Through the domestic market of our Life Insurance segment, we provide ordinary whole life, credit life insurance, and final expense policies to middle income families and individuals in certain markets in the mid-west and southern U.S. The majority of our revenues are the result of acquisitions of domestic life insurance companies since 1987.
Profitability of our operations depends heavily upon the Company’s underwriting discipline, which seeks to manage exposure to loss through favorable risk selection and diversification, management of claims, use of reinsurance, the size of our in force block, actual mortality and morbidity experience, and our ability to manage our expense ratio, which we accomplish through economies of scale and management of acquisition costs and other underwriting expenses.
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 available-for-sale securities, including, among other asset classes, corporate bonds, municipal bonds, and government obligation bonds.
In 2008, the Company acquired ONLIC, an Arkansas domiciled life company. This entity provided an Arkansas field force of home service agents and funeral homes selling pre-need and final expense policies and was merged into SPLIC as of December 31, 2009, and is included in the Home Service segment. In the first quarter of 2009, the Company completed its acquisition of Integrity Capital Corporation (“ICC”). ICC is the parent of Integrity Capital Insurance Company (“ICIC”), an Indiana life insurance company that is included in the Life Insurance segment.
Net Investment Income. Net investment income increased $0.5 million with $30.1 million in 2010 compared to $29.6 million in 2009, primarily reflecting higher average invested balances as a result of investment of new premium revenue, partially offset by lower interest rates.
Investment yields have declined over the past several years, as the Company experienced significant calls by issuers of fixed maturity securities and those proceeds were reinvested into new securities yielding lower returns as the market rates declined. In the current low yield environment, we anticipate investment income will decline despite the higher invested asset balances.
We continue to invest in bonds of U.S. Government-sponsored enterprises, such as Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Association (“FHLMC”), due to our conservative investment strategy of investing in high quality issuers. The Company increased holdings in corporate and municipal bonds during the current year and over 87.1% of total investment income in 2010 was attributable to the Company holdings of fixed maturity securities. Policy loan income increased in the current year due to the growth in the asset balance, as policyholders utilized the policy loan feature to pay premiums and keep policies in force.
Income related to equity securities declined in the current year due to the fact the Company disposed of a significant number of these securities during the year, resulting in lower investment income from dividends. The majority of the disposed securities had been previously impaired. Other investment income for the year ended December 31, 2009 included a legal settlement of $0.2 million in connection with a defaulted bond investment.
Claims and Surrenders. As noted in the table below, claims and surrenders increased 1.8% from $60.0 million in 2009 to $61.0 million in 2010. The 2010 increase primarily related to an increase in endowment benefits, as well as an increase in other policy benefits, which is mostly interest on other policyholder liabilities. These policy related interest bearing liabilities increased $7.3 million in 2010 over 2009.
The Company monitors death claims based upon expectations. The claims experience has remained relatively consistent over the last three years. These values may routinely fluctuate from year to year.
Policy surrenders increased in 2010 and 2009 compared to 2008, but remained at a level that represents approximately 0.4% of direct insurance inforce. 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. 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 inforce reported in 2010 was $4.5 billion, and in 2009 was $4.4 billion compared to $4.3 billion in 2008.
Endowment benefits increased in each of the last three years. We have a series of international policies that carry an immediate endowment benefit of an amount elected 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. Like policy dividends, endowments are factored into the premium and, as such, the increase has no impact on profitability. The Company expects these benefits to continue to increase as this block of business increases.
Property claims remained consistent in 2010 with the amount reported for 2009. In 2008, Hurricanes Gustav and Ike swept through Louisiana resulting in an increase in property claims of $800,000.
Commissions. Commission expense fluctuates in a direct relationship to new and renewal insurance premiums.
Cost of Customer Relationships Acquired and Other Intangibles. The 2009 increase related primarily to the ICC acquisition and greater amortization due to the increase in lapses on this new block of business.
