recorded as assets under the caption “Value of Insurance Purchased” as indicated in Note 5-Deferred Acquisition Costs and Value of Insurance Purchased in the Notes to Consolidated Financial Statements. Our policies for accounting for deferred acquisition costs and the associated amortization are reported in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements.
Approximately 97% of our recorded amounts for deferred acquisition costs at December 31, 2010 were related to traditional products and are being amortized over the premium-paying period in proportion to the present value of actual historic and estimated future gross premiums. The projection assumptions for this business are set at the time of contract issue. These assumptions are “locked-in” at that time and, except where there is a loss recognition issue, are not revised for the lifetime of the contracts. Absent a premium deficiency, variability in amortization after policy issuance is caused only by variability in premium volume. We have not recorded a deferred acquisition cost loss recognition event for assets related to this business for any period in the three years ended December 31, 2010.
The remaining portion of deferred acquisition costs pertain to deposit business for which deferred acquisition costs are amortized over the estimated lives of the contracts in proportion to actual and estimated future gross profits. These contracts are not subject to lock-in. The assumptions must be updated when actual experience or other evidence suggests that earlier estimates should be revised. As noted earlier in this report, our variable annuity block was disposed of as of December 31, 2010. Revisions related to our deposit business assets have not had a material impact on the amortization of deferred acquisition costs during the three years ended December 31, 2010.
During recent periods, the values of our fixed maturities were also affected by illiquidity in the financial markets, which contributed to a spread widening, and accordingly unrealized losses, on many securities that we 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 4-Investments under the caption Fair Value Measurements.
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 material differences in reported results for these plans. While we have used our best efforts to determine the most reliable assumptions, given the information available from company experience, economic data, independent consultants and other sources, we cannot be certain that actual results will be the same as expected. Our discount rate, rate of
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2010
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31,
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.
Torchmark accounts for its variable interest entities under accounting guidance which clarifies the definition of a variable interest and the instructions for consolidating variable interest entities (VIE’s). Primary beneficiaries only are required to consolidate VIE’s. Therefore, a company may have voting control of a VIE, but if it is not the primary beneficiary of the VIE, it is not permitted to consolidate the VIE. The trust that is liable for Torchmark’s Trust Preferred Securities meets the definition of a VIE. However, Torchmark is not the primary beneficiary of this entity because its interest is not variable. Therefore, Torchmark is not permitted to consolidate its interest, even though it owns 100% of the voting equity of the trust and guarantees its performance. For this reason, Torchmark reports its 7.1% Junior Subordinated Debentures due to the trust as “Due to affiliates” each period at its carrying value. However, Torchmark views the Trust Preferred Securities as it does any other debt offering and consolidates the trust in its segment analysis because GAAP requires that the segment analysis be reported as management views its operations and financial condition.
Consolidated Statements of Operations for current and prior periods commencing in the period in which the business is either disposed of or is accounted for as a disposal group, including any gain or loss recognized on the sale or adjustment of the carrying amount to fair value less cost to sell. Major components of the income from discontinued operations are separately disclosed in Note 3 - Discontinued Operations in the Notes to the Consolidated Financial Statements. Because the business has been sold or classified as held for sale, and its operations are discontinued, the financial results of the business are excluded from the Notes to the Consolidated Financial Statements, other than in Note 3, the Consolidated Statements of Cash Flows, and Note 2 - Statutory Accounting.
Fair Value Measurements: Fair values for cash, short-term investments, short-term debt, receivables and payables approximate carrying value. Fair values for long-term debt investments and equity securities are determined in accordance with specific accounting guidance. Fair values are based on quoted market prices, where available. Otherwise, fair values are based on quoted market prices of comparable instruments in active markets, quotes in inactive markets, or other observable criteria. For specific information regarding Torchmark’s measurements and procedures in valuing financial instruments, please see Note 4-Investments under the caption Fair value measurements. The fair values of Torchmark’s long-term debt issues, along with the trust preferred securities, are based on quoted market prices. Mortgage loans are valued at discounted cash flows.
