The following discussion analyzes significant items affecting the results of operations and the financial condition of the Company. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the "SEC"). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Statements using verbs such as "plan", "anticipate", "believe" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company's beliefs concerning future levels of sales and surrenders of the Company's products, investment spreads and yields, or the earnings and profitability of the Company's activities.
The Company intends to continue its focus on the sale of life insurance and annuity products through its marketing and distribution systems. Specifically, the Company will continue its efforts in the ARS operations which resulted in significant sales growth during 1999. In addition, the Company may also pursue selected acquisitions of blocks of life insurance policies and life insurance companies.
Revenues and income before income taxes for the Company's operating segments, as defined by Statement of Financial Accounting Standard ("SFAS") No. 131, "Financial Reporting for Segments of a Business Enterprise", is summarized as follows (in millions) :
Asset accumulation products operations. Income before income taxes decreased $3.3 million from 1998 to 1999. The primary reasons for the decrease were (i) adjustments to deferred policy acquisition costs resulting from revisions made to the Company's estimate of future gross profits from its interest sensitive and annuity products in both 1999 and 1998, and (ii) increased mortality in 1999. Income before income taxes increased $6.9 million from 1997 to 1998. The primary reasons for the increase were (i) adjustments to deferred policy acquisition costs resulting from revisions made to the Company's estimate of future gross profits from its interest sensitive and annuity products, and (ii) the addition in 1998 of the results of operations from business which was previously ceded to an affiliated insurance company and recaptured in 1998 in conjunction with the Company's consolidation of its asset accumulation operations.
The difference between the segment revenues and income before income taxes shown above and the amounts reported in the Company's consolidated financial statements appearing elsewhere in this Form 10-K result from items not allocated to specific segments. The significant reconciling items are interest expense and a portion of (i) net investment income, (ii) operating expenses, (iii) net realized investment gains (losses) and (iv) certain non-recurring transactions such as gains from the sale of subsidiaries. These reconciling items had the effect of increasing income before income taxes $20.7 million from 1998 to 1999. The primary reasons for the increase were (i) a $14.8 million increase in net realized investment gains not allocated to segments, (ii) a $3.7 million increase in net investment income related to a reduction in the unrecovered ceding commission due to the Reinsurer, (iii) a $5.9 million decrease in advisory and data processing fees paid to FHC, and (iv) a $6.8 million decrease in expenses not allocated to specific segments, offset by (v) a $4.9 million gain from the sale of a subsidiary in 1998 and (vi) expenses related to costs associated with litigation in 1999.
Similar reconciling items had the effect of decreasing income before income taxes $23.0 million from 1997 to 1998. The primary reasons for the decrease were (i) a $11.4 million increase in net realized investment losses in 1998 and (ii) an increase in operating expenses not allocated to segments in 1998.
Net investment income. Net investment income totaled $227.6 million in 1999 compared to $226.5 million in 1998. Net investment income increased due to (i) an increase in net investment income on the Company's bond portfolio, (ii) a $1.3 million increase in mortgage loan net investment income, and (iii) a $3.7 million increase in net investment income related to a reduction in the unrecovered ceding commission due to the Reinsurer, offset by an $10.3 million decrease in net investment income on investments held by the Reinsurer.
The decrease related to investments held by the Reinsurer is due primarily to a $8.5 million decrease in net investment income on a closed block of annuity business resulting from lower fund values. The associated interest credited on policyholder fund values decreased $6.2 million.
Other income. Other income totaled $6.1 million in 1999 compared to $12.2 million in 1998. In May 1998, the Company realized a gain of $4.9 million from the sale of Investors Guaranty.
Included in amortization expense are adjustments to deferred policy acquisition costs and the cost of business acquired asset which increased the assets by $0.5 million in 1999 and decreased the assets by $0.9 million in 1998. 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 asset on interest-sensitive life products are amortized based on the estimated future gross profits of the related policies.
Income before income taxes decreased $19.3 million to $12.0 million in 1998. The primary reasons for the decrease were (i) realized investment losses, (ii) an increase in amortization expense and (iii) an increase in other operating expenses, partially offset by (iv) lower death benefits. The Company recorded $2.8 million of expense for the relocation of its Columbus, Ohio operations during 1998. These items and significant changes in individual income statement components are discussed in more detail below.
Premiums and policy revenues. Premiums and policy revenues totaled $218.6 million in 1998 compared to $203.7 million in 1997. Excluding the Acquisitions, premiums and policy revenues increased $3.3 million from 1997 to 1998. Traditional life insurance premiums decreased $5.1 million because lapses of the Company's traditional policies exceeded the premium volume from newly-issued traditional policies. This decrease was offset by an increase in policy revenues of $4.0 million resulting from policy charges on increased interest-sensitive life and annuity policy fund values and increased surrender charges of $2.7 million from a closed block of annuity business.
The decrease related to investments held by the Reinsurer is due primarily to a decrease in net investment income on a closed block of annuity business resulting from lower fund values. The associated interest credited on policyholder fund values decreased $8.8 million.
Net realized investment gains. Net realized investment gains totaled $8.3 million in 1998 compared with $3.0 million in 1997. Excluding the effect of the Acquisitions, net realized investment gains decreased $1.4 million. In 1998, the Company reported $8.3 million of realized gains including $16.7 million of gains from the sale of fixed maturity investments held by the Reinsurer. As described below, the sale of fixed maturity investments held by the Reinsurer resulted in increased amortization of the cost of business acquired asset. Excluding the $16.7 million of gains described above, the Company realized losses of $8.4 million in 1998 compared to gains of $3.0 million in 1997. There were no sales of investments held by the Reinsurer in 1997 and no impact on amortization from other gains realized in 1997. The difference between realized losses in 1998 and realized gains in 1997 resulted in an $11.4 million reduction in income before provision for income taxes in 1998 compared with 1997.
Included in 1998 realized losses of $8.4 million is $6.0 million of realized losses on short positions held on common stocks owned by the Company. There was a like amount of increase in market value on the related long position of the common stocks which is included in unrealized gains in stockholder's equity.
Other income. Other income totaled $12.2 million in 1998 compared to $12.3 million in 1997. Other income includes an administrative service fee paid to the Company associated with the reinsurance of 30% of the Ohio State and Investors Guaranty policies, which amounts are included in the effects of the Acquisitions. Excluding these amounts, other income decreased $0.5 million from 1997 to 1998. The Company recorded a gain of $4.9 million from the sale of Investors Guaranty in May 1998 and a gain of $4.8 million from the sale of Loyalty Life in 1997.
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 asset 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 asset on interest-sensitive life products are amortized based on the estimated future gross profits of the related policies.
At December 31, 1999, United Fidelity had outstanding to Americo four surplus debentures with an aggregate unpaid balance of $121.9 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.
The changes occurring in the Company's consolidated balance sheet between December 31, 1999 and December 31, 1998 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 credit quality of its portfolio is high with minimal amounts of securities below investment grade. 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, 1999:
The Company continually reviews its non-investment grade debt securities (NAIC designations 3 through 6) for evidence of declines in value which are other than temporary. The Company does not anticipate any material increase in its investments in non-investment grade debt securities. At December 31, 1999, the Company's investment portfolio contained no securities which were in default as to principal or interest.
During 1999, the Company began selling equity-indexed life insurance and annuity products. These products include an interest credit component which is based on changes in the Standard and Poor's 500 Index ("S&P Index"). In order to hedge its exposure to changes in the S&P index, the Company purchased option contracts on the S&P Index. The impact of these transactions are currently not material to the Company's consolidated financial statements.
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. The adoption of this accounting standard did not have a material impact on the consolidated financial statements.
The Company's audited consolidated financial statements for the three years ended December 31, 1999 and the related report of independent accountants thereon are set forth at pages to hereof and are incorporated herein by reference. Reference is made to the Index to Financial Statements on page herein.