Federal Income Tax. Federal income tax expense was $4.1 million, $3.3 million and $3.1 million in 2010, 2009 and 2008, respectively, resulting in effective tax rates of 20.9%, 15.8% and 24.7%, respectively. The Company established a tax valuation allowance related to other-than-temporary impairment (“OTTI”) losses on its mutual funds of $6.9 million in 2008. The establishment of the valuation allowance had the effect of increasing tax expense. In 2009, $2.8 million of this allowance was released as a reduction of tax expense primarily due to the sale of approximately 42% of the mutual fund portfolio in 2009. The remaining $2.5 million valuation allowance was released in 2010, as the Company sold investments at a gain that enabled it to realize the tax basis losses, thereby making the valuation allowance no longer necessary. In addition, the fair value change related to outstanding warrants of $0.2 million reported as an increase in revenues in 2010 and $3.2 million in 2009 compared to a decrease in revenues of $2.7 million in 2008, which was not taxable and also impacted the corporate tax rate.
Premiums. Premium revenues increased for 2010 compared to 2009 and 2008, primarily due to higher renewal premiums, which have been trending up as this block of insurance ages. In addition, sales from Venezuela, Taiwan, Colombia and Ecuador represented the majority of the first year premium increase.
Realized Gains (Losses), Net. Realized gains of $6.6 million were recognized in 2010, due primarily to disposals of previously impaired equity mutual funds. Realized gains totaled $1.1 million in 2009 resulting from sales of available-for-sale fixed income securities, compared to realized losses of $13.9 million in 2008, primarily resulting from other-than-temporary impairments recognized on equity mutual fund holdings in 2008.
Endowment benefits have increased due to overall increase of endowment product sales in the past several years. Other policy benefits includes most notably interest credited on policy funds and dividends and coupons left on deposit at interest.
Other Underwriting, Acquisition and Insurance Expenses. The operating expenses increased from 2009 to 2010, due to renegotiating our agreement with Texas International Life Insurance Company (“TILIC”) whereby we paid $0.2 million, and an increase in credit card processing fees of approximately $0.2 million, as an increased number of policyholders are using our credit card payment option. The operating expenses have declined from 2008 to 2009 due to lower expenses related to staffing reductions, accountants and other consultants. The Company monitors all operating expenses and continues to seek efficiencies in our operations.
Premiums. The premium increases were due to enhanced marketing efforts to promote the Home Service segment, as well as a SPFIC rate increase that was effective in the latter part of 2009. The Company has received approval for an additional rate increase for SPFIC of approximately 5.7% that became effective January 1, 2011.
Net Investment Income. The current year increase was due to the increased size of the asset portfolio provided by new business sales and income earned on the portfolio. The Company experienced significant call activity beginning in the second quarter of 2009, which depressed our investment income and lowered portfolio yields. Call activity was again significant in the latter part of the second quarter of 2010, which resulted in a further reduction of investment income The 2009 results included a one-time positive adjustment from a legal settlement of $0.2 million related to a defaulted bond.
Realized Gains (Losses), Net. Gains of $1.5 million in 2010 relate primarily to sales of below investment grade securities that were added to the portfolio as part of an acquisition and had been previously impaired. Gains reported in 2009 totaled $6.6 million compared to losses of $9.9 million in 2008. The net gains in 2009 related primarily to sales of equity mutual funds that had been previously impaired. The impairments in 2008 relating to equity mutual funds totaled $9.9 million relative to the Home Service segment. Additional impairments of $0.3 million were recorded in 2009 due to further declines in fair values relating to credit issues.
Claims and Surrenders. Death claims vary from year to year, but were within expected actuarial expectations. Surrenders have been increasing as the Home Service block grows. The results in 2008 included incurred claims from Hurricanes Ike and Gustav totaling $0.8 million.
Increase in Future Policy Benefit Reserves. The reserves in 2009 included a decrease of $0.4 million resulting from a correction related to Ozark National Life Insurance Company, which was acquired in 2008.
Other Underwriting, Acquisition and Insurance Expenses. The decrease in 2010 was related to a reduction in premium taxes due to the utilization of larger tax credits and a reduction in salary expenses as part of a staff reduction plan.
The administration of our investment portfolios is handled by our management, pursuant to board-approved investment guidelines, with all trading activity approved by a committee of the respective boards of directors of our insurance company subsidiaries. The guidelines used require that bonds, both government and corporate, are of high quality, investment grade and comprise a majority of the investment portfolio. State insurance statutes prescribe the quality and percentage of the various types of investments that may be made by insurance companies and generally permit investment in qualified state, municipal, federal and foreign government obligations, high quality corporate bonds, preferred and common stock, real estate, mortgage loans and real estate within certain specified percentages. The assets selected are intended to mature in accordance with the average maturity of the insurance products and to provide the cash flow for our insurance company subsidiaries to meet their respective policyholder obligations.
