WNC's home office building is a five-story, 175,000 square-foot office building located at 300 Tower Parkway, Lincolnshire, Illinois, that was first occupied by WNC in May, 1993. The building is being leased for a period of twenty years from a joint venture partnership in which Washington National Development Company (WNDC), a subsidiary of WNIC, has a one-third interest.
Washington National Corporation (WNC or the Company) is an insurance holding company that is engaged primarily in marketing and underwriting life insurance, annuities, medical, disability, and specialty insurance for individuals and groups. The major operating subsidiaries of the Company are Washington National Insurance Company (WNIC) and United Presidential Life Insurance Company (UPI).
In 1988, the Company began restructuring to narrow its focus on fewer businesses, reduce its work force, and recruit new operating managers with significant insurance industry experience. Since that time, the operating businesses have continually adjusted their specific strategies to remain competitive and profitable. Late in 1994, the Company began a broad review of its corporate strategy which it expects to complete in 1995.
Year Ended December 31, 1994 Compared to Year Ended December 31, 1993
Insurance and General Expenses. Insurance and general expenses increased $6.9 million, or 5.3%, from $131.5 million in 1993 to $138.4 million in 1994, primarily due to higher expenses in the health insurance segment of $13.3 million principally related to the individual health reinsurance transactions.
Income Taxes. Income taxes on operations increased $2.6 million to $16.1 million in 1994 compared to $13.5 million in 1993 primarily due to increased operating income.
Change in Accounting Principle. In the first quarter of 1993, the Company recorded a one-time charge of $1.6 million after taxes for the adoption of a new accounting standard, Employers' Accounting for Postemployment Benefits. The adoption did not have a material impact on income before accounting changes.
The Company has two operating business segments. The life insurance and annuities segment consists of universal life insurance and other interest- sensitive life insurance and annuity products marketed to individuals and small businesses by UPI and closed blocks of similar business at WNIC. The health insurance segment consists primarily of employer-sponsored health and associated life insurance, stop-loss insurance, and administrative services only for employers with from 2 to 1,000 employees, employee-paid disability insurance and other specialty insurance products for educators, and individual health insurance products, primarily major medical and hospital indemnity coverage for persons under the age of 65 without employer-sponsored insurance. The third segment, corporate and other, includes the non-insurance operations of the Company.
Over the last several quarters, the sales environment for the Company's group and individual major medical health insurance products has become more competitive as other insurance companies have priced their products more aggressively in order to obtain additional market share in these product lines. As a result of the sales environment, the Company expects an increase in the level of policy lapses in the segment and an increase in the benefit ratio over the next 1-2 years.
The Company prices its products to emphasize maintaining desired profit margins and, as a result, has seen a decline in new business sold. To help offset the decline, the Company has expanded its distribution network. As part of the reinsurance transactions, the Company is utilizing the sales force of Harvest Life, whose agents generated approximately 10% of 1994 new sales. In addition, National Casualty agents began marketing the Company's individual health products in the first quarter of 1995 and are expected to add significantly to new sales volume.
Corporate and Other. For 1994, the corporate and other segment had pretax operating income of $7.2 million compared to a loss of $0.6 million in 1993. The improvement was due to increased investment income on the Company's surplus funds in 1994 and expenses in 1993 related to the relocation of the Company's headquarters.
Net Investment Income. Net investment income decreased $3.4 million, or 1.8%, to $183.7 million in 1993 from $187.1 million in 1992. The decrease was due to a general decline in market interest rates that caused a decline in the Company's portfolio yield from 8.6% in 1992 to 8.0% in 1993.
Insurance and General Expenses. Insurance and general expenses increased $24.4 million, or 22.8%, from $107.1 million in 1992 to $131.5 million in 1993. Included in 1993 were expenses of $6.9 million related to the individual health reinsurance transaction, charges of $1.7 million for the combination of the individual health and employee benefits divisions, and $1.6 million related to reengineering in the life insurance and annuities segment. Also included in 1993 were move-related costs, primarily due to the relocation of the Company's headquarters.
Amortization of Deferred Acquisition Costs. Amortization of deferred acquisition costs increased $10.8 million, or 39.9%, from $27.1 million in 1992 to $37.9 million in 1993. The change was primarily due to increased amortization of $3.5 million in the health insurance segment resulting from an increase in the block of in force individual health insurance business and $3.6 million due to the annual review of amortization assumptions in the life insurance and annuities segment, partially offset by the decrease in benefits, described above.
Changes in Accounting Principles. In 1993, the Company recorded a one-time charge of $1.6 million after taxes for the adoption of a new accounting standard on accounting for postemployment benefits. The adoption did not have a material impact on income before accounting changes. 1992 included a $22.8 million after- tax charge relating to the 1992 adoption of new accounting standards, related to postretirement benefits other than pensions and income taxes.
Life Insurance and Annuities. Revenues for the life insurance and annuities segment for 1993 were $229.0 million, compared to $233.5 million in 1992. A decline in investment income of $5.8 million resulted from lower portfolio yield rates, offset in part by an increase in invested assets. A $1.5 million improvement in insurance revenues was primarily due to an increase in life insurance in force combined with increased policy charges at UPI, offset in part by a decline in insurance revenues on the closed blocks of business at WNIC.
Pretax operating income for the life insurance and annuities segment increased 26.5% to $27.6 million in 1993 from $21.9 million in 1992. The increase was primarily due to improved interest rate spreads and favorable mortality experience. Also contributing to the improvement was a charge of $2.8 million for anticipated guaranty fund assessments recorded in 1992 compared to $0.5 million in 1993. Partially offsetting these increases were charges in 1993 of $1.6 million to combine the Company's data centers, implement work flow reengineering at UPI, and transfer the administration of WNIC's closed block of life insurance to UPI.
Health Insurance. Revenues for the health insurance segment were $394.6 million in 1993 compared to $338.8 million in 1992, an increase of 16.5%. The increase was due to an individual health reinsurance transaction that added $23.4 million of revenue, an increase in the amount of business in force in the education product line resulting from sales in 1992 and 1993, and premium rate increases averaging 7% in group products. The increase in revenues was partially offset by a decline of approximately $6 million of premium revenue from the termination of a large group life insurance contract in 1993. The annual premiums and related benefits related to this contract were each approximately $11 million in 1992. The termination of the large group life insurance contract, which had approximately $3 billion of life insurance in force, did not materially affect net income.
The health insurance segment reported pretax operating income of $11.5 million in 1993 compared to $7.0 million in 1992. The increase in pretax income was due to an improved ratio of claims to premiums in 1993 over 1992, offset in part by increased expenses.
Corporate and Other. For 1993, the pretax operating loss was $0.6 million compared to a loss of $1.9 million in 1992. The improvement was primarily due to an increase in investment income on the Company's surplus funds from the secondary stock offering of 2.1 million shares in 1993 which generated $47.3 million.
On January 1, 1994, the Company adopted Statement of Financial Accounting Standards 115, "Accounting for Certain Investments in Debt and Equity Securities." As a result, most of the Company's fixed maturity investments are classified as available for sale and carried at fair value at December 31, 1994. The remaining fixed maturity investments are classified as held to maturity and carried at amortized cost, less write-downs for other-than-temporary impairments. See Note A to the Consolidated Financial Statements for further information.
The Company's policy for rating fixed maturity investments is to use the rating determined by Standard & Poor's Company or Moody's Investor Service, Inc. for publicly-traded investments. For privately-traded securities, the ratings of Duff & Phelps Credit Rating Company and Fitch Investors Service, Inc. are also recognized in defining rated securities. If an investment has a split rating (i.e., different ratings from the rating services) the Company categorizes the investment under the lowest rating. For those investments that do not have a rating from these services, the Company categorizes those investments on ratings assigned by the National Association of Insurance Commissioners (NAIC), whose ratings are as follows: NAIC Class 1 is considered equivalent to a AAA/Aaa, AA/Aa, or A rating; NAIC Class 2, BBB/Baa; and NAIC Classes 3-6, BB/Ba and below. At December 31, 1994, 7% of fixed maturity investments were rated with comparable NAIC ratings, the majority of which is $61.7 million of BBB-rated and $45.0 million of investments rated BB and lower.
The composition of the Company's fixed maturity portfolio at December 31, 1994, based on ratings follows (dollars in millions):
In some instances, the Company invests in non-agency mortgage-backed securities, primarily highly-rated CMOs. At December 31, 1994, $20.2 million, or 88.2%, of the Company's non-agency CMOs were rated AAA. The credit risk associated with non-agency mortgage-backed securities is generally greater than that of agency mortgage-backed securities.
Sequential classes, which comprised 0.8% of the Company's invested assets at December 31, 1994, may have prepayment characteristics similar to mortgage- backed pass-through securities. Accrual classes, which comprised 0.5% of the Company's invested assets at December 31, 1994, have prepayment characteristics similar to sequential classes when receiving principal payments. Support classes, which comprised 0.2% of the Company's invested assets at December 31, 1994, are the most sensitive to prepayment risk.
The Company's mortgage loan portfolio at December 31, 1994, shown by geographic distribution, year of maturity, and property type follows (dollars in millions):
The Company had investments in mortgage loans of $357.6 million at December 31, 1994 compared to $391.7 million at December 31, 1993. Investments in mortgage loans declined primarily due to prepayments and amortization of the mortgage loan portfolio during 1994. Of the outstanding loans at December 31, 1994, loans with a carrying value of $1.6 million (net of allowances of $0.3 million) or 0.5% were delinquent 60 days or more as to interest or principal, far better than recent industry averages.
The Company actively manages its non-current investments through restructuring of mortgages and sales and leasing of foreclosed real estate in order to achieve the highest current return as well as to preserve capital. Restructured loans, where modifications of the terms of the mortgage loan have generally occurred and which are considered current investments, had a carrying value of $16.6 million at December 31, 1994 compared to $16.9 million at December 31, 1993.
In the first quarter of 1994, the Company decided that in order to provide better matching between the characteristics of its assets and liabilities to no longer make new investments in mortgage loans except for purchase money loans and expansion of the Company's properties. The Company will retain its existing mortgage loans.
At December 31, 1994, the Company had investments in common stocks and nonredeemable preferred stocks of $1.7 million that are carried at fair value. The remaining $11.3 million of equity securities is the Company's investment in its Separate Account and is carried at cost. The Company does not anticipate any significant change in the size of its equity securities portfolio.
Financing activities used cash of $39.1 million in 1994 and provided cash of $27.1 million in 1993. In 1993, $48.2 million of cash was provided by the sale of the Company's Common Stock, partially offset by the payment of $17.4 million of short-term notes payable and $9.5 million of mortgage and other notes payable. The decrease in cash from financing was also caused by increased policyholder withdrawals primarily at WNIC, where the Company maintains a closed block of interest-sensitive business.
The Company held cash and short-term investments of $59.7 million at December 31, 1994. Management believes the balance of cash and short-term investments plus cash inflow from premium revenues, investment income, and investment maturities is more than sufficient to meet the requirements of the Company and its subsidiaries.
Dividends. The Company's primary sources of funds to pay dividends to shareholders are investments held at the parent and dividends from WNIC. These dividends are subject to restrictions set forth by the Illinois Insurance Department. Illinois regulations limit the amount of cash that can be withdrawn from WNIC to the greater of the previous year's statutory earnings or 10% of statutory capital and surplus.
UPI is wholly owned by United Presidential Corporation, an insurance holding company that is 71% owned by WNIC and 29% owned by WNC. UPI is not considered a source of funds for dividends to shareholders of the Company for the foreseeable future in order to conserve capital at that subsidiary. Stock Offering. During the third quarter of 1993, the Company issued 2,133,000 shares of Common Stock in a secondary stock offering. The sale of the additional shares resulted in an increase in shareholders' equity of $47.3 million and a decrease in 1993 primary earnings of 4.3% or $.11 per share.
Congress adjourned in the fall of 1994 without passing a health care reform proposal. However, the Company expects that health care reform will again be an issue before Congress in 1995. With the make-up of the new Congress decidedly different than last year, there is speculation that the legislature would attempt steps at insurance reform, as opposed to large-scale health care reform.
The ability of an insurance company to compete successfully depends, in part, on its financial strength, operating performance, and claims- paying ability as rated by A.M. Best and other rating agencies. The Company's insurance subsidiaries are each currently rated "A- (Excellent)" by A.M. Best, based on their 1993 statutory financial results and operating performance.
A. M. Best uses a variety of qualitative and quantitative measures in determining a company's rating and surplus adequacy. The Company expects that both WNIC and UPI will continue to meet A.M. Best's standards for an "A-" rating based on 1994 results.
At December 31, 1994, the unrealized loss was primarily due to the increase in interest rates in 1994.
In 1993, these securities were primarily classified as held for sale and carried at the lower of market or amortized cost less write-downs for other- than-temporary impairments.
The Company foresees that this standard will continue to result in an increase in the volatility of shareholders' equity as the standard does not permit a corresponding adjustment to the liabilities that these assets support.
SFAS 114, "Accounting by Creditors for Impairment of a Loan," and its amendments, will be adopted by the Company effective January 1, 1995. The standard provides measurement criteria for determining the carrying value when it is probable that a loan has been impaired and for disclosing of information about investments in impaired loans. A loan is considered impaired when it is probable that the Company will not collect all amounts due under the contractual terms. The impairment is recognized by a valuation allowance which may be subsequently increased or decreased based on changes in the measurement criteria. The statement applies to essentially all loans in the Company's mortgage loan portfolio. The adoption will not have a material impact on the financial statements.
Net income in 1993 includes a one-time cumulative effect adjustment of $1,550,000, net of taxes of $834,000, for the adoption of SFAS 112 "Employers' Accounting for Postemployment Benefits." Net income in 1992 includes one-time cumulative effect adjustments of $20,126,000, net of taxes of $10,368,000, for the adoption of SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and $2,693,000 for the adoption of SFAS 109, "Accounting for Income Taxes."
Fixed Maturities. Fixed maturity investments are securities that mature more than one year after issuance. They include bonds, notes, and redeemable preferred stocks. Investments in fixed maturities are intended to be used by WNC as part of its asset/liability matching strategy. Effective in 1994 with the adoption of SFAS 115, the Company classifies its fixed maturity investments as either available for sale investments or held to maturity investments.
Mortgage Loans on Real Estate. Mortgage loans on real estate are carried at unpaid principal net of unearned discount and allowance for possible loan losses. Allowance for mortgage loan losses is based on an evaluation of the mortgage loan portfolio, past credit loss experience, and current economic conditions. Loans considered permanently impaired are written down to their net realizable value.
Provisions for depreciation of real estate investments and home office properties are computed using primarily the straight-line method over the estimated useful lives. Accumulated depreciation on real estate investments at December 31 was $25,086,000 and $24,184,000 in 1994 and 1993, respectively. Accumulated depreciation on home office property and equipment at December 31 was $2,434,000 and $1,101,000 in 1994 and 1993, respectively.
Insurance premiums and policy charges include reinsurance premiums assumed and are net of reinsurance ceded. Health insurance premiums are earned and recognized pro rata over the terms of the policies. Premiums for traditional life insurance products are recognized as revenues when due. Revenues for certain interest-sensitive products consist of charges earned and assessed against policy account balances during the period for the cost of insurance, policy initiation fees, policy administration expenses, and surrender charges.
DAC is increased for the estimated effect of realizing unrealized investment losses and decreased for the estimated effect of realizing unrealized investment gains. The offset to these amounts is recorded directly to shareholders' equity.
The changes in the unamortized cost of purchased insurance in force for the years ended December 31 follow:
The estimated percentage of the December 31, 1994 balance before the effect of unrealized investment losses to be amortized over the next five years follows:
Liabilities for future policy benefits of certain interest- sensitive products are policy account balances before applicable surrender charges, certain deferred policy initiation fees that are recognized as income over the term of the policies, and a provision for the return of the cost of insurance charges. Policy benefits and claims that are charged to expense include interest credited to policy account balances, benefit claims incurred in the period in excess of related policy account balances, and provision for the return of the cost of insurance charges. Credited interest rates for these products ranged from 4.0% to 7.3% at December 31, 1994.
The cost of purchased businesses in excess of net assets acquired is reported as goodwill and is amortized on a straight-line basis, generally over thirty-five years. Goodwill is evaluated based on the prospect of continued growth and the long-term nature of the insurance policies sold. The asset value is considered appropriate. Accumulated amortization of goodwill was $6,842,000 and $6,023,000 at December 31, 1994 and 1993, respectively.
The accounting policies of WNC result in deferred taxes being provided for significant temporary differences between financial statement and tax return bases, using the asset and liability method. These differences result primarily from policy reserves, DAC, certain investments, and reserves for postretirement benefits. WNC and its subsidiaries file a consolidated life/nonlife federal income tax return.
Benefit amounts paid directly by the Company for insurance claims covered under reinsurance ceded agreements are recorded as reinsurance recoverables to the extent not already reimbursed. The cost of reinsurance related to long-duration contracts is accounted for over the life of the underlying reinsured policies using assumptions consistent with those used to account for the underlying policies.
Substantially all of the reinsurance assumed by the Company as of December 31, 1994, relates to individual health insurance. It is on a 50% or 100% coinsurance basis and is accounted for in a manner similar to the direct business.
A comparison of amortized cost to fair value of fixed maturity investments by category at December 31, 1994 and 1993 follows:
The amortized cost and fair value of fixed maturities at December 31, 1994, by contractual maturity, follow. Expected maturities differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
At December 31, 1994, gross unrealized gains and losses on investments in equity securities amounted to $88,000 and $259,000, respectively.
At December 31, 1994, WNC had capital loss carryforwards for tax return purposes of $1,510,000 that expire in 1996. For financial reporting purposes, a valuation allowance of $15,706,000 has been recognized to offset the deferred tax assets related to those carryforwards, investment loss reserves, and other capital-loss-related deferred tax assets not expected to be realized. The valuation allowance was increased by $803,000 in 1994 and reduced by $3,272,000 in 1993.
The Omnibus Budget Reconciliation Act of 1993 changed WNC's prevailing federal income tax rate from 34% to 35% effective January 1, 1993.
Under current and prior law, income of WNC's life insurance subsidiaries taxed on a current basis is accumulated in a shareholders' surplus account and can be distributed without tax to WNC. At December 31, 1994, this shareholders' surplus was $256,043,000.
WNC has 10,000,000 authorized shares of $5 par value Preferred Stock that is designated as $2.50 Convertible Preferred Stock. Each share is entitled to a cumulative annual dividend of $2.50 and a preference of $50 in the event of involuntary liquidation of WNC and $55 in the event of voluntary liquidation of WNC. Further, each share is convertible at any time into 1.875 shares of Common Stock at the option of the holder and is redeemable at $55 at the option of WNC. Each holder is entitled to one vote for each share held and, except as otherwise provided by law, the $2.50 Convertible Preferred Stock and the Common Stock vote together as one class.
The effect of reinsurance on premiums and policy charges for the years ended December 31 follows:
Reinsurance benefits ceded were $22,850,000, $22,685,000, and $22,516,000, in 1994, 1993, and 1992, respectively.
As a result of past divestitures, the Company reinsures 100% of certain supplemental health insurance, life insurance, and annuity business with unaffiliated companies. At December 31, 1994, 50% of WNC's total reinsurance recoverables were ceded to Combined Life Insurance Company of America, and 16% were ceded to American Founders Life Insurance Company. In addition, 16% of reinsurance ceded was to UNUM Life Insurance Company in the normal course of business.
WNC has a stock benefit plan under which the compensation committee of WNC's Board of Directors may grant stock options, stock appreciation rights, and shares of restricted stock. The following summarizes the changes in the shares of Common Stock of WNC under the Plan:
Shares of restricted stock may be granted either separately or in tandem with the grant of a stock option to key employees and others and are subject to certain terms and conditions defined in the plan. Options for 7,500 restricted shares granted in tandem with options were granted in 1992.
The Company has three qualified defined contribution retirement plans: a non-contributory money-purchase retirement plan, a non-contributory discretionary profit sharing plan, and a contributory 401(k) plan. The plans cover substantially all employees who have met the prescribed requirements for participation. The Company contribution to the money-purchase retirement plan is 3% of each employee's compensation plus an additional 3% of compensation in excess of the Social Security wage base. The Company contribution to the profit sharing plan is at the discretion of the insurance subsidiaries' Boards of Directors in consultation with the WNC Board of Directors and is based on financial performance. Employees' may contribute up to 12% of compensation to the 401(k) plan. The Company matches employee contributions dollar for dollar up to a maximum of 3% of compensation. The net pension expense for the defined contribution plans in 1994, 1993, and 1992 was $3,006,000, $3,760,000, and $2,808,000, respectively. The Company has a non-qualified supplemental retirement plan under which benefits are paid to certain employees equal to the amounts by which the qualified plan benefits are reduced due to provisions of the Internal Revenue Code (IRC). At December 31, 1994 and 1993, the unfunded liability for the supplemental retirement plan was immaterial.
Both WNIC and UPI have a defined benefit retirement plan that covers certain grandfathered employees and agents. Both plans have been amended to terminate the accrual of future benefits which resulted in the Company recording a curtailment gain. Benefits are based principally on years of service and compensation. Generally, the funding policies are to contribute annually at least the minimum amounts required by the IRC. Contributions are intended to provide benefits attributed to service to date.
The unrecognized transition asset in the preceding schedule is the amount by which the plans' net assets exceeded the actuarial present value of projected benefit obligations, net of amortization, as of January 1, 1985, the date current pension accounting standards were adopted. The transition asset is being amortized by credits to income over a fourteen-year period. In addition, the excess of actual investment and actuarial gains and losses realized over those expected are deferred and, when the cumulative deferred amounts exceed certain limits, will be amortized at a rate consistent with a fourteen-year amortization period. Costs created by plan amendments that are associated with prior employee service are also deferred and amortized over fourteen years.
The weighted-average discount rates used in calculating the projected benefit obligations at December 31, 1994 and 1993 were 7.5% and 6.7%, respectively. The expected weighted-average rate of return on plan assets was 7.6% in 1994 and 7.5% in 1993 and 1992.
The funded status of the plan and the amounts recognized in WNC's consolidated balance sheet at December 31 follow:
WNC has noncancelable operating leases primarily for office space and office equipment, the most significant of which is a twenty-year lease of WNIC's home office building with a related party as lessor. Future minimum lease payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year at December 31, 1994 follow:
The financial guarantees are scheduled to expire in 1995 and 1997. The Company has not funded any of its financial guarantees to date and feels it has adequate reserves for potential losses in the future.
In September 1994, two retired employees filed a lawsuit in the United States District Court for the Northern District of Illinois against WNC, WNIC, and the three individual trustees of the Washington National Insurance Company Home Office Group Insurance Plan (the Plan). The plaintiffs purport to act as members of a class consisting of all employees of WNC and WNIC who retired or tendered their irrevocable notice of retirement on or before July 24, 1989 and who are eligible to receive benefits under the Plan.
The complaint is brought under the Employee Retirement Income Security Act and alleges that WNC, WNIC, and the trustees have taken and threatened to take actions to modify, amend, or terminate the Plan in violation of written and oral promises and representations and the terms of the Plan. The alleged violations include changing the method for computing claims payable under the Plan, requiring retired employees to contribute to the payment of premiums for their Medicare supplemental health insurance coverage, and maintaining that WNC, WNIC, and the trustees have reserved the right to modify or terminate benefits under the Plan. Plaintiffs seek a declaration of their rights under the Plan, with respect to these actions, an award of attorneys' fees and other relief, and a certification of the class.
See Management's Discussion and Analysis, page 26, for a discussion of health care reform and its possible effect on the Company's business.
The NAIC is currently working on a project to codify statutory accounting practices (SAP). This process will result in a single source of SAP, possibly eliminating the concept of permitted practices.
A reconciliation of SAP net income to GAAP net income (loss) for the years ended December 31 follows:
The fair value of the mortgage payable is estimated by discounting cash flows, using current incremental borrowing rates for similar types of borrowing arrangements.
WNC has three business segments: life insurance and annuities; health insurance (previously reported as the individual health insurance and group products segments); and corporate and other. The segments are based on WNC's insurance products and organization. The corporate and other segment includes realized investment gains and losses, a curtailment gain in 1992 of $4,033,000 resulting from a change to WNIC's postretirement health benefits program, and operations that do not specifically support one of the other segments. Assets not individually identifiable by segment are allocated, generally, based on the amount of segment liabilities. Depreciation expense and capital expenditures are not material. Revenues, income or loss before income taxes and cumulative effect of changes in accounting principles, and assets by segment for the years ended and at December 31 follows: