The Company and its consolidated subsidiaries have three principal needs for cash - the insurance companies contractual obligations to policyholders, the payment of operating expenses and servicing of its long-term debt. Cash and cash equivalents as a percentage of total assets were 5% and 4% as of December 31, 1996, and 1995, respectively. Fixed maturities as a percentage of total invested assets were 80% and 78% as of December 31, 1996 and 1995, respectively.
Consolidated operating activities of the Company produced cash flows of $2,559,000, $687,000 and $1,338,000 in 1996, 1995 and 1994, respectively. The net cash provided by operating activities plus net policyholder contract deposits after the payment of policyholder withdrawals, equalled $9,370,000 in 1996, $9,701,000 in1995, and $9,555,000 in 1994. Management utilizes this measurement of cash flows as an indicator of the performance of the Company's insurance operations, since reporting regulations require cash inflows and outflows from universal life insurance products to be shown as financing activities.
Cash provided by (used in) investing activities was $16,163,000, ($8,030,000) and ($26,847,000), for 1996, 1995 and 1994, respectively. The most significant aspect of cash provided by (used in) investing activities is the fixed maturity transactions. Fixed maturities account for 82%, 76% and 79% of the total cost of investments acquired in 1996, 1995 and 1994, respectively. The net cash provided by investing activities in 1996, is due to the fixed maturities sold in conjunction with the coinsurance agreement with FILIC. The Company has not directed its investable funds to so-called "junk bonds" or derivative investments.
Policyholder contract deposits decreased 11% in 1996 compared to 1995, and increased 8% in 1995 when compared to 1994. Policyholder contract withdrawals has decreased 4% in 1996 compared to 1995, and increased 7% in 1995 compared to 1994. The changes in policyholder contract withdrawals is not attributable to any one significant event. Factors that may be causing the increase are the fluctuation of interest rates, competition and other economic factors. The Company's current marketing strategy and portfolio is directly structured to conserve the existing customer base and at the same time increase the customer base through new policy production.
The NAIC's risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. These requirements are intended to allow insurance regulators to identify inadequately capitalized insurance companies based upon the types and mixtures of risks inherent in the insurer's operations. The formula includes components for asset risk, liability risk, interest rate exposure, and other factors. Based upon their December 31, 1996, statutory financial reports, the Company's insurance subsidiaries are adequately capitalized under the formula.
Premium income, net of reinsurance premium, decreased 8% when comparing 1996 to 1995. The decrease in premium income is primarily attributed to the change in marketing strategy and to a lesser extent the change in distribution systems. The Company changed its marketing strategy from traditional life insurance products to universal life insurance products. Universal life and interest sensitive products contribute only the risk charge to premium income, however traditional insurance products contribute all monies received to premium income. The Company changed its marketing strategy to remain competitive.
Commissions and amortization of deferred policy acquisition costs decreased 8% in 1996 compared to 1995. The decrease was due to the decline in first year premium production.
Amortization of cost of insurance acquired decreased 12% in 1996 compared to 1995. Cost of insurance acquired is amortized in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The Company did not have any charge-offs during the periods covered by this report. The decrease in amortization during the current period is a normal fluctuation due to the expected future profits. Amortization of cost of insurance acquired is particularly sensitive to changes in persistency of certain blocks of insurance in-force.
Operating expenses increased 9% in 1996 compared to 1995. The primary factor that caused the increase in operating expenses is directly related to increased legal costs and reserves established for litigation. The legal costs are due to the settlement of non-standard insurance policies as was discussed in the review of life benefits. The Company incurred legal costs of $906,000, $687,000 and $229,000 in 1996, 1995 and 1994, respectively in relation to the settlement of the non-standard insurance policies.
Interest expense decreased 11% in 1996 compared to 1995. Since December 31, 1995, notes payable decreased approximately $1,623,000 which has directly attributed to the decrease in interest expense during 1996. Interest expense was also reduced as a result of the refinancing of the senior debt under which the new interest rate is more favorable. Please refer to Note 10 "Notes Payable" of the Notes to the Consolidated Financial Statements for more information on this matter.
