SCL leases its home office complex at 20 Security Drive, Avon, Connecticut under a lease agreement which provides for a 25-year lease period that expires in 2009 and contains options for SCL to renew the lease thereafter for six additional terms of five years each. The lease agreement also grants to SCL (i) a right to purchase the property at fair market value on the last day of the 25-year period or any renewal period and (ii) a right of first refusal to purchase the property upon the terms and conditions of any offer by a third party. The annual rental payment was $1.3 million for 1996. SCL also leases an office suite at Suite 304, 740 North Blue Parkway, Lee's Summit, Missouri for an annual cost of approximately $10,000. The lease term expires February 28, 1998 and can be extended for three additional periods of one year each.
1. Prevailing interest rate levels, which may affect the ability of the Company to sell its products, mortality experience, the market value of the Company's investments and the lapse rate of the Company's policies, notwithstanding product design features intended to enhance persistency of the Company's products. 2. Changes in the federal income tax laws and regulations which may affect the relative tax advantages of the Company's products. 3. Changes in the regulation of financial services, including bank sales and underwriting of insurance products, which may affect the competitive environment for the Company's products. 4. Other factors affecting the performance of the Company, including, but not limited to, stock market performance, litigation and industry insolvencies.
The demand for life insurance and tax-advantaged investment products should continue to increase as the aging population grows and becomes more aware of the need for income protection and retirement savings. According to the American Council of Life Insurance ("ACLI"), life insurance companies have realized significant growth with total industry assets increasing at a compound annual growth rate of approximately 8% from 1991 to 1995, from $1.6 trillion in 1991 to $2.1 trillion in 1995. In addition, based on ACLI data, life insurance in-force increased at a compound annual growth rate of approximately 6% from 1991 to 1995, from $10.0 trillion in 1991 to $12.6 trillion in 1995. The market for annuity products has grown significantly as well. According to the ACLI, annuity premiums have grown at an average rate of more than 10% per year since 1991. Individual annuity considerations increased from $51.7 billion in 1991 to $77.4 billion in 1995, according to ACLI data.
Premiums - Premiums decreased $5.8 million or 9.1% from $64.1 million in 1995 to $58.3 million in 1996 primarily due to the decrease in single premium immediate annuity premiums of $8.4 million and an increase in ceded premiums under various reinsurance agreements of $16.7 million, partially offset by an increase in term insurance premiums of $9.0 million and assumed reinsurance premiums of $9.5 million.
Net Investment Income - Net investment income increased $3.4 million, or 2.6%, from $132.0 million in 1995 to $135.4 million in 1996. This reflects the increase in the cost basis of invested assets, offset by a lower effective yield on such assets. The amortized cost of invested assets was $1.8 billion at December 31, 1996 compared to $1.7 billion at December 31, 1995, reflecting an increase due to cash flow from sales of life insurance and annuities. The effective yield on invested assets was 7.6% for 1996 compared with 7.9% for 1995.
Benefits and Reserve Increases - Benefits and reserve increases decreased $14.7 million, or 7.0%, from $207.6 million in 1995 to $192.9 million in 1996. Life and annuity benefits decreased $9.6 million, or 9.4%, from $99.7 million in 1995 to $90.1 million in 1996. The Company's life claim experience for 1996 was favorable compared to plan by $2.8 million, or approximately $0.21 per share, after-tax, and was approximately $7.4 million below 1995. Interest credited to policyholders decreased $2.1 million, or 2.4%, from $87.0 million in 1995 to $84.9 million in 1996 due primarily to a slight decrease in crediting rates as a result of rate resets on contract anniversary dates.
Federal Income Taxes - Federal income taxes increased $5.9 million from $12.3 million in 1995 to $18.2 million in 1996. This was primarily due to higher pre-tax operating income. Effective tax rates were 34.0% and 33.8% in 1996 and 1995, respectively, compared to a statutory rate of 35%.
Year Ended December 31, 1995 compared to Year Ended December 31, 1994
Premiums - Premiums decreased $2.4 million, or 3.6%, from $66.5 million in 1994 to $64.1 million in 1995 due principally to a decrease in accident and health premiums from $4.8 million in 1994 to $2.5 million in 1995.