Includes $53,979,000 of securities guaranteed by third parties for the year ended December 31, 2010.
As noted, the Company held municipal securities with third party guarantees. Detailed below is a presentation by rating.
The Company experienced a significant amount of maturities and call activity relative to the fixed income portfolio, with $387.4 million reported in 2010 compared to $292.7 million and $162.3 million in 2009 and 2008. As interest rates declined over the past two years, issuers called those holdings and the Company reinvested into lower yielding securities. The gross investment yield on the fixed maturity securities portfolio dropped approximately 40 basis points from 2009 compared to 2010. We expect lower yields on our investment portfolio due to the current low interest rate environment.
With the exception of SPLIC, virtually all of our subsidiaries fixed maturity investments are in U.S. Government or U.S. Government-sponsored enterprises or U.S. Government instruments. SPLIC has significant investments in corporate and municipal bonds. An additional impairment of $27,000 was recorded in 2010 to write a security down to zero carrying value. In 2009, the Company impaired three bonds for $0.1 million and a number of common stocks totaling $0.2 million. These 2009 impairments resulted from declines due to credit quality of the issuers and have been reflected as a realized loss in the accompanying income statement. The Company impaired two bonds totaling $0.3 million during 2008, because the Company did not expect these securities to recover in value. The Company recorded other-than-temporary impairment charges on its mutual fund equity securities in 2008 in the amount of $23.5 million because the Company did not expect these securities to recover in value in the near term. Based upon our emphasis on investing in fixed maturity securities primarily composed of obligations of U.S. Government-sponsored corporations and 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, 2010 were not impaired, and no additional other-than-temporary losses need to be recorded.
Our insurance subsidiaries monitor the solvency of their reinsurers in seeking to minimize the risk of loss in the event of default by a reinsurer. The primary reinsurers of our insurance subsidiaries are large, well capitalized entities.
Virtually all of the Company’s non-credit accident and health insurance has been reinsured and is administered by Texas International Life Insurance Company (“TILIC”), an unaffiliated party. The reinsurance recoverables under this agreement are collateralized by assets held in a trust for the benefit of the reinsured policies.
Cash flows from our insurance operations historically have been sufficient to meet current needs. Cash flows from operating activities were $60.5 million, $52.1 million and $46.4 million for the years ended December 31, 2010, 2009 and 2008, respectively. We have traditionally also had significant cash flows from both scheduled and unscheduled investment security maturities, redemptions, and prepayments, which totaled $387.4 million, $292.7 million and $162.3 million in 2010, 2009 and 2008. These cash flows, for the most part, are reinvested in fixed income securities. Net cash outflows from investment activity totaled $62.1 million, $68.8 million and $14.3 million for the years ended December 31, 2010, 2009 and 2008, respectively. The outflows from investing activities for the year ended December 31, 2010, primarily related to the investment of excess cash and cash equivalents generated from operations during 2010. The Company’s cash flows from financing activities were $2.6 million in 2010, $1.5 million in 2009 and $10.6 million in 2008. In 2008, the Company received $9.4 million from capital contributions relating to our Series A-1 preferred stock.
Policy loans comprised 4.9% of invested assets at December 31, 2010 compared to 4.8% at December 31, 2009. These loans, which are secured by the underlying policy values, have yields ranging from 5% to 12% and maturities that are related to the maturity or termination of the applicable policies. Management believes we maintain adequate liquidity despite the uncertain maturities of these loans.
Our cash balances at our primary depositories were significantly in excess of Federal Deposit Insurance Corporation coverage at December 31, 2010 and December 31, 2009. Management monitors the solvency of all financial institutions in which we have funds to minimize the exposure for loss. Management does not believe we are at significant risk for such a loss.
The NAIC has established minimum capital requirements in the form of Risk-Based Capital (“RBC”). Risk-based capital factors the type of business written by an insurance company, the quality of its assets, and various other aspects of an insurance company’s business to develop a minimum level of capital called “Authorized Control Level Risk-based Capital” and compares this level to an adjusted statutory capital that includes capital and surplus as reported under statutory accounting principles, plus certain investment reserves. Should the ratio of adjusted statutory capital to control level risk-based capital fall below 200%, a series of actions by the affected company would begin. At December 31, 2010, all of our insurance subsidiaries were above the required minimum levels.
Two of our subsidiaries fell below the minimum RBC threshold at December 31, 2008. A capital contribution of $1.0 million was made to SPFIC during the first quarter of 2009. An additional $1.0 million capital contribution was made to SPFIC in the third quarter of 2009. A capital contribution of $1.0 million was also made to Ozark National Life Insurance Company (“ONLIC”) during the first quarter of 2009 due to its RBC ratio falling below 200% at December 31, 2008. The decline in SPFIC’s capital balance mainly resulted from hurricane losses in 2008 and an increase in operating expenses. The reduction in ONLIC’s capital balance resulted from declines in asset values of preferred and common stock holdings. These capital contributions increased the RBC ratios and RBC action plans were submitted to the relevant insurance departments. The capital balance of ONLIC was determined to be at the Company Action Level at March 31, 2009 due to continued declines relative to its investment holdings. The capital contributions made in 2009 increased the ratios as anticipated in action plans submitted to the appropriate state insurance departments. The Company received approval from the respective state insurance departments to merge ONLIC into SPLIC as of October 1, 2009. The capital contributions did not impact the overall consolidated financial position or results of operations of the Company. All insurance subsidiaries were above the RBC minimums at December 31, 2010.
Due to a decline in statutory surplus, CNLIC no longer met minimum capital and surplus requirements as of June 30, 2010 in two states it is licensed in, Florida, deficient by approximately $0.4 million, and Mississippi, deficient by approximately $0.5 million. CNLIC currently maintains its Certificate of Authority, but voluntarily suspended sales in these states and its licenses were suspended. Life premiums collected in 2009 were $2,000 and $9,800 and in 2010 were $1,200 and $8,000 relating exclusively to policy renewals in Florida and Mississippi, respectively.
We continue to use the original assumptions (including a provision for the risk of adverse deviation) in subsequent periods to determine the changes in the liability for future policy benefits (the “lock-in concept”) unless a premium deficiency exists. Management monitors these assumptions and has determined that a premium deficiency did not exist as of December 31, 2010. Management believes that our policy liabilities and increase in future policy benefit reserves as of the years ended December 31, 2010, 2009 and 2008 are based upon assumptions, including a provision for the risk of adverse deviation, that do not warrant revision. The relative stability of these assumptions and management’s analysis is discussed below.
A recoverability test that considers, among other things, actual experience and projected future experience is performed at least annually. These annual recoverability tests initially calculate the available premium (gross premium less benefit and expense portion of premium) for the next 30 years. The available premium per policy and the deferred policy acquisition costs per policy are then calculated. The deferred policy acquisition costs are then evaluated over two methods utilizing reasonable assumptions and two other methods using pessimistic assumptions. The two methods using reasonable assumptions illustrate an early-deferred policy acquisition recoverability period. The two methods utilizing pessimistic assumptions still support early recoverability of our aggregate deferred policy acquisition costs. Management believes that our deferred policy acquisition costs and related amortization for the years ended December 31, 2010, 2009 and 2008 limits the amount of deferred costs to its estimated realizable value. This belief is based upon the analysis performed on capitalized expenses that vary with and are primarily related to the acquisition of new and renewal insurance business, utilization of the factor method and annual recoverability testing.
A recoverability test that considers, among other things, actual experience and projected future experience is performed at least annually. These annual recoverability tests initially calculate the available premium (gross premium less benefit and expense portion of premium) for the next thirty years. The CCRA is then evaluated utilizing reasonable assumptions. Management believes that our CCRA and related amortization is recoverable for the years ended December 31, 2010, 2009 and 2008. This belief is based upon the analysis performed on estimated future results of the block and our annual recoverability testing.
The evaluation of securities for impairments is a quantitative and qualitative process, which is subject to risks and uncertainties and is intended to determine whether declines in the fair value of investments should be recognized in current period earnings. The risks and uncertainties include changes in general economic conditions, the issuer’s financial condition or future prospects, the effects of changes in interest rates or credit spreads and the expected recovery period.
See Item 8. Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 1. Accounting Pronouncements.