SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For Quarter Ended June 30, 2006
Commission File Number 1-8052
TORCHMARK CORPORATION
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code (972) 569-4000
NONE
Former name, former address and former fiscal year, if changed since last report.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
Indicate the number of shares outstanding for each of the issuer’s classes of common stock, as of the last practicable date.
CLASS
OUTSTANDING AT July 27, 2006
Common Stock,
$1.00 Par Value
Index of Exhibits (Page 53).
Total number of pages included are 54.
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 1A. Risk Factors
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits
PART I - FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(Dollar amounts in thousands except per share data)
June 30,
2006
December 31,
2005
Assets
Investments:
Fixed maturities, available for sale, at fair value(amortized cost: 2006 - $8,876,011 ; 2005 - $8,411,635)
Equity securities, at fair value(cost: 2006 - $45,797 ; 2005 - $45,797)
Policy loans
Other long-term investments, at fair value
Short-term investments
Total investments
Cash
Securities lending collateral
Accrued investment income
Other receivables
Deferred acquisition costs and value of insurance purchased
Goodwill
Other assets
Separate account assets
Total assets
Liabilities and Shareholders’ Equity
Liabilities:
Future policy benefits
Unearned and advance premiums
Policy claims and other benefits payable
Other policyholders’ funds
Total policy liabilities
Deferred and accrued income taxes
Securities lending obligation
Other liabilities
Short-term debt
Long-term debt (fair value: 2006 - $651,514 ; 2005 - $427,280)
Due to affiliates
Separate account liabilities
Total liabilities
Shareholders’ equity:
Preferred stock, par value $1 per share - Authorized 5,000,000 shares; outstanding: -0- in 2005 and in 2004
Common stock, par value $1 per share - Authorized 320,000,000 shares; outstanding: (2006 - 104,874,748 issued, less 5,948,898 held in treasury and 2005 - 104,874,748 issued, less 1,305,849 held in treasury)
Additional paid-in capital
Accumulated other comprehensive income (loss)
Retained earnings
Treasury stock, at cost
Total shareholders’ equity
Total liabilities and shareholders’ equity
See accompanying Notes to Consolidated Financial Statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and in thousands except per share data)
Revenue:
Life premium
Health premium
Other premium
Total premium
Net investment income
Realized investment gains (losses)
Other income
Total revenue
Benefits and expenses:
Life policyholder benefits
Health policyholder benefits
Other policyholder benefits
Total policyholder benefits
Amortization of deferred acquisition costs
Commissions and premium taxes
Other operating expense
Interest expense
Total benefits and expenses
Income before income taxes
Income taxes
Net income
Basic net income per share:
Diluted net income per share:
Dividends declared per common share
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited and in thousands)
Other comprehensive income (loss):
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period
Less: reclassification adjustment for gains (losses) on securities included in net income
Less: reclassification adjustment for amortization of discount and premium
Less: foreign exchange adjustment on securities marked to market
Unrealized gains (losses) on securities
Unrealized gains (losses) on other investments
Unrealized gains (losses) adjustment to deferred acquisition costs
Foreign exchange translation adjustments
Other comprehensive income (loss), before tax
Income tax benefit (expense) related to other comprehensive income (loss)
Other comprehensive income (loss)
Comprehensive income (loss)
See accompanying Notes to Consolidated Financial Statements
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash provided from operations
Cash provided from (used for) investment activities:
Investments sold or matured:
Fixed maturities available for sale - sold
Fixed maturities available for sale - matured, called, and repaid
Other long-term investments
Total investments sold or matured
Investments acquired:
Fixed maturities
Total investments acquired
Net (increase) decrease in short-term investments
Net effect of change in payable or receivable for securities
Disposition of properties
Additions to properties
Acquisitions of low income housing tax credit interests
Cash used for investment activities
Cash provided from (used for) financing activities:
Proceeds from exercise of stock options
Issuance of 7.1% Junior Subordinated Debentures
Issuance of 6 3/8% Senior Notes
Additions to short - term debt
Repayments of short - term debt
Tax benefit from stock option exercises
Acquisition of treasury stock
Cash dividends paid to shareholders
Net receipts (withdrawals) from deposit product operations
Cash used for financing activities
Net increase (decrease) in cash
Cash at beginning of year
Cash at end of period
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note A—Accounting Policies
The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q. Therefore, they do not include all of the disclosures required by accounting principles generally accepted in the United States of America (GAAP). However, in the opinion of management, these statements include all adjustments, consisting of normal recurring adjustments, which are necessary for a fair presentation of the consolidated financial position at June 30, 2006, and the consolidated results of operations, comprehensive income and cash flows for the periods ended June 30, 2006 and 2005.
Note B—Stock Options
Certain employees, directors, and consultants have been granted options to buy shares of Torchmark stock at the market value of the stock on the date of grant, under the provisions of the Torchmark stock option plans. The options are exercisable during the period commencing from the date they vest until expiring according to the terms of the grant. Options generally expire the earlier of employee termination or option contract term, which ranges from seven to eleven years. Employee and consultant stock options generally vest one-half in two years and one-half in three years. Formula-based director grants generally vest in six months. Stock options awarded in connection with compensation deferrals by certain directors and executives generally vest over a range of six to ten years. All options vest immediately upon the attainment of age 65, subject to a minimum vesting period of one year for employees or six months for directors. Torchmark generally issues shares for the exercise of stock options from treasury stock. The Company generally uses the proceeds from option exercises to buy shares of Torchmark common stock in the open market to reduce the dilution from option exercises. The majority of Torchmark’s stock option grants are made annually in the fourth quarter.
As of January 1, 2006, Torchmark adopted revised Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 123 – Share-Based Payment (SFAS 123R). This Statement requires companies to recognize an expense in their financial statements for stock options based on the “fair value method.” The fair value method requires that a fair value be assigned to a stock option on its grant date and that this value be amortized over the grantees’ service period. Prior to January 1, 2006, Torchmark accounted for stock options in accordance with SFAS 123 – Accounting for Stock-Based Compensation as amended by SFAS 148 – Accounting for Stock-Based Compensation – Transition. These Statements permitted companies to choose between two methods of recording the expense for stock options in their financial statements; either the fair value method, or the “intrinsic value method,” in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations. Under the intrinsic value method, compensation expense for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—CONTINUED
(UNAUDITED)
Note B—Stock Options (continued)
Torchmark’s option grants was only recognized if the exercise price of the employee stock option was less than the market price of the underlying stock on the date of grant. If a company elected to use the intrinsic value method, pro forma disclosures of earnings and earnings per share were required as if the fair value method of accounting had been applied. Torchmark previously elected to account for its stock options under the intrinsic value method and therefore computed and disclosed the required pro forma disclosures.
SFAS 123R provides for two alternative methods of adoption: the “modified retrospective” method and the “modified prospective” method. While the modified retrospective method permits restatement of prior periods for comparability, Torchmark has elected to apply the modified prospective method. The modified prospective method calls for unvested options as of January 1, 2006 and options granted after January 1, 2006 to be expensed in accordance with SFAS 123R after that date. Compensation expense under the fair value method for prior periods is not reflected in the financial statements of those periods but is disclosed on a pro forma basis in the Notes to the Financial Statements as previously reported. The table below presents Torchmark’s pro forma earnings information as if stock options issued prior to January 1, 2006, were expensed in prior periods.
Six Months
Ended June 30,2005
Net income as reported
Stock-based compensation, as reported, net of tax benefit of $17 and $109, respectively
Effect of stock-based compensation, fair value method, net of tax benefit of $8,295 and $10,902, respectively
Pro forma net income
Earnings per share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
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. While approximately 16% of these options vested immediately, the majority of these options vested six months from grant. As a result of this transaction, $10.4 million in pro forma after-tax option expense
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was incurred in the second quarter of 2005. Additionally, a grant to executives made in December, 2004, vested in June, 2005. This grant accounted for $7.0 million after-tax in pro forma expense in the first six months of 2005.
The fair value method as outlined by SFAS 123R requires the use of an option valuation model to value employee stock options. Torchmark has elected to use the Black-Scholes valuation model for option expensing as it had done for previous pro forma expense disclosures. A summary of assumptions for options granted in the first six months of 2006 and 2005 is as follows:
Volatility factor
Dividend yield
Expected term (in years)
Risk-free rate
The adoption of SFAS 123R has not materially altered Torchmark’s methodology of computing option expense from that used to prepare the pro forma disclosures in previous years. Furthermore, at the present time, Torchmark does not plan to change its policies of stock option compensation with respect to the number of grants, terms, or alternative instruments as a result of the adoption of SFAS 123R. At this time, Torchmark continues to anticipate that 2006 after-tax stock option expense will be approximately $4 million or $.04 per diluted share.
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The effect of the adoption of SFAS 123R on selected line items is as follows for the three months and six months ended June 30, 2006:
Stock option expense *
Income tax (benefit)
Cash flow from operations
Cash flow from financing activities
Basic earnings per share
Diluted earnings per share
In the fourth quarter of 2005, the FASB issued FASB Staff Position No. 123R-3 (FSP123R3), 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 FSP123R3 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 net income in the six months ended June 30, 2006.
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A summary of option activity for the six-month period ended June 30, 2006 is presented below:
Options
Weighted-AverageRemainingContractualTerm
(in years)
Outstanding at January 1, 2006
Granted
Exercised
Forfeited or expired
Outstanding at June 30, 2006
Exercisable at June 30, 2006
The weighted-average grant-date fair value of options granted during the six months ended June 30, 2006 was $9.55 per option compared with $8.91 per option in the 2005 period. The total intrinsic value of options exercised during the six months of 2006 was $5.2 million, compared with $106.6 million in the 2005 period.
Information about Torchmark’s unrecognized stock-based compensation at June 30, 2006 is as follows:
Unrecognized compensation
Weighted average period of expected recognition (in years)
Cash received from the exercise of stock options was $14.1 million in the 2006 six months compared with $216.1 million in the 2005 period. The actual tax benefit was $1.8 million and $36.4 million in the 2006 and 2005 six months, respectively.
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Note C—Earnings Per Share
A reconciliation of basic and diluted weighted-average shares outstanding is as follows:
Basic weighted average shares outstanding
Weighted average dilutive options outstanding
Diluted weighted average shares outstanding
Antidilutive shares*
Unless otherwise specified, earnings per share data is assumed to be on a diluted basis.
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Note D—Postretirement Benefit Plans
Components of Post-Retirement Benefit Costs
Service cost - benefits earned during the period
Interest cost on benefit obligation
Expected return on assets
Amortization of prior service cost
Recognition of net actuarial (gain) loss
Net periodic pension cost
As of June 30, 2006, Torchmark contributed $9 million to pension plans. The Company plans to contribute a total amount not to exceed $20 million in 2006.
Note E—Business Segments
Torchmark is comprised of life insurance companies which market primarily individual life and supplemental health insurance products through niche distribution systems to middle income Americans. To a limited extent, the Company also markets annuities. Torchmark’s core operations are insurance marketing and underwriting, and management of its investments. Insurance marketing and underwriting is segmented by the types of insurance products offered: life, health and annuity. Management’s measure of profitability for each insurance segment is insurance underwriting margin, which is
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Note E—Business Segments (continued)
underwriting income before other income and insurance administrative expenses. It represents the profit margin on insurance products before administrative expenses, and is calculated by deducting net policy obligations, commissions and other acquisition expenses from premium revenue. Torchmark further views the profitability of each insurance product segment by the marketing groups that distribute the products of that segment: direct response, independent, or captive/career agencies.
Investment management operations is the segment that includes the management of the investment portfolio, debt, and cash flow. Management’s measure of profitability for this segment is excess investment income, which is the income earned on the investment portfolio less the interest credited on net policy liabilities and financing costs. Financing costs include the interest on Torchmark’s debt and net cash settlements on Torchmark’s swap instruments. Other income and insurance administrative expense are classified in a separate “Other” segment.
As noted, Torchmark’s “core operations” are insurance and investment management. The insurance segments issue policies for which premiums are collected for the eventual payment of policy benefits. In addition to policy benefits, operating expenses are incurred including acquisition costs, administrative expenses, and taxes. Because life and health contracts can be long term, premium receipts in excess of current expenses are invested. Investment activities, conducted by the Investment segment, focus on seeking quality investments with a yield and term appropriate to support the insurance product obligations. These investments generally consist of fixed maturities, and, over the long term, the expected yields are taken into account when setting insurance premium rates and product profitability expectations. As a result, fixed maturities are generally held for long periods to support the liabilities, and Torchmark generally expects to hold investments until maturity. Dispositions of investments occur from time to time, generally as a result of credit deterioration, calls by issuers, or other factors the occurrence of which is usually beyond the control of management. Dispositions are also sometimes required in order to maintain the Company’s investment policies and objectives. Torchmark does not actively trade investments for profit. As a result, realized gains and losses from the disposition of investments are incidental to operations and are not considered in insurance pricing or product profitability. While from time to time these realized gains and losses could be material to net income in the period in which they occur, they have an immaterial effect on the yield of the total investment portfolio. Further, because the proceeds of the disposals are reinvested in the portfolio, the disposals have little effect on the size of the portfolio and the income from the reinvestments is included in net investment income. Therefore, management removes realized investment gains and losses from results of core operations when evaluating the performance of the Company. For this reason, these gains and losses are excluded from Torchmark’s operating segments.
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Torchmark previously entered into several interest-rate swap agreements in connection with its debt issues exchanging its fixed-rate obligations for variable rates. The cash inflows (outflows) from settlements of these swaps were considered to be reductions (additions) to Torchmark’s financing costs by management in the evaluation of the performance of its Investment segment, and were reported as such in this segment analysis. However, because of accounting guidance requiring that all income components of non-hedged derivatives be recorded in the same line item as the derivative’s periodic adjustment to fair value, Torchmark has reported cash settlements on all of its swaps as realized investment gains or losses in the Consolidated Statements of Operations. As of June 30, 2006, Torchmark had sold all its swap agreements and had no swap agreements in place.
As described in Note B –Stock Options, Torchmark adopted accounting rule SFAS 123R at January 1, 2006 requiring stock option expensing. As a result, an expense for stock options has been reported in the Consolidated Statement of Operations for 2006 based on the fair value method specified by that Statement. There is no such expense charge in prior periods. Management considers stock option expense to be an expense of the Parent Company. Therefore, stock option expense is treated as a Corporate expense in Torchmark’s segment analysis.
Coverage under Torchmark’s Medicare Part D prescription drug plan for Medicare beneficiaries began January 1, 2006. For GAAP, Part D premiums are recognized evenly throughout the year when they become due but benefit costs are recognized when the costs are incurred. Due to the design of the Part D product, premiums are evenly distributed throughout the year, but benefit costs are much higher earlier in the year. As a result, under GAAP, benefit costs can exceed premiums in the first part of the year, but be less than premiums during the remainder of the year. For segment reporting purposes, Torchmark has elected to defer $36 million excess benefits incurred in the first six months of 2006 to later periods in order to more closely match the benefit cost with the associated revenue. For the full year, the total premiums and benefits are expected to be the same under this alternative method as they are under GAAP. The Company’s presentation results in the underwriting margin percentage of each interim period reflecting the expected margin percentage for the full year. In addition, GAAP recognizes in each quarter a risk-sharing premium adjustment consistent with the contract as if the quarter represented an entire contract period. Torchmark did not include this $30 million GAAP adjustment in this six month period for segment reporting purposes because Torchmark does not anticipate making a risk-sharing payment at the end of the contract period and because its interim profit margins for Part D are based upon estimated full year profit margins.
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In the first quarter of 2006, Torchmark received a litigation settlement, net of expenses, of $6.3 million ($4.1 million after tax) from litigation regarding a subsidiary disposed of several years ago. Management removes this settlement receipt when analyzing its ongoing core results. In the second quarter of 2005, Torchmark recorded an after-tax benefit of $6.2 million, pertaining to net settlements after expenses of its Waddell & Reed and other litigation.
The following tables total the components of Torchmark’s operating segments and reconcile these operating results to its pretax income and each significant line item in its Consolidated Statements of Operations.
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Reconciliation of Segment Operating Information to the Consolidated Statement of Operations
For the six months ended June 30, 2006
Premium
Expenses:
Policy benefits
Required interest on net reserves
Amortization of acquisition costs
Commissions and premium tax
Insurance administrative expense(5)
Parent expense
Stock option expense
Financing costs:
Debt
Benefit from interest rate swaps
Total expenses
Subtotal
Non-operating items
Measure of segment
profitability (pretax)
Deduct applicable income taxes
Segment profits after tax
Add back income taxes applicable to segment profitability
Remove benefit from interest rate swaps (included in “Realized investment gains (losses)”)
Add (deduct) realized investment gains (losses)
Add net proceeds from legal settlement(4)
Deduct Part D adjustment(1)
Pretax income per Consolidated Statements of Operations
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For the six months ended June 30, 2005
Insurance administrative expense(2)
Net proceeds from legal settlements
Add net proceeds from legal settlements
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The following table summarizes the measures of segment profitability for comparison. It also reconciles segment profits to net income.