Recognition of Premium Revenue and Related Expenses: Premium income for traditional long-duration life and health insurance products is recognized when due from the policyholder. Premiums for short-duration health contracts are recognized as revenue over the contract period in proportion to the insurance protection provided. Profits for limited-payment life insurance contracts are recognized over the contract period. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Life premium includes policy charges of $26 million, $28 million, and $31 million for the years ended December 31, 2010, 2009, and 2008, respectively. Other premium consists of annuity policy charges in each year. Profits are also earned to the extent that investment income exceeds policy liability interest requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period.
Deferred Acquisition Costs and Value of Insurance Purchased: The costs of acquiring new business are generally deferred and recorded as an asset. Deferred acquisition costs consist primarily of sales commissions and other underwriting costs of new insurance sales. Additionally, deferred acquisition costs include the value of insurance purchased, which are the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies. Deferred acquisition costs and the value of insurance purchased are amortized in a systematic manner which matches these costs with the associated revenues. Policies other than universal life-type policies are amortized with interest over the estimated premium-paying period of the policies in a manner which charges each year’s operations in
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. The estimate of unreported claims is based on prior experience. Torchmark makes an estimate after careful evaluation of all information available to the Company. 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.
Separate Accounts: Separate accounts were previously established in connection with Torchmark’s variable life and annuity businesses. Torchmark disposed of this business as of December 31, 2010. Accordingly, separate account assets and liabilities were included in “Assets or Liabilities of subsidiary held for sale,” respectively, as of December 31, 2009.
Low-Income Housing Tax Credit Interests: As of December 31, 2010, Torchmark had $283 million invested in limited partnerships that provide low-income housing tax credits and other related Federal income tax and state premium tax benefits to Torchmark. The carrying value of Torchmark’s investment in these entities was $169 million at December 31, 2009. As of December 31, 2010, Torchmark was obligated under future commitments of $122 million, which amount is included in the above carrying value. Interests for which the return has been guaranteed by unrelated third-parties are accounted for using the effective-yield method. The remaining interests are accounted for using the amortized-cost method.
For 2010, the Federal income benefits accrued during the year, net of the amortization associated with guaranteed interests, were recorded in “Income Tax Expense.” Amortization associated with non-guaranteed interests was reflected as a component of “Net Investment Income.” For years prior to 2010, the Federal income tax benefits accrued during the year, net of amortization associated with all interests,
Goodwill: The excess cost of businesses acquired over the fair value of their net assets is reported as goodwill. Goodwill is subject to annual impairment testing based on certain procedures outlined by GAAP. Amortization of goodwill is not permitted. Torchmark tested its goodwill annually in each of the years 2008 through 2010. The tests involve assigning the Company’s carrying value to each of the reporting units of Torchmark’s segments, including the portion of goodwill assigned to each reporting unit. The fair value of each reporting unit is measured against that reporting unit’s corresponding carrying value. Because the estimated fair value exceeded the carrying value, including goodwill, of each reporting unit in each period, Torchmark’s goodwill was not impaired in any of the periods. Approximately $27 million of goodwill was associated with a subsidiary sold in 2010, described more fully in Note 3-Discontinued Operations.
Torchmark received an additional pre-tax litigation settlement, net of expenses, of $1.3 million in 2008 ($.9 million after tax) from investment litigation. Legal settlement costs in the amount of $2.5 million in 2008 ($1.6 million after tax) were expensed relating to litigation issues arising in prior periods and concerning events occurring many years ago.
The investment litigation receipts were included in “Other income” in the Consolidated Statement of Operations. The legal settlement costs were included in “Other operating expense.” The income tax settlements were included as reductions to “Income taxes.”
