Torchmark, through its subsidiaries, owns or leases buildings that are used in the normal course of business. Torchmark owns and occupies a 300,000 square foot facility in McKinney, Texas (a north Dallas suburb). This facility is Torchmark’s corporate headquarters and also houses the operations of a subsidiary, United American, as well as the operations of other subsidiaries. In addition, United American leases 5,000 square feet of space in Omaha, Nebraska and, through a subsidiary, leases 2,500 square feet in an office area in Syracuse, New York.
(2) Includes Torchmark’s 7.1% Junior Subordinated Debentures reported as “Due to affiliates” on the Consolidated Balance Sheets at year ends 2010 through 2011 in the amount of $123.7 million.
Insurance Product Line Segments. As fully explained in Note 14, the insurance product line segments involve the marketing, underwriting, and the administration of policies. Each product line is further segmented by the various distribution units that market the insurance policies. Each distribution unit operates in a niche market offering insurance products designed for that particular market. Whether analyzing profitability of a segment as a whole, or the individual distribution units within the segment, the measure of profitability used by management is the underwriting margin, which is:
The tables in Note 14 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, 2014. 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.
* Retrospectively adjusted to give effect to the reorganization of segments described in Note 14 in the Notes to Consolidated Financial Statements.
As shown in the above chart, after-tax segment results of operations rose each year over the prior year from $507 million in 2012 to $531 million in 2013 to $534 million in 2014. The primary contributor to the growth in both 2014 and 2013 was the underwriting margin in our life insurance segment, in which margins rose $11 million in 2014 and $36 million in 2013. The life insurance segment is our strongest segment and is the largest contributor to earnings in each year presented. Also contributing to growth in income in both years was our health insurance segment, which provided $3 million of additional margin in 2014 and $33 million in 2013. The 2013 larger increase in health margin was primarily due to the inclusion of Family Heritage’s health business for a full year since its acquisition in late 2012. Family Heritage accounted for $32 million of the increase in 2013 margin. Margins for the Medicare Part D segment declined 23% in 2014 to $27 million, primarily due to two costly Hepatitis C drugs which were not required to be covered until well after our 2014 pricing was finalized, as discussed more fully later in this report.
Excess investment income, the measure of profitability of our investment segment, increased to $225 million or 3% over the prior year amount of $219 million. This was the first time in four years the dollar
amount of excess investment income exceeded the prior year’s amount. In 2013, excess investment income declined 8%. Although interest rates rebounded slightly during the first half of 2014, the low interest rate environment continued to pressure investment yields and spreads related to required interest on net policy liabilities throughout the three-year period. Excess investment income has also been hampered by a lag in government reimbursement of Medicare Part D costs. The effects of the low-interest-rate environment and the impact of the Part D business on investment income is discussed more fully later in this report under the caption Investments.
The inclusion of Family Heritage’s administrative expenses for a full year for the first time added $8 million of additional administrative expense in 2013. In addition, in both 2014 and 2013, there were increases in stock compensation expense which negatively affected the results during the year. Stock compensation increased $7 million in 2014 and $4 million in 2013. These increases in stock compensation expense resulted primarily from the increase in the value of Torchmark’s stock rather than an increase in the number of grants.
Total revenues rose 5% in 2014 to $3.96 billion, after having risen 5% in 2013 to $3.77 billion. Life premium rose 4% or $81 million in 2014 to $1.97 billion. Life premium increased $77 million in 2013 to $1.89 billion. Net investment income rose $16 million in 2013, and rose 3% or $19 million in 2014. Health premium increased 7% to $1.24 billion in 2014 and contributed $76 million to 2014 revenue growth, after having gained 11% to $1.17 billion in 2013. Health premium contributed $119 million to 2013 revenue growth.
With regard to health insurance, we primarily market Medicare Supplement insurance, other limited-benefit products including cancer, and accident and health products. As noted earlier, 2013 and 2014 health premiums were positively affected by the inclusion of Family Heritage’s health premium for the full years. The inclusion of Family Heritage also caused our limited-benefit health premium, which is their primary focus, to exceed our Medicare Supplement premium in 2013 for the first time in several years. Prior to 2013, Medicare Supplement was our largest contributor to total health premium. Limited-benefit health continued to exceed Medicare Supplement in 2014. Limited-benefit health premium was $446 million in 2014, compared with $447 million in 2013. Limited-benefit premium increased 50% over 2012 limited-benefit health premium of $298 million, a result of the inclusion of Family Heritage’s business. Medicare Supplement premium was $423 million in 2014, increasing over the prior year’s premium for the first time in many years, as lapses exceeded new sales in prior year periods. Medicare Supplement premium was $417 million in 2013 and $432 million in 2012. The increase in 2014 premium resulted from sales in 2014 to certain large groups. Health margins have remained somewhat stable as a percentage of premium throughout the three-year period. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
Torchmark’s current investment policy regarding fixed maturities limits new fixed maturity acquisitions to investment-grade securities generally with longer maturities (often exceeding twenty years) that meet our quality and yield objectives. Approximately 97% of our invested assets at fair value consist of fixed maturities of which 96% were investment grade at December 31, 2014. The average quality rating of the portfolio was A-. The portfolio contains no securities backed by sub prime or Alt-A mortgages, no direct investment in residential mortgages, no counterparty risks, no credit default swaps, or other derivative contracts. See the analysis of excess investment income and investment activities under the caption Investments in this report and Note 4-Investments in the Notes to Consolidated Statements of Operations for a more detailed discussion of this segment.
In 2012 and 2013, we engaged in a debt restructuring program which resulted in a reduction in financing costs. We issued two new debt offerings during 2012: our $300 million principal amount 3.8% Senior Notes due 2022 and our $125 million principal amount 5.875% Junior Subordinated Debentures due 2052, both issued in September. Proceeds from the Senior Notes were $297 million, but $150 million were purchased by our insurance subsidiaries and were eliminated in consolidation. Proceeds from this offering provided funding for the retirement of our 7 3/8% Senior Notes, which matured and were repaid in August, 2013, and for the acquisition of Family Heritage in November, 2012. The $121 million net proceeds from the Subordinated Debentures were used to fund the call of our $120 million principal amount 7.1% Trust Originated Preferred Securities in October, 2012. More information on these transactions can be found in Note 6-Acquisition and Note 11-Debt in the Notes to Consolidated Financial Statements and in our discussion of Capital Resources in this report.
under the caption Settlements, we were involved in certain issues in which we incurred settlement losses and expenses. In connection with the 2012 purchase of Family Heritage, as described in Note 6-Acquisition, we incurred $2.9 million of acquisition-related expenses ($1.9 million after tax). During 2013, Torchmark incurred a state guaranty fund assessment in the amount of $1.2 million ($751 thousand after tax), resulting from events in years prior to 2012. Also in 2013, we resolved a legal matter related to a non-insurance issue in the amount of $500 thousand ($325 thousand after tax), and settled additional litigation related to prior years in the amount of $8.6 million ($5.6 million after tax). During 2014, Torchmark accrued for certain litigation matters in the net amount of $3.7 million ($2.4 million after tax) that were not directly related to its insurance operations. Additionally, Torchmark received $1.3 million ($853 thousand after tax) in settlement of litigation regarding investments. Also in 2014, the Company recorded $8.2 million in administrative settlements ($5.3 million after tax) related to benefits paid for deaths occurring in prior years where claims were not filed. All of these items have been expensed in the Consolidated Statements of Operations. However, as described in Note 1, we remove items such as these that relate to prior periods or are non-operating items when evaluating the results of current operations, and therefore exclude such matters from our segment analysis for current periods.
