The Company leases approximately 100 offices throughout its sales territories and has a separate Canadian business office facility that includes office and storage space. SFSC leases approximately 125,000 square feet in Dallas, Texas. American-Amicable owns its home office facility in Waco, Texas and United Life leases office space in Baton Rouge, Louisiana. In addition, the Company leases office space for its holding company operations in Bethesda, Maryland and New York City. The Company believes that the current makeup of its properties is adequate for its operations and, based on its recent experience, that it will be able to find suitable replacement properties on acceptable terms for any properties the Company chooses to replace or for which leases are terminated or not renewed.
Cautionary Statement for purposes of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995. The statements below that relate to future plans, events or performances are forward-looking statements that involve a number of risks or uncertainties. Among those items that could adversely affect the Company's financial condition, results of operations and cash flows are the following: changes in regulations affecting insurance companies, interest rates, the federal income tax code (to the extent the Company's product mix includes tax deferred accumulation products), the ratings assigned to the Company's insurance subsidiaries by independent rating organizations such as A.M. Best Company ("A.M. Best") (which the Company believes are particularly important to the sale of annuity and other accumulation products) and unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect the Company's results of operations.
The Company's financial condition and results of operations for the periods covered by this and future "Management's Discussion and Analysis of Financial Condition and Results of Operations" are or will be affected by several common factors, each of which is discussed below.
Strategic Review of Business Units. As a result of the tremendous growth the Company has experienced, the diversification of the underlying business units resulting from acquisitions over time, and the need for the Company to be able to rapidly integrate future acquisitions, the Company began a strategic business evaluation during the third quarter of 1996. The review resulted in the Company establishing three primary divisional platforms, Career Sales Division, Payroll Sales Division and Financial Services Division.
On January 2, 1998, the Company acquired the Controlling Interest in SW Financial. As a result of such acquisition, the Company is able to complete its divisional restructuring which began in 1997. As a result of the Company's plans to consolidate certain of its operating locations and corporate functions, the Company expects to incur restructuring and certain other charges during 1998 not to exceed approximately $25.0 million.
On February 18, 1998, the Company announced that it had engaged investment banking firms to review strategic alternatives for maximizing shareholder value, including the sale of the Career Sales Division. The Company anticipates the disposition of the Career Sales Division within one year. See Note 19 of Notes to Consolidated Financial Statements.
Each of the operating considerations outlined above as well as the cost of capital to the Company, expected cash flows from the target acquisition and actuarial factors, such as future premium, mortality, morbidity, surrenders, operating expenses and yields on assets held to back policy liabilities are considered and weighted in determining the relative risk of financial rewards for taking on the acquisition target.
On July 22, 1996, the Company acquired United Life & Annuity Insurance Company ("United Life") from United Companies Financial Corporation. United Life markets fixed and variable annuity products through independent agents and financial institution marketing channels.
On December 14, 1995, Southwestern Financial Corporation ("SW Financial"), a newly organized corporation formed by the Company and Knightsbridge (see Notes 15 and 16 to Notes to Consolidated Financial Statements), purchased Southwestern Life Insurance Company, Union Bankers Insurance Company and certain other related assets from I.C.H. Corporation for $260,000.
insurance subsidiaries amounting to $14.9 million, (iii) the acquisition of the SW Financial subordinated indebtedness and preferred stock of Acordia aggregating a total of $65.6 million, (iv) repurchase the previously outstanding Series B Redeemable Preferred Stock in the amount of $14.7 million, (v) fund restructuring costs incurred by various operating subsidiaries aggregating $14.9 million, and (vi) for other corporate purposes.
During 1997, the Company announced a stock repurchase program in which the Company was authorized by its Board of Directors to purchase up to 4.5 million shares of common stock in the open market, through arranged transactions and otherwise. During 1997, the Company borrowed approximately $28.8 million to repurchase approximately 819,000 shares.
In May 1996, the Company entered into its previously outstanding revolving credit agreement with a syndicate of banks for up to $175.0 million of funds available at any one time to replace the $100.0 million bridge facility utilized by the Company to make the investment in SW Financial, which was repaid out of the proceeds of the February 1996 Common Stock Offering. During the remainder of 1996, the Company borrowed amounts aggregating $92.0 million for: (i) the repurchase of $35.4 million in principal amount of the Company's 9 1/4% Senior Subordinated Debenture due 2003 (the "Notes") for $37.7 million, including interest and premium on early redemption of $2.3 million, (ii) the refinancing of $20.0 million of indebtedness under the previously outstanding bridge facility, (iii) the repayment of $16.5 million of amounts owed certain subsidiaries, and (iv) $17.8 million for general corporate purposes including the United Life acquisition, interest payments and common and preferred stock dividend payments.
As part of the financing for the Integon Life acquisition, PennCorp issued Series B Preferred Stock with an initial value of $12.8 million, which accretes at 10.4% per annum until its maturity on June 30, 1997, and Series C Preferred Stock with an initial value (subject to offset) of $17.9 million, which accretes at 9.3% per annum until its maturity on June 30, 1998. The Series C Preferred Stock's estimated initial value for financial statement purposes was approximately $16.0 million. Preferred stock dividends accreted during 1997, 1996 and 1995, on the Series B and Series C Preferred Stock amounted to $1.7 million, $2.9 million and $1.3 million, respectively. On March 14, 1997, the Company redeemed all the
outstanding Series B Preferred Stock for $14.7 million, utilizing proceeds available under the bank credit facility. On March 31, 1998, the Company plans to redeem the Series C Preferred Stock into shares of the Company's Common Stock under provision of the Series C Preferred Stock certificate of designation.
