As part of the administrative transition of the Company from Springfield, IL to Stanford, KY, the Company leases space in the Stanford, KY from an affiliate, FSNB, to house insurance operations. The Company rents approximately 8,000 square feet of office space and pays $2,000 per month in rent.
Valuation of Securities - The Company’s investment portfolio consists of fixed maturities, equity securities, trading securities, mortgage loans and real estate to provide funding of future policy contractual obligations. The Company’s fixed maturities and equity securities are classified as available-for-sale. Available-for-sale investments are carried at fair value with unrealized gains and losses reported in accumulated other comprehensive income (loss) in the Consolidated Balance Sheets.
The Company’s trading securities are carried at fair value with unrealized gains and losses reported in income in the Consolidated Statements of Operations. Fair value is the price that the Company would expect to receive upon sale of the asset in an orderly transaction.
Deferred Income Taxes - The provision for deferred income taxes is based on the asset and liability method of accounting for income taxes. Under this method, deferred income taxes are recognized by applying enacted statutory tax rates to temporary differences between amounts reported in the Consolidated Financial Statements and the tax basis of existing assets and liabilities. A valuation allowance is recognized for the portion of deferred tax assets that, in Management's judgment, is not likely to be realized. The effect on deferred income taxes of a change in tax rates or laws is recognized in income tax expense in the period that includes the enactment date. Refer to Note 1 - Summary of Significant Accounting Policies in the Notes to the Consolidated Financial Statements for detailed information regarding the Company’s significant accounting policies.
On a consolidated basis, the Company had net income attributable to common shareholders of $1.2 million and $917,000 in 2016 and 2015, respectively. In 2016, income before income taxes was $2.1 million compared to $273,000 in 2015. Total revenue was $27.8 million in 2016 and $28.8 million in 2015.
One-time events, primarily reflected in realized gains, comprise a substantial portion of the net income and revenue reported by the Company during 2016 and 2015. The magnitude of realized investment gains and losses in a given year is a function of the timing of trades of investments relative to the markets themselves as well as the recognition of any impairments on investments. Future earnings will be significantly negatively impacted should earnings from these one-time items not be realizable in a future period. While Management believes there remain additional investments with such one-time earnings, when or if realized remains uncertain.
Premiums and policy fee revenues, net of reinsurance premiums and policy fees, decreased approximately 15% when comparing 2016 to 2015. The Company writes very little new business. Unless the Company acquires a new company or a block of in-force business, Management expects premium revenue to continue to decline on the existing block of business at a rate consistent with prior experience. The Company’s average persistency rate for all policies in-force for 2016 and 2015 was approximately 96.6% and 96.2%, respectively. Persistency is a measure of insurance in-force retained in relation to the previous year.
During 2016, income was notably higher in the following portfolios, compared to the prior year in the fixed maturities and notes receivable investment portfolios. Income from the fixed maturities investment portfolio was up approximately 8%, compared to the prior year, and is the result of the Company holding certain higher yielding fixed maturity securities during 2016. The notes receivable investment portfolio produced income of approximately $1.5 million, an increase of 85%, compared to the prior year. During 2016, the Company increased its note receivable holdings by approximately 59%, and as a result, additional income was earned.
Investment income from equity securities, mortgage loans and short-term investments was down in 2016 as compared to 2015 results. While income from equity securities was less in 2016, as compared to 2015, overall, it appears reasonable and comparable to the prior year. Income from the mortgage loan portfolio was down approximately 68%, when comparing 2016 and 2015 activity. This is the result of the continued pay off of loans within the portfolio, particularly the discounted mortgage loans that in recent periods provided significant earnings.
For a period of time, during 2016, the Company held one short term investment, which provided a small amount of income for the Company. During 2015, the Company financed a short-term note receivable. The note was fully repaid during the fourth quarter of 2015 and the Company recognized income of approximately $443,000 at the time of payoff.
The Company recognized approximately $3 million more in net realized gains in 2016 as compared to 2015. Gains from fixed maturities were comparable from year to year. The gains from equity securities were up approximately $800,000 and are the result of selling certain equity securities.
