Globe owns a 300,000 square foot office building in Oklahoma City, Oklahoma of which Globe occupies 56,000 square feet as its home office and the remaining space is either leased or available for lease. Globe also owns an 80,000 square foot office building also in Oklahoma City which is available for lease. Further, Globe owns a 112,000 square foot facility located in Oklahoma City which houses the Direct Response operation.
The tables in Note 16-Business Segments demonstrate the measures of profitability. Those tables also reconcile Torchmark’s revenues and expenses by segment to its major income statement line items for each of the years in the three-year period ending December 31, 2003. Additionally, this Note provides a summary of the profitability measures that demonstrates year-to-year comparability and which reconciles to Torchmark’s net income. That summary is reproduced below from the Consolidated Financial Statements to present Torchmark’s overall operations in the manner that management uses to manage the business.
The investment segment’s profitability increased $26 million on a pretax basis in 2003 and $39 million on a pretax basis in 2002. The investment segment, which includes net investment income offset by financing costs, has benefited from the lower interest rates on financing costs and a greater benefit from the interest-rate swaps on Torchmark’s debt. See the analysis of excess investment income under the caption Investments for a more detailed discussion.
Included in net income were after-tax realized investment losses which can fluctuate greatly from period to period. In 2003, they were $2 million compared with $25 million in 2002 and $815 thousand in 2001. Therefore, the 2002 realized investment losses resulted in an after-tax decline in 2002 net income of $24 million but an increase in 2003 net income of $23 million. Realized losses in 2002 were primarily
Total revenues rose 6% in 2003 to $2.93 billion. In 2002, total revenues increased 2% to $2.76 billion from $2.71 billion in 2001. The change in pretax realized investment losses accounted for 1% of the 2003 increase but offset 1% of the 2002 increase. The life premium increase was the primary contributor to revenue growth in both periods, adding 3% to revenue growth each year. Net investment income added 1% of the growth in each period, but the decline in annuity premium reduced 2002 revenues by 1%.
In 2001 through 2003, a number of significant, unusual, and nonrecurring items affected Torchmark’s net income. Torchmark management does not view these items as components of its core operating results because they are not indicative of past performance or future prospects of the insurance operations. A discussion of these items follows.
Also in 2001, Torchmark adopted a new accounting standard concerning the way asset-backed securities are to be accounted for and set forth new rules regarding their impairment. In accordance with this rule, Torchmark determined that certain of these assets were impaired, and an after-tax impairment charge in the amount of $27 million was taken upon adoption of this standard as a cumulative effect of a change in accounting principle. Please see Note 11-Change in Accounting Principle in the Consolidated Financial Statements for more detail on this item. As of December 31, 2003, Torchmark held $35 million at market value ($37 million at book value) of the securities subject to this standard.
Life insurance. Life insurance is Torchmark’s largest and fastest growing insurance segment. In 2003, life premium represented 55% of total premium, compared with 54% in 2002 and 52% in 2001. Life underwriting income before other income and administrative expense represented 65% of the total in 2003, up from 62% in 2002 and 59% in 2001.
The Direct Response Group is Torchmark’s leading writer of life insurance. Direct Response marketing is conducted primarily through direct mail, but also through co-op mailings, television and consumer magazine advertising, and direct mail solicitations endorsed by groups, unions and associations. Direct Response markets a line of life products primarily to juveniles, their parents, and other adults over age 50. The Direct Response operation accounted for almost 27% of Torchmark’s life insurance premium during 2003. Direct Response life premium rose 11% in 2003 and 9% in 2002. At December 31, 2003, Direct Response life annualized premium in force was $405 million, which represented 28% of Torchmark’s total, the largest of any distribution group. Direct Response life insurance annualized premium in force rose 13% in 2003 after growing 10% in 2002.
The Liberty National Exclusive Agency distribution system markets primarily to middle-income markets in several Southeastern states. Liberty’s life premium rose 1% in 2003 to $304 million, representing 23% of Torchmark’s total life premium. In 2002, life premium grew 2% over the prior year. The annualized life premium in force at the Liberty Agency was $321 million at December 31, 2003, representing 22% of Torchmark’s total life annualized premium in force. Annualized life premium in force rose 1% in each of the last two years. Life premium sales for this agency, in terms of annualized premium issued, declined 5% during 2003 to $54 million, compared with growth of 3% in 2002. The 2003 decline in sales resulted primarily from a new procedure adopted in April, 2003 whereby agents no longer accept the initial premium in the form of cash, a type of business prone to higher lapse rates. Instead, customers are required to pay the initial premium with a check. Management believes that the lower life insurance sales from this change in procedure will be temporary, and that over time, the new procedure is expected to result in sales of life policies that are more persistent, resulting in higher margins. The “cash with application” sales comprised 25% of life sales at the time this procedure was changed. Therefore, excluding these “cash with application” sales, issued premium would have increased 15% in 2003. The positive effect of this change is a factor in the increase of 2% in first-year collected premium in 2003, compared with no change in 2002.
Torchmark’s Military Agency consists of a nationwide independent agency whose sales force is comprised of former commissioned and noncommissioned military officers who sell exclusively to commissioned and noncommissioned military officers and their families. This business consists of whole- life products with term insurance riders and is characterized by low lapse rates. The Military Agency has steadily grown. In 2003, Military Agency life premium was $166 million or 13% of Torchmark’s total life premium. Premium rose 12% in 2003 and 11% in 2002. Growth in this agency continues to accelerate as annualized premium in force rose 13% in 2003 to $179 million after an increase in 2002 of 12%. One key to the growth of premium income and premium in force in the Military Agency is the high persistency associated with military business, as lapses are very low and most premium sold is retained. Sales of this agency grew 15% in terms of annualized premium issued in 2003 to $27 million, after an 11% increase in 2002. First year collections were $24 million in 2003, increasing 13% in 2003 and 9% in 2002.
