Family Heritage owns 50% of a partnership that owns an approximate 66,000 square foot building in Broadview Heights, Ohio (a suburb of Cleveland) that serves as Family Heritage’s headquarters. The partnership also leases a portion of the building to unrelated tenants.
(2) Includes Torchmark’s 7.1% Junior Subordinated Debentures reported as “Due to affiliates” on the Consolidated Balance Sheets at year ends 2009 through 2011 in the amount of $123.7 million.
How Torchmark Views Its Operations: Torchmark is the holding company for a group of insurance companies which market primarily individual life and supplemental health insurance, and to a limited extent annuities, to middle income households throughout the United States. We view our operations by segments, which are the insurance product lines of life, health, and annuities, and the investment segment that supports the product lines. Segments are aligned based on their common characteristics, comparability of the profit margins, and management techniques used to operate each segment.
As shown in the above chart, after-tax segment results of operations rose each year over the prior year from $494 million in 2011 to $507 million in 2012 to $531 million in 2013. The primary contributor to the growth in both 2013 and 2012 was the underwriting margin in our life insurance segment, in which margins rose $36 million in 2013 and $49 million in 2012. 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 $34 million of additional margin in 2013 and $8 million in 2012. The 2013 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. The 2012 improvement was largely due to the increased volume in our Medicare Part D program. Both of the years 2013 and 2012 have been negatively impacted by declines in excess investment income, the measure of profitability of our investment segment. These declines in excess investment income have resulted from the continuing low interest rate environment which has pressured investment yields and spreads related to required interest on net policy liabilities, discussed more fully under the caption Investments in this report. Especially in 2012, the impact of the lower interest-rate environment increased as an unusual number of calls, resulting
While life insurance premium has grown steadily in each of the three years ending December 31, 2013, margins as a percentage of premium have risen even more, rising in 2013 to 29% from 28% in 2012 and 27% in 2011. Segment profits for life insurance were not only positively affected by the premium growth, but also by improvements in persistency in both periods and reductions in non-deferred acquisition costs. Life net sales declined 1% in 2013 to $339 million, but increased 6% in 2012 to $343 million. Life insurance segment results are discussed further in this report under the caption Life Insurance.
With regard to health insurance, we primarily market Medicare Supplement insurance, Medicare Part D prescription drug insurance, other limited-benefit products including cancer, and accident and health products. As noted above, 2013 health premium was positively affected by the inclusion of Family Heritage’s health premium for a full year. The 13% increase in 2012 health premium was a result of the addition of a large number of new low-income Medicare Part D auto-enrollees in the 2012 plan year. 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 premium was $447 million in 2013, increasing 50% over 2012 limited-benefit health premium of $298 million. This increase was a result of the inclusion of Family Heritage’s business. Medicare Supplement premium was $417 million in 2013 but has declined slightly in each successive year from 2011 as lapses have exceeded new sales. Our Medicare Part D premium declined 6% in 2013 to $300 million after having risen 62% to $318 million in 2012. The 2012 increase was a result of the previously-noted addition of low-income auto-enrollees in the 2012 plan. Due to increased competition in the 2013 plan year, we experienced a decrease in 2013 Part D premium. For the 2014 Part D plan year, we were able to qualify for new auto-enrollees in 15 regions, compared with 7 in 2013. As a result, we expect growth in Part D sales and premium in 2014. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
As previously mentioned, the investment segment’s pretax profitability, or excess investment income, declined in both 2013 and 2012. Profitability in this segment is based on three major components: net investment income, required interest on net policy liabilities (interest applicable to insurance products), and financing costs. In recent years, net investment income has not grown as fast as the portfolio. One reason that investment income has grown at a lower rate than mean invested assets has grown in recent years is that new investments have been made at yield rates lower than the yield rates earned on securities that matured or were otherwise disposed of. Also, there is sometimes a lag between the time when proceeds from maturities and dispositions are received and when the proceeds are reinvested, during which the funds are held in cash. Growth in total investment income is also somewhat negatively affected by Torchmark’s share repurchase program (described later under this caption), which has diverted cash that could have otherwise been used to acquire investments. In 2013, net investment income rose 2% (3% as in accordance with our segment analysis) while the portfolio (at amortized cost) grew 9%.
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 96% of our invested assets at fair value consist of fixed maturities of which 96% were investment grade at December 31, 2013. 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.
As noted earlier, 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.
In each of the years 2011 through 2013, net income was affected by certain significant, unusual, and nonrecurring nonoperating items. We do not view these items as components of core operating results because they are not indicative of past performance or future prospects of the insurance operations. As reported in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements under the caption Settlements, we were involved in certain issues in which we incurred settlement losses and expenses. In 2011, we settled a state administrative matter in the pretax amount of $6.9 million ($4.5 million after tax) and accrued an estimated liability for a litigation amount which settled in early 2012 in the pretax amount of $12.0 million ($7.8 million after tax). Both of these issues involved matters arising many years ago. Additionally, 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). 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.
Option proceeds were unusually high in 2011 and 2012 due to option holders exercising several years of option grants that expired in 2012.
Index to Financial Statements Annualized life premium in force was $1.96 billion at December 31, 2013, an increase of 3% over $1.90 billion a year earlier. Annualized life premium in force was $1.81 billion at December 31, 2011.
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 2013. Life premium for this agency rose 8% to $715 million, after having risen 9% in 2012. Net sales declined 4% in 2013 to $153 million, after having risen 12% in 2012. Net sales rose 3% in 2011. The average face amount of policies issued in 2013 was approximately $33 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 5,302 at December 31, 2013 compared with 5,176 a year earlier, an increase of 2%. The agent count increased 18% in 2012 and 12% in 2011. 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. This agency has recently opened new offices in territories where there are existing offices, but where there is an excess capacity of leads. We believe that these initiatives will promote increased enthusiasm in the field and will drive increases in agent retention and sales activity.
Index to Financial Statements The Direct Response Unit targets its market through a variety of direct-to-consumer approaches which include direct mailings, insert media, internet, and inbound telephone calls. These different approaches support and complement one another in the unit’s efforts to reach the consumer. The Direct Response unit’s growth has been fueled by constant innovation. In recent years, the internet and inbound call center production has grown rapidly as management has aggressively increased internet marketing activities and focused on driving traffic to the inbound call center. We have also introduced certain new initiatives to increase response rates in this unit from which we have seen positive results. These initiatives include lower premium rates as well as offerings of higher face amounts on the adult products.
Direct response focuses primarily on young middle-income households with children. The juvenile life insurance policy is a key product for this unit. Not only is the juvenile market an important source of sales, it is also a vehicle to reach the parents and grandparents of the juvenile policyholders. Also, both the juvenile policyholders and their parents are low acquisition cost targets for sales of additional coverage over time. At this time, we believe that the Direct Response unit is the largest U.S. writer of juvenile direct mail life insurance. We expect that sales to this demographic group will continue as one of Direct Response’s premier markets.
Liberty has historically focused its marketing efforts in smaller rural areas in the southeastern United States. Going forward, management expects to grow this agency through nationwide geographic expansion into more urban areas where there are larger pools of potential agent recruits and customers. We believe that expansion of this Agency’s presence into more heavily populated, less penetrated areas will help reverse the declines in agent count and create long term agency growth. As a result, 6 new offices were opened in larger metropolitan areas during 2013 and we expect to open an additional 5 offices in 2014. As agents in these offices become more experienced, their productivity should improve. We have also implemented a new prospecting training program designed to improve the ability of our agents to develop new worksite marketing business.
Gross margins, as indicated by insurance underwriting margin before other income and administrative expense, rose 7% in 2013 and 11% in 2012. The margin increased to $545 million in 2013 after rising to $509 million in 2012. Margin growth in all periods was primarily the result of premium growth. As a percentage of life insurance premium, the margins have risen steadily each year, largely due to improved persistency. In 2013, these increases were positively affected by our conservation program and permitted increases in the deferrals of our internet-related direct response acquisition costs.
Total health premium represented 38% of Torchmark’s total premium income in 2013. Excluding Part D premium, health premium represented 28% of total premium income in 2013, compared with 26% in 2012 and 28% in 2011. Health underwriting margin, excluding Part D, accounted for 25% of the total in 2013, compared with 23% in 2012 and 25% in 2011. Health results in 2013 were positively affected by the late 2012 addition of Family Heritage. Family Heritage added $191 million of health premium in 2013 compared with $30 million in 2012. However, health results have been negatively affected by the discontinuance of sales and the run-off of a block of hospital-surgical limited-benefit products which became less marketable due to healthcare reform developments. These products were also our highest-premium, lowest-margin products. Health results have also been negatively affected by the restructuring of the Liberty National Agency as discussed under the caption Life Insurance. The following table indicates health insurance premium income by distribution channel for each of the last three years.
Total Medicare Part D premium and health premium exclude $2.6 million of risk-sharing premium received in 2013, and $404 thousand in 2012 and $1.0 million in 2011 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.
Net sales for Medicare Part D represents only new first-time enrollees.
Index to Financial Statements The addition of Family Heritage’s sales and premium from limited-benefit products has resulted in limited-benefit health premium exceeding Medicare Supplement premium income in 2013 for the first time in several years. Limited-benefit premium represented 52% of total non-Part D health premium in 2013, but represented 41% in 2012 and 40% in 2011. Prior to our acquisition of Family Heritage, Medicare Supplement provided the greatest amount of health premium. Family Heritage also added a boost to limited-benefit net sales in relation to Medicare Supplement net sales, as they rose to 60% of total non-Part D net sales in 2013 from 41% in both 2012 and 2011.
The UA Independent Agency is Torchmark’s largest in terms of health premium income, producing 35% of health premium in 2013. This Agency is composed of independent agencies appointed with Torchmark whose size range from very large, multi-state organizations down to one-person offices. All of these agents generally sell for a number of insurance companies. Torchmark had 2,414 active producing agents at December 31, 2013 compared with 2,003 a year earlier. This Agency is our largest producer of Medicare Supplement insurance, with $274 million or 66% of our Medicare Supplement premium income in 2013. Net sales for this Agency were $41 million in 2013, a decline of 2% from 2012 net sales of $42 million. In 2012, they had increased 29% over 2011 net sales. Total health premium income for the UA Independent Agency was $298 million in 2013, a slight decline from 2012 premium of $299 million. Premium income also declined 3% in 2012. These declines in premium have resulted due to lapses of limited-benefit products being greater than new sales.
Health premium at this agency declined slightly in 2013 to $79 million from $80 million. However, health net sales declined in both periods, falling 20% in 2013 to $7 million and declining 9% to $9 million in 2012. Because this agency focuses on life products, health net sales comprised only 4% of the American Income Agency’s total net sales in 2013.
Part D net sales were $79 million in 2013, compared with $114 million in 2012 and $115 million in 2011. We count only sales to new first-time enrollees in net sales, and the majority of premium income was from previous enrollees. Total Medicare Part D premium was $300 million in 2013, compared with $318 million in 2012 and $197 million in 2011. Total enrollees in the program were 254 thousand at the beginning of the 2013 plan year, 215 thousand at the beginning of the 2012 plan year, and 144 thousand at the beginning of the 2011 plan year.
Index to Financial Statements As presented in the following table, Torchmark’s health insurance underwriting margin before other income and administrative expense increased 17% to $232 million in 2013, after an increase of 4% to $197 million in 2012. Family Heritage contributed $32 million of the $34 million 2013 increase. As a percentage of premium income, margins were 20% in both 2013 and 2011 as compared with 19% in 2012. The lower 2012 percentage reflected the greater proportion of Medicare Part D business which had a higher benefit ratio.
While the fixed annuity account balance has increased modestly each year over the prior year and underwriting income has increased each year as well, 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 2012, however, spreads tended to level as crediting rates reached guaranteed minimums.
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, 2013.
Index to Financial Statements Insurance administrative expenses rose 8% in 2013, after having increased 4% in 2012. As a percentage of premium, they increased .1% in 2013 to 5.9%, but declined .2% in 2012 to 5.8%. The inclusion of Family Heritage’s administrative expenses accounted for $8.1 million of the $13.5 million increase in total administrative expense in 2013. The 2012 increase in total insurance administrative expense of $6.3 million was primarily the result of the expiration of a third party agreement under which we were reimbursed a net of $5.2 million in 2011 for providing policy administration services, and $1.6 million from the addition of Family Heritage’s expenses in 2012. Stock compensation expense has risen in each successive year as the value of Torchmark stock has increased, resulting in higher values for grants of stock and options and not because of an increase in the number of grants. As stated in Note 14-Business Segments in the Notes to Consolidated Financial Statements, management views stock compensation expense as a corporate expense, and therefore treats it as a Parent Company expense.
During 2013, Torchmark recorded two non-operating charges: (1) a state guaranty fund assessment in the amount of $1.2 million ($751 thousand after tax), resulting from events in years prior to 2012 and (2) a legal settlement related to a non-insurance matter in the amount of $500 thousand ($325 thousand after tax). We incurred expenses of $2.9 million related to the acquisition of Family Heritage in late 2012 as described in Note 6-Acquisition in the Notes to Consolidated Financial Statements. Additionally, as mentioned in Note 1-Significant Accounting Policies, we incurred two settlement expense issues in 2011 that related to events occurring many years ago: the settlement of a state administrative issue of $7 million and a litigation issue in the estimated amount of $12 million. The latter item was settled in that amount in 2012. In addition to these two 2011 items, we sold aviation equipment in 2011 at a loss of $979 thousand. While all of these nonrecurring expenses were included in “Operating expenses” for the respective year in the Consolidated Statements of Operations in accordance with accounting guidance, they are considered as non-operating expenses by management.
Investments. We manage our capital resources including investments, debt, and cash flow through the investment segment. Excess investment income represents the profit margin attributable to investment operations. It is the measure that we use to evaluate the performance of the investment segment as described in Note 14-Business Segments in the Notes to the Consolidated Financial Statements. It is defined as net investment income less both the required interest attributable to net policy liabilities and the interest cost associated with capital funding or “financing costs.” We also view excess investment income per diluted share as an important and useful measure to evaluate the performance of the investment segment. It is defined as excess investment income divided by the total diluted weighted average shares outstanding, representing the contribution by the investment segment to the consolidated earnings per share of the Company. Since implementing our share repurchase program in 1986, we have used over $5.7 billion of cash flow to repurchase Torchmark shares after determining that the repurchases provided a greater return than other investment alternatives. Share repurchases reduce excess investment income because of the foregone earnings on the cash that would otherwise have been invested in interest-bearing assets, but they also reduce the number of shares outstanding. In order to put all capital resource uses on a comparable basis, we believe that excess investment income per diluted share is an appropriate measure of the investment segment.
The largest component of excess investment income is net investment income, as adjusted for the segment analysis, which rose 3% to $735 million in 2013. It increased 1% to $716 million in 2012 from $707 million in 2011. 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 2013, fixed maturity yields averaged 5.94% on a tax-equivalent and effective-yield basis, compared with 6.35% in 2012 and 6.56% in 2011. 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 was primarily a 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 2013, its lower-yielding portfolio also contributed to the decline in the average fixed-maturity yield.
Approximately 62% of the invested assets added in 2011 through 2013 replaced higher-yielding assets that matured, were called, or were otherwise disposed of during that period. A major factor negatively affecting net investment income was calls of fixed-maturity securities. During 2012, and to a lesser extent in 2013, we had an unusually large number of these calls, including $129 million of bank-issued hybrid securities in 2013 and $339 million in 2012. Fixed maturity securities are more likely to be called in a declining interest-rate environment, as these callable securities can often be refinanced at lower prevailing rates. In addition to bonds with scheduled call dates, our portfolio includes bank-issued hybrid securities with provisions allowing the security to be called in the event of a change in capital treatment. Many banks chose to call their hybrid securities because the Dodd-Frank Act phased out the partial equity credit historically allowed for these securities. Of our $12 billion fixed maturity portfolio at amortized cost as of December 31, 2013, we held $134 million book value of bank hybrid securities with a weighted average yield of 6.87% that were callable without a make-whole provision and $175 million of other fixed maturity securities with a weighted average yield of 5.85% that were callable solely at the discretion of the issuer but that had not been called as of December 31, 2013. In addition, we also held $186 million book value of non-bank hybrid securities with a weighted average yield of 6.31% that become callable solely at the discretion of the issuer on various scheduled dates during the next three years. Many factors can be involved in an issuer’s decision to call a bond. Therefore, it is difficult to predict whether or not a bond will be called in the future, and, if so, when it will be called. If these bonds were to be called, there would be a reduction in future net investment income if the average yield on called securities exceeds prevailing new money rates. Approximately 66% of the callable bank hybrid securities at December 31, 2013 were rated below-investment-grade. If called, both the ratio of below-investment-grade securities to our investment portfolio and statutory required capital would also decrease.
In addition to the aforementioned calls, we had more sales of investments than usual, particularly in 2011 and 2012, from which proceeds were reinvested at lower yields. These sales were generally made due to credit concerns or for tax purposes.
Index to Financial Statements Information about interest on policy liabilities is shown in the following table.
The combined weighted average discount rate decreased in 2013 due to the inclusion of Family Heritage for a full year. Increases in the weighted average discount rate in 2012 and 2011 are due to changes in the mix of the in-force business discussed above.
Excess investment income is also impacted by financing costs. Financing costs for the investment segment primarily consist of interest on our various debt instruments and are deducted from excess investment income.
Financing costs increased $163 thousand or .2% in 2013. They rose $3 million or 3% in 2012. The increase in financing costs in 2012 over 2011 reflects the increased interest expense from the issuance in September 2012 of $300 million principal amount of our 3.8% Senior Notes due in 2022, $150 million of which is eliminated in consolidation. Also in September, 2012, we issued our 5.875% Junior Subordinated Debentures due 2052 for $125 million principal amount but called our $120 million 7.1% Trust Preferred Securities one month later. In August, 2013, we repaid our 7.375% Notes that matured. These debt transactions will decrease interest expense on our long-term funded debt going forward. In 2013, interest on short-term debt declined primarily because of the reduction in the average balance outstanding of short-term debt. The 2011 and 2012 increases in interest on short-term debt were primarily a result of the $2.1 million increase in financing charges on our letter of credit facility, arising from the December, 2010 restructuring of our credit facility. More information on our debt transactions are disclosed in the Financial Condition section of this report and in Note 11-Debt in the Notes to Consolidated Financial Statements.
In response to the lower interest rates, we raised the premium rates for new business on major life products in early 2012 and again in late 2013. The increased premium provides additional margin on these policies to help offset higher mandatory cash values and the possible future reductions in excess investment income. These increases in premium have not had a detrimental impact on sales.
Index to Financial Statements Investment Acquisitions. Torchmark’s current investment policy calls for investing almost exclusively in investment-grade fixed maturities generally with long maturities (maturity date more than 20 years after acquisition date) that meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. Further, we believe this strategy is appropriate because our strong positive cash flows are generally stable and predictable. If such longer-term securities do not meet our quality and yield objectives, we consider investing in short-term securities, taking into consideration the slope of the yield curve and other factors at the time. During calendar years 2011 through 2013, Torchmark invested almost exclusively in fixed-maturity securities, primarily with longer-term maturities as presented in the chart below.
During the three years 2011 through 2013, we have invested almost entirely in investment-grade corporate bonds. Acquisitions in 2012 and 2013 have been primarily in industrial and utility bonds. New cash flow available for investment has been primarily provided through our insurance operations, but has also been affected by other factors. Issuer calls, as a result of the low-interest environment experienced during the past three years were an important factor, especially in 2012. Calls increase funds available for investment, but as noted earlier in this discussion, they can have a negative impact on investment income if the proceeds from the calls are reinvested in bonds that have lower yields than that of the bonds that were called. Issuer calls were $344 million in 2013, $650 million in 2012, and $187 million in 2011. The higher level of acquisitions in 2012 was primarily due to the additional funds available from the higher level of 2012 calls.
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, 2013 and December 31, 2012 is as follows:
At December 31, 2013, approximately 25% of the fixed maturity assets at amortized cost (26% at fair value) were in the financial sector, including 14% in life and health or property casualty insurance companies and 6% in banks. Financial guarantors, mortgage insurers, and insurance brokers comprised approximately 5% of the portfolio at amortized cost. After financials, the next largest sector was utilities, which comprised 18% of the portfolio at amortized cost. The balance of the portfolio is spread among 399 issuers in a wide variety of sectors.
Index to Financial Statements An analysis of the fixed-maturity portfolio by a composite rating at December 31, 2013 is shown in the table below. The composite rating for each security, other than private-placement securities managed by a third party, is the average of the security’s ratings as assigned by Moody’s Investor Service, Standard & Poor’s, Fitch Ratings, and Dominion Bond Rating Service, LTD. The ratings assigned by these four nationally recognized statistical rating organizations are evenly weighted when calculating the average. Included in the chart below are private placement fixed-maturity holdings of $313 million at amortized cost ($300 million at fair value) for which the ratings were assigned by the third-party manager.
Index to Financial Statements Realized Gains and Losses. Our life and health insurance companies collect premium income from policyholders for the eventual payment of policyholder benefits, sometimes paid many years or even decades in the future. In addition to the payment of these benefits, we also incur acquisition costs, administrative expenses, and taxes as a part of insurance operations. Because benefits are expected to be paid in future periods, premium receipts in excess of current expenses are invested to provide for these obligations. For this reason, we hold a significant investment portfolio as a part of our core insurance operations. This portfolio consists primarily of high-quality fixed maturities containing an adequate yield to provide for the cost of carrying these long-term insurance product obligations. As a result, fixed maturities are generally held for long periods to support the liabilities. Expected yields on these investments are taken into account when setting insurance premium rates and product profitability expectations.
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 2013, the Parent received $488 million of cash dividends from its insurance subsidiaries, as compared with $437 million in 2012 and $769 million in 2011. The 2011 dividend included $305 million of additional dividends available as a result of the sale of United Investors. 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 2013 of approximately $364 million, compared with $371 million in 2012. Parent Company cash flow in excess of its operating requirements is available for other corporate purposes, such as strategic acquisitions or share repurchases. In 2014, it is expected that the Parent Company will receive approximately $475 million in dividends from subsidiaries, and that an approximate range of $370 to $380 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 $8 million of cash and short-term investments at December 31, 2013, compared with $2 million a year earlier. The Parent also had available a $50 million receivable from subsidiaries at December 31, 2013.
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 $600 million. As of December 31, 2013, we had available $173 million of additional borrowing capacity under this facility, compared with $177 million a year earlier. There have been no difficulties in accessing the commercial paper market under this facility during the three years ended December 31, 2013. For detailed information about this line of credit facility, see the Commercial Paper section of Note 11-Debt.
In summary, Torchmark expects to have readily available funds for 2014 and the foreseeable future to conduct its operations and to maintain target capital ratios in the insurance subsidiaries through internally generated cash flow and the credit facility. In the unlikely event that more liquidity is needed, the Company could generate additional funds through multiple sources including, but not limited to, the issuance of additional debt, a short-term credit facility, and intercompany borrowing.
Consolidated Liquidity. Consolidated net cash inflows provided from operations were $1.1 billion in 2013, compared with $943 million in 2012 and $859 million in 2011. In addition to cash inflows from operations, our companies have received $369 million in investment calls and tenders and $125 million of scheduled maturities or repayments during 2013. Maturities, tenders, and calls totaled $737 million in 2012 and $410 million in 2011.
Off-Balance Sheet Arrangements. As described in Note 11-Debt in the Notes to Consolidated Financial Statements and under the subcaption Funded Debt, Torchmark had outstanding $120 million (par amount) 7.1% Trust Preferred Securities at December 31, 2011, but these securities were redeemed during 2012. The capital trust liable for these securities was the legal entity responsible for the securities and facilitated the payment of dividends to shareholders. The trust was an off-balance sheet arrangement which we were required to deconsolidate in accordance with GAAP rules, because the capital trust was considered to be a variable interest entity in which we had no variable interest. While these liabilities were not on our Consolidated Balance Sheets, they were represented by Torchmark’s 7.1% Junior Subordinated Debentures due to the trust in the amount of $124 million. The redemption of these Debentures funded the redemption of the Trust Preferreds.
As a part of its above-mentioned credit facility, Torchmark had outstanding $198 million in stand-by letters of credit at December 31, 2013. 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.
The following table presents information about future payments under our contractual obligations for the selected periods as of December 31, 2013.
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, 2013, these pension obligations were $384 million, but there were also assets of $292 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. Please refer to Note 10-Postretirement Benefits in the Notes to Consolidated Financial Statements for more information on pension obligations.
At December 31, 2012, our 7 3/8% Notes due 2013 in the principal amount of $94.5 million were reclassified to short-term debt because of its maturity in 2013. The principal balance and accrued interest for that debt issue was then repaid on its maturity date of August 1, 2013 in the total amount of $97.5 million.
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, 2013, our insurance subsidiaries in the aggregate had RBC ratios of approximately 341%. 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%.
As noted under the caption Summary of Operations in this report, we have an ongoing share repurchase program. Under this program, we acquired 6 million shares at a cost of $360 million in 2013, 7 million shares at a cost of $360 million in 2012, and 19 million shares for $788 million in 2011. The majority of purchased shares are retired each year. Please refer to the description of our share repurchase program under the caption Summary of Operations in this report.
Shareholders’ equity was $3.8 billion at December 31, 2013, compared with $4.4 billion at December 31, 2012. During the twelve months since December 31, 2012, shareholders’ equity was reduced by the $360 million in share purchases under the repurchase program and another $122 million to offset the dilution from stock option exercises. It was also reduced by $762 million of after-tax unrealized losses in the fixed maturity portfolio, but was increased by the $528 million of net income.
We plan to use excess cash available at the Parent Company as efficiently as possible in the future. Excess cash flow could be used for share repurchases, acquisitions, increases in shareholder dividends, investment in fixed maturities, or repayment of short-term debt. We will determine the best use of excess cash after ensuring that desired capital levels are maintained in our companies.
Includes Torchmark’s 7.1% Junior Subordinated Debentures in 2011 in the amount of $124 million.
FASB guidance provides for an option which, if elected, would permit us to value our interest-bearing policy liabilities and debt at fair value in our Consolidated Balance Sheets. However, unlike the accounting rule which permits us to account for changes in our available-for-sale bond portfolio through other comprehensive income, the guidance requires such changes to be recorded in earnings. Because both the size and duration of the investment portfolio do not match those attributes of our policyholder
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 four largest insurance subsidiaries at December 31, 2013.
The AA financial strength rating category is assigned by Standard & Poor’s Corporation 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 that are insurers with higher ratings. The plus sign (+) or minus sign (-) shows the relative standing within the major rating category.
Approximately 83% of our liabilities for future policy benefits at December 31, 2013 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, 2013.
The remaining 1% of deferred acquisition costs pertain to deposit business for which deferred acquisition costs are amortized over the estimated lives of the contracts in proportion to actual and estimated future gross profits. These contracts are not subject to lock-in. The assumptions must be updated when actual experience or other evidence suggests that earlier estimates should be revised. Revisions related to our deposit business assets have not had a material impact on the amortization of deferred acquisition costs during the three years ended December 31, 2013.
Index to Financial Statements Defined benefit pension plans. We maintain funded defined benefit plans covering most full-time employees. We also have unfunded nonqualified defined benefit plans covering certain key and other employees. Our obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are offset, at least in part, by the growth in value of the assets in the funded plans. At December 31, 2013, our gross liability under these funded plans was $322 million, but was offset by assets of $292 million.
10) The customer response to new products and marketing initiatives; and
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2013
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, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Torchmark’s internal control over financial reporting as of December 31, 2013, based on the criteria established in Internal Control-Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2014 expressed an unqualified opinion on Torchmark’s internal control over financial reporting.
Additionally, as further described under the caption Low-Income Housing Tax Credit Interests below in this note, Torchmark holds passive interests in limited partnerships which provide investment returns through the provision of tax benefits (principally from the transfer of Federal or state tax credits related to federal low-income housing). These interests are also considered to be VIEs. They are not consolidated because the Company has no power to control the activities that most significantly affect the economic performance of these entities and therefore the Company is not the primary beneficiary of any of these interests. Torchmark’s involvement is limited to its limited partnership interest in the entities. Torchmark has not provided any other financial support to the entities beyond its commitments to fund its limited partnership interests, and there are no arrangements or agreements with any of the interests to provide other financial support. The maximum loss exposure relative to these interests is limited to their carrying value.
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, 2013 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 corroborated prices produce small variations, the close correlation indicates observable inputs, and the
median value is used. When corroborated prices present greater variations, additional analysis is required to determine which value is the most appropriate. When only one price is available, management evaluates observable inputs and performs additional analysis to confirm that the price is appropriate. All fair value measurements based on prices determined with observable market data are reported as Level 1 or Level 2 measurements.
Impairment of Investments: Torchmark’s portfolio of fixed maturities fluctuates in value due to changes in interest rates in the financial markets as well as other factors. Fluctuations caused by market interest rate changes have little bearing on whether or not the investment will be ultimately recoverable.
Recognition of Premium Revenue and Related Expenses: Premium income for traditional long-duration life and health insurance products is recognized when due from the policyholder. Premiums for short-duration health contracts are recognized as revenue over the contract period in proportion to the insurance protection provided. Profits for limited-payment life insurance contracts 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). Life premium includes policy charges of $22 million, $23 million, and $25 million for the years ended December 31, 2013, 2012, and 2011, respectively. Other premium consists of annuity policy charges in each year. Profits are also earned to the extent that investment income exceeds policy liability interest requirements. The related benefits and expenses are matched with revenues by means of the provision of future policy benefits and the amortization of deferred acquisition costs in a manner which recognizes profits as they are earned over the same period.
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 83% 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% for Torchmark’s insurance companies with an overall weighted average assumed rate of 5.8%. 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 either Company experience or the assumptions used in determining statutory reserves. 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.
Deferred Acquisition Costs: Certain costs of acquiring new insurance business are deferred and recorded as an asset. These costs are essential for the acquisition of new insurance business and are directly related to the successful issuance of an insurance contract including sales commissions, policy issue costs, and underwriting costs. Additionally, deferred acquisition costs include the value of insurance purchased, which are the costs of acquiring blocks of insurance from other companies or through the acquisition of other companies. These costs represent the difference between the fair value of the contractual insurance assets acquired and liabilities assumed compared against the assets and liabilities for insurance contracts that the Company issues or holds measured in accordance with GAAP. Deferred acquisition costs and the value of insurance purchased are amortized in a systematic manner which matches these costs with the associated revenues. Policies other than universal life-type policies are amortized with interest over the estimated premium-paying period of the policies in a manner which charges each year’s operations in proportion to the receipt of premium income. Universal life-type policies are amortized with interest in proportion to estimated gross profits. The assumptions used to amortize acquisition costs with regard to interest, mortality, morbidity, and persistency are consistent with those used to estimate the liability for future policy benefits. For interest-sensitive and deposit-balance type products, these assumptions are reviewed on a regular basis and are revised if actual experience differs significantly from original expectations. For all other products, amortization assumptions are generally not revised once established. Deferred acquisition costs are subject to periodic recoverability and loss recognition testing to determine if there is a premium deficiency. These tests ensure that the present value of future contract-related cash flows will support the capitalized deferred acquisition cost asset. These cash flows consist primarily of premium income, less benefits and expenses taking inflation into account. The present value of these cash flows, less the benefit reserve, is then compared with the unamortized deferred acquisition cost balance. In the event the estimated present value of net cash flows is less, the deficiency would be recognized by a charge to earnings and either a reduction of unamortized acquisition costs or an increase in the liability for future benefits, as described under the caption Future Policy Benefits.
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 $6 million, $16 million, and $16 million in 2013, 2012, and 2011, respectively. Capitalized advertising costs included within deferred acquisition costs were $1.09 billion at December 31, 2013 and $1.04 billion at December 31, 2012.
Low-Income Housing Tax Credit Interests: As of December 31, 2013, Torchmark had $290 million invested in limited partnerships that provide low-income housing tax credits and other related Federal income tax and state premium tax benefits to Torchmark. The carrying value of Torchmark’s investment in these entities was $285 million at December 31, 2012. As of December 31, 2013, Torchmark was obligated under future commitments of $58 million, which is included in the above carrying value. Interests for which the return has been guaranteed by unrelated third-parties are accounted for using the effective-yield method. The remaining interests are accounted for using the amortized-cost method.
Torchmark has tested its goodwill annually in each of the years 2011 through 2013. These tests, performed in the third quarter each year, involved assigning carrying value by allocating the Company’s net assets to each of the reporting units of Torchmark’s segments, including the portion of goodwill assigned to the unit. In 2012, the qualitative assessment was employed as permitted by accounting guidance. Based on the analyses as outlined in the guidance, it was determined that an impairment of goodwill was not likely. In 2013 and 2011, the fair values of the various reporting units were developed. The fair value of each reporting unit was determined using discounted expected cash flows associated with that unit. Judgment and assumptions are used in developing the projected cash flows for the
reporting units, and such estimates are subject to change. The Company also exercises judgment in the determination of the discount rate, which management believes to be appropriate for the risk associated with the cash flow expectations. The fair value of each reporting unit is then measured against that reporting unit’s corresponding carrying value. Because the estimated fair value substantially exceeded the carrying value, including goodwill, of each reporting unit in each period, Torchmark’s goodwill was not impaired in any of those periods.
over three years as permitted by the previous plans. The Company has sufficient experience with seven-year grants that vest in three years, but no historical experience with five-year vesting. Therefore, Torchmark has used the simplified method to determine the expected term for the ten-year grants with five-year vesting and will do so until such experience is developed. Volatility and risk-free interest rates are assumed over a period of time consistent with the expected term of the option. Volatility is measured on a historical basis. Monthly data points are utilized to derive volatility for periods greater than three years. Expected dividend yield is based on current dividend yield held constant over the expected term. Once the fair value of an option has been determined, it is amortized on a straight-line basis over the employee’s service period for that grant (from the grant date to the date the grant is fully vested).
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 $437 million at December 31, 2013. More information on the restrictions on the payment of dividends can be found in Note 12-Shareholders’ Equity.
An analysis in the change in balance by component of Accumulated Other Comprehensive Income is as follows for the twelve months ended December 31, 2013.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2013 and 2012 is as follows:
Fair value measurements: The following tables represent the fair value of assets measured on a recurring basis at December 31, 2013 and 2012:
The collateral underlying collateralized debt obligations for which fair values are reported as Level 3 consists primarily of trust preferred securities issued by banks and insurance companies. None of the collateral is subprime or Alt-A mortgages (loans for which the typical documentation was not provided by the borrower). Collateralized debt obligations are valued at the present value of expected future cash flows using an unobservable discount rate. Expected cash flows are determined by scheduling the projected repayment of the collateral assuming no future defaults, deferrals, or recoveries. The discount rate is risk-adjusted to take these items into account. A significant increase (decrease) in the discount rate will produce a significant decrease (increase) in fair value. Additionally, a significant increase (decrease) in the cash flow expectations would result in a significant increase (decrease) in fair value.
Other-than-temporary impairments: Torchmark has determined that certain of its holdings in fixed maturity investments were other-than-temporarily impaired during the three years ended December 31, 2013. The following table presents the writedowns recorded due to these impairments in accordance with accounting guidance and whether the writedown was charged to earnings or other comprehensive income.
Unrealized gains/loss analysis. Conditions in financial markets improved during 2011 and 2012, resulting in increases in net unrealized gains in the portfolio in both years. In 2011, net unrealized gains rose from $108 million in the beginning of the year to $964 million at December 31, and then further increased to $1.6 billion at December 31, 2012. In 2013, however, increases in interest rates in financial markets caused the net unrealized gain balances to decline to $390 million at December 31, 2013. At December 31, 2013, investments in securities in the financial sector were in a $180 million net unrealized gain position. These investments in the financial sector represented 25% of the portfolio at amortized cost and 26% at fair value. This is compared with a net unrealized gain position of $339 million at the end of the prior year. Investments and securities in the other sectors had net unrealized gains of $210 million at year end 2013 and $1.2 billion at year end 2012. The following tables disclose gross unrealized investment losses by class of investment at December 31, 2013 and December 31, 2012 for the period of time in a loss position. Torchmark considers these investments to be only temporarily impaired.
Torchmark’s entire fixed-maturity and equity portfolio consisted of 1,619 issues at December 31, 2013 and 1,630 issues at December 31, 2012. The weighted-average quality rating of all unrealized loss positions as of December 31, 2013 was BBB+, compared with BBB+ a year earlier. The weighted-average quality ratings are based on amortized cost.
Torchmark had $125 thousand in fixed maturities at book value ($126 thousand at fair value) that were non-income producing during the twelve months ended December 31, 2013. Torchmark did not have any other invested assets that were non-income producing during the twelve months ended December 31, 2013.
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. 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.
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. Torchmark believes that Family Heritage is an excellent fit with Torchmark’s existing insurance business, given that Family Heritage’s operations are consistent with Torchmark’s strategy of selling basic protection products in relatively non-competitive markets through controlled distribution channels. 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.
The acquisition was accounted for under the acquisition method of accounting as required by accounting guidance. This guidance requires that the identifiable assets acquired and liabilities assumed be based on their fair values at the acquisition date. The results of operations since the acquisition date have been consolidated. A summary of the net assets acquired is as follows:
The amount recorded as the value of insurance purchased at November 1, 2012, represents the difference between the fair value of the contractual insurance assets acquired and liabilities assumed compared against the assets and liabilities measured in accordance with the Company’s accounting policies for insurance contracts that it issues or holds in accordance with GAAP. The fair value of this asset was determined based on an actuarial analysis performed by management. The value of insurance purchased is included with “Deferred acquisition costs” on the Consolidated Balance Sheets and will be amortized in proportion with the premium income of the acquired insurance business in accordance with accounting guidance.
No goodwill related to the acquisition is deductible for tax purposes. Because the operations of Family Heritage are considered a part of Torchmark’s health segment, goodwill arising from the transition has been assigned to that reporting unit.
Torchmark’s tax liability is adjusted to include the provision for uncertain tax positions taken or expected to be taken in a tax return. A reconciliation of the beginning and ending amount of unrecognized tax benefits (excluding effects of accrued interest, net of Federal tax benefits) for the years 2011 through 2013 is as follows:
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 $0, $56 thousand, and $0, net of Federal income tax benefits, in its Consolidated Statements of Operations for 2013, 2012, and 2011, respectively. The Company had no accrued interest or penalties at December 31, 2013 or 2012.
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, life insurance policies on the lives of plan participants have been established for this plan with an unaffiliated insurance carrier. The premiums for this coverage paid were $2.9 million in 2013, $1.7 million in 2012, and $3.9 million in 2011. The cash value of these policies at December 31, 2013 was $22 million and was $18 million a year earlier. Additionally, a Rabbi Trust which involves an investment account has been established to support the liability for this plan. Deposits of $6 million in 2013, $5 million in 2012, and $5 million in 2011 were added to the investment account in this trust. Investments consist of exchange traded funds. As of December 31, 2013, the combined value of the insurance policies and the trust investments was $66 million, compared with $54 million a year earlier. Because this plan is unqualified, the Rabbi Trust and the policyholder value of these policies 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, 2013 was $58 million and was $59 million a year earlier.
Plan assets in the funded plans consist primarily of investments in marketable fixed maturities and equity securities and are valued at fair value. Torchmark measures the fair value of its financial assets, including the assets in its benefit plans, in accordance with accounting guidance which establishes a hierarchy for asset values and provides a methodology for the measurement of value. Please refer to 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, 2013 and 2012.
The accumulated benefit obligation (ABO) for Torchmark’s funded defined benefit pension plans was $295 million and $321 million at December 31, 2013 and 2012, respectively. In the unfunded plans, the ABO was $52 million and $52 million at December 31, 2013 and 2012, respectively.
The amount of debt that becomes due during each of the next five years is: 2014-$229 million; 2015-$0; 2016-$250 million; 2017-$0; 2018-$0 and thereafter-$753 million.
Capital Trust III, which held the Trust Preferred Securities, was a variable interest entity in which Torchmark was not the primary beneficiary. Therefore, Torchmark was prohibited by accounting rules from consolidating Capital Trust III even though it had 100% ownership, complete voting control, and had guaranteed the performance of the trust. Accordingly, prior to redemption, Torchmark carried its 7.1% Junior Subordinated Debentures due to Capital Trust III as a liability under the caption “Due to Affiliates” on its Consolidated Balance Sheets. Expenses related to the original offering reduced long-term debt and were amortized over the forty-year redemption period.
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 excess cash flows. Share repurchases under this program were 5.5 million shares at a cost of $360 million in 2013, 7.5 million shares at a cost of $360 million in 2012, and 18.9 million shares at a cost of $788 million in 2011. When stock options are exercised, proceeds from the exercises are generally used to repurchase approximately the number of shares available with those funds in order to reduce dilution. Shares repurchased for dilution purposes were 1.9 million shares at a cost of $122 million in 2013, 4.3 million shares at a cost of $210 million in 2012, and 4.4 million shares at a cost of $185 million in 2011.
Retirement of Treasury Stock: Torchmark retired 5 million shares of treasury stock in 2013, 6.5 million in 2012, and 7.5 million in 2011.
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 dividends to the parent company in the amount of $488 million in 2013 and $437 million in 2012. In 2011, subsidiaries of Torchmark paid $769 million in dividends to the parent company, including $305 million available from the proceeds from the sale of United Investors completed in 2010. As of December 31, 2013, dividends and transfers from insurance subsidiaries to parent available to be paid in 2014 were limited to the amount of $451 million without regulatory approval, such that $878 million was considered restricted net assets of the subsidiaries. The Company believes that total dividends and transfers of $471 million will be available to the parent in 2014. Please refer to Schedule II. Condensed Financial Information of Registrant for more information about Torchmark’s transactions with its subsidiaries. While there are no legal restrictions on the payment of dividends to shareholders from Torchmark’s retained earnings, retained earnings as of December 31, 2013 were restricted by lenders’ covenants which require the Company to maintain and not distribute $3.18 billion from its total consolidated retained earnings of $3.55 billion.