During 2016 and 2015, realized gains were offset by other-than-temporary impairments of approximately $467,000 and $3.6 million, respectively. The other-than-temporary impairments were taken as a result of Management’s assessment and consideration of the length of time the securities have remained in an unrealized loss position and as a result of management’s analysis and determination of value. The investments were written down to better reflect their current estimated fair value.
During 2015, Management determined it was in the Company’s best long term interest to relocate its main operations from Springfield, Illinois to Stanford, Kentucky. The Company’s majority shareholder, Jess Correll, headquarters his other operating entities in Stanford, Kentucky. Management believes this move will provide the Company with significant synergies, improve efficiencies and reduce overall operating expenses. The relocation was substantially complete as of December 31, 2016.
Effective January 1, 2017, the Company and FSNB began sharing certain services. The shared services focuses on departments commonly utilized by both organizations such as Financial Accounting, Human Resources and Information Technology.
As of December 31, 2016, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets, shareholders’ equity or results from operations. To provide additional flexibility and liquidity, the Company has identified all fixed maturity securities as "investments available for sale". Investments available for sale are carried at market value, with changes in market value charged directly to the other comprehensive component of shareholders' equity. Changes in the market value of available for sale securities resulted in net unrealized gains of approximately $22.4 million during 2016 and net unrealized losses of approximately $(7.2) million during 2015. The variance in the net unrealized gains and losses is the result of normal market fluctuations mainly related to changes in interest rates in the market place.
Net cash used in financing activities was approximately $2 million and $6 million during 2016 and 2015, respectively. On July 22, 2016, the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company’s outstanding common stock. The acquisition was made under the Company’s stock buy-back program. As part of this transaction, two promissory notes totaling $2.9 million were issued. The notes require principal payments of one half of the note value to be paid one year from the date of purchase and the other one half to be paid two years from the date of purchase. The notes bear interest at 0%.
During 2015, the Company made principal payments on its outstanding debt of approximately $4.4 million and as of December 31, 2015 the Company had no debt outstanding with third parties.
The Company had cash and cash equivalents of approximately $15.2 million and $11.8 million as of December 31, 2016 and 2015, respectively. The Company has a portfolio of marketable fixed and equity securities that are available for sale, if an unexpected event were to occur. These securities had a fair value of approximately $239 million and $231 million at December 31, 2016 and 2015, respectively. However, the strong cash flows from investing activities, investment maturities and the availability of the line of credit facilities make it unlikely that the Company would need to sell securities for liquidity purposes. See Note 2 - Investments in the Notes to the Consolidated Financial Statements for detailed disclosures regarding the Company’s investment portfolio.
The Company’s capital structure consists of short-term debt, long-term debt and shareholders’ equity. A complete analysis and description of the short-term and long-term debt issues outstanding as of December 31, 2016 and 2015 are presented in Note 7 - Credit Arrangements in the Notes to the Consolidated Financial Statements.
The NAIC's risk-based capital requirements require insurance companies to calculate and report information under a risk-based capital formula. The risk-based capital (RBC) formula measures the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, mortality and morbidity, asset and liability matching and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized.
At December 31, 2016, UG has a ratio of approximately 4.97, which is 497% of the authorized control level. Accordingly, the Company meets the RBC requirements.
The Board of Directors of UTG has authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. At a meeting of the Board of Directors on June 15, 2016, the Board of Directors of UTG authorized the repurchase of up to an additional $2 million of UTG’s common stock and on July 14, 2016, the Board of Directors again increased the amount available by an additional $4.5 million, for a total repurchase of $14.5 million. Repurchased shares are available for future issuance for general corporate purposes. Company Management has broad authority to operate the program, including the discretion of whether to purchase shares and the ability to suspend or terminate the program. Open market purchases are made based on the last available market price but may be limited. During 2016, the Company repurchased approximately 370,172 shares through the stock repurchase program for $5,432,195. Through December 31, 2016, UTG has spent approximately $11.9 million in the acquisition of approximately 1,059,000 shares under this program.
This document at times will refer to the Registrant’s largest shareholder, Mr. Jesse T. Correll and certain companies controlled by Mr. Correll. Mr. Correll holds a majority ownership of First Southern Funding, LLC (“FSF”), a Kentucky corporation, and First Southern Bancorp, Inc. (“FSBI”), a financial services holding company. FSBI operates through its 100% owned subsidiary bank, First Southern National Bank (“FSNB”). Banking activities are conducted through multiple locations within south-central and western Kentucky. Mr. Correll is Chief Executive Officer and Chairman of the Board of Directors of UTG and is currently UTG’s largest shareholder through his ownership control of FSF, FSBI and affiliates. At December 31, 2016, Mr. Correll owns or controls directly and indirectly approximately 63.75% of UTG’s outstanding stock.
Notes Receivable - Notes receivable are reported at their unpaid principal balances, adjusted for valuation allowances. Valuation allowances are established for impaired loans when it is probable that contractual principal and interest will not be collected. Interest accruals are analyzed based on the likelihood of repayment. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status.
Future Policy Benefits and Expenses - The liabilities for traditional life insurance and accident and health insurance policy benefits are computed using a net level method. These liabilities include assumptions as to investment yields, mortality, withdrawals, and other assumptions based on the life insurance subsidiary’s experience adjusted to reflect anticipated trends and to include provisions for possible unfavorable deviations. The Company makes these assumptions at the time the contract is issued or, in the case of contracts acquired by purchase, at the purchase date. Future policy benefits for individual life insurance and annuity policies are computed using interest rates ranging from 2% to 6% for life insurance and 2.5% to 7.5% for annuities. Benefit reserves for traditional life insurance policies include certain deferred profits on limited-payment policies that are being recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred. The mortality rate assumptions for policies currently issued by the Company are based on 2001 select and ultimate tables. Withdrawal rate assumptions are based upon Linton B or C, which are industry standard actuarial tables for forecasting assumed policy lapse rates.
Income Taxes - Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax impact attributable to differences between the financial statement book values and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. More information concerning income taxes is provided in Note 6 - Income Taxes.
Accounting Standards Update (ASU) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory - The amendments included in ASU 2016-16 require an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. The amendments eliminate the exception for an intra-entity transfer of an asset other than inventory. The amendments do not include new disclosure requirements; however, existing disclosure requirements might be applicable when accounting for the current and deferred income taxes for an intra-entity transfer of an asset other than inventory. ASU 2016-16 is effective for public companies for fiscal years beginning after December 15, 2017. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.
Accounting Standards Update (ASU 2016-13), Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments - The amendments included in ASU 2016-13 require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better evaluate their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. ASU 2016-13 is effective for public companies for fiscal years beginning after December 15, 2019. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements.
Accounting Standards Update (ASU) 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities - The amendments included in ASU 2016-01 requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. ASU 2016-01 also requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables). The guidance eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. ASU 2016-01 is effective for public companies for fiscal years beginning after December 15, 2017. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements.
The Company held below investment grade investments with an estimated market value of $33,064,563 and $13,352,934 as of December 31, 2016 and 2015, respectively. The investments are all classified as “All other corporate bonds”.
Substantially all of the unrealized losses on fixed maturities available for sale at December 31, 2016 and 2015 are attributable to changes in market interest rates and general disruptions in the credit market subsequent to purchase. The unrealized losses on equity investments were primarily attributable to normal market fluctuations. The Company does not currently intend to sell nor does it expect to be required to sell any of the securities in an unrealized loss position. Based upon the Company’s expected continuation of receipt of contractually required principal and interest payments and its intent and ability to retain the securities until price recovery, as well as the Company’s evaluation of other relevant factors, the Company deems these securities to be temporarily impaired as of December 31, 2016 and 2015
Approximately 12% and 30% of the mortgage loan portfolio consists of discounted commercial mortgage loans as of December 31, 2016 and 2015, respectively. The Company began purchasing discounted commercial mortgage loans in 2009. Management has extensive background and experience in the analysis and valuation of commercial real estate. The discounted loans are available through the FDIC’s sale of assets of closed banks and from banks wanting to reduce their loan portfolios. The loans are available on a loan by loan bid process. Once a loan has been acquired, contact is made with the appropriate individuals to begin a dialog with a goal of determining the borrower’s willingness to work together. There are generally three paths a discounted loan will take: the borrowers pay as required; a settlement is reached with the loan being paid off at a discounted value; or the loan is foreclosed.
During 2016 and 2015, the Company acquired $6,935,273 and $13,774,698 in mortgage loans, respectively, including both regular participation mortgage loans as well as discounted mortgage loans. FSNB services the majority of the Company’s mortgage loan portfolio. The Company pays FSNB a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan.
Changes in the current economy could have a negative impact on the loans, including the financial stability of the borrowers, the borrowers’ ability to pay or to refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices. Given the uncertainty of the current market, Management has taken a conservative approach with the discounted mortgage loans and has classified all discounted mortgage loans held as non-accrual. In such status, the Company is not recording any accrued interest income nor is it recording any accrual of discount on the loans held. The Company records repayments on loans as discount accrual when the loan basis has been paid in full.
A mortgage loan reserve is established and adjusted based on Management's quarterly analysis of the portfolio and any deterioration in value of the underlying property which would reduce the net realizable value of the property below its current carrying value. The Company acquired the discounted mortgage loans at below contract value, and believes that it will fully recover its carrying value upon disposal, therefore no reserve for delinquent loans is deemed necessary. Those not currently paying are being vigorously worked by Management. The current discounted commercial mortgage loan portfolio has an average price of 32% and 39% of face value as of December 31, 2016 and 2015, respectively. Management has determined that this deep discount provides a financial cushion or built in allowance for any of the loans that are not currently performing within the portfolio of loans purchased. The mortgage loan reserve was $0 at December 31, 2016 and 2015.
The following table reflects the Company’s net realized investments gains and losses for the periods ended December 31:
Equity securities may experience other-than-temporary impairments in the future based on the prospects for full recovery in value in a reasonable period of time and the Company’s ability and intent to hold the security to recovery. If a decline in fair value is judged by Management to be other-than-temporary or Management does not have the intent or ability to hold a security, a loss is recognized by a charge to other-than-temporary impairment losses in the Consolidated Statements of Operations.
The other-than-temporary impairments recognized during 2016 and 2015 were taken as a result of Management’s assessment and consideration of the length of time the securities have remained in an unrealized loss position and as a result of management’s analysis and determination of value. The investments were written down to better reflect their current expected market value.
The inputs used in the valuation techniques employed by the Company are provided by nationally recognized pricing services, external investment managers and internal resources. To assess these inputs, the Company’s review process includes, but is not limited to, quantitative analysis including benchmarking, initial and ongoing evaluations of methodologies used by external parties to calculate fair value, and ongoing evaluations of fair value estimates based on the Company’s knowledge and monitoring of market conditions.
Equity securities available for sale consist of common and preferred stocks mainly in private equity investments, financial institutions and insurance companies. Equity securities for which there is sufficient market data are categorized as Level 1 or 2 in the fair value hierarchy. For the equity securities in which quoted market prices are not available, the transaction price is used as the best estimate of fair value at inception. When evidence is believed to support a change to the carrying value from the transaction price, adjustments are made to reflect the expected exit values. The Company performs ongoing reviews of the underlying investments. The reviews consist of the evaluations of expected cash flows, material events and market data. These investments are included in Level 3 of the fair value hierarchy.
The Level 3 securities include collateralized debt obligations of trust preferred securities issued by banks and insurance companies and certain equity securities with unobservable inputs. The Company computed fair value of Level 3 equity investments based on a review of current financial information, earnings trends and similar companies in the same industries.
The Company does not have any short-duration reinsurance contracts. The effect of the Company's long-duration reinsurance contracts on premiums earned in 2016 and 2015 were as follows:
The Company's Federal income tax returns are periodically audited by the Internal Revenue Service ("IRS"). There are currently no examinations in process, nor is Management aware of any pending examination by the IRS. The Company follows the accounting guidance for uncertainty in income taxes using the provisions of Financial Accounting Standards Board ("FASB") ASC 740, Income Taxes. Using that guidance, tax positions initially need to be recognized in the financial statements when it is more-likely-than-not the position will be sustained upon examination by the tax authorities. Such tax positions initially and subsequently need to be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and relevant facts. The Company has evaluated its tax positions, expiring statutes of limitations, changes in tax law and new authoritative rulings and believes that no disclosure relative to a provision of income taxes is necessary, at this time, to cover any uncertain tax positions. Tax years that remain subject to examination are the years ended December 31, 2013, 2014, 2015 and 2016.
At December 31, 2016 and 2015, the Company had the following outstanding debt:
On July 22, 2016, the Company entered in to an agreement to acquire 300,000 shares of its outstanding common stock from a shareholder that owned approximately 8% of the Company’s outstanding common stock. The acquisition was made under the Company’s stock buy-back program. As part of this transaction, two promissory notes totaling $2.9 million were issued. The notes require principal payments of one half of the note value to be paid one year from the date of purchase and the other one half to be paid two years from the date of purchase. The notes bear interest at 0%.
Within the Company’s trading accounts, certain trading securities carried as liabilities represent securities sold short. A gain, limited to the price at which the security was sold short, or a loss, potentially unlimited in size, will be recognized upon the termination of the short sale.
Statutory Restrictions - Restrictions exist on the flow of funds to UTG from its insurance subsidiary. Statutory regulations require life insurance subsidiaries to maintain certain minimum amounts of capital and surplus. UG is required to maintain minimum statutory surplus of $2,500,000. At December 31, 2016, substantially all of the consolidated shareholders' equity represents net assets of UTG’s subsidiaries.
On February 20, 2003, UG purchased $4 million of a trust preferred security offering issued by First Southern Bancorp, Inc. (“FSBI”). The security has a mandatory redemption after 30 years with a call provision after 5 years. The security pays a quarterly dividend at a fixed rate of 6.515%. The Company received dividends of $264,946 and $264,219 during 2016 and 2015, respectively. On March 30, 2009, UG purchased $1 million of FSBI common stock. The sale and transfer of this security is restricted by the provisions of a stock restriction and buy-sell agreement.
The Company from time to time acquires mortgage loans through participation agreements with FSNB. FSNB services the Company's mortgage loans including those covered by the participation agreements. The Company pays a .25% servicing fee on these loans and a one-time fee at loan origination of .50% of the original loan cost to cover costs incurred by FSNB relating to the processing and establishment of the loan. The Company paid $13,517 and $11,622 in servicing fees and $0 and $25,000 in origination fees to FSNB during 2016 and 2015, respectively.
The Company reimbursed expenses incurred by employees of FSNB relating to salaries, travel and other costs incurred on behalf of or relating to the Company. The Company paid $269,262 and $324,918 in 2016 and 2015, respectively to FSNB in reimbursement of such costs. In addition, the Company reimburses FSNB a portion of salaries and pension costs for Mr. Correll and Mr. Ditto. The reimbursement was approved by the UTG Board of Directors and totaled $335,769 and $349,351 in 2016 and 2015, respectively, which included salaries and other benefits.
As previously disclosed in the Notes Receivable section of Note 2 - Investments, several of the Company’s notes have participation agreements in place with third parties. Certain participation agreements are with FSF, a related party. The participation agreements are sold without recourse and assigned to the participant based on their pro-rata share of the principal, interest and collateral as specified in the participation agreements. The undivided participations in the notes receivable range from 20% - 50%. The total amount of loans participated to FSF were $250,000 and $3,170,000 as of December 31, 2016 and 2015, respectively.
During 2016, UTG and FSF established a partnership agreement and formed a limited liability company to purchase real estate. FSF contributed $140,000 to the partnership, which gave them a 10% ownership in the LLC.