The Company also occupies leased office space located at 3755 Capitol of Texas Highway South, Austin, Texas 78704. The two leases related to this office space expire in May 2001 and 2003.
The historical financial information for the five years ended December 31, 1998 and at December 31, 1998, 1997, 1996, 1995 and 1994 has been derived from the audited Consolidated Financial Statements of the Company. The selected consolidated financial data set forth below is qualified in its entirety by reference to and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Company's Consolidated Financial Statements and the Notes thereto included elsewhere in this Form 10-K.
(3) On April 15, 1997, the Company acquired all of the outstanding common stock of Ohio State and Investors Guaranty.
(4) On October 1, 1998, the Company acquired the 50% of College Insurance Group, Inc. not previously owned by the Company.
The volume of the Company's life insurance in force has increased 134% from $18.5 billion in 1989 to $43.3 billion in 1998. This growth has been the result of a combination of acquisitions, reinsurance assumed and new business written. Changes in the Company's volume of life insurance inforce for the last three years is summarized in the following table.
The following table summarizes the Company's sales in terms of annualized premiums over the three year period ended December 31, 1998:
The Company intends to continue its focus on the sale of life insurance and annuity products through its marketing and distribution systems. In addition, the Company may also pursue selected acquisitions of blocks of life insurance policies and life insurance companies.
Non-life insurance investments. Income before income taxes decreased $3.8 million from 1997 to 1998. The primary reasons for the decrease were (i) a decrease in income from Argus and (ii) a decrease in net realized investment gains on the sale of investment properties in 1998 compared with 1997. Income before income taxes increased between 1996 and 1997. The primary reasons for the increase were (i) an increase in income from Argus and (ii) an increase in net realized investment gains on the sale of investment properties in 1997 compared with 1996.
In July 1996, in connection with administrative agreements entered into with Fremont Life, an unaffiliated company (the "Reinsurer") reinsured 100% of the insurance business of Fremont Life on a coinsurance basis. The Reinsurer then reinsured certain risks on these same liabilities to Great Southern on a modified coinsurance basis. The associated policy liabilities were approximately $335.4 million at December 31, 1998.
On April 15, 1997, Great Southern acquired all of the outstanding common stock of Ohio State Life and Investors Guaranty ("Ohio State Acquisition") from Farmers Group, Inc. On the acquisition date, Ohio State and Investors Guaranty had combined assets of $1,039 million and combined liabilities of $694 million. The acquisition was accounted for as a purchase. On April 16, 1997, Ohio State and Investors Guaranty entered into separate coinsurance agreements to reinsure 100% of their insurance liabilities to the Reinsurer in exchange for a ceding commission of $145.7 million. Concurrently, the Reinsurer and Great Southern entered into a modified coinsurance agreement under which the Reinsurer ceded certain risks on a 70% quota share basis on the same insurance liabilities to Great Southern. The results of operations of these acquired policies from the date of acquisition, less the net 30% coinsurance, are included in the Company's results of operations. The Reinsurer will receive 100% of the statutory profits from the reinsured policies until the Reinsurer has recovered the initial ceding commission.
In each of the above transactions with the Reinsurer, the invested assets related to the reinsured businesses are owned by the Reinsurer. At December 31, 1998, the insurance liabilities associated with these reinsurance transactions totaled $1.0 billion. Results from this reinsurance transaction and the Ohio State Acquisition are included in the Company's results of operations from the respective dates of the transactions.
The effects of the above transactions, collectively referred to herein as the Acquisitions, on the individual income statement components, excluding the costs of financing, are set forth in the table below (in millions).
(1) Includes the results from the Ohio State Acquisition in 1997. (2) Includes the results from the Ohio State Acquisition in 1997 and the agreements with the Reinsurer in 1997 and 1996.
Net investment income. Net investment income totaled $226.5 million in 1998 compared to $219.3 million in 1997. Excluding the effect of the Acquisitions, net investment income decreased $1.1 million, which includes a $1.6 million decrease in income from equity subsidiaries.
Amortization expense. Amortization expense totaled $87.2 million in 1998 compared with $43.7 million in 1997. Amortization expense in 1998 increased $16.7 million as a result of realized investment gains on the sale of fixed maturity investments, including $6.7 million related to the Acquisitions. The sale of these fixed maturity investments at a gain will reduce future investment income, requiring the recognition of additional amortization expense in 1998. Excluding the Acquisitions, amortization expense increased $29.5 million from 1997 to 1998. This increase resulted from (i) $10.0 million of realized investment gains as discussed above, (ii) increased surrenders in a closed block of annuity business and (iii) increased amortization of deferred policy acquisition costs on Great Southern's universal life insurance business. Included in amortization expense are adjustments to decrease deferred policy acquisition costs and the cost of business acquired assets of $0.9 million in 1998 and $2.5 million in 1997. These adjustments result from revisions made to the Company's estimate of future gross profits from its interest-sensitive life and annuity policies. Under GAAP, deferred policy acquisition costs and the cost of business acquired assets on interest-sensitive life products are amortized based on the estimated future gross profits of the related policies.
