In addition to its headquarters, the Company and its subsidiaries lease approximately 72,000 square feet of space in the Columbus, Ohio vicinity, 15,000 square feet of space on Chamberlain Lane in Louisville, Kentucky and subleases approximately 1,000 square feet of office space in New York City from New ARMCA. The operations of the Company's New York insurance subsidiary, National Integrity, are conducted from the New York facility. Additional office space owned in New Ulm, Minnesota supports the distribution operations of SBM Certificate Company. The Chamberlain Lane space in Louisville, Kentucky serves as the Company's primary distribution center for all of its operations. The Columbus office space was vacated upon the consolidation of the Company's Columbus operations with the corporate headquarters in Louisville and the Company intends to either sublease this space or buy out the remainder of the lease at a discount.
The following table sets forth selected historical financial information of the Company and its subsidiaries for the years ended December 31, 1997, 1996, 1995 and 1994, for the period from November 27, 1993 through December 31, 1993, and for the period from January 1, 1993 through November 26, 1993 (for the Historical Integrity Companies). The financial information has been derived from consolidated financial statements of the Company, prepared in conformity with GAAP, that have been audited by Ernst & Young LLP.
(2) The Company recorded non-recurring charges of $14.8 million for 1997 including a one-time non-cash stock-based compensation charge of $8.1 million related to the Company's initial public offering of common stock, and other non-recurring costs primarily attributable to the relocation and consolidation of the Company's operations facilities from Columbus, Ohio to Louisville, Kentucky. The Company recorded a non-recurring charge of $5.0 million in 1996 that also included $3.2 million for facilities consolidation and costs of $1.8 million primarily related to merger and acquisition activity that did not result in a transaction.
(5) Total cash and investments, total assets and carrying amount shareholders' equity for the periods ending subsequent to December 31, 1993 reflect a change in accounting principle for the January 1, 1994 adoption of SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities."
(6) Excludes from carrying amount shareholders' equity the net unrealized gains and losses on securities classified as available-for-sale, net of related amortization and taxes.
The Company specializes in the growing asset accumulation business with particular emphasis on retirement savings and investment products. The Company's products and services are sold in two principal markets, the retail and institutional markets, through a broad spectrum of distribution channels.
On December 13, 1996, the Company transferred its contracts to perform management and advisory services for the State Bond Mutual Funds to Federated Investors for $4.5 million. Had the sale of ARM Capital Advisors' operations and the sale of the management contracts for the State Bond Mutual Funds occurred on January 1, 1995, they would not have had a material effect on the Company's net income for the years ended December 31, 1997, 1996 and 1995.
acquired SBM business operations compared to seven months in 1995. Therefore, results of operations for 1995 are not completely comparable with 1996 and 1997.
Pro forma operating earnings (operating earnings including a pro forma adjustment to reflect investment income that the Company believes could have been earned at an assumed rate of 7.5% on the net proceeds of the Company's initial public offering of common stock assuming it occurred on January 1, 1996) were $36.3 million and $26.8 million for 1997 and 1996, respectively. Pro forma operating earnings per share were $1.51 and $1.13 for the same respective years. This pro forma information is not necessarily indicative of what would have occurred had the offering occurred on the date indicated.
The decrease in the overall investment spread rate from 2.08% in 1996 to 1.77% in 1997 is attributable to a greater proportion of institutional spread product deposits in 1997, which generate lower spreads. Changes in investment yield and interest credited rates must be analyzed in relation to the liability portfolios to which they relate. When analyzed individually, investment spread rates increased in 1997 for both retail and institutional spread products. The investment yield on cash and investments, excluding assets supporting institutional spread product deposits, was 8.04% for 1997, up from 8.01% in 1996. In comparison, the investment yield on cash and investments supporting institutional spread product deposits was 6.74% and 6.53% for 1997 and 1996, respectively. These increases reflect the benefits of ongoing investment portfolio management. Average cash and investments related to institutional spread product deposits grew from $567.7 million during 1996 to $1.48 billion during 1997, causing the aggregate decrease in investment yields. The proceeds from institutional spread product sales are invested in securities of shorter duration (which generally have lower investment yields) than the Company's other investment portfolios. The average credited rate pattern is dependent upon the general trend of market interest rates (which were somewhat higher on the average in 1997), frequency of credited rate resets and business mix. Crediting rates are reset monthly based on the LIBOR for institutional spread products and semi-annually or annually for certain fixed annuities. To date, the Company has been able to react to changes in market interest rates and maintain a desired investment spread without a significant effect on surrender and withdrawal activity, although there can be no assurance that the Company will be able to continue to do so.