Stock options to purchase 3.5 million shares during the years 2011 were considered to be anti-dilutive and are excluded from the calculation of diluted earnings per share. There were no anti-dilutive shares in 2013 and 2012. Income available to common shareholders for basic earnings per share is equivalent to income available to common shareholders for diluted earnings per share.
A summary of stock compensation activity for each of the three years ended December 31, 2013 is presented below:
An analysis of option activity for each of the three years ended December 31, 2013 is as follows:
Certain senior executives of the Company have been granted performance shares. On February 27, 2013, a grant was made of 99 thousand performance shares at a price of $56.10 per share for an aggregate grant price of $5.5 million. On February 21 and 22, 2012 grants were made of 80 thousand performance shares with grant prices ranging from $48.72 to $49.09 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 99 thousand shares and 80 thousand shares for the 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 197 thousand shares for the 2013 grants, and 0 to 160 thousand shares for the 2012 grants. The performance shareholders are not entitled to dividend equivalents, and are not entitled to dividend payments until vested and settled.
Restricted stock units outstanding at each of the year ends 2013, 2012, and 2011 were 57,145, 53,272, and 42,938, respectively. Restricted stock units are only available to directors, and are not converted to shares until the director’s retirement, death, or disability. There were no unvested director restricted shares outstanding at the end of any of the years 2011 through 2013. Director restricted stock and restricted stock units are generally granted on the first working day of the year and vest in six months. Dividend equivalents are earned on restricted stock units only. They are granted in the form of additional restricted stock units and vest immediately upon grant.
The measure of profitability for the Investment segment is excess investment income, which represents the income earned on the investment portfolio in excess of net policy requirements and financing costs associated with Torchmark’s debt. Other than the above-mentioned interest allocations and an intersegment commission, there are no other intersegment revenues or expenses. Expenses directly attributable to corporate operations are included in the “Corporate” category. Stock-based compensation expense is considered a corporate expense by Torchmark management and is included in this category. All other unallocated revenues and expenses on a pretax basis, including insurance administrative expense, are included in the “Other” segment category.
Torchmark holds a sizeable investment portfolio to support its insurance liabilities, the yield from which is used to offset policy benefit, acquisition, administrative and tax expenses. This yield or investment income is taken into account when establishing premium rates and profitability expectations of its insurance products. In holding such a portfolio, investments are sold, called, or written down from time to time, resulting in a realized gain or loss. These gains or losses generally occur as a result of disposition due to issuer calls, a downgrade in credit quality, compliance with Company investment policies, or other reasons often beyond management’s control. Unlike investment income, realized gains and losses are incidental to insurance operations, and only overall yields are considered when setting premium rates or insurance product profitability expectations. While these gains and losses are not relevant to segment profitability or core operating results, they can have a material positive or negative result on net income. For these reasons, management removes realized investment gains and losses when it views its segment operations.
The following tables set forth a reconciliation of Torchmark’s revenues and operations by segment to its major income statement line items.
Concentrations of Credit Risk: Torchmark maintains a diversified investment portfolio with limited concentration in any given issuer. At December 31, 2013, the investment portfolio, at fair value, consisted of the following:
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, 2013, based on fair value:
At year-end 2013, 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 $681 million, amortized cost was $566 million, and fair value was $523 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, 2013, 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, 2013, Torchmark had no liability with respect to these guarantees.
Equipment leases: Torchmark has guaranteed performance of a subsidiary as lessee under two leasing arrangements for aviation equipment. One of the leases expires in January, 2017 and the other expires in August, 2019. At December 31, 2013, total remaining undiscounted payments under the leases were approximately $6.5 million. Torchmark (parent company) would be responsible for any subsidiary obligation in the event the subsidiary did not make payments or otherwise perform under the terms of the lease.
Unclaimed Property Audits. Torchmark subsidiaries are currently the subject of audits regarding the identification, reporting, and escheatment of unclaimed property arising from life insurance policies and a limited number of annuity contracts. These audits are being conducted by private entities that have contracted with forty seven states through their respective Departments of Revenue, and have not resulted in any financial assessment from any state nor indicated any Company liability. These audits are wide-ranging, and seek large amounts of data regarding claims handling, procedures, and payments of contract benefits arising from unreported death claims. Additionally, the Torchmark subsidiary companies
are the subject of multiple regulatory departments’ inquiries and examinations with similar focus on abandoned property and unreported claims, but also which deal with the accounting for general expenses, commissions, and other payments. These audits and examinations could result in additional payments to insurance beneficiaries, the escheatment of abandoned property to various states, and/or possible administrative penalties. Amounts that could be payable to insurance beneficiaries and to the states for the escheatment of abandoned property represent insurance liabilities and are included in the Company’s estimate of policy benefits under the caption “Total policy liabilities” on the Consolidated Balance Sheets. No estimate of range can be made for loss contingencies related to possible administrative penalties at this time.
In January 2013, the West Virginia Treasurer filed actions against Torchmark subsidiaries, United American, Globe and American Income in the Circuit Court of Putnam County, West Virginia (State of West Virginia ex rel. John D. Perdue v. United American Insurance Company, et al, Civil Action No. 12-C-439). The actions, which also name numerous other unaffiliated insurance companies, allege violations of the West Virginia Uniform Unclaimed Property Act and seek to compel compliance with that Act through the reporting and remittance of unclaimed life insurance proceeds to the State Treasurer as administrator of the West Virginia Unclaimed Property Fund. This litigation was stayed as to these Torchmark subsidiaries pending completion of the unclaimed property audits being conducted by various State Departments of Revenue, discussed more fully under the caption Unclaimed Property Audits in this footnote, and a motion to dismiss the West Virginia litigation was subsequently granted as to all defendants in the case by the Court in January 2014. West Virginia has filed an appeal of this decision and thus, the stay of the litigation against the Torchmark subsidiaries has been reinstated.