Includes 7 3/4% Junior Subordinated Debentures reported as “Due to affiliates” on the Consolidated Balance Sheets at each year end 2004 and 2005 in the amount of $154.6 million. Also included at year end 2006 through 2008 are Torchmark’s 7.1% Junior Subordinated Debentures in the amount of $123.7 million, which are also reported as “Due to affiliates” on the Consolidated Balance Sheets.
The tables in Note 13-Business Segments 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, 2008. Additionally, this Note provides a summary of the profitability measures that demonstrates year-to-year comparability and which reconciles to net income. That summary is reproduced below from the Consolidated Financial Statements to present our overall operations in the manner that we use to manage the business.
** Included as an addition to income of both the Investment Segment and Realized investment gains.
Summary of Operations: Net income declined $75 million or 14% to $452 million in 2008. On a diluted per share basis, net income declined 7% to $5.11. The primary cause for the 2008 decline was after-tax realized investment losses of $70 million ($108 million before tax). These losses were due mostly to writedowns of fixed-maturity securities issued by Lehman Brothers and Washington Mutual. In 2007, net income grew 2% or $9 million over the prior year to $528 million. On a per share basis, 2007 net income grew 7% to $5.50. Per share earnings growth exceeded the growth in dollar earnings in both periods as a result of our share repurchase program discussed later under this caption. Life insurance was our strongest performing segment in both years, contributing $15 million to 2008 pretax growth and $20 million to 2007 growth. Margin improvements in this segment were a result of premium growth and lower obligation ratios in both periods. The investment segment also contributed to the growth in pretax income in each year, rising $4 million in 2008 and $5 million in 2007. Excess investment income, measuring the profit of the investment segment, was benefited by reduced financing costs and growth in the size of the investment portfolio in both years. The growth in excess investment income was attained even though significant cash flow has been used to buy Torchmark stock in all three periods.
In 2008, the contributions to growth in our life insurance and investment segments were more than offset by declines in our annuity and health segments. Our 2008 annuity underwriting loss was $6 million, compared with gains of $9 million in 2007 and $12 million in 2006. In 2008, declines in equity markets have caused variable policyholder account values to decline, guaranteed minimum death benefit costs to increase, policyholders to withdraw funds, and changes in actuarial assumptions all of which have resulted in the underwriting losses. We do not emphasize this segment and have discontinued the sale of variable annuities in 2008, only offering a fixed annuity product. Health insurance underwriting margin improved $2 million to $208 million in 2007, but declined 7% or $14 million in 2008 to $195 million. This
While we still offer fixed annuities, we do not emphasize sales of annuity products, favoring life insurance instead. See the caption Annuities for further discussion of the Annuity segment.
As previously mentioned, the investment segment’s pretax profitability, or excess investment income, increased $4 million in 2008 and $5 million in 2007. It had declined 2% in the previous year. This segment benefited from lower financing costs in each successive year. In 2008, these costs declined primarily due to lower rates and a lower average balance on our short-term debt. In 2007, our interest expense on funded debt declined due to the refinancing of the two funded debt issues noted below. Prior to 2008, the average yield on new investments acquired had been lower than the average portfolio yield, restricting growth in net investment income in relation to the size of the portfolio. In 2008, however, the yield on new investments exceeded the portfolio yield by 25 basis points. Growth in total investment income has been negatively affected by Torchmark’s share repurchase program (described later under this caption), which has diverted cash that could have otherwise been used to acquire investments. Management believes that the acquisition of Torchmark stock at favorable prices provides a superior return on available cash.
Index to Financial Statements As mentioned earlier in this summary, we wrote down certain fixed maturities and equities during 2008, including bonds issued by Lehman Brothers, Washington Mutual, and various other institutions in the pretax amount of $106 million. The write downs were taken as these securities met our criteria for other-than-temporary impairment. These writedowns compared with $11 million taken in 2007 and none in 2006. Please refer to Note 3-Investments in the Notes to Consolidated Financial Statements under the caption Other-than-temporary impairments for more information on these writedowns and our criteria for consideration of other-than-temporary impairment. Including the writedowns, we had total after-tax realized investment losses of $70 million in 2008 ($.79 per share), compared with a $2 million gain in 2007 ($.02 per share), and a $7 million loss in 2006 ($.07 per share). Realized investment gains and losses can vary significantly from period to period and may have a material positive or negative impact on net income. Under the caption Realized Gains and Losses in this report, we present a complete analysis and discussion of our realized gains and losses including the writedowns. Also, as explained in Note 13-Business Segments in the Notes to the Consolidated Financial Statements, we do not consider realized gains and losses to be a component of our core insurance operations or operating segments.
In 2006, Liberty began a program to dispose of its agency office buildings, replacing them with rental facilities. In 2006, 21 buildings were sold for gross proceeds of $6.7 million and a pre-tax gain of $4.8 million. In 2007, 21 additional buildings were sold for proceeds of $6.4 million and a pretax gain of $4.3 million ($2.8 million after tax). The program began to wind down in 2008 as five buildings were sold for proceeds of $787 thousand and a pretax gain of $278 thousand ($181 thousand after tax). Four buildings remained to be sold at December 31, 2008. Because of the significant scale of this nonoperating activity, we have removed $4.3 million ($2.8 million after tax) from our core results representing the gain in 2006 and the gains on the sales in 2007 and 2008.
Torchmark has in place an ongoing share repurchase program which began in 1986 and was reaffirmed at its October 30, 2008 Board of Director’s meeting. With no specified authorization amount, we determine the amount of repurchases based on the amount of the Company’s excess cash flow, general market conditions, and other alternative uses. The majority of these purchases are made from excess operating cash flow when market prices are favorable. Additionally, when stock options are exercised, proceeds from these exercises and the tax benefit are used to repurchase additional shares on the open market to minimize dilution as a result of the option exercises. The following chart summarizes share purchase activity for each of the three years ended December 31, 2008.
Throughout the remainder of this discussion, share purchases refer only to those made from excess cash flow and borrowings.
Life insurance premium rose 3% to $1.62 billion in 2008 after having increased 3% in 2007 to $1.57 billion. Life insurance products are marketed through several distribution channels. Premium income by channel for each of the last three years is as follows:
Index to Financial Statements Insert media, which targets primarily the adult market, involves placing insurance solicitations as advertising inserts into a variety of media, such as coupon packets, newspapers, bank statements, and billings. This media was historically placed by Direct Marketing and Advertising Distributors, Inc. (DMAD), previously an unrelated entity with which we have had a business relationship for over fifteen years. We acquired DMAD in January, 2007 for $47 million, and integrated their operations during 2007. This acquisition allowed the Company to expand marketing opportunities through increased solicitation volume and also improve margins through cost savings in the insert media component.
The Direct Response operation accounted for 32% of our life insurance premium during 2008, the largest of any distribution group. Direct Response’s share of total life premium has risen steadily in each of the last three years as illustrated in the chart above. Life premium for this channel rose 6% in both 2008 and 2007. Net sales rose 8% in 2008 to $123 million after a 1% decline in 2007 to $114 million. First-year collected premium increased 5% in 2008 to $80 million after a 2% decline in 2007.