Net investment income increased 9% when comparing 1995 to 1994. The change reflected an increase in the amount of invested assets, which was partially offset by a lower effective yield on investments acquired during 1995. The overall investment yields for 1995, 1994 and 1993, are 7.10%, 7.19% and 7.40%, respectively. The Company has been able to increase its investment portfolio through financing cash flows, generated by cash received through sales of universal life insurance products. Although the Company sold no fixed maturities during the last few years, it did experience a significant turnover in the portfolio. Many companies with bond issues outstanding took advantage of the lower interest rates and retired older debt which carried higher rates. This was accomplished through early calls and accelerated pay-downs of fixed maturity investments.
Realized investment losses were $349,000 and $146,000 in 1995 and 1994, respectively. Fixed maturities and equity securities realized net investment losses of $169,000 and real estate realized net investment losses $180,000 in 1995. The net realized investment losses for fixed maturities in 1995 is not attributable to any one specific transaction. The Company experienced moderate turnover in its fixed maturities portfolio during 1995. This was the result of many companies taking advantage of lower interest rates and refinancing higher coupon rate bonds with new securities at current lower rates. This was accomplished through early calls and accelerated pay downs that generated the net investment losses of fixed maturities. The realized investment losses for real estate is primarily attributable to one property. The property was re-evaluated during the year in relation to property values in the surrounding area of the property owned by the Company. In 1994, the Company realized net investment losses from equity securities and real estate of $119,000 and $513,000, respectively and realized an investment gain of $467,000 due to the sale of an insignificant subsidiary. The realized investment losses from real estate in 1994, was due to permanent impairment of the value of property located in Louisiana. The permanent impairment was due to recent appraisals and marketing analysis. The Company had other gains and losses during the period that comprised the remaining amount reported but were routine or immaterial in nature to disclose on an individual basis.
During the third quarter of 1994, UG became aware that certain new insurance business was being solicited by certain agents and issued to individuals considered to be not insurable by Company standards. These non-standard policies had a face amount of $22,700,000 and represented 1/2 of 1% of the insurance in force in 1994. Management's initial analysis indicated that the expected death claims on the business in force to be adequately covered by the mortality assumptions inherent in the calculation of statutory reserves. Nevertheless, management determined it was in the best interest of the Company to repurchase as many of the non-standard policies as possible. As of December 31, 1995, there remained approximately $5,738,000 of the original face amount which had not been settled. Through December 31, 1995, the Company spent a total of $2,886,000 for the repurchase of the non-standard policies and for the legal defense of related litigation. In relation to settlement of non- standard policies the Company incurred life benefits of $720,000 and $1,250,000 in 1995 and 1994, respectively. The Company incurred legal costs of $687,000 and $229,000 in 1995 and 1994, respectively.
Amortization of cost of insurance acquired decreased 11% in 1995 compared to 1994. Cost of insurance acquired is amortized in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The Company did not have any charge-offs during the periods covered by this report. The decrease in amortization during the current period is a normal fluctuation due to the expected future profits. Amortization of cost of insurance acquired is particularly sensitive to changes in persistency of certain blocks of insurance in force. The Company's average persistency rate for all policies in force for 1995 and 1994 has been approximately 87.5% and 86.3%, respectively.
Operating expenses increased 19% in 1995 compared to 1994. The increase was caused by several factors. The primary factor for the increase in operating expenses is due to the decrease in production. The decrease in production was discussed in the analysis of premium income. As such, the Company was positioned to handle significantly more first year production than was produced. First year operating expenses that were deferred and capitalized as a deferred policy acquisition costs asset was $532,000 in 1995 compared to $1,757,000 in 1994. The difference between the policy acquisition costs deferred in 1995 compared to 1994, effected the increase in operating expenses. The increase in operating expenses was offset, to a lesser extent, from a 12% reduction in staff in 1995 compared to 1994. The reduction in staff was achieved by attrition.