Torchmark’s other life insurance distribution systems consist of the United Investors Agency, the United American Independent and Branch Office Agencies, and other small miscellaneous sales agencies. The United Investors Agency is comprised of several independent agencies, but prior to 2001, United Investors’ distribution was primarily through the sales representatives of a former Torchmark subsidiary, Waddell & Reed. Torchmark spun off Waddell & Reed in 1998, and United Investors terminated the Waddell & Reed agency contract in 2001. The loss of the Waddell & Reed sales group has had a negative impact on production in the United Investors Agency. The United American Independent and Branch Office Agencies combined represented approximately 41% of Other Agency premium in 2003, or 5% of the Torchmark total. Life premium for these agencies has been relatively flat for the past three years, because these two agencies focus on health insurance, with life sales being incidental.
life account balance was negatively impacted in those periods. However, in 2003, a rebound in markets had a favorable impact on the account balance. At December 31, 2003, the variable life account balance was $148 million, increasing 24% over the prior-year balance of $119 million. The following table summarizes selected variable life insurance information.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 9% in 2003 and 5% in 2002 over the respective prior year. As a percentage of life insurance premium, gross margins have remained fairly stable, with a slight improvement in 2003. Improvement in life margins should continue as the percentage of American Income premium to total premium continues to grow, because that agency’s margins are Torchmark’s highest. Also, Direct Response margins have increased from 24% to 25% in 2003, as it has emphasized sales of its juvenile policy, a higher-margin product.
Health products sold by Torchmark insurance companies are all supplemental plans that include Medicare Supplements sold to enrollees in the federal Medicare program, as well as other limited-benefit
Medicare Supplement annualized premium issued fell 23% in 2003 to $77 million from $99 million in 2002. In 2002, Medicare Supplement sales were down 37% from $159 million the prior year. The primary factor in the declining sales has been price competition. In recent periods, Medicare Supplement sales faced increased premium rate pressure from competition in some markets. Torchmark implemented premium rate increases on its Medicare Supplement policies earlier than some competitors in order to maintain the level of underwriting margins. In 2003, Torchmark was able to seek lower rate increases than obtained in recent years. Management believes that competitive pressures will subside as competitors obtain necessary rate increases. In addition to the increased competition, the number of producing agents at the United American Branch Office Agency declined in 2001 to 1,644 agents and further declined 22% in 2002 to 1,280 agents at December 31, 2002. These declines in counts occurred as agents in some markets left for easier sales for those competitors whose Medicare Supplement products were priced lower than Torchmark’s, negatively impacting Torchmark’s Medicare Supplement sales. In 2003, this trend reversed and the United American Branch Office Agency’s count grew 18% to 1,510 producing agents, as the focus of this agency was expanded to other supplemental health products discussed below which have experienced increased demand.
Medicare Supplement policies are highly regulated at both the federal and state levels with standardized benefit plans, limits on first year agent compensation, and mandated minimum loss ratios. Other regulatory issues continue to affect the Medicare Supplement market. Medical cost inflation and changes to the Medicare program necessitate annual rate increases, which generally require state insurance department approval. The Medicare program is constantly being studied and reviewed by Congress and the Executive Branch, with changes in the program expected from time to time.
However, Medicare Supplements remain a popular supplemental health policy with the country’s large and growing group of Medicare beneficiaries. About 85% of all Medicare beneficiaries have Medicare Supplements to cover at least some portion of the deductibles and coinsurance that the federal Medicare program does not pay. Because of minimum loss ratio regulation, underwriting margins on Medicare Supplements are lower than those on Torchmark’s life business. However, due to United American’s low cost, service-oriented customer assistance and claims administration, as well as its economies of scale, it is a profitable line of business. In 2003, Congress passed legislation that in 2006
will provide Medicare covered prescription drugs, a benefit not previously covered by Medicare. While this is a major addition to the Medicare program, it will have little effect on Torchmark’s Medicare supplement business because the legislation does not require Medicare supplements to cover the co-pays and deductibles that the Medicare drug program does not cover. In the past, Torchmark did not write any Medicare supplement plans that provided prescription drug coverage. At this time, it appears that there will continue to be an important role for private insurers such as Torchmark in helping senior citizens cover their healthcare costs. As a result, Medicare Supplements should continue as a popular product for senior-age consumers.
Cancer business is primarily produced by the Liberty National Agency. Cancer annualized premium in force represented 17% of Torchmark’s total health premium in force at December 31, 2003. Annualized premium in force rose 5% in 2003 and 2% in 2002. Approximately $79 million of the total $182 million of the cancer annualized premium in force consists of a closed block of cancer business which arose from a class action settlement in the mid-nineties. Cancer sales, in terms of annualized premium issued, were $14 million in 2003, 17% above $12 million sold in 2002. Sales in 2002 increased 9% over the prior year.
Health insurance underwriting margin before other income and administrative expense declined 2% in 2003 from $167 million to $164 million. In 2002, health underwriting income declined 3% from $173 million in 2001. As a percentage of premium, underwriting income before other income and administrative expense declined in each year from their respective prior years. The decreases in margins were caused
primarily by increased policy obligations in the previously-mentioned closed block of cancer policies as loss ratios on this block continue to exceed 100%. These increases in claims cost on this block resulted from additional benefits required in the class action settlements.
United Investors now markets variable annuities through other broker-dealers. In addition, a small amount of fixed annuities are sold by the United American Independent Agency and the Liberty National Agency. While Torchmark continues to sell annuity products, it does not expect to emphasize this product line in the future.
Fixed-annuity premium collections more than doubled in 2003 and almost doubled in 2002. The fixed-annuity deposit balance rose 18% in 2003 and 3% in 2002, reversing an 8% decline in 2001. The strong growth in the fixed-annuity deposits and account balance in 2003 resulted in large part from production by a United American General Agency through arrangements with banks. Additionally, many United Investors policyholders transferred funds from variable annuities to fixed products in both 2002 and 2003. Management believes that the poor market conditions in the past three years are a major factor in the transfers to the lower-risk fixed products.
Administrative expenses. Torchmark’s operating expenses are classified in two categories: insurance administrative expenses and expenses of the parent company. Consider the following information for the three years ended December 31, 2003.
Insurance administrative expenses as a percentage of premium and total operating expenses as a percentage of total revenue have held steady throughout the period considered. Increases in 2003 were mainly a result of an increase in pension expense of $2.7 million and slightly higher litigation expense.
the interest cost associated with capital funding or “financing costs.” Tax-equivalent investment income includes an adjustment to the yield on tax-exempt securities to produce a yield equivalent to the pretax yield on taxable securities. Tax-equivalent investment income is useful because it places all fixed maturities on a comparable-yield basis, regardless of tax treatment.
Net investment income rose 7% to $557 million in 2003 and 5% to $519 million in 2002. Included in 2003 investment income was a nonrecurring interest income item resulting from a tax settlement of $4.3 million pretax. On a tax-equivalent basis, as management views investment income, investment income also rose 7% in 2003 and 5% in 2002. The increases in 2003 and 2002 were caused by the growth in mean invested assets at book value, which were $7.8 billion in 2003, compared with $7.3 billion in 2002 and $6.9 billion in 2001. The impact of the 8% growth in assets in 2003 on investment income was partially offset by lower yields available on new investments. The growth in mean invested assets was achieved in 2003 and 2002 even though $225 million and $182 million, respectively, were used to buy back Torchmark stock under its ongoing share repurchase program each year. Growth in average invested assets has resulted from the investment of new cash flow into taxable fixed-maturity securities in both 2003 and 2002. These securities consisted primarily of investment-grade corporate bonds and trust preferred securities. More information about investment acquisitions follows under this caption.
Prior to July 1, 2003, preferred securities distributions were reported net of tax on the Consolidated Statements of Operations after income taxes in accordance with GAAP. Subsequent to July 1, 2003, upon adoption of SFAS 150, these distributions are included with interest expense.
Excess investment income rose 9% in 2003 to $321 million. It increased 15% in 2002 and 13% in 2001. Excess investment income per diluted share increased 14% in 2003 to $2.78 per share from $2.44
Torchmark’s investment strategy is to maintain a positive spread between yields on new investments and the Company’s required yield on policy and financing costs. It is this positive spread that results in excess investment income. At the same time, Torchmark desires to invest predominately in investment-grade quality corporate fixed maturities. In prolonged periods of low interest rates, maintaining sufficient spread while limiting new investments to high quality becomes more challenging. Because Torchmark’s policy liabilities are very long-term in nature with fixed rates, a low-rate environment must exist for a considerable period of time before any meaningful negative impact will be made on the spread. Nevertheless, Torchmark has addressed this issue in the recent periods of declining rates by lengthening maturities of new investment purchases and revising the crediting rates on various products.
Torchmark’s emphasis has been on bond investments over investments in equities, mortgages, or real estate. Therefore, the relative percentage of Torchmark’s investments by type continues to vary from industry norms. The following table presents a comparison of Torchmark’s components of invested assets at amortized cost as of December 31, 2003 with the latest industry data.
Torchmark calculates the average life and duration of the fixed-maturity portfolio two ways: (1) based on the same date used to calculate the yield, which is the “worst call” date for callable bonds and the maturity date for all other bonds, and (2) based on the maturity date of all bonds, whether callable or not.
The following table illustrates the market risk sensitivity of Torchmark’s interest-rate sensitive fixed-maturity portfolio at December 31, 2003 and 2002. This table measures the effect of a change in interest rates (as represented by the U.S. Treasury curve) on the fair value of Torchmark’s fixed-maturity portfolio. The data are prepared through a model which incorporates various assumptions and estimates to measure the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points. It takes into account the effect that special option features such as call options, put options, and unscheduled repayments could have on the portfolio, given the changes in rates. The valuation of these option features is dependent upon assumptions about future interest rate volatility that are based on past performance.
The following table summarizes Torchmark’s tax-effected realized gains (losses) by component for each of the years in the three-year period ended December 31, 2003.
Cash flows provided from operations increased in each of the three years ended December 31, 2003 over their respective prior year. They were $740 million in 2003, $651 million in 2002, and $618 million in 2001. In addition, Torchmark received $682 million in investment maturities and repayments in 2003, adding to available cash flows. Such repayments were $304 million in 2002 and $219 million in 2001.
Pension obligations are liabilities in trust funds that are funded by Torchmark to provide for the pensions. At December 31, 2003, these pension obligations were $170 million but there were also assets of $162 million in the plans to fund those obligations. The schedule of pension benefits is based on the same assumptions used to measure the pension obligations. All other benefit plan obligations are direct liabilities of Torchmark and are included in other long-term obligations.
Torchmark’s other long-term contractual obligations at December 31, 2003 consisted of its long-term future policy liabilities in the amount of $6.2 billion and its long-term employee benefit liabilities other than pensions in the amount of $12.5 million. Of these amounts, $26 million of insurance policy obligations and no employee benefit obligations were fixed and determinable as of December 31, 2003. These fixed and determinable obligations include amounts in which a specified balance is due to be paid at a certain specified date, such as an annuity certain. All other insurance and benefit liabilities contain life, death, or health contingencies causing either the timing, the amount of benefit, or both not to be known until the event occurs. Therefore, Torchmark has scheduled as contractual obligations only those long-term obligations which are fixed and determinable at December 31, 2003. In accordance with GAAP, Torchmark carries insurance and benefit liabilities on a discounted basis on its Consolidated Balance Sheet. However, for the purpose of this disclosure, total benefits are shown on an undiscounted basis.
Capital Resources. Torchmark’s capital structure consists of short-term debt (the commercial paper facility described above), long-term funded debt, trust preferred securities, and shareholders’ equity. An analysis of long-term debt issues outstanding is as follows at December 31, 2003.
The carrying value of the funded debt was $693 million at December 31, 2003, compared with $552 million a year earlier. Effective July 1, 2003, Torchmark adopted Statement of Financial Accounting Standard No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). This Statement specifies that Torchmark’s trust preferred securities are to be reported as a component of long-term debt subsequent to adoption, rather than as an item reported between liabilities and equity, and that prior periods may not be restated for comparative purposes. The inclusion of the trust preferred securities with funded debt added $144 million to the 2003 balance. Additionally, in accordance with accounting rules, Torchmark adjusts the carrying value of the 2006 Senior Notes for the change in value of the above-mentioned swap instrument, since that derivative qualifies as a hedge. This fair value adjustment for the swap declined $3 million in 2003 but increased $15 million in 2002. For more information about specific debt issues, please refer to Note 13-Debt in the Notes to the Consolidated Financial Statements.
Torchmark maintains a significant available-for-sale fixed-maturity portfolio to support its insurance policyholders’ liabilities. Torchmark is required by an accounting rule (SFAS 115) to revalue this portfolio to fair market value at the end of each accounting period. The period-to-period changes in fair value, net of their associated impact on deferred acquisition costs and income tax, are reflected directly in shareholders’ equity. Changes in the fair value of the portfolio result from changes in interest rates in financial markets. While SFAS 115 requires invested assets to be revalued, accounting rules do not permit interest-bearing insurance policy liabilities to be valued at fair value in a consistent manner. Due to the size of Torchmark’s policy liabilities in relation to its shareholders’ equity, this inconsistency in measurement usually has a material impact in the reported value of shareholders’ equity. If these liabilities were revalued in the same manner as the assets, the effect on equity would be largely offset. Fluctuations in interest rates cause undue volatility in the period-to-period presentation of Torchmark’s shareholders’ equity, capital structure, and financial ratios which would be essentially removed if interest-bearing liabilities were valued in the same manner as assets. For this reason, Torchmark’s management, credit rating agencies, lenders, many industry analysts, and certain other financial statement users prefer
to remove the effect of SFAS 115 when analyzing Torchmark’s balance sheet, capital structure, and financial ratios.
First Command. Lamar C. Smith, a director of Torchmark, is an officer and director of First Command Financial Services, Inc. (First Command), a corporation 100% owned by the First Command Employee Stock Ownership Plan (First Command ESOP). Mr. Smith is a beneficiary of the First Command ESOP although he has no ability to vote the stock of First Command that is held by the First Command ESOP. First Command, with 572 home office employees and more than 1,000 appointed agents both inside and outside the United States, receives commissions as the Military Agency distribution system for selling certain life insurance products offered by Torchmark’s insurance subsidiaries. These commissions were $59.4 million in 2003, $52.6 million in 2002, and $48.2 million in 2001. Torchmark held balances due from these agents of $15.0 million at year-end 2003 and $13.1 million at year-end 2002.
Torchmark has entered into two loan agreements with First Command, a construction loan agreement and a collateral loan agreement. The construction loan was entered into in 2001 and called for Torchmark to finance the construction of a building subject to a maximum amount of borrowing of $22.5 million. Upon completion, Torchmark committed to permanently finance the building with a fifteen-year mortgage at a rate of 2.25% over the ten-year treasury rate at that time, subject to a minimum rate of 7.0%. The building was completed in April, 2003 and the interest rate was reset to 7.0%. The outstanding balance is being repaid in equal monthly payments over fifteen years beginning May 1, 2003. At year-end 2003, the outstanding balance was $21.7 million. The loan is collateralized by a four-story building in Fort Worth, Texas. In addition to the office building as collateral, in the event of default, Torchmark has the right of offset to any commission due First Command.
Mr. Richey was a 25% investor in Stonegate Realty Company, LLC, the parent company of Elgin Development Company until December 31, 2003, at which time he became a 50% investor. Until December 31, 2003, he was also a one-third investor in Stonegate Management Company, LLC, which, in turn, is a 50% owner of Commercial Real Estate Services. As of December 31, 2003, he became a two-thirds investor in Stonegate Management. Commercial Real Estate Services manages certain of Torchmark’s company-occupied and investment real estate properties along with those of other clients. Fees paid by Torchmark subsidiaries for these management and maintenance services were $683 thousand in 2003, $750 thousand in 2002, and $757 thousand in 2001. Lease rentals paid by Torchmark subsidiaries were $261 thousand, $260 thousand, and $261 thousand in 2003, 2002, and 2001, respectively.
Guaranteed Minimum Policy Benefits. The American Institute of Certified Public Accountants issued Statement of Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1). This Statement is effective for Torchmark beginning January 1, 2004. This Statement covers various aspects of accounting for nontraditional product features in order to increase uniformity in practice. The primary issue affecting Torchmark is the accounting for liabilities for certain guaranteed minimum policy benefits. Torchmark believes that this accounting change will result in a charge to earnings in a range from $4 to $8 million net of tax in 2004 to establish the required additional liability. This charge will be recorded as the cumulative effect of a change in accounting principle.