The American Income Exclusive Agency focuses primarily on members of labor unions, but also on credit unions and other associations for its life insurance sales. It is a high profit margin business characterized by lower policy obligation ratios. Life premium for this agency rose 8% to $474 million in 2008, after having also increased 8% in 2007. Net sales increased 17% in 2008 to $108 million from $92 million in 2007. Net sales rose 7% in 2007. First-year collected premium rose 11% in 2008 to $82 million, after having increased 2% in 2007. As in the case of all of Torchmark’s agency distribution systems, continued increases in product sales are largely dependent on increases in agent count. Growth in the agent count has contributed to the improvements in sales in this agency. The American Income agent count was 3,085 at December 31, 2008 compared with 2,545 a year earlier, an increase of 21%. The agent count rose 8% in 2007 from 2,353 at year end 2006. This agency continues to recruit new agents focusing on an incentive program to reward growth in both the recruiting of new agents and in the production of new business. Additionally, the systematic, centralized internet recruiting program has enhanced the recruiting of new agents.
noncommissioned military officers and their families. This business consists of whole-life products with term insurance riders. Military premium represented 12% of life premium. The United American Independent and Branch Office Agencies combined represented approximately 3% of Torchmark’s total life premium. In the past, these agencies focused on health insurance, with life sales being incidental.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 4% in 2008 to $432 million after rising 5% in 2007. As a percentage of life insurance premium, gross margins have increased slightly each year and were 27% in 2008. Improvements in life margins have resulted from several factors. Margin improvements in both 2008 and 2007 were primarily the result of premium growth, but favorable mortality was also a positive factor. This improvement in mortality is not expected to be a trend. An important factor in the 2008 increase was that American Income’s obligation ratios decreased from 34% to 32%. Additionally, the proportion of American Income premium to total premium has grown each year, and that has caused life margins to increase because that agency’s margins are Torchmark’s highest, well exceeding 30% in all periods.
Index to Financial Statements Health Insurance. Health products sold by Torchmark insurance companies consist of supplemental plans that include limited-benefit hospital/surgical plans, cancer, and accident plans sold to people under age 65. We also sell Medicare Supplements to enrollees in the Federal Medicare program, as well as providing coverage under the Medicare Part D prescription drug program beginning January 1, 2006. Health premium represented 41% of Torchmark’s total premium income in 2008. Excluding Part D premium, health premium represented 37% in 2008, compared with 39% in 2007 and 40% in 2006. Health underwriting margin, excluding Part D, accounted for 29% of the total in 2008, compared with 30% in 2007 and 31% in 2006. These declines in the health percentages are indicative of the growth in the premium and profitability of our life segment in relation to our health segment. Health results have also been negatively affected by increased competition in recent periods. The following table indicates health insurance premium income by distribution channel for each of the last three years.
Total Medicare Part D premium and health premium exclude $7.3 million in 2007 of risk-sharing premium paid to the Centers for Medicare and Medicaid Services consistent with the Medicare Part D contract. In 2008, $122 thousand of risk-sharing premium was received. This risk-sharing amount is a portion of the excess or deficiency of actual over expected claims, and therefore we view this payment as a component of policyholder benefits in our segment analysis.
The following table presents net sales by distribution method for the last three years.
Index to Financial Statements The UA Branch Office is an exclusive agency, meaning the agents in its 85 offices nationwide sell only for us. In recent years, this agency has focused its efforts on sales of limited-benefit products, and has been successful in building the sales of these plans replacing the decline in Medicare Supplement sales.
In 2008, the UA Branch Office represented 51% of Torchmark’s non-Medicare Part D sales. Beginning in late 2007 and throughout 2008, this agency has experienced increased agent turnover and a decline in agent count due to increased competition in the sales of health products. As a result, sales and premium at the UA Branch Office declined in 2008. As is the case with all of our captive agencies, growing the agency size translates into increased sales and premium growth. After growing very rapidly in periods prior to mid-2007, the producing agent count in the UA Branch Office has declined since that time. At year end 2008, the producing agent count was 1,583, compared with 2,979 at the end of 2007 and 3,015 at December 31, 2006. These declines in agent count have resulted in the declines in net sales and premium growth shown in the charts above, especially in 2008. Efforts are underway to rebuild this agency. Going forward, we are shifting the emphasis in the UA Branch Office Agency to life and health products currently marketed by Liberty National agents. These products are priced to achieve higher profit margins and have better persistency than UA’s limited-benefit health insurance. We will continue to offer the current product portfolio, but the majority of our financial incentives will be used to encourage agents to sell the Liberty National product line. We believe this will improve the stability and profitability of the UA Branch Office Agency.
The UA Independent Agency is composed of independent agencies appointed with Torchmark whose size range from very large, multi-state organizations down to one-person offices. All of these agents generally sell for a number of insurance companies, of which 2,838 were active producing agents for Torchmark at December 31, 2008. This agency is our largest carrier of Medicare Supplement insurance, with $278 million or 57% of our Medicare Supplement premium income in 2008. Overall, this agency’s contribution to Torchmark’s total health sales and premium has declined in each of the past three years, as a result of the increased competition in Medicare Supplement sales. Health premium for the UA Independent Agency declined 8% to $357 million in 2008, after declining 7% in 2007. The declines in premium have resulted as new sales have not compensated for lapses.
The Liberty National Exclusive Agency, predominantly a life insurance distribution channel, is the third largest writer of Torchmark health business based on premium collected. Cancer supplemental plans are the type of limited-benefit health products primarily produced by this agency. Liberty is our only distribution channel for which cancer insurance is its primary health product. Liberty’s health premium declined 4% in 2008 to $135 million after a 3% drop in 2007. Several factors have contributed to the decline in health premium in this agency. Most notable has been the increased emphasis on sales of the higher-margin life products at Liberty. Another factor, prior to 2008, was the decline in agent count discussed earlier under the caption Life Insurance as a result of the change in the agent compensation system in 2006 to improve persistency and margins. However, recruiting and training initiatives have resulted in a significant increase in the Liberty agent count in 2008. Additionally, there was a settlement of a class-action lawsuit in early 2005 concerning a closed block of cancer business over the timing and size of the premium rate increases on this block. This block represented approximately half of Liberty’s cancer business at that time and approximately 37% at year end 2008. Prior to the settlement, significant rate increases to offset deteriorating margins on this block resulted in higher health premium, but increasing claims continued to reduce underwriting margins. The settlement provided for reduced benefits paid going forward and further required Liberty to reduce premiums and to maintain an 85% claims loss ratio over the remaining life of the business. Net health sales in the Liberty agency rose 22% to $12 million, compared with 2007 net health sales of $10 million. Net health sales had declined 16% from 2006 sales of $12 million.
American Income Exclusive Agency, also predominantly a life insurance distribution channel, is our fourth largest health insurance distributor based on 2008 premium collected. Its health plans are comprised of various limited-benefit plans for which approximately 69% of the agency’s 2008 health premium was from accident policies. Sales of the health plans by this agency are generally made in conjunction with a life policy being sold to the same customer.
Index to Financial Statements Annuities generate earnings from periodic policy fees and charges to the account balances, reduced by net policy obligations and acquisition costs. Policy charges and underwriting margins have declined in each of the periods presented, primarily due to the declines in our variable annuity business. Because policy charge revenues for variable annuities are based on the size of the policyholder’s account value, policy charges have declined each period as declining equity markets, voluntary terminations, and lower sales have resulted in decreases in the variable account balance, especially in 2008. In addition to the revenue declines, underwriting income for the variable product has been negatively affected by two other factors. First, we have guaranteed minimum death benefits to variable policyholders providing that a certain minimum death benefit will be payable to them regardless of the policyholders’ account value upon death. For this reason, we provide a reserve for this benefit for which the cost increases as the policyholder’s account value declines. This reserve is subject to the periodic review of underlying assumptions and a revision or “unlocking” when experience so indicates. In 2008, the additional charge to policy obligation expense from unlocking was $6.1 million, compared with reduced expense of $1.4 million in 2007 and $1.1 million in 2006. The other factor is that the deferred acquisition cost asset with regard to variable annuities is also subject to the unlocking of assumptions. Because of the variable account balance decline, future revenues and profits on variable business would also be expected to decline. This unlocking of assumptions resulted in a net charge of $7.5 million in 2008, compared with charges of $2.3 million in 2007 and $.9 million in 2006. Without these unlocking adjustments, variable underwriting income would have been $5.7 million in 2008 (42% of revenue), compared with $8.7 million (45% of revenue) in 2007 and $9.9 million (46% of revenue) in 2006. The unamortized deferred acquisition cost balance was $42 million at December 31, 2008 compared with $53 million at year end 2007. If equity markets do not stabilize, we could see higher amortization of acquisition costs in the future. The variable annuity business is our only business where margins are significantly impacted by changes in equity markets.