Mortgage loans decreased 21% in 1996 as compared to 1995. The Company is not actively seeking new mortgage loans, and the decrease is due to early pay-offs from mortgagee's seeking refinancing at lower interest rates. All mortgage loans held by the Company are first position loans. The Company has $603,000 in mortgage loans, net of a $10,000 reserve allowance, which are in default or in the process of foreclosure, this represents approximately 5% of the total portfolio. The mortgage delinquency rate for the insurance industry as published by the NAIC as the "Industry Experience Factor" is 6.5%.
Investment real estate and real estate acquired in satisfaction of debt decreased 17% in 1996 compared to 1995. The decrease was due to the sale of lots from the Company's Lake Pointe development and the sale of two foreclosed properties. Real estate holdings represent approximately 4% of the total assets of the Company. Total real estate is separated into four categories: Home Office 19%, Commercial 17%, Residential Development 37% and Foreclosed Properties 27%.
Total liabilities increased 2% in 1996 compared to 1995. Future policy benefits increased 4% in 1996 and represented 84% of total liabilities at December 31, 1996. Management expects future policy benefits to increase in the future due to the aging of the volume of insurance in force and continued production by the Company's sales force.
Other policyholder funds decreased 9% in 1996 compared to 1995. The decrease can be attributed to a decrease in premium deposit funds. Premium deposit funds are funds deposited by the policyholder with the insurance company to accumulate interest and pay future policy premiums. The change in marketing from traditional insurance products to universal life insurance products is the primary reason for the decrease. Universal life insurance products do not have premium deposit funds. All premiums received from universal life insurance policyholders are credited to the life insurance policy and are reflected in future policy benefits.
Most states also have insurance holding company statutes which require registration and periodic reporting by insurance companies controlled by other corporations licensed to transact business within their respective jurisdictions. The insurance subsidiaries are subject to such legislation and are registered as controlled insurers in those jurisdictions in which such registration is required. Statutes vary from state to state but typically require periodic disclosure concerning the corporation that controls the registered insurers and all subsidiaries of such corporation. In addition, prior notice to, or approval by, the state insurance commission of material intercorporate transfers of assets, reinsurance agreements, management agreements (see Note 9 of the Notes to the Financial Statements), and payment of dividends (see Note 2 of the Notes to the Financial Statements) in excess of specified amounts by the insurance subsidiary within the holding company system are required.
The National Association of Insurance Commissioners (NAIC) is an association whose membership consists of the insurance commissioners or their designees of the various states. The NAIC has no direct regulatory authority over insurance companies, however its primary purpose is to provide a more consistent method of regulation and reporting from state to state. This is accomplished through the issuance of model regulations, which can be adopted by individual states unmodified, modified to meet the state's own needs or requirements, or dismissed entirely.
At year end 1996, UG had two ratios outside the normal range. The first ratio compared commission allowances with statutory capital and surplus. The ratio was outside the normal range due to the coinsurance agreement with First International Life Insurance Company ("FILIC"). Additional information about the coinsurance agreement with FILIC can be found in Note 7 of the Notes to the Consolidated Financial Statements. Management does not believe that this ratio will be outside the normal range in future periods.
At December 31, 1996, each of the Company's insurance subsidiaries has a Ratio that is in excess of 300% of the authorized control level; accordingly the Company's subsidiaries meet the RBC requirements.
The NAIC has recently released the Life Illustration Model Regulation. This regulation requires products which contain non-guaranteed elements, such as universal life and interest sensitive life, to comply with certain actuarial established tests. These tests are intended to target future performance and profitability of a product under various scenarios. The regulation does not prevent a company from selling a product which does not meet the various tests. The only implication is the way in which the product is marketed to the consumer. A product which does not pass the tests uses guaranteed assumptions rather than current assumptions in presenting future product performance to the consumer.
The insurance industry is a mature industry. In recent years, the industry has experienced virtually no growth in life insurance sales, though the aging population has increased the demand for retirement savings products. Management believes that the Company's ability to compete is dependent upon, among other things, its ability to attract and retain agents to market its insurance products and its ability to develop competitive and profitable products.
Consolidated Statements of Shareholders' Equity . . . . . . . 33