Investments. The Company's investment portfolio is managed with the objectives of maintaining high credit quality and liquidity, maximizing current income within acceptable levels of risk, minimizing market and credit risk, and matching the anticipated maturities of investments to the Company's liabilities. The Company believes that a conservative
The Company held $1,287.6 million and $1,428.3 million of mortgage-backed bonds which represented 38.8% and 38.9% of total invested assets as of December 31, 1997 and 1996, respectively. The Company invests in mortgage- backed securities in order to enhance portfolio yields and maintain a reliable cash flow stream from the invested asset portfolio. The Company maintains sophisticated models to measure the effective duration and option-adjusted duration of the consolidated investment portfolio. These models are updated on a monthly basis and are designed to allow accurate measurement of the convexity risks inherent in that percentage of the portfolio invested in mortgage-backed securities and other callable securities. The Company manages the portfolio convexity risk within the context of the overall asset and liability model and the quantification of disintermediation risk.
Final Determination of Pre-Acquisition Contingencies and Purchase Price Allocation. For each of the periods presented, the Company has made certain valuation determinations with respect to pre-acquisition contingencies or allocations. For the year ended December 31, 1997, the Company determined the following with respect to certain material
For the year ended December 31, 1996, the Company determined the following with respect to certain material acquisition contingencies or allocations: (i) the Company incurred additional costs associated with the acquisition of United Life of $2.5 million, which resulted in a corresponding increase to costs in excess of net assets acquired, (ii) the Company decreased real estate and mortgage loan loss valuations of Integon Life by $6.8 million, which resulted in a decrease in costs in excess of net assets acquired of $4.4 million and deferred tax assets of $2.4 million, and (iii) the Company increased certain policy reserves of Integon Life aggregating $10.0 million, which resulted in a corresponding increase to costs in excess of net assets acquired of $10.0 million.
Cash Flows From Operations. The periods covered by Management's Discussion and Analysis of Financial Condition and Results of Operations indicate cash provided by operating activities of $53.3 million, $152.1 million and $85.0 million in 1997, 1996 and 1995, respectively. The positive cash flow from operating activities is not necessarily indicative of the Company's cash flow as $275.7 million, $205.2 million and $53.2 million of cash was used to fund cash flows for interest sensitive life and accumulation products during 1997, 1996 and 1995, respectively, which are classified as financing activities in accordance with generally accepted accounting principles.
In February 1998, the FASB adopted SFAS No. 132 "Employers' Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 132 is effective for fiscal years beginning after December 31, 1997. Earlier application is encouraged. Restatement of disclosures for earlier periods provided for comparative purposes is required. SFAS No. 132 standardizes employers' disclosures about pension and other postretirement benefits, requires additional information on changes in the benefit obligations and fair values of plan assets to facilitate financial analysis, and eliminates certain irrelevant disclosures. The Company is currently evaluating the changes to its related disclosures.
The following analysis should be read in conjunction with the historical financial statements of the Company and related notes thereto contained elsewhere herein. Significant financial information, percentage changes and ratios of the Company's insurance operations (excluding realized gains and losses on sale of investments and equity in earnings of unconsolidated affiliates) are shown in the following table:
Operating Ratios. Pretax operating margin declined considerably to 12.0% of revenues during 1997 from 19.5% and 19.6% in 1996 and 1995, respectively. The significant decline in operating ratios was primarily the result of increases in benefits and insurance expense ratios. The continual increase in the benefits ratio was anticipated as a result of the Company's most recent acquisitions which shifted the product base away from lower benefit fixed benefit products to life and accumulation products.
The Company's insurance expense ratio increased to 18.8% of revenues from 14.0% during 1996. The increase in the insurance expense ratio was primarily a result of improved gross profit margins for OLIC and Integon during 1997 as compared with those of 1996, which resulted in greater amortization of deferred acquisition costs and present value of insurance in force increasing the insurance expense ratio by approximately 1.8 percent. Also contributing to higher insurance expense ratios was amortization associated with deferred acquisition costs for AA Life which added approximately 0.7% to the insurance expense ratio. AA Life anticipates increasing levels of amortization associated with its primary new sales product, the "wealth builder." For the year ended December 31, 1996, certain interest sensitive blocks of business had significantly less amortization of deferred policy acquisition costs and present value of insurance in force, as compared to 1995 due to reduced short-term profit margins from adverse mortality. The Company believes that profit margins have stabilized and recent variability will not impact the long-term profitability of such products. However, if mortality experience would deteriorate, the ultimate recoverability of deferred policy acquisition costs and present value of insurance in force could be adversely affected.
Other operating expenses declined as a percentage of revenues to 13.8% during 1997, from 14.8% and 16.8% during 1996 and 1995, respectively. This downward trend was due to the acquisitions of United Life and Integon Life, which are administered by the Company at overhead expense rates less than the business in force prior to their respective acquisitions. Despite the growing revenue base, the Company's total underlying expense infrastructure has increased only moderately. In addition, expense costs have shifted from overhead and maintenance expenses to those more closely related to the production of new business.
Policy Revenues. Policy revenues remained relatively constant during 1997 at $345.6 million compared to $348.1 million during 1996 after increasing from $301.9 million during 1995. The very modest decline was primarily the result of a decline in policy charges associated with accumulation products due to increased surrenders.
concentrated primarily on increasing life policy revenues to achieve a balance of life policy revenues with those of fixed benefit products. In addition, during 1996 the Company effectively ceased marketing its "instant issue" fixed benefit products and as a result of higher than anticipated loss ratios which resulted in a decline in fixed benefit policy revenues for 1997 and 1996.
Life policy revenues remained nearly constant at $169.5 million for 1997 after increasing 43.9% and 75.0% to $170.0 million and $118.1 million for the years ended 1996 and 1995, respectively. The acquisition of United Life in July 1996, and Integon Life in July 1995, added $72.4 million and $22.9 million of life policy revenues during 1996 and 1995, respectively.
Net Investment Income. The effects of a larger average invested asset base and improved average portfolio yields to 7.6% in 1997 from 7.5% during 1996 and 7.3% in 1995, resulted in net investment income increasing 29.7%, 106.0% and 97.1% in 1997, 1996 and 1995, to $273.2 million, $210.7 million and $102.3 million, respectively. The acquisitions of United Life, which added invested assets of $1,492.9 million in July 1996 and Integon Life, which added invested assets of $1,339.1 million in July 1995, contributed to the increase in investment income. During 1997 and 1996, United life incrementally added $61.4 and $49.3 million of investment income and Integon Life incrementally added $57.6 million during 1996 as a result of being included for the entire year.