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 2008 through 2010 is as follows:
All of the above assumptions, with the exception of the expected term, are obtained from independent data services. The expected term is generally derived from Company experience. However, expected terms of grants made under the Torchmark Corporation 2005 Incentive Plan (2005 Plan) and the 2007 Long-Term Compensation Plan (2007 Plan), involving grants made in the years 2005 through 2010, were determined based on the simplified method as permitted by Staff Accounting Bulletins 107 and 110. This method was used because the 2005 and 2007 Plans limited grants to a maximum contract term of seven years, and Torchmark had no previous experience with seven-year contract terms. Prior to 2005, substantially all grants contained ten-year terms. Because a large portion of these grants vest over a three-year period, the Company did not have sufficient exercise history during 2010 or previous years to determine an appropriate expected term on these grants. 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).
Due to the sale, Torchmark’s consolidated financial statements are presented to reflect the transactions as discontinued operations. The primary operations of United Investors involve lines of business that Torchmark no longer emphasizes. Therefore, Torchmark management believes this transaction will allow the Company to focus on its core protection life and health insurance businesses, as well as provide additional capital.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2010 and 2009 is as follows:
A schedule of fixed maturities by contractual maturity at December 31, 2010 is shown below on an amortized cost basis and on a fair value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions.
The collateral underlying collateralized debt obligations for which fair values are reported as Level 3 consists primarily of trust preferred securities issued by banks and insurance companies. None of the collateral is subprime or Alt-A mortgages (loans for which the typical documentation was not provided by the borrower). Of the change in the fair value of Level 3 assets still held at December 31, 2010, $500 thousand of net realized investment gains was included in net income. At December 31, 2009, the charge to earnings was $86 million.
Torchmark adopted additional new guidance concerning the disclosures of fair value as of January 1, 2010. This new guidance expanded fair value disclosures by requiring the disclosure of transfers between the Level 1 and Level 2 classifications and the reasons for the transfers; more detail about the activity
Other-than-temporary impairments: Torchmark’s portfolio of fixed maturities fluctuates in value due to changes in interest rates in the financial markets as well as other factors. Fluctuations caused by market interest rate changes have little bearing on whether or not the investment will be ultimately recoverable. Therefore, Torchmark considers these declines in value resulting from changes in market interest rates to be temporary. In certain circumstances, however, Torchmark determines that the decline in the value of a security is other-than-temporary and writes the book value of the security down to its fair value, realizing an investment loss. The evaluation of Torchmark’s securities for other-than-temporary impairments is a process that is undertaken not less frequently than quarterly and is overseen by a team of investment and accounting professionals. Each security which is impaired because the fair value is less than the cost or amortized 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:
During 2009, the Company determined that certain of its holdings in fixed maturities were other-than-temporarily impaired, resulting in writedowns of $143 million ($94 million after tax) on CDOs and corporate bonds. The pretax writedown included the writedowns of CDOs with a carrying amount of $117 million to a fair value of $13 million, resulting in a total pretax writedown of $104 million. However, in accordance with accounting guidance regarding other-than-temporary impairments, $83 million of the writedown was determined to be the result of a credit loss and was charged to earnings while the remaining $21 million was charged to other comprehensive income. The credit loss portion on the CDOs was determined as the difference between the securities’ amortized cost and the present value of expected future cash flows. These expected cash flows were determined using judgment and the best information available to the Company, and were discounted at the securities’ original effective yield rate. Inputs used to derive expected cash flows included expected default rates, current levels of subordination, and loan-to-collateral value ratios. Management has determined that the present value of future cash flows is a better measure of fair value due to limited observable market data and because the market for these securities is not active and does not reflect orderly transactions. The pre-tax writedown for other-than-temporary impairment on corporate bonds of $77 million was all credit related and was included in the charge to earnings.
As of year end 2010, previously written down securities remaining in the portfolio were carried at a fair value of $68 million. Otherwise, as of December 31, 2010, Torchmark has no information available to cause it to believe that any of its investments are other-than-temporarily impaired. Torchmark has the ability and intent to hold these investments to recovery, and does not intend to sell nor expects to be required to sell its other impaired securities.