Torchmark has in place an ongoing share repurchase program which began in 1986. 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. 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 Board of Directors has authorized the Company’s share repurchase program in amounts and with timing that management, in consultation with the Board, determines to be in the best interest of the Company and its shareholders. The following chart summarizes share purchase activity for each of the three years ended December 31, 2014.
Share purchases for the years 2013 and 2012 have been retrospectively adjusted for the three-for-two stock split effective July 1, 2014.
Index to Financial Statements Life Insurance. Life insurance is our largest insurance segment, with 2014 life premium representing 62% of total premium. Life underwriting income before other income and administrative expense represented 71% of the total in 2014. Additionally, investments supporting the reserves for life products produce the majority of excess investment income attributable to the investment segment.
Life insurance premium rose 4% to $1.97 billion in 2014 after having increased 4% in 2013 to $1.89 billion. Life insurance products are marketed through several distribution channels. Premium income by channel for each of the last three years is as follows:
We use three statistical measures as indicators of premium growth and sales over the near term: “annualized premium in force,” “net sales,” and “first-year collected premium.” Annualized premium in force is defined as the premium income that would be received over the following twelve months at any given date on all active policies if those policies remain in force throughout the twelve-month period. Annualized premium in force is an indicator of potential growth in premium revenue. Net sales is annualized premium issued, net of cancellations in the first thirty days after issue, except in the case of Direct Response where net sales is annualized premium issued at the time the first full premium is paid after any introductory offer period has expired. We believe that net sales is a superior indicator of the rate of premium growth relative to annualized premium issued. First-year collected premium is defined as the premium collected during the reporting period for all policies in their first policy year. First-year collected premium takes lapses into account in the first year when lapses are more likely to occur, and thus is a useful indicator of how much new premium is expected to be added to premium income in the future.
Annualized life premium in force was $2.04 billion at December 31, 2014, an increase of 5% over $1.96 billion a year earlier. Annualized life premium in force was $1.90 billion at December 31, 2012.
The American Income Exclusive Agency has historically focused primarily on marketing to members of labor unions. While the labor union market is still the backbone of American Income’s business, the agency has diversified in recent years by focusing heavily on other affinity groups and referrals to help to ensure sustainable growth. It is Torchmark’s highest margin business. The American Income Agency was also the largest contributor to life premium and net sales of any Torchmark distribution method in 2014. Life premium for this agency rose 7% to $766 million, after having risen 8% in 2013. Net sales rose 13% in 2014 to $172 million, after having declined 4% in 2013. Net sales rose 12% in 2012. The average face amount of policies issued in 2014 was approximately $30 thousand. As is the case with all of Torchmark’s agency distribution systems, continued increases in product sales are largely dependent on increases in agent count. The American Income agent count was 6,434 at December 31, 2014 compared with 5,302 a year earlier, an increase of 21%. The agent count increased 2% in 2013 and 18% in 2012. The average agent count for 2014 was 5,868. The average agent count is based on the actual count at the end of each week during the year. Management’s primary objective is to grow middle management in the agency to help ensure sustainable growth. This is being achieved through an increased emphasis on agent training programs and financial incentives that appropriately reward agents at all levels for helping develop and train personnel. We have also begun providing more home-office and webinar training programs. These programs are designed to provide each agent, from new recruits to top level managers, coaching and instruction specifically designed for each individual’s level of experience and responsibilities. We believe that these initiatives will continue to promote enthusiasm in the field and will drive increases in agent retention and sales activity.
While the juvenile market is an important source of sales, it also is a vehicle to reach the parents and grandparents of the juvenile policyholders, who are more likely to respond favorably to a Direct Response solicitation for life coverage on themselves than is the general adult population. Also, both the juvenile policyholders and their parents are low acquisition-cost targets for sales of additional coverage over time.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 2% in 2014 and 7% in 2013. The margin increased to $556 million in 2014 after rising to $545 million in 2013. The steady growth in premium contributed to margin growth in all periods. As a percentage of premium, however, an increase in policy obligations resulted in a slightly lower margin in 2014. Policy obligations fluctuate from period to period as a result of mortality. In both 2013 and 2014, percentage margins were positively affected by our conservation program and the permitted increases in the deferrals of our internet-related direct response acquisition costs.
Index to Financial Statements Health Insurance. Health insurance sold by Torchmark includes primarily Medicare Supplement coverage to enrollees in the federal Medicare program, cancer coverage, accident coverage, and other limited-benefit supplemental health products. As discussed in Note 14-Business Segments in the Notes to Consolidated Financial Statements, Medicare Part D is now reported as a separate Torchmark segment and is no longer included in the discussion of Torchmark’s other health products. See the discussion of Medicare Part D later in this report. In this discussion of health business, all health coverage plans other than Medicare Supplement are classified here as limited-benefit plans.
Health premium represented 27% of Torchmark’s total premium income in 2014, compared with 28% in 2013 and 26% in 2012. Health underwriting margin accounted for 25% of the total in 2014, compared with 25% in 2013 and 23% in 2012. Health results in 2014 and 2013 were positively affected by the late 2012 addition of Family Heritage. Family Heritage added $205 million and $191 million of health premium in 2014 and 2013, respectively, compared with $30 million in 2012. The following table indicates health insurance premium income by distribution channel for each of the last three years.
Index to Financial Statements We market supplemental health insurance products through a number of distribution channels. The following table presents net sales by distribution method for the last three years.
Health premium, rose 1% to $869 million in 2014, after having increased 18% in 2013 to $864 million. However, if the premium of Family Heritage were removed for comparability in 2013 and 2012, health premium would have declined 4% in 2013. The decline in 2013 premium resulted primarily from a run-off of a block of discontinued hospital-surgical plans. This runoff had been ongoing for a number of years. In 2014, this runoff is thought to have substantially run its course. Net sales increased 63% in 2014 to $181 million, after having increased 42% in 2013. The 2014 increase was caused by the more than double growth in Medicare Supplement sales. These sales occurred in both the United American Independent Agency and in the Direct Response Group. These increases were primarily the result of strong group sales of Medicare Supplement which can vary significantly from period to period. The 2013 increase was primarily a result of the acquisition of Family Heritage, which contributed $44 million to the growth in 2013 compared with $7 million in 2012. First-year collected premium increased 18% in 2014 and 47% in 2013, as a result of the increased sales in both 2014 and 2013, and the addition of Family Heritage first-year premium for a full year in 2013 for the first time.
The UA Independent Agency is Torchmark’s largest in terms of health premium income, producing 35% of health premium in 2014. This Agency is composed of independent agencies appointed with Torchmark whose sizes range from very large, multi-state organizations down to one-person offices. All of these agents generally sell for a number of insurance companies. Torchmark had 3,161 active producing agents at December 31, 2014 compared with 2,414 a year earlier. This Agency is our largest producer of Medicare Supplement insurance, with $286 million or 68% of our Medicare Supplement premium income in 2014. Net sales for this Agency were $84 million in 2014, consisting almost entirely of Medicare Supplement business. These net sales were more than double the net sales of $41 million in 2013. In 2013, they had declined 2%. Total health premium income for the UA Independent Agency was $305 million in 2014, an increase of 2% from $298 million in 2013. Premium income had declined very slightly in 2013.