Sales of retail and institutional spread products include premiums and deposits received for products issued by the Company's insurance and face-amount certificate subsidiaries. Sales of retail variable products include premiums for the investment portfolio options of variable annuity products issued by the Company's insurance subsidiaries.
Sales by market and type of product for 1997 and 1996 were as follows:
Total sales during 1997 rose to $2,297.5 million, an increase of approximately 113% over 1996. The growth is primarily attributable to continued diversification and expansion in the retail and institutional markets. The growth in retail spread product sales is largely due to an increase in marketing efforts for the Company's guaranteed rate option annuity products. Institutional spread product sales increased as a result of (i) the addition of sales staff and further penetration into institutional channels and (ii) the launching of a new funding agreement product. In November 1997, the Company received a deposit of $500 million for the new product, which was sold in partnership with BLB and initially matures in five years and is renewable annually thereafter.
Net surrenders of retail fixed and variable annuity products issued by the Company's insurance subsidiaries were $344.5 million for 1997 compared to $326.2 million for 1996. Surrender charge income decreased to $4.5 million in 1997 from $5.0 million in 1996. The decrease in surrender charge income is attributable to a larger portion of the surrenders being partial surrenders which do not result in a surrender charge penalty. Retail products issued by the Company's insurance subsidiaries generally include lapse protection provisions that provide a deterrent to surrenders when interest rates rise. These provisions can include surrender charges and market value adjustments on annuity withdrawals. During the period that surrender charges are assessable (generally the first five to seven years after a policy is issued) surrenders are relatively low. The surrender and withdrawal activity in 1996 and 1997 was generally expected by the Company due to the level of customer deposits written several years ago that were subject to declining or expiring surrender charges, and the Company's strategy of maintaining investment spreads. The Company attempts to reduce surrender activity and improve persistency through various programs.
Amortization of value of insurance in force related to operations of $9.3 million and $7.3 million for 1997 and 1996, respectively, primarily reflects the amortization of the value of insurance in force established as an asset by the Company in connection with the acquisition of SBM's insurance subsidiary. The increase in amortization expense corresponds with lower than expected gross margins for that block of annuity business.
The Company recorded non-recurring charges of $14.8 million for 1997 including a one-time non-cash stock-based compensation charge of $8.1 million related to the Company's initial public offering of common stock, and other non-recurring costs primarily attributable to the relocation and consolidation of the Company's operations facilities from Columbus, Ohio to Louisville, Kentucky. The Company recorded a non-recurring charge of $5.0 million in 1996 that also included $3.2 million for facilities consolidation and costs of $1.8 million primarily related to merger and acquisition activity that did not result in a transaction.
Other expenses, net decreased to $0.4 million in 1997 from $5.4 million in 1996. This decrease is attributable to higher mortality costs in 1996 related to immediate annuity deposits. In addition, 1997 benefited from mortgage loan prepayment penalty income of $2.1 million and the favorable resolution of a reinsurance claim of $2.4 million.
During 1996, net income for the Company was $23.4 million compared to $11.9 million for 1995. Operating earnings (net income applicable to common shareholders, excluding, net of tax, realized investment gains and losses, non-recurring charges and income from defined benefit pension plan asset management operations which were sold during November 1997) were $22.2 million and $4.5 million for 1996 and 1995, respectively. The increase in operating earnings is primarily attributable to (i) an increase in net investment spread due to ongoing asset/liability management and deposit growth from the full year's effects of the May 31, 1995 acquisition of the SBM assets and business operations and additional sales of retail and institutional spread products and (ii) an increase in fee income as a result of a growing base of variable annuity deposits. Such increases in revenues were partially offset by an increase in operating expenses as a result of business growth.
Operating earnings for retail spread products were 1.30% and 0.91% of average assets under management of $2.66 billion and $2.43 billion for that segment during 1996 and 1995, respectively. This increase in retail spread margins is primarily attributable to ongoing asset/liability management, which generated higher net investment spreads. Operating earnings for institutional spread products were 0.57% and 0.60% of average assets under management of $567.7 million and $38.5 million for that segment during 1996 and 1995, respectively. Operating earnings for retail variable products for 1996 were slightly higher than the corresponding prior period as evidenced by the increase to 0.66% from 0.64% of average retail variable assets under management of $728.2 million and $491.5 million during 1996 and 1995, respectively.
The decrease in investment yields on cash and investments primarily relates to a significant increase in institutional spread product deposits which grew from zero to $143.2 million during 1995 and to $891.9 million at December 31, 1996. The proceeds from institutional spread product sales are invested in securities of shorter duration (which generally have lower investment yields) than the Company's other investment portfolios. The investment yield on cash and investments supporting institutional spread product deposits was 6.53% for 1996. In comparison, the investment yield on cash and investments, excluding assets supporting institutional spread product deposits, was 8.01% for 1996, up from 7.85% for 1995, which reflects the benefits of the ongoing management of the Company's investment portfolios. The decrease in the average rate of interest credited on customer deposits during 1996 was due primarily to annual or semi-annual crediting rate resets occurring at a time when the overall interest rate environment was generally lower (the last half of 1995 and the first half of 1996 compared to the last half of 1994 and the first half of 1995).
Fee income increased to $17.8 million in 1996 from $11.3 million in 1995. This increase is in part attributable to variable annuity fees which are based on the market value of assets supporting the investment portfolio options of variable annuity customer deposits in separate accounts. Variable annuity fees increased to $10.8 million in 1996 from $7.2 million in 1995 principally due to asset growth from the receipt of variable annuity deposits and from a market-driven increase in the value of existing variable annuity deposits invested in mutual funds. Variable annuity deposits increased to $844.3 million in 1996 from $617.3 million in 1995. In addition, asset management fees earned by ARM Capital Advisors on off-balance sheet assets, related to defined benefit pension plans and the State Bond Mutual Funds, increased to $5.8 million in 1996 from $3.2 million in 1995. This increase in asset management fees reflects a significant increase in the average amount of corresponding off-balance sheet assets managed due to new defined benefit pension plan accounts. The average amount of off-balance sheet assets managed by ARM Capital Advisors was $2.16 billion in 1996 compared to $1.10 billion in 1995.
Sales by market and type of product for 1996 and 1995 were as follows:
The increase in retail sales was primarily attributable to an increase in sales of investment portfolio options of variable annuity contracts due, in part, to the strong stock market returns during 1996 and an increased emphasis on marketing efforts of retail products during the fourth quarter, principally through stockbrokers and independent agents. Expanded distribution of funding agreement and GIC products through bank trust departments, mutual fund companies, investment managers, insurance companies and investment consultants contributed to the increase in sales of such products. The decrease in institutional fee-based sales was attributable to the Company's marketing partnership arrangement with General American which was converted from a fee-based to primarily a spread-based arrangement in late 1995.
Net surrenders of annuity products issued by the Company's insurance subsidiaries were $326.2 million and $319.8 million in 1996 and 1995, respectively. Of these amounts, $106.9 million and $62.8 million, respectively, can be attributed to fixed annuity business acquired from SBM. Surrender charge income increased to $5.0 million in 1996 from $3.3 million in 1995, due to higher average surrender charges associated with SBM products compared to other products of the Company's insurance subsidiaries and to the overall increase in the volume of surrenders. The surrender and withdrawal activity during 1995 and 1996 was generally expected by the Company due to the level of customer deposits written several years ago that were subject to declining or expiring surrender charges and the Company's strategy of maintaining investment spreads.
Operating expenses increased to $31.1 million in 1996 from $23.0 million in 1995. The increase was primarily attributable to (i) the inclusion of twelve months of incremental operating expenses related to the acquired SBM operations in the 1996 results versus seven months for the comparable 1995 period, (ii) the expansion of product distribution channels and (iii) a charge of $1.6 million to increase the reserve for anticipated future guaranty fund assessments.
Commissions, net of deferrals, were $2.4 million and $1.6 million in 1996 and 1995, respectively. The increase was primarily attributable to the inclusion in 1996 results of twelve months' renewal and trailer commissions under certain deferred annuity contracts acquired through the SBM acquisition versus seven months for the comparable 1995 period.
Amortization of deferred policy acquisition costs related to operations was $6.8 million and $2.9 million during 1996 and 1995, respectively. This increase was the result of growth in the deferred policy acquisition cost asset due to additional sales of fixed and variable annuity products.
Amortization of acquisition-related deferred charges was $1.5 million and $9.9 million in 1996 and 1995, respectively. The decrease was primarily attributable to the accelerated amortization during the third quarter of 1995 of certain costs and charges deferred during 1993 and 1994. During the third quarter of 1995, Company management determined that changes in facts and circumstances had resulted in a change in their original estimate of the periods benefited by these costs and charges. As a result of this change in estimate, the remaining unamortized balances of these deferred costs and charges were fully amortized as of September 30, 1995, resulting in lower amortization in future periods.
Realized investment gains, which are reported net of related amortization of deferred policy acquisition costs and value of insurance in force, were $0.9 million in 1996 compared to $4.0 million in 1995. Realized investment gains in 1996 include an estimated loss of $15.2 million related to the write-down to fair value of an investment in a fixed income security and a gain of $4.5 million, before selling expenses, related to the transfer of the State Bond Mutual Funds management
contracts. Other 1996 and all 1995 realized investment gains and losses were interest-rate related and attributable to the ongoing management of the Company's fixed maturity securities classified as available-for-sale which can result in period-to-period swings in realized investment gains and losses since securities are sold during both rising and falling interest rate environments.
ARM CAPITAL ADVISORS Through its acquisition of the U.S. fixed income unit of KBIMA in January 1995, the Company obtained a recognized fixed income management service which became part of the then newly-formed ARM Capital Advisors. In addition to providing asset management services to institutional clients, ARM Capital Advisors managed the investment portfolios of the Company's subsidiaries. Although third-party assets managed by ARM Capital Advisors grew since the acquisition, the Company believes that market attitudes towards developing an asset management service for defined benefit pension plans within a holding company structure consisting predominantly of insurance companies constrained ARM Capital Advisors' growth. Accordingly, on November 7, 1997, the Company transferred substantially all of the assets and operations of ARM Capital Advisors to New ARMCA and sold an 80% interest in New ARMCA.
SBM COMPANY Effective May 31, 1995, the Company completed the acquisition of substantially all of the assets and business operations of SBM, including all of the issued and outstanding capital stock of SBM's subsidiaries, SBM Life and ARM Securities (formerly known as SBM Financial Services, Inc.), as well as the management contracts for the State Bond Mutual Funds. The aggregate purchase price for the SBM acquisition was $38.8 million. The Company financed the acquisition by issuing approximately 6.9 million shares of common stock, primarily to the Morgan Stanley Stockholders, for an aggregate sale price of $63.5 million. The Company used proceeds from the issuance of the new common equity in excess of the adjusted purchase price for the acquisition to make a $19.9 million capital contribution to SBM Life and acquire SBM Certificate Company from SBM Life for $3.3 million. The capital contribution to SBM Life of $19.9 million was used to strengthen SBM Life's financial position and allowed for a significant investment portfolio restructuring immediately following the acquisition with no net adverse effect on statutory adjusted capital and surplus. On December 31, 1995, SBM Life was merged with and into Integrity to create certain operating efficiencies. The SBM acquisition provided the Company with expanded distribution channels, as well as a deposit base in the 403(b) tax-deferred annuity marketplace. On December 13, 1996, the Company transferred its responsibility for performing management and investment advisory services
The Company primarily invests in securities with fixed maturities with the objective of earning reasonable returns while limiting credit and liquidity risks. At amortized cost, fixed maturities at December 31, 1997 totaled $4.0 billion, compared with $3.0 billion at December 31, 1996, both representing approximately 91% of total cash and investments. This increase in investments in fixed maturities primarily resulted from the investment of the proceeds from sales of institutional spread products.
Agency pass-through certificates are mortgage-backed securities ("MBSs") which represent an undivided interest in a specific pool of residential mortgages. The payment of principal and interest is guaranteed by the U.S. government or U.S. government agencies. Collateralized mortgage obligations ("CMOs") are pools of mortgages that are segregated into sections, or tranches, which provide prioritized retirement of bonds rather than a pro rata share of principal return as in the pass-
Total cash and investments were 95% and 96% investment grade or equivalent as of December 31, 1997 and 1996, respectively. Investment grade securities are those classified as 1 or 2 by the NAIC or, where such classifications are not available, having a rating on the scale used by S&P of BBB- or above. Yields available on non-investment grade securities are generally higher than are available on investment grade securities. However, credit risk is greater with respect to such non-investment grade securities. The Company has a diversified foreign portfolio of Yankee Bonds, including a limited exposure to the Asian market. The Company reduces the risks associated with buying foreign securities by limiting the exposure to both issuer and country. The Company closely monitors the creditworthiness of such issuers and the stability of each country. Additionally, the
The fluctuations in interest rates during 1997 resulted in unrealized gains on available-for-sale securities which totaled $20.3 million (net of $15.8 million of related amortization of deferred policy acquisition costs and value of insurance in force and $10.9 million of deferred income taxes) at December 31, 1997, compared to unrealized gains of $3.7 million (net of $1.3 million of related
The Company manages assets and liabilities in a closely integrated manner, with the aim of reducing the volatility of investment spreads during a changing interest rate environment. As a result, adjusting shareholders' equity for changes in the fair value of the Company's fixed maturities and equity securities without reflecting offsetting changes in the value of the Company's liabilities or other assets creates volatility in reported shareholders' equity but does not reflect the underlying economics of the Company's business. The Company's accompanying consolidated financial statements include fair value balance sheets which demonstrate that the general rise in interest rates during 1996 and subsequent decrease during 1997 did not have a material effect on the financial position of the Company when all assets and liabilities are adjusted to estimated fair values.
The ability of the Company's insurance subsidiaries to pay dividends and enter into agreements with affiliates for the payment of service or other fees is limited by state insurance laws. During 1997, the Company received dividends of $14.9 million from Integrity. The maximum dividend payments that may be made by Integrity to the Company during 1998 without the prior approval of the Ohio Insurance Director are $38.2 million of which $6.0 million was paid in the first quarter of 1998. The Company had cash and investments at the holding company level of $41.9 million at
Except for historical information contained in the Annual Report on Form 10-K, certain matters discussed herein, including (without limitation) in particular under Part I, Item 1, "Business - General" and "Business - Strategy" and under Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" are forward looking statements that involve risks and uncertainties, including (without limitation) the Company's belief as to its competitive position in the industry and factors affecting its business. In particular, the statements of the Company's belief as to the growth of the long-term savings and retirement market, the stimulation of future demand for the long-term savings and retirement products and the statements regarding the development of future products to meet the changing needs of the markets that the Company serves. Factors that could cause actual results to differ materially from the forward-looking statements related to the demand for variable, indexed and fixed annuity products include, but are not limited to, a change in population demographics, development of alternative investment products, a change in economic conditions, and changes in current federal income tax laws. In addition, there can be no assurance that (i) the Company has correctly identified and assessed all of the factors affecting its business; (ii) the publicly available and other information on which the Company has based its analyses is complete or correct; (iii) the Company's analyses are correct; or (iv) the Company's strategy, which is based in part on these analyses, will be successful.