Unrealized loss analysis. Net unrealized losses on fixed maturities declined from $1.7 billion at December 31, 2008 to $455 million at December 31, 2009, and then became a net unrealized gain of $108 million at December 31, 2010. At December 31, 2010, investments in securities in the financial sector were in a $115 million unrealized loss position, while investments in securities in the other sectors had net gains of $223 million. The financial sector accounted for over 99% of the net unrealized losses in 2009. At December 31, 2008, the financial sector accounted for 56% of the net unrealized losses. Based upon conditions experienced by companies in the bond market and the commercial paper market,
management believes that much of the unrealized loss at December 31, 2008 and during the early part of 2009 was attributable to illiquidity in the financial market which contributed to a spread widening, resulting in increased unrealized losses on many securities that management expects to be fully recoverable. Accordingly, as conditions in financial markets have improved since early 2009, unrealized gains in the portfolio have occurred. Due to the strong and stable cash flows generated by its insurance products, Torchmark has the ability to hold securities with temporary unrealized losses until recovery. Even though these fixed maturity investments are available for sale, Torchmark generally expects and intends to hold any securities which are temporarily impaired until they mature.
Torchmark had $9.6 million in fixed maturities at book value ($17.1 million at fair value) that were non-income producing during the twelve months ended December 31, 2010. Torchmark had $349 thousand in investment real estate at December 31, 2010 which was non-income producing during the previous twelve months. Torchmark did not have any other invested assets that were non-income producing during the twelve months ended December 31, 2010.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $2.6 million, $2.9 million, and $3.2 million for the years ended December 31, 2010, 2009, and 2008, respectively. The average interest rates used for the years ended December 31, 2010, 2009, and 2008 were 5.6%, 5.6%, and 5.5%, respectively. The estimated amortization, net of interest accrued, on the unamortized balance at December 31, 2010 during each of the next five years is: 2011, $4.8 million; 2012, $4.8 million; 2013, $4.7 million; 2014, $2.2 million; and 2015, $2.7 million.
Claims paid in each of the years 2008 through 2010 were settled for amounts less than anticipated when estimated at the previous year end. The most significant components of these favorable variances were in Torchmark’s UA Independent, UA Branch, and Medicare Part D distribution channels. In each of the years 2008 through 2010, paid health claims have trended downwards and were settled more favorably than the original estimates, resulting in reduced estimates of the claim liability in each year compared with the prior year. The Company’s estimates at each point have reflected the emerging data and trends. In the Medicare Part D channel, the Company is required to estimate claim discounts that will be received from drug manufacturers. In each of the years 2008 through 2010, the discounts from the drug manufacturers received in the current year but related to prior year claims were higher than anticipated when the claim liability was determined.
Torchmark’s Federal income tax returns are routinely audited by the Internal Revenue Service (IRS). The IRS completed its examination of the Company’s 2005, 2006, and 2007 tax years during 2009. The Company recorded a $2.5 million tax benefit to reflect the results of the examination, including a reduction in its liability for uncertain tax positions relating to these years. The statutes of limitation for the assessments of additional tax are closed for all tax years prior to 2007. Management believes that adequate provision has been made in the financial statements for any potential assessments that may result from future tax examinations and other tax-related matters for all open tax years.
If recognized in future periods, $-0-, $145 thousand, and $518 thousand of the balances at December 31, 2010, 2009, and 2008, respectively, would reduce the effective tax rate. The remaining balances relate to timing differences which, if recognized, would have no effect on the Company’s effective tax rate.
Short-term divergences due to rapid market movements are allowed. In recent periods, our holdings in equities declined while our holdings in fixed maturities increased. Contributions in each of the years 2010, 2009, and 2008 were $13 million, $15 million, and $63 million, respectively. These contributions were invested primarily in fixed maturities. The decline in equity values in both 2008 and early 2009 was also a contributing factor. While equity values have recovered somewhat in 2009 and 2010, fixed maturity values have also increased. Our asset allocation targets are currently under review.
The accumulated benefit obligation (ABO) for Torchmark’s funded defined benefit pension plans was $228 million and $191 million at December 31, 2010 and 2009, respectively. In the unfunded plans, the ABO was $27 million at December 31, 2010 and December 31, 2009.
