We lease our principal office in Austin, Texas to service all business entities and operations. We also own properties in Austin and Buchanan Dam, Texas used for our general business operations and Louisiana related to our Home Service segment and business operations.
The following is management's discussion and analysis of the consolidated financial condition and consolidated results of operations of the Company. It is intended to be a discussion of certain key financial information regarding the Company and should be read in conjunction with the consolidated financial statements and related Notes to this Annual Report on Form 10-K.
Pricing adequacy depends on a number of factors, including the ability to obtain regulatory approval for rate changes, proper evaluation of underwriting risks, the ability to project future losses based on historical loss experience adjusted for known trends, the Company’s response to competitors, and expectations about regulatory and legal developments and expense levels. The Company seeks to price our insurance policies such that insurance premiums and future net investment income earned on premiums received will cover underwriting expenses and the ultimate cost of paying claims reported on the policies and provide for a profit margin. The Company has the ability to adjust dividend scales and interest crediting rates at its discretion based on economic and other factors. The profitability of fixed annuities, riders and other “spread-based” product features depends largely on the Company’s ability to earn target spreads between earned investment rates on assets and interest credited to policyholders.
The investment return, or yield, on invested assets is an important element of the Company’s earnings since insurance products are priced with the assumption that premiums received can be invested for a period of time before benefits are paid. The majority of the Company’s invested assets have been held in fixed maturities available-for-sale and held-to-maturity securities, primarily in asset classes of corporate bonds, municipal bonds, and government obligation bonds. The interest rate environment has a significant impact on the determination of insurance contract liabilities, our investment rates and yields and our asset/liability management.
Total stockholders' equity decreased from $249.1 million at December 31, 2016, to $223.5 million at December 31, 2017 due to the New Tax Act enacted on December 22, 2017, which resulted in tax expense for the current period of $35.1 million in 2017.
Insurance premiums decreased 0.1% in 2017 and rose 1.7% in 2016, respectively, primarily from our life insurance segment, which decreased $0.5 million from 2016.
Realized net investment gains in the current year resulted from a gain on the sale of a real estate holding totaling $1.1 million offset by other-than-temporary impairments ("OTTI") on investment securities. OTTI items recorded totaled $0.2 million and $4.3 million in 2017 and 2016, respectively, and are reported as realized losses. The OTTI in 2016 was somewhat offset by realized investment gains on sales of fixed maturity securities in our available-for-sale portfolio and sales of equity securities.
Policyholders' dividends decreased 8.3% in 2017 compared to 2016, due to the dividend rate actions taken by us at the end of 2016 to improve our product profitability.
General expenses increased 39.1% in 2017, due primarily to additional audit fees related to the 2016 audit, higher legal and consulting fees and higher permanent executive salaries and temporary salaries, offset by a decrease in our 7702/72(s)
Amortization of deferred policy acquisition expenses increased from $28.5 million at December 31, 2016 to $29.7 million at December 31, 2017 primarily due to the higher surrender activity.
Life Insurance. For over thirty-seven years, CICA and its predecessors have accepted policy applications from foreign nationals for U.S. dollar-denominated ordinary whole life insurance and endowment policies. We make our insurance products available using third-party marketing organizations and independent marketing consultants.
Premiums in this segment increased slightly in 2017 compared to 2016, as renewal premiums and first year premiums increased. We noted slight increases in 2016 compared to 2015 which were driven by renewal premiums.
Slow increases in the interest rate environment will limit increases in profit margins for insurers. We have been impacted by the historically low interest rate environment over the past several years as our fixed income investment portfolio, primarily invested in callable securities, has been reinvested at lower yields. The Company’s conservative investment strategy has not changed but we have focused new investments into securities of state, municipalities, essential services and corporate issuers compared to our historical investment in U.S. government holdings. Our investment earnings also impact the reserve and DAC balances, as assumptions are used in the development of the balances. Due to the recent decline in investment yields on our portfolio, our projection of long-term investment returns has declined. This has resulted in increasing the reserves on policies issued in the current year, as well as reducing the DAC asset.
