American Income owns and is the sole occupant of an office building located at 1200 Wooded Acres Drive, Waco, Texas. The building is a two story structure containing approximately 72,000 square feet of usable floor space.
A Torchmark subsidiary, Torchmark Development Corporation ("TDC"), as a part of a joint venture with unaffiliated entities, is developing 3,400 acres as a planned community development known as Liberty Park, which is located along Interstate 459 in Birmingham, Alabama.
TMK Income Properties, L.P. ("TIP"), a partnership which is wholly-owned by Torchmark subsidiaries, owns seven office buildings. These properties include: 1.) a 330,000 square foot office building complex at 14000 Quail Springs Parkway Plaza Boulevard, Oklahoma City, which is 96% leased; 2.) six office buildings in Liberty Park in suburban Birmingham, Alabama containing approximately 675,000 square feet which are 95% leased.
Torchmark, and its primary subsidiaries, have significant information technology capabilities at their disposal. The corporation uses centralized mainframe computer systems, company-specific local-area networks, workstations, and personal computers to meet its ongoing information processing requirements. Torchmark and its primary subsidiaries also use data communications hardware and software to support their remote data communications networks, intranets, and internet-related telecommunications capabilities.
Torchmark's computer hardware, data communications equipment, and associated software programs are managed by information technology staff. All of the corporation's computer hardware and software support, information processing schedules, and computer-readable data-management requirements are met through company-specific policies and procedures. These company-specific policies and procedures also provide for the off-site storage and retention of backup computer software, financial, and business data files.
- ------------------------------------------------------------------------------- (1) Excludes realized investment gains (losses), the related adjustment to deferred acquisition costs, equity in Vesta earnings, and discontinued operations. (2) Computed after deduction of preferred shareholders' equity. (3) Annualized life premium in force excludes $5.3 million representing the Family Service business sold in 1998.
Cautionary Statements. Torchmark cautions readers regarding certain forward- looking statements contained in the following discussion and elsewhere in this document, and in any other statements made by, or on behalf of Torchmark whether or not in future filings with the Securities and Exchange Commission. Any statement that is not a historical fact, or that might otherwise be considered an opinion or projection concerning Torchmark or its business, whether express or implied, is meant as and should be considered a forward- looking statement. Such statements represent management's opinions concerning future operations, strategies, financial results or other developments.
1) Deteriorating general economic conditions leading to increased lapses and/or decreased sales of Torchmark's policies;
3) Financial markets trends that adversely affect sales of Torchmark's market-sensitive products;
9) Developments involving Vesta Insurance Group, Inc., described more fully elsewhere in this document under the caption "Transactions involving Vesta Insurance Group" on page 34 of this report;
12) Adverse levels of mortality, morbidity, and utilization of healthcare services relative to Torchmark's assumptions; and
13) The inability of Torchmark to obtain timely and appropriate premium rate increases.
Divestiture of Asset Management Operations. Waddell & Reed, Torchmark's asset management subsidiary, completed an initial public offering in March, 1998 of approximately 24 million shares of its common stock. The offering represented approximately 36% of Waddell & Reed's shares. Net proceeds from the offering were approximately $516 million after underwriters' fees and expenses. Waddell & Reed used $481 million of the proceeds to repay existing notes owed to Torchmark and other Torchmark subsidiaries and retained the remaining $35 million. Torchmark's $481 million proceeds from the note repayments were invested or used to pay down debt. (See the discussion on Investments on page 27, Liquidity on page 31, and Capital Resources on page 31 of this report.) The initial public offering resulted in a $426 million gain which was added to Torchmark's additional paid-in capital. Torchmark retained the remaining 64% of the Waddell & Reed stock.
Torchmark's share of Waddell & Reed's earnings for 1998 was $48 million after reduction for the minority interest during the period subsequent to the initial public offering but before the spin-off. This compares with $77 million for 1997 and $66 million for 1996, when Torchmark owned 100% of Waddell & Reed for the entire periods.
Summary of Operating Results. Torchmark's management computes a classification of income called "net operating income." Net operating income is the measure of income Torchmark's management focuses on to evaluate the performance of the operations of the company. It differs from net income as reported in the financial statements in that it excludes unusual and nonrecurring income or loss items which distort operating trends.
Realized investment losses in 1998, which were $51 million net of tax, included a $23 million after-tax loss from the sale of Family Service, a $24 million after-tax loss on the writedown of Torchmark's Vesta holdings, and a $2 million after-tax loss from the sale of a portion of the Vesta holdings. Losses in 1997, in the after-tax amount of $24 million, were primarily a result of intentional sales of fixed-maturity investments at a loss to offset current and prior-year taxable gains. The Vesta adjustment and the disposal of energy operations is discussed on page 34 and the redemption of Torchmark debt is discussed under the caption "Capital Resources" on page 32 of this report.
Reconciliation of Per Share Insurance Net Operating Income to Reported Net Income*
In accordance with accounting rules, Torchmark reports earnings per share data as basic and diluted. Basic earnings per share are based on average shares outstanding during the period. Diluted earnings per share assume the exercise of Torchmark's employee stock options for which the exercise price was lower than the market price during the year and their impact on shares outstanding. Diluted earnings per share differ from basic earnings per share in that they are influenced by changes in the
market price of Torchmark stock and the number of options as well as the number of shares outstanding. Unless otherwise indicated, all references to per share data in this report are on the basis of diluted shares.
A comparison of Torchmark's basic and diluted earnings per share is as follows:
Insurance Operations. Revenues in 1998 were $2.16 billion, growing 4% over 1997 revenues of $2.07 billion. Revenues rose 3% in 1997 over 1996 revenues of $2.02 million. After adjustment for realized investment gains and losses in each year, revenues gained 5% in 1998 from $2.11 billion in 1997 to $2.22 billion in 1998. They rose 5% in 1997 over the prior year. Total premium increased $76 million or 5% in 1998, accounting for 70% of the $107 million increase in total revenues excluding realized gains and losses. Life insurance premium increased $50 million, or 5% and health premium grew $20 million or 3% in 1998. Net investment income increased 7% in 1998 to $460 million.
The $97 million or 5% growth in 1997 revenues excluding realized investment gains and losses resulted largely from the increase in life premium of $55 million or 6%. Investment income, which rose 7%, also contributed $29 million to 1997 revenue growth.
The effective tax rate for Torchmark was 34.5% in 1998, compared with 35.3% in 1997 and 35.8% in 1996. Excluding goodwill, the effective tax rates for insurance operations were 33.0%, 32.9%, and 33.5% in 1998, 1997 and 1996, respectively. The 1997 decline in the effective rate resulted from additional energy tax credits that were available as a part of the consideration from the 1996 disposition of the energy segment.
net policy liabilities and financing costs. Financing costs include the interest on Torchmark's debt and the net cost of the Monthly Income Preferred Securities ("MIPS").
Pretax insurance net operating income rose 18% in 1998 after a 13% increase in 1997 due to increases in both periods in insurance underwriting income and investment results and declines in financing costs. Torchmark's core operations are segmented into insurance underwriting operations and investment operations. Insurance underwriting activities are further segmented into life insurance, health insurance, and annuity product groups. A discussion of each of Torchmark's segments follows.
Life insurance. Life insurance is Torchmark's largest segment, with life premium representing 55% of total premium and life underwriting income before other income and administrative expense representing 61% of the total. Sales of this group of products continues to be emphasized because of its higher underwriting margins and larger asset base resulting from higher reserve levels. A larger asset base provides Torchmark the opportunity to increase investment income.
Life insurance premium increased 5% in 1998 to $960 million from $910 million in 1997. Life premium rose 6% in 1997. Sales of life insurance, in terms of annualized premium, were $244 million in 1998, increasing 6% over 1997 sales of $230 million. This compares with 7% growth in 1997 sales over 1996. Annualized life premium in force was $1.06 billion at December 31, 1998, compared with $1.01 billion at 1997 year end, an increase of 5%. Annualized premium grew 6% in 1997 from $947 million at year-end 1996. Annualized premium in force and issued data includes amounts collected on certain interest- sensitive life products which are not recorded as premium income but excludes single-premium income and policy account charges.
The sale of Family Service on June 1, 1998 caused some distortion in life insurance results for 1998. Excluding Family Service operations, life insurance premium income would have increased 6% to $957 million in 1998 and 7% to $901 million in 1997. Annualized life premium in force would have increased 6% in 1998 and 7% in 1997.
In addition to growth in life insurance sales and premium, the Direct Response operation has promoted growth in some of Torchmark's agent-based distribution channels through providing marketing support. Direct Response marketing support directly contributed to the increase in health sales by the United American Exclusive Agency and its resulting agent recruiting success. Methods to extend Direct Response marketing support to other Torchmark agent- based distribution channels are being explored.
The Liberty National Exclusive Agency distribution system represented Torchmark's largest portion of life insurance premium income in each of the three years presented, with 1998 premium of $281 million representing 29% of total life premium. The annualized life premium in force of the Liberty Agency was $298 million at year-end 1998, compared with $299 million and $298 million at year-ends 1997 and 1996, respectively. Life premium sales, in terms of annualized premium issued, grew 5% during 1998 to $46 million. This 1998 growth in life insurance sales compares to a decline in life sales during 1997 of 5% to $43 million. The turnaround in sales growth in the Liberty Agency was largely attributable to growth in the number of agents from 1,750 agents at year-end 1997 to 1,829 agents at year-end 1998, an increase of 5%. The number of first-year agents climbed 7% in 1998 to 804, after having increased 20% in 1997. New agent recruitment programs were implemented in late 1996 resulting in the new agent growth. Additionally, training programs have been employed to improve the retention of newly recruited agents. Management believes that the continued recruiting of new agents and the retention of productive agents are critical to the continued growth of sales in controlled agency distribution systems.
The Liberty National Agency has completed the transition from a debit-style renewal premium collection system to a direct bill or bank draft collection system. As a result, less than 1% of premium was debit collected in 1998.
Another of Torchmark's distribution channels for life insurance is a nationwide independent agency whose sales force is comprised of former commissioned and non-commissioned military officers who sell exclusively to commissioned and non-commissioned military officers and their families. This business is comprised of whole life products with term insurance riders. The quality of the business produced by this Military Agency is outstanding and is characterized by extremely low lapse rates. Life premium income from this distribution system grew 16% to $92 million in 1998, representing the largest percentage growth in life premium of any Torchmark distribution channel in 1998. Premium for this Agency rose 12% to $80 million in 1997. Annualized life premium in force for the Military distribution system grew 15% in 1998 to $99 million, after having increased 16% to $86 million in 1997. In both years this distribution system produced the greatest amount of growth in annualized life premium in force on a percentage basis. A major factor in this growth of in- force premium relates to the very high persistency associated with this business. Annualized premium sold during 1998 by this Agency was $17 million, an increase of 7% over sales of $16 million in 1997. Production almost doubled in 1997 from 1996 sales of $8 million.
The United Investors Exclusive Agency is made up of Waddell & Reed sales representatives, who market the life insurance products of United Investors Life under a marketing agreement with Waddell & Reed. This Agency accounted for 9% of Torchmark's life premium in 1998. Premium income rose 5% in 1998 to $82 million, following a 6% increase in 1997 to $78 million. Sales growth in this Agency in terms of annualized premium issued was 50% in 1998, the highest life production of any Torchmark Agency in terms of percentage growth. Sales were $15 million in 1988, compared with $10 million in 1997. Annualized life premium in force increased 12% to $100 million at December 31, 1998, 9% of Torchmark's total life premium in force. In addition to the growth in life insurance sales, this agency has also increased production of variable life collections from $5 million in 1997 to $18 million in 1998, almost a fourfold increase. Although variable life collections are not included in premium in force data, they are indicative of growth in the variable life account balance. Indirectly, they add to premium revenue through the policy account charges for insurance coverage and administration as the account balance grows.
Life insurance gross margins, as indicated by insurance underwriting income before other income and administrative expense as a percentage of premium, have remained at approximately 27% throughout the three-year period measured. The underwriting margin rose 3% in 1998 to $255 million, after having increased 8% to $247 million in 1997. Excluding Family Service, the underwriting margin increased 5% in 1998 to $253 million and 9% in 1997 to $241 million. Obligation ratios for life business rose slightly in 1998, caused by an increase in mortality. Fluctuations in mortality are normal in the life insurance industry and are not indicative of a trend.
Health Insurance. Torchmark markets its supplemental health insurance products through a number of distribution channels. The following table indicates health insurance premium income during each of the three years ended December 31, 1998 by distribution method.
Medicare Supplement policies are highly regulated at both the federal and state levels with limits on agent compensation and mandated minimum loss ratios. However, they remain a popular supplemental health policy with the country's large and growing group of Medicare beneficiaries. About 85% of all Medicare beneficiaries obtain Medicare supplements to cover at least some of the deductibles and coinsurance for which the federal Medicare program does not pay. During the last few years, Torchmark has focused on developing its United American Exclusive Agency to serve this market. Using the Direct Response operation, both targeted marketing support and increased agent recruiting have successfully led to increased sales. Because of loss ratio regulation, underwriting margins on Medicare supplements are less than on Torchmark's life business. However, due to United American's low cost, service-oriented customer service and claims administration, as well as its economies of scale, it is a profitable line of business.
the future as it is anticipated that the program could be insolvent within the next decade. This would occur because of the growth in the number of "baby boomers" becoming eligible for Medicare during that period and increasing medical cost inflation generally due to increased utilization. Therefore, it is likely that changes will be made to the Medicare program at sometime in the future. However, regardless of proposed changes, it appears that there will continue to be an important role for private insurers in helping senior citizens cover their healthcare costs. As a result, Medicare Supplements should continue as a popular product for senior-age consumers.
Annuities. Annuity products are marketed by Torchmark to service a variety of needs, including retirement income and long-term, tax-deferred growth opportunities. Torchmark's annuities are sold almost entirely by the United Investors' Exclusive Agency. This agency consists of the Waddell & Reed sales force which markets United Investors' annuities and other products under a marketing agreement. In 1998, this agency collected $309 million of Torchmark's total $368 million in annuity collections. The United Investors Agency accounted for 97% of total annuity policy charges in 1998.
During 1998, Torchmark sold Family Service, a wholly-owned provider of preneed annuities. While the sale of these preneed annuities had been discontinued in 1995, this block of annuities remained on deposit until Family was sold. At the date of sale, this deposit balance was approximately $396 million.
Torchmark's share repurchase program, which was renewed after the Waddell & Reed spin-off, had little impact on excess investment income in 1998 because purchases were made late in the year. However, in 1999, share purchases will negatively affect growth in excess investment income. While there is a cost of capital associated with share purchases, per share earnings could be improved.
Market Risk Sensitivity. Market risk is a risk that the value of a security will change because of a change in market conditions. Torchmark's primary exposure to market risk is interest rate risk which is the risk that a change in a securities' value could occur from a change in interest rates. This risk is significant to Torchmark's investment portfolio because its fixed-income holdings amount to 91% of total investments. The effects of these interest rate fluctuations on fixed investments are reflected on an after-tax basis in Torchmark's shareholders' equity from marking these investments to market.
The actual interest rate risk to Torchmark is reduced because the effect that changes in rates have on assets is offset by the effect they have on insurance liabilities and on debt. Interest assumptions are used to compute the majority of Torchmark's insurance liabilities. These liabilities, net of deferred acquisition costs, were $3.3 billion at December 31, 1998, compared with fixed income investments of $5.5 billion at amortized cost at the same date. Because of the long-term nature of insurance liabilities, temporary changes in value caused by rate fluctuations have little bearing on ultimate obligations. These liabilities are not marked to market.
The following table illustrates the market risk sensitivity of Torchmark's interest-rate sensitive fixed-maturity portfolio at December 31, 1998. This table measures the effect of a change in interest rates (as represented by the U.S. Treasury curve) on the fair value of Torchmark's fixed-maturity portfolio. The data is prepared through a model that measures the change in fair value arising from an immediate and sustained change in interest rates in increments of 100 basis points. It takes into account the effect that special option features such as call options, put options, and unscheduled repayments would have on the portfolio, given the changes in rates. The valuation of these option features is dependent upon assumptions about future interest rate volatility that are based on past performance.
Torchmark's insurance operations generate positive cash flows in excess of its immediate needs. Cash flows provided from operations were $398 million in 1998, compared with $410 million in 1997 and $327 million in 1996. In addition to operating cash flows, Torchmark received $474 million in investment maturities and repayments during 1998, adding to available cash flows. Such repayments were $513 million in 1997 and $346 million in 1996. Cash flows in excess of immediate requirements are used to build an investment base to fund future requirements.
Torchmark's cash and short-term investments were $81 million at December 31, 1998, compared with $77 million at year-end 1997. In addition to Torchmark's liquid assets, Torchmark has a portfolio of marketable fixed and equity securities which are available for sale should the need arise. These securities had a value of $5.8 billion at December 31, 1998.
Capital Resources. Torchmark's capital structure consists of long and short- term debt, MIPS, and shareholders' equity. Torchmark's debt consists primarily of its funded debt and its commercial paper facility. An analysis of Torchmark's funded debt outstanding at year-ends 1998 and 1997 on the basis of par value is as follows:
The carrying value of the funded debt was $383 million at December 31, 1998, compared with $772 million a year earlier.
During 1998, Torchmark received approximately $481 million in intercompany note repayments from Waddell & Reed as a result of their initial public offering. Torchmark utilized a portion of these funds to pay down funded debt. It has also taken advantage of the lower interest rate environment in 1998 to refinance existing funded debt at lower short-term rates. In early 1998, Torchmark repaid $20 million principal amount on its 8 5/8% Sinking Fund Debentures due in 2017, of which $8 million was a mandatory redemption and $12 million was an optional repayment under the terms of the agreement. On April 1, 1998, Torchmark called the remaining $160 million principal balance of this debt at the prevailing call price of 103.76, or $166 million. A loss on the redemption of debt was recorded in the second quarter of 1998 in the after-tax amount of $5 million, representing the difference between the total call price and the carrying value of $158 million. In addition to the call, Torchmark's 9 5/8% Senior Notes, principal amount $200 million, matured on May 1, 1998. Torchmark borrowed on its commercial paper facility to repay the Sinking Fund Debentures that were called and to repay its Senior Notes upon maturity with accrued interest, in the combined amount of $377 million. Additionally, in October, 1998, Torchmark, through a subsidiary, acquired $10.8 million principal amount of its 7 7/8% notes due 2023 in the open market at a cost of $10.6 million.
During 1997, Torchmark repaid $20 million principal amount on its Sinking Fund Debentures due In 2017, of which $8 million was a mandatory redemption and $12 million was an optional repayment under the terms of the agreement. It also repaid $550 thousand principal amount of its Senior Debentures in 1996 under the terms of a put provision.
The MIPS were issued in November, 1994 at a redemption amount of $200 million with an annual dividend rate of 9.18%. They are subject to a mandatory redemption in full at September 30, 2024, although Torchmark may elect to extend the MIPS for up to an additional 20 years if certain conditions are met. They are redeemable at Torchmark's option at any time after September 30, 1999. While Torchmark is obligated to pay dividends at a fixed rate of 9.18%, Torchmark has in place a ten-year interest-rate swap agreement with an unaffiliated party to reduce financing costs. The swap expires in 2004. The swap agreement calls for Torchmark to pay a variable rate on the $200 million face amount in exchange for payment of the fixed dividend by the other party. Torchmark is at risk on this instrument for higher financing costs to the extent interest rates rise during the remaining term. This risk is limited, however, by a five-year interest-rate cap which Torchmark acquired in conjunction with the swap agreement that insures the variable rate cannot exceed 10.39%. The cap expires on September 30, 1999. At December 31, 1998, the variable rate was 7.02%. During 1998, Torchmark's after-tax dividend cost for the MIPS was $9.8 million, compared with $11.9 million that would have been incurred without the swap and cap transactions. Torchmark's after-tax cost in 1997 was $9.9 million and in 1996 was $9.7 million, saving $2.0 million and $2.2 million in each of those years, respectively.
proceeds for repayment. The commercial paper borrowing balance fluctuates based on Torchmark's current cash needs. There was no current maturity of long-term debt at year-end 1998, compared with $208 million a year earlier.
Total debt as a percentage of total capitalization continues to decline and was 24% at December 31, 1998. In the computation of this ratio, the MIPS are counted as equity and the effect of fluctuations in security values based on changes in interest rates in financial markets are excluded. This debt-to- capitalization ratio was 31% at year-end 1997 and 32% at year-end 1996. The 1998 decline in this ratio resulted primarily from the funded debt paydowns, net of the increase in short-term debt. The debt-to-capitalization ratio was also favorably impacted by the net increase in Torchmark's shareholders' equity resulting from the Waddell & Reed offering and spin-off. Torchmark's ratio of earnings before interest, taxes and discontinued operations to interest requirements also continues to improve and was 8.9 for 1998, compared with 6.5 in 1997 and 6.3 in 1996. Torchmark's interest expense declined 22% in 1998 from $72 million to $56 million. Interest expense was $74 million in 1996.
As of December 31, 1998, the terms of the agreement were not met by the unaffiliated insurance carrier and the contract to sell the Vesta shares was terminated. In the meantime, on December 29, 1998, Torchmark sold 680 thousand Vesta shares to another unrelated institution at a price of $4.75 per share. Torchmark realized a $2 million after-tax loss on the sale. The sale reduced Torchmark's ownership of Vesta to 4.45 million shares or approximately 24% of Vesta at December 31, 1998. Because Torchmark's interest in Vesta exceeded 20% and the sale contract with the insurance carrier expired, Torchmark continued equity-method accounting for its holdings in Vesta. Torchmark's carrying value for Vesta continues to reflect the previously-taken writedown.
organizations have been processing computer systems and programs that cannot always identify a proper date. For many years, programs were written using a two digit code to represent a year. At the beginning of the year 2000, more digits are needed to accurately determine the date in these programs. Without addressing this issue, many computer programs could fail or produce erroneous results. Additionally, companies which are electronically engaged with other businesses or which rely on other businesses for services are exposed to risk of failure by the electronic devices and computer systems of those other entities to the extent they are not Year 2000 compliant. The potential of failure of these systems creates considerable uncertainty and could potentially adversely affect the ongoing operations and stability of a business.
Torchmark is exposed to these risks should its computer systems fail due to date-related problems. Torchmark is also reliant on a number of third party businesses and governmental agencies with which it either interacts electronically or depends upon for services in the conduct of its business. These institutions include but are not limited to banks, financial institutions, telecommunication companies, utilities, mail delivery organizations, and a variety of governmental agencies. Should Torchmark's computer systems or the systems of its third-party business partners not be compliant, Torchmark may be exposed to considerable risks, including business interruption, loss of revenue, increased expense, loss of policyholders, and litigation.
To reduce its business risk to an acceptable level, Torchmark has established a project plan to insure that the company's business-critical computer systems will be Year 2000 compliant. This plan also addresses third- party compliance issues. Under the direction of executive management, objectives and timetables have been set forth to achieve compliance in each geographic location where Torchmark operates. Progress toward achieving those objectives is constantly monitored. Torchmark currently expects the entire project, including all Year 2000 testing activities, to be completed during 1999.
As of December 31, 1998, Torchmark remains on schedule to meet all of its Year 2000 compliance requirements. All known required software changes have been completed, and the related testing is in process with plans for completion in 1999. With regard to third party concerns, Torchmark has in process the following procedures:
1) Torchmark is confirming, with its software vendors, the Year 2000 readiness of its purchased software packages because Torchmark has purchased software packages on all of its computer platforms;
3) All of Torchmark's electronic operational systems (telephones, security, utility, environmental) are being evaluated for Year 2000 compliance.
As an example of Torchmark's interface testing with selected third parties, Torchmark is utilizing electronic data from selected third parties in processing Medicare Supplement benefit data using Year 2000 test data. Torchmark is also arranging similar testing with a selected number of banks. While Torchmark is making every effort to verify the compliance of third parties, no assurances as to the compliance of their computer systems can be given.
Torchmark has used primarily its own employees to complete its Year 2000 project. Other than completion of software testing, all significant Year 2000 project milestones for internal computer systems have been completed. Confirmation of third party compliance and electronic data interface testing with third parties is continuing with completion expected during 1999. Torchmark has spent $5 million on its Year 2000 project activities to date, including internal programming costs, outside contractors, and replacement costs. These costs have been expensed as incurred. Total project cost is expected to be approximately $6 million.
TORCHMARK CORPORATION CONSOLIDATED BALANCE SHEET (Dollar amounts in thousands except per share data)
TORCHMARK CORPORATION CONSOLIDATED STATEMENT OF OPERATIONS (Amounts in thousands except per share data)
Investments. Torchmark classifies all of its fixed maturity investments, which include bonds and redeemable preferred stocks, as available for sale. Investments classified as available for sale are carried at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in shareholders' equity. Investments in equity securities, which include common and nonredeemable preferred stocks, are reported at fair value with unrealized gains and losses, net of deferred taxes, reflected directly in shareholders' equity. Policy loans are carried at unpaid principal balances. Mortgage loans are carried at amortized cost. Investments in real estate are reported at cost less allowances for depreciation, which are calculated on the straight line method. Short-term investments include investments in certificates of deposit and other interest-bearing time deposits with original maturities within three months. If an investment becomes permanently impaired, such impairment is treated as a realized loss and the investment is adjusted to net realizable value.
Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark's net income. Investment income attributable to all other insurance policies and products is included in Torchmark's net investment income. Net investment income for the years ended December 31, 1998, 1997, and 1996 included $296.7 million, $308.6 million, and $298.4 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocable to insurance policyholders' liabilities.
Recognition of Premium Revenue and Related Expenses: Premiums for insurance contracts which are not defined as universal life-type according to Statement of Financial Accounting Standards ("SFAS") No. 97 are recognized as revenue over the premium-paying period of the policy. Profits for limited-payment life insurance contracts as defined by SFAS 97 are recognized over the contract period. Premiums for universal life-type and annuity contracts are added to the policy account value, and revenues for such products are recognized as charges to the policy account value for mortality, administration, and surrenders (retrospective deposit method). Variable annuity products are also assessed an investment management fee and a sales charge. Life premium includes policy charges of $71.7 million, $72.3 million, and $72.8 million for the years ended December 31, 1998, 1997, and 1996,
Note 1--Significant Accounting Policies (continued) respectively. Other premium includes annuity policy charges for the years ended December 31, 1998, 1997, and 1996 of $33.5 million, $28.2 million, and $22.4 million, respectively. Profits are also earned to the extent that investment income exceeds policy requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period.
Impairments: Torchmark accounts for impairments in accordance with the provisions of SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. This standard requires that certain long-lived assets used in Torchmark's business as well as certain intangible assets be reviewed for impairment when circumstances indicate that these assets may not be recoverable, and further provides how such impairment shall be determined and measured. It also requires that long-lived assets and intangibles to be disposed of be reported at the lower of carrying amount or fair value less cost to sell. Except for Torchmark's writedown of its investment in Vesta Insurance Group ("Vesta"), as discussed in Note 19, there were no significant impairments in the three years ending 1998.
Litigation: Torchmark and its subsidiaries continue to be named as parties to legal proceedings. Because much of Torchmark's litigation is brought in Alabama, a jurisdiction known for excessive punitive damage verdicts bearing little or no relationship to actual damages, the ultimate outcome of any particular action cannot be predicted. It is reasonably possible that changes in the expected outcome of these matters could occur in the near term, but such changes should not be material to Torchmark's reported results or financial condition.
Stock Split: On August 1, 1997, Torchmark distributed one share for every one share owned by shareholders of record as of July 1, 1997 in the form of a stock dividend. The dividend was accounted for as a stock split. All prior- year share and per share data have been restated to give effect for this split.
Comprehensive Income: Torchmark adopted SFAS 130, "Reporting Comprehensive Income," effective January 1, 1998. This standard defines comprehensive income as the change in equity of a business enterprise during a period from transactions from all nonowner sources. It requires the company to display comprehensive income for the period, consisting of net income and other comprehensive income. In compliance with SFAS 130, a Consolidated Statement of Comprehensive Income is included as an integral part of the financial statements.
Torchmark had $24.7 million and $30.5 million in investment real estate at December 31, 1998 and 1997, respectively, which was nonincome producing during the previous twelve months. These properties included primarily construction in process and land. Torchmark had $124 thousand in non-income producing mortgages as of year end 1998. There were no fixed maturity investments, or other long-term investments which were nonincome producing at December 31, 1998.
Derivative investments were immaterial to Torchmark at December 31, 1998. These investments consist of interest-only and principal-only collateralized mortgage obligations. Torchmark's total carrying value of these investments was $9.6 million and $26.4 million at December 31, 1998 and 1997, respectively. Torchmark has no off-balance sheet exposure in connection with these investments.
A summary of property and equipment used in the business is as follows:
Depreciation expense on property used in the business was $4.2 million, $4.6 million, and $4.1 million, in each of the years 1998, 1997, and 1996, respectively.
The amount of interest accrued on the unamortized balance of value of insurance purchased was $13.2 million, $16.6 million, and $18.9 million, for the years ended December 31, 1998, 1997, and 1996, respectively. The average interest rates used for the years ended December 31, 1998, 1997, and 1996 were 6.8%, 7.19%, and 7.26%, respectively. The estimated amount of the unamortized balance at December 31, 1998 to be amortized during each of the next five years is: 1999, $17.8 million; 2000, $15.8 million; 2001, $14.0 million; 2002, $12.5 million; and 2003, $11.2 million
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Dollar amounts in thousands except per share data) Note 6--Initial Public Offering and Divestiture of Asset Management Segment (continued)
On September 30, 1996, Torchmark completed the sale of its energy business segment including its energy asset management subsidiary, Torch Energy, and its Black Warrior coalbed methane investment. After the sale, Torchmark had no controlling ownership interest in any energy asset management organization. These operations were reclassified as discontinued operations in Torchmark's financial statements.
Prior to the Sale, Torch Energy transferred to Torchmark marketable securities, warrants, and Section 29 energy-related tax credits, which approximated $112 million at closing. Torchmark received at closing subordinated debt and notes totaling $32.5 million along with $15.5 million in cash. After closing costs and retained liabilities, Torchmark recorded a pretax loss of $23 million and an after-tax loss of $7 million from the sale, or $.05 per share.
In the first quarter of 1996, Torch Energy sold 1.5 million of its shares in Nuevo Energy common stock for proceeds of $35.6 million. These proceeds were transferred to Torchmark in the form of a dividend prior to the sale. Additionally, there were 1.3 million shares of Nuevo common stock included in the above mentioned transferred marketable securities which were sold in the fourth quarter of 1996 for proceeds of $57.6 million.
The valuation allowance for deferred tax assets as of December 31, 1998 and 1997 was $2.1 million. Subsequently recognized tax benefits of $2.1 million relating to the December 31, 1998 valuation allowance will be allocated to goodwill.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.38% in 1998 and 7.37% in 1997.