Commercial Paper: In December, 2010, Torchmark entered into a new credit facility with a group of lenders allowing unsecured borrowings and stand-by letters of credit up to $600 million. The facility includes a provision which allows Torchmark to increase the facility limit by $200 million if certain conditions are met. The Company also has the ability to request up to $250 million in letters of credit to be issued against the facility. This agreement replaces an earlier agreement which would have expired in August, 2011. The new agreement is set to terminate on January 7, 2015. The credit facility is further designated as a back-up credit line for a commercial paper program, whereby Torchmark may borrow from either the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed the facility limit less any letters of credit issued. Interest is charged at variable rates. At December 31, 2010, Torchmark had $199 million face amount ($199 million carrying amount) of commercial paper outstanding, $198 million of letters of credit issued, and no borrowings under the line of credit. During 2010, the short term borrowings under the facility averaged approximately $196 million, and were made at an average yield of .4%, compared with an average balance of $251 million at an average yield of 1.1% a year earlier. The facility does not have a ratings-based acceleration trigger which would require early payment. A facility fee is charged for the entire facility at a rate of 17.5 basis points. For letters of credit issued, there is an issuance fee of 132.5 basis points. Torchmark is subject to certain covenants for the agreements regarding capitalization and earnings, with which it was in compliance at December 31, 2010 and throughout the three-year period ended December 31, 2010. Borrowings on the credit facilities are reported as short-term debt on the Consolidated Balance Sheets.
Acquisition of Common Shares: Torchmark shares are acquired from time to time through open market purchases under the Torchmark stock repurchase program when it is believed to be the best use of Torchmark’s excess cash flows. Torchmark suspended its share repurchase program temporarily from the first quarter of 2009 until the first quarter of 2010 because of uncertain economic conditions. Share repurchases under this program were 3.8 million shares at a cost of $204 million in 2010, 2.1 million shares at a cost of $47 million in 2009, and 7.6 million shares at a cost of $427 million in 2008. When stock options are exercised, proceeds from the exercises are generally used to repurchase approximately the number of shares available with those funds in order to reduce dilution. Shares repurchased for dilution purposes were 716 thousand shares at a cost of $42 million in 2010, 20 thousand shares at a cost of $869 thousand in 2009, and 487 thousand shares at a cost of $29 million in 2008.
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 limited to the greater of prior year statutory net income excluding realized capital gains on an annual noncumulative basis, or 10% of prior year surplus, in the absence of special regulatory approval. Additionally, insurance company distributions are generally not permitted in excess of statutory surplus. Subsidiaries are also subject to certain minimum capital requirements. In 2010, subsidiaries of Torchmark paid $371 million in dividends to the parent company. During 2011, a maximum amount of $742 million is expected to be available to Torchmark from subsidiaries without regulatory approval.
Stock options to purchase 6.8 million shares, 9.4 million shares, and 3.5 million shares, during the years 2010, 2009, and 2008, respectively, are considered to be anti-dilutive and are excluded from the calculation of diluted earnings per share. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
No equity awards were cash settled during the three years ended December 31, 2010.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represented 3.3% of life insurance in force at December 31, 2010 and reinsurance assumed on life and accident and health products represented .9% of premium income for 2010.
Leases: Torchmark leases office space and office equipment under a variety of operating lease arrangements. Rental expense for operating leases was $4.9 million in 2010, $4.9 million in 2009, and $5.1 million in 2008. Future minimum rental commitments required under operating leases having remaining noncancelable lease terms in excess of one year at December 31, 2010 were as follows: 2011, $3.7 million; 2012, $2.6 million; 2013, $2.4 million; 2014, $2.0 million; 2015, $2.0 million and in the aggregate, $16.8 million.
Low-Income Housing Tax Credit Interests: As described in Note 1, Torchmark has invested $283 million in entities which provide certain tax benefits. As of December 31, 2010, Torchmark remained obligated under these commitments for $122 million, of which $66 million is due in 2011, $52 million in 2012, and $4 million in 2013.