As an increasing percentage of the world population reaches retirement age, we believe we will benefit from increased demand for living benefit products rather than death benefit products, as customers will require cash accumulation to pay expenses to meet their lifetime income needs. Our ordinary life products are designed to accumulate cash values to provide for living expenses in a policy owner's later years, while continuously providing a death benefit.
There has been a trend toward consolidation of domestic life insurance companies, due to significant losses incurred by the life insurance industry as a result of the credit crisis and related economic pressures, as well as increasing costs of regulatory compliance for domestic life insurance companies.
Innovation and digital development strategies will be implemented in various industries including the insurance industry in the coming years which could significantly impact our business. It will be critical that we embrace these changes to the benefit of our policyholders, agents and stockholders.
Premium Income. Premium income derived from life, accident and health, and property insurance sales remained relatively flat during 2017 compared to 2016, and increased 1.7% during 2016 compared to 2015. Life insurance reflected an increase resulting primarily from renewal premiums, which increased 2.2% in 2017 and 2.4% in 2016 and totaled $171.9 million, $168.3 million and $164.4 million on the consolidated level in 2017, 2016 and 2015, respectively. New sales, reflected as first year premiums, decreased 18.8% and 0.5%, and 2.7% in the life segment in 2017, 2016 and 2015, respectively. In 2017, to increase productivity, we introduced a set of repriced products in our international markets that are more expensive policies for our customers and likely negatively impacted our new sales. In addition, Venezuela, which has historically been one of our top markets, has experienced economic and social turmoil, which has negatively impacted our sales in the country, decreasing 10% year over year based upon total premiums from 2016 to 2017.
Endowment sales represent a significant portion of new business sales internationally with the 20-year endowment and endowment to age 65 as our top products. In addition, most of our life insurance policies contain a policy loan provision, which allows the policyholder to use cash value within a policy to pay premiums. The policy loan asset balance increased 10.6% and 10.8% in 2017 and 2016, year over year and remains in line with historical levels when compared to policy benefit liabilities.
Net Investment Income. Net investment income increased to $53.1 million in 2017 compared to $48.6 million in 2016, as we experienced higher average invested assets as a result of our investment of incoming premium revenue. Our yield on average invested assets increased three basis points from 2016 to 2017 as rates stayed similar on investments.
We have traditionally invested in fixed maturity securities with a large percentage held in callable issues. The sustained low interest rate environment of the past several years is holding down yields. While U.S. Treasury interest rates have risen recently after a fairly significant decline during 2016, yields on high quality corporate and municipal securities have been slower to rise. The interest rate direction is uncertain but as market interest rates begin to rise, our call risk will diminish, resulting in our fixed securities maturing at the stated maturity dates and our portfolio yield will rise more slowly over time, as new money investments would be made at higher rates.
Investment income from fixed maturity securities accounted for approximately 88.0% of total investment income for the year ended December 31, 2017. We have increased our investment purchases of corporate and municipal securities over the past several years, with no focus on any particular industry sectors in these security categories, but rather a focus on higher yielding, investment quality securities. In addition, we currently have $15.6 million invested in equity securities related to bond and stock mutual funds as these securities offer a competitive yield with a shorter duration. However, we have reduced our holdings over the last several years due to higher earnings volatility and RBC charges.
Realized Losses on Investments. Net realized gains in 2017 resulted primarily from a gain of $1.1 million recognized on the sale of a real estate holding reduced by impairments. Net realized investment losses recorded from OTTI on both fixed maturity and equity securities totaling $0.2 million and $4.3 million, in 2017 and 2016. The OTTI in 2016 was somewhat offset by realized investment gains on sales of fixed maturity securities in our available-for-sale portfolio and sales of equity securities.
Claims and Surrenders. As noted in the table below, claims, benefits and surrenders increased from $81.4 million in 2016 to $82.9 million in 2017.
