The following tableshows a breakout of property, net of accumulated depreciation, owned and occupied by the Company and the distribution of real estate by type.
Property owned Amount % of Total Home Office $ 2,815,241 20% Investment real estate Commercial $ 4,355,450 30% Residential development $ 5,405,282 38% Foreclosed real estate $ 1,724,544 12% $11,485,276 80%
Total investment real estate holdings represent approximately 3% ofthe total assets of the Company net of accumulated depreciation of $539,366 and $442,373 at year end 1997 and 1996 respectively.The Company owns an office complex in Springfield, Illinois, which houses the primary insuranceoperations. The office buildings contain 57,000 squarefeet ofoffice and warehouse space. The properties are carried at approximately $2,394,360. In addition, an insurance subsidiary owns a home office building in Huntington, West Virginia. The building has 15,000 square feet and is carried at $165,882.The facilities occupied by the Company are adequate relative tothe Company's present operations.
Foreclosedproperty is carried at the unpaid loan principal balance plus accrued interest on the loan and other costs associated with the foreclosure process. The carrying value of foreclosed property does not exceed management's estimate of net realizable value. Management's estimate of net realizable value is based on significant internal real estate experience, local market experience, independent appraisals and evaluation of existing comparable property sales.
A positive impact on premium income is the improvement of persistency. Persistency is a measure of insurance in force retained in relation to the previous year. The Companies' average persistency rate for all policies in force for 1997 and 1996 has been approximately 89.4% and 87.9%, respectively.
The overall investment yields for 1997, 1996 and 1995, are 7.24%, 7.29% and 7.12%, respectively. Since 1995, investment yield improved due to the fixed maturity investments. Cash generated from the sales of universal life insurance products, has been invested primarily in our fixed maturity portfolio.
Realized investment losses were $279,000 and $988,000 in 1997 and 1996, respectively. Approximately $522,000 of realized losses in 1996 are due to the charge-off of two specific investments. The Company realized a loss of $207,000 from a single loan and $315,000 from an investment in First Fidelity Mortgage Company ("FFMC"). The charge-off of the loan represented the entire loan balance at the time of the charge-off. Additionally, the Company sold two foreclosed real estate properties that resulted in approximately $357,000 in realized losses in 1996.The Company had other gains and losses during the period that comprisedthe remaining amount reported but were immaterial in nature on an individual basis.
In 1994, UG became aware that certain new insurance business was being solicited by certain agents and issued to individuals considered to be not insurable by Company standards. These nonstandard policies had a face amount of $22,700,000 and represented 1/2 of 1% of the insurance in-force in 1994. Management's initial analysis indicated that expected death claims on the business in-force was adequate in relation to mortality assumptions inherent in the calculation of statutory reserves. Nevertheless, management determined it was in the best interest of the Company to repurchase as many of the non-standard policies as possible. Through December 31, 1996, the Company spent approximately $7,099,000 for the settlement of non-standard policies and for the legal defense of related litigation. In relation to settlement of non-standard policies the Company incurred life benefit costs of $3,307,000, and $720,000 in 1996 and 1995, respectively. The Company incurred legal costs of $906,000 and $687,000 in 1996 and 1995, respectively. All policies associated with this issue have been settled as of December 31, 1996. Therefore, expense reductions for 1997 would follow.
Amortization of cost of insurance acquired decreased 57% in 1997 compared to 1996. Cost of insurance acquired is amortized in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The Company did not have any charge-offs during the periods covered by this report.The decreasein amortization duringthe current period is a normal fluctuation due to the expected future profits. Amortizationof costofinsurance acquired is particularly sensitive to changes in persistency of certain blocks of insurance in-force.The improvement of persistency during the year had a positive impact on amortization of cost of insurance acquired. Persistency is a measure of insurance in force retained in relation to the previous year. The Company's average persistency rate for all policies in force for 1997 and 1996 has been approximately 89.4% and 87.9%, respectively.
Operating expenses decreased 23% in 1997 compared to 1996. The decrease in operating expenses is directly related to settlement of certain litigation in December of 1996. The Company incurred legal costs of $0, $906,000 and $687,000 in 1997, 1996 and 1995, respectively in relation to the settlement of the non-standard insurance policies.
In addition, the Company changed its focus from primarily a broker agency distribution system to a captive agent system. Business written by the broker agency force, in recent years, did not meet Company expectations. With the change in focus of distribution systems, most of the broker agents were terminated. (The termination of the broker agency force caused a nonrecurring write down of the value of agency force asset in 1995, see discussion of amortization of agency force for further details.). The change in distribution systems effectively reduced the total number of agents representing and producing business for the Company. Broker agents sell insurance and related products for several companies. Captive agents sell for only one company.