In October, 1994, Torchmark, through its wholly-owned finance subsidiary, Torchmark Capital L.L.C., completed a public offering of eight million shares of 9.18% MIPS at a face amount of $200 million. The securities are subject to a mandatory redemption in full at September 30, 2024, although Torchmark may elect to extend the MIPS for up to an additional 20 years if certain conditions are met. They are redeemable at Torchmark's option after September 30, 1999. Torchmark subsequently entered into a ten-year swap agreement with an unaffiliated party whereby Torchmark agreed to pay a variable rate on the $200 million face amount in exchange for payment of the fixed dividend. In a related transaction, Torchmark purchased a five-year cap on the swap agreement that insures that the variable rate cannot exceed 10.39% through September 30, 1999. The interest rate was 7.02% at December 31, 1998 and 7.36% at December 31, 1997. Torchmark paid the final yearly fee of $860 thousand for the cap agreement on September 30, 1998. The market value of the swap agreement was a benefit of $24.7 million December 31, 1998 and $18.7 million at December 31, 1997. The market value of the cap agreement, net of the present value of future annual payments, was $0 at December 31, 1998 and $.8 million at December 31, 1997. Except as otherwise described in Note 3--Investments, Torchmark is a party to no other derivative instruments as defined by SFAS 119.
Acquisition of Common Shares: Torchmark shares are acquired from time to time through open market purchases under the Torchmark stock repurchase program when it is believed to be the best use of Torchmark's funds and for future employee stock option exercises. Share repurchases under this program were 3.4 million shares at a cost of $126 million in 1998 and 5.2 million shares at a cost of $183 million in 1997, and 4.6 million shares at a cost of $107 million in 1996.
Grant of Restricted Stock: On January 1, 1998, 117,500 shares were granted to four executive officers of Torchmark or its subsidiaries. These shares vest over eight years in accordance with the following schedule: 16% on the first anniversary, with the vesting percentage declining one percent each year thereafter until the eighth anniversary. The market value of Torchmark stock was $42.1875 per share on the grant date.
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. These restrictions generally limit the payment of dividends by insurance subsidiaries to statutory net gain on an annual noncumulative basis in the absence of special approval. Additionally, insurance companies are not permitted to distribute the excess of shareholders' equity as determined on a GAAP basis over that determined on a statutory basis. In 1999, $258 million will be available to Torchmark for dividends from insurance subsidiaries in compliance with statutory regulations without prior regulatory approval.
Weighted average options outstanding considered to be anti-dilutive under SFAS 128 totaled 0, 742,472, and 598,342 as of December 31, 1998, 1997 and 1996, respectively, and are excluded from the calculation of diluted earnings per share. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
An analysis of shares available for grant in terms of shares adjusted for the stock dividend is as follows:
- -------- (1) This stock grant was made from the 1987 Stock Incentive Plan. (2) The 1987 Stock Incentive Plan, the 1998 Directors' Stock Option Plan, and the 1998 Executive Deferred Compensation Stock Option Plan were closed in 1998. (3) Granted from the 1998 Stock Incentive Plan.
A summary of Torchmark's stock option activity adjusted for the stock dividend, and related information for the years ended December 31, 1998, 1997, and 1996 follows:
The weighted average fair value of options granted during the years ended December 31, 1998, 1997 and 1996 were $8.88, $8.43, and $5.08, respectively.
Concentrations of Credit Risk: Torchmark maintains a highly-diversified investment portfolio with limited concentration in any given region, industry, or economic characteristic. At December 31, 1998, the investment portfolio consisted of securities of the U.S. government or U.S. government-backed securities (12%); non government-guaranteed mortgage-backed securities (6%); short-term investments, which generally mature within one month (1%); securities of state and municipal governments (10%); securities of foreign governments (1%) and investment-grade corporate bonds (57%). The remainder of the portfolio was in real estate (3%), which is not considered a financial instrument according to GAAP; policy loans (4%), which are secured by the underlying insurance policy values; and equity securities, noninvestment grade securities, and other long-term investments (6%). Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. Most of the investments in foreign government securities are in Canadian government obligations. Corporate debt and equity investments are made in a wide range of industries. At December 31, 1998, 1% or more of the portfolio was invested in the following industries: Financial services (19%); regulated utilities (7%); consumer goods (5%); chemicals and allied products (4%); manufacturing (4%); transportation (4%); services (4%); retailing (3%); machinery and equipment (3%); media/communications (3%); petroleum (3%); asset-backed securities (2%); and forestry, paper, and allied products (1%). Otherwise, no individual industry represented 1% or more of Torchmark's investments. At year-end 1998, 5% of the carrying value of fixed maturities was rated below investment grade (BB or lower as rated by Standard & Poor's or the equivalent NAIC designation). Par value of these investments was $294.7 million, amortized cost was $294.5 million, and market value was $295.3 million. While these investments could be subject to additional credit risk, such risk should generally be reflected in market value.