Policy surrenders increased 10.4% in 2017 from 2016 and 6.3% from 2015 to 2016, or 0.8% and 0.7% of direct ordinary whole life insurance in force for 2017 and 2016, respectively. The increase in surrender expense is primarily related to our international business and is expected to increase over time due to the aging of this block of business. Our premium persistency rates have remained consistent for 2017 and 2016. A significant portion of surrenders relates to policies that have been in force over fifteen years and no longer have a surrender charge associated with them. Total direct insurance in force reported in 2017 was $5.0 billion and was consistent with 2016 and 2015.
Endowment benefits decreased slightly in 2017 compared to 2016 amounts. We have a series of international policies that carry an immediate endowment benefit of an amount selected by the policy owner. These benefits have been popular in the Pacific Rim and Latin America, where the Company has experienced increased interest in our guaranteed products in recent years. Annual guaranteed endowments are factored into the premium, and, as such, the increase or decrease is expected to have little impact on expected profitability.
Property claims decreased 10% to approximately $1.7 million in 2017 compared with the amount reported for 2016 due to a decrease in weather-related claims.
Increase in Future Policy Benefit Reserves. The change in future policy benefit reserves has increased in 2017 by 0.2% and decrease in 2016 by 1.5%. The 2016 decrease was mainly due to higher surrender activity recorded when compared to the prior year. Changes in future policy benefit reserves are largely driven by policyholder activity (e.g. premiums, surrenders, etc.)
Our Life Insurance segment primarily issues ordinary whole life insurance and endowment policies in U.S. dollar-denominated amounts to foreign residents in more than 30 countries through approximately 1,244 independent marketing consultants, and domestically through over 36 independent marketing firms and consultants throughout the United States.
Realized Investment Losses, Net. In 2017, 2016 and 2015, this segment recognized losses on other-than-temporary impairments totaling $13,500, $2.3 million and $3.8 million, respectively, related to bond and mutual fund holdings.
We noted increases in surrender expense over the last several years which is primarily related to our international business and is expected to increase over time due to the aging of this block of business. The majority of policy surrender benefits paid is attributable to our international business and historically was related to policies that have been in force over fifteen years, when surrender charges are no longer applicable. However, in 2017 and 2016, the increased surrender activity is also in the earlier durations (years 1-15), which still have surrender charges. We are seeing various reasons for individuals surrendering their policies, including the sustained slow world-wide economy, individuals simply needing their money and former independent consultants moving business to other insurance carriers.
Endowment benefit expense results from the election by policyholders of a product feature that provides an annual benefit. This is a fixed benefit over the life of the contract, and this expense will increase with new sales and improved persistency.
Other policy benefits resulted primarily from interest paid on premium deposits and policy benefit accumulations and increased as these policy liabilities also increased.
Increase in Future Policy Benefit Reserves. Policy benefit reserves in 2017 decreased compared to the same period in 2016, primarily as a result of the higher surrenders and the lower new sales as noted above.
Capitalization and Amortization of Deferred Policy Acquisition Costs. Capitalized costs decreased, as commission-related costs have decreased in the current year compared to 2016 based upon first year and renewal sales levels. Amortization of DAC increased in the current year by 3.5% from 2016 as we experienced increased surrender activity in the current year, including early duration elections to convert to reduced paid up ("RPU") or extended term insurance ("ETI") in 2017 and 2016. There are higher deferred acquisition costs associated with early duration conversions to RPU or ETI, which, when converted, increases amortization expense. Amortization of deferred policy acquisition costs is impacted by persistency and the higher level of surrenders is impacting our amortization.
Our Home Service Insurance segment provides pre-need and final expense ordinary life insurance and annuities to middle and lower income individuals primarily in Louisiana, Mississippi and Arkansas. Our policies in this segment are sold and serviced through funeral homes and a home service marketing distribution system utilizing over 650 employees and independent agents.
Death claims expense was relatively flat in 2017 compared to 2016, after decreasing in 2016 from 2015. Death claims can fluctuate from year to year. Mortality experience is closely monitored by the Company as a key performance indicator and these amounts were within expected levels.