On a statutory-basis, the Company's first year annualized life premiums on new life insurance sales for individual life insurance increased $0.2 million, or 0.4%, from $46.7 million in 1994 to $46.9 million in 1995. This was primarily the result of a 9.5% increase in universal life sales offset by a 8.8% decrease in term life insurance sales. Annualized annuity sales decreased $83.3 million or 46.0% from $181.0 million in 1994 to $97.7 million in 1995 due primarily to the changing interest rate environment that had made longer-term annuities less attractive than other investments such as certificates of deposit and equity securities and the Company's election to maintain interest rate spreads on its annuity products. First year annualized life premium from Lincoln Financial Group ("LFG") in 1995 accounted for approximately $6.6 million or 14.1% of the Company's total, compared with $6.6 million or 14.2% in 1994. LFG annuity sales in 1995 were $6.3 million, or 6.4% of the Company's total, compared with $13.3 million, or 7.3% in 1994. The level of life sales produced by LFG for SCL in 1996 was expected to decrease as LNC subsidiaries are manufacturing similar life products which LFG was permitted to sell in 1996.
Insurance Fees - Insurance fees increased $8.6 million, or 7.4%, from $116.9 million in 1994 to $125.5 million in 1995, reflecting primarily an increase in the mortality and expense assessments for universal life products of $4.8 million and $5.0 million, respectively. The mortality and expense assessment increases resulted from (i) increased sales of universal life products, (ii) growth of in-force universal life business from $12.4 billion at December 31, 1994 to $13.4 billion at December 31, 1995 and (iii) aging of the in-force business resulting in higher average mortality charges.
Net Investment Income - Net investment income increased $16.6 million, or 14.3%, from $115.4 million in 1994 to $132.0 million in 1995. This reflects the increase in the amount of invested assets and a slightly higher effective yield on such assets. The amortized cost of invested assets was $1.7 billion at December 31, 1995 compared to $1.6 billion at December 31, 1994, reflecting an increase due to cash flow from sales of life insurance and annuities. The effective yield on invested assets was 7.8% for 1994 compared with 7.9% for 1995.
Federal Income Taxes - Federal income taxes decreased $0.5 million from $12.8 million in 1994 to $12.3 million in 1995. This was primarily due to lower pre-tax operating income. Effective tax rates were 33.8% and 33.7% in 1995 and 1994, respectively compared to a statutory rate of 35%.
On June 8, 1995, the Company registered $100 million of debt securities on Form S-3 with the Securities and Exchange Commission. The Company sold $75 million of medium term debt securities ("Debt") on March 1, 1996 and used $65 million of the net proceeds to repay the Term Note to LNL. The remainder of the proceeds was used for general corporate purposes. The Debt has an effective rate of 7.39% and is due March 1, 2003 and may not be redeemed prior to maturity. Interest on the Debt is payable semiannually in arrears on March 1 and September 1 of each year. Interest payments began on September 1, 1996.
The Company's net cash flows used in operating activities were $69.0 million in 1996, $60.7 million in 1995 and $38.5 million in 1994. The cash flow statement for the Company has been prepared in accordance with Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows" ("FAS 95") which requires deposits of a financial institution to be recorded as financing activities. As universal life and single premium deferred annuity contracts are similar to deposits of a financial institution, cash receipts from policyholders and payments that represent a return of policyholder balances have been reported as financing activities in the Company's statement of cash flows. Net cash receipts of $126.1 million, $180.0 million and $265.1 million from these contracts were reported in financing activities in 1996, 1995 and 1994, respectively. If these net cash receipts are considered in conjunction with the Company's net cash used in operating activities, then cash derived from operating activities for 1996, 1995 and 1994 were $57.1 million, $119.3 million and $226.6 million, respectively. Operating cash flows in 1996 were negatively impacted by higher insurance and operating expenses.
At December 31, 1996, the fair value of Security-Connecticut's investment in fixed maturity securities was $1.6 billion, 93.8% of which were investment-grade securities. This includes $368.5 million, or 23.2% of the investment-grade securities that were invested in fixed maturity securities rated BBB by S&P, which represents the lowest category of investment grade, or were of a comparable credit quality. A rating of "BBB," according to S&P, indicates that the security "exhibits adequate protection parameters, but adverse economic conditions or changing circumstances are more likely to lead to weakened capacity to pay." Security-Connecticut maintains approximately 66.7% ($1.2 billion at December 31, 1996) of its invested assets in cash, equities and highly liquid investment-grade securities, which could be sold to meet unusual liquidity needs.
The Company has entered into several interest rate cap agreements as a hedge against rising interest rates in its SPDA investment portfolio. As of December 31, 1996, these agreements established cap rates ranging from 7.07% to 12.5% on notional principal of $510 million with termination dates through 2001. The aggregate cost of $3.6 million is being amortized to net investment income over the effective life of the caps. These investments are reported as fixed maturity securities and classified as available-for-sale and are carried at fair value ($1.9 million as of December 31, 1996) with unrealized gains and losses reported in shareholders' equity. The Company is exposed to credit loss in the event of non-performance by counterparties on the caps. Due to the high quality rating of the counterparties, the Company does not anticipate non-performance by any of the counterparties. The amount of such exposure is approximately the unrealized gain in such contracts as interest rates rise.
SCL's capital and surplus increased from $121.8 million at December 31, 1992 to $148.3 million at December 31, 1996, due to favorable earnings offset, in part, by dividends paid to its parent. It is expected that SCL will continue to make dividend payments to its parent and continue to add new business, which may result in a decline of surplus. Even if SCL's surplus increases, the ratings from A.M. Best, S&P and Moody's could be subject to a downgrade as the Company experienced in November 1996 by A.M. Best. If a downgrade were to materialize, sales of the Company's products could be adversely affected. The Company continues to pursue courses of action, such as expense containment and limits on capital purchases, which could help mitigate any future decrease in surplus or rating reclassifications. There are no assurances that any of these, or other actions, would result in alleviating future surplus declines or rating reclassifications.
Interest rate changes may have temporary effects on the sale and profitability of the universal life and annuity products offered by the Company. For example, if interest rates rise, competing investments (such as annuities or life insurance offered by the Company's competitors, certificates of deposit, mutual funds, and similar instruments) may become more attractive to potential purchasers of the Company's products until the Company increases the rate credited to holders of its universal life and annuity products. The Company monitors interest rates with respect to a spectrum of durations and sells policies and annuities that permit flexible responses to interest rate changes as part of the Company's management of interest spreads.
The consolidated financial statements of Security-Connecticut and subsidiaries follow on pages 30 through 58.
The unaudited operating results by quarter are reported in Note 14 of the consolidated financial statements of Security-Connecticut Corporation.
We have audited the accompanying consolidated balance sheets of Security-Connecticut Corporation as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(2). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
SECURITY-CONNECTICUT CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data)
BENEFITS AND EXPENSES Benefits and reserve increases 192,933 207,558 177,094 Insurance and other expenses 91,843 85,203 83,310 ---------- --------- --------- Total benefits and expenses 284,776 292,761 260,404 --------- --------- ---------
Federal income taxes 18,226 12,286 12,808 --------- --------- --------- NET INCOME $ 35,345 $ 24,110 $ 25,159 ========= ========= =========
EARNINGS PER COMMON SHARE $ 4.10 $ 2.81 $ 2.94 ========= ========= =========
On October 13, 1993, Lincoln National Life Insurance Company ("LNL") formed the Company to serve as a holding company for SCL and its subsidiary LSL. On January 19, 1994, LNL effected a reorganization in which it contributed $10 million in capital and all of the outstanding shares of SCL to the Company in exchange for 8,500,000 shares of the Company's Common Stock and a Term Note in the principal amount of $65 million. On February 2, 1994, LNL sold 100% of the outstanding common stock of the Company in an Initial Public Offering ("IPO") for $187 million. All of the proceeds of the IPO, net of related issuance expenses, were received by LNL. Also at that date, certain officers were granted 47,727 shares of stock subject to restrictions which lapsed upon repayment of the Term Note on March 1, 1996. The Company sold $75 million of medium term debt securities on March 1, 1996 and used $65 million of the net proceeds to repay the Term Note to LNL. (See Note 4)
On February 23, 1997, ReliaStar Financial Corp. ("ReliaStar") and Security-Connecticut signed a definitive agreement to combine the two companies through the merger of Security-Connecticut into ReliaStar in a stock-for-stock exchange (see Notes 7, 9 and 13).
Interest rate caps are used as part of an overall interest rate risk management strategy for certain annuity products primarily to hedge the risk of investment losses due to product surrenders in an increasing interest rate environment. The cost is amortized over the lives of the caps. Interest rate caps are reported as fixed maturity securities and classified as available-for-sale and, accordingly, are carried at fair value with unrealized gains and losses reported as a separate component of shareholders' equity.
Interest assumptions for traditional direct individual life reserves for all policies range from 2.25% level to 10.00% level. Mortality assumptions for traditional life business issued prior to mid-1987 are equal to varying percentages of the 1965-70 Select and Ultimate Table depending on age, duration and underwriting classification; for issues after mid-1987, the underlying table is the 1975-80 Select and Ultimate Table. Withdrawal assumptions are based on Company experience and vary by plan and policy duration.
The Company is involved in both the cession and assumption of reinsurance with other companies, including former affiliates. The Company has established retention limits which it believes are appropriate for its business. The portion of risk that exceeds the retention limits is reinsured with other insurers.
Risk associated with universal life and traditional life insurance is reinsured through first dollar quota share, yearly renewable-term and co-insurance reinsurance contracts. Expenses associated with ceded reinsurance are recognized over the life of the reinsured policies.
The Company grants stock options for a fixed number of shares to employees, with an exercise price equal to the fair value of the shares at the date of the grant. The Company accounts for stock option grants in accordance with APB Opinion No. 25 and, accordingly, recognizes no compensation expense for the stock option grants.
Certain 1995 and 1994 amounts have been reclassified to conform to the 1996 presentation. These reclassifications had no impact on the previously reported net income.
In October 1995, the FASB issued Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS 123") which became effective in 1996, and provides an alternative to APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"), in accounting for stock-based compensation issued to employees. FAS 123 allows for a fair value based method of accounting for employee stock options and similar equity instruments. However, for companies that continue to account for stock-based compensation arrangements under APB No. 25, FAS 123 requires disclosure of the pro-forma effect on net income and earnings per share of its fair value based accounting for those arrangements. The Company has not adopted the recognition and measurement provisions of FAS 123 and will continue to account for stock-based compensation under APB No. 25. Accordingly, adoption of FAS 123 only requires additional financial statement footnote disclosures. See Note 7 for disclosures.
In June 1996, the FASB issued Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," which requires an entity to recognize the financial and servicing assets it controls and the liabilities it has incurred and to derecognize financial assets when control has been surrendered in accordance with the criteria provided in the Statement. The Company will apply the new rules prospectively to transactions beginning in the first quarter of 1997. Based on current circumstances, the Company believes the application of the new rules will not have a material impact on the financial statements.
Increases (decreases) in provisions for losses, which are included in the realized gains (losses) on investments shown above are as follows:
Year ended December 31, --------------------------------- 1996 1995 1994 --------- --------- --------- (000s omitted)
Mortgage loans on real estate $ (896) $ (852) $ (2,586) Policy loans 22 21 19 Other invested assets (4,601) 2,976 1,625 --------- --------- --------- Total $ (5,475) $ 2,145 $ (942) ========= ========= =========
The components of the balance sheet caption "net unrealized gains (losses) on securities available-for-sale" in shareholders' equity are summarized as follows: December 31, ----------------------------------- 1996 1995 1994 ---------- ---------- --------- (000s omitted)
Fair value of securities $1,589,239 $1,570,907 $1,267,342 Amortized cost of securities 1,557,797 1,473,405 1,326,460 ---------- ---------- --------- Net unrealized gains (losses) 31,442 97,502 (59,118) Adjustments: DAC (16,563) (47,526) 21,002 Other policy liabilities 1,832 5,012 (2,280) Deferred income taxes (5,838) (19,240) (6,334) ---------- ---------- --------- Net unrealized gains (losses) on available-for-sale securities $ 10,873 $ 35,748 $ (46,730) ========== ========== ==========
The Company's recorded investment in impaired mortgage loans, net of allowances for loan losses, was $4.2 million, and $7.7 million, as of December 31, 1996 and 1995, respectively. The average recorded investment in impaired mortgage loans was $2.1 million, $1.5 million and $1.8 million for December 31, 1996, 1995 and 1994, respectively. Interest income of $0.6 million, $0.9 million and $1.8 million was recorded in 1996, 1995 and 1994, respectively. Progression of the allowance for loan losses for impaired mortgage loans is as follows:
The Company has entered into several interest rate cap agreements, as a hedge against rising interest rates in its single premium deferred annuity investment portfolio. As of December 31, 1996, these agreements established cap rates ranging from 7.07% to 12.5% on notional principal of $510 million with termination dates through 2001. The aggregate cost of $3.6 million is being amortized to net investment income over the effective life of the caps. These investments are reported as fixed maturity securities and classified as available-for-sale and are carried at fair value ($1.9 million and $0.7 million in 1996 and 1995, respectively) with unrealized gains and losses reported in shareholders' equity. The Company is exposed to credit loss in the event of non-performance by counterparties on the caps. Due to the high quality rating of the counterparties, the Company does not anticipate non-performance by any of the counterparties. The amount of such exposure is approximately the unrealized gain in such contracts as interest rates rise.
At December 31, 1995, the Company was obligated under a note payable to LNL for $65 million which bore interest at the 90-day LIBOR rate plus 0.75%. The note payable was incurred in connection with the pre-IPO reorganization (see Note 1).
Year ended December 31, ------------------------------ 1996 1995 1994 -------- -------- -------- (000s omitted) Current $ 25,075 $ 20,247 $ 10,804 Deferred (6,849) (7,961) 2,004 -------- -------- -------- Total $ 18,226 $ 12,286 $ 12,808 ======== ======== ========
Tax rate times pre-tax income $ 18,750 $ 12,739 $ 13,288 Effect of: Tax-exempt investment income (212) (295) (397) Goodwill amortization 317 317 317 R&D tax credit (336) Other (293) (475) (400) -------- -------- -------- Provision for income taxes $ 18,226 $ 12,286 $ 12,808 ======== ======== ======== Effective tax rate 34.0% 33.8% 33.7% ======== ======== ========
December 31, --------- --------- 1996 1995 --------- --------- (000s omitted) Total deferred tax liabilities: DAC $ 107,486 $ 93,606 Unrealized gains on available-for-sale securities 11,005 34,126 Other 6,183 9,244 --------- --------- Total deferred tax liabilities 124,674 136,976
Total deferred tax assets: Acquired insurance in-force 16,540 18,388 Liabilities for future policy benefits and claims 61,339 54,160 Acquisition load liability 16,817 11,618 Tax basis adjustments on invested assets (258) 1,859 Other 8,817 9,241 --------- --------- Total deferred tax assets 103,255 95,266 --------- --------- Net deferred tax liability $ 21,419 $ 41,710 ========= =========
For purposes of pro-forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro-forma information follows (in thousands except for earnings per share information): 1996 1995 ---------- ----------
The preceding pro-forma disclosures are not indicative of future amounts until the new rules are applied to all outstanding nonvested awards; and since the FASB 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro-forma effect will not be fully reflected until 1997.
A summary of the Company's stock option activity, and related information for the three years ended December 31, 1996 follows:
Exercise prices for options outstanding as of December 31, 1996 ranged from $19.25 to $33.875. The weighted-average remaining contractual life of those options is 7.8 years.
The Company has adopted an Employees' Retirement Plan, which is a noncontributory, defined benefit plan (the "Retirement Plan"), and covers all employees of the Company who meet age and service requirements. Benefits for employees are based on total years of service and the highest 60 months of compensation during the last 10 years of employment. The plan is funded by contributions to a tax-exempt trust. The Company's funding policy is consistent with the funding requirements of federal law and regulations. Contributions are intended to provide not only benefits attributable to service to date, but also those expected to be earned in the future. Plan assets consist principally of deposits in separate accounts of LNL.
The Company also sponsors unfunded, nonqualified defined benefit pension plans. A supplemental retirement plan provides employees with defined pension benefits in excess of limits imposed by federal tax law, and a salary continuation plan provides certain officers of the Company with defined pension benefits based on years of service and final average salary as well as with a pre-retirement death benefit.
The status of the funded defined benefit pension plan and the amounts recognized on the balance sheets were as follows: December 31, ------------------- 1996 1995 -------- -------- (000s omitted) Actuarial present value of benefit obligation: Vested benefits $ (5,445) $ (4,760) Nonvested benefits (86) (140) -------- -------- Accumulated benefit obligation (5,531) (4,900) Effect of projected future compensation increases (3,442) (3,127) -------- -------- Projected benefit obligation (8,973) (8,027) Plan assets at fair value 8,871 8,132 -------- -------- Plan assets in excess of (less than) projected benefit obligations (102) 105 Unrecognized transition asset (117) (126) Unrecognized net gain (1,255) (946) -------- -------- Pension liability included in other liabilities $ (1,474) $ (967) ======== ========
The status of the unfunded nonqualified defined benefit pension plans and the amounts recognized on the balance sheets were as follows:
Determination of the projected obligation for the defined benefit plans was based on an assumed discount rate of 7.75% and 7.5% for December 31, 1996 and 1995, respectively. The assumed long-term rate of increase in compensation was 4.5% (6.5% for the salary continuation plan) for December 31, 1996 and 1995. The assumed long-term rate of return on plan assets was 9.0% for 1996, 1995 and 1994.
The Company also sponsors a contributory defined contribution plan for eligible employees. The Company's contributions to the plan are equal to a participant's pre-tax contributions, not to exceed 6% of base pay, multiplied by a percentage, ranging from 25% to 100%, which varies according to the achievement of predetermined goals. Expenses for the plan amounted to $0.7 million, $0.2 million and $0.7 million in 1996, 1995 and 1994, respectively.
Year ended December 31, ------------------------ 1996 1995 1994 ------- ------- ------- (000s omitted) Service cost $ 27 $ 193 $ 183 Interest cost 28 174 153 Amortization of prior service costs (116) (28) Amortization of (gain) loss (1) 10 ------- ------- ------- Net periodic postretirement (benefit) cost $ (62) $ 349 $ 336 ======= ======= =======
The calculation of the accumulated postretirement benefit obligation assumes a weighted-average annual rate of increase in the per capita cost of covered benefits (i.e. health care cost trend-rate) of 3.5% for 1996 and thereafter and a long-term rate of increase in compensation of 4.5% for December 31, 1996 and 1995, respectively. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.75% and 7.5% for December 31, 1996 and 1995, respectively. A one percentage point increase in the assumed health care cost trend-rate would not be material to the financial statements.
Life insurance companies are subject to certain Risk-Based Capital ("RBC") requirements as specified by the NAIC. Under those requirements, the amount of capital and surplus maintained by the life insurance company is to be determined based on the various risk factors related to it. At December 31, 1996, the Company met the RBC requirements.
The Company's Board of Directors has adopted a Shareholder Rights Plan. The rights provide protection against coercive or unfair takeover tactics, and are intended to encourage anyone seeking to acquire the Company to negotiate with the Board of Directors first. The plan was not adopted in response to any known effort to acquire the Company. This plan is similar to plans adopted by many public companies, and should provide a sound and reasonable means of safeguarding the interest of all shareholders if an effort is made to acquire the Company at a price not reflective of its fair value. The distribution of the rights were made on March 6, 1995, payable to shareholders of record at the close of business on that date. The rights expire on February 16, 2005. The rights distribution is not taxable to shareholders. Pursuant to the merger agreement the Company signed with ReliaStar, prior to the effective date of the merger, Security-Connecticut intends to amend the Shareholder Rights Plan to provide for the expiration of the rights issued under the plan prior to the effective date of the merger.
The following table reconciles consolidated net income and shareholders' equity as reported herein on the basis of GAAP with SCL's consolidated statutory-basis net income and consolidated statutory-basis capital and surplus. SCL's consolidated results include those of its wholly owned subsidiary, LSL.
Consolidated GAAP income $ 35,345 $ 24,110 $ 25,159 Eliminate parent company loss 4,693 3,271 2,814 Eliminate AHL income (2,955) --------- --------- --------- SCL consolidated GAAP income 37,083 27,381 27,973 Add (subtract) GAAP adjustments: DAC (21,883) (28,216) (34,274) Deferred income tax expense (5,913) (6,199) 3,519 Change in future policy benefits 16,554 22,057 5,471 Policyholders' share of earnings on participating business 355 335 1,002 Acquired insurance in-force and goodwill 1,586 1,630 1,742 Other (6,391) (2,731) 4,518 --------- --------- ---------
Data processing for the Company is provided by Electronic Data Systems Corporation ("EDS"). Pursuant to an agreement expiring December 31, 2011, EDS provides the Company with services, including: (i) systems development and operations for existing products and in-force business, (ii) technology planning, (iii) programming and development for new products and (iv) ongoing systems management. The agreement was amended effective October 1, 1996. The amendment extended the term of the agreement from 2008 to 2011. It also provides for various termination options available to the Company after December 31, 1998, provided 12 months written notice is given. If the agreement is terminated between December 1998 and 2001 the Company must pay EDS a termination fee. If termination occurs on or subsequent to December 31, 2001, no additional fee must be paid. The Company incurred expenses of $7.8 million, $7.7 million and $8.4 million in 1996, 1995 and 1994, respectively, for services provided under the EDS agreement. Future minimum service costs are as follows (000s omitted) at December 31, 1996:
1997 $ 4,126 1998 4,007 1999 3,918 2000 3,809 2001 3,705 Thereafter 23,555 --------- Total $ 43,120 =========
December 31, ------------------------------ 1996 1995 1994 -------- -------- -------- (000s omitted)
The amortization, net of interest accretion, is included in insurance and other expenses in the accompanying consolidated statements of income. During each of the next five years, the balance of the value of acquired insurance in-force at December 31, 1996 is expected to decrease (representing the net of amortization and interest accretion) at a rate of approximately 8% per year.
The Company is involved in litigation concerning policy terms and benefits and the actions of independent agents, which seek both punitive and compensatory damages. Management believes these suits are substantially without merit, that valid defenses exist, and that the results of such litigation will not have a material adverse effect on the accompanying financial statements.
In June 1995, the Pennsylvania court ordered the case certified as a class action. The court later limited the class to Pennsylvania residents "who purchased life insurance policies from Security-Connecticut Life Insurance Company designated as 'Premium Rate Class Special Non-Smoker' on or after November 17, 1986." SCL has filed a motion for revocation of class certification. Management believes this suit is without merit and will continue to vigorously defend the action.
Plaintiffs seek contractual damages, punitive damages, attorneys' fees and the imposition of a constructive trust as to any excess amounts allegedly paid by the plaintiffs. The parties are presently pursuing settlement discussions; however, management does not believe that any resulting settlement would be material to the Company's financial statements.
Semler vs. First Colony Life Insurance Company, et al., Superior Court, San Francisco, California.
The plaintiff seeks restitution, injunctive relief, attorneys' fees and expenses. Management believes this suit is without merit and will vigorously defend the action.
The increase in the number of insurance companies that are under regulatory supervision has resulted, and is expected to continue to result, in increased assessments by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated insurance companies. At December 31, 1996 and 1995, the Company held a liability for $3.3 million and $8.4 million, respectively, to cover its share of estimated guaranty fund assessments. This liability was based on estimates provided by the National Organization of Life and Health Guaranty Associations ("NOLHGA"). Mandatory assessments may be partially recovered through a reduction in future premium taxes in certain states; and at December 31, 1996 and 1995, the Company recorded an asset of $4.5 million and $6.1 million, respectively, for such expected recoveries.
In the fourth quarter of 1996, lower-than-expected life claims increased after-tax earnings by $0.18 per share. A release of a portion of the liability held for anticipated guaranty fund assessments based on the Company's understanding of information provided by NOLHGA also increased after-tax earnings by $0.25 per share. Partially offsetting these positive factors in 1996 was a $0.20 per share increase in litigation expenses, including additions to reserves, compared to 1995.
In the fourth quarter of 1995, a charge of $0.26 per share, after tax, was incurred for anticipated guaranty fund assessments based on the Company's understanding of information provided by NOLHGA. Also, in the fourth quarter of 1995, higher-than-expected life claims reduced after-tax earnings by $0.41 per share.
Due to changes in the number of average common stock and equivalent shares outstanding, quarterly earnings per share may not add to the totals for the years.