Policy Claims and Other Benefits Payable. This liability consists of known benefits currently 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 and is made after careful evaluation of all information available to the Company. However, the factors upon which these estimates are based can be subject to change from historical patterns. Factors involved include medical trend rates and medical cost inflation, the litigation environment, regulatory mandates, and the introduction of policy types for which claim patterns are not well established. Changes in these estimates, if any, are reflected in the earnings of the period in which the adjustment is made. Torchmark management believes that the estimates used to produce the liability for claims and other benefits, including the estimate of unsubmitted claims, are the most appropriate under the circumstances. However, there is no certainty that the resulting stated liability will be Torchmark’s ultimate obligation.
Revenue Recognition. Premium income for Torchmark’s subsidiaries’ insurance contracts is generally recognized as the premium is collected. However, in accordance with GAAP, revenue on limited-payment contracts and universal life-type contracts (deposit balance products) are recognized differently. Revenues on limited-payment contracts are recognized over the contract period. Premium for deposit balance products, such as Torchmark’s annuity and interest-sensitive life policies, is added to the policy account value. The policy account value (or deposit balance) is a Torchmark liability. This deposit balance is then charged a fee for the cost of insurance, administration, surrender, and certain other charges which are recognized as revenue in the period the fees are charged to the policyholder. In each case, benefits and expenses are matched with revenues in a manner by which they are incurred as the revenues are earned.
The actuarial assumptions used in determining Torchmark’s 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 Torchmark’s pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. These assumptions are subjective in many cases and small changes in certain assumptions may cause material differences in reported results. While management has used its best efforts to determine the most reliable assumptions, given the information available from company experience, economic data, independent consultants and other sources, no assurance can be given that actual results will be the same as expected. The assumptions are reviewed annually and revised, if necessary, based on more current information available to the company. Torchmark’s discount rate, rate of return on assets, and projected salary increase assumptions are disclosed in Note 12-Postretirement Benefits in the Notes to Consolidated Financial Statements in this report. This note also contains information about pension plan assets, investment policies, funded status, and other related data.
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2003
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Recognition of Premium Revenue and Related Expenses: Premiums for insurance contracts which are not defined as universal life-type according to SFAS 97 are recognized as revenue over the premium-paying period of the policy. Profits for limited-payment life insurance contracts as defined by SFAS 97 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). Variable life and annuity products are also assessed an investment management fee and a sales charge. Life premium includes policy charges of $64.7 million, $69.0 million, and $71.3 million for the years ended December 31, 2003, 2002, and 2001, respectively. Other premium includes annuity policy charges for the years ended December 31, 2003, 2002, and 2001 of $31.2 million, $39.0 million, and $59.5 million, respectively. Profits are also earned to the extent that investment income exceeds policy liability 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.
Separate Accounts: Separate accounts have been established in connection with Torchmark’s variable life and annuity businesses. The investments held for the benefit of contractholders (stated at fair value) are reported as “Separate Account Assets” and the corresponding deposit balance liabilities are reported as “Separate Account Liabilities.” The separate account investment portfolios and liabilities are segregated from Torchmark’s other assets and liabilities. Deposit collections, investment income, and realized and unrealized gains and losses on separate accounts accrue directly to the contractholders. Therefore, these items are added to the separate account balance and are not reflected in income. Fees are charged to the deposit balance for insurance risk, administration, and surrender. There is also a sales charge and an investment management fee. These fees and charges are included in premium revenues.
Property and Equipment: Property and equipment is reported at cost less allowances for depreciation. Depreciation is recorded primarily on the straight line method over the estimated useful lives of these assets which range from two to ten years for equipment and five to forty years for buildings and improvements. Ordinary maintenance and repairs are charged to income as incurred. Impairments, if any, are accounted for in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Earnings Per Share: Torchmark presents basic and diluted earnings per share (EPS) on the face of the income statement. Basic EPS is computed by dividing income available to common stockholders by the weighted average common shares outstanding for the period. Diluted EPS is calculated by adding to shares outstanding the additional net effect of potentially dilutive securities or contracts, such as stock options, which could be exercised or converted into common shares. For more information on earnings per share, see Note 14-Shareholders’ Equity.
Reclassifications: Certain amounts in the consolidated financial statements presented have been reclassified from amounts previously reported in order to be comparable between years. These reclassifications have no effect on previously reported shareholders’ equity or net income for the periods involved.
The following table discloses unrealized investment losses by class of investment at December 31, 2003. Torchmark considers these investments to be only temporarily impaired.
In the event of lapses or early withdrawals in excess of those assumed, deferred acquisition costs and the value of insurance purchased may not be recoverable.
In 1996, Torchmark divested itself of the majority of its energy operations, which was accounted for as the disposal of a segment. At the time of the disposition, there was pending litigation in which Torchmark was named as a party. This litigation was settled in 2001, resulting in an after-tax charge of $3.3 million which is reflected in discontinued operations.
In 2003, 2002, and 2001, deferred income tax expense was incurred because of certain differences between net income from continuing operations before income taxes as reported on the consolidated statement of operations and taxable income as reported on Torchmark’s income tax returns. As explained in Note 1, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
Torchmark has not recognized a deferred tax liability for the undistributed earnings of its wholly-owned subsidiaries because such earnings are remitted to Torchmark on a tax-free basis. A deferred tax liability will be recognized in the future if the remittance of such earnings becomes taxable to Torchmark. In addition, Torchmark has not recognized a deferred tax liability of approximately $10 million that arose prior to 1984 on temporary differences related to the policyholders’ surplus accounts in the life insurance subsidiaries. A current tax expense will be recognized in the future if and when it becomes probable that all or a portion of the policyholders’ surplus accounts will become taxable.
Torchmark has net operating loss carryforwards of approximately $26.5 million at December 31, 2003 of which $.2 million expire in 2008; $21.6 million expire in 2020; and $4.7 million expire in 2021. A valuation allowance is to be provided when it is more likely than not that deferred tax assets will not be realized by the company. No valuation allowance has been recorded relating to Torchmark’s deferred tax assets since, in management’s judgment, Torchmark will more likely than not have sufficient taxable income in future periods to fully realize its existing deferred tax assets.
The excess benefit pension plan provides the benefits that an employee would have otherwise received from a defined benefit pension plan in the absence of the Internal Revenue Code’s limitation on benefits payable under a qualified plan. This plan is limited to a select group of employees and was closed as of December 31, 1994. Although this plan is unfunded, pension cost is determined in the same manner as for the funded plans. Liability for the excess benefit plan was $5.6 million at December 31, 2003 and $5.4 million at December 31, 2002.
The increase in pension assets during 2003 resulted primarily from improved financial markets and a $10.4 million contribution during the period.
The investment portfolio is to be well diversified to avoid undue exposure to a single sector, industry, business, or security. The equity and fixed-maturity portfolios are not permitted to invest in any single issuer that would exceed 10% of total plan assets at the time of purchase.
Torchmark does not employ any other special risk management techniques, such as derivatives, in managing the pension investment portfolio.
The accumulated benefit obligations (ABO) for Torchmark’s defined benefit pension plans were $150.4 million and $119.7 million at December 31, 2003 and 2002, respectively. Because the Excess Benefit Plan is unfunded, its ABO of $5.6 million and $5.4 million at December 31, 2003 and 2002, respectively exceeded plan assets.
For measurement purposes of the healthcare benefits, a 7.5% annual rate of increase in per capita cost of covered healthcare benefits was assumed for the years 2001 through 2003. Torchmark has assumed that the health care cost trend rate will remain stable at 7.5% in future periods. This trend rate assumption can have a significant effect on the amounts reported. The following table presents the effect of a one percentage point increase and decrease on the service and interest cost components and the benefit obligation:
Funded debt: Effective July 1, 2003, Torchmark adopted Financial Accounting Standards Board Statement 150-Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). SFAS 150 requires the reclassification in the financial statements of certain financial instruments which have both characteristics of liabilities and equity as liabilities. Included in the scope of this Standard are mandatorily redeemable securities, such as Torchmark’s Trust Preferred Securities (trust preferreds). Upon adoption of SFAS 150, Torchmark reclassified its trust preferreds as a component of long-term debt as of July 1, 2003. Restatement of prior periods for comparability is prohibited by the Standard. As such, the December 31, 2002 balance of $144,427 is shown on the Consolidated Balance Sheet between liabilities and equity. Pretax distributions were $11.6 million in both 2003 and 2002 and $1.6 million in 2001. As a result of the adoption of SFAS 150 in 2003, only the distributions prior to July 1 were reported as “Preferred securities distributions (net of tax)” on the Consolidated Statements of Operations. The distributions in the second half of 2003 of $5.8 million were reported in the Consolidated Statements of Operations as “Interest expense”. Torchmark’s other debt instruments were unaffected by the adoption of this Standard.
an annual 7 3/4% rate which is equivalent to an annual rate of $1.9375 per share. All dividends are cumulative. The trust preferreds are subject to a mandatory redemption on November 2, 2041, but Torchmark has the option to redeem in part or whole the securities at par value on or after November 2, 2006. All payments by the Capital Trusts regarding the trust preferreds are guaranteed by Torchmark. The Capital Trusts are wholly-owned consolidated trusts of Torchmark. The two offerings resulted in net proceeds of $145 million to the Capital Trusts. The Capital Trusts in turn used the proceeds to buy 7 3/4% Junior Subordinated Debentures from Torchmark in a like amount. Torchmark used these proceeds to redeem its outstanding 9.18% monthly income preferred securities (MIPS) in 2001 in the approximate amount of $110 million, with the remaining proceeds used to pay down short-term debt.
In a related transaction, Torchmark entered into a ten-year swap agreement to exchange a variable rate payment for the 7 3/4% fixed dividend obligation. The variable rate is based on the three-month LIBOR plus 221 basis points and resets each quarter in arrears when payments are made.
During 2001, Torchmark used funds received from short-term borrowings and the issuance of the trust preferreds to redeem its 8 million shares of 9.18% MIPS for a total cost of $200 million plus accrued dividends. Torchmark recognized an after-tax loss of approximately $4.3 million during 2001 as a result of the redemption. The loss was included in realized investment losses.
When the MIPS were originally issued in 1994, Torchmark entered into a ten-year swap agreement with an unrelated party which remains in effect. The agreement provides for Torchmark to exchange a variable rate based on the one-month LIBOR plus 139 basis points for a fixed rate of 9.18%. The rate resets each month.
The Notes, due May 15, 2023, were issued in May, 1993 in the principal amount of $200 million. Interest is payable on May 15 and November 15 of each year at a rate of 7 7/8%. In 2002 and 2001, Torchmark purchased principal amounts of $75 thousand and $8.1 million in the open market at a cost of $76 thousand and $8.3 million, respectively. Losses on the redemption of debt of $3 thousand and $425 thousand were included in realized investment losses in accordance with SFAS 145 during 2002 and 2001, respectively. These notes are not callable prior to maturity and have equal priority with other Torchmark unsecured indebtedness.
In connection with the issuance of the Senior Notes, Torchmark entered into a five-year swap agreement with an unaffiliated party to swap the 6 1/4% fixed rate payment obligation for a floating rate obligation. The floating rate is based on the six-month LIBOR plus 120.5 basis points and resets every six months.
Due to the Securities and Exchange Commission’s interpretive guidance concerning SFAS 133, the benefit of the interest spread has been reclassified from “Interest expense” to “Realized investment losses” in 2003 with all prior periods reclassified.
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 funds and for future employee stock option exercises. Share repurchases under this program were 5.9 million shares at a cost of $225 million in 2003, 4.8 million shares at a cost of $182 million in 2002, and 7.8 million shares at a cost of $303 million in 2001.
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. These restrictions generally limit the payment of dividends by insurance subsidiaries to statutory net gain from operations before realized capital gains or losses on an annual noncumulative basis in the absence of special approval. Additionally, insurance companies are generally not permitted to distribute the excess of shareholders’ equity as determined on a GAAP basis over that determined on a statutory basis. In 2004, $341 million will be available to Torchmark for dividends from insurance subsidiaries in compliance with statutory regulations without prior regulatory approval.
Certain employees, directors, and consultants have been granted options to buy shares of Torchmark stock, generally at the market value of the stock on the date of grant, under the provisions of the various Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring ten years and two days or eleven years after grant. Employee and consultant stock options generally vest one-half in two years and one-half in three years. Formula-based director grants generally vest in six months. A grant in August, 2001 vested immediately for all optionees other than those subject to SEC Section 16(a) reporting, whose options vest in six months. Stock options awarded in connection with compensation deferrals by certain directors and executives generally vest over ten years. Torchmark generally issues shares for the exercise of stock options from treasury stock.
As previously stated in Note 1-Significant Accounting Policies, Torchmark accounts for its employee stock options in accordance with SFAS 123, Accounting for Stock-Based Compensation as amended by SFAS 148, and has elected to account for its stock options under the intrinsic value method as outlined in APB 25 and permitted by SFAS 123. The fair value method requires the use of an option valuation model, such as the Black-Scholes option valuation model, to value employee stock options, upon which compensation expense is based. The estimated fair value of the options is then amortized to expense over the options’ vesting period. Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Changes in the valuation assumptions can materially affect the fair value estimate of its employee stock options. Under the intrinsic value method, compensation expense for Torchmark’s option grants is only recognized if the exercise price of the employee stock option is less than the market price of the underlying stock on the date of grant.
As required by SFAS 148, Accounting for Stock-Based Compensation-Transition and Disclosure, the pro forma earnings giving effect to the fair value method of option accounting has been reported in Note 1-Significant Accounting Policies. The fair value for Torchmark’s employee stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for 2003, 2002, and 2001:
Differs from Net investment income on Statement of Operations by $4,337 interest on tax settlement
Differs from Other operating expense on Statement of Operations by $807 loss on sale of airplane
Reinsurance: Insurance affiliates of Torchmark reinsure that portion of insurance risk which is in excess of their retention limits. Retention limits for ordinary life insurance range up to $2.5 million per life. Life insurance ceded represents 1.2% of total life insurance in force at December 31, 2003. Insurance ceded on life and accident and health products represents .5% of premium income for 2003. Torchmark would be liable for the reinsured risks ceded to other companies to the extent that such reinsuring companies are unable to meet their obligations.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represents 1.8% of life insurance in force at December 31, 2003 and reinsurance assumed on life and accident and health products represents .9% of premium income for 2003.
Concentrations of Credit Risk: Torchmark maintains a highly diversified investment portfolio with limited concentration in any given region, industry, or economic characteristic. At December 31, 2003, the investment portfolio consisted of the following:
Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. Most of the investments in foreign government securities are in Canadian government obligations. Corporate debt and equity investments are made in a wide range of industries. At December 31, 2003, 2% or more of the portfolio was invested in the following industries:
Guarantees: Torchmark has in place four guarantee agreements, all of which are 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, 2003, Torchmark had no liability with respect to these guarantees.
Letters of Credit: Torchmark has guaranteed letters of credit in connection with its credit facility with a group of banks. The letters of credit were issued by TMK Re, Ltd., a wholly-owned subsidiary, to secure TMK Re, Ltd.’s obligation for claims on certain policies reinsured by TMK Re, Ltd. that were sold by other Torchmark insurance companies. These letters of credit facilitate TMK Re, Ltd.’s ability to reinsure the business of Torchmark’s insurance carriers. The agreement is an annually renewable contract expiring in 2006. The maximum amount of letters of credit available is $200 million. Torchmark (parent company) would be liable to the extent that TMK Re, Ltd. does not pay the reinsured party. At December 31, 2003, $159 million of letters of credit were outstanding.
Equipment leases: Torchmark has guaranteed performance of two subsidiaries as lessees under leasing arrangements for aviation equipment. The leases commenced in 2003 for lease terms of approximately 10 years. Lessees have certain renewal and early termination options, however. At December 31, 2003, total remaining undiscounted payments under the leases were approximately $7.8 million. Torchmark (parent company) would be responsible for any subsidiary obligation in the event the subsidiary did not make payments or otherwise perform under the terms of the lease.
Many of these lawsuits involve claims for punitive damages in state courts of Alabama and Mississippi, jurisdictions particularly recognized for their large punitive damage verdicts. Torchmark’s management recognizes that large punitive damage awards continue to occur bearing little or no relation to actual damages awarded by juries in jurisdictions in which Torchmark has substantial business, particularly Alabama and Mississippi, creating the potential for unpredictable material adverse judgments in any given punitive damage suit. As of December 31, 2003, Liberty was a party to approximately 93 active lawsuits (including 7 employment related cases and excluding interpleaders and stayed cases), 66 of which were Alabama proceedings and 12 of which were Mississippi proceedings in which punitive damages were sought.
As previously reported in Forms 10-K and 10-Q, beginning in October 1999, Liberty was served with subpoenas from the Departments of Insurance of several states (Florida, Alabama, Georgia, Kentucky, Texas, South Carolina and Minnesota) in connection with investigations into Liberty’s sales practices and disclosures regarding industrial and low face amount coverage life insurance policies, specifically the historical use of race-distinct mortality in the design or pricing of industrial insurance, a practice discontinued by Liberty years ago. Liberty responded to all of these subpoenas in a timely fashion.
Liberty is a party to a number of lawsuits (both a large number of lawsuits brought by individual plaintiffs and purported class action litigation with extremely broad class periods and relief sought) involving allegations of racially discriminatory pricing in the sale of insurance to African Americans. This litigation began with the filing on December 8, 1999 of Moore v Liberty National Life Insurance Company, Case No. CV-99-BU-3262-S in the United States District Court for the Northern District of Alabama. There are currently a total of 17 race-distinct mortality cases with in excess of 700 named plaintiffs, which have been consolidated in the Moore case that are pending in the U.S. District Court for the Northern District of Alabama (either originally filed with the Court or transferred to that Court), two pending cases in Alabama Circuit Courts (Edwards v Liberty National Life Insurance Company, Case No. CV0005872 and Baldwin v. Liberty National Life Insurance Company, Case No. CV 00-684), which are currently stayed pending disposition of the Moore case, and three individual, multi-plaintiff lawsuits which were originally filed in various state courts in Mississippi and subsequently transferred to U.S. District Court for the North District of Mississippi. As previously reported, Liberty is awaiting a ruling from the Alabama Federal District Court on the issue of class certification in Moore. Additional information regarding the race-distinct mortality/dual pricing litigation can be found in the Company’s prior Forms 10-K and Forms 10-Q.
As previously reported in Forms 10-Q, Liberty and Torchmark are parties to purported class action litigation filed in the Circuit Court of Choctaw County, Alabama on behalf of all persons who currently or in the past were insured under Liberty cancer policies which are no longer marketed regardless of whether the policies remain in force or have lapsed (Roberts v. Liberty National Life Insurance Company, Case No. CV-2002-009-B). These cases are based on allegations of breach of contract in the implementation of premium rate increases, misrepresentation regarding the premium rate increases, fraud and suppression concerning the closed block of business and unjust enrichment. On December 30, 2003, the Alabama Supreme Court issued an opinion granting Liberty’s and Torchmark’s petition for a writ of mandamus, concluding that the Choctaw Circuit Court did not have subject matter jurisdiction and ordering that Circuit Court to dismiss the action. The plaintiffs have filed a petition asking the Alabama Supreme Court to reconsider this decision. Additionally, the plaintiffs refiled their purported class action litigation against Liberty and Torchmark in the Circuit Court of Barbour County, Alabama on December 30, 2003 (Roberts v. Liberty National Life Insurance Company, Civil Action No. CV2003 0137). Additional information regarding the Roberts case can be found in the Company’s prior Forms 10-Q.
As previously reported in the Form 10-Q for the third quarter, 2002, a trial court jury in Chambers County, Alabama Circuit Court returned a $3.2 million verdict against Liberty in Ingram v. Liberty National Life Insurance Company (Civil Action No. DV-96-62). This case, originally filed in March 1996, involved allegations that an interest-sensitive life insurance policy would have paid-up policy status in ten years. Liberty pursued appellate relief from this verdict and on February 20, 2004, the Alabama Supreme Court reversed and rendered the trial court’s judgment in Ingram. The Supreme Court held that the plaintiff’s claims were barred by the statute of limitations and that the plaintiff failed to demonstrate reasonable reliance on Liberty’s representations to him regarding the policy or that Liberty suppressed material facts.
During 2001, Torchmark entered into a coinsurance agreement with First Command’s life subsidiary whereby Torchmark cedes to First Command approximately 5% of the new life insurance business sold by First Command on behalf of Torchmark’s insurance subsidiaries. Under the terms of this agreement, First Command pays Torchmark a maintenance expense allowance equal to 5.5% of all premium collected and an issue allowance of 2.9% of first year premium collected. Torchmark is also reimbursed for actual commissions, premium taxes, and claims paid on the business ceded to First Command. Also under the agreement, Torchmark provides First Command certain administrative, accounting, and investment management services. Premium ceded in 2003 was $1.6 million, in 2002 was $780 thousand, and in 2001 was $108 thousand. At December 31, 2003, the face amount of life insurance ceded was $241 million and annualized ceded premium was $2.0 million.
Real Estate. Torchmark sold the majority of its investment real estate properties in two transactions in 1999. One of these transactions involved Elgin Development Company, of which R. K. Richey, the Chairman of the Executive Committee of Torchmark, was an investor. This transaction involved the sale of properties to an investor group of which Elgin Development Company was a 30% investor. At the time of the transaction, Mr. Richey was a one-third investor in Elgin Development Company, with a total investment in Elgin Development of approximately $1.5 million.
MidFirst Bank. Torchmark has engaged MidFirst Bank as the servicing agent for a portion of Torchmark’s subsidiaries’ commercial mortgages portfolios. George J. Records, a Torchmark director, was an officer, director, and 38.3% beneficial owner of Midland Financial Co., the parent corporation of MidFirst Bank until December 31, 2003. After that date, he is no longer a beneficial owner. Fees paid for these services were $110 thousand in 2003, $118 thousand in 2002, and $109 thousand in 2001.