In conjunction with the Company's acquisition and investment activities, Management is regularly presented with investment opportunities to invest in substantially undervalued securities in corporations which will likely undertake some form of restructuring. In 1995, the Company established a trading security account for such investments. The Company reported trading gains amounting to $1.1 million, $1.3 million and $5.7 million during 1997, 1996 and 1995, respectively.
Revenues generated by Marketing One aggregated $17.1 million, $20.0 million and $7.4 million during 1997, 1996 and 1995, respectively. Marketing One was acquired by the Company in August 1995.
Insurance Related Expenses. Insurance related expenses (including commissions, amortization of deferred policy acquisition costs and amortization of the present value of insurance in force) increased 39.6%, 8.9% and 41.2% to $127.0 million, $91.0 million and $83.6 million during 1997, 1996 and 1995, respectively. The increase in insurance related expenses during 1997 as compared with 1996 and 1995 was primarily related to the amortization of deferred acquisition costs and the value of insurance in force as commission expenses increased slightly to $34.9 million for 1997 from $34.7 million and $31.9 million for the years ended 1996 and 1995, respectively. Of the $35.8 million increase in amortization during 1997, the inclusion of United Life for the full year resulted in additional amortization expense of $10.5 million, the amortization associated with realized gains on the sale of investments increased $9.4 million, increased gross profit margins and unlocking of lapse assumptions for increased policy surrenders resulted in additional amortization of approximately $6.0 million with the remainder of the increase due to additional amortization associated with deferred acquisition costs, primarily associated with AA Life's wealth builder products and decreased persistency of PennLife's in force block of business. The increase in the amortization of deferred acquisition costs and value of insurance in force during 1996 was primarily the result of the United Life acquisition. The increase during 1995 was the result of the Integon Life acquisition and a full year of amortization of value of business in force associated with the AA Life acquisition.
The Audit Committee of the Board of Directors, which is composed of outside directors, serves in an oversight role to assure the integrity and objectivity of the Company's financial reporting process. The committee meets periodically with representatives of management, as well as the independent and internal auditors, to review matters of a material nature related to financial reporting and the planning, results and recommendations of audits. The independent and internal auditors have free access to the Audit Committee, without management present, to discuss any matter they believe should be brought to the attention of the committee. The committee is also responsible for making recommendations to the board of directors concerning the selection of the independent auditors.
The Shareholders and Board of Directors of PennCorp Financial Group, Inc.
PENNCORP FINANCIAL GROUP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Fixed maturities classified as held for investment are recorded at cost, adjusted for amortization of premium or discount, as the Company has the intent and ability to hold them to maturity. Fixed maturities and equity securities classified as available for sale are recorded at fair value, as they may be sold in response to changes in interest rates, prepayment risk, liquidity needs, the need or desire to increase income, capital or other economic factors. Changes in unrealized gains and losses related to securities available for sale are recorded as a separate component of shareholders' equity, net of income taxes. Securities classified as trading securities are reported at fair value with realized gains and losses and changes in unrealized gains and losses included in the determination of net income as a component of other income. The classification of securities as held for investment, available for sale or trading is generally determined at the date of purchase. The Company carries a certain equity investment in an affiliate on the equity basis of accounting as a result of its percentage ownership and lack of voting control. Mortgage-backed fixed maturity securities held for investment or available for sale are amortized using the interest method including anticipated prepayments at the date of purchase. Significant changes in estimated cash flows from original assumptions are reflected in the period of such change. Mortgage loans on real estate are recorded at cost, adjusted for amortization of premium or discount and provision for loan loss, if necessary. Policy loans, short-term investments, and other investments are recorded at cost, which approximates fair value.
Company marked all assets subject to the transfer to fair value resulting in a net increase in shareholders' equity, net of applicable income taxes, of $1,800.
Accounts and notes receivable consist primarily of agents' balances and premiums receivable from agents and policyholders. Agents' balances are partially secured by commissions due to agents in the future and premiums receivable are secured by policy liabilities. An allowance for doubtful accounts is established, based upon specific identification and general provision, for amounts which the Company estimates will not ultimately be collected.
The present value of insurance in force represents the anticipated gross profits to be realized from future revenues on insurance in force at the date such insurance was purchased, discounted to provide an appropriate rate of return and amortized, with interest based upon the policy liability or contract rate, over the years that such profits are anticipated to be received in proportion to the estimated gross profits. Accumulated amortization was $192,049 and $144,327 as of December 31, 1997 and 1996, respectively.
Estimated costs of acquiring new business which vary with, and are primarily related to, the production of new business, have been deferred to the extent that such costs are deemed recoverable from future revenues. Such estimated costs include commissions, certain costs of policy issuance, underwriting, certain variable agency and marketing expenses and other costs directly associated with these functions to the extent such costs are determined to vary with and are primarily related to the production of new business. Costs deferred associated with accident and sickness and traditional life policies are amortized, with interest, over the anticipated premium-paying period of the related policies in proportion to the ratio of annual premium revenue to expected total premium revenue to be received over the life of the policies. Expected premium revenue is estimated by using the same mortality, morbidity and withdrawal assumptions used in computing liabilities for future policy benefits. For interest sensitive products and limited pay life products, policy acquisition costs are amortized in relation to the emergence of anticipated gross profits over the life of the policies.
For the year ended December 31, 1996, the Company determined the following with respect to certain material acquisition contingencies or allocations: (i) the Company incurred additional costs associated with the acquisition of United Life of $2.5 million, which resulted in a corresponding increase to costs in excess of net assets acquired, (ii) the Company
The Company continually monitors the value of costs in excess of net assets acquired based upon estimates of future earnings. Any amounts deemed to be impaired are charged, in the period in which such impairment was determined, as an expense against earnings. For the periods presented there was no charge to earnings for the impairment of costs in excess of net assets acquired.