The Family Heritage Exclusive Agency was acquired by Torchmark’s acquisition of Family Heritage on November 1, 2012 as discussed in Note 6-Acquisition in the Notes to Consolidated Financial Statements. This agency markets primarily limited-benefit supplemental health insurance in non-urban areas. Most of their policies include a cash-back feature, such as a return-of-premium, whereby any excess of premiums over claims paid is returned to the policyholder at the end of a specified period stated within the insurance policy. The Family Heritage Agency is our largest agency in terms of limited-benefit health net sales, adding $47 million in net sales in 2014, compared with $44 million in 2013, an increase of 8%. This agency’s $205 million in health premium income during 2014 represented 24% of Torchmark’s total. Premium in 2014 increased 7% over 2013 premium of $191 million. The producing agent count was 785 agents at December 31, 2014, compared with 695 agents at December 31, 2013. The average agent count for 2014 was 740. The agent count was 702 at December 31, 2012. Management expects to grow this agency going forward through geographic expansion and incorporation of Torchmark’s recruiting programs.
The Liberty National Exclusive Agency represented 25% of all Torchmark health premium income at $222 million in 2014. The Liberty Agency markets limited-benefit health supplemental products consisting primarily of cancer insurance. Much of the Liberty’s health business is now generated through worksite marketing which targets small businesses of 10 to 25 employees. In 2014, health premium income in the Agency declined 8% from prior year premium of $241 million, after also declining 8% in 2013. These premium declines were due primarily to the runoff of a block of discontinued hospital-surgical business as well as an earlier restructuring of this Agency to a variable-cost, commission-driven model. The Liberty Agency experienced growth in net health sales in 2014 of 22% to $17 million. The agent count at Liberty was 1,498 at 2014 year end, an increase of 5% over year end 2013 and 6% over year end 2012.
Health premium at this agency was $79 million in both 2014 and 2013. In 2013, it had declined slightly from $80 million. However, health net sales rose 31% in 2014 to $9 million, after falling 20% in 2013 to $7 million. Because this agency focuses on life products, health net sales comprised only 5% of the American Income Agency’s total net sales in 2014.
Index to Financial Statements Direct Response, primarily a life operation, also offers health insurance, which is predominantly Medicare Supplements sold directly to employer or union sponsored groups. In 2014, net health sales were $23 million, compared with $4 million in 2013 and $5 million in 2012. The large increase in Direct Response net sales in 2014 was due to the addition of a large Medicare Supplement group, which is not indicative of a trend. In 2014, health net sales for this group represented approximately 13% of Direct Response’s total life and health net sales. Direct Response health premium income was $59 million in 2014, increasing 9% over 2013 premium of $54 million. Health premium declined 7% in 2013.
As presented in the following table, Torchmark’s health insurance underwriting margin before other income and administrative expense increased 1% to $199 million in 2014, after an increase of 20% to $197 million in 2013. Family Heritage contributed $32 million of the $33 million 2013 increase. As a percentage of premium income, margins were 23% in both 2014 and 2013 as compared with 22% in 2012.
Index to Financial Statements Medicare Part D. Torchmark, through its subsidiary United American, offers coverage under the government’s Medicare Part D plan. The Medicare Part D plan is a stand-alone prescription drug plan for Medicare beneficiaries. Part D is regulated and partially funded by CMS for participating private insurers like United American. Under Part D, private carriers are the primary insurers, while CMS provides significant premium subsidies and reinsurance. Our Medicare Part D product is sold through the Direct Response operation and to groups through the UA Independent Agency.
Total Medicare Part D premium excludes $25.5 million and $2.6 million of risk-sharing premium received in 2014 and 2013, respectively, and $404 thousand in 2012 of risk-sharing premium paid to the Centers for Medicare and Medicaid Services consistent with the Medicare Part D contract. 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.
First-year collected premium for Medicare Part D represents only premium collected within the first twelve months from new first-time enrollees.
Changes in Part D premium generally result from changes in the number of enrollees, which are heavily influenced by new sales. In 2012, the Company issued a new lower cost Part D plan allowing us to pick up a large number of auto-enrollees in 21 regions with resulting higher sales. In 2013, due to intensified price competition, we qualified for new low-income auto-enrollees in only 7 regions but were able to keep prior year auto-enrollees in 14 regions and maintain our presence in 21 regions. In 2014, Torchmark qualified to receive new Part D auto-enrollees in 15 regions and also qualified to retain prior year auto-enrollees in 8 regions, for a total of 23 regions. These variations in the number of new auto-enrollees caused the changes in Part D net sales, premium, and enrollee counts, including the large increases in 2014 and the declines in 2013. The 2013 decline was also influenced by the loss of several employer group Part D cases at the end of 2012.
As presented in the following table, margins decreased 23% in 2014 to $27 million, even though premium rose 16%. Premiums were increased for the year 2014 to cover higher anticipated non-deferred acquisition expenses. As such, we expected significantly lower obligation ratios in 2014. However, due primarily to unexpected costs related to two Hepatitis C drugs, the coverage of which was mandated by CMS Administration early in 2014, well after our 2014 pricing was finalized, the obligation ratios for 2014 increased from 82% to 83%. Non-deferred acquisition cost ratios were significantly higher, as planned in our pricing, due to (1) new taxes imposed by the Affordable Care Act, (2) higher costs related to a change in the structure of drug rebates, and (3) higher costs related to the increased volume of enrollees. As a percentage of premium, underwriting margin for 2014 fell to 8%, compared with 12% for 2013. In 2013, margins increased 6% to $35 million, even though premium declined 6%. As a percentage of premium, margins rose from 10% to 12%. The benefit ratio declined 2%, as a result of lower claims experience in the group market in 2013. Group Part D claims tend to fluctuate from year to year.
Total Medicare Part D premium excludes $25.5 million and $2.6 million of risk-sharing premium received in 2014 and 2013 respectively, and $404 thousand in 2012 of risk sharing premium paid to the Centers for Medicare and Medicaid Services consistent with the Medicare Part D contract. 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.
For 2015, we do not expect Hepatitis C claims to have the same negative impact on margins that they had in 2014, as our 2015 pricing reflects the cost of these drugs. In addition, we will have significantly less auto-enrollees in 2015. Auto-enrollees accounted for approximately 85% of our 2014 Hepatitis C claims.
While the fixed annuity account balance has remained relatively stable each year over the prior year, underwriting income has increased each year over the prior year. Policy charges have actually declined slightly in each successive year. The majority of policy charges consist of surrender charges which are not based on account size. A considerable portion of fixed annuity profitability is derived from the spread of investment income exceeding contractual interest requirements, which can result in negative net policy obligations. In the three-year period, however, spreads tended to level as crediting rates reached guaranteed minimums.
Index to Financial Statements Administrative expenses. Operating expenses are included in the Other and Corporate Segments and are classified into two categories: insurance administrative expenses and expenses of the parent company. The following table is an analysis of operating expenses for the three years ended December 31, 2014.
(4) Net of deferred acquisition costs, excluding the associated unrealized gains and losses thereon.
Index to Financial Statements Excess investment income increased $6 million or 3% in 2014 over the prior year. Excess investment income declined $18 million or 8% in 2013. Excess investment income has been pressured over the past three years as a result of the impact of lower interest rates on net investment income coupled with the increase in required interest on net policy liabilities discussed later under this caption. On a per diluted share basis, excess investment income increased 8% to $1.70 in 2014. Excess investment income declined 2% to $1.57 per share in 2013, after having risen 3% in the prior year. The greater increase in 2014 per-share amounts, as well as the smaller decline in 2013 relative to the changes in dollar amounts for excess investment income are a result of share repurchases.
The largest component of excess investment income is net investment income, as adjusted for the segment analysis, which rose 3% to $758 million in 2014. It increased 3% to $735 million in 2013 from $716 million in 2012. The inclusion of Family Heritage, acquired in late 2012, added $21 million of net investment income in 2013 compared with $3 million in 2012, accounting for the majority of the 2013 increase. However, growth in net investment income has generally been slower than growth in mean invested assets in recent years due to the declining interest rate environment. In 2014, fixed maturity yields averaged 5.91% on a tax-equivalent and effective-yield basis, compared with 5.94% in 2013 and 6.35% in 2012. Even though mean invested assets have increased each period, net investment income has grown at a slower pace as a result of the decline in average yields. In a declining rate environment, the overall portfolio yield will decrease as new money is invested at lower prevailing yields. The reduction in the average yields has primarily been the result of reinvesting proceeds from bonds that matured or were called at yield rates less than the rates we earned on the bonds before they matured or were called. While Family Heritage added incrementally to net investment income during 2014 and 2013, its lower-yielding portfolio has also contributed to the decline in the average fixed-maturity yield.
Net investment income has also been negatively affected in 2014 by the CMS requirement for us to pay certain Medicare Part D claims costs during the current period that are ultimately the responsibility of the government, but are not reimbursed until the following year. Because Part D claims have been unusually high in 2014, due to the approval of new Hepatitis C drugs discussed earlier in this report and higher overall drug costs, we have incurred extensive upfront costs that will not be reimbursed by CMS until late 2015. This delay in reimbursement has caused a delay in cash flows available for new investments that resulted in a loss of approximately $5 million of pre-tax net investment income in 2014, and will cause us to lose approximately $4 million of additional investment income in 2015. Please refer to Note 10¯Supplemental Disclosures of Cash Flow Information in the Notes to Consolidated Financial Statements.
While net investment income in recent years has been negatively impacted by the factors discussed above, we would expect to see only modest declines in the average portfolio yield rate over the next few years compared with the larger declines in recent years. We anticipate that less than 2% of fixed maturities
on average are expected to run off each year over the next five years. Overall, we are encouraged that the prospect of additional significant calls seems to be behind us and expected maturities should have lower yields than in the past.
Excess investment income is reduced by the required interest on net insurance policy liabilities because we consider these amounts to be components of the profitability of our insurance segments. Required interest is based on the actuarial interest assumptions used in discounting the benefit reserve liability and the amortization of deferred acquisition costs for our insurance policies in force. The great majority of our life and health insurance policies are fixed interest-rate protection policies, not investment products, and are accounted for under current accounting guidance for long-duration insurance products (formerly SFAS 60, now incorporated into ASC 944-20-05). This guidance mandates that interest rate assumptions be “locked in” for the life of that block of business. Each calendar year, we set the assumed discount rate to be used to calculate the benefit reserve liability and the deferred acquisition cost asset for all insurance policies issued that year. That rate is based on the new money yields that we expect to earn on the premiums received in the future from policies of that issue year, and cannot be changed except in the event of a premium deficiency. The discount rate used for policies issued in the current year has no impact on the in force policies issued in prior years as the rates of all prior issue years are also locked in. As such, the overall discount rate for the entire in force block is a weighted average of the discount rates being used from all issue years. Changes in the overall weighted-average discount rate over time are caused by changes in the mix of the in force business by issue year.
Because actuarial discount rates are locked in for life on essentially all of our business, benefit reserves and deferred acquisition costs are not affected by interest rate fluctuations unless a loss recognition event occurs. Due to the strength of our underwriting margins and the current positive spread between the yield on our investment portfolio and the weighted-average discount rate of our in force block, we don’t expect an extended low-interest-rate environment to cause a loss recognition event.
The combined weighted average discount rate decreased in 2013 due to the inclusion of Family Heritage for a full year.
The table below presents the components of financing costs and reconciles interest expense per the Consolidated Statements of Operations.
Index to Financial Statements Portfolio Analysis. Because Torchmark has recently invested almost exclusively in fixed-maturity securities, the relative percentage of our assets invested in various types of investments varies from industry norms. The following table presents a comparison of Torchmark’s components of invested assets at amortized cost as of December 31, 2014 with the latest industry data.
Because fixed maturities represent such a significant portion of our investment portfolio, the remainder of the discussion of portfolio composition will focus on fixed maturities. An analysis of our fixed-maturity portfolio by component at December 31, 2014 and December 31, 2013 is as follows:
Index to Financial Statements Credit Risk Sensitivity. Credit risk relates to the level of uncertainty that a security’s issuer will maintain its ability to honor the terms of that security until maturity. Approximately 87% 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, we continually monitor credit risk. We mitigate this ongoing risk, in part, by acquiring only 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 spreading investments over a large number of issuers and a wide range of industry sectors.
The following table presents the relative percentage of our fixed maturities by industry sector at December 31, 2014.
Our energy sector investments accounted for 12% of fixed maturities at amortized cost as of December 31, 2014. While this sector has seen recent volatility, we believe the risk of losses in the foreseeable future is minimal. Over 98% of these holdings are investment grade, and the portfolio had a net unrealized gain of $151 million at year end 2014. Less than 8% of our holdings are in the oil field service and drilling area. While there may be some downgrades in this sector, we believe that our investments will be able to withstand lower energy prices for an extended duration.
The portfolio has a weighted average quality rating of A- based on amortized cost. Approximately 96% of the portfolio at amortized cost was considered investment grade. Our investment portfolio contains no securities backed by sub-prime or Alt-A mortgages (loans for which some of the typical documentation was not provided by the borrower). We have no direct investments in residential mortgages, nor do we have any counterparty risks as we are not a party to any credit default swaps or other derivative contracts. We do not participate in securities lending. There are no off-balance sheet investments, as all investments are reported on our Consolidated Balance Sheets. Other than $9 million of German government bonds at amortized cost and fair value, we have no direct exposure to European sovereign debt.
Index to Financial Statements Market Risk Sensitivity. Torchmark’s financial securities are exposed to interest rate risk, meaning the effect of changes in financial market interest rates on the current fair value of the company’s investment portfolio. Since 96% of the book value of our investments is attributable to fixed-maturity investments (and virtually all of these investments are fixed-rate investments), the portfolio is highly subject to market risk. Declines in market interest rates generally result in the fair value of the investment portfolio exceeding the book value of the portfolio and increases in interest rates cause the fair value to decline below the book value. Under normal market conditions, we do not expect to realize these unrealized gains and losses because we have the ability and generally the intent to hold these investments to maturity. The long-term nature of our insurance policy liabilities and strong cash-flow operating position substantially mitigate any future need to liquidate portions of the portfolio. The increase or decrease in the fair value of insurance liabilities and debt due to increases or decreases in market interest rates largely offsets the impact of rates on the investment portfolio. However, as is permitted by GAAP, these liabilities are not recorded at fair value.
Per share amounts for 2013 and 2012 have been retrospectively adjusted for the three-for-two stock split effective July 1, 2014.
Parent Company Liquidity. Cash flows from the insurance subsidiaries are used to pay interest and principal repayments on Parent Company debt, operating expenses of the Parent, and Parent Company dividends to Torchmark shareholders. In 2014, the Parent received $479 million of cash dividends from its insurance subsidiaries, compared with $488 million in 2013 and $437 million in 2012. Including transfers from other subsidiaries and after paying debt obligations, shareholder dividends, and other expenses (but before share repurchases), Torchmark Parent had excess operating cash flow in 2014 of approximately $377 million, compared with $364 million in 2013. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2015, it is expected that the Parent Company will receive approximately $473 million in dividends from subsidiaries, and that an approximate range of $355 to $365 million will be available as excess cash flow. 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 12-Shareholders’ Equity in the Notes to Consolidated Financial Statements. Although these restrictions exist, dividend availability from subsidiaries historically has been sufficient for the cash flow needs of the Parent Company. As additional liquidity, the Parent held $6 million of cash and short-term investments at December 31, 2014, compared with $8 million a year earlier. The Parent also had available a $50 million receivable from subsidiaries at 2014 year end.
Short-Term Borrowings. 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 $750 million. In July 2014, Torchmark replaced a $600 million facility with this new agreement, as discussed in Note 11-Debt in the Notes to Consolidated Financial Statements, under the caption Commercial Paper. The new facility, like the previous, is further designated as a back-up line of credit for a commercial paper program. As of December 31, 2014, we had available $314 million of additional borrowing capacity under this new facility, compared with $173 million a year earlier. There have been no difficulties in accessing the commercial paper market during the three years ended December 31, 2014. For detailed information about this new line of credit facility, please refer to Note 11-Debt.
Off-Balance Sheet Arrangements. As a part of its above-mentioned credit facility, Torchmark had outstanding $198 million in stand-by letters of credit at December 31, 2014. However, these letters are issued among our subsidiaries, one of which is an offshore captive reinsurer, and have no impact on company obligations as a whole. Any future regulatory changes that restrict the use of off-shore captive reinsurers might require Torchmark to obtain third-party financing, which could cause an immaterial increase in financing costs.
As of December 31, 2014, we had no unconsolidated affiliates and no guarantees of the obligations of third-party entities. All of our guarantees were guarantees of the performance of consolidated subsidiaries, as disclosed in Note 15-Commitments and Contingencies.
Pension obligations are primarily liabilities in trust funds that are calculated in accordance with the terms of the pension plans. They are offset by invested assets in the trusts, which are funded through periodic contributions by Torchmark in a manner which will provide for the settlement of the obligations as they become due. Therefore, our obligations are offset by those assets when reported on Torchmark’s Consolidated Balance Sheets. At December 31, 2014, these pension obligations were $477 million, but there were also assets of $323 million in the pension entities. The schedule of pension benefit payments covers ten years and is based on the same assumptions used to measure the pension obligations, except there is no interest assumption because the payments are undiscounted. There are also obligations for benefits other than pensions with a liability of $23 million. Please refer to Note 10-Postretirement Benefits in the Notes to Consolidated Financial Statements for more information on pension obligations.
Future insurance obligations consist primarily of estimated future contingent benefit payments on policies in force at December 31, 2014. These estimated payments were computed using assumptions for future mortality, morbidity and persistency. The actual amount and timing of such payments may differ significantly from the estimated amounts shown. Management believes that the assets supporting the liability of $11.7 billion at December 31, 2014, along with future premiums and investment income, will be sufficient to fund all future insurance obligations.
Our insurance subsidiaries generally target a capital ratio of at least 325% of required regulatory capital under Risk-Based Capital (RBC), a formula designed by insurance regulatory authorities to monitor the adequacy of capital. The 325% target is considered sufficient for the subsidiaries because of their strong reliable cash flows, the relatively low risk of their product mix, and because that ratio is in line with rating agency expectations for Torchmark. At December 31, 2014, our insurance subsidiaries in the aggregate had RBC ratios of approximately 326%. Should we experience additional impairments and/or ratings downgrades in the future that cause the ratio to fall below 325%, management has more than sufficient liquidity at the Parent Company to make additional contributions as necessary to maintain the ratios at or above 325%.
Outstanding shares and per share amounts have been retrospectively adjusted for the three-for-two stock split effective July 1, 2014.
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 have not elected this option.
Financial Strength Ratings. The financial strength of our major insurance subsidiaries is rated by Standard & Poor’s and A. M. Best. The following chart presents these ratings for our five largest insurance subsidiaries at December 31, 2014.
A.M. Best states that it assigns an A+ (Superior) rating to those companies which, in its opinion, have demonstrated superior overall performance when compared to the norms of the life/health insurance industry. A+ (Superior) companies have a superior ability to meet their ongoing insurance obligations. Companies rated A (Excellent) are considered to have excellent ability to meet those obligations.
The AA financial strength rating category is assigned by Standard & Poor’s Corporation (S&P) to those insurers which have very strong financial security characteristics, differing only slightly from those rated higher. An insurer rated A has strong financial security characteristics, but is somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings. The plus sign (+) or minus sign (-) shows the relative standing within the major rating category.
Approximately 84% of our liabilities for future policy benefits at December 31, 2014 were traditional insurance liabilities where the liability is determined as 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. 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. Torchmark did not have a premium deficiency event for its traditional business during the three years ended December 31, 2014.
Approximately 99% of our recorded amounts for deferred acquisition costs at December 31, 2014 were related to traditional products and are being amortized over the premium-paying period in proportion to the present value of actual historic and estimated future gross premiums. The projection assumptions for this business are set at the time of contract issue. These assumptions are “locked-in” at that time and, except where there is a loss recognition issue, are not revised for the lifetime of the contracts. Absent a premium deficiency, variability in amortization after policy issuance is caused only by variability in premium volume. We have not recorded a deferred acquisition cost loss recognition event for assets related to this business for any period in the three years ended December 31, 2014.
At times, the values of our fixed maturities can also be affected by illiquidity in the financial markets. Illiquidity would contribute to a spread widening, and accordingly unrealized losses, on many securities that we would expect to be fully recoverable. Even though our fixed maturity portfolio is available for sale, we have the ability and intent to hold the securities until maturity as a result of our strong and stable cash flows generated from our insurance products. Considerable information concerning the policies, procedures, classification levels, and other relevant data concerning the valuation of our fixed-maturity investments is presented in Note 1-Significant Accounting Policies and in Note 4-Investments under the captions Fair Value Measurements in both notes.
discount rate and the long-term rate of return on assets assumed on our defined benefit pension plans expense for the year 2014 and projected benefit obligation as of December 31, 2014.
The discount rate was 5.12% for 2014 expense and 4.23% for the projected benefit obligation at December 31, 2014
3) Market trends in the senior-aged health care industry that provide alternatives to traditional Medicare, such as health maintenance organizations (HMOs) and other managed care or private plans, and that could affect the sales of traditional Medicare Supplement insurance;
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2014
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries (Torchmark) as of December 31, 2014 and 2013, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
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, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, 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.
* Amounts have been retrospectively adjusted for the stock split described in Note 1.
expected to be sold, the operations and cash flows of the business have been or will be eliminated from the ongoing operations as a result of the disposal transaction, and Torchmark will not have any significant continuing involvement in the operations of the business after the disposal transaction. The results of discontinued operations are reported in discontinued operations in the Consolidated Statements of Operations for current and prior periods commencing in the period in which the business is either disposed of or is accounted for as a disposal group, including any gain or loss recognized on the sale or adjustment of the carrying amount to fair value less cost to sell.
The great majority of the Company’s fixed maturities are not actively traded and direct quotes are not generally available. Management therefore determines the fair values of these securities after consideration of data provided by third-party pricing services and independent broker/dealers. Over 99% of the fair value reported at December 31, 2014 was determined using data provided by third-party pricing services. Prices provided by third-party pricing services are not binding offers but are estimated exit values. They are based on observable market data inputs which can vary by security type. Such inputs include benchmark yields, available trades, broker/dealer quotes, issuer spreads, benchmark securities, bids, offers, and other market data. Management reviews and analyzes all prices obtained to insure the reasonableness of the values, taking all available information into account. In addition, management corroborates the prices obtained from third-party sources against other independent sources. When
When third-party vendor prices are not available, the Company attempts to obtain at least three quotes from broker/dealers for each security. When at least three quotes are obtained, and the standard deviation of such quotes is less than 3%, (suggesting that the independent quotes were likely derived using similar observable inputs), the Company uses the mean quote and classifies the measurement as Level 2. At December 31, 2014 and 2013, there were no assets valued as Level 2 in this manner with broker quotes.
When the standard deviation is 3% or greater, or the Company cannot obtain three quotes, then additional information and management judgment are required to establish the fair value. Further review is performed on the available quotes to determine if they can be corroborated within reasonable tolerance to any other observable evidence. If one of the quotes or the mean of the available quotes can be corroborated with other observable evidence, then the value is reported as Level 2. Otherwise, the value is classified as Level 3. The Company uses information and valuation techniques deemed appropriate for determining the point within the range of reasonable fair value estimates that is most representative of fair value under current market conditions. As of December 31, 2014 and 2013, fair value measurements classified as Level 3 represented 4.0% and 2.8%, respectively, of total fixed maturities and equity securities. Transfers between levels are recognized as of the end of the period of transfer.
Beginning in 2012, Torchmark began investing in a portfolio of private placement bonds which are not actively traded. This portfolio is managed by a third party and was $497 million at amortized cost on December 31, 2014, compared with $313 million a year earlier. The portfolio manager provides valuations for the bonds based on a pricing matrix utilizing observable inputs, such as the benchmark treasury rate and published sector indices, and unobservable inputs such as an internally-developed credit rating. If the unobservable inputs can be closely corroborated with publicly available information, the fair values are classified as Level 2. If they cannot be corroborated, the fair values are classified as Level 3. As of December 31, 2014 and 2013, all private placements were classified as Level 3.
Fair Value Measurements, Other Financial Instruments: Fair values for cash, short-term investments, short-term debt, receivables and payables approximate carrying value. Policy loans are an integral part of Torchmark’s subsidiaries’ life insurance policies in force and cannot be valued separately. The fair values of Torchmark’s long-term debt issues are based on the same methodology as investments in fixed maturities. Because observable inputs were available for these debt securities at December 31, 2014, they were classified as Level 2 in the valuation hierarchy. The fair value for each debt instrument as of December 31, 2014 is disclosed in Note 11-Debt. As described in Note 9-Postretirement Benefits, Torchmark maintains an unqualified supplemental retirement plan. Because this plan is unfunded, the assets which support the liability for this plan are considered general assets of the Company. These assets consist of the cash value of corporate-owned life insurance policies and exchange traded funds (ETF’s). The fair value of the insurance cash values approximates carrying value. Fair values for the ETF’s are derived from direct quotes and are considered Level 1 in the valuation hierarchy.
Therefore, Torchmark considers these declines in value resulting from changes in market interest rates to be temporary. In certain circumstances, however, Torchmark determines that the decline in the value of a security is other-than-temporary and writes the book value of the security down to its fair value, realizing an investment loss. The evaluation of Torchmark’s securities for other-than-temporary impairments is a process that is undertaken at least quarterly and is overseen by a team of Company investment and accounting professionals. Each security which is impaired because the fair value is less than the cost or amortized cost is identified and evaluated. The determination that an impairment is other-than-temporary is highly subjective and involves the careful consideration of many factors. Among the factors considered are:
The length of time and extent to which the security has been impaired
The financial condition of the issuer and the near-term prospects for recovery in fair value of the security
Future Policy Benefits: The liability for future policy benefits for universal life-type products is represented by policy account value. The liability for future policy benefits for all other life and health products, approximately 84% of total future policy benefits, is determined on the net level premium method. This method provides for the present value of expected future benefit payments less the present value of expected future net premiums, based on estimated investment yields, mortality, morbidity, persistency and other assumptions which were considered appropriate at the time the policies were issued. For limited-payment contracts, a deferred profit liability is also recorded which causes profits to emerge over the life of the contract in proportion to policies in force. Assumptions used for traditional life and health insurance products are based primarily on Company experience. Assumptions for interest rates range from 2.5% to 7.0% for Torchmark’s insurance companies with an overall weighted average assumed rate of 5.7%. Mortality tables used for individual life insurance include various statutory tables and modifications of a variety of generally accepted actuarial tables. Morbidity assumptions for individual health are based on Company experience and industry data. Withdrawal and termination assumptions are based on Torchmark’s experience. Once established, assumptions for these products are generally not changed. An additional provision is made on most products to allow for possible adverse deviation from the assumptions. These estimates are periodically reviewed and compared with actual experience. If it is determined that existing contract liabilities, together with the present value of future gross premiums, will not be sufficient to cover the present value of future benefits and to recover unamortized deferred acquisition costs, then a premium deficiency exists. Such a deficiency would be recognized immediately by a charge to earnings and either a reduction of unamortized deferred acquisition costs or an increase in the liability for future policy benefits. From that point forward, the liability for future policy benefits would be based on the revised assumptions.
Advertising Costs: Costs related to advertising are generally charged to expense as incurred. However, certain direct response advertising costs are capitalized when there is a reliable and demonstrated relationship between total costs and future benefits that is a direct result of incurring these costs. Torchmark’s Direct Response advertising costs consist primarily of the production and distribution costs of direct mail advertising materials, and when capitalized are included as a component of deferred acquisition costs. They are amortized in the same manner as other deferred acquisition costs. Direct response advertising costs charged to earnings and included in other operating expense were $8 million, $6 million, and $16 million in 2014, 2013, and 2012, respectively. Capitalized advertising costs included within deferred acquisition costs were $1.15 billion at December 31, 2014 and $1.09 billion at December 31, 2013.
