The principal operations of the insurance subsidiaries are conducted from Kansas City, Missouri and Dallas, Texas. United Fidelity, College Life, National Farmers Union and Loyalty Life operate from approximately 45,000 square feet of leased office space located at 1055 Broadway, Kansas City, Missouri 64105. The property is leased from Broadway Square Partners, a Missouri limited partnership of which a corporation controlled by the Merriman family is a 50% partner. The lease expires on February 28, 1998.
Great Southern's operations are conducted from approximately 51,000 square feet of leased office space located at 500 N. Akard, Dallas, Texas 75221. The lease was renewed in May 1995 and expires in May 1997. The Company has entered into a ten year lease for office space at the same location commencing in June 1997.
Victory Life's operations were conducted in a building owned by the Company in Murfreesburo, Tennessee until July 1996, when Victory Life's operations were relocated to the Company's Kansas City offices. The Company sold the Murfreesburo building in September 1996.
The Company also has operations in leased office space of approximately 8,000 square feet located at 790 The City South Drive, Orange, California 92668. The lease expires in November 1997.
The Company is engaged in the life insurance and tax-qualified annuity business and has sought to improve profitability by pursuing a strategy of selective acquisitions and the issuance of profitable new business. Historically, the Company's objective had been to increase the volume of life insurance in force through the acquisition of companies and blocks of business. With the acquisition of Great Southern in 1989, the Company decided to supplement this growth by developing its marketing and distribution systems to generate sales of new business. The volume of insurance in force has increased 49% from $18.5 billion in 1989 to $27.6 billion in 1996. The growth since 1989 has been a result of a combination of acquisitions, reinsurance assumed and new business. The growth in the Company's volume of life insurance inforce for the last three years is summarized in the following table.
In 1995 and 1996, the Company entered into significant transactions which impacted its results of operations and balance sheet. In July 1995, the Company acquired all the outstanding common stock of Victory Life for $42.8 million. In connection with the purchase of Victory Life, the Company reinsured all the insurance business of Kansas Life, the former parent of Victory Life. The Victory Life and Kansas Life transactions added approximately $270.0 million of insurance liabilities and $32.9 million of notes payable to the Company's consolidated balance sheet. The insurance business of Victory Life and Kansas Life is collectively referred to as Victory Life in the following discussion. The results of operations of Victory Life are included in the Company's results of operations for the period from the date of acquisition.
Income before provision for income taxes increased $9.9 million to $40.8 million in 1996 from $30.9 million in 1995. The primary reasons for the net increase were (i) income from the Acquisitions and (ii) gain from the disposition of the Company's interest in GSSW, partially offset by (iii) a decrease in net investment income, (iv) an increase in death benefits and (v) an increase in other operating expenses. The items and significant changes in individual income statement components are discussed in more detail below.
Net investment income. Net investment income increased $34.7 million to $186.7 million in 1996 from $152.0 million in 1995. Excluding the investment income of the Acquisitions, investment income decreased $6.1 million, primarily attributable to (i) a decrease in income of the Company's equity subsidiaries and (ii) changes in expected prepayments on mortgage-backed securities.
Gain on disposition of partnership interest. In December 1996, in a transaction negotiated with the party owning the other 50% interest in GSSW, the Company disposed of its 50% interest in GSSW in exchange for cash of $22.6 million and 100% interests in several real estate limited partnerships formerly owned by GSSW. The Company recorded the limited partnerships at their aggregate historical book value of $18.7 million and recorded a gain of $15.8 million on the transaction.
Interest expense. Interest expense increased $1.7 million to $12.3 million in 1996 from $10.6 million in 1995. Average outstanding indebtedness was $133.5 million with an average cost of 9.19% in 1996 compared to average outstanding indebtedness of $116.5 million with an average cost of 9.10% in 1995. Average outstanding indebtedness was higher in 1996 than 1995 due to the issuance of $32.8 million of notes payable in connection with the acquisition of Victory Life in July 1995.
Other operating expenses. Other operating expenses increased to $56.7 million in 1996 from $47.1 million in 1995. The increase in other operating expenses primarily resulted from increased expenses associated with servicing the policies of the Acquisitions. Other operating expenses also increased in 1996 as a result of increased product development and marketing expenses, partly in connection with the Ohio Life and Fremont Life marketing alliances.
Year Ended December 31, 1995 Compared to Year Ended December 31, 1994
Income before provision for income taxes increased $8.4 million to $30.9 million in 1995 from $22.5 million in 1994. The primary reasons for the increase, in addition to the Acquisitions were (i) an increase in
net investment income, (ii) a decrease in net realized investment losses, and (iii) a decrease in death benefits. These items and significant changes in individual income statement components are discussed in more detail below.
Because the Company currently writes little new traditional business, traditional premiums will decrease as the amount of in-force traditional business decreases. After subtracting the effect of the Acquisitions, traditional premiums decreased $5.5 million in 1995. This decrease was partially offset by an increase in policy revenues on interest-sensitive and annuity products. Collected premiums on interest-sensitive and annuity products increased by $26.3 million in 1995. This increase in collected premiums is not reflected in premiums and policy revenues because GAAP requires that premiums collected on these types of products be treated as deposit liabilities rather than revenue.
Net investment income. Net investment income increased $21.9 million from $130.1 million in 1994 to $152.0 million in 1995. The increase, excluding the investment income of the Acquisitions, is attributable to (i) changes in expected prepayments on mortgage-backed securities, (ii) an increase in income of the Company's equity subsidiaries and (iii) an increase in interest earned on short-term investments.
Net realized investment gains (losses). In 1995, the Company recorded net realized investment losses of $0.3 million on sales of $392.6 million compared to net realized investment losses of $2.0 million on sales of $264.7 million in 1994. The decrease in net realized investment losses incurred reflects increased market values of the Company's investment portfolio in 1995. Additionally, the Company recognized a $1.5 million loss in 1994 on the write-down of its investment in ImmunOnc, Inc., a related party.
Policyholder benefits. Policyholder benefits were $17.3 million higher in 1995 than in 1994. Excluding the effects of the Acquisitions, policyholder benefits decreased $1.0 million from 1994 to 1995. The primary reason for the reduction in policyholder benefits is a decrease in death benefits of $2.0 million. The Company experienced unusually high mortality in the first three months of 1994. Death benefits for the last nine months of 1994 and throughout 1995 returned to levels expected by the Company.
Interest expense. Interest expense increased $1.3 million to $10.6 million in 1995 from $9.3 million in 1994. The increase is due to approximately $32.8 million of notes payable issued in connection with the acquisition of Victory Life in July 1995. The average interest rate on this newly issued debt during 1995 was 7.09%. See Note 7 to the Consolidated Financial Statements of the Company, included elsewhere in this Form 10-K, for further explanation of the terms of the newly issued debt.
Liquidity. The liquidity needs of Americo, whose principal assets are investments in its insurance subsidiaries, are dependent upon receipt of sufficient funds from its subsidiaries. The cash requirements of Americo consist of debt service requirements on notes payable, amounts due FHC under Advisory and Data Processing Agreements with FHC and its own operating expenses. These cash requirements are met by payments of principal and interest on surplus debentures issued by United Fidelity and dividends from United Fidelity. Americo also receives payments under investment advisory and data processing agreements with the insurance subsidiaries which permit Americo to recover a portion of the amounts paid by it under similar agreements with FHC. On a stand-alone basis, Americo had $12.8 million of cash and cash equivalents and marketable equity securities at December 31, 1996 available for debt service and other corporate requirements.
The Company has outstanding the $100.0 million senior subordinated notes it issued in 1993. These senior subordinated notes bear interest at 9.25% and mature in May 2005. The notes are redeemable at the option of the Company beginning in 1998. The redemption prices are in excess of par in 1998 and 1999.
In connection with the acquisition of Victory Life in July 1995, the Company issued notes payable totalling $32.9 million. The Company borrowed $21.0 million under a $70.0 million credit agreement with a syndicate of banks and issued notes payable with face amounts totalling $17.0 million to the seller of Victory Life. The credit agreement, as amended in December 1996 and February 1997, is a revolving credit facility until December 1999; amounts then outstanding convert into a term loan repayable in six equal semi-annual installments. Amounts outstanding under the credit agreement bear interest at either a bank prime rate or 7/8% over a LIBOR rate. At December 31, 1996, the discounted value of the notes payable that were issued to the seller of Victory Life was $11.6 million, assuming an average effective rate of 11.6%. $5.0 million of the $17.0 million face amount matures in 2015; the remaining $12.0 million of notes is payable in 24 equal semi-annual installments which began in 1995.
At December 31, 1996, United Fidelity has four surplus debentures payable to Americo with an aggregate outstanding unpaid balance of $137.8 million. The surplus debentures have been approved by the Texas Department of Insurance. The surplus debentures contain restrictions which prevent United Fidelity from making principal and interest payments if such payments reduce United Fidelity's statutory capital and surplus below an amount specified in the surplus debenture agreements. The most restrictive minimum surplus requirement contained in the surplus debentures is $37.5 million; United Fidelity's capital and surplus at December 31, 1996 was $86.7 million. Any future payment of principal or interest on such surplus debentures will be limited by the ability of the subsidiaries of United Fidelity to pay dividends to United Fidelity and may be further limited by United Fidelity's RBC requirements. The Company does not believe that United Fidelity will have any difficulty in meeting its obligations under these surplus debentures in the foreseeable future.
The terms of the surplus debentures have been established to provide for the payment of principal and interest to Americo in amounts sufficient to make payments on the Company's external debt in accordance with their payment schedules. The surplus debentures and their payment schedules have been approved by the Texas Department of Insurance; therefore, each scheduled payment will not require the approval of the Texas Department of Insurance.
The ability of the life insurance subsidiaries to pay dividends is also affected by the AVR and IMR, as these statutory reserves directly impact capital and surplus of the life insurance subsidiaries. Also, the need to maintain an RBC ratio in excess of minimum requirements could affect the dividend paying ability of a life insurance subsidiary.
The principal sources of liquidity for the Company's insurance subsidiaries are premium receipts, net investment income received and net proceeds from investments that have been sold or matured or from mortgage loans that have been repaid. Cash flows from premiums received and investment income are generally sufficient to meet the obligations which consist of the payment of claims and benefits on insurance policies, purchases of investments and the payment of operating expenses. Although there is no intent to dispose of investments at this time, the Company's investments are substantially in readily marketable securities.
The Company has structured its interest-sensitive life insurance and annuity products to include substantial surrender charges so as to reduce the probability of unexpected increases in policy or contract surrenders, which would create a need for increased liquidity. At December 31, 1996, approximately 90% of the reserves for interest-sensitive life insurance products were for policies with surrender charges or otherwise not subject to discretionary withdrawal by the policyholder.
The policy liabilities related to the Ohio Life and Fremont Life business totalled approximately $774.0 million and $348.0 million at December 31, 1996 and 1995, respectively. As Great Southern completes the assumption of these policies, these liabilities will become direct liabilities of Great Southern and will be recorded on the Company's consolidated balance sheet. As of December 31, 1996, Great Southern had completed the assumption of policies with liabilities totalling $245.4 million.
reinsurer. National Farmers Union is restricted from declaring dividends if adjusted surplus is less than $27.5 million. Adjusted surplus is defined in the treaties as statutory capital and surplus plus the AVR less the admitted asset value of all affiliated investments. At December 31, 1996, National Farmers Union had adjusted surplus of $36.5 million.
In November 1995, the FASB issued "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities" (the Guide) which, among other things, provided entities with a one time opportunity to transfer some or all securities from held to maturity. In December 1995, the Company transferred fixed maturity securities with an amortized book value of $195,207 and a market value of $198,329 out of the held to maturity category into the available for sale category. Additionally, the Company transferred fixed maturity securities with an amortized book value of $169,439 and a market value of $178,883 out of the available for sale category into the held to maturity category.
- ------------------------- (1) The ratings set forth above are based on the ratings assigned by S&P and Moody's Investors Service, Inc. ("Moody's"). If S&P's ratings were unavailable, ratings assigned by Moody's were used. If ratings assigned by S&P and Moody's were not equivalent, securities were categorized in this table based upon the rating assigned by S&P. Bonds not rated by S&P or Moody's are classified for the purpose of the table according to the rating assigned to them by the NAIC as follows: NAIC class 1 is included in the "A" rating; class 2, in "BBB" and class 3, "BB or below".
Immediately following the acquisition, Ohio State and IGL will reinsure 100% of their insurance liabilities to an unaffiliated reinsurer (the "Reinsurer") on a coinsurance basis. Ohio State and IGL will transfer approximately $685.0 million of assets to the Reinsurer and will receive a ceding commission of $133.0 million from the Reinsurer. The Reinsurer will reinsure certain risks on a 70% quota share of the same insurance liabilities to Great Southern on a modified coinsurance basis, which provides that the Reinsurer retains the assets and liabilities. The Reinsurer will receive 100% of the statutory profits from the reinsured policies until the Reinsurer has recovered the initial ceding commission. After that time, the Reinsurer will receive 30% of the statutory profits from the reinsured policies.
Management does not believe that inflation has had a significant effect on its consolidated results of operations.
Management is aware that prevailing market interest rates may shift significantly and has strategies in place to manage either an increase or decrease in prevailing rates. In a rising interest rate environment, the Company's average cost of funds would increase over time as it prices its new and renewing interest-sensitive and investment products to maintain generally competitive market rates. Management would seek to place new funds in investments which were matched in duration to, and higher yielding than, its liabilities. Management believes that liquidity to fund withdrawals would be available through incoming cash flow, the sale of short-term or floating rate instruments or reverse repurchase agreements on the Company's substantial mortgage-backed securities portfolio, thereby avoiding the sale of fixed rate assets in an unfavorable bond market.
The Company's audited consolidated financial statements for the three years ended December 31, 1996 and the related report of independent accountants thereon are set forth at pages to hereof and are incorporated herein by reference. Reference is made to the Index to Financial Statements on page herein.