Income before provision for income taxes decreased $9.5 million to $31.3 million in 1997 from $40.8 million in 1996. The primary reasons for the net decrease were (i) the gain from the disposition of the Company's interest in GSSW in 1996, (ii) an increase in death benefits and (iii) an increase in other operating expenses, partially offset by (iv) a gain from the disposition of Loyalty Life in 1997 and (v) income resulting from the Acquisitions. The items and significant changes in individual income statement components are discussed in more detail below.
The Company's share of earnings from its equity subsidiaries decreased from $5.5 million in 1996 to $3.6 million in 1997. Equity earnings in GSSW of $4.5 million in 1996 did not recur in 1997 as the Company disposed of GSSW in 1996 in exchange for 100% interests in several real estate limited partnerships formerly owned by GSSW. These limited partnerships added $1.9 million to net investment income in 1997. This decrease in earnings from GSSW was offset by an increase in the income from the Company's other equity subsidiaries.
Net realized investment gains. The Company recorded net realized investment gains of $3.0 million in 1997. During 1997, the Company recorded gains of $5.1 million from the sale of three real estate investment properties, which were offset by various other investment losses.
Policyholder benefits. Policyholder benefits increased $44.2 million from $218.7 million in 1996 to $262.9 million in 1997. Excluding the effects of the Acquisitions, policyholder benefits decreased $5.1 million from 1996 to 1997. The decrease in policyholder benefits primarily resulted from lower benefit reserve increases in 1997 resulting from the decreasing traditional premiums, partially offset by a $5.1 million increase in death benefits.
Other operating expenses. Other operating expenses increased $20.3 million to $77.0 million in 1997 from $56.7 million in 1996. Excluding the effects of the Acquisitions, other operating expenses increased $6.1 million from 1996 to 1997. The primary reasons for the increase in operating expenses from 1996 to 1997 are expenses associated with a marketing office opening in California in September 1996, increased depreciation expense in 1997 resulting from purchases of computer equipment in 1996 and 1997, and increased legal and professional fees in 1997. Financial Condition and Liquidity
Americo has outstanding $100.0 million aggregate principal amount of senior subordinated notes that it issued in 1993. These senior subordinated notes bear interest at 9.25% and mature in May 2005. They are redeemable at the option of Americo beginning in 1998. The redemption prices are in excess of par in 1999.
In connection with the acquisition of The Victory Life Insurance Company in July 1995, Americo issued notes payable to the seller with face amounts aggregating $17 million and borrowed $21 million under a $70 million credit agreement with a syndicate of banks. Of the $17 million face amount of notes payable issued to the seller, $5 million mature in 2015 and the remaining $12 million mature in 24 equal semi-annual installments the first of which was due in 1995. The notes are carried at their discounted value, which assumes an average effective rate of 11.6%.
At December 31, 1998, United Fidelity had outstanding to Americo four surplus debentures with an aggregate unpaid balance of $122.8 million. The terms of the surplus debentures have been established to provide for the payment of principal and interest to Americo in amounts sufficient to make payments on the Company's external debt obligations in accordance with their payment schedules. The surplus debentures and their payment schedules have been approved by the Texas Department of Insurance; therefore, no scheduled payment will require the approval of the Texas Department of Insurance.
In order to meet its obligations under the surplus debentures, United Fidelity uses funds generated by its insurance operations and dividends from its insurance subsidiaries. The ability of the insurance subsidiaries to pay dividends is subject to regulatory restrictions. The insurance holding company statues of Texas in which the Company's insurance subsidiaries are domiciled regulate payment of dividends by an insurance company to its parent. Generally, without the consent of the state's insurance commissioner, an insurance company may not pay dividends to its parent in excess of the greater of (i) the insurer's prior year statutory net gain from operations, or (ii) 10% of its prior year ending statutory capital and surplus, subject in either case to sufficient earned statutory surplus from which such dividends may be paid. Additionally, an insurance company is required to notify the respective insurance department prior to the payment of ordinary dividends.
Financial condition. Stockholder's equity increased to $257.2 million at December 31, 1998 from $246.9 million at December 31, 1997. The increase was the result of net income of $8.8 million and an increase in net unrealized investment gains of $3.5 million, less a $2.0 million dividend to FHC. Net unrealized investment gains in 1998 were recorded due to an increase in the market value of the Company's marketable equity securities offset by a decrease in its available for sale fixed maturities. See Note 4 to the Company's Consolidated Financial Statements included elsewhere in this Form 10-K for further discussion of the components of the change in net unrealized investment gains.
The changes occurring in the Company's consolidated balance sheet from December 31, 1998 to December 31, 1997 primarily reflect the normal operations of the Company's life insurance subsidiaries.
