Other regulatory issues continue to affect the Medicare Supplement market. Medical cost inflation and changes to the Medicare program necessitate annual rate increases, which generally require state insurance department approval. In addition, Congress and the Executive Branch have begun studying ways to restructure the Medicare program. Therefore, it is likely that changes will be made to the Medicare program at sometime in the future. However, it appears that there will continue to be an important role for private insurers in helping senior citizens cover their healthcare costs. As a result, Medicare Supplements should continue as a popular product for senior-age consumers.
Torchmark is now marketing the variable annuities of United Investors through other broker-dealers. In addition, a small amount of fixed annuities are sold by the United American Independent Agency and the Liberty National Agency. While Torchmark continues to sell annuity products, it does not expect to emphasize this product line in the future.
Excess investment income grew 15% in 2002 to $295 million. It previously increased 13% in 2001 and 5% in 2000. Because excess investment income is a measure of the efficient use of cash flow, and cash has been used for share purchases, excess investment income should be viewed on a per share basis. Excess investment income per diluted share increased 20% in 2002 to $2.44 per share. It increased 15% in 2001 and 10% in 2000. The growth in excess investment income in both 2002 and 2001 resulted in large part from the reductions in financing costs through the lower interest rate environment and the redemption of the MIPS during 2001. In 2002, Torchmark reduced financing costs by $23 million through the swap agreements on its debt and preferred security instruments, accounting for the majority of the growth in excess investment income. These agreements reduced financing costs by $8 million in 2001.
In 2002, new investments in fixed maturities totaled $1.2 billion, compared with $1.5 billion in 2001 and $1.1 billion in 2000. While principal and interest available for commitment are rather stable, investments from year to year can fluctuate due to the extent of tax driven sales or, infrequently, from portfolio restructurings. Acquisitions in 2002 were made at an effective compounded yield of 7.53%, compared with an effective compounded yield of 7.49% in 2001 and 8.07% in 2000. These yields equate to nominal yields on acquisition of 7.39%, 7.35%, and 7.87% in those years, respectively. Acquisitions in 2002 had an average life of 13.7 years, little changed from 11.4 years in 2001 and higher than 7.6 years in 2000.
Torchmark’s insurance operations have historically generated positive cash flows in excess of its immediate needs. Cash flows provided from operations increased in each of the three years ended December 31, 2002 over their respective prior year. They were $651 million in 2002, compared with $618 million in 2001 and $523 million in 2000. In addition to operating cash flows, Torchmark received $304 million in investment maturities and repayments during 2002, adding to available cash flows. Such repayments were $263 million in 2001 and $226 million in 2000. Cash flows in excess of immediate requirements are used to build an investment base to fund future requirements. Available cash flows are also used to repay debt, to buy back Torchmark shares, to pay shareholder dividends, and for other corporate uses. While Torchmark’s cash flows have historically been positive and very strong, a reduction in cash flow could negatively affect its liquidity.
The carrying value of the funded debt was $552 million at December 31, 2002, compared with $536 million a year earlier. In accordance with accounting rules, Torchmark carries the 2006 Senior Notes at fair value since they are backed by derivatives that qualify as a hedge. This market value increase accounted for $15 million of the 2002 increase in the carrying value of total funded debt.
At the present time, Mr. Richey is a 25% investor in Stonegate Realty Company, LLC, the parent company of Elgin Development Company. He is also a one-third investor in Stonegate Management Company, LLC, which, in turn, is a 50% owner of Commercial Real Estate Services. Commercial Real Estate Services manages certain of Torchmark’s company-occupied and investment real estate properties along with those of other clients. Fees paid by Torchmark subsidiaries for these management and maintenance services were $750 thousand in 2002, $757 thousand in 2001, and $750 thousand in 2000. Lease rentals paid by Torchmark subsidiaries were $260 thousand, $261 thousand, and $260 thousand in 2002, 2001, and 2000, respectively.
Impairment of Investments. Torchmark continually monitors its investment portfolio for investments that have become impaired in value. While the values of the investments in Torchmark’s portfolio constantly fluctuate due to market conditions, an investment is considered to be impaired only when it has experienced a decline in fair market value which is deemed other than temporary (“permanent”). In accordance with GAAP, a permanently impaired investment is written down to fair value.
Defined benefit pension plans. Torchmark maintains funded defined benefit plans covering most full-time employees. It also has unfunded nonqualified defined benefit plans covering certain key and other employees. Torchmark’s obligations under these plans are determined actuarially based on specified actuarial assumptions. In accordance with GAAP, an expense is recorded each year as these pension obligations grow due to the increase in the service period of employees and the interest cost associated with the passage of time. These obligations are offset by the growth in value of the assets in the funded plans. Torchmark’s pension cost for the defined benefit plans was $2.3 million, $2.5 million, and $2.6 million in each of the years 2002, 2001, and 2000, respectively.
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2002
We have audited the accompanying consolidated balance sheets of Torchmark Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of Torchmark’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Torchmark Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Gains and losses realized on the disposition of investments are determined on a specific identification basis. Realized investment gains and losses and investment income attributable to separate accounts are credited to the separate accounts and have no effect on Torchmark’s net income. Investment income attributable to all other insurance policies and products is included in Torchmark’s net investment income. Net investment income for the years ended December 31, 2002, 2001, and 2000, included $332 million, $321 million, and $305 million, respectively, which was allocable to policyholder reserves or accounts. Realized investment gains and losses are not allocated to insurance policyholders’ liabilities.
Goodwill: The excess cost of businesses acquired over the fair value of their net assets is reported as goodwill. Effective January 1, 2002, Torchmark adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS 142 changed the accounting for goodwill from an amortization method to an impairment method. Accordingly, Torchmark ceased amortizing goodwill in 2002, and continues to carry it at the December 31, 2001 balance of $378 million. Restatement of prior year results to exclude the amortization of goodwill is not permitted. Goodwill amortization was $12.1 million in both 2001 and 2000. Goodwill is subject to impairment testing upon implementation and annually thereafter based on the procedures outlined in SFAS 142.
A summary of fixed maturities available for sale and equity securities by cost or amortized cost and estimated fair value at December 31, 2002 and 2001 is as follows:
Proceeds from sales of fixed maturities available for sale were $424 million in 2002, $881 million in 2001, and $629 million in 2000. Gross gains realized on those sales were $25.4 million in 2002, $20.6 million in 2001, and $8.2 million in 2000. Gross losses were $14.7 million in 2002, $21.4 million in 2001, and $10.7 million in 2000. There were no sales of equity securities available for sale during 2002 or 2001. Proceeds from sales of equity securities available for sale were $39.7 million in 2000. In 2000, gross gains realized on those sales were $6.5 million while gross realized losses were $3.2 million.
On June 25, 2002, the Jefferson County Circuit Court entered an order in United Investor’s Alabama state court litigation granting a declaratory judgment for United Investors against W&R. The Circuit Court refused to set aside or reduce the $50,000,000 compensatory damage verdict awarded against W&R by the trial jury in the original litigation. The Circuit Court’s order stated that there was no valid and binding contractual or other obligation requiring United Investors to pay certain additional compensation that W&R had sought in connection with United Investor’s in-force block of variable annuity business for which W&R had formerly been the distributor. Escrowed funds for the commissions owed by W&R to United Investors were ordered to be released to United Investors. The Circuit Court also denied W&R’s motions to set aside the jury’s verdict or to order a new trial and denied United Investor’s motion for additional injunctive relief to prohibit future replacements of United Investors policies by W&R since United Investors has an adequate remedy at law through additional litigation against W&R.