Concentrations of Credit Risk: Torchmark maintains a diversified investment portfolio with limited concentration in any given issuer. At December 31, 2010, the investment portfolio, at fair value, consisted of the following:
At year-end 2010, 7% of invested assets was represented by fixed maturities rated below investment grade (BB or lower as determined by the weighted average of available ratings from rating services). Par value of these investments was $1.2 billion, amortized cost was $863 million, and fair value was $731 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value of the securities.
Guarantees: At December 31, 2010, Torchmark had in place four guarantee agreements, all of which were either parent company guarantees of subsidiary obligations to a third party, or parent company guarantees of obligations between wholly-owned subsidiaries. As of December 31, 2010, Torchmark had no liability with respect to these guarantees.
As previously disclosed in filings with the Securities and Exchange Commission (SEC), United American was named as a defendant in purported class action litigation originally filed on September 16, 2004, in the Circuit Court of Saline County, Arkansas on behalf of the Arkansas purchasers of association group health insurance policies or certificates issued by United American through Heartland Alliance of America Association and Farm & Ranch Healthcare, Inc. (Smith and Ivie v. Collingsworth, et al., CV2004-742-2). The plaintiffs asserted claims for fraudulent concealment, breach of contract, common law liability for non-disclosure, breach of fiduciary duties, civil conspiracy, unjust enrichment, violation of the Arkansas Deceptive Trade Practices Act, and violation of Arkansas law and the rules and regulations of the Arkansas Insurance Department. Declaratory, injunctive, and equitable relief, as well as actual and punitive damages, were sought by the plaintiffs. On September 7, 2005, the plaintiffs amended their complaint to assert a nation-wide class, defined as all United American insureds who simultaneously purchased both an individual Hospital and Surgical Expense health insurance policy (Form HSXC) and an individual supplemental term life insurance policy (Form RT85) from Farm & Ranch through Heartland. Defendants removed this litigation to the United States District Court for the Western District of Arkansas (No. 4:05-cv-1382) but that Court remanded the litigation back to the state court on plaintiffs’ motion. On July 22, 2008, the plaintiffs filed a second amended complaint, asserting a class defined as “all persons who, between January 1998 and the present, were residents of Arkansas, California, Georgia, Louisiana or Texas, and purchased through Farm & Ranch: (1) a health insurance policy issued by United American known as Flexguard Plan, CS-1 Common Sense Plan, GSP Good Sense Plan, SHXC Surgical & Hospital Expense Policy, HSXC 7500 Hospital/Surgical Plan, MMXC Hospital/Surgical Plan, SMXC Surgical/Medical Expense Plan and/or SSXC Surgical Safeguard Expense Plan, and (ii) a membership in Heartland.” Plaintiffs assert claims for breach of contract, violation of Arkansas Deceptive Trade Practices Act and/or applicable consumer protection laws in other states, unjust enrichment, and common law fraud. Plaintiffs seek actual, compensatory, statutory and punitive damages, equitable and declaratory relief. On September 8, 2009, the Saline County Circuit Court granted the plaintiff’s motion certifying the class. On October 7, 2009, United American filed its notice of appeal of the class certification and subsequently filed its appellate brief on April 8, 2010. On December 2, 2010, the Arkansas Supreme Court affirmed the lower court’s decision to certify the class. Discovery is ongoing.
As reported in previous SEC filings, on June 3, 2009, the Florida Office of Insurance Regulation (Florida Office) issued an order to Liberty National to show cause why the Florida Office should not issue a final order suspending or revoking Liberty National’s certificate of authority to do insurance business in the State of Florida. The order asserted that Liberty National has engaged in alleged unfair trade practices in violation of Florida law through past underwriting practices used by Liberty National with regard to insurance applications submitted by persons who live in the United States but who were not U.S. citizens and persons traveling to certain foreign countries. Liberty National denies the allegations made by the Florida Office. Liberty National responded to the Florida Office’s order in a timely manner and the matter was transmitted to the Division of Administrative Hearings on July 10, 2009. The matter was assigned to an administrative law judge and was set for hearing commencing on February 1, 2010. On January 21, 2010, the Florida Office filed a motion for continuance which was granted and the hearing in the Florida Department of Administrative Hearings was held June 7-11, 2010. Each of the parties submitted proposed orders to the Administrative Law Judge on August 18, 2010 for her review. On November 9, 2010, the Administrative Law Judge issued a recommended order and transmitted it to all parties. The Florida Office filed exceptions to the order and Liberty National filed its response to those exceptions as well as its own exceptions on December 3, 2010. On February 9, 2011, the Florida Office issued a Final Order that essentially adopted the Administrative Law Judge’s previously recommended findings of fact and conclusions of law. However, in its Final Order, the Florida Office increased the recommended fines for the four non-willful violations and trebled the fine for each non-willful violation resulting in a total fine of $60,000. A decision whether or not the Final Order will be appealed has not been made.