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 three 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 recorded when, based on events and circumstances, it becomes evident that the fair value of the asset is less than its carrying amount. Original cost of property and equipment was $139 million at December 31, 2014 and $136 million at December 31, 2013. Accumulated depreciation was $85 million at year end 2014 and $85 million at the end of 2013. Depreciation expense was $7.4 million in 2014, $6.4 million in 2013, and $7.1 million in 2012. During 2013, Liberty National Life Insurance Company (Liberty National), a Torchmark subsidiary, sold real estate for a loss of $265 thousand after a previous write-down for other-than-temporary impairment of $2.7 million earlier in the year. The sale of this property eliminated substantially all asbestos-related liability for Torchmark.
The Federal income benefits accrued during each of the years presented, net of the amortization associated with guaranteed interests, were recorded in “Income taxes.” Amortization associated with non-guaranteed interests and interests providing for state premium tax benefits was reflected as a component of “Net investment income.” All state premium tax benefits, net of the related amortization, were recorded in “Net investment income.” At December 31, 2014, $313 million associated with the Federal interests was included in “Other assets” with the remaining $5 million state-related interests included in “Other invested assets.” At December 31, 2013, the comparable amounts were $283 million and $7 million, respectively. Any unpaid commitments to invest are recorded in “Other liabilities.” In the segment analysis, the amortization associated with the non-guaranteed interests is reflected as a component of “Income tax expenses,” and not “Net investment income,” consistent with the treatment of the guaranteed interests. Management views this presentation as a more accurate matching of costs with the associated revenues with respect to the low-income housing interests.
Postretirement Benefits: Torchmark accounts for its postretirement defined benefit plans by recognizing the funded status of those plans on its Consolidated Balance Sheets in accordance with accounting guidance. Periodic gains and losses attributable to changes in plan assets and liabilities that are not recognized as components of net periodic benefit costs are recognized as components of other comprehensive income, net of tax. More information concerning the accounting and disclosures for postretirement benefits is found in Note 9-Postretirement Benefits.
Revenue recognition: The FASB issued Accounting Standard Update No. 2014-09 Revenue from Contracts with Customers (ASU 2014-09), to clarify the principles for recognizing revenue, to provide more consistency and comparability in revenue recognition practices, and to simplify recognition requirements along with other improvements. ASU 2014-09 will be effective for Torchmark beginning in calendar year 2017. The Company is currently evaluating this new guidance. Torchmark’s revenues consist of insurance premium and revenues related to financial instruments. These forms of revenue are not within the scope of ASC 2014-09 because they are addressed by other guidance. Therefore, Torchmark does not expect that the implementation of this guidance will result in any significant change in the manner the Company recognizes its revenue.
Going concern: The FASB has issued Presentation of Financial Statements - Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (ASU 2014-15). This new standard requires management to perform interim and annual assessments of the entity’s ability to continue its business operations within one year of the date of issuance of its financial statements. The Company must then provide certain disclosures if there is substantial doubt about its ability to continue as a going concern. ASU 2014-15 is effective for Torchmark for the year ended December 31, 2016 and for interim periods thereafter. Early adoption is permitted.
Life insurance subsidiaries of Torchmark are required to file statutory financial statements with state insurance regulatory authorities. Accounting principles used to prepare these statutory financial statements differ from GAAP. Consolidated net income and shareholders’ equity (capital and surplus) on a statutory basis for the insurance subsidiaries were as follows:
The excess, if any, of shareholder’s equity of the insurance subsidiaries on a GAAP basis over that determined on a statutory basis is not available for distribution by the insurance subsidiaries to Torchmark without regulatory approval. Insurance subsidiaries’ statutory capital and surplus necessary to satisfy regulatory requirements in the aggregate was $439 million at December 31, 2014. More information on the restrictions on the payment of dividends can be found in Note 12-Shareholders’ Equity.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2014 and 2013 is as follows:
Fair value measurements: The following tables represent the fair value of assets measured on a recurring basis at December 31, 2014 and 2013:
Acquisitions of Level 3 investments in 2014 and 2013 are comprised of private-placement fixed maturities managed by an unaffiliated third-party.
Accumulated depreciation on investment real estate was $1.7 million at both December 31, 2014 and December 31, 2013. Torchmark did not have any invested assets that were non-income producing during the twelve months ended December 31, 2014.
On November 1, 2012, Torchmark acquired all of the outstanding common stock of Family Heritage Life Insurance Company of America (Family Heritage), a privately-held supplemental health insurance provider. Family Heritage was founded in 1989 and is headquartered in Cleveland, Ohio. It is a specialty insurer focused primarily on selling protection-oriented individual supplemental health insurance products through a captive agency force. The purchase price was approximately $234 million, including post-closing adjustments and the assumption of $20 million par value of debt in the form of trust preferred securities issued by Family Heritage’s previous parent company ($20 million fair value at the purchase date). The balance of the purchase price of approximately $214 million was funded primarily with cash provided from borrowings as described in Note 11-Debt. There was approximately $27 million of cash acquired in the transaction. Acquisition expenses in connection with the transaction charged to Torchmark’s earnings in 2012 were $2.9 million ($1.9 million after tax). These costs were included as “Other operating expense” in the Consolidated Statement of Operations for 2012. In 2013, a one-time adjustment for the finalization of accounting for the insurance assets and liabilities for the Family Heritage acquisition was completed. The result of this adjustment was a $1.5 million increase in pretax income ($522 thousand after tax), due to the net effect of an increase in the policyholder benefit reserve of $8.5 million and a greater increase in the deferred acquisition asset of $10.0 million.
Claims paid in each of the years 2012 through 2014 were settled for amounts less than anticipated when estimated at the previous year end. The most significant component of these favorable variances was in Torchmark’s Medicare Part D business and, to a lesser extent, Torchmark’s UA Independent and Liberty National agencies. The Company’s estimates at each point have reflected the emerging data and trends. In the Medicare Part D channel, the Company is required to estimate claim discounts that will be received from drug manufacturers. In each of the years 2012 through 2014, the discounts from the drug manufacturers received in the current year but related to prior year claims were higher than anticipated when the claim liability was determined.
In each of the years 2012 through 2014, 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.
Torchmark’s tax liability is adjusted to include a provision for uncertain tax positions taken or expected to be taken in a tax return. However, during the years 2012 through 2014, Torchmark did not have any uncertain tax positions which resulted in unrecognized tax benefits.
Torchmark’s continuing practice is to recognize interest and/or penalties related to income tax matters in income tax expense. The Company recognized interest income of $465 thousand, $0, and $56 thousand, net of Federal income tax benefits, in its Consolidated Statements of Operations for 2014, 2013, and 2012, respectively. The Company had no accrued interest or penalties at December 31, 2014 or 2013.
Torchmark has a Supplemental Executive Retirement Plan (SERP), which provides to a limited number of executives an additional supplemental defined pension benefit. The supplemental benefit is based on the participant’s qualified plan benefit without consideration to the regulatory limits on compensation and benefit payments applicable to qualified plans, except that eligible compensation is capped at $1 million. The SERP is unfunded. However, a Rabbi Trust has been established to support the liability for this plan. This trust consists of life insurance policies on the lives of plan participants with an unaffiliated insurance carrier as well as an investment account. The premiums paid for the insurance coverage were $2.2 million in 2014, $2.9 million in 2013, and $1.7 million in 2012. The cash value of these policies at December 31, 2014 was $24 million and was $22 million a year earlier. Investments in the investment account consist of exchange traded funds. Deposits of $6 million in 2013 and $5 million in 2012 were added to the investment account in this trust. There were no deposits in 2014. As of December 31, 2014, the combined value of the insurance policies and the trust investments was $74 million, compared with $66 million a year earlier. Because this plan is unqualified, the investments and the policyholder value of the insurance policies in the Rabbi Trust are not included as defined benefit plan assets but as assets of the Company. They are included with “Other Assets” in the Consolidated Balance Sheets. The liability for this SERP at December 31, 2014 was $71 million and was $58 million a year earlier.