Future policy benefits for traditional life insurance products generally have been computed on the net level premium method, based on estimated future investment yield, mortality, morbidity and withdrawals. Estimates used are based on experience adjusted to provide for possible adverse deviation. These estimates are periodically reviewed and compared with actual experience. Future policy benefits for interest sensitive products include the balance that accrues to the benefit of the policyholders and amounts that have been assessed to compensate the life insurance subsidiaries for services to be provided in the future.
In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 128, "Earnings Per Share." SFAS No. 128 supersedes and simplifies the former computation,
Business combinations accounted for as a purchase result in the allocation of the purchase consideration to the fair values of the assets and liabilities acquired establishing such fair values as the new accounting bases. Purchase consideration in excess of the fair value of net assets acquired is allocated to "costs in excess of net assets acquired." Should the fair value of the net assets acquired exceed the purchase consideration, such excess is utilized to reduce certain intangible assets, primarily "present value of insurance in force." Allocation of purchase price is performed in the period in which the purchase is consummated and may be preliminary. Adjustments resulting from completion of the purchase allocation process affect the value of the assets and liabilities acquired.
Financial reinsurance that does not transfer significant insurance risk is accounted for as deposits. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies. Balances due to, or from, reinsurers have been reflected as assets and liabilities rather than being netted against the related account balances. Realized gains on retroactive reinsurance arrangements are deferred and amortized into net income over the estimated duration of the reinsured business.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 is effective for annual and interim periods beginning after December 15, 1997. This statement establishes standards for reporting and displaying comprehensive income and its components and requires all items to be recognized under accounting standards as comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Examples of items to be included in the Company's presentation of comprehensive income, in addition to net income applicable to common stock, are unrealized foreign currency translation gains and losses as well as unrealized gains and losses on securities available for sale. The Company will adopt the provisions of SFAS No. 130 in 1998.
In December 1997, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 97-3. SOP 97-3 provides: (1) guidance for determining when an entity should recognize a liability for guaranty-fund and other insurance-related assessments, (2) guidance on how to measure the liability, (3) guidance on when an asset may be recognized for a portion or all of the assessment liability or paid assessment that can be recovered through premium tax offsets or policy surcharges, and (4) requirements for disclosure of certain information. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998. Early adoption is encouraged. Previously issued annual financial statements are not restated. The Company will report the effect of initially adopting this SOP in a manner similar
On July 25, 1995, the Company consummated the acquisition of Integon Life for a total purchase price of $48,596 including acquisition expenses of approximately $3,200. The fair value of net assets acquired amounted to $28,575 (as adjusted) resulting in $20,021 (as adjusted) of costs in excess of net assets acquired which will be amortized over 20 years.
The acquisition of Integon Life was initiated on January 20, 1995, when the Company and its subsidiaries entered into a series of related agreements to acquire all of the issued and outstanding capital stock of Salem Holding Corporation (formerly Integon Life Corporation), including the purchase for $15,000 in cash, of a 49% limited partnership interest in the ultimate limited partner that controlled Integon Life. Prior to the consummation of the acquisition, the Company's 49% equity interest in the net income of Integon Life, which aggregated $3,808, was reported on the equity method of accounting as undistributed earnings in unconsolidated affiliates for the period from January 20, 1995 to July 25, 1995.
The following unaudited pro forma financial information represents the Company's consolidated results of operations as if the United Life acquisition occurred as of January 1, 1996. This unaudited pro forma financial information has been prepared for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisition been made as of January 1, 1996, or results which may occur in the future.
The Company's only reportable industry segment is life insurance, and its only significant foreign operations are conducted in Canada. Within the life insurance segment the Company's significant lines of business include fixed benefit, life and accumulation products. Assets and related investment income are allocated based upon related insurance liabilities which are backed by such assets. Other operating expenses are allocated in relation to the mix of related revenues.
The components of operations were as follows for the years ended December 31:
The amortized cost and fair value of fixed maturities available for sale as of December 31, 1997, by contractual maturity, are shown below:
by similar mortgage loans, adjusted for the differences in loan characteristics. For mortgage loans on real estate where quoted market prices are not available, the fair values are estimated using discounted cash flow analysis and interest rates for loans with similar credit ratings.
As of December 31, 1997, commercial and residential mortgage loan investments were concentrated in the following states:
Realized, and changes in unrealized gains and losses, on investments were as follows for the years ended December 31:
The Company had non-income producing fixed maturity investments with an amortized cost of $ -- and $17,115 as of December 31, 1997 and 1996, respectively.
On September 1, 1997, the Company purchased $25,000 of ACO Acquisition Corp. (subsequently re-named Acordia, Inc. ("Acordia") subordinated indebtedness and $20,000 of ACO Brokerage Holdings Corporation ("ACO"), an affiliate of Acordia, preferred stock. The Acordia subordinated notes pay interest on a current basis at 12.5%, per annum, payable in semi-annual installments. The ACO preferred stock dividends are payable in cash (subject to certain restrictions), or in-kind at the option of ACO, at a rate of 17 percent. Acordia is an insurance broker specializing in the marketing of commercial property and casualty programs. Acordia is 28.6% owned by Knightsbridge Capital Fund I, L.P.
The Company accounts for its investment in SW Financial utilizing the equity method. The consolidated condensed results of operations and financial position of SW Financial, are provided below:
Expected future cash flows used in determining such values are based on actuarial determinations of future premium collection, mortality, morbidity, surrenders, operating expenses and yields on assets held to back policy liabilities as well as other factors. Variances from original projections, whether positive or negative, are included in income as they occur and will affect the present value of insurance in force amortization rates for insurance products accounted for under SFAS No. 97. To the extent that these variances indicate that future cash flows will differ from those included in the original scheduled amortization of the present value of insurance in force, future amortization may be adjusted. Recoverability of the present value of insurance in force is evaluated annually and appropriate adjustments are then determined and reflected in the financial statements for the applicable period.