Insurance administrative expenses rose 3% in 2008, after a slight decline in 2007. As a percentage of premium, they rose to 5.8% in 2008, after having decreased from 5.6% in 2006 to 5.5% in 2007. The 2008 increase was primarily a result of higher salary expenses, pension costs, and other costs such as postage and property taxes. The 2008 increases were partially offset by lower legal expenses and Medicare Part D administrative expense. One factor in the higher 2007 legal expense was the affirmation of an earlier jury verdict in insurance claim litigation in the amount of $1.9 million. Medicare Part D administrative expenses were lower in both 2008 and 2007 than in 2006 because open enrollment remained in effect in 2006 until May 15, causing us to incur additional administrative expenses in that year. Open enrollments for the 2007 and 2008 plan years were closed on December 31 of the respective prior year. Salaries, particularly in 2007, were favorably impacted by the previously-mentioned changes to Liberty National’s agent compensation system. While these changes resulted in reductions in agent salaries and related employee costs of approximately $2.8 million in 2007 compared with 2006, new initiatives have resulted in an increase in these costs in 2008 of approximately $1.6 million over 2007. Management believes that these salary reductions could be replaced by higher deferred acquisition costs going forward, however, as the compensation system changes emphasize a commission-based agent compensation system rather than salaries. Commissions on new product sales are deferred and amortized over the premium-paying life of the business. Management believes that pension cost will increase approximately $8 million in 2009, as a result of the impact that declining financial markets have had on pension funding.
Parent company expense rose $640 thousand or 7% in 2008 and $2.0 million or 25% in 2007. Included in 2008 and 2007 expenses were charges in the amount of $2.9 million in 2008 and $1.6 million in 2007 for expenses incurred related to potential acquisition bids that were not successful.
* Deconsolidation of trusts liable for Trust Preferred Securities required by accounting rule FIN46R. See Note 10-Debt in the Notes to Consolidated Financial Statements.
Excess investment income increased $4 million or 1% in 2008 over the prior year. Excess investment income increased $5 million or 2% in 2007. On a per diluted share basis, 2008 excess investment income rose 10% to $3.71. Per share excess investment income increased 7% in 2007 and 3% in 2006.
The largest component of excess investment income is net investment income, which rose 3.5% to $671 million in 2008. It increased 3.2% to $649 million in 2007 from $628 million in 2006. As presented in the following chart, the growth in net investment income in both periods was not as great as the growth in mean invested assets.
Investment Acquisitions. Torchmark’s current investment policy calls for investing almost exclusively in investment-grade fixed maturities with long maturities (maturity date more than 20 years after acquisition date) that meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. We believe this strategy is appropriate because our cash flows are generally stable and predictable. If such longer-term securities do not meet our quality and yield objectives, new money is invested short-term, with maturities less than five years. During calendar years 2006 through 2008, Torchmark invested almost exclusively in fixed-maturity securities, primarily corporate securities. There were no below investment grade securities acquired. Investment-grade corporate securities include both bonds and trust-preferred securities (which are classified as redeemable preferred stocks) with a diversity of issuers and industry sectors.
Index to Financial Statements The following table summarizes selected information for fixed-maturity purchases. The effective annual yield shown in the table is the yield calculated to the potential termination date that produces the lowest yield. This date is commonly known as the “worst call date.” For noncallable bonds, the worst call date is always the maturity date. For callable bonds, the worst call date is the call date that produces the lowest yield (or the maturity date, if the yield calculated to the maturity date is lower than the yield calculated to each call date). Two different average life calculations are shown, average life to the next call date and average life to the maturity date.
At the end of 2008 and 2007, the fixed-maturity portfolio had a gross unrealized gain of $126 million and $247 million, respectively. Gross unrealized losses on fixed maturities were $1.9 billion at December 31, 2008, compared with $350 million a year earlier. For further analysis of our fixed-maturity portfolio by component at December 31, 2008 and 2007, an analysis of unrealized investment losses, and a schedule of maturities, see Note 3-Investments in the Notes to Consolidated Financial Statements.
The decline in effective duration during 2008 was a result of significantly higher discount rates implied by the decline in the market value of the portfolio, reducing sensitivity to changes in rates.
Index to Financial Statements Credit Risk Sensitivity. Credit risk is the level of certainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. Approximately 94% of our fixed-maturity holdings at book value are in corporate securities (including redeemable preferred and asset-backed securities). As we continue to invest in corporate bonds with relatively long maturities, credit risk is a concern. We mitigate this ongoing risk, in part, by acquiring investment-grade bonds and by analyzing the financial fundamentals of each prospective issuer. We continue to monitor the status of issuers on an ongoing basis. We also seek to reduce credit risk by maintaining investments in a large number of issuers over a wide range of industry sectors.
The following table presents the relative percentage of our corporate fixed maturities by industry sector at December 31, 2008.
Index to Financial Statements An analysis of the fixed-maturity portfolio by the Bloomberg Composite Rating at December 31, 2008 is shown in the table below.
The following table illustrates the market risk sensitivity of our interest-rate sensitive fixed-maturity portfolio at December 31, 2008 and 2007. This table measures the effect of a change in interest rates (as represented by the U.S. Treasury curve) on the fair value of the fixed-maturity portfolio. The data measures the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points.
As described in Note 3-Investments under the caption Other-than temporary impairments in the Notes to Consolidated Financial Statements, we wrote certain securities down to fair value during 2008 as a result of other-than-temporary impairment. The impaired securities met our criteria for other-than-temporary impairment as discussed in Note 3 and in our Critical Accounting Policies in this report. The writedown resulted in a 2008 pretax charge of $106 million ($69 million after tax). Of this pre-tax amount, $94 million consisted of bonds of Lehman Brothers and Washington Mutual and perpetual preferred stock of Federal National Mortgage Association as shown in the table below.
In 2007, we wrote down certain non-financial institution holdings because of other-than-temporary impairment. The pretax charge for this impairment was $11 million ($7 million after tax). At the time of impairment, these securities were carried at a value of $48 million. Since the writedown, a portion of these securities were sold for proceeds of $19 million in 2007 and the remainder was sold in 2008 for proceeds of $15 million.
Index to Financial Statements As discussed in Note 10-Debt in the Notes to Consolidated Financial Statements, we redeemed our 7¾% Trust Preferred Securities in 2006, recording a pretax loss of $5.5 million ($3.6 million after tax). Additionally in 2006, we repurchased with the intent to retire $3.3 million principal amount of our 7 7/8% Notes, recording a pretax loss of $415 thousand ($270 thousand after tax).
In years prior to 2007, we entered into interest-rate swap agreements, swapping our fixed-rate commitments on our long-term debt for floating-rate commitments. Accounting rules required us to value our interest-rate swaps at their fair value at the end of each accounting period, and we recorded changes as a component of “Realized investment gains (losses)”. During the first half of 2006, we sold all remaining swap instruments, so that no swaps were held after June, 2006. More information on our swaps, including the accounting policies, is found in Note 1-Significant Accounting Policies and in Note 10-Debt in the Notes to Consolidated Financial Statements.
Parent Company Liquidity. An important source of cash flow to the parent company is dividends paid by the insurance subsidiaries. As allowed by insurance regulations, the insurance subsidiaries generally pay dividends to Torchmark Parent in amounts equal to their prior year earnings calculated on a statutory basis. These dividends are received in order to meet the Parent Company’s dividend payments on common and preferred stock, interest and principal repayment requirements on debt of the Parent Company, and operating expenses of the Parent. In 2008, $404 million in dividends were paid to the Parent Company, as compared with $458 million in 2007 and $428 million in 2006. After paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), Torchmark Parent had excess operating cash flow in 2008 of approximately $343 million. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2009, it is expected that the Parent Company will receive $348 million in dividends from subsidiaries and that a range of $320 million to $330 million will be available as excess cash flow, assuming that our Senior Debt due in August, 2009 is refinanced. Certain restrictions exist on the payment of these dividends. For more information on the restrictions on the payment of dividends by subsidiaries, see the restrictions section of Note 11-Shareholders’ Equity in the Notes to Consolidated Financial Statements. Although these restrictions exist, dividend availability from subsidiaries historically has substantially exceeded the cash flow needs for parent company operations.