Investment Portfolio. The Company has what it believes to be a conservative investment philosophy. The Company's investment portfolio is designed to match investment maturities as closely as possible to the projected cash flow requirements of the Company's outstanding liabilities. The Company's policy is to have a substantial portion of its investment portfolio in fixed income securities with call protection.
The following table sets forth the composition of the Company's fixed maturity securities according to NAIC designations and S&P and Moody's ratings at December 31, 1998:
At December 31, 1998, approximately $190.1 million in carrying value of the Company's investment portfolio consisted of mortgage loans, which were collateralized primarily by multi-family apartments, office buildings and retail properties located in 30 states. Approximately 34% of the portfolio was multi-family apartments, 18% was office buildings, 27% was retail space and 21% was other types of properties. At December 31, 1998, approximately 16% of the mortgage loan portfolio was secured by properties in Texas, 15% in Missouri, 11% in Connecticut and 10% in Kansas. No more than 10% of the remaining portfolio was secured by properties in any one state. At December 31, 1998, 1.11% of the mortgage loan portfolio consisted of loans with balloon payments that mature before January 1, 2000. At December 31, 1998, mortgage loans delinquent by more than 90 days, as determined on a contract delinquency basis, totaled approximately $0.9 million, which constituted 0.5% of mortgage loans and was 0.04% of cash and invested assets. There were no loans foreclosed upon and transferred to real estate owned in the Company's consolidated balance at December 31, 1998. The favorable default experience is principally attributed to the Company's selectivity in the purchase of mortgages in connection with acquisitions of its life insurance subsidiaries. In light of the current market interest rate environment, the Company may experience prepayments on its mortgage loan portfolio, thus reducing its yield on such portfolio. The Company plans to continue applying its historical underwriting standards to future investments in mortgage loans.
Real estate investments were only 1.2% of the carrying value of the Company's cash and invested assets at December 31, 1998.
As part of its asset-liability management, the Company conducts detailed computer simulations that model its fixed-rate assets and liabilities under commonly used stress-test interest rate scenarios. With the results of these computer simulations, the Company can measure the potential gain or loss in fair value of its interest-rate sensitive instruments and seek to protect its economic value and achieve a predictable spread between what it earns on its invested assets and what it pays on its liabilities. At December 31, 1998, the Company's assets had an effective duration of 5.1 and its liabilities had an effective duration of 6.8. If interest rates were to decrease 10% from December 31, 1998 levels, the increase in the value of the Company's liabilities would exceed the increase in the value of the Company's assets by approximately $23 million. Because the Company actively manages its assets and liabilities and has developed strategies to reduce its exposure to loss as interest rate changes occur, it expects that actual losses would be less than the estimated potential loss.
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes standards for reporting and displaying comprehensive income and its components in a full set of general-purpose financial statements. Comprehensive income includes all changes in stockholder's equity during a period except those resulting from investments by owners and distributions to owners. The adoption of SFAS 130 resulted in revised and additional disclosures but had no effect on the financial position, results of operations, or liquidity of the Company.
In December 1997, the American Institute of Certified Public Accountants ("AICPA") approved Statement of Position ("SOP") 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." SOP 97-3 provides guidance for determining when an entity should recognize a liability for guaranty-fund and other insurance-related assessments and a related asset for assessments which may be recovered through future premium tax offsets. The SOP is effective for financial statements for fiscal years beginning after December 15, 1998 with early adoption encouraged. Adoption of this accounting standard will not have a significant impact on the consolidated financial statements of the Company.
The Company had met its milestone of having all administration systems prepared for Year 2000 processing by December 31, 1998. These systems are used by the Company to process its insurance business, including premium receipts and claim payments. Currently, all administrative systems have been renovated and the Company, working with its outsource provider, has tested all Year 2000 remediations and has placed these tested systems into production use. All internal and corporate systems, such as file servers and desktop systems, are scheduled to be Year 2000 ready by June 30, 1999. Approximately 95% of these systems have been assessed for Year 2000 readiness and substantially all of these are believed to be Year 2000 ready. The Company's imbedded systems, such as phone switches, will be upgraded, as necessary, during 1999. The affected systems have been identified. If the Company fails to successfully complete a significant portion of the Year 2000 plan such failure may have a material adverse impact on the Company's financial condition. Currently, management considers the possibility of such a failure to be unlikely; however, in the event management's assessment changes in the future, an appropriate contingency plan will be developed.
The Company incurred expense through December 1998 related to this project is $160,000. It is expected additional expenses will total $250,000 during 1999. As these expenses are not significant to the Company's overall information technology budget, this remediation plan will be funded from the Company's normal operating cash flows. The remediation costs are nominal due to the Company's service agreement with its third party provider. At this point in time, other information systems projects have not suffered due to Year 2000 compliance efforts so as not to have an adverse effect on the Company's operations.