Commissions and amortization of deferred policy acquisition costs decreased 14% in 1996 compared to 1995. The decrease is due to a decreasein commissions expense. Commissions decreased 15% in 1996compared to 1995. The decrease in commissions was due to the decline innew business production. There is a direct relationship betweenpremium revenuesandcommission expenses. First year premium production decreased15% andfirst year commissions decreased 32% when comparing1996 to1995. Amortization of deferred policy acquisition costs decreased 12% in 1996 compared to 1995. Management expects commissionsand amortization of deferred policy acquisition costs to decrease in the future if premium revenues continue to decline.
Amortization of cost of insurance acquired increased 25% in 1996 compared to1995. Cost of insurance acquired is amortized in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The Company did not have any charge-offs during the periods covered by this report.The increaseinamortization during thecurrent period is a normal fluctuation due to the expected future profits. Amortization of cost of insurance acquired is particularly sensitive to changes in persistency of certain blocks of insurance in-force.
Operating expenses increased 4% in 1996 compared to 1995.The primary factor that caused the increase in operating expensesis directly relatedtoincreased legal costs and reserves establishedfor litigation.The legal costs are due to the settlement of non-standard insurance policies as was discussed in the review of life benefits. The Company incurred legal costs of $906,000 and $687,000 in 1996 and 1995, respectively in relation to the settlement of the non-standard insurance policies.
Investment real estate and real estate acquired in satisfaction ofdebt decreased slightly in 1997 compared to 1996.Investment real estate holdings represent approximately 3% of the total assets of the Company. Totalinvestment real estate is separated intothree categories: Commercial 38%, Residential Development 47% and Foreclosed Properties 15%.
Policy loans decreased 2% in 1997 compared to 1996. Industry experience for policy loans indicates few policy loans are ever repaid by the policyholder other than through termination of the policy. Policy loans are systematically reviewed to ensure that no individual policy loan exceeds the underlying cash value of the policy.Policy loans will generally increase due to new loans and interest compounding on existing policy loans.
Income taxes payable and deferred income taxes payable increased 7% in 1997 compared to 1996. The change in deferred income taxes payableis attributableto temporary differences between Generally Accepted Accounting Principles ("GAAP") and tax basis accounting. Federal income taxes are discussed in more detail in Note 3 of the Consolidated Notes to the Financial Statements.
Notes payable increased approximately $1,886,000 in 1997 compared to 1996. On July 31, 1997, United Trust Inc. issued convertible notes totaling $2,560,000 to seven individuals, all officers or employees of United Trust Inc. The notes bear interest at a rate of 1% over prime, with interest paymentsdue quarterly and principal due upon maturity of July 31, 2004.The conversion price of the notes are graded from $12.50 per share for the first three years, increasing to $15.00 per share for the next two years and increasing to $20.00 per share for the last two years. As of December 31, 1997, the notes were convertible into 204,800 shares of UTI common stock with no conversion privileges having been exercised. The Company's long-term debt is discussed in more detail in Note 12 of the Notes to the Financial Statements.
Totalshareholders' equity decreased 15% in 1997 compared to 1996. The decrease is attributable to the Company's acquisition of treasury stock. As indicated in the notes payable paragraph above, on July 31, 1997 UTI issued convertible notes totaling $2,560,000. The notes were issued to provide UTI with additional funds to be used for the following purposes.
A portion of the proceeds in combination with debt instruments were used to acquire approximately 16% of the Larry E. Ryherd and family stock holdingsin UTI. This transaction reduced the largest shareholder's stock holdings for the purpose of making UTI stock more attractive to the investment community.
Additionally, a portion of the proceeds in combination with debt instruments were used to acquire the stock holdings of Thomas F. Morrow and family in UTI and UII. Simultaneous to this stock acquisition Mr. Morrow retired as an executive officer of UTI. Mr. Morrow's retirement will provide an annual cost savings to the Company in excess of debt service on the new notes.
Net cash provided by (used in)financing activities was $1,746,000, ($14,150,000) and $8,408,000 for 1997, 1996 and 1995, respectively. The change between 1997 and 1996 is due to a coinsurance agreement with FILIC as of September 30, 1996. At closing of the transaction, UG received a reinsurance credit of $28,318,000 for policy liabilities covered under the agreement. UG transferred assets equal to the credit received. This transfer included policy loans of $2,855,000 associated with policies under the agreement and a net cash transfer of $19,088,000 after deducting the ceding commission due UG of $6,375,000.
At December 31, 1997, the Company had a total of $21,460,000 in long-term debt outstanding. Long-term debt principal reductions are approximately $1.5 million per year over the next several years. The senior debt is through First of America Bank - NA and is subject to a credit agreement. The debt bears interest to a rate equal to the "base rate" plus nine sixteenths of one percent. The Base rate is definedasthe floatingdaily, variable rate of interest determined and announced by First of America Bank from time to time as its "base lending rate".The base rate at issuance of the loan was 8.25%, and has remained unchanged through March 1, 1997, when it increased to 8.5%. Interestis paid quarterly and principal payments of $1,000,000 are due in May of each year beginning in 1997, with a final payment due May 8, 2005. On November 8, 1997,the Company prepaid the $1,000,000 May 8,1998, principal payment.
The subordinated debt was incurred June 16, 1992 as a part of the acquisition ofthe nowdissolved Commonwealth Industries Corporation, (CIC). The 10-year notes bear interest at the rate of 7 1/2% per annum, payable semi-annually beginning December 16, 1992. These notes, except for one $840,000 note, provide for principalpayments equal to 1/20th of the principal balancedue with each interest installment beginning December 16, 1997, with a final payment due June 16, 2002. The aforementioned $840,000 note provides for a lump sum principal payment due June 16, 2002. Principal reductions of $516,500 per year are required on the aforementioned notes.
As of December 31, 1997 the Company has a total $22,575,000 of cash and cash equivalents, short-term investments and investments held for sale in comparison to $21,460,000 of notes payable. UTI and FCC servicethis debt through existing cash balances and management fees received from the insurance subsidiaries. FCC is further able to service this debt through dividends it may receive from UG.See note 2 in the notes to theconsolidated financial statements for additional information regarding dividends.
Ohio domiciledinsurance companiesrequire five days prior notification to the insurance commissioner for the payment of an ordinary dividend. Ordinary dividends are defined as the greater of: a) prior year statutory earnings or b) 10% of statutory capitaland surplus. For the year ended December 31, 1997, UG had a statutory gain from operations of $1,779,000. At December 31, 1997, UG's statutory capital and surplus amounted to $10,997,000. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation.
A life insurance company's statutory capital is computed accordingto rules prescribed by the National Association of Insurance Commissioners ("NAIC"), as modified by the insurance company's state of domicile. Statutory accounting rules are different from generally accepted accounting principles and are intended to reflect a more conservative viewby, for example, requiring immediate expensing of policy acquisition costs. The achievement of long-term growth will require growth in the statutory capital of the Company's insurance subsidiaries. The subsidiaries may secure additional statutory capital through varioussources, such as internally generated statutory earnings or equity contributions by the Company from funds generated through debt or equity offerings.
The Company's insurance subsidiaries operate under the regulatory scrutiny of the respective state insurance department where each companyis licensed. The Company is not aware of any current recommendations by these regulatory authorities which, if they were to be implemented, would have a material effecton the Company's liquidity, capital resources or operations.
The Company's insurance subsidiaries are assessed contributions by life and health guaranty associations in almost all states to indemnify policyholders of failed companies.In several states the company may reduce premium taxes paid to recover a portion of assessments paid to the states' guaranty fund association. This right of "offset" may come under review by the various states, and the company cannotpredict whether and to what extent legislative initiatives may affect this right to offset.Also, some state guaranty associations have adjusted the basis by which they assess the cost of insolvencies to individual companies. The Company believes that its reserve for future guaranty fund assessments is sufficient to provide for assessments relatedto known insolvencies. This reserve is based upon management's current expectation ofthe availabilityof this right of offset, known insolvencies and state guaranty fund assessment bases. However, changes in the basis whereby assessments are charged to individual companies and changes in the availability of the right tooffset assessmentsagainst premium tax payments could materially affect the company's results.
Currently,the Company's insurance subsidiaries are subjectto government regulation in each of the states in which they conduct business. Such regulation is vested in state agencies having broad administrative power dealing with all aspects of the insurance business, including the power to: (i) grant and revoke licenses to transact business; (ii) regulate and supervise trade practices and market conduct; (iii) establish guaranty associations;(iv) license agents; (v) approve policyforms; (vi) approve premium rates for some lines of business; (vii) establish reserve requirements; (viii) prescribe the formand content of required financial statements and reports;(ix) determine the reasonableness and adequacy of statutory capital and surplus; and (x) regulate the type and amount of permitted investments. Insurance regulation is concerned primarily with the protection of policyholders. The Company cannot predict the form of any future proposals or regulation. The Company's insurance subsidiaries, USA, UG, APPL and ABE are domiciled in the states ofOhio, Ohio, WestVirginiaand Illinois, respectively.
The insurance regulatory framework continues to be scrutinized by various states, the federal governmentand the National Association of Insurance Commissioners ("NAIC"). The NAIC is an association whose membership consistsof the insurance ommissioners or their designees of the various states. The NAIC has no direct regulatory authority over insurance companies, however itsprimary purpose is to provide a more consistent method of regulation and reporting from state to state. Thisis accomplished through the issuance of model regulations, which can be adopted
by individual states unmodified, modified to meet the state's own needs or requirements, or dismissed entirely. Most states also have insurance holding company statutes which require registrationand periodic reporting by insurance companiescontrolled by other corporations licensed totransact business within their respective jurisdictions. The insurancesubsidiaries are subject to such legislationand registered as controlled insurersin those jurisdictions in which such registration is required. Statutes vary from state to statebut typically require periodic disclosure, concerning the corporation, that controls the registered insurers and all subsidiaries of such corporation. In addition, prior notice to, or approval by, the state insurance commission of material intercorporate transfers of assets, reinsurance agreements, management agreements (see Note 9 in the notes to the consolidated financial statements), and payment of dividends (see note 2 in the notes to the consolidated financial statements) in excess of specified amounts by the insurance subsidiary, within the holding company system, are required.
Each year the NAIC calculates financial ratio results (commonly referred to as IRIS ratios) for each company. These ratios compare various financial information pertaining to the statutory balancesheetand incomestatement. The results are then compared to pre-established normal ranges determined by the NAIC. Results outside the range typically require explanation to the domiciliary insurance department.
A task force of the NAIC is currently undertaking a project to codify a comprehensive set of statutory insurance accounting rules and regulations. This project is not expected to be completed earlier than 1999. Specific recommendations have been set forth in papers issued by the NAIC for industry review. The Company is monitoring the process, but the potential impact of any changes in insurance accounting standards is not yet known.
Under SFAS No. 128, primary EPS computed in accordance with previous opinions is replaced with a simpler calculation called basic EPS. Basic EPS is calculated by dividing income available to commonstockholders (i.e., net income or loss adjusted for preferred stock dividends) by the weighted-average number of common shares outstanding. Thus, in the most significant change in current practice, options, warrants,and convertible securities are excluded from the basic EPS calculation. Further, contingently issuable shares are included in basic EPS only if all the necessary conditions for the issuance of such shares have been satisfied by the end of the period.
Fully diluted EPS has not changed significantly but has been renamed diluted EPS. Income available to common stockholders continues to be adjusted for assumed conversion of all potentially dilutive securities using the treasury stock method to calculatethe dilutive effect of options and warrants. However,unlikethe calculation of fully diluted EPS under previous opinions, a new treasury stock method is applied using the average market price or the ending market price. Further, prior opinion requirement to use the modified treasury stock method when the number of options or warrants outstanding is greater than 20% of the outstanding shares also has been eliminated. SFAS 128 also includes certain shares thatare contingently issuable; however, the test for inclusion under the new rules is much more restrictive.
SFAS No. 128 requires companies reportingdiscontinued operations, extraordinary items, or the cumulativeeffect of accounting changes are to use income from operations as the control number or benchmark to determine whether potential common sharesare dilutive or antidilutive. Only dilutive securities are to be included in the calculation of diluted EPS.
The FASB has issued SFAS No. 130 entitled Reporting Comprehensive Income and SFAS No. 132 Employers' Disclosures about Pensions and Other Postretirement Benefits. Both of the above statements are effectivefor financial statements with fiscal years beginning after December 15, 1997.
The Company will adopt both SFAS No. 130 and SFAS No. 132 for the 1998 financialstatements. Management does not expect either adoptionto have a material impact on the Company's financial statements.
The Company established a project to address year 2000 processing concerns in September of 1996. In 1997 the Company completed the review of the Company'sinternally and externally developed software, and made correctionsto all year 2000 non-compliant processing. The Company also secured verification of current and future year 2000 compliance from all major external software vendors. In December of 1997, a separate computeroperating environment was established with the system dates advancedto December of 1999. A parallel model office was established with alldates in the data advanced to December of 1999. Parallel model office processing is being performed using dates from December of 1999 to January of 2001, to insure all year 2000 processing errors have been corrected.Testing should be completed by the end of the first quarter of 1998. After testing is completed, periodic regression testing will be performed to monitor continuing compliance. By addressing year 2000 compliance in a timely manner, compliance will be achieved using existing staff and without significant impact on the Company operationally or financially.
UTI owns 53% of United Trust Group, Inc., an insurance holding company, and UII owns 47% of United Trust Group, Inc. Neither UTI nor UII have any other significant holdings or business dealings. The Board of Directors of each company thus concluded a merger of the two companies would be in the best interests of the shareholders. The merger will result in certain cost savings, primarily related to costs associated with maintaining a corporation in good standing in the states in which it transacts business. A vote of the shareholders of UTI and UII regarding the proposed merger is anticipated to occur sometime during the third quarter of 1998.
UTI intends to use the equity that is being contributed to expand their operations through the acquisition of other life insurance companies.The transaction is subject to negotiation of a definitive purchase agreement; completion of due diligence by Mr. Correll; the receipt of regulatory and other approvals; and the satisfaction of certain conditions. The transaction is not expected to be completed before June 30, 1998, and there can be no assurance that the transaction will be completed.