Note 1-Significant Accounting Policies under the caption Fair Value Measurements, Investments in Securities for a complete discussion of valuation procedures. The following table presents the assets of Torchmark’s defined benefit pension plans for the years ended December 31, 2014 and 2013.
Torchmark’s investment objectives for its plan assets include preservation of capital, preservation of purchasing power, and long-term growth. Torchmark seeks to preserve capital through investments made in high quality securities with adequate diversification by issuer and industry sector to minimize risk. The portfolio is monitored continuously for changes in quality and diversification mix. The preservation of purchasing power is intended to be accomplished through asset growth, exclusive of contributions and withdrawals, in excess of the rate of inflation. Torchmark intends to maintain investments that when combined with future plan contributions will produce adequate long-term growth to provide for all plan obligations. The Company’s expectation for the portfolio is to achieve a compound total rate of return of 3% in excess of the inflation rate, to be reviewed on a three-year basis. It is also Torchmark’s objective that the portfolio’s investment return will meet or exceed the return of a balanced market index.
The net loss for benefit plans other than pensions reduces other comprehensive income.
(9) Interest paid at 3 month LIBOR plus 330 basis points, resets each quarter.
Commercial Paper: As of July 16, 2014, Torchmark entered into a new credit facility with a group of lenders allowing for unsecured borrowings and stand-by letters of credit up to $750 million, replacing a previous facility that had a maximum limitation of $600 million. Up to $250 million in letters of credit can be issued against the new facility. The facility is further designated as a back-up credit line for a commercial paper program under which the Company may either borrow from the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed the facility maximum, less any letters of credit issued. Interest is charged at variable rates. The facility has no ratings-based acceleration triggers which would require early repayment. The new facility terminates July 16, 2019. In accordance with the agreement, Torchmark is subject to certain covenants regarding capitalization, as was the case with the previous credit facility. As of December 31, 2014, and throughout the three-year period ended December 31, 2014, Torchmark was in full compliance with the appropriate covenants. Borrowings on the credit facilities are reported as short-term debt on the Consolidated Balance Sheets. A table presenting selected information concerning Torchmark’s short-term borrowings is presented below.
Share Data: A summary of preferred and common share activity is presented in the following chart. All share data in this Note has been retrospectively restated to give effect to the three-for-two stock split described in Note 1.
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 income excluding 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. Subsidiaries of Torchmark paid cash dividends to the parent company in the amount of $479 million in 2014, $488 million in 2013, and $437 million in 2012. As of December 31, 2014, dividends and transfers from insurance subsidiaries to parent available to be paid in 2015 were limited to the amount of $438 million without regulatory approval, such that $825 million was considered restricted net assets of the subsidiaries. The Company believes that total dividends and transfers of $473
There were no anti-dilutive shares as of December 31, 2012, 2013, or 2014. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
Seven year grants - vest one half in two years, and one half in three years.
A summary of stock compensation activity for each of the three years ended December 31, 2014 is presented below:
Certain senior executives of the Company have been granted performance shares. On February 24 and March 4, 2014, grants were made of 179 thousand performance shares with grant prices ranging from $50.69 to $52.40 per share for an aggregate grant price of $9.2 million. On February 27, 2013, a grant was made of 148 thousand performance shares at a price of $37.40 per share for an aggregate grant price of $5.5 million. On February 21 and 22, 2012 grants were made of 120 thousand performance shares with grant prices ranging from $32.48 to $32.73 per share for an aggregate grant price of $3.9 million. Performance grants have a three year contract life, and they do not vest prior to the termination of the contract period. While the target distribution is 179 thousand, 148 thousand, and 120 thousand shares for the 2014, 2013, and 2012 grants, respectively, the determination of the actual settlement in shares will be based on the achievement of certain performance objectives of Torchmark over the respective three-year contract periods. The actual shares could be distributed in a range from 0 to 359 thousand shares for the 2014 grants and 0 to 295 thousand shares for the 2013 grants. A final determination for the 2012 grants has been made as of December 31, 2014 to be 211 thousand shares, as those shares became fully vested at January 27, 2015. The performance shareholders are not entitled to dividend equivalents, and are not entitled to dividend payments until vested and settled.
An analysis of the weighted-average grant-date fair values of unvested restricted stock is as follows for the year 2014:
Additional information about Torchmark’s stock-based compensation as of December 31, 2014 and 2013 is as follows:
Effective January 1, 2014, Torchmark reorganized its segment structure to separate its Medicare Part D health insurance business from its other health insurance activities as a stand-alone segment. Management has concluded that Medicare Part D meets the criteria of a distinct segment. Previously, Part D was included in the health segment. Prior periods’ segment results have been retrospectively adjusted for comparability. Premium income for Medicare Part D health insurance is included with the premium for other health products in the Consolidated Statements of Operations.
Life insurance products include traditional and interest-sensitive whole life insurance as well as term life insurance. Health products are generally guaranteed-renewable and include Medicare Supplement, cancer, accident, long-term care, and limited-benefit hospital and surgical coverages. Medicare Part D includes prescription drug coverage for Medicare beneficiaries. Annuities include fixed-benefit contracts.
Retrospectively adjusted to give effect to the reorganization of segments described earlier in this Note.
Low-Income Housing Tax Credit Interests: As described in Note 1, Torchmark had $318 million invested in entities which provide certain tax benefits at December 31, 2014. As of December 31, 2014, Torchmark remained obligated under these commitments for $76 million, of which $44 million is due in 2015, $19 million in 2016, $6 million in 2017, and $7 million thereafter.
As of December 31, 2014, securities of state and municipal governments represented 10% of invested assets at fair value. Such investments are made throughout the U.S. At year-end 2014, 5% or more of the state and municipal bond portfolio at fair value was invested in securities issued within the following states: Texas (31%), Ohio (7%), Washington (7%), Illinois (6%), and Alabama (5%). Otherwise, there was no significant concentration within any given state.
Corporate debt and equity investments are made in a wide range of industries. Below are the ten largest industry concentrations held in the corporate portfolio at December 31, 2014, based on fair value:
At year-end 2014, 4% of invested assets at fair value was represented by fixed maturities rated below investment grade (BB or lower as determined by the weighted average of available ratings from rating services). Par value of these investments was $635 million, amortized cost was $561 million, and fair value was $550 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in their fair value.
Guarantees: At December 31, 2014, Torchmark had in place three guarantee agreements, of which were either parent company guarantees of subsidiary obligations to a third party, or parent company guarantees of obligations between wholly-owned subsidiaries. As of December 31, 2014, Torchmark had no liability with respect to these guarantees.
The following is a summary of quarterly results for the two years ended December 31, 2014. The information is unaudited but includes all adjustments (consisting of normal accruals) which management considers necessary for a fair presentation of the results of operations for these periods.