The investment segment’s pretax profitability declined $6 million in 2005 after increasing $13 million in 2004 and $26 million in 2003. The low long-term interest rates available for new investments since 2002 have caused Torchmark’s average portfolio yield to decline in each successive year, restricting growth in net investment income and excess investment income. Yields on new fixed-maturity investments have been lower than the average portfolio yield since January 1, 2003. In 2005 and late 2004, excess investment income was further compressed as short-term rates rose with no meaningful change in long-term rates. The increase in short-term rates caused short-term financing costs to increase and the income spread on Torchmark’s fixed-to-variable interest-rate swaps to narrow. See the analysis of excess investment income and investment activities under the caption Investments for a more detailed discussion.
Torchmark additionally reduces credit risk by maintaining investments in a wide range of industry sectors. The following table presents the industry sectors that exceeded 2% of the corporate fixed-maturity portfolio at fair value at December 31, 2005.
In both 2004 and 2003, Torchmark wrote down several individual holdings to estimated fair value as a result of other-than-temporary impairment. The impaired securities met some or all of Torchmark’s criteria for other-than-temporary impairment as discussed in Note 3-Investments in the Notes to Consolidated Financial Statements and in its Critical Accounting Policies in this report. Pretax charges for these impairments were $6 million in 2004 and $15 million in 2003. Regarding all bonds previously written down, the bonds of 3 issuers were still held at December 31, 2005 at a fair value of $46.0 million and a recorded book value of $29.5 million.
The following table presents information about payments under Torchmark’s contractual obligations for the selected periods as of December 31, 2005.
The carrying value of Torchmark’s 6 1/4% Senior Notes is adjusted each period to reflect the change in fair value of a swap instrument which hedges the value of the note. This swap increased the value of long-term debt by $.3 million and $5.7 million at December 31, 2005 and December 31, 2004, respectively. Additionally, Torchmark entered into a swap agreement on its 8 1/4% Senior Debentures in August, 2004 which qualified as a fair-value hedge on that security. That swap was disposed of in September, 2005. It increased the value of long-term debt by $2.4 million at December 31, 2004.
As previously mentioned, Torchmark’s Board reaffirmed its continued authorization of the Company’s stock repurchase program in July, 2005 in amounts and timing that management, in consultation with the Board, determined to be in the best interest of the Company. Torchmark has repurchased its common stock every year since 1986, except for 1995, the year following the acquisition of American Income. Since the beginning of 1998, Torchmark has repurchased 40 million shares at a total cost of $1.6 billion, and has acquired no fewer than 3.4 million shares in any one year. Management believes that Torchmark share purchases at favorable prices add incrementally to per share earnings, return on equity, and are an excellent way to increase total shareholder value. As noted earlier in this report, Torchmark acquired 5.6 million shares at a cost of $300 million in 2005 with excess cash flow. If the $300 million free cash flow used for the repurchase of Torchmark common stock had alternatively been invested in corporate bonds, an estimated $9 million of additional investment income, after tax, would have resulted and net income per diluted share would have increased 10% to $4.59. Because share purchases were made, actual net income per share was $4.68, an increase of 12%. Torchmark intends to continue the repurchase of its common shares when financial markets are favorable.
Earnings per Share: As described in Note 1-Significant Accounting Policies, diluted earnings per share include the dilution resulting from the potential conversion of dilutive securities such as stock options into Torchmark common stock. The potential dilution from stock options has traditionally been calculated using the “treasury stock method” required by GAAP. This method assumes that Torchmark uses the funds derived from the assumed exercise of options to buy treasury stock, thus reducing the net number of new shares outstanding resulting from the exercise.
The issuance by the FASB of Statement 123R, requiring the expensing of stock options, revises the method of computing dilutive shares. The revised method does not allow the traditional treasury stock method which simulates cash flow, but instead limits cash receipts from the tax benefit and injects a hypothetical concept known as “unrecognized option expense” to the dilution model. As a result, diluted shares outstanding under the new Standard will bear no relationship to diluted shares outstanding under the historical model or to a pattern that the Company could actually replicate with its cash flow as before. Management does not believe that these modifications to the treasury stock method will materially impact earnings per share.
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, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, 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.
Subsequent to adoption, the liability for these minimum guarantees is determined each period end by estimating the expected value of death benefits in excess of the projected account balance using actuarial methods and assumptions including mortality, lapses, and interest. This excess benefit is then recognized ratably over the accumulation period based on total expected assessments. The Company regularly evaluates estimates used. If actual experience or other evidence suggests that earlier assumptions should be revised, Torchmark adjusts the additional liability balance with a related charge or credit to benefit expense. At December 31, 2005, this liability was $3.5 million and at December 31, 2004 was $3.8 million.
Low-Income Housing Tax Credit Interests: As of December 31, 2005, Torchmark has invested approximately $122 million in flow-through entities that provide low-income housing tax credits and other related Federal income tax benefits to Torchmark. Significantly all of the return on the investments has been guaranteed by unrelated third-parties and has been accounted for using the effective-yield method. The remaining investments are non-guaranteed and are accounted for using the amortized-cost method. The federal income tax benefits accrued during the year, net of related amortization of the investment, is recorded in Income tax expense. The unamortized cost of the investments is included in Other assets and any unpaid commitments to invest are recorded in Other liabilities.
Torchmark had $5 million in investment real estate at December 31, 2005, which was nonincome producing during the previous twelve months. These properties consisted primarily of undeveloped land. Torchmark had $10 million in nonincome producing mortgages as of December 31, 2005. Torchmark had no nonincome producing fixed maturities or other long-term investments during the twelve months ended December 31, 2005.
During 2004, Torchmark decided to reduce its exposure to mortgage loans. As a result, it sold mortgages with a carrying value of $75.7 million for proceeds of $74.4 million, resulting in a small loss. The sale included mortgages previously written down. As more fully described in Note 15-Related Party Transactions, these mortgages were sold to MidFirst Bank, the Chairman of the Board of Directors of whose parent company was also a Torchmark director.
(3) Represents amounts pertaining to investments relating to universal life-type products.
A tax deferred component of statutory income accumulated prior to 1984 in a “policyholders’ surplus account” is not taxable unless it exceeds certain statutory limitations or is distributed to shareholders. As of December 31, 2004, Torchmark had not recognized a deferred tax liability of approximately $10 million that related to this accumulated income as management considered the situations causing taxation of the account to be remote. During 2004, the American Jobs Creation Act of 2004 amended Federal income tax law to permit life insurance companies to distribute amounts from policyholders’ surplus accounts in 2005 and 2006 without incurring Federal income tax on the distributions. Each of the affected insurance subsidiaries distributed to Torchmark all the amounts held in its policyholders’ surplus accounts in 2005, thereby permanently eliminating this potential liability for tax years after 2004.
Torchmark has net operating loss carryforwards of approximately $20.3 million at December 31, 2005 of which $120 thousand expire in 2008; $4.4 million expire in 2020; $4.6 million expire in 2021; and $11.2 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.
Portfolio risk is managed through quality standards, diversification, and continuous monitoring. Equities must be listed on major exchanges and adequate market liquidity is required. Fixed maturities must be rated investment grade at purchase by a major rating agency. Short-term investments in commercial paper must be rated at least A-2 by Standard & Poor’s with the issuer rated investment grade. Invested cash is limited to banks rated A or higher. Investments outside of the aforementioned list are not permitted, except by prior approval of the Plans’ Trustees. At December 31, 2005, there were no restricted investments contained in the portfolio.
* Due to the Securities and Exchange Commission’s interpretive guidance concerning SFAS 133, the benefit of the interest spread has been reclassified from “Interest expense” to “Realized investment losses.”
During 2001, Torchmark entered into a coinsurance agreement with First Command’s life subsidiary whereby Torchmark ceded back to First Command approximately 5% of the new life insurance business sold by First Command on behalf of Torchmark’s insurance subsidiaries. In 2004, the ceding rate was changed to 3% on newly ceded business. Under the terms of this agreement, First Command pays Torchmark a maintenance expense allowance equal to 5.5% of all premium collected and an issue allowance of 2.9% of first year premium collected. Torchmark is also reimbursed for actual commissions, premium taxes, and claims paid on the business ceded to First Command. Also under the agreement, Torchmark provides First Command certain administrative, accounting, and investment management services. Premium ceded in 2005 was $2.6 million, in 2004 was $2.3 million, and in 2003 was $1.6 million. At December 31, 2005, the face amount of life insurance ceded was $316 million and annualized ceded premium was $2.7 million.
Torchmark currently has two loan agreements with First Command, a mortgage loan agreement and a collateral loan agreement. The mortgage loan bears interest at a rate of 7.0%. The initial balance of $22.3 million is being repaid in equal monthly payments over fifteen years, beginning May 1, 2003. At year end 2005, the outstanding balance was $19.9 million, compared with $20.9 million one year ago. The loan is collateralized by a four-story office building in Fort Worth, Texas, which was appraised by an independent firm in 2001 at $22.8 million. In addition to the office building as collateral, Torchmark has the right of offset to any commissions due First Command, in the event of default.
The collateral loan bears interest at the rate of 7.0%. First Command is making fixed monthly payments which are scheduled to repay the loan by May, 2010. First Command has the right to make additional, unscheduled payments. At year end 2005, the outstanding balance was $9.3 million, compared with $11.1 million at year end 2004. The loan is collateralized by real estate and a parking garage in Fort Worth, Texas. The property was appraised by an independent firm in 2002 at $17.6 million.
Richey. R. K. Richey, Chairman of the Executive Committee of Torchmark until April 2005 and formerly a director and chief executive officer of Torchmark, is 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, $702 thousand in 2004, and $683 thousand in 2003. Mr. Richey is 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, $261 thousand, and $261 thousand in 2005, 2004, and 2003, respectively.