The fair value of amounts outstanding as notes payable for the years ended December 31, 1997 and 1996, amounted to $364,914 and $215,341, respectively. All recorded amounts other than the Senior Subordinated Notes approximate market as they carry variable rates of interest which adjust at least every 90 days. The fair value of the Senior Subordinated Notes is determined based upon quotes from market makers.
Taxes computed using the federal statutory rate of 35% are reconciled to the Company's actual income tax expense attributable to income before extraordinary charge as follows for the years ended December 31:
Temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to the deferred tax assets and liabilities relate to the following as of December 31:
The valuation allowance for deferred tax assets as of January 1, 1997 and 1996, was $15,892 and $17,157, respectively. The net change in the total valuation allowance for the years ended December 31, 1997 and 1996, was a decrease of $5,525 (including $5,000 that was used to reduce costs in excess of net assets acquired) and $1,265, respectively. During 1997, an additional $14,635 increase to the deferred tax asset was used to reduce costs in excess of net assets acquired related to the Integon Life acquisition as acquisition date tax contingencies were resolved. If recognized as a tax benefit, a portion of the December 31, 1997, valuation allowance totaling $2,349 would be allocated to reduce costs in excess of net assets acquired.
In assessing the realization of deferred taxes, management considers whether it is more likely than not that some portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon those considerations, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowance as of December 31, 1997.
The approximate net operating loss carryforwards for income tax purposes expire as follows:
Under provisions of the Life Insurance Company Tax Act of 1959, certain special deductions were allowed to life insurance companies for federal income tax purposes. These special deductions were repealed by the Tax Reform Act of 1984, and the untaxed balances were frozen at their December 31, 1983 levels. These balances aggregate approximately $42,301 for the Company's life insurance subsidiaries and are subject to taxation if certain levels of premium income or life insurance reserves are not maintained, or if the life insurance companies make excess distributions to shareholders. It is not expected that a tax would become due on any such balance and no deferred income taxes have been provided. However, if such tax were to become payable, it would amount to approximately $14,805.
The Company issued 2,875,000 shares of $50 redemption value $3.50 Series II Convertible Preferred Stock (the "Series II Convertible Preferred Stock") on August 2, 1996. The Series II Convertible Preferred Stock is convertible at the option of the holder, unless previously redeemed, into 1.4327 shares of common stock for each share, subject to adjustment in certain events. Dividends accrued and unpaid as of December 31, 1997 and 1996, were $1,677. As of December 31, 1997, the estimated fair value of the Series II Convertible Preferred Stock, based upon market-maker quotes, was $166,750.
On July 25, 1995, the Company issued 127,500 shares of 10% Series B Preferred Stock and 178,500 shares of 9% Series C Preferred Stock to fund a portion of the Integon Life purchase price. The Series B Preferred Stock and the Series C Preferred Stock are mandatorily redeemable on or before June 30, 1997 and June 30, 1998, respectively. The redemption price of the Series C Preferred Stock is subject to certain offsets related to the Integon Life stock purchase agreement. Dividends accrued and unpaid were $ -- , and $1,939 on the Series B Preferred Stock and $3,867 and $2,175 on the Series C Preferred Stock, respectively, as of December 31, 1997 and 1996. On March 15, 1997, the Company redeemed all of the previously outstanding Series B preferred stock at its stated redemption value of $14,705.
The Company issued 2,300,000 shares of $50 redemption value $3.375 Convertible Preferred Stock (the "Convertible Preferred Stock") on July 14, 1995. The Convertible Preferred Stock is convertible at the option of the holder, unless previously redeemed, into 2.2124 shares of common stock for each share, subject to adjustment in certain events. Dividends accrued and unpaid as of December 31, 1997 and 1996 were $1,617. As of December 31, 1997, the estimated fair value of the Convertible Preferred Stock, based upon active market quotes, was $186,599.
As allowed under the provisions of SFAS No. 123, the Company applies APB Opinion 25 and related Interpretations in accounting for its stock option and warrant plans and, accordingly, does not recognize compensation cost based on fair value as a component of net income applicable to common stock. If the Company had elected to recognize compensation cost based on the fair value of the options and warrants as of the grant date, estimated utilizing the Black- Scholes multiple options approach prescribed by SFAS No. 123, the Company's net income applicable to common stock as well as earnings per share would have been reduced by the pro forma amounts indicated in the following table:
Dividend payments by the Company's insurance subsidiaries are limited by, or subject to the approval of the insurance regulatory authority of each subsidiary's state of domicile. Such dividend requirements and approval processes vary significantly from state to state. In 1998, the insurance subsidiaries (including SW Financial), subject to availability of cash, statutory capital and surplus and regulatory approval, will be able to pay a maximum of $56,749 in dividends to the Surplus Note Companies (including SW Financial). In 1998, the Surplus Note Companies, subject to availability of cash and the dividend capacity of the insurance subsidiaries, could pay a maximum of $76,408 on surplus note payments to the Company.
The Company's Canadian branch and Canadian subsidiary report to Canadian regulatory authorities based upon Canadian statutory accounting principles that vary in some respects from U.S. statutory accounting principles. Consolidated Canadian net assets based upon Canadian statutory accounting principles were $51,428 and $51,567 as of December 31, 1997 and 1996, respectively.
Remittances to PLIC from the Canadian operations totaled $ --, $ -- and $2,485 for the years ended December 31, 1997, 1996 and 1995, respectively.
On October 1, 1990, the Company established a defined contribution retirement plan (the "Defined Contribution Plan") for all employees of the Company who have attained age 21, and for certain agents whose commission earnings represent more than 50% of their income from the Company. Contributions to the Defined Contribution Plan are made pursuant to salary deferral elections by participants in an amount equal to 1% to 15% of their annual compensation. In addition, the Company makes matching contributions in an amount equal to 50% of each participant's salary deferral to a maximum of 3% of annual compensation. The Defined Contribution Plan also provides for a discretionary employer profit sharing contribution, which is determined annually by the Board of Directors for the succeeding plan year. Profit sharing contributions are credited to participants' accounts on the basis of their respective compensation in accordance with a formula that provides a higher percentage contribution for compensation in excess of the federal Social Security wage base. Salary deferral contribution accounts are at all times fully vested, while matching contribution accounts vest ratably from one to two years of service, and profit sharing contribution accounts vest ratably from one to five years of service. All participant accounts are fully vested at death, disability or attainment of age 65. Payment of vested benefits under the Defined Contribution Plan may be elected by a participant in a variety of forms of payment. The Company's funding policy is to contribute annually an amount that can be deducted for federal income tax purposes. Expenses related to this plan for the years ended December 31, 1997, 1996 and 1995, amounted to $1,483, $1,520 and $1,335, respectively.
The Company has an established bonus plan for insurance subsidiary officers. The amount available to pay awards for any year is determined by a committee of senior executives of the Company and is subject to the review and recommendation of the Compensation Committee and approval of the Board of Directors of the Company. Awards are based primarily on the income growth of the Company and the performance of eligible participants. The Company accrued or paid $1,417, $1,144 and $691 under this plan during the years ended December 31, 1997, 1996 and 1995, respectively.
If the Company meets established performance goals, the Company's two most senior officers are eligible to receive annual cash bonuses based primarily on annual growth rates in diluted earnings per share. Bonus awards range from 0% to 200% of a predetermined target annually. During 1997 and 1996, the Company did not accrue for such bonuses as the employment arrangements containing the bonus plan were contingent upon the purchase by the Company of The Fickes and Stone Knightsbridge Interests (see Notes 15 and 16 below).
KM receives management fees from all of its limited partners, including the Company, for the management of Knightsbridge. KM also receives payment in kind consideration in lieu of additional management fees from PennCorp for providing corporate and financial management services to the Company. Fees received by KM from the Knightsbridge limited partners including PennCorp, as well as the management fees paid in kind by the Company are subject to offset in future periods based upon a portion of transaction fees generated by KM.
In addition, PennCorp shareholders approved the acquisition of the interests of Messrs. Stone and Fickes in Knightsbridge Management, L.L.C. ("Knightsbridge Management"), Knightsbridge Capital L.L.C. and Knightsbridge Consultants L.L.C. (collectively, "The Fickes and Stone Knightsbridge Interests") for total consideration estimated to be $10,000. Fickes and Stone will each receive consideration in the form of estimated annual payments of $330 due April 15, 1997, each year through 2001 and issuance by PennCorp of 173,160 shares of PennCorp Common Stock to each of Fickes and Stone on April 15, 2001.
As part of the Knightsbridge restructuring plan as approved, PennCorp must acquire Fickes and Stone's co- investment in Acordia for $5,200, which amount represents Fickes' and Stone's actual cost.
In January 1996, stockholder derivative lawsuits styled Tozour Energy Systems Retirement Plan v. David J. Stone et al and the PennCorp Financial Group, Inc., C.A. No. 14775 (the "Tozour Case") and Lois Miller v. David J. Stone et al, and the PennCorp Financial Group, Inc., C. A. No. 14795 (the "Miller Complaint") were filed against the Company and each of its directors, individually, in the Delaware Court of Chancery. The complaint in the Miller suit has not yet been served on the Company or the other defendants. Both suits allege that the SW Financial Investment involved the usurpation of a corporate opportunity and a waste of the Company's assets by Messrs. Stone and Fickes, and that the directors of the Company in approving that transaction, failed to act in good faith and breached their fiduciary duties, including the duty of loyalty to the Company and its stockholders, having favored the interests of Messrs. Stone and Fickes over the Company and its stockholders. These lawsuits seek judgments against each of the defendants for the amount of damages sustained, or to be sustained, by the Company as a result of the breaches of fiduciary duty alleged in the complaint, the imposition of a constructive trust for the benefit of the Company on profits or benefits obtained by any defendant through the alleged breaches of fiduciary duty, attorney's fees and costs, and such other relief as the court determines to be just, proper or equitable.
The defendants in the Tozour Case have filed a motion seeking its dismissal on the ground that the plaintiff failed to comply with the requirements of Delaware law before instituting a derivative suit and intend to defend the lawsuit vigorously. Because the Company has not been served with the Miller Complaint, no action has been taken in that case, although the Company would also defend it vigorously. The defendants believe, however, that it would not be in the best interests of the Company and its shareholders to expend considerable management and director time and to incur substantial expenses to litigate the actions. Consequently, the Company's legal advisors have met or spoken by telephone with the plaintiffs' counsel on several occasions to discuss the terms of a potential settlement.
The defendants and the plaintiffs' counsel entered into a stipulation of settlement on March 28, 1997 (the "Original Proposed Settlement"). The Original Proposed Settlement consisted of the following principal elements: (i) Messrs. Stone and Fickes will cancel the 335,564 SW Financial common stock warrants they hold for no consideration enabling PennCorp to purchase the SW Financial Controlling Interest for $67.5 million, reducing the price to be paid by PennCorp for the SW Financial Controlling Interest by approximately $2.0 million, (ii) the PennCorp Board will proceed with the purchase of The Fickes and Stone Knightsbridge Interests, having received a fairness opinion of a nationally recognized investment banking firm with respect to the price to be paid for The Fickes and Stone Knightsbridge Interests, (iii) the PennCorp Board will proceed with the acquisition of the SW Financial Controlling Interest, having received a fairness opinion of a nationally recognized investment banking firm with respect to the price to be paid for the SW Financial Controlling Interest, (iv) the PennCorp Board will submit the purchases of The Fickes and Stone Knightsbridge Interests and the SW Financial Controlling Interest to a shareholder vote of a majority of the PennCorp stockholders present at a meeting and entitled to vote, and stockholders must approve both transactions, (v) Messrs. Stone and Fickes will abstain from voting on the proposals to approve the purchase of The Fickes and Stone Knightsbridge Interests and the SW Financial Controlling Interest, and (vi) the plaintiffs' counsel will be entitled to conduct confirmatory discovery.