Property claims decreased in 2017 compared to 2016 related to reported weather claims. The large increase in 2016 was primarily due to tornado activity in Louisiana earlier in the year and high winds that accompanied the severe flooding in Louisiana.
Capitalization and Amortization of DAC. DAC capitalization is directly correlated to fluctuations in first year commissions. Amortization of DAC increased from 2016 to 2017 by 7.5% and by 21.1% from 2015 to 2016. This increase in
This operating unit represents the administrative support entities to the insurance operations whose revenues are primarily intercompany and have been eliminated in consolidation under U.S. GAAP, which typically results in a segment loss.
(1) Includes $244.3 million and $273.4 million of securities guaranteed by third parties for the years ended December 31, 2017 and 2016, respectively.
(2) Includes $1.8 million and $2.2 million of U.S. Government agencies and government-sponsored enterprise for the years ended December 31, 2017 and 2016, respectively.
At December 31, 2017, investments in fixed maturity and equity securities were 90.5% of our total cash, cash equivalents and investments. All of our fixed maturities were classified as either available-for-sale or held-to-maturity securities at December 31, 2017 and 2016. We had no fixed maturity or equity securities that were classified as trading securities at December 31, 2017 or 2016.
The Company made new investments in A and BBB rated corporate bonds during 2017. Non-investment grade securities are the result of downgrades of issuers or securities acquired during acquisitions of companies, as the Company does not purchase below investment grade securities.
The Company held investments in special revenue bonds that were greater than 10% of fair value based upon the Company's portfolio of fixed maturity securities at December 31, 2017, as shown in the table below.
The Company invests in municipal securities of issuers in the state of Louisiana and receives a credit that reduces its premium tax liability in that state. At December 31, 2017, total holdings of municipal securities in Louisiana represented 4.2% of all municipal holdings based upon fair value.
In 2017 and 2016, the Company recognized losses on other-than-temporary impairments totaling $0.2 million and $4.3 million, respectively, related to bond and mutual fund holdings. In 2015, impairments of $5.4 million were recorded as a result of our OTTI analysis. Based upon our analysis of whether declines in fair value below cost are temporary or other-than-temporary, management believes that our investments in fixed maturity investments at December 31, 2017 were not impaired, and no additional other-than-temporary losses were recorded. Information on realized gains and losses by category, including OTTI, is set forth in our consolidated financial statements, Note 2 - "Investments."
As is customary among insurance companies, our insurance company subsidiaries reinsure with other companies portions of the life insurance risks they underwrite. A primary purpose of reinsurance agreements is to enable an insurance company to reduce the amount of risk by reinsuring the amount exceeding the maximum amount the insurance company is willing to retain. Even though a portion of the risk may be reinsured, our insurance company subsidiaries remain liable to perform all the obligations imposed by the policies issued by them and could be liable if their reinsurers were unable to meet their obligations under the reinsurance agreements.
A large portion of our debt security investment portfolio will mature in the next seven years and could be called sooner as we were subject to significant call activity beginning in 2009 due to the declining interest rate environment and we reinvested into shorter durations that are now approaching maturity. We will need to reinvest these maturing funds in the current interest rate environment. Our profitability could be negatively impacted depending on the market rates at the time of reinvestment. This could result in a decrease in our spread between our policy liability crediting rates and our investment earned rates. This could also negatively impact our liquidity.
Cash flows from our insurance operations historically have been sufficient to meet current needs. Cash flows from operating activities were $93.0 million, $102.3 million and $87.2 million for the years ended December 31, 2017, 2016 and 2015, respectively. Operating cash flow declined in 2017, due primarily to additional audit fees related to the 2016 audit, internal audit support, higher legal and consulting fees and higher permanent executive salaries and policyholder benefits. We have traditionally also had significant cash flows from both scheduled and unscheduled fixed maturity security calls, maturities, redemptions, and prepayments, which totaled $84.0 million, $70.4 million and $95.6 million in 2017, 2016 and 2015. These cash flows, for the most part, are reinvested in fixed income securities. Net cash outflows from investment activity totaled $85.0 million, $152.1 million and $58.0 million for the years ended December 31, 2017, 2016 and 2015, respectively. The outflows from investing activities for the year ended December 31, 2017, primarily related to the investment of excess cash and cash equivalents generated from operations during 2017 and 2016, in addition to the investment of excess cash held at the end of 2015. The Company's cash flows from financing activities were $2.5 million in 2017, $2.5 million in 2016 and $3.0 million in 2015.
On November 1, 2016, SPLIC paid a $20.0 million extraordinary dividend to its parent, CICA. The dividend had no impact on the consolidated financial statements of the Company and was used by CICA for general corporate purposes. The dividend was approved by the Louisiana Department of Insurance, SPLIC’s state of domicile. SPLIC’s risk-based capital after the dividend remains is in excess of minimum capital requirements.
In the second quarter of 2016, Citizens, Inc. purchased Class A Common shares from CTI with an approximate fair value of $0.8 million.
The Company does not have off-balance sheet arrangements at December 31, 2017 and, therefore, does not expect any future effects on the Company's financial condition related to any such arrangements. We do not utilize special purpose entities as investment vehicles, nor are there any such entities in which we have an investment that engages in speculative activities of any nature, and we do not use such investments to hedge our investment positions.
We utilize the factor method to determine the amount of costs to be capitalized and the ending asset balance. The factor method is based on the ratio of premium revenue recognized for the policies in force at the end of each reporting period compared to the premium revenue recognized for policies in force at the beginning of the reporting period. The factor method ensures that policies which lapsed or surrendered during the reporting period are no longer included in the deferred policy acquisition costs calculation. The factor method limits the amount of deferred costs to its estimated realizable value, provided actual experience is comparable to that contemplated in the factors.
Inherent in the capitalization and amortization of deferred policy acquisition costs are certain management judgments about what acquisition costs are deferred, the ending asset balance and the annual amortization. Approximately 95.0% of our capitalized deferred acquisition costs are attributed to first year and renewal excess commissions. The remaining 5.0% are attributed to other costs that vary with and are directly related to the successful acquisition of new insurance business. Those costs generally include costs related to the production, underwriting and issuance of new business.
DAC is subject to recoverability testing at the time of policy issuance and loss recognition testing on an annual basis, or when an event occurs that might require loss recognition testing. If loss recognition or impairment is necessary, DAC would be written off to the extent that anticipated future premiums and investment income is insufficient to cover expected future policy benefits and expenses. Loss recognition testing that considers, among other things, actual experience and projected future experience calculates the available premium (gross premium less the benefit and expense portion of premium) for the next 50 years. The available
The Company historically has performed a goodwill impairment test that follows a multi-step process as defined under current accounting guidance. An initial review may be performed whereby the assessment is based upon qualitative factors before performing the first test step. In the first step, the fair value of a reporting unit is compared to its carrying value. If the carrying value of a reporting unit exceeds its fair value, the second step of the impairment test is performed for purposes of measuring the impairment. In the second step, the fair value of the reporting unit is allocated to all of the assets and liabilities of the reporting unit to determine an implied goodwill value. If the carrying amount of the reporting unit goodwill exceeds the implied goodwill value, an impairment loss is recognized in an amount equal to that excess.
We elected to early adopt the FASB's issued Accounting Standards Update ("ASU") No. 2017-04, Simplifying the Test for Goodwill Impairment as discussed in Part IV, Note 1 - "Summary of Significant Accounting Policies". This ASU eliminates the step two test as noted above.
held-to-maturity and carried at amortized cost when management has the positive intent and the Company has the ability to hold the securities to maturity. Securities not classified as held-to-maturity are classified as available-for-sale and are carried at fair value, with the unrealized holding gains and losses, net of tax, reported in other comprehensive income and do not affect earnings until realized.
An estimated loss from a contingency is accrued and charged to results of operations only if both of the following conditions are met: