Property owned Amount % of Total -------------- ---------- ----------- Home Office $ 2,367,935 23%
Premiums and policy fee revenues, net of reinsurance premiums and policy fees, decreased 18% when comparing 1999 to 1998 and 8% from 1998 to 1997. The Company currently writes little new traditional business, consequently, traditional premiums will decrease as the amount of traditional business in-force decreases. Collected premiums on universal life and interest sensitive products is not reflected in premiums and policy revenues because Generally Accepted Accounting Principles ("GAAP") requires that premiums collected on these types of products be treated as deposit liabilities rather than revenue. Unless the Company acquires a block of in-force business or marketing changes its focus to traditional business, premium revenue will continue to decline at a rate consistent with prior experience. The Companies' average persistency rate for all policies in force for 1999 and 1998 has been approximately 89.4% and 89.9%, respectively. Persistency is a measure of insurance in force retained in relation to the previous year.
With a continued decline in new business, costs associated with supporting new business, primarily salary costs, as a percentage of new business received continued to grow. In March of 1999, the Company determined it could no longer continue to support these fixed costs in light of the new business trend and no indication it would reverse any time soon. It was determined these fixed costs should be reduced to be commensurate with the level of new sales production activity currently being experienced. As such, in March 1999 seven employees of the Company (approximately 8% of the total staff) were terminated due to lack of business activity.
The Company is currently reviewing the feasibility of a marketing opportunity with First Southern National Bank, an affiliate of UTG's largest shareholder. The Company is looking at different types of products, including credit insurance, as a potential to sell to credit customers of First Southern National Bank. Other products are also being explored, including annuity type products and existing insurance products, as a possibility to market to all banking customers.
Net investment income decreased 4% when comparing 1999 to 1998 and increased 1% when comparing 1998 to 1997. The decrease in net investment income in 1999 is due to the decline of the national prime rate during September and October of 1998. During September and October of 1998, the national prime rate declined three quarters of one percent (.75%). This decline reduced the yields on investments available in the marketplace in which the Company invests primarily fixed maturities. The interest rate environment improved later in 1999. The national prime rate rose a total of three-quarters of one percent (.75%) in the second half of 1999. Changes in the national prime rate may impact net investment income in the future. Approximately 13% of the total fixed maturity portfolio will mature within the next year, with another 53% maturing in the next two to five years. The Company has recently begun looking at the mortgage loan market for possible investments, due to the affiliation with First Southern Funding and its affiliates ("FSF"). FSF is the largest shareholder of UTG. The affiliation with FSF provides additional resources in the mortgage loan market. FSF is in the banking industry and has experience and expertise in underwriting commercial and residential mortgage loans. The Company believes it can issue or acquire loans, which will provide attractive yields while maintaining high quality and low risk.
The Company's investments are generally managed to match related insurance and policyholder liabilities. The comparison of investment return with insurance or investment product crediting rates establishes an interest spread. The minimum interest spread between earned and credited rates is 1% on the "Century 2000" universal life insurance
product, which currently is the Company's primary sales product. The Company monitors investment yields, and when necessary adjusts credited interest rates on its insurance products to preserve targeted interest spreads. It is expected that monitoring of the interest spreads by management will provide the necessary margin to adequately provide for associated costs on the insurance policies the Company currently has in force and will write in the future. At the September 1998 Board of Directors meeting, the Boards of the insurance subsidiaries lowered crediting rates one half percent on all products crediting 5.5% or more. The change affected approximately $60,000,000 of policy reserves and will result in interest crediting reductions of $300,000 per year. At the March 1999 Board of Directors meeting, the Boards of the insurance subsidiaries again lowered crediting rates one half percent on all products that could be lowered. The change will result in interest crediting reductions of approximately $600,000 per year. These adjustments were in response to continued declines in interest rates in the marketplace. Policy interest crediting rate changes become effective on an individual policy basis on the next policy anniversary. Therefore, it will take a full year from the time the change is determined for the full impact of such change to be realized.
Realized investment losses, net of realized gains, were $530,894, $851,822 and $268,982 in 1999, 1998 and 1997, respectively. During the last two years the Company re-evaluated its real estate holdings, especially those properties acquired through acquisitions of other companies and mortgage loan foreclosures, and determined it would be in the long term interest of the Company to dispose of certain of these parcels. Parcels targeted for sale were generally non-income or low income producing and located in parts of the country where management has little other reason to travel to. The disposal of these properties will free up management time to focus on the properties that have a more viable long-term benefit to the Company. Approximately 99% of the realized loss in 1999 is from two parcels of real estate. In June 1999, the Company sold its shopping center in Gulfport, MS realizing a loss on sale of $401,000. This property was originally acquired through the foreclosure of a mortgage loan. The property was income producing, but due to the distance from the Company's headquarters, was difficult to manage and required the use of an outside property manager. Given this circumstance and the eventual need for updates and improvements, the Company determined it was in its best long-term interest to sell the property. At year-end the Company wrote down another parcel of real estate $178,000 that it determined to attempt to sell during 2000. The write down was the result of Management's determination of the amount it would be willing to accept for the property. Approximately $440,000 of realized losses in 1998 is due to the sale of real estate. The Company reduced its non-income producing investments approximately $1,610,000 during 1998, as a result of these actions. The Company incurred losses of approximately $339,000 on the foreclosure of three mortgage loans during the second quarter of 1998. The foreclosed properties were sold before the end of 1998. As a result of these foreclosures, management reassessed its remaining mortgage loan portfolio and determined an allowance of $70,000 was appropriate to cover potential future losses in the portfolio. The Company realized a loss of approximately $88,000 on the investment in John Alden Financial Corporation common stock. Under the terms of an acquisition agreement beween Fortis, Inc. and John Alden all outstanding common shares of John Alden were acquired. The Company had other gains and losses during the periods that comprised the remaining amounts reported but were immaterial on an individual basis.
Benefits, claims and settlement expenses net of reinsurance benefits and claims, decreased 16% in 1999 as compared to 1998 and decreased 7% comparing 1998 to 1997. Two events occurred in 1999, which differ from 1998 experience. The decrease in premium revenues from normal policy terminations resulted in lower benefit reserve increases in each of the periods presented compared to the previous period. Approximately 8% of the current year decrease is from the premium reduction on certain participating policies resulting in a lower dividend to policyholders expense than in the previous year. See discussion above in premiums and policy fee revenues for a more detailed explanation of this event. Policyholder benefits were further impacted due to an increase in death benefit claims of $202,000 from 1998 results. The 1998 death claims were $1,036,000 less than 1997 and accounted for approximately 4% of the decrease from 1997. There is no single event that caused the mortality variances. Policy claims vary from year to year and therefore, fluctuations in mortality are to be expected and are not considered unusual by management. At the September 1998 Board of Directors meeting, the Boards of the insurance subsidiaries lowered crediting rates one half percent on all products crediting 5.5% or more. The change affected approximately $60,000,000 of policy reserves and will result in interest crediting reductions of $300,000 per year. At the March 1999 Board of Directors meeting, the Boards of the insurance subsidiaries again lowered crediting rates
Amortization of cost of insurance acquired increased 5% in 1999 compared to 1998 and decreased 18% in 1998 compared to 1997. Cost of insurance acquired is established when an insurance company is acquired. The Company assigns a portion of its cost to the right to receive future cash flows from insurance contracts existing at the date of the acquisition. The cost of policies purchased represents the actuarially determined present value of the projected future cash flows from the acquired policies. Cost of insurance acquired is comprised of individual life insurance products including whole life, interest sensitive whole life and universal life insurance products. Cost of insurance acquired is amortized with interest in relation to expected future profits, including direct charge-offs for any excess of the unamortized asset over the projected future profits. The interest rates utilized in the amortization calculation are 9% on approximately 74% of the balance and 15% on the remaining balance. The interest rates vary due to risk analysis performed at the time of acquisition on the business acquired. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. The Company did not have any charge-offs during the periods covered by this report. Amortization of cost of insurance acquired is particularly sensitive to changes in persistency of certain blocks of insurance in-force. 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 1999, 1998 and 1997 has been approximately 89.4%, 89.9% and 89.4%, respectively.
During the fourth quarter of 1999, the Company transferred the policy administration functions of its insurance subsidiary APPL from Huntington, WV to its Springfield, IL location. The transfer was completed to reduce operating costs. APPL policy administration was then converted to the same computer system used to administer the other insurance subsidiaries. Following the transfer and system conversion, all insurance administration is located at the Springfield, IL office and administered on the same computer system. This action did not result in any cost savings in 1999, but is expected to save approximately $250,000 per year in administrative costs in future periods.
The following table summarizes the Company's fixed maturities distribution at December 31, 1999 and 1998 by ratings category as issued by Standard and Poor's, a leading ratings analyst.
Fixed Maturities Rating % of Portfolio ---------------------- 1999 1998 ---------- ---------- Investment Grade AAA 38% 38% AA 19% 18% A 35% 36% BBB 7% 7% Below investment grade 1% 1% ---------- ---------- 100% 100% ========== ==========
Policy loans remained consistent for the periods presented. 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.
Deferred policy acquisition costs decreased 17% in 1999 compared to 1998. Deferred policy acquisition costs, which vary with, and are primarily related to producing new business, are referred to as ("DAC"). DAC consists primarily of commissions and certain costs of policy issuance and underwriting, net of fees charged to the policy in excess of ultimate fees charged. To the extent these costs are recoverable from future profits, the Company defers these costs and amortizes them with interest in relation to the present value of expected gross profits from the contracts, discounted using the interest rate credited by the policy. The Company had $720,000 in policy acquisition costs deferred, $436,000 in interest accretion and $3,219,012 in amortization in 1999.
Total shareholders' equity decreased 5% in 1999 compared to 1998. This decrease is primarily attributable to the loss included in accumulated other comprehensive income, which for the Company represents unrealized holding losses on securities which are carried at market value, decreasing shareholders equity $1,283,991 in 1999 compared to 1998. The Company's net loss of $377,957 in 1999 also contributed to the decline.
Future policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations. The Company has the ability and intent to hold these investments to maturity; consequently, a significant portion of the Company's investment in long-term fixed maturities is reported in the financial statements at their amortized cost.
Cash provided by (used in) investing activities was $(4,974,503), $5,556,955 and $(2,994,652), for 1999, 1998 and 1997, respectively. The most significant aspect of cash provided by (used in) investing activities are the fixed maturity transactions. Fixed maturities account for 68%, 84% and 72% of the total cost of investments acquired in 1999, 1998 and 1997, respectively. The Company has not directed its investable funds to so-called "junk bonds" or derivative investments.
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 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. In addition, the formula defines new minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the insurance company's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Insurance companies below specific trigger points or ratios are classified within certain levels, each of which requires specific corrective action.
At year-end 1999, the insurance companies had one ratio outside the normal range. The ratio is related to the decrease in premium income. The results fell outside the normal range because of the permanent premium reduction on certain of the Company's participating products in force commonly referred to as the initial contract and the presidents plan. The premium reduction, which took effect with the 1999 premium payment, was generally 20% with 35% used on initial contract plans of UG with original issue ages less than 56 years old. The dividends were also reduced, and the net effect to the policyholder was a slightly lower net premium. This action was taken by the Boards
of UG and USA to ensure these policyholders will be protected in future periods from potential dividend reductions at least to the extent of the permanent premium reduction amount.
The Clinton Administration has recently proposed tax changes that would affect the insurance industry. One proposal is to require recapture of untaxed profits on policyholder surplus accounts. Between 1959 and 1983, stock life insurance companies deferred tax on a portion of their profits. These untaxed profits were added to a policyholders surplus account ("PSA"). In 1984, Congress precluded life insurance companies from continuing to defer taxes on any future profits. The Clinton Administration argues that there is no continuing justification for permitting stock life insurance companies to defer tax on profits that were earned between 1959 and 1983. Accordingly, the stock life companies would be required to include in their gross income over ten years their PSA balances. The second proposal modifies rules for capitalizing policy acquisition costs because life insurance companies generally only capitalize a fraction of their actual policy acquisition costs. This modification would increase the current capitalization percentages. Either of these changes would be onerous to the Company and to the insurance industry as a whole. The outcome and timing of these proposals cannot be anticipated at this time.
The NAIC adopted the Life Illustration Model Regulation. Many states have adopted the regulation effective January 1, 1997. This regulation requires products, which contain non-guaranteed elements, such as universal life and interest sensitive life, to comply with certain actuarially established tests. These tests are intended to target future performance and profitability of a product under various scenarios. The regulation does not prevent a company from selling a product that does not meet the various tests. The only implication is the way in which the product is marketed to the consumer. A product that does not pass the tests uses guaranteed assumptions rather than current assumptions in presenting future product performance to the consumer. The Company conducts an ongoing thorough review of its sales and marketing process and continues to emphasize its compliance efforts.
The "Year 2000 Issue" is the inability of computers and computing technology to recognize correctly the Year 2000 date change. The problem results from a long-standing practice by programmers to save memory space by denoting years using just two digits instead of four digits. Thus, systems that are not Year 2000 compliant may be unable to read dates correctly after the Year 1999 and can return incorrect or unpredictable results.
Independent Auditor's Report for the Years ended December 31, 1999, 1998, 1997.............................33
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of First Commonwealth Corporation and subsidiaries as of December 31, 1999 and 1998, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 1999, in conformity with generally accepted accounting principles.
We have also audited Schedule I as of December 31, 1999, and Schedules II, IV and V as of December 31, 1999 and 1998, of First Commonwealth Corporation and subsidiaries and Schedules II, IV and V for each of the three years in the period then ended. In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein.
FIRST COMMONWEALTH CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS Three Years Ended December 31, 1999
United Trust Group, Inc. ("UTG") is the ultimate controlling company. UTG owns 80% of First Commonwealth Corporation ("FCC") and 100% of North Plaza of Somerset Inc. ("North Plaza") and 100% of Roosevelt Equity Corporation ("REC"). FCC owns 100% of Universal Guaranty Life Insurance Company ("UG"). UG owns 86% of Appalachian Life Insurance Company ("APPL") and APPL owns 100% of Abraham Lincoln Insurance Company ("ABE").
D. BASIS OF PRESENTATION - The financial statements of First Commonwealth Corporation's life insurance subsidiaries have been prepared in accordance with generally accepted accounting principles which differ from statutory accounting practices permitted by insurance regulatory authorities.
Real estate - Investment real estate at cost less allowance for depreciation and, as appropriate, provisions for possible losses. At year-end 1999, the Company wrote down a parcel of real estate $178,000 it determined to attempt to sell during 2000. The write down was the result of Management's determination of the amount it would be willing to accept for the property. Foreclosed real estate is adjusted for any impairment at the foreclosure date. Accumulated depreciation on investment real estate was $1,824,484 and $1,696,428 as of December 31, 1999 and 1998, respectively.
Interest Net Accretion Amortization Amortization --------- ------------ ------------ 2000 $ 1,423,000 $ 2,608,000 $1,185,000 2001 1,334,000 2,450,000 1,116,000 2002 1,243,000 2,202,000 959,000 2003 1,162,000 1,976,000 814,000 2004 1,092,000 1,774,000 682,000
are to be periodically updated whenever actual experience and/or expectations for the future change from initial assumptions. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised.
M. COST IN EXCESS OF NET ASSETS PURCHASED - Cost in excess of net assets purchased is the excess of the amount paid to acquire a company over the fair value of its net assets. Costs in excess of net assets purchased are amortized on the straight-line basis over a 40-year period. Management continually
reviews the value of goodwill based on estimates of future earnings. As part of this review, management determines whether goodwill is fully recoverable from projected undiscounted net cash flows from earnings of the subsidiaries over the remaining amortization period. If management were to determine that changes in such projected cash flows no longer supported the recoverability of goodwill over the remaining amortization period, the carrying value of goodwill would be reduced with a corresponding charge to expense (no such changes have occurred). Accumulated amortization of cost in excess of net assets purchased was $6,848,192 and $6,415,642 as of December 31, 1999 and 1998, respectively.
Q. TREASURY SHARES - The Company holds 947 and 946 shares of common stock as treasury shares with a cost basis of $3,464,100 and $3,464,000 at December 31, 1999 and 1998, respectively.
The Company has established a deferred tax asset of $670,367 for its total unrealized losses on investments of $1,915,335, and has established an allowance of $670,367.
The provision or (credit) for income taxes differed from the amounts computed by applying the applicable United States statutory rate of 35% to the loss before taxes as a result of the following differences:
At December 31, 1999, the Company had a total of $4,311,000 of investments, comprised of $3,197,000 in real estate, $1,048,000 in equity securities and $66,000 in other long-term investments, which did not produce income during 1999.
The amortized cost and estimated market value of debt securities at December 31, 1999, by contractual maturity, is shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
An analysis of sales, maturities and principal repayments of the Company's fixed maturities portfolio for the years ended December 31, 1999, 1998 and 1997, is as follows:
The Company holds a $840,066 note receivable for which the determination of fair value is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. In addition, the Company has invested $66,212 in a joint real estate venture.
Reinsurance contracts do not relieve the Company from its obligations to policyholders. Failure of reinsurance companies to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers to minimize its exposure to significant losses from reinsurance company insolvencies.
One of the Company's insurance subsidiaries (UG) entered a coinsurance agreement with First International Life Insurance Company ("FILIC") as of September 30, 1996. Under the terms of the agreement, UG ceded to FILIC substantially all of its paid-up life insurance policies. Paid-up life insurance generally refers to non-premium paying life insurance policies. A.M. Best assigned FILIC a Financial Performance Rating (FPR) of 7 (Strong) on a scale of 1 to 9. A.M. Best assigned a Best's Rating of A++ (Superior) to The Guardian Life Insurance Company of America ("Guardian"), parent of FILIC, based on the consolidated financial condition and operating performance of the company and its life/health subsidiaries. During 1997, FILIC changed its name to Park Avenue Life Insurance Company ("PALIC"). The agreement with PALIC accounts for approximately 64% of the reinsurance receivables as of December 31, 1999.
Shown in thousands -------------------------------------------------------- 1999 1998 1997 Premiums Premiums Premiums Earned Earned Earned ---------------- ---------------- ---------------- Direct $ 25,539 $ 30,919 $ 33,374 Assumed 20 20 0 Ceded (3,978) (4,543) (4,735) ---------------- ---------------- ---------------- Net premiums $ 21,581 $ 26,396 $ 28,639 ================ ================ ================
Following necessary regulatory approval, on December 29, 1999, UG was the survivor to a merger with its 100% owned subsidiary, USA. The merger was completed as a part of management's efforts to reduce costs and simplify the corporate structure.
holding group with lower administrative costs, a simplified corporate structure, and more readily marketable securities. Following the merger approval, UTG issued 817,517 shares of its authorized but unissued common stock to former UII shareholders, net of any dissenter shareholders in the merger. Immediately following the merger, UTGL99, which was then 100% owned by UTG, was liquidated and UTG changed its name to United Trust Group, Inc. ("UTG").
At December 31, 1999 and 1998, the Company has $14,864,193 and $17,369,993 in long term debt outstanding, respectively. The debt is comprised of the following components:
The subordinated debt was incurred June 16, 1992 as a part of the acquisition transactions of the now dissolved Commonwealth Industries Corporation, (CIC) and is payable to UTG. The 10-year notes bear interest at the rate of 7 1/2% per annum, payable semi-annually beginning December 16, 1992. These notes provide for principal payments equal to 1/20th of the principal balance due with each interest installment beginning December 16, 1997. During second quarter 1999, the Company prepaid all of the outstanding 10-year notes.
In November 1997, FCC borrowed $1,000,000 to facilitate the prepayment of a May 1998 principal payment due on the senior debt. The note bears interest at the rate of 1% over the prime rate of interest as published in the Wall Street Journal, with interest payments due quarterly and principal due upon maturity of the note on November 8, 2006.
In November 1998, FCC borrowed $2,608,099 to facilitate the prepayment of principal on its subordinated 10-year debt. The note bears interest at the rate of 7.50%, with interest payments due quarterly and principal due upon maturity of the note on December 31, 2005. In addition, FCC borrowed $6,300,000 to facilitate the prepayment of principal on the senior debt. This note bears interest at the rate of 9/16% over the prime rate of interest as published in the Wall Street Journal, with interest payments due quarterly and principal due upon maturity of the note on December 31, 2006.
On a cash basis, the Company paid $1,353,653, $1,655,297 and $1,595,699 in interest expense for the years 1999, 1998 and 1997, respectively. The Company paid $516,200, $10,630 and $49,520 in federal income tax for the years 1999, 1998 and 1997 respectively.