The following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the "Company") for the years ended December 31, 2017 and 2016. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report.
Impairment of Investments - The Company continually monitors the investment portfolio for investments that have become impaired in value; where fair value has declined below carrying value. While the value of the investments in the Company's portfolio continuously fluctuate due to market conditions, an other-than-temporary impairment charge is recorded only when a security has experienced a decline in fair market value which is deemed to be other than temporary. The policies and procedures the Company uses to evaluate and account for impairments of investments are disclosed in Note 1 - Summary of Significant Accounting Policies and Note 2 - Investments in the Notes to the Consolidated Financial Statements. The Company makes every effort to appropriately assess the status and value of the securities with the information available regarding an other-than-temporary impairment. However, it is difficult to predict the future prospects of a distressed or impaired security.
On a consolidated basis, the Company had net income attributable to common shareholders of $4.8 million and $1.2 million in 2017 and 2016, respectively. In 2017, income before income taxes was $3.3 million compared to $2.1 million in 2016. Total revenue was $28.7 million in 2017 and $27.8 million in 2016.
One-time events, primarily reflected in realized gains, comprise a substantial portion of the net income and revenue reported by the Company during 2017 and 2016. The magnitude of realized investment gains and losses in a given year is a function of the timing of trades of investments relative to the markets themselves as well as the recognition of any impairments on investments. Future earnings will be significantly negatively impacted should earnings from these one-time items not be realizable in a future period. While Management believes there remain additional investments with such one-time earnings, when or if realized remains uncertain.
Total benefits and other expenses paid in 2017 were $25.4 million compared to $25.7 million in 2016.
The 2017 net earnings of the Company include approximately $1.5 million attributable to a one-time net benefit from the enactment of the TCJA on December 22, 2017. Refer to Note 1 - Summary of Significant Accounting Policies and Note 6 - Income Taxes in the Notes to the Consolidated Financial Statements for further disclosure regarding the TCJA. The benefit is the result of a one-time non-cash reduction of the Company's net deferred tax liabilities that arose from the reduction in the statutory U.S. corporate income tax rate from 35% to 21%. The Company does not anticipate the TCJA to have a material impact going forward as the Company historically paid an average corporate income tax rate of 20% and will now pay a corporate income tax rate of 21%.
Premiums and policy fee revenues, net of reinsurance premiums and policy fees, were comparable for 2017 to 2016. The Company writes very little new business. Unless the Company acquires a new company or a block of in-force business, Management expects premium revenue to continue to decline on the existing block of business at a rate consistent with prior experience. The Company's average persistency rate for all policies in-force for 2017 and 2016 was approximately 96.7% and 96.6%, respectively. Persistency is a measure of insurance in-force retained in relation to the previous year.
As mentioned above, the Company made the decision to sell some lower rated, higher yielding securities and replace them with higher rated, lower yielding securities. The gains reported in the fixed maturities investment portfolio during 2017 are mainly the result of sale of the lower rated, higher yielding securities.
During 2017, the Company made the decision to sell certain equity securities, which produced gains of approximately $2.9 million. The decision to sell was based upon Management's analysis of current market conditions and it was deemed to be an appropriate time to sell certain equity securities and recognize the associated gains. During 2016, the Company sold certain equity securities as well.
Benefits, claims and settlement expenses, net of reinsurance benefits, decreased approximately 5% in 2017 compared to 2016. The decrease primarily relates to changes in the Company's death claim experience. Policy claims vary from year to year and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.
As mentioned above in the Overview section of the Management Discussion and Analysis, UTG has a strong philanthropic program. The Company generally allocates a portion of its earnings to be used for its philanthropic efforts primarily targeted to Christ-centered organizations or organizations that help the weak or poor. Charitable contributions made by the Company are expected to vary from year to year depending on the earnings of the Company.
The Company's total investments represented 82% and 86% of the Company's total assets as of December 31, 2017 and 2016, respectively. Fixed maturities consistently represented a substantial portion, 53% and 55%, respectively, of the total investments during 2017 and 2016. The overall investment mix, as a percentage of total investments, remained fairly consistent when comparing the investments held as of December 31, 2017 and 2016.
As of December 31, 2017, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders' equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as "investments available for sale". Investments available for sale are carried at market value, with changes in market value charged directly to the other comprehensive component of shareholders' equity. Changes in the market value of available for sale securities resulted in net unrealized gains of approximately $17.3 million and $22.4 million as of December 31, 2017 and 2016, respectively. The variance in the net unrealized gains and losses is the result of normal market fluctuations mainly related to changes in interest rates in the market place.
Management continues to view the Company's investment portfolio with utmost priority. Significant time has been spent internally researching the Company's risk and communicating with outside investment advisors about the current investment environment and ways to ensure preservation of capital and mitigate losses. Management has put extensive efforts into evaluating the investment holdings. Additionally, members of the Company's Board of Directors and investment committee have been solicited for advice and provided with information. Management reviews the Company's entire portfolio on a security level basis to be sure all understand our holdings, potential risks and underlying credit supporting the investments. Management intends to continue its close monitoring of its bond holdings and other investments for possible deterioration or market condition changes. Future events may result in Management's determination that certain current investment holdings may need to be sold which could result in gains or losses in future periods. Such future events could also result in other than temporary declines in value that could result in future period impairment losses.
UTG is a holding company that has no day-to-day operations of its own. Cash flows from UTG's insurance subsidiary, UG, are used to pay costs associated with maintaining the Company in good standing with states in which it does business and purchasing outstanding shares of UTG stock. UTG's cash flow is dependent on management fees received from its insurance subsidiary, stockholder dividends from its subsidiary and earnings received on cash balances. As of December 31, 2017 and 2016, substantially all of the consolidated shareholders' equity represents net assets of its subsidiaries. In 2017, the Parent company received $2 million in dividends from its insurance subsidiary and $1 million in 2016. Certain restrictions exist on the payment of dividends from the insurance subsidiary to the Parent company. For further information regarding the restrictions on the payment of dividends by the insurance subsidiary, see Note 9 - Shareholders' Equity in the Notes to the Consolidated Financial Statements. Although these restrictions exist, dividend availability from the insurance subsidiary has historically been sufficient to meet the cash flow needs of the Parent company.
Sources of cash flows for the insurance subsidiary primarily consist of premium and investment income. Cash outflows from operations include policy benefit payments, administrative expenses, taxes and dividends to the Parent company.
An additional source of liquidity to the Parent company and its subsidiaries is the line of credit facilities extended to them. As of December 31, 2017 and 2016, the Company and its subsidiaries had available $18 million in line of credit facilities. For additional information regarding the line of credit facilities, see Note 7 - Credit Arrangements in the Notes to the Consolidated Financial Statements.
During 2017 and 2016, the Company's investing activities provided net cash of approximately $27 million and $16.7 million, respectively. Proceeds from investments sold decreased approximately 17% or $11.4 million when comparing 2017 to 2016. Investment purchases decreased approximately 43% or $22 million. The net cash provided by investing activities is expected to vary from year to year depending on market conditions and management's ability to find and negotiate favorable investment contracts.
The Company's capital structure consists of short-term debt, long-term debt and shareholders' equity. A complete analysis and description of the short-term and long-term debt issues outstanding as of December 31, 2017 and 2016 are presented in Note 7 - Credit Arrangements in the Notes to the Consolidated Financial Statements.
The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors on June 15, 2016, the Board of Directors of UTG authorized the repurchase of up to an additional $2 million of UTG's common stock and on July 14, 2016, the Board of Directors again increased the amount available by an additional $4.5 million, for a total repurchase of $14.5 million. Repurchased shares are available for future issuance for general corporate purposes. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During 2017, the Company repurchased 30,395 shares through the stock repurchase program for approximately $604,000. Through December 31, 2017, UTG has spent approximately $12.5 million in the acquisition of approximately 1,089,000 shares under this program.
We have audited the accompanying consolidated balance sheets of UTG, Inc. and subsidiaries (the "Company") as of December 31, 2017 and 2016, and the related consolidated statements of operations, comprehensive income (loss), shareholders' equity, and cash flows for each of the years in the two-year period ended December 31, 2017, and the related notes to the consolidated financial statements (collectively referred to as the "consolidated financial statements"). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
This document at times will refer to the Registrant's largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC ("FSF"), a Kentucky corporation, and First Southern Bancorp, Inc. ("FSBI"), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank ("FSNB"). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG's largest shareholder through his ownership control of FSF, FSBI and affiliates. At December 31, 2017, Mr. Correll owns or controls directly and indirectly approximately 64.25% of UTG's outstanding stock.
Investment Real Estate - Investment real estate held for sale is reported at the lower of cost or fair value less cost to sell. Expenses to maintain the property are expensed as incurred.
Current accounting guidance states that if an entity intends to sell or if it is more likely than not that it will be required to sell an impaired security prior to recovery of its cost basis, the security is to be considered other-than-temporarily impaired and the full amount of impairment must be charged to earnings. Otherwise, losses on fixed maturities which are other-than-temporarily impaired are separated into two categories, the portion of the loss which is considered credit loss and the portion of the loss which is due to other factors. The credit loss portion is charged to earnings while the loss due to other factors is charged to other comprehensive income.
Property and Equipment - Company-occupied property, data processing equipment and furniture and office equipment are stated at cost less accumulated depreciation of $5,225,333 and $4,779,216 at December 31, 2017 and 2016, respectively. Depreciation is computed on a straight-line basis for financial reporting purposes using estimated useful lives of three to thirty years. Depreciation expense was $446,117 and $451,667 for the years ended December 31, 2017 and 2016, respectively.
Benefit reserves for universal life insurance and interest sensitive life insurance products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims in excess of related policy account balances. Interest crediting rates for universal life and interest sensitive products range from 3% to 6% as of December 31, 2017 and 2016.
Accounting Standards Update (ASU) 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of certain tax effects from accumulated other comprehensive income. The purpose of this update is to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. ASU 2018-02 is effective for public companies for fiscal years beginning after December 15, 2018. Early adoption is permitted. See the Consolidated Statements of Comprehensive Income (Loss) for the impact of ASU 2018-02.
Accounting Standards Update (ASU) 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment - The amendments included in ASU 2017-04 eliminate Step 2 from the goodwill impairment test. The annual, or interim, goodwill impairment test is performed by comparing the fair value of a reporting unit with its carrying amount. An impairment charge should be recognized for the amount by which the carrying amount exceeds the reporting unit's fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In addition, income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit should be considered when measuring the goodwill impairment loss, if applicable. The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. ASU 2017-04 is effective for public companies for fiscal years beginning after December 15, 2019. The adoption of this guidance is not expected to have a material impact on the Company's consolidated financial statements.
Accounting Standards Update (ASU) 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments - The amendments included in ASU 2016-15 provide cash flow statement classification guidance for debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective Interest Rate of the Borrowing, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies, distributions received from equity method investees, beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. ASU 2016-15 is effective for public companies for fiscal years beginning after December 15, 2017. The adoption of this guidance is not expected to have a material impact on the Company's consolidated financial statements.
Accounting Standards Update (ASU 2016-13), Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments - The amendments included in ASU 2016-13 require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better evaluate their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 is effective for public companies for fiscal years beginning after December 15, 2019. The Company is currently evaluating the impact that the adoption of this guidance will have on it's consolidated financial statements.
Substantially all of the unrealized losses on fixed maturities available for sale at December 31, 2017 and 2016 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The unrealized losses on equity investments were primarily attributable to normal market fluctuations. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company's expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company's evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of December 31, 2017 and 2016
Approximately 12% of the mortgage loan portfolio consists of discounted commercial mortgage loans as of December 31, 2017 and 2016. The Company began purchasing discounted commercial mortgage loans in 2009. Management has extensive background and experience in the analysis and valuation of commercial real estate. The discounted loans are available through the FDIC's sale of assets of closed banks and from banks wanting to reduce their loan portfolios. The loans are available on a loan by loan bid process. Once a loan has been acquired, contact is made with the appropriate individuals to begin a dialog with a goal of determining the borrower's willingness to work together. There are generally three paths a discounted loan will take: the borrowers pay as required; a settlement is reached with the loan being paid off at a discounted value; or the loan is foreclosed.
During 2017 and 2016, the Company acquired $360,531 and $6,935,273 in mortgage loans, respectively, including both regular participation mortgage loans as well as discounted mortgage loans. FSNB services the majority of the Company's mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.
The following table summarizes the number of loans held in the discounted mortgage loan portfolio and the carrying value of the loans:
The other-than-temporary impairments recognized during 2017 and 2016 were taken as a result of Management's assessment and consideration of the length of time the securities have remained in an unrealized loss position and as a result of management's analysis and determination of value. The investments were written down to better reflect their current expected market value.
The Company had investments with a fair value of $8,642,633 and $8,692,705 on deposit with various state insurance departments as of December 31, 2017 and 2016, respectively.
The following table presents the Company's assets and liabilities measured at fair value in the consolidated balance sheet on a recurring basis as of December 31, 2016.
The Level 3 securities include one fixed maturity and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries.
There were no transfers in or out of Level 3 during 2017. The Company transferred one fixed maturity security in to Level 3 during 2016 based upon a change in rating. Transfers occur when there is a lack of observable market information.
The carrying values and estimated fair values of certain of the Company's financial instruments not recorded at fair value in the Consolidated Balance Sheets are shown below. Because the fair value for all Consolidated Balance Sheet items are not required to be disclosed, the aggregate fair value amounts presented below are not reflective of the underlying value of the Company.
The Company does not have any short-duration reinsurance contracts. The effect of the Company's long-duration reinsurance contracts on premiums earned in 2017 and 2016 were as follows:
The Company also has a deferred tax asset of $118,693 and 155,930 relating to an AMT tax carryforward as of December 31, 2017 and 2016, respectively. The Company established an allowance of $155,930 against this deferred tax asset as of December 31, 2016, based on Management's assessment of the recoverability of these deferred assets. As a result of the changes to the Alternative Minimum Tax and corresponding credits resulting from the TCJA, Management has determined that an allowance against this asset it no longer required.
The UTG line of credit carries interest at a fixed rate of 4.00% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, Universal Guaranty Life Insurance Company ("UG").
During May of 2017, the Federal Home Loan Bank approved UG's Cash Management Advance Application ("CMA"). The CMA gives the Company the option of selecting a variable rate of interest for up to 90 days or a fixed rate for a maximum of 30 days. The variable rate CMA is prepayable at any time without a fee, while the fixed CMA is not prepayable prior to maturity.
On July 22, 2016, the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company's outstanding common stock. The acquisition was made under the Company's stock buy-back program. As part of this transaction, two promissory notes totaling $2.9 million were issued. The notes required principal payments of one half of the note value to be paid one year from the date of purchase and the other one half to be paid two years from the date of purchase. The notes had an interest rate of 0%. The notes were fully repaid during 2017.
The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business, the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a materially adverse effect on the Company's results of operations or financial position.
During 2012, the Company committed to invest in Sovereign's Capital, LP Fund I ("Sovereign's"), which invests in companies in emerging markets. Sovereign's makes capital calls to investors as funds are needed.
Stock Repurchase Program - The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors on June 15, 2016, the Board of Directors of UTG authorized the repurchase of up to an additional $2 million of UTG's common stock and on July 14, 2016, the Board of Directors again increased the amount available by an additional $4.5 million, for a total repurchase of $14.5 million. Repurchased shares are available for future issuance for general corporate purposes. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During 2017, the Company repurchased 30,395 shares through the stock repurchase program for $604,052. Through December 31, 2017, UTG has spent $12.5 million in the acquisition of approximately 1,089,184 shares under this program.
UG is domiciled in the state of Ohio. Ohio requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. UG paid ordinary dividends of $2 and $1 to UTG in 2017 and 2016, respectively. No extraordinary dividends were paid during the two year period. UTG used the dividends received during 2017 and 2016 to purchase outstanding shares of UTG stock and for general operations of the Company.
On February 20, 2003, UG purchased $4 million of a trust preferred security offering issued by First Southern Bancorp, Inc. ("FSBI"). The security has a mandatory redemption after 30 years with a call provision after 5 years. The security pays a quarterly dividend at a fixed rate of 6.515%. The Company received dividends of $259,138 and $264,946 during 2017 and 2016, respectively. On March 30, 2009, UG purchased $1 million of FSBI common stock. The sale and transfer of this security is restricted by the provisions of a stock restriction and buy-sell agreement.
The Company from time to time acquires mortgage loans through participation agreements with FSNB. FSNB services the Company's mortgage loans including those covered by the participation agreements. The Company pays a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan. The Company paid $11,108 and $13,517 in servicing fees and $0 in origination fees to FSNB during 2017 and 2016.
Effective January 1, 2017, UTG entered into a shared services contract with FSNB. The Company reimbursed expenses incurred by employees of FSNB relating to salaries, travel and other costs incurred on behalf of or relating to the Company. The Company paid $186,251 and $269,262 in 2017 and 2016, respectively to FSNB in reimbursement of such costs. In addition, the Company reimburses FSNB a portion of salaries and pension costs for Mr. Correll and Mr. Ditto. The reimbursement was approved by the UTG Board of Directors and totaled $346,486 and $335,769 in 2017 and 2016, respectively, which included salaries and other benefits.