Torchmark qualifies for and is participating in the Commercial Paper Funding Facility (CPFF), a facility created by the Federal Reserve Board to purchase commercial paper from eligible issuers. Torchmark can issue $305 million under the CPFF, which was the par amount outstanding at December 31, 2008 (book value $304 million).
Index to Financial Statements An additional source of parent company liquidity is a line of credit facility with a group of lenders which allows unsecured borrowings and stand-by letters of credit up to $600 million. As of December 31, 2008, we had available $95 million on this facility. For a detailed discussion of this line of credit facility, see the Commercial Paper section of Note 10-Debt in the Notes to Consolidated Financial Statements.
Off-Balance Sheet Arrangements. As fully described and discussed in Note 10-Debt in the Notes to the Consolidated Financial Statements and under the subcaption Funded Debt, Torchmark had outstanding $120 million (par amount) 7.1% Trust Preferred Securities at both December 31, 2008 and 2007. The capital trust liable for these securities is the legal entity which is responsible for the securities and facilitates the payment of dividends to shareholders. The trust is an off-balance sheet arrangement which we are required to deconsolidate in accordance with GAAP rules. Deconsolidation is required because the capital trust is considered to be a variable interest entity in which we have no variable interest. Therefore Torchmark is not the primary beneficiary of the entity, even though we own all of the entity’s voting equity and have guaranteed the entity’s performance. While these liabilities are not on our Consolidated Balance Sheets, they are represented by Torchmark’s 7.1% Junior Subordinated Debentures due to the trust. These Junior Subordinated Debentures were a Torchmark liability of $124 million par and book value at both December 31, 2008 and 2007. These securities are indicated as a capital resource to us under the caption Capital Resources in this report. The 7.1% preferred dividends due to the preferred shareholders are funded by our 7.1% interest payment on our debt to the trusts. As described in Note 14-Commitments and Contingencies in the Notes to Consolidated Financial Statements, we have guaranteed the performance of the capital trust to meet its financial obligations to the Trust Preferred shareholders.
As of December 31, 2008, we had no other significant unconsolidated affiliates and no guarantees of the obligations of third-party entities other than as described above. All of our guarantees, other than the Trust Preferred guarantee, were guarantees of the performance of consolidated subsidiaries, as disclosed in Note 14-Commitments and Contingencies.
The following table presents information about future payments under our contractual obligations for the selected periods as of December 31, 2008.
(1) Funded debt is itemized in Note 10-Debt in the Notes to Consolidated Financial Statements.
The carrying value of the funded debt was $722 million at December 31, 2008, the same as a year earlier. Our 8.25% Senior Debentures are due in August, 2009 at a redemption amount of $99.5 million plus accrued interest, and are classified as short-term debt because they are due within a year. As a result, reported long-term debt at December 31, 2008 was $499 million. If conditions in financial markets stabilize, we intend to refinance this debt with another issue. Otherwise, we intend to repay the debt with our excess cash flow.
Over the past several years, we have entered into swap agreements to exchange the fixed-rate commitments on our funded debt for floating-rate commitments. During the low interest-rate environment in recent years, these swaps were very beneficial in reducing our interest cost. However, as short-term rates rose in 2006 with no meaningful change in long-term rates, these swaps became less profitable. Because we believed that the swap settlements could have possibly become unprofitable, we disposed of our two remaining swap agreements during 2006 and held no swap agreements after June 2006. More information about our swaps is found in Note 10-Debt in the Notes to Consolidated Financial Statements under the caption Interest Rate Swaps.
Index to Financial Statements We maintain a significant available-for-sale fixed-maturity portfolio to support our insurance policyholders’ liabilities. Accounting rule (SFAS 115) requires that we revalue our 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 can result from changes in interest rates and liquidity 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 our policy liabilities in relation to our shareholders’ equity, this inconsistency in measurement usually has a material impact on 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 our 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, our management, credit rating agencies, lenders, many industry analysts, and certain other financial statement users prefer to remove the effect of SFAS 115 when analyzing our balance sheet, capital structure, and financial ratios.
Includes Torchmark’s 7.1% Junior Subordinated Debentures in 2008, 2007, and 2006 in the amount of $124 million.
*** Torchmark’s debt covenants require that the effect of SFAS 115 be removed to determine this ratio.
Effective in 2008, the FASB issued a new Statement SFAS 159, offering an option which, if elected, would permit us to value our interest-bearing policy liabilities and debt at fair value in our Consolidated Balance Sheets. However, unlike current accounting rules which permit us to account for changes in our available-for-sale bond portfolio through other comprehensive income, the new rule requires such changes to be recorded in earnings. Because both the size and duration of the investment portfolio do not match those attributes of our policyholder liabilities and debt, the impact on earnings could be very significant and volatile, causing reported earnings not to be reflective of core results. Therefore, we do not intend to elect this option.
The financial strength of our major insurance subsidiaries are also rated by Standard & Poor’s and A.M. Best. In 2007, Standard & Poor’s lowered its financial strength rating of United Investors to A from A+ and the ratings of Liberty, Globe, United American and American Income from AA to AA-, as a result of an expected lag in new business sales in the short term. In 2006, A. M. Best lowered its financial strength rating of United Investors to A (Excellent) from A+ (Superior), as a result of Torchmark’s diminished emphasis of that subsidiary’s business. The following chart presents these ratings for our five largest insurance subsidiaries at December 31, 2008.
Litigation. Torchmark and its subsidiaries are subject to being named as parties to pending or threatened litigation, much of which involves punitive damage claims based upon allegations of agent misconduct at the insurance subsidiaries. Such punitive damage claims that are tried in Alabama state courts may have the potential for significant adverse results since punitive damages in Alabama are based upon the compensatory damages (including mental anguish) awarded and the discretion of the jury in awarding compensatory damages is not precisely defined. Additionally, it should be noted that our subsidiaries actively market insurance in the State of Mississippi, a jurisdiction which is nationally recognized for large punitive damage verdicts. This bespeaks caution since it is impossible to predict the likelihood or extent of punitive damages that may be awarded if liability is found in any given case. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, contingent liabilities arising from threatened and pending litigation are not presently considered by us to be material. For more information concerning litigation, please refer to Note 14-Commitments and Contingencies in the Notes to the Consolidated Financial Statements.
The FASB has issued certain new standards potentially applicable to Torchmark, effective in future periods:
Financial Guarantee Insurance Contracts: Statement No. 163, Accounting for Financial Guarantee Insurance Contracts-an interpretation of FASB Statement No. 60 (SFAS 163) was issued in May, 2008 to clarify accounting for such instruments. Torchmark does not offer this form of insurance and therefore this Statement will not apply to us.
Approximately 73% of our liabilities for future policy benefits at December 31, 2008 are accounted for under the provisions of Statement of Financial Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises (SFAS 60), under which the liability is the present value of future benefits less the present value of the portion of the gross premium required to pay for such benefits. The assumptions used in estimating the future benefits for this portion of business are set at the time of contract issue. Under SFAS 60, these assumptions are “locked in” and are not revised for the lifetime of the contracts, except where there is a premium deficiency, as defined in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements under the caption Future Policy Benefits. Otherwise, variability in the accrual of policy reserve liabilities after policy issuance is caused only by variability of the inventory of in force policies. A premium deficiency event for Torchmark’s SFAS 60 business is very rare, and did not occur during the three years ended December 31, 2008.
The remaining portion of liabilities for future policy benefits pertains to business reported under Statement of Financial Accounting Standards No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments (SFAS 97). Under SFAS 97, the recorded liability is the fund balance attributable to the benefit of policyholders as determined by the policy contract at the financial statement date. Accordingly, there are no assumptions used in the determination of the SFAS 97 future policy benefit liability.