The Amended Proposed Settlement is subject to approval by the Chancery Court after notice to PennCorp stockholders. A settlement hearing is scheduled for May 12, 1998 in the Chancery Court. As discussed above, Messrs. Stone and Fickes have agreed that, if the Amended Proposed Settlement is approved by the Chancery Court, they will cancel their SW Financial common stock warrants and they will not participate in the increased consideration (other than the possible price protection right) for the SW Financial Controlling Interest to the extent it relates to their $7,000 personal investment in SW Financial, which together will reduce the price to be paid by PennCorp for the SW Financial Controlling Interest by approximately $3,667. Because the Knightsbridge restructuring will have the effect of substantially eliminating potential future conflicts of interest between Messrs. Stone and Fickes and PennCorp, and because the Amended Proposed Settlement will have the effect of reducing the price to be paid for the SW Financial Controlling Interest and will obviate the need to expend considerable management and director time to litigate the actions, the PennCorp Board has determined that the Amended Proposed Settlement is in the best interests of PennCorp and its shareholders and confers a substantial economic benefit on PennCorp. Accordingly, the PennCorp Board has authorized the payment to plaintiffs' counsel of legal fees of $785 and documented expenses not to exceed $50 in connection with the lawsuits and the related settlement negotiations, if the Amended Proposed Settlement is approved by the Delaware Chancery Court after notice to PennCorp stockholders. Such amounts were expensed in the accompanying financial statements.
Effective January 1, 1996, the Company outsourced the vast majority of its data center operations and administrative systems programming to a third party vendor. The processing agreement extends through December 2002 and requires the Company or its insurance subsidiaries to make payments ranging from approximately $8,399 to $9,248 during each of the contract years. The contract has standard provisions for early cancellation, including breakage fees.
In addition during the year ended December 31, 1997, the Company incurred $7,646 of pre-tax transaction costs associated with the terminated Washington National merger agreement. Such costs are included in the Company results of operations.
The Company initiated a redemption, effective March 31, 1998, of the Series C Preferred Stock into shares of the Company's Common Stock under provision of the Series C Preferred Stock certificate of designation.
The following unaudited selected pro forma financial information has been prepared to illustrate the pro forma effects of (i) the acquisition of the controlling interest of SW Financial including the financing thereof, (ii) the acquisition of the Fickes and Stone Knightsbridge Interests, including the financing thereof ((i) and (ii) collectively the SW Financial pro forma) and (iii) the impact of the Company's decision to dispose of the Career Sales Division ((i), (ii) and (iii) collectively the Retained Businesses pro forma). The pro forma statement of operations for the year ended December 31, 1997 gives effect to the foregoing as though each had occurred on January 1, 1997. The selected pro forma balance sheet information as of December 31, 1997, gives effect to the foregoing as through each had occurred on December 31, 1997. The selected pro forma financial information is not necessarily indicative of either future results or the results that might have occurred had the transactions occurred on January 1, 1997 or December 31, 1997 as the case might be.
The following is a summary of the quarterly results of operations for the years ended December 31, 1997 and 1996:
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.
reviewed and compared with actual experience. Liabilities for future policy benefits for interest sensitive products include the balance that accrues to the benefit of the policyholders and amounts that have been assessed to compensate the life insurance subsidiaries for services to be provided in the future.
The Company continually monitors long-lived assets and certain intangible assets, such as costs in excess of net assets acquired and present value of insurance in force, for impairment. An impairment loss is recorded in the period in which the carrying value of the assets exceeds the fair value or expected future cash flows. Any amounts deemed to be impaired are charged, in the period in which such impairment was determined, as an expense against earnings. For the period presented there was no charge to earnings for the impairment of long-lived assets.
Investments in a single entity, other than obligations of the U.S. Government or agencies thereof, totaling in excess of 10% of total shareholders equity at December 31, 1997 and 1996 are listed below:
In addition, during 1997, the Company acquired 41,605 shares of redeemable preferred stock of Portsmouth Financial Group, Inc. (Portsmouth) for $4,161. The preferred stock pays dividends of 18.0% of which 12.5% is in cash with the remainder in the form of additional preferred stock. The shares are mandatorily redeemable on June 30, 2002. Portsmouth underwrites, acquires, and holds to receipt of benefits, life insurance contracts covering individuals facing terminal illnesses. Portsmouth is owned by Knightsbridge and its affiliates. The Company has agreed, subject to required regulatory approvals to make up to a $10,000 preferred equity investment in Portsmouth.
The Company had non-income producing investments at December 31, 1997 with an amortized cost and fair value as follows:
At December 31, 1997 net unrealized appreciation of equity securities of $391 consisted of gross unrealized gains of $415, less unrealized losses of $24. At December 31, 1996 net unrealized appreciation of $170 consisted of gross unrealized gains of $207, less unrealized losses of $37.
During 1996, the Company had a limited partnership investment representing a 50% interest in a partnership, GSSW, L.P. (GSSW) formed to acquire through auction certain mortgage loans and real estate formerly held by failed savings and loan associations. Effective December 31, 1996, GSSW liquidated the general partner interests through distribution of certain assets at fair value, sold substantially all remaining investments and utilized the proceeds to buy the limited partnership interest not owned by the Company. As a result of these transactions, the Company became the parent of GSSW, realized earnings on GSSW of $13,171, received net cash distributions of $47,520 and paid PennCorp, a shareholder, a fee of $1,000 as guarantor in GSSW's sale of assets.
SOUTHWESTERN FINANCIAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Following is an analysis of the investment in the GSSW limited partnership for the year ended December 31, 1996:
For interest sensitive life products and annuity products, the liability for future policy benefits is equal to the accumulated fund value. Fund values are equal to the excess premium received and interest credited to the fund value less deductions for mortality costs and expense charges. Current interest rates credited range from 4% to 8%. Mortality costs and expense charges are established by the Company based upon its experience and cost structure.
The Company has carefully monitored a block of interest sensitive life policies where overall financial performance was not satisfactory. During the third quarter of 1997, management implemented certain corrective actions. These actions included reduction in credited interest rates, increased monthly expense charges and cost of insurance increases on selected policy forms. As a result, reserves on this block were reduced approximately $17,000.
As a result of changes in estimates of insured events in prior years, the liability for policy and contract claims decreased, net of reinsurance, by $6,012 in 1997 and $2,646 in 1996.
On December 14, 1995, the Company issued 210,000 shares of Series A preferred stock with a liquidation value of $21,000 to PennCorp and one of its subsidiaries. The Series A preferred stock accrues dividends at a rate of 10.0% per annum, compounded quarterly and is mandatorily redeemable at December 31, 2005. Dividends on the Series A preferred stock are payable in cash, or at SWF's option, are payable in kind. The Series A preferred stock is not redeemable at the option of the Company but at maturity will be required to be redeemed for approximately $56 million in cash assuming no cash dividend distributions. If the Company fails to satisfy its mandatory redemption obligation, the holders of the Series A preferred stock
will be entitled to elect 49.0% of the members of the Board of SWF and, upon receipt of regulatory approval, a majority of the directors of SWF. The Series A preferred stock is senior preferred stock. The holders of the Series A preferred stock are entitled to class voting rights under certain circumstances, including in connection with a merger of SWF or a sale of all or substantially all its assets or the authorization or issuance of senior or pari passu preferred stock, and as otherwise provided by law. For the years ended December 31, 1997 and 1996, 24,180 and 21,900 additional shares were issued with a redemption value of $2,418 and $2,190, respectively in lieu of cash to satisfy dividend requirements.
Income taxes computed using the prevailing corporate tax rate of 35% are reconciled to the Company's actual income tax expense attributable to income for the years ended December 31, 1997 and 1996, as follows:
The insurance subsidiaries prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their respective state insurance departments. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are approved by insurance regulatory authorities; such practices differ from state to state, and may differ from company to company within
In the normal course of business, the Company reinsures portions of certain policies that it underwrites to limit disproportionate risks. The Company retains varying amounts of individual insurance up to a maximum retention of $500 on any life. Amounts not retained are ceded to other insurance enterprises or reinsurers on an automatic or facultative basis.
Effective July 1, 1996, Union Bankers entered into reinsurance agreements with Cologne Life Reinsurance Company ("Cologne") to coinsure 80% of its Medicare supplement business in force on July 1, 1996 and to coinsure 80% of its Medicare policies issued on or after July 1, 1996. The Company recorded a deferred gain on the transaction of $53,893 as of July 1, 1996, which is being amortized into income over the life of the business. For the year ended December 31, 1997 and for the period from July 1, 1996 to December 31, 1996 $14,222 and $6,445, respectively of the deferred gain has been recognized and is included in other income. The Company is not subject to any negative experience adjustments if the ceded business is unprofitable; however, the Company may participate in a portion of future earnings from the ceded business after Cologne recovers its initial ceding commission plus interest at a specified rate. Union Bankers retained administration for the ceded block of business and is reimbursed by Cologne for administrative costs at the rate of 8.5% of ceded renewal premiums and 11.5% of ceded first year premiums.
In addition, the Company has a bonus plan for certain key officers. The amount available to pay awards for any year is determined by a committee of senior executives of the Company and is subject to approval of the Board of Directors of the Company. Awards are based on the performance of the Company and the performance of eligible participants. The Company accrued or paid $1,350 and $1,700 under this plan during the years ended December 31, 1997 and 1996, respectively.
health and welfare benefits is unfunded. Following is an analysis of the change in the liability for accrued postretirement benefits for the years ended December 31, 1997 and 1996:
The Company and its subsidiaries have management and services agreements with entities affiliated with Knightsbridge, a shareholder. In connection with an Advisory and Management Services Agreement with Knightsbridge Management, L.L.C., the Company pays an annual fee of $1,500 plus expenses. Each insurance subsidiary has an Investment Management Agreement with Knightsbridge Consultants, L.L.C. For the years ended December 31, 1997 and 1996, fees incurred totaled $1,871 and $1,658, respectively.
The Company agreed to pay PennCorp, a shareholder, $1,000 in conjunction with the GSSW transaction in 1996 (see Note 3). The Company paid interest of $1,400 in 1997 in conjunction with PennCorp's acquisition of the Company's 7.0% convertible subordinated note.
The Company and its subsidiaries are obligated under operating leases, primarily for office space. Rent expense was $2,169 in 1997 and $2,058 in 1996. There was no significant sublease income in 1997 or 1996.
Policy Loans: Policy loans are an integral part of life insurance policies which the Company has in force and, in the Company's opinion, cannot be valued separately. These loans typically carry an interest rate that is tied to the crediting rate applied to the related policy and contract reserves.
On January 2, 1998, PennCorp acquired all of the outstanding common stock held by Knightsbridge and certain other parties for aggregate cash consideration ranging from $73,777 to $77,444 (excluding anticipated acquisition expenses) depending upon the outcome of certain contingencies. As a result, SWF became a wholly-owned subsidiary of PennCorp. After the acquisition of the common stock, PennCorp repaid SWF's bank revolving debt in the amount of $90,250 and its bank term debt in the amount of $24,500. Consequently, the Company will realize an extraordinary charge in 1998 for the writeoff of deferred costs of $2,571 associated with these loans. In addition, PennCorp canceled the $40,000 SWF note it acquired from ICH.
On February 18, 1998, PennCorp announced that it had engaged investment banking firms to review strategic alternatives for maximizing shareholder value, including the sale of certain divisions, which include Union Bankers, Constitution, Marquette and affiliated service providing companies ("SW Financial businesses held for sale"). As of and for the year ended December 31, 1997, the total assets, excess of liabilities over assets, total revenues and net loss of the SW Financial businesses held for sale aggregated $530,866, $49,697, $109,387 and $5,201, respectively.