The following is Management's discussion and analysis of the financial condition and results of operations of UTG, Inc. and its subsidiaries (collectively with the Parent, the "Company") for the years ended December 31, 2012 and 2011. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report.
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 in the Consolidated Balance Sheets.
Investment real estate held for sale is reported at the lower of cost or fair value less cost to sell. Expenses to maintain the property are expensed as incurred.
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.
Income from the fixed maturities portfolio increased approximately 75% or $3.2 million when comparing 2012 and 2011 results. In the first half of 2012, the Company invested a significant portion of its excess cash balances in fixed maturity investments, mainly BB and BBB rated corporate securities, which produced higher yields. Interest spreads on these investments are higher than historic trends and Management believes this is an opportunity to enhance yield and provide more recurring investment income. Lower rated bonds are viewed by the marketplace to inherently hold more default risk. The trade-off on this risk is a higher interest yield. Each investment is analyzed prior to acquisition to determine if Management is comfortable with the increased risk relative to the yield. Management believes there are opportunities currently available in this area where certain corporate bond issues have been more harshly impacted by the marketplace than may really be justified.
During 2012, the Company reported income of approximately $2.6 million in the trading securities portfolio compared to a loss of approximately $2.3 million during 2011. The 2011 losses primarily resulted from holdings relating to market volatility and options relating to U.S. Treasury securities. The losses mainly occurred during the third quarter 2011 when the investment market took a sudden sharp decline as a result of the U.S. debt rating being lowered and concerns of the European nations' debt and potential defaults. During 2012, the Company has seen a positive turn in earnings from the trading securities portfolio. Volatility as well as possible losses should be expected in the trading securities portfolio. Management's target return on the trading securities portfolio is 6% to 8%.
Discounted mortgage loans have become more difficult to purchase as result of an increase in market competition. Management expects the discounted mortgage loan portfolio to continue to shrink as a result of the market competition and mortgage loan pay offs. While Management believes the discounted loans will continue to have favorable earnings and outcomes as they are worked through, there can be no assurance this will remain true in future periods. 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 refinance, the value of the property held as collateral and the ability to find purchasers at favorable prices.
Realized gains from real estate decreased approximately 38% or $2.8 million when comparing 2012 and 2011 results. Real estate gains are the result of one-time events and are expected to vary from year to year based upon the Company's real estate sales. The 2011 real estate gains are mainly attributable to the sale of timber from Cumberland Woodlands, LLC, a wholly owned subsidiary of UG.
In recent periods, Management's focus has been directed towards promoting and growing TPA services to unaffiliated life insurance companies. The Company receives monthly fees based on policy in force counts and certain other activity indicators, such as number of premium collections performed, or services performed. For the years ended 2012 and 2011, the Company received $2.1 million and $2 million for this work, respectively. These TPA revenue fees are included in the line item "other income" on the Company's consolidated statements of operations. During 2010, the Company obtained an additional contract for these services, which provides approximately $300,000 of additional revenues annually. Administration for this block of business began in the first quarter of 2011. The Company intends to continue to pursue other TPA arrangements as well. The Company provides TPA services to insurance companies seeking business process outsourcing solutions. Management believes the Company is positioned to generate additional revenues by utilizing the Company's current excess capacity and administrative services.
In summary, the Company's basis for future revenue growth is expected to come from the following primary sources: expansion of TPA revenues, conservation of business currently in force, the maximization of investment earnings and the acquisition of other companies or policy blocks in the life insurance business. Management has placed a significant emphasis on the development of these revenue sources to enhance these opportunities.
Benefits, claims and settlement expenses, net of reinsurance benefits, increased approximately 3% in 2012 compared to 2011. The increase primarily relates to changes in the Company's death claim experience. Policy claims vary from year to year and therefore, fluctuations in mortality are to be expected and are not considered unusual by Management.
Net amortization of cost of insurance acquired decreased approximately 7% in 2012 compared to 2011. Cost of insurance acquired is established when an insurance company is acquired or when the Company acquires a block of in-force business. The Company assigns a portion of its cost to the right to receive future profits from insurance contracts existing at the date of the acquisition. 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 may vary due to risk analysis performed at the time of acquisition on the business acquired. The Company utilizes a 12% discount rate on the remaining unamortized business. The amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised. Amortization of cost of insurance acquired is particularly sensitive to changes in interest rate spreads and persistency of certain blocks of insurance in-force. This expense is expected to decrease, unless the Company acquires a new block of business.
Operating expenses increased approximately 14% in 2012 compared to 2011. The increase in 2012 expenses, in comparison to 2011, is primarily attributable to an increase in legal expenses, charitable contributions and information technology expenses.
Management continues to view the Company's investment portfolio with utmost priority. Significant time has been spent internally researching the Company's risk and communicating with outside investment advisors about the current investment environment and ways to ensure preservation of capital and mitigate losses. Management has put extensive efforts into evaluating the investment holdings. Additionally, members of the Company's board of directors and investment committee have been solicited for advice and provided with information. Management reviews the Company's entire portfolio on a security level basis to be sure all understand our holdings, potential risks and underlying credit supporting the investments. Management intends to continue its close monitoring of its bond holdings and other investments for additional deterioration or market condition changes. Future events may result in Management's determination that certain current investment holdings may need to be sold which could result in gains or losses in future periods. Such future events could also result in other than temporary declines in value that could result in future period impairment losses.
Cash used in operating activities was $10.6 million and $10.5 million in 2012 and 2011, respectively. Sources of operating cash flows of the Company, as with most insurance entities, is comprised primarily of premiums received on life insurance products and income earned on investments. Uses of operating cash flows consist primarily of payments of benefits to policyholders and beneficiaries and operating expenses. The Company has not marketed any significant new products for several years. As such, premium revenues continue to decline. Management anticipates future cash flows from operations to remain similar to historic trends.
During 2012, the Company used net cash of $56 million for investing activities. During 2011, the investing activities provided net cash of $78.9 million. Proceeds from investments sold decreased approximately 42% or $109 million when comparing 2012 to 2011. Investment purchases increased approximately 15% or $26.5 million. The net cash provided by and used in investing activities is expected to vary from year to year depending on market conditions and management's ability to find and negotiate favorable investment contracts.
The Company had cash and cash equivalents of $23.3 million and $83 million as of December 31, 2012 and 2011, 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 $218 million at December 31, 2012. 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 Board of Directors of UTG authorized the repurchase in the open market or in privately negotiated transactions of UTG's common stock. During September 2012, the Board of Directors approved a resolution to increase the repurchase amount by $1 million, for a total repurchase of $6 million. Repurchased shares are available for future issuance for general corporate purposes. This program can be terminated at any time. Open market purchases are made based on the last available market price and are generally limited to a maximum per share price of the most recent reported per share GAAP equity book value of the Company. Through December 31, 2012, UTG has spent $4,611,696 in the acquisition of 562,690 shares under this program.
Shareholders' equity was $79.7 million and $75.8 million as of December 31, 2012 and 2011, respectively. Total shareholders' equity increased approximately 5% in 2012 compared to 2011. This increase is primarily due to the Company's current year earnings of $9.3 million.
In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of UTG, Inc. and subsidiaries as of December 31, 2012 and 2011, and the consolidated results of their operations and their consolidated cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
Fair Value - Fair values for cash, short-term investments, short-term debt, receivables and payables approximate carrying value. Fair values for fixed maturities, equity securities and certain other assets are determined in accordance with specific accounting guidance. Fair values are based on quoted market prices, where available. Otherwise, fair values are based on quoted market prices of comparable instruments in active markets, quotes in inactive markets, or other observable criteria. Mortgage loans on real estate are valued using discounted cash flow analyses. Discounted mortgage loans on real estate are reported at original purchase price, which Management believes reflects fair value. For more specific information regarding the Company's measurements and procedures in valuing financial instruments, see Note 3 - Fair Value Measurements.
Cost of Insurance Acquired - 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 profits from the acquired policies. 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 amortization is adjusted retrospectively when estimates of current or future gross profits to be realized from a group of products are revised.
Property and Equipment - Company-occupied property, data processing equipment and furniture and office equipment are stated at cost less accumulated depreciation of $3,399,309 and $3,235,642 at December 31, 2012 and 2011, respectively. Depreciation is computed on a straight-line basis for financial reporting purposes using estimated useful lives of three to thirty years. Depreciation expense was $168,442 and $162,941 for the years ended December 31, 2012 and 2011, respectively.
Benefit reserves for universal life insurance and interest sensitive life insurance products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims in excess of related policy account balances. Interest crediting rates for universal life and interest sensitive products range from 4.0% to 5.5% as of December 31, 2012 and 2011.
Intangibles-Goodwill and Other - In July 2012, the Financial Accounting Standards Board ("FASB") issued guidance on the testing of indefinite-lived intangible assets for impairment, which is intended to reduce the cost and complexity of the impairment test for indefinite-lived intangible assets by providing an entity with the option to first assess qualitatively whether it is necessary to perform the impairment test that is currently in place. An entity would not be required to quantitatively calculate the fair value of an indefinite-lived intangible asset unless the entity determines that it is more likely than not that its fair value is less than its carrying value. This guidance is effective for interim and annual impairment tests beginning after September 15, 2012, with early adoption permitted. The adoption of this guidance did not have a material effect on the Company's consolidated financial statements.
Comprehensive Income - In June and December 2011, the FASB issued guidance that requires all non-owner changes in stockholders' equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. For public entities, the amendments were effective for fiscal years and interim periods within those years, beginning after December 15, 2011 and should be applied retrospectively. This standard only affected the Company's presentation of comprehensive income.
The following table provides a summary of fixed maturities by contractual maturity as of December 31, 2012. Actual maturities could differ from contractual maturities due to call or prepayment provisions:
On the remainder of the mortgage loan portfolio, interest accruals are analyzed based on the likelihood of repayment. In no event will interest continue to accrue when accrued interest along with the outstanding principal exceeds the net realizable value of the property. The Company does not utilize a specified number of days delinquent to cause an automatic non-accrual status.
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 fair value, 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 36.1% of face value and 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, 2012 and 2011.
The other-than-temporary impairments recognized during 2012 were due to Management's assessment and consideration of the length of time the securities have remained in an unrealized loss position.
The other-than-temporary impairments recognized during 2011 were due to appraisal valuations and Management's analysis of discounted mortgage loans and real estate. The mortgage loans and real estate were written down to better reflect current expected market values.
The Company determines the existence of an active market for an asset or liability based on its judgment as to whether transactions for the asset or liability occur in such markets with sufficient frequency and volume to provide reliable pricing information. If the Company concludes that there has been a significant decrease in the volume and level of activity for an investment in relation to normal market activity for such investment, adjustments to transactions and quoted prices are made to estimate fair value.
Fixed maturities available for sale mainly consist of U.S. treasury securities and corporate debt securities. The Company employs a market approach to the valuation of securities where there are sufficient market transactions involving identical or comparable assets. If sufficient market data is not available for identical or comparable assets, the Company uses an income approach to valuation. The majority of the financial instruments included in fixed maturity securities available for sale are evaluated utilizing observable inputs; accordingly, they are categorized in either Level 1 or Level 2 of the fair value hierarchy. However, in instances where significant inputs utilized in valuation of the securities are unobservable, the securities are categorized in Level 3 of the fair value hierarchy.
Corporate securities primarily include fixed rate corporate bonds. Inputs utilized in connection with the Company's valuation techniques relating to this class of securities include recently executed transactions, market price quotations, benchmark yields and issuer spreads. Corporate securities are categorized in Level 2 of the fair value hierarchy.
Securities designated as trading securities consist of bonds, exchange traded equities, exchange traded options and exchange traded futures. These securities are primarily valued at quoted active market prices, and are therefore categorized as Level 1 in the fair value hierarchy. The exchange-traded bonds consist of corporate bonds and are classified as Level 2, consistent with the classification of the fixed maturity corporate bonds.
The fair values of mortgage loans on real estate are estimated using discounted cash flow analyses and interest rates being offered for similar loans to borrowers with similar credit ratings.
The carrying value is a reasonable estimate of fair value for notes payable subject to floating rates of interest. The fair value of notes payable with fixed rate borrowings is determined based on the borrowing rates currently available to the Company for loans with similar terms and average maturities.
As is customary in the insurance industry, the insurance subsidiary cedes insurance to, and assumes insurance from, other insurance companies under reinsurance agreements. Reinsurance agreements are intended to limit a life insurer's maximum loss on a large or unusually hazardous risk or to obtain a greater diversification of risk. The ceding insurance company remains primarily liable with respect to ceded insurance should any reinsurer be unable to meet the obligations assumed by it. However, it is the practice of insurers to reduce their exposure to loss to the extent that they have been reinsured with other insurance companies. The Company sets a limit on the amount of insurance retained on the life of any one person. The Company will not retain more than $125,000, including accidental death benefits, on any one life. At December 31, 2012, the Company had gross insurance in force of $1.6 billion of which approximately $335 million was ceded to reinsurers. At December 31, 2011, the Company had gross insurance in force of $1.7 billion of which approximately $401 million was ceded to reinsurers.
At December 31, 1992, UG (formerly American Capitol) entered into a reinsurance agreement with Canada Life Assurance Company ("the Canada Life agreement") that fully reinsured virtually all of its traditional life insurance policies. The reinsurer's obligations under the Canada Life agreement were secured by assets withheld by UG representing policy loans and deferred and uncollected premiums related to the reinsured policies. UG continues to administer the reinsured policies. At December 31, 2012, the Canada Life agreement has insurance in-force of approximately $7,433,000, with no reserves being held on that amount. At December 31, 2011, the Canada Life agreement has insurance in-force of approximately $52,560,000, with reserves being held on that amount of approximately $34,193,000.
The Canada Life agreement was fully repaid in August 2012. With the reinsurance recaptured by the Company, a 15% profit share will continue to be paid to the reinsurer going forward relative to the block of business. As a result of the reinsurance being repaid, the Company recognized assets in exchange for reducing its reinsurance recoverable. See Note 12 - Other Cash Flow Disclosures for additional information regarding the reinsurance recapture.
At December 31, 2012 and 2011, respectively, the Company had gross deferred tax assets of $2,793,932 and $2,879,079, and gross deferred tax liabilities of $15,095,508 and $16,624,830, resulting from temporary differences primarily related to the life insurance subsidiary. A valuation allowance is to be provided when it is more likely than not that deferred tax assets will not be realized by the Company. No valuation allowance has been recorded relating to the Company's deferred tax assets since, in Management's judgment, the Company will more likely than not have sufficient taxable income in future periods to fully realize its existing deferred tax assets.
The Company's Federal income tax returns are periodically audited by the Internal Revenue Service ("IRS"). In February 2011, the IRS audited UTG's 2009 federal income tax return. The examination was closed with no adjustments to the return. There are currently no examinations in process, nor is Management aware of any pending examination by the IRS. The statutes of limitation for the assessments of additional tax are closed for all tax years prior to 2009. Management believes that adequate provision has been made in the consolidated financial statements for any potential assessments that may result from future tax examinations and other tax-related matters for all open tax years.
At December 31, 2012 and 2011, the Company had the following outstanding debt:
The UTG promissory note was secured by the pledge of 100% of the common stock of UG. The promissory note carried a variable rate of interest based on the 3 month LIBOR rate plus 180 basis points. Interest was payable quarterly and principal was payable annually beginning at the end of the second year. During the fourth quarter 2012, UTG repaid the outstanding principal balance of this note.
The HPG Acquisitions promissory note issued on February 7, 2007 bears interest at a fixed rate of 5%.
UTG's line of credit issued on July 14, 2011 had a variable rate of interest based on the 90 day LIBOR rate plus 2.75 percentage points, but at no time would the rate be less than 3.25%. The collateral held on the above promissory note also secured this line of credit. This line of credit expired on December 7, 2012 and was replaced by a new line of credit.
UTG's line of credit issued November 20, 2012 replaced the line of credit that expired on December 7, 2012. The line of credit carries interest at a fixed rate of 3.75% and is payable monthly. As collateral, UTG has pledged 100% of the common voting stock of its wholly owned subsidiary, UG.
UG is a member of the Federal Home Loan Bank ("FHLB"). This membership allows the Company access to additional credit up to a maximum of 50% of the total assets of UG. To be a member of the FHLB, the Company was required to purchase shares of common stock of FHLB. Borrowing capacity is based on 50 times each dollar of stock acquired in FHLB above the "base membership" amount.
The insurance industry has experienced a number of civil jury verdicts which have been returned against life and health insurers in the jurisdictions in which the Company does business involving the insurers' sales practices, alleged agent misconduct, failure to properly supervise agents, and other matters. Some of the lawsuits have resulted in the award of substantial judgments against the insurer, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive damages in these circumstances. In the normal course of business the Company is involved from time to time in various legal actions and other state and federal proceedings. Management is of the opinion that the ultimate disposition of the matters will not have a material adverse effect on the Company's results of operations or financial position.
During 2006, the Company committed to invest in RLF III, LLC ("RLF"), which makes land-based investment in undervalued assets. RLF does capital calls as funds are needed for continued land purchases.
During 2012, the Company made a commitment to invest in Dew Learning, LLC ("Dew"), which is involved in the marketing and distribution of an electronic education based classroom model. Dew does capital calls to investors as funds are needed for continued development of the program.
ACAP Merger - On November 14, 2011, ACAP was merged into UTG. The merger was a share exchange with ACAP shareholders receiving 233 UTG shares for each ACAP share held. UTG issued 50,328 shares of common stock under this transaction.
The computation of diluted earnings per share is the same as basic earnings per share for the years ending December 31, 2012 and 2011, as there were no outstanding securities, options or other offers that give the right to receive or acquire common shares of UTG.
UG is domiciled in the state of Ohio. Ohio requires notification within five business days to the insurance commissioner following the declaration of any ordinary dividend and at least ten calendar days prior to payment of such dividend. Ordinary dividends are defined as the greater of: a) prior year statutory net income or b) 10% of statutory capital and surplus. Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation. UG paid ordinary dividends of $3,316,722 and $3,530,000 to UTG in 2012 and 2011, respectively. No extraordinary dividends were paid during the two year period.
On February 20, 2003, UG purchased $4,000,000 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 $264,943 and $264,219 during 2012 and 2011, respectively. On March 30, 2009, UG purchased $1,000,000 of FSBI common stock. The sale and transfer of this security is restricted by the provisions of a stock restriction and buy-sell agreement.
During 2011, the Company closed on an ACAP share for UTG share transaction. All ACAP shareholders, other than UTG or UG, have the right to receive 233 shares of UTG common stock for each share of ACAP common stock they owned at closing. Accordingly, the Company no longer reports a non-controlling interest component of equity for the minority ownership in ACAP. The difference between the carrying value of the non-controlling interest and the consideration received was recorded as a non-cash flow increase to additional paid-in capital of $4,100,000.
Because UTG serves primarily individuals located in four states, the ability of our customers to pay their insurance premiums is impacted by the economic conditions in these areas. As of December 31, 2012, approximately 55% of the Company's total direct premium was collected from Illinois, Ohio, Texas and West Virginia. As of December 31, 2011, approximately 52% of the Company's total direct premium was collected from Illinois, Louisiana, Ohio and Texas. Thus, results of operations are heavily dependent upon the strength of these economies.