As previously reported in filings with the SEC, on September 23, 2009, purported class action litigation was filed against American Income Life Insurance Company in the Superior Court of San Bernardino County, California (Hoover v. American Income Life Insurance Company, Case No. CIVRS 910758). The plaintiffs, former insurance sales agents of American Income who are suing on behalf of all current and former American Income sales agents in California for the four year period prior to the filing of this litigation, assert that American Income’s agents are employees, not independent contractors as they are classified by American Income. They allege failure to indemnify and reimburse for business expenses as well as failure to pay all wages due upon termination in violation of the California Labor Code; failure to pay minimum wages in violation of the California Industrial Welfare Commission Wage Order No. 4-2001, originally and as amended; and unfair business practices in violation of the California Business and Professions Code §§17200, et seq. They seek, in a jury trial, reimbursement for business expenses and indemnification for losses, payment of minimum wages for their training periods, payment of moneys due immediately upon termination under the California Labor Code, disgorgement of profits resulting from unfair and unlawful business practices, and injunctive relief granting employee status to all of American Income’s California agents. On October 29, 2009, American Income filed a motion seeking to remove this litigation from the Superior Court in San Bernadino County to the U.S. District Court for the Central District of California, Eastern Division. The U.S. District Court remanded the case without prejudice to the Superior Court and denied American Income’s motion to dismiss on December 15, 2009. On January 19, 2010, American Income filed a motion to dismiss which was denied by the Superior Court after a hearing held on March 16, 2010. On September 20, 2010, American Income again filed a motion to remove the case to federal court based upon jurisdictional grounds that had not been available previously. The Company’s motion was not successful, however, and the case was remanded back to Superior Court. On January 12, 2011, the Superior Court denied the Company’s motion to exercise the arbitration clauses of those agent contracts that contain them; the Company has appealed that denial. Discovery is proceeding.
William J. Baxley is a partner in the law firm of Baxley, Dillard, Dauphin, McKnight & James which performs legal services for Torchmark and certain of its subsidiaries. In 1997, Mr. Baxley was loaned $668 thousand on an unsecured basis at a rate of 6.02%. Repayments are made in the form of legal services at customary rates and are applied against the outstanding balance, amortizing the loan with interest over its remaining term. In October, 2001, the terms of the loan were revised and an additional amount of $395 thousand was loaned to Baxley. The interest rate was revised to 5.6% and the term of the loan was extended until July, 2013. The loan is being repaid in accordance with its amortization schedule and all payments are current. At December 31, 2010 and 2009, the outstanding balance of this loan was $217 thousand and $296 thousand, respectively.
Torchmark also holds funds on behalf of Mr. Baxley as a part of an agreement established in 2006. Interest is paid to Baxley based on a variable rate computed as the average yield for Aa corporate bonds less fifty basis points, which was 5.0% at December 31, 2010. This account balance was $74 thousand at year end 2010 and $58 thousand at year end 2009.
Torchmark grants options to certain consultants for their services in addition to their fees. Mr. Baxley received Torchmark options in each of the years 2008 through 2010.
The following is a summary of quarterly results for the two years ended December 31, 2010. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.
Basic and diluted net income per share by quarter may not add to per share income on a year-to-date basis due to share weighting and rounding.