The remaining portion of deferred acquisition costs pertain to business reported under SFAS 97 for which deferred acquisition costs are amortized over the estimated lives of the contracts in proportion to actual and estimated future gross profits. These contracts are not subject to lock-in. Under SFAS 97, the assumptions must be updated when actual experience or other evidence suggests that earlier estimates should be revised. With the exception of variable annuities, as discussed earlier in this report, revisions related to our SFAS 97 assets have not had a material impact on the amortization of deferred acquisition costs during the three years ended December 31, 2008. The variable annuity block could sustain further increases in the level of amortization if equity markets do not stabilize. Amortization for SFAS 97 blocks other than variable annuities is not expected to have a material impact on operations for the foreseeable future.
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 us. The estimate of unreported
claims is based on prior experience and is made after careful evaluation of all information available to us. 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. We believe 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 our ultimate obligation. At this time, we do not expect any change in estimate to have a material impact on earnings or financial position consistent with our historical experience.
Revenue Recognition. Premium income from our subsidiaries’ insurance contracts is generally recognized as the premium is collected. However, in accordance with GAAP, revenues 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 our 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.
Valuation of Fixed Maturities: We hold a substantial investment in high-quality fixed maturities to provide for the funding of our future policy contractual obligations over long periods of time. While these securities are generally expected to be held to maturity, they are classified as available for sale and are sold from time to time, primarily to maintain our investment quality and diversification standards. We report this portfolio at fair value. Fair value is the price that we would expect to receive upon sale of the asset in an orderly transaction. The fair value of the fixed-maturity portfolio is primarily affected by changes in interest rates in financial markets, having a greater impact on longer-term maturities. Because of the size of our fixed-maturity portfolio, small changes in rates can have a significant effect on the portfolio and the reported financial position of the Company. This impact is disclosed in 100 basis point increments under the caption Market Risk Sensitivity in this report. However, as discussed under the caption Financial Condition in this report, we believe these unrealized fluctuations in value have no meaningful impact on our actual financial condition and, as such, we remove them from consideration when viewing our financial position and financial ratios.
impairments of investments are disclosed in Note 1-Significant Accounting Policies and Note 3-Investments in the Notes to Consolidated Financial Statements and the discussions under the captions Investments and Realized Gains and Losses in this report. While every effort is made to make the best estimate of status and value with the information available regarding an other-than-temporary impairment, it is difficult to predict the future prospects of a distressed or impaired security.
Defined benefit pension plans. We maintain funded defined benefit plans covering most full-time employees. We also have unfunded nonqualified defined benefit plans covering certain key and other employees. Our obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are offset, at least in part, by the growth in value of the assets in the funded plans. At December 31, 2008, our net liability under these plans was $56 million.
The actuarial assumptions used in determining our 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 the pension obligation. A decrease in projected salary increases will cause a decrease in this obligation. Small changes in assumptions may cause material differences in reported results for these plans. While we have used our best efforts to determine the most reliable assumptions, given the information available from company experience, economic data, independent consultants and other sources, we cannot be certain that actual results will be the same as expected. Our discount rate, rate of return on assets, and projected salary increase assumptions are disclosed and the criteria used to determine those assumptions are discussed in Note 9-Postretirement Benefits in the Notes to Consolidated Financial Statements. The assumptions are reviewed annually and revised, if necessary, based on more current information available to us. Note 9 also contains information about pension plan assets, investment policies, and other related data.
5) General economic, industry sector or individual debt issuers’ financial conditions that may affect the current market value of securities that we own, or that may impair issuers’ ability to pay interest due us on those securities;
9) Our inability to obtain timely and appropriate premium rate increases for health insurance policies due to regulatory delay;
11) Reported amounts in the financial statements which are based on our estimates and judgments which may differ from the actual amounts ultimately realized.
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2008
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31,
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, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, 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.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Torchmark’s internal control over financial reporting as of December 31, 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2009 expressed an unqualified opinion on Torchmark’s internal control over financial reporting.
Torchmark accounts for its variable interest entities under Financial Accounting Standards Board (FASB) Interpretation 46(R), Consolidation of Variable-Interest Entities, an interpretation of ARB No. 51 (FIN46R). This Standard clarifies the definition of a variable interest and the instructions for consolidating variable interest entities (VIE’s). Primary beneficiaries only are required to consolidate VIE’s. Therefore, a company may have voting control of a VIE, but if it is not the primary beneficiary of the VIE in accordance with FIN46R, it is not permitted to consolidate the VIE. The trust that is liable for Torchmark’s Trust Preferred Securities meets the definition of a VIE. However, Torchmark is not the primary beneficiary of this entity because its interest is not variable. Therefore, Torchmark is not permitted to consolidate its interest, even though it owns 100% of the voting equity of the trust and guarantees its performance. For this reason, Torchmark reports its 7.1% Junior Subordinated Debentures due to the trust as “Due to Affiliates” each period at its carrying value. However, Torchmark views the Trust Preferred Securities as it does any other debt offering and consolidates the trust in its segment analysis because GAAP requires that the segment analysis be reported as management views its operations and financial condition.
Investments: Torchmark classifies all of its fixed-maturity investments, which include bonds and redeemable preferred stocks, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in accumulated other comprehensive income. Policy loans are carried at unpaid principal balances. Mortgage loans, included in “Other long-term investments,” are carried at amortized cost. Investments in real estate, included in “Other long-term investments,” are reported at cost less allowances for depreciation. Depreciation is calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities of twelve months or less.
measured at fair value. The provisions of SFAS 157 are to be applied prospectively. The adoption of SFAS 157 had no material impact on Torchmark’s financial position or results of operations, as Torchmark’s assets and liabilities have historically been measured substantially in accordance with its provisions. For more information regarding Torchmark’s measurements and procedures, please see Note 3-Investments under the caption Fair Value Measurements.
As of the fourth quarter of 2008, Torchmark adopted FASB Staff Position EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20. The objective of this Statement was to make the impairment model for various asset-backed securities more consistent with other accounting guidance concerning other-than-temporary impairments of investment securities. It was adopted prospectively for interim and annual periods ending after December 15, 2008. The adoption of this Statement had no impact on Torchmark’s results or financial condition.
Determination of Fair Values of Financial Instruments: Fair values for cash, short-term investments, short-term debt, receivables and payables approximate carrying value. Fair values for long-term debt and equity securities are determined in accordance with SFAS 157. Fair values are based on quoted market prices, where available. Otherwise, fair values are based on quoted market prices of comparable instruments in active markets, quotes in inactive markets, or other observable criteria. Additional
Recognition of Premium Revenue and Related Expenses: Premium income for traditional long-duration life and health insurance products is recognized when due from the policyholder. Premiums for short-duration health contracts are recognized as revenue over the contract period in proportion to the insurance protection provided. Profits for limited-payment life insurance contracts as defined by Statement of Financial Accounting Standards No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments (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 $51 million, $52 million, and $54 million for the years ended December 31, 2008, 2007, and 2006, respectively. Other premium includes annuity policy charges for the years ended December 31, 2008, 2007, and 2006, of $14 million, $20 million, and $23 million, respectively. Profits are also earned to the extent that investment income exceeds policy liability interest 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.
As of January 1, 2007, Torchmark adopted Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides accounting guidance for deferred policy acquisition costs associated with internal replacements of insurance and investment contracts other than those already described in SFAS 97. The adoption of SOP 05-1 had no material impact on Torchmark’s financial position or results of operations.
The liability for these minimum guarantees is determined each period end by estimating the expected value of death benefits in excess of the projected account balance using actuarial methods and assumptions including mortality, lapses, and interest. This excess benefit is then recognized ratably over the accumulation period based on total expected assessments. The Company regularly evaluates estimates used. If actual experience or other evidence suggests that earlier assumptions should be revised, Torchmark adjusts the additional liability balance with a related charge or credit to benefit expense. At December 31, 2008, this liability was $2.5 million and at December 31, 2007 was $1.1 million.
Income Taxes: Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between
the financial statement book values and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Property and Equipment: Property and equipment, included in “Other assets,” 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. Original cost of property and equipment was $106 million and $131 million at December 31, 2008 and 2007, respectively. Accumulated depreciation was $55 million at year end 2008 and $82 million at the end of 2007. Depreciation expense was $5.0 million in 2008, $4.3 million in 2007, and $5.2 million in 2006. During 2008, Torchmark completed the construction of an office building adjacent to the home office building of its subsidiary United American Insurance Company (United American) in McKinney, Texas. As of December 31, 2008, the Company has spent approximately $23 million on the building and land, and approximately $3 million on equipment. Subsidiary Liberty National Life Insurance Company (Liberty) has sold the majority of its agency office buildings. In 2008, five offices were sold for proceeds of $787 thousand, recording a realized gain of $278 thousand before tax. In 2007, 21 buildings were sold for gross proceeds of $6.4 million, for a realized gain of $4.3 million. During 2006, 21 buildings were sold for gross proceeds of $6.7 million and a realized gain from the sales of $4.8 million. In 2008, Globe Life And Accident Insurance Company (Globe), a wholly-owned Torchmark subsidiary, sold two office buildings in Oklahoma City, Oklahoma for total proceeds of $7.5 million, recognizing a gain on the sale of $2.6 million.
Low-Income Housing Tax Credit Interests: As of December 31, 2008, Torchmark had $138 million invested in limited partnerships that provide low-income housing tax credits and other related Federal income tax and state premium tax benefits to Torchmark. The carrying value of these entities was $129 million at December 31, 2007. Significantly all of the return on the investments has been guaranteed by unrelated third-parties and has been accounted for using the effective-yield method. The remaining investments are non-guaranteed and are accounted for using the amortized-cost method. The Federal income tax benefits accrued during the year, net of related amortization of the investment, are recorded in “Income tax expense.” The premium tax benefits, net of the related amortization, are recorded in “Net investment income.” At December 31, 2008, $106 million of the investment is included in “Other assets” with the remaining $32 million included in “Other invested assets.” At December 31, 2007, the comparable amounts were $103 million and $26 million, respectively. Any unpaid commitments to invest are recorded in “Other liabilities.”
Litigation and Tax Settlements: Four significant legal and tax matters were settled in Torchmark’s favor in 2006. The first settlement involved a subsidiary disposed of several years ago, resulting in proceeds of $5.1 million after expenses. The second involved state income tax refunds of $6.7 million related to prior years. The third settlement related to the Company’s investments in Worldcom, amounting to $6.3 million, and representing a partial recovery of investment losses incurred prior to 2004. The final settlement involved Federal income tax issues related to prior years, and consisted of a benefit due of $7.4 million.
The litigation receipt related to the disposed subsidiary in 2006 and the WorldCom receipts were included in “Other income” on the Consolidated Statements of Operations. The legal settlement costs in 2008 and 2007 were included in “Other operating expense.” The state and Federal income tax settlements were included as reductions to “Income taxes.”
Stock Options: Torchmark accounts for its stock options under revised SFAS No. 123-Share-Based Payment (SFAS 123R). This Statement requires companies to recognize an expense in their
financial statements for stock options based on the “fair value method.” The fair value method requires that a fair value be assigned to a stock option on its grant date and that this value be amortized over the grantees’ service period.
The fair value method as outlined by SFAS 123R requires the use of an option valuation model to value employee stock options. Torchmark has elected to use the Black-Scholes valuation model for option expensing. A summary of assumptions for options granted in each of the three years 2006 through 2008 is as follows:
All of the above assumptions, with the exception of the expected term, are obtained from independent data services. The expected term is generally derived from Company experience. However, expected terms of grants made under the Torchmark Corporation 2005 Incentive Plan (2005 Plan) and the 2007 Long-Term Compensation Plan (2007 Plan), involving grants made in the years 2005 through 2008, were determined based on the simplified method as permitted by Staff Accounting Bulletins 107 and 110. This method was used because the 2005 and 2007 Plans limited grants to a maximum contract term of seven years, and Torchmark had no previous experience with seven-year contract terms. Prior to 2005, substantially all grants contained ten-year terms. Because a large portion of these grants vest over a three-year period, the Company still does not have sufficient exercise history to determine an appropriate expected term on these grants. Volatility and risk-free interest rates are assumed over a period of time consistent with the expected term of the option. Volatility is measured on a historical basis. Monthly data points are utilized by the independent quote service to derive volatility for periods greater than three years. Expected dividend yield is based on current dividend yield held constant over the expected term. Once the fair value of an option has been determined, it is amortized on a straight-line basis over the employee’s service period for that grant (from the grant date to the date the grant is fully vested).
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2008 and 2007 is as follows:
A schedule of fixed maturities by contractual maturity at December 31, 2008 is shown below on an amortized cost basis and on a fair value basis. Actual maturities could differ from contractual maturities due to call or prepayment provisions.
The collateral underlying asset-backed securities for which fair values are reported as Level 3 consists primarily of trust preferred securities issued by banks and insurance companies. None of the collateral is subprime or Alt-A mortgages (loans for which the typical documentation was not provided). None of the change in the fair value of Level 3 assets still held at the reporting date was included in net income.
During 2007, the securities of five issuers met the other-than-temporary impairment criteria and were written down to fair value, resulting in a pre-tax loss of $11.2 million ($7.3 million after tax). After the write downs, these securities were valued at $36.5 million. In 2008, the securities of two of these issues were written down an additional $3.3 million ($2.2 after tax). All of the securities impaired during 2007 were subsequently sold for an aggregate after tax gain of $733 thousand. As of year end 2008, previously written down securities remaining in the portfolio were carried at a fair value of $8.3 million. Otherwise, as of December 31, 2008, Torchmark has no information available to cause it to believe that any of its investments are other-than-temporarily impaired.
Net unrealized losses on fixed maturities increased from $103 million at December 31, 2007 to $1.8 billion at December 31, 2008. More than 56% of the net unrealized loss at December 31, 2008 was attributable to fixed maturity securities in the financial sector. Based upon conditions experienced by companies in the bond market and the commercial paper market, management believes that much of the unrealized loss at December 31, 2008 was attributable to illiquidity in the market, which contributed to a spread widening, and accordingly unrealized losses, on many securities that management expects to be fully recoverable. Due to the strong and stable cash flows generated by its insurance products, Torchmark has the ability to hold these securities until recovery and intends to do so.
Torchmark subsidiaries held 373 issues (CUSIP numbers) at December 31, 2008 that had been in an unrealized loss position for less than twelve months, compared with 303 issues a year earlier. Additionally, 330 and 121 issues had been in an unrealized loss position twelve months or longer at December 31, 2008 and 2007, respectively. Torchmark’s entire fixed-maturity and equity portfolio consisted of 1,686 issues at December 31, 2008 and 1,819 issues at December 31, 2007. The weighted average quality rating of all unrealized loss positions as of December 31, 2008 was BBB+.
The estimated fair value of mortgage loans, based on discounted cash flows, was approximately $18.0 million at December 31, 2008 and $18.5 million at December 31, 2007. Accumulated depreciation on investment real estate was $1.8 million and $22.9 million at December 31, 2008 and 2007, respectively.
(2) Amortization includes $7.5 million, $2.3 million, and $.9 million in 2008, 2007, and 2006, respectively, from unlocking adjustments due to actuarial assumption revisions related to Torchmark’s variable annuity business.
At the end of each period, the liability for unpaid health claims includes an estimate of claims incurred but not yet reported to the Company. This estimate is based on historical trends. The difference between the estimate made at the end of each prior period and the actual experience is reflected above under the caption “Incurred related to: Prior years.” Prior-year claims incurred during the year result from claim settlements at different amounts from those amounts originally estimated.
In 2008, 2007, and 2006, deferred income tax expense was incurred because of certain differences between net income before income taxes as reported on the Consolidated Statements of Operations and taxable income as reported on Torchmark’s income tax returns. As explained in Note 1-Significant Accounting Policies, these differences caused the financial statement book values of some assets and liabilities to be different from their respective tax bases.
For the tax years 1993 through 1998, Torchmark filed unitary state income tax returns with certain of its subsidiaries, including subsidiaries disposed of in 1998. Disputes arose regarding whether Torchmark was entitled to receive certain state tax benefit payments relating to these unitary returns. In 2006, an arbitration panel ruled in favor of the Company and payments of the state income taxes in dispute were made to Torchmark. As a result, in 2006, Torchmark recorded a state income tax benefit of $4.3 million, net of federal income tax.
Torchmark transacts business in Canada through a branch of one of its subsidiaries. For tax years prior to 2003, Canadian income tax authorities asserted that the branch carried on business in Canada through a permanent establishment and proposed additional taxes and interest. Torchmark challenged their assertion and litigated the issue before the Tax Court of Canada. In the second quarter of 2008, the Tax Court in Canada ruled in the Company’s favor and the Canadian tax authorities declined to appeal the Court’s decision. As a result, the Company recorded an $11.9 million tax benefit in 2008, including $5.4 million relating to the removal of amounts previously recorded by the Company for interest expense anticipated to be owed, net of Federal income tax, and $6.5 million relating to estimated interest income,
net of Federal income tax, required to be paid by the Canadian tax authorities on amounts previously deposited with the tax authorities. No tax years are currently under examination by Canadian tax authorities.
Torchmark has net operating loss carryforwards of approximately $26.9 million at December 31, 2008 which will begin to expire in 2021 if not otherwise used to offset future taxable income. In addition, Torchmark has a net capital loss carryover of $16.1 million at December 31, 2008 which will expire in 2010 if not otherwise utilized to offset capital gains. 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.
As noted in Note 1 - Significant Accounting Policies, On January 1, 2007, Torchmark adopted FIN 48, an interpretation which was issued to clarify the accounting for income taxes by providing a methodology for the financial statement recognition and measurement of uncertain income tax positions taken or expected to be taken in a tax return. As a result of the adoption, Torchmark recognized a $2.3 million decrease to its liability for unrecognized tax benefits. This decrease was accounted for as an adjustment to the January 1, 2007 balance of “Retained earnings” on the Consolidated Balance Sheet. Including the cumulative effect decrease at January 1, 2007, Torchmark had approximately $12.3 million of total gross unrecognized tax benefits, excluding $6.0 million of accrued interest expense net of Federal tax benefits. If recognized in future periods, $1.2 million of the gross unrecognized tax benefits as of January 1, 2007 would have reduced the effective tax rate. The remaining $11.1 million related to timing differences which, if recognized, would have had no effect on the Company’s effective tax rate.
Torchmark’s continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company has recognized interest income of $11.9 million, net of Federal income tax benefits, in its Consolidated Statement of Operations for 2008. The Company has an accrued interest receivable of $10.9 million, net of Federal income tax benefits, which is comprised of a $1.2 million interest payable relating to uncertain tax positions offset by a $12.1 million interest receivable relating to prior year IRS and Canadian examination settlements. The Company has no accrued penalties as of December 31, 2008.
Cost for the defined benefit pension plans has been calculated on the projected unit credit actuarial cost method. All plan measurements for the defined benefit plans are as of December 31 of the respective year. The defined benefit pension plan covering the majority of employees is funded. Contributions are made to this funded pension plan subject to minimums required by regulation and maximums allowed for tax purposes. Defined benefit plan contributions were $63 million in 2008 and $13 million in each of the years 2007 and 2006. Torchmark estimates as of December 31, 2008 that it will contribute an amount not to exceed $20 million to these plans in 2009. The actual amount of contribution may be different from this estimate.
The other supplemental benefit pension plan is limited to a very select group of employees and was closed as of December 31, 1994. It provides the full benefits that an employee would have otherwise received from a defined benefit plan in the absence of the limitation on benefits payable under a qualified plan. This plan is unfunded. Liability for this closed plan was $5 million at both December 31, 2008 and December 31, 2007. Pension cost for both supplemental defined benefit plans is determined in the same manner as for the qualified defined benefit plans.
The discount rate is determined based on the expected duration of plan liabilities. A yield is then derived based on the current market yield of a hypothetical portfolio of higher-quality corporate bonds which match the liability duration. The rate of compensation increase is projected based on Company experience, modified as appropriate for future expectations. The expected long-term rate of return on plan assets is management’s best estimate of the average rate of earnings expected to be received on the assets invested in the plan over the benefit period. In determining this assumption, consideration is given to the historical rate of return earned on the assets, the projected returns over future periods, and the spread between the long-term rate of return on plan assets and the discount rate used to compute benefit obligations.
For measurement purposes of the healthcare benefits, a range of 7-10% annual rate of increase in per capita cost of covered healthcare benefits was assumed for the years 2006 through 2008. Torchmark has assumed that the health care cost trend rate will remain stable at the 7-10% range in future periods. This trend rate assumption could have a significant effect on the amounts reported. However, because participants substantially pay the cost of this benefit, a 1% increase or decrease in the health care cost trend rate is not expected to have a significant effect in the service and interest cost components.
The amount of debt that becomes due during each of the next five years is: 2009-$404 million; 2010-$0; 2011-$0; 2012-$0; 2013-$94 million and thereafter-$539 million.
On June 20, 2006, Torchmark issued $250 million principal amount of 6 3/8% Senior Notes due June 15, 2016. Interest on the Notes is payable semi-annually and commenced on December 15, 2006. Proceeds from the issuance of this debt, net of expenses, were $246 million. The Notes are redeemable by Torchmark in whole or in part at any time subject to a “make-whole” premium, whereby the Company would be required to pay the greater of the full principal amount of the Notes or otherwise the present value of the remaining repayment schedule of the Notes discounted at a rate of interest equivalent to the rate of a United States Treasury security of comparable term plus a spread of 25 basis points.
On November 2, 2006, Torchmark’s 7¾% Trust Preferred Securities were called and redeemed in the amount of $150 million plus accrued dividends. These securities were originally issued in 2001 as preferred securities of Torchmark’s Capital Trusts I and II, deconsolidated variable interest entities similar to Trust III. Upon redemption of these securities, Capital Trusts I and II were liquidated. A loss of $3.6 million after tax was recorded on this redemption. Additionally, on December 15, 2006, Torchmark’s $180 million of 6¼% Senior Notes, due 2006, matured and were repaid with accrued interest.
Commercial Paper: On November 18, 2004, Torchmark entered into a credit facility with a group of lenders allowing unsecured borrowings and stand-by letters of credit up to $600 million. Originally a five-year facility set to terminate on November 18, 2009, the lending banks agreed in August, 2006 to extend the maturities to August 31, 2011. As a part of the facility, as of December 31, 2008, the Company has the ability to request up to $200 million in letters of credit to be issued against the facility. The credit facility is further designated as a back-up credit line for a commercial paper program, whereby Torchmark may borrow from either the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed $600 million less any letters of credit issued. Interest is charged at variable rates. At December 31, 2008, Torchmark had $305 million face amount ($304 million carrying amount) of commercial paper outstanding, $200 million of letters of credit issued, and no borrowings under the line of credit. During 2008, the short term borrowings under the facility averaged approximately $229 million, and were made at an average yield of 3.5%, compared with an average balance of $238 million at an average yield of 5.4% a year earlier. The facility does not have a ratings-based acceleration trigger which would require early payment. A facility fee is charged for the entire $600 million facility at a rate of 10 basis points. For letters of credit issued, there is an issuance fee of 27.5 basis points. Additionally, if borrowings on both the line of credit and letters of credit exceed 50% of the total $600 million facility, there is a usage fee of 10 basis points. Torchmark is subject to certain covenants for the agreements regarding capitalization and earnings, with which it was in compliance at December 31, 2008 and throughout the three-year period ended December 31, 2008. Borrowings on this facility are reported as short-term debt on the Consolidated Balance Sheets.
There was no capitalized interest during the three years ended December 31, 2008.
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. Dividends from insurance subsidiaries of Torchmark are limited to the greater of prior year statutory net gain from operations not including realized capital gains on an annual noncumulative basis, or 10% of prior year surplus, in the absence of special regulatory approval. Additionally, insurance company distributions are generally not permitted in excess of statutory surplus. Subsidiaries are also subject to certain minimum capital requirements. In 2008, subsidiaries of Torchmark paid $404 million in dividends to the parent company. During 2009, a maximum amount of $363 million is expected to be available to Torchmark from subsidiaries without regulatory approval.
Shareholders approved a new stock compensation plan in April, 2007, the Torchmark Corporation 2007 Long-Term Compensation Plan (2007 Plan), authorizing a total of 3,250,000 shares for potential grant. Of this total, a maximum of 250,000 shares may be granted as restricted stock. All shares available for grant under previous plans were no longer available for grant under the 2007 Plan.
A summary of stock compensation activity for each of the years in the three years ended December 31, 2008 is presented below:
An analysis of option activity for each of the three years ended December 31, 2008 is as follows:
A summary of restricted stock and restricted stock units granted during each of the years in the three year period ended December 31, 2008 is presented in the table below. Restricted stock holders are entitled to dividends on the stock and holders of restricted stock units are entitled to dividend equivalents. All grants vest over five years.
Additional information about Torchmark’s stock-based compensation as of December 31, 2008 and 2007 is as follows:
No equity awards were cash settled during the three years ended December 31, 2008.
(2) Reclassification of interest amount due to adoption of FIN46R (accounting rule requiring deconsolidation of Trust Preferred Securities)
(1) Reclassification of interest amount due to adoption of FIN46R (accounting rule requiring deconsolidation of Trust Preferred Securities)
Prior to 2006, management entered into swap derivative contracts to exchange certain of its fixed-rate debt securities to floating rates to reduce its interest cost. For this reason, management views the difference between the floating-rate interest paid and the fixed-rate interest received (the “spread”) as an adjustment to its financing cost in the Investment Segment and has reported it as such in this analysis. In
accordance with current accounting rules, this spread on a non-hedged swap must be included in the same line item as the swap’s change in fair value each period. Because of this rule, Torchmark includes the spread on all swaps in Realized investment gains and losses in the Consolidated Statements of Operations, as this is the line item that contains the fair value adjustment each period.
Assets for each segment are reported based on a specific identification basis. The insurance segments’ assets contain deferred acquisition costs (including the value of insurance purchased) and separate account assets. The investment segment includes the investment portfolio, cash, and accrued investment income. Goodwill is assigned to the insurance segments based on SFAS 142. All other assets, representing less than 2% of total assets, are included in the other category. The table below reconciles segment assets to total assets as reported in the consolidated financial statements.
Insurance affiliates also assume insurance risks of other companies. Life reinsurance assumed represented 1.3% of life insurance in force at December 31, 2008 and reinsurance assumed on life and accident and health products represented .7% of premium income for 2008.
Trust Preferred Securities: Torchmark entered into a performance guarantee for the obligations of the Torchmark Capital Trust III when the trust preferred securities were issued by that trust. It
guarantees payment of distributions and the redemption price of the securities until the securities are redeemed in full, or all obligations have been satisfied should Trust III default on an obligation. The total redemption price of the trust preferred securities is $120 million.
As previously reported, on March15, 1999, Torchmark was named as a defendant in consolidated derivative securities class action litigation involving Vesta Insurance Group, Inc. filed in the U.S. District
Vesta, its officers and directors, its insurance carriers and KPMG settled their portions of the litigation with class plaintiffs in 2001; Torchmark did not. Subsequently, in May 2003, Torchmark instituted separate litigation against KPMG which was resolved in March, 2006. In April, 2006, class plaintiffs In Re Vesta Insurance Group Securities Litigation filed a motion in U.S. District Court for the Northern District of Alabama renewing their claims against Torchmark based upon an allegation of control person liability. This matter was set for trial in the District Court on October 2, 2006 and was stayed pending resolution of an interlocutory appeal to the U.S. Circuit Court of Appeals for the Eleventh Circuit filed by class plaintiffs. The interlocutory appeal, which was filed August 23, 2006, sought a ruling whether and to what extent proportionate liability provisions might apply if the allegations of controlling person liability against Torchmark were ultimately proven. Arguments on the interlocutory appeal were heard by the Eleventh Circuit on July 31, 2007. On April 30, 2008, the Eleventh Circuit issued an opinion in the interlocutory appeal affirming the District Court’s denial of class plaintiffs’ motion to dismiss Torchmark’s affirmative defenses under the Private Securities Litigation Reform Act of 1995 (PSLRA). The Eleventh Circuit concluded that substantive controlling person liability under the federal securities law remained the same and survived the proportionate liability scheme established by PSLRA. The Court found that damages allocated against a controlling person found liable for a securities law violation were based upon the proportionate liability provisions in the PSLRA. A trial date of September 8, 2008 was set in the U.S. District Court for the Northern District of Alabama. The parties reached a settlement of the Vesta litigation on September 15, 2008. On September 25, 2008, the District Court issued an order preliminarily approving the settlement and directed the giving of notice thereof to the class members. After a final settlement hearing, the District Court entered a Final Judgment and Order of Dismissal With Prejudice approving the final settlement on December 12, 2008.
As previously reported in Forms 10-K and 10-Q, Liberty and Torchmark were 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 were no longer being marketed, regardless of whether the policies remained in force or lapsed (Roberts v. Liberty National Life Insurance Company, Case No. CV-2002-009-B). These cases were 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 then filed essentially identical purported class action claims 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. CV-03-0137).
In an opinion issued on September 29, 2006, the Alabama Supreme Court voided the Barbour County Circuit Court’s final judgment and dismissed the Roberts appeal. The Supreme Court held that the Barbour County Court lacked subject-matter jurisdiction in the separate Roberts action to certify the Roberts class and to enter a final judgment approving the settlement since Roberts was filed as an independent class action collaterally attacking Robertson rather than being filed in Robertson itself under the Barbour County Court’s reserved continuing jurisdiction over that case. On October 23, 2006, Liberty filed a petition with the Barbour County Circuit Court under its continuing jurisdiction in Robertson for clarification, or in the alternative, to amend the Robertson final judgment. Liberty sought an order from the Circuit Court declaring that Liberty pay benefits to Robertson class members based upon the amounts accepted by providers in full payment of charges. A hearing was held on Liberty’s petition on March 13, 2007.
On January 10, 2007, purported class action litigation was filed against Globe Life And Accident Insurance Company and additional unaffiliated defendants in the U.S. District Court for the Eastern
District of Texas (Taylor v. Texas Farm Bureau Mutual Insurance Company, Case No. 2-07-CV-014). Plaintiffs allege violations of the Driver Privacy Protection Act (DPPA) in Globe’s marketing activities. DPPA is federal legislation restricting the ability to obtain and use driver’s license and motor vehicle registration title information maintained by each state. Initially, DPPA allowed use of such personal information for marketing activities so long as the states provided individuals the opportunity to prohibit disclosure of their information. DPPA was amended effective June 1, 2000 to provide that using or obtaining personal information from motor vehicle records for marketing purposes is permitted only if the state involved obtained the express consent (“opt-in”) of the person whose data is being released. Plaintiffs, all residents and holders of Texas driver’s licenses, allege that Globe wrongfully obtained, possessed and/or used motor vehicle record information from the Texas Department of Public Safety after the June 1, 2000 effective date of the “opt-in” amendment to the DPPA. They seek, in a jury trial, liquidated damages as provided in the DPPA for each purported class member in the amount of $2,500 for each use of the personal information, punitive damages, the destruction of any personal information determined to be illegally obtained from motor vehicle records and other appropriate equitable relief. On September 8, 2008, the District Court entered an order granting the defendants’ consolidated motion to dismiss with prejudice all plaintiffs’ claims in this litigation pursuant to Federal Rules of Civil Procedure 12(b)(1) and 12(b)(6). On October 8, 2008, plaintiffs filed a notice of appeal, which has been subsequently amended twice, with the U.S. Circuit Court of Appeals for the Fifth Circuit.
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 was $2.7 million in each of the years 2006 and 2007. At December 31, 2007, the face amount of life insurance ceded was $321 million and annualized ceded premium was $2.7 million.