The tables in Note 13-Business Segments reconcile Torchmark’s revenues and expenses by segment to its major income statement line items for each of the years in the three-year period ending December 31, 2006. Additionally, this Note provides a summary of the profitability measures that demonstrates year-to-year comparability and which reconciles to net income. That summary is reproduced below from the Consolidated Financial Statements to present our overall operations in the manner that we use to manage the business.
Torchmark’s operations on a segment-by-segment basis are discussed in depth under the appropriate captions following in this report.
Health premium rose 22% or $223 million to $1.2 billion in 2006, but $212 million of the growth came from Medicare Part D premium. Health premium declined 3% in 2005. Medicare Supplement accounts for the largest portion of our health premium. Over the past few years, increased competition in the Medicare Supplement business has continued to dampen health sales, and has resulted in declines in the premium from this product each year. However, net sales of our under-age-65 limited-benefit health products have grown significantly over the past few years, as demand for these products continues to increase. See the discussion under Health Insurance for a more detailed discussion of health insurance results.
Liberty National Exclusive Agency, predominately a life insurance distribution channel, is the third largest writer of Torchmark health business based on premium collected. Cancer supplemental plans are the type of limited-benefit health products primarily produced by this agency. Liberty is our only distribution channel for which cancer insurance is its primary health product. Liberty’s health premium declined 3% in 2006 to $145 million after a 9% drop in 2005. The declines in both years were the result of the settlement of a class-action lawsuit in early 2005 concerning a closed block of cancer business over the timing and size of the premium rate increases on this block. This block represented approximately half of Liberty’s cancer business in 2005 and approximately 37% at year end 2006. Prior to 2005, significant rate increases to offset deteriorating margins on this block were a continuing factor causing growth in health premium, but increasing claims continued to reduce underwriting margins. The settlement provided for claims incurred after the effective date of the settlement in March 2005 to be paid on an actual incurred basis, rather than a billed basis, which reduced benefits paid going forward. The settlement further required Liberty to reduce premiums and to maintain an 85% claims loss ratio over the remaining life of the business. Prior to the settlement, Liberty had a claims loss ratio above 100% on this block.
Torchmark’s health insurance underwriting margin excluding Part D before other income and administrative expense increased 2% in 2006 from $177 million to $181 million. In 2005, margin rose 1% even though there was a 3% decline in premium. As a percentage of premium, underwriting margin increased from 17.5% in 2005 to 17.7% in 2006, after having risen from 16.6% in 2004. These increases were largely the result of the reduced loss ratios in the previously-mentioned closed block of cancer business at Liberty and improvements in American Income’s loss ratios, especially in 2006. Liberty’s health margins increased $7 million or 36% in 2005, or 17% of health premium. They rose another $3 million to $29 million in 2006, representing 20% of premium. American Income’s margins rose $3 million to $24 million in 2006, 36% of premium.
(1) See Principals of Consolidation in Note 1-Significant Accounting Policies in the Notes to Consolidated Financial Statements. for an explanation of deconsolidation.
In 2004, we wrote down certain holdings to estimated fair value as a result of other-than-temporary impairment. The impaired securities met some or all of our criteria for other-than-temporary impairment as discussed in Note 3-Investments in the Notes to Consolidated Financial Statements and in our Critical Accounting Policies in this report. The pretax charge for this impairment was $6 million. A previously written down bond of 1 issuer was still held at December 31, 2006 at a fair value of $26 million and a recorded book value of $10 million.
Credit Ratings. The credit quality of Torchmark’s debt instruments and capital securities are rated by various rating agencies. During 2006, A.M. Best downgraded Torchmark’s funded debt one notch from a to a-, and its preferred stock from a- to bbb+. Moody’s downgraded our funded debt from A3 to Baa1, and our preferred stock from Baa1 to Baa2. Both downgrades were to reflect the “notching,” or widening of rating levels between the insurance companies and their parent company which has issued the debt. This notching is typical for these rating agencies as they rate other insurance companies. It does not reflect any change in the creditworthiness of the Company. The chart below presents Torchmark’s credit ratings as of December 31, 2006.
First, evaluate if the investment is impaired (fair value is less than cost or amortized cost). Second, determine whether the impairment is other-than-temporary. While specific procedures were outlined, this step required considerable evidence-based judgment as to the ultimate recoverability of amounts due, taking into account the severity and duration of the impairment. An assessment of the ability and intent to hold the security to recovery was also a factor. In the event there was an other-than-temporary impairment, the third step involved a writedown of the cost basis of the security to fair value, which became the new cost basis. EITF 03-1 also called for certain disclosures.
In 2005, Torchmark settled three significant legal matters. These cases involved Torchmark’s race-distinct mortality/dual-pricing litigation, its class-action cancer case, and its Waddell & Reed litigation. All of these cases related to litigation arising many years ago. The Waddell & Reed litigation was settled with Torchmark recording the $13.5 million proceeds net of costs as “Other income.” The other two settlements resulted in a $15 million pre-tax charge to “Other operating expenses.”
In May, 2005, Torchmark executed a voluntary option exercise and restoration program whereby directors and executives exercised their vested options and received a lesser number of new grants at the then current market price. All of these options vested during 2005. As a result of this transaction, Torchmark incurred $20.1 million in pro forma after-tax option expense in 2005. Additionally, a grant to executives made in December, 2004 vested in June, 2005. This grant accounted for $7.0 million in 2005 after-tax pro forma option expense.
In the fourth quarter of 2005, the FASB issued FASB Staff Position No. 123R-3 (FSP123R-3), providing an alternative method for accounting for income taxes related to stock option expensing. SFAS 123R requires that tax benefits for book purposes previously recorded in excess of actual tax benefits realized at the time of exercise, in addition to a cumulative pool of previously-realized actual tax benefits allowed by SFAS 123R, must be charged to income. The alternative described in FSP123R-3 is a simplified method of computing this cumulative pool of actual tax benefits. Torchmark has elected the simplified alternative method. This election had no impact on Torchmark’s 2006 net income.
As of December 31, 2006, Torchmark subsidiaries held 182 issues (CUSIP numbers) that had been in an unrealized loss position for less than twelve months and 139 issues that had been in an unrealized loss position twelve months or longer. At December 31, 2006, Torchmark’s entire fixed-maturity and equity portfolio consisted of 2,199 issues.
$10.8 million expire in 2025. 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 Torchmark’s deferred tax assets since, in management’s judgment, Torchmark will more likely than not have sufficient taxable income in future periods to fully realize its existing deferred tax assets.
The portion of other comprehensive income that is expected to be reflected in pension expense in 2007 is as follows:
During the second quarter of 2006, Torchmark established Torchmark Capital Trust III (Trust III) to facilitate the public offering of 4.8 million shares of $25 par value Trust Preferred Securities. Trust III completed the offering on June 8, 2006 for total proceeds of $120 million. It then exchanged $3.7 million of its common stock and the $120 million of proceeds from the offering for $123.7 million of Torchmark Junior Subordinated Debentures, due June 1, 2046. Trust III pays quarterly dividends on the Trust Preferred Securities at an annual rate of 7.1%, and receives quarterly payments at the same annual rate from Torchmark on the Junior Subordinated Debentures. All payments due to be paid by Trust III on the Trust Preferred Securities are guaranteed by Torchmark (see Note 14). The securities are redeemable on June 1, 2046, and first callable by Trust III on June 1, 2011.
The contractual life of one option was extended in 2005 for the benefit of a retiring officer. This modification, which was accounted for under the intrinsic value method, resulted in an after-tax charge of $369 thousand. No equity awards were cash settled during the three years ended December 31, 2006.
Investments in municipal governments and corporations are made throughout the U.S. with no concentration in any given state. Corporate debt and equity investments are made in a wide range of industries. At December 31, 2006, 2% or more of the corporate portfolio was invested in the following industries:
Richey. R. K. Richey, Chairman of the Executive Committee of Torchmark until April, 2005 and formerly a director and Chief Executive Officer of Torchmark, was at that time a minority investor in a real estate management company, Commercial Real Estate Services (CRES). CRES 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 $680 thousand in 2005 and $702 thousand in 2004. Mr. Richey was also a 50% investor in Stonegate Realty Company, LLC., the parent company of Elgin Development Company, LLC. (Elgin Development). Elgin Development leases commercial space to Torchmark subsidiaries. Lease rentals paid by Torchmark subsidiaries were $262 thousand and $261 thousand in 2005 and 2004, respectively.
Four significant legal and tax matters were settled in Torchmark’s favor in 2006. The first settlement involved a subsidiary disposed of several years ago, resulting in proceeds after expenses of $5.1 million ($3.3 million after tax) in the first quarter. These proceeds were included in revenues. The second matter involved state income tax refunds of $6.7 million ($4.3 million after tax) related to prior years. This receipt, net of tax, was recorded in the third quarter as a reduction to taxes. The third settlement related to the Company’s investments in Worldcom, amounting to $6.3 million ($4.1 million after tax) in the fourth quarter of 2006, and represented a partial recovery of prior period investment losses. This settlement is included in revenues. The final settlement involved Federal income tax issues related to prior years, and consisted of a refund due of $7.4 million in the fourth quarter that reduced taxes. More information on these litigation and tax settlements is provided in Note 8 - Income Taxes, Note 14 - Commitments and Contingencies, and Note 1 - Significant Accounting Policies in the Notes to Consolidated Financial Statements. Additionally, as described in Note 1, agency office buildings were sold in the fourth quarter of 2006 for a pretax gain of $4.8 million ($3.1 after tax) included in total revenues.
In 2005, Torchmark recorded settlements on three significant legal matters. The first settlement related to the Waddell & Reed litigation and resulted in $13.5 million of additional revenue in the second quarter. The other two cases were Torchmark’s race-distinct mortality/dual-pricing litigation and its class-action cancer case. These two cases involved charges of $4 million in the second quarter and $11 million in the fourth quarter. The after-tax effect of these items was a positive $6 million in the second quarter and a charge of $7 million in the fourth quarter. Also in the fourth quarter of 2005, Torchmark recorded a $16 million settlement benefit from an Internal Revenue Service examination covering several years.