Litigation: Torchmark and its subsidiaries continue to be named as parties to pending or threatened legal proceedings. These lawsuits involve tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark's subsidiaries, employment discrimination, and miscellaneous other causes of action. Many of these lawsuits involve claims for punitive damages in state courts of Alabama, a jurisdiction particularly recognized for its large punitive damage verdicts. A number of such actions involving Liberty also name Torchmark as a defendant. As a practical matter, a jury's discretion regarding the amount of a punitive damage award is not limited by any clear, objective criteria under Alabama law. Accordingly, the likelihood or extent of a punitive damage award in any given case is virtually impossible to predict. As of December 31, 1998, Liberty was a party to approximately 125 active lawsuits (including 29 employment related cases and excluding interpleaders and stayed cases), more than 110 of which were Alabama proceedings in which punitive damages were sought. Liberty faces trial settings in these cases on an on- going basis.
As previously reported, Torchmark, its insurance subsidiaries Globe and United American, and certain Torchmark officers were named as defendants in purported class action litigation filed in the District Court of Oklahoma County, Oklahoma (Moore v. Torchmark Corporation, Case No. CJ-94-2784-65, subsequently amended and restyled Tabor v. Torchmark Corporation). This suit claims damages on behalf of individual health policyholders who are alleged to have been induced to terminate such policies and to purchase Medicare Supplement and/or other insurance coverages. On February 6, 1998, the defendants renewed their motion to dismiss the class claims for failure to prosecute. The District Court, in an order dated April 2, 1998, allowed bifurcation of Tabor into Medicare Supplement policy claims and non-Medicare Supplement policy claims. The non-Medicare Supplement claims were stayed pending disposition of a related case involving the same plaintiffs filed in Mississippi while discovery was allowed to proceed on plaintiffs' motion to certify a class of Medicare Supplement policyholders' claims.
Torchmark has previously reported the case of Lawson v. Liberty National Life Insurance Company (Case No. CV-96-01119), filed in the Circuit Court of Jefferson County, Alabama, where the plaintiffs sought to represent a class of interest-sensitive life insurance policyholders, including those allegedly induced to exchange life insurance policies or where the existing policy's cash value was allegedly depleted, in litigation alleging fraud, negligence and breach of contract in the sale or exchange of interest- sensitive policies by Liberty. Torchmark was subsequently added as a defendant. In May 1996, the Circuit Court entered an order conditionally certifying a plaintiffs class, which was subsequently redefined in March 1997. The Circuit Court's order allowed the parties to challenge the conditional certification based upon subsequent discovery in the case. In March 1998, the defendants challenged the conditional certification and a hearing on final certification was held in October 1998. On February 9, 1999, the Circuit Court entered an order decertifying the conditional class and denying all petitions to certify a class in Lawson.
It has been previously reported that in July 1998, a jury in U.S. District Court in the Middle District of Florida recommended an aggregate total verdict amounting to $21.6 million against Liberty in Hipp v. Liberty National Life Insurance Company (Case No. 95-1332-CIV-T-17A). This case, originally filed in 1995 in the Florida state court system, is a collective action under the Fair Labor Standards Act, alleging age discrimination by Liberty in violation of the Age Discrimination in Employment Act and the Florida Civil Rights Act. The plaintiffs, ten present or former Liberty district managers, sought damages for lost wages, loss of future earnings, lost health and retirement benefits and lost raises and expenses. Three of these plaintiffs, Florida residents, also sought compensatory and punitive damages allowable under Florida law. On November 20, 1998, the District Court remitted the $10 million punitive damage portion of the jury
Torchmark's segments are based on the insurance product lines it markets and administers, life insurance, health insurance, and annuities. These major product lines are set out as segments because of the common characteristics of products within these categories, comparability of margins, and the similarity in regulatory environment and management techniques. There is also an investment segment which manages the investment portfolio, debt, and cash flow for the insurance segments and the corporate function.
Because of the nature of the insurance industry, Torchmark has no individual or group which would be considered a major customer. Substantially all of Torchmark's business is conducted in the United States, primarily in the Southeastern and Southwestern regions.
The measure of profitability for insurance segments is underwriting income before other income and administrative expenses, in accordance with the manner the segments are managed. It essentially represents gross profit margin on insurance products before insurance administrative expenses and consists of premium, less net policy obligations, acquisition expenses, and commissions. It differs from GAAP pretax operating income before other income and administrative expense for two primary reasons. First, there is a reduction to policy obligations for interest credited by contract to policyholders because this interest is earned and credited by the investment segment. Second, interest is also added to acquisition expense which represents the implied interest cost of deferred acquisition costs, which is funded by and is attributed to the investment segment.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (Dollar amounts in thousands except per share data) Note 18--Business Segments (continued)
Transactions Regarding Vesta. Since 1993, Torchmark has held a passive investment in 5.1 million shares of Vesta, a property insurance carrier, representing approximately 28% of the outstanding shares of Vesta. In June, 1998, Vesta announced that (a) an investigation of accounting irregularities that occurred during the fourth quarter of 1997 and the first quarter of 1998 would result in an aggregate $14 million net after-tax reduction in previously reported net income, and, in addition, that (b) it would restate its historical financial statements for the period of 1993 through the first quarter of 1998, reflecting reductions in reported net after-tax earnings of $49 million for the period of 1993 through 1997 and $10 million for the first quarter of 1998. To reflect its pro rata share of Vesta's cumulative reported financial corrections, Torchmark recorded a pre-tax charge of $20 million ($13 million after tax) or $.09 per diluted share in the second quarter of 1998. Additionally, Vesta is now subject to numerous class action lawsuits in state and Federal courts filed subsequent to such announcements.
The following is a summary of quarterly results for the two years ended December 31, 1998. 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.