Independence Holding Company, a Delaware corporation ("IHC"), is a holding company engaged principally in the life and health insurance business through its wholly-owned subsidiaries, Standard Security Life Insurance Company of New York ("Standard Life") and Madison National Life Insurance Company, Inc. ("Madison Life") and their subsidiaries (collectively, the "Insurance Group"). IHC and its subsidiaries (including the Insurance Group) are collectively referred to as the "Company." Corporate consists of investment income from parent company liquidity, interest expense on debt and general expenses associated with parent company activities (see Item 1 for a discussion of the Company's business).
The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States ("GAAP") and to general practices within the insurance industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. A summary of the Company's significant accounting policies can be found in Note 1 of the Notes to the Consolidated Financial Statements included in Item 8. Management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of the Company's consolidated financial statements and management's discussion and analysis.
The Company accounts for its investments in debt and equity securities under Statement of Financial Accounting Standards No. 115 ("SFAS 115"), Accounting for Certain Investments in Debt and Equity Securities. The Company has classified all of its investments as available-for-sale securities. These investments are carried at fair value based on quoted market prices with unrealized gains and losses reported in accumulated other comprehensive income (loss) in the accompanying consolidated balance sheets. Net realized gains and losses on investments are computed using the specific identification method and are reported in the accompanying consolidated statements of operations. Declines in value judged to be other-than-temporary are determined based on the specific identification method and are reported in the accompanying consolidated statements of operations as net realized losses. The factors considered by management in determining when a decline is other than temporary include but are not limited to: the length of time and extent to which the fair value has been less than cost; the financial condition and near-term prospects of the issuer; adverse changes in ratings announced by one or more rating agencies; whether the issuer of a debt security has remained current on principal and interest payments; whether the decline in fair value appears to be issuer specific or, alternatively, a reflection of general market or industry conditions; and the Company's intent and ability to hold the security for a period of time sufficient to allow for a recovery in fair value. For securities within the scope of Emerging Issues Task Force Issue 99-20, such as purchased interest-only securities, an impairment loss is recognized when there has been a decrease in expected cash flows combined with a decline in the security's fair value below cost.
The Company's pre-tax income increased $3.0 million to $25.5 million for the year ended December 31, 2002 from $22.5 million for the same period in 2001. Net income was $15.8 million, or $1.98 per share, diluted, for the year ended December 31, 2002 compared to $14.4 million, or $1.80 per share, diluted, for the year ended December 31, 2001. The Company had net realized and unrealized losses of $7.6 million in 2002 compared to net gains of $4.3 million in 2001. The net loss in 2002 is primarily attributable to other than temporary impairments on certain investment securities (see Liquidity). Decisions to sell securities are based on cash flow needs, investment opportunities and economic and market conditions, thus creating fluctuations in gains and losses from year to year. Excluding net realized and unrealized gains and losses, the Company had pre-tax income of $33.1 million in 2002 as compared to $18.2 million in 2001, an increase of $14.9 million, which approximately consists of: a pre-tax gain of $8.1 million on the sale of a subsidiary, an increase in profitability from the stop-loss line of business, an increase in income from the group business and a pre-tax gain of $1.3 million on the sale of real estate. Income tax expense increased $1.5 million to $9.6 million in 2002 from $8.1 million in 2001 reflecting the increase in income and a higher effective income tax rate in 2002.
The Insurance Group's pre-tax income decreased $6.2 million to $20.0 million in 2002 from $26.2 million in 2001. These results include net realized and unrealized losses of $7.5 million in 2002 compared to net gains of $4.3 million in 2001. Pre-tax income excluding net realized and unrealized gains was $27.5 million in 2002 compared to $21.9 million in 2001, an increase of $5.6 million or 25%.
Total net investment income increased $1.7 million primarily due to an increase in assets slightly offset by a decrease in returns on certain market neutral partnerships. The annualized return on investments of the Insurance Group was 7.1% for 2002 and 6.8% in 2001.
Equity loss on AMIC amounted to $1.9 million in 2002, with no comparable amount for 2001. The Company purchased a 19.9% equity interest in AMIC on July 30, 2002 and accordingly recorded 19.9% of AMIC's losses from July 30, 2002 to December 31, 2002 under the equity method of accounting. This loss primarily relates to the wind-down of AMIC's previous Internet operations.
Other income increased $1.2 million due to an increase of $1.0 million in fee income earned at IndependenceCare due to an increase in premiums written in 2002 and $.2 million in additional income earned by RAS. Both of these subsidiaries were sold on November 14, 2002 to AMIC.
The Insurance Group's pre-tax income increased $6.7 million to $26.2 million in 2001 from $19.5 million in 2000. These results include net realized and unrealized gains of $4.3 million in 2001 compared to losses of $.2 million in 2000. Pre-tax income excluding net realized and unrealized gains was $21.9 million in 2001 compared to $19.7 million in 2000, an increase of 11%.
Total net investment income increased $.4 million primarily due to an increase in assets slightly offset by a decrease in returns on certain market neutral partnerships. These partnerships earned on average 6.8% in 2001 compared to 9.9% in 2000 due to the difficult investment markets in the after-math of September 11th. The annualized return on investments of the Insurance Group was 6.8% for 2001 and 7.1% in 2000.
The Company reviews its investments quarterly and monitors its investments continually for impairments. For the years ended December 31, 2002 and 2001, the Company recorded a realized loss for other than temporary impairments of $7.2 million and $1.2 million, respectively. In 2002, $6.4 million of the loss relates to an interest related impairment recognized on certain interest only securities ("IO Securities") resulting from expected prepayments of the mortgage obligations underlying the IO Securities due to falling interest rates. The Company has invested in IO Securities to help actively manage its interest rate exposure. Typically these securities account for less than 2% of IHC's total portfolio assets and are rated AAA or better. In a rising interest rate environment, IO Securities will increase in value which acts to mitigate the loss on the balance of the bond portfolio. In a decreasing interest rate environment, IO Securities will lose value, but there will be gains in the rest of the bond portfolio. Although these securities performed as expected, the Company applies the methodology of Emerging Issues Task Force 99-20, "Recognition of Interest Income and Impairment of Purchased and Retained Beneficial Interests in Securitized Financial Assets" ("EITF 99-20") in determining when an IO Security is considered other than temporarily impaired. The Company recorded a realized loss in 2002 under EITF 99-20, since there had been a decrease in expected cash flows combined with a decline in the IO Securities' fair value below cost.
The Company's gross unrealized losses on fixed maturities totaled $7.5 million at December 31, 2002. Substantially all of these securities were investment grade. The remaining unrealized losses, primarily within the corporate securities portfolio, have been evaluated in accordance with the Company's policy and were determined to be temporary in nature at December 31, 2002.
The Company holds all securities as available-for-sale and accordingly marks all of its securities to market through accumulated other comprehensive income. Therefore, any realized loss generated by impairment losses will have no economic impact on the Company's total stockholders' equity. Moreover, since every security is marked to market through
The following summarizes the estimated pre-tax change in fair value (based upon hypothetical parallel shifts in the U.S. Treasury yield curve) of the fixed income portfolio assuming immediate changes in interest rates at specified levels at December 31, 2002:
In the Company's analysis of the asset-liability model, a 100 to 300 basis point change in interest rates on the Insurance Group's liabilities would not be expected to have a material adverse effect on the Company. With respect to its liabilities, if interest rates were to increase, the risk to the Company is that policies would be surrendered and assets would need to be sold. This is not a material exposure to the Company since a large portion of the Insurance Group's interest sensitive policies are burial policies that are not subject to the typical surrender patterns of other interest sensitive policies, and many of the Insurance Group's universal life and annuity policies come from liquidated companies which tend to exhibit lower surrender rates than such policies of continuing companies. Additionally, there are charges to help offset the benefits being surrendered. If interest rates were to decrease substantially, the risk to the Company is that some of its investment assets would be subject to early redemption. This is not
Total investments increased $7.5 million to $544.6 million at December 31, 2002 largely due to an increase in fixed maturities. An increase in securities purchased under agreements to resell was offset by a decrease in equity securities. The $13.8 million increase in future insurance policy benefits reflects growth in the business. The $16.2 million increase in total stockholders' equity is due to net income generated in the year ended December 31, 2002, and an increase in unrealized gains on the fixed maturity investments partially offset by the net purchase of the Company's common stock.
In accordance with SFAS No. 115, the Company may carry its portfolio of fixed income securities either as held to maturity (carried at amortized cost), as trading securities (carried at fair market value) or as available-for-sale (carried at fair market value). The Company has chosen to carry all of its debt securities as available-for-sale. The Company experienced a change in unrealized gains of $1.6 million, net of deferred taxes of $1.0 million and net of deferred policy acquisition costs of $1.0 million in total stockholders' equity, reflecting net unrealized gains of $1.7 million at December 31, 2002 versus $.1 million at December 31, 2001. From time to time, as warranted, the Company employs investment strategies to mitigate interest rate and other market exposures.
As of March 2003, Standard Life and Madison Life expect to have in-force approximately $250 million of Medical Stop-Loss business through 17 MGUs. The Company and its affiliates own or have significant equity investments in 7 MGUs that, as of March 2003, expect to have an in-force block of over $165 million of Medical Stop-Loss. The Company expects to significantly increase its production of Employer Medical Stop-Loss in 2003 as a result of a full year of production from the 4 MGUs appointed in 2002, increased production for the Insurance Group from the MGUs that it owns or in which it has equity investments, MGU appointments, and acquisitions of new MGUs.
The Company has increased its average retention from 27% in 2002 to 33% in 2003. The Company made the decision to increase its retention largely because of its greater control over the MGUs that are producing and administering the business. In addition to controlling the MGUs which are owned by the Company and its affiliates or in which they have significant equity interests, the Company exerts great influence over its other MGUs through its high retention of risk and by working with only a selected group of reinsurers that share IHC's commitment to underwriting excellence. For all of its MGUs, Standard Life and Madison Life regularly audit the MGUs' compliance with the Company's underwriting, claims and policy issuance guidelines.
The Company owns 19.9% of the common stock of AMIC, and has tendered for approximately 12% more of AMIC's outstanding shares. AMIC is an insurance holding company that is currently engaged in the Medical Stop-Loss business through Independence American and the AMIC MGUs. IHC anticipates that AMIC will earn meaningful income in 2003.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses costs associated with an exit activity (including restructuring) or with disposal of long-lived assets. Those activities can include eliminating or reducing product lines, terminating employees and contracts, and relocating plan facilities and personnel. The provisions of SFAS 146 will not supersede the accounting requirements for costs to restructure operations acquired in a business combination. Under SFAS 146, companies are required to record a liability for a cost associated with an exit or disposal activity when that liability is incurred and can be measured at fair value. The new requirements are effective prospectively for exit and disposal activities initiated after December 31, 2002. The Company does not expect the adoption of SFAS 146 effective as of January 1, 2003 to have a material effect on its Consolidated Financial Statements.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). This interpretation provides guidance on the identification of entities controlled through means other than voting rights. FIN 46 specifies how a business enterprise should evaluate its interests in a variable interest entity to determine whether to consolidate that entity. A variable interest entity must be consolidated by its primary beneficiary if the entity does not effectively disperse risks among the parties involved. A public company with a variable interest in an entity created before February 1, 2003 must apply FIN 46 in the first interim or annual period beginning after June 15, 2003. The adoption of FIN 46 is not expected to have a significant effect on the Company's Consolidated Financial Statements.
At December 31, 2002, $429.2 million of the Company's $544.6 million investment portfolio was invested in fixed income securities. The fair market value of these fixed income securities and the investment income from these fixed income securities fluctuate depending on general economic and market conditions. With respect to the Company's investments in fixed income securities, the fair market value of these investments generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by the Company from future investments in fixed income securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Historically, the impact of market fluctuations has affected the Company's financial statements. Because all of the Company's fixed income securities are classified as available for sale, changes in the fair market value of the Company's securities are reflected in the Company's accumulated other comprehensive income. No adjustment is made for liabilities to reflect a change in interest rates. Therefore, interest rate fluctuations and economic conditions could adversely affect the Company's stockholders' equity, total comprehensive income and/or cash flows.
Restrictions on the size of risks insurable under a single policy;