Analysis of Profitability by Segment
(Dollar amounts in thousands)
Life insurance
Health insurance
Annuity
Other insurance:
Administrative expense
Investment
Corporate and adjustments
Pretax total
Applicable taxes
After-tax total
Reconciling items:
Remove benefit from interest rate swaps(after tax) from Investment Segment *
Realized gains (losses) (after tax)
Part D adjustment (after tax)
Tax settlement
Net proceeds from legal settlement (after tax)
Net Income
Note F – Capital Transactions
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. Interest will be paid quarterly at an annual rate of 7.1%, and the securities are redeemable on June 1, 2046, and first callable by Trust III on June 1, 2011. Aggregate proceeds from the offering were $120 million.
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Note F—Capital Transactions (continued)
Trust III completed the offering on June 8, 2006. It then exchanged $3.7 million of its common stock and the $120 million of proceeds from the Trust Preferred offering for $123.7 million of Torchmark Junior Subordinated Debentures, due June 1, 2046. Trust III will pay quarterly dividends on the Trust Preferred Securities at an annual rate of 7.1%, and receive 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.
Trust III is a variable interest entity in which Torchmark is not the primary beneficiary under GAAP. Therefore, Torchmark is prohibited from consolidating Trust III even though it has 100% ownership, complete voting control, and has guaranteed the performance of Trust III. Accordingly, Torchmark will carry its 7.1% Junior Subordinated Debentures due to Trust III as a liability under the caption “Due to Affiliates” on its balance sheet. Expenses of $4.3 million related to the offering will reduce long-term debt and will be amortized over the forty-year redemption period.
On June 20, 2006, Torchmark issued $250 million principal amount of 6.375% Senior Notes due June 15, 2016. Interest on the Notes is payable semi-annually commencing on December 15, 2006. Proceeds from the issuance of this debt, net of expenses, were $246 million. The Notes are redeemable by Torchmark in whole or in part at any time subject to a “make-whole” premium, whereby the Company would be required to pay the greater of the full principal amount of the Notes or otherwise the present value of the remaining repayment schedule of the Notes discounted at a rate of interest equivalent to the rate of a United States Treasury security of comparable term plus a spread of 25 basis points.
Torchmark intends to use the net proceeds from both offerings to repay its $180 million 6 1/4% Senior Notes which mature on December 15, 2006 (plus accrued interest), to possibly redeem other callable securities, and for other general working-capital purposes.
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Results of Operations
Summary of Operations. Torchmark’s operations are segmented into its insurance underwriting and investment operations as described in Note E—Business Segments. The measures of profitability described in Note E are useful in evaluating the performance of the segments and the marketing groups within each insurance segment, because each of Torchmark’s distribution units operates in a niche market. These measures enable management to view period-to-period trends, and to make informed decisions regarding future courses of action.
The tables in Note E—Business Segments demonstrate how the measures of profitability are determined. Those tables also reconcile Torchmark’s revenues and expenses by segment to its major income statement line items for the six-month periods ended June 30, 2006 and 2005. Additionally, this note provides a summary of the profitability measures that demonstrates year-to-year comparability and which reconciles those measures to Torchmark’s net income. That summary is reproduced below from the Consolidated Financial Statements to present Torchmark’s overall operations in the manner that management views the business.
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Remove benefit from interest rate swaps(after tax) from Investment Segment*
A discussion of operations by each segment follows later in this report. These discussions compare the first six months of 2006 with the same period of 2005, unless otherwise noted.
Highlights, comparing the first six months of 2006 with the first six months of 2005. Net income per diluted share increased 3% to $2.42. Included in 2006 net income is $2.3 million of after-tax stock option expense or $.02 per share compared with none for the prior period. Also included in net income are after-tax realized investment gains of $.01 per share in 2006 compared with $.05 per share in 2005. One component of investment gains in both periods was net cash settlements on interest-rate swaps, which increased 2005 investment gains by $.03 per share, but had no material effect on 2006 gains per share.
Torchmark management uses two statistical measures as indicators of product sales over the near term: “net sales” and “first-year collected premium.” Net sales is defined as annualized premium issued, net of cancellations in the first thirty days after issue, except in the case of Direct Response, where net sales is annualized premium issued at the time the first full premium is paid after any introductory offer has expired. Annualized premium issued is the gross premium expected to be received during the
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policies’ first year in force. Management believes that net sales is a useful indicator of the rate of acceleration of premium growth. First-year collected premium is defined as the premium collected during the reporting period for all policies in their first policy year. First-year collected premium takes lapses into account in the first policy year when lapses are more likely to occur, and thus is a useful indicator of how much new premium is expected to be added to premium income in the future.
Torchmark’s total premium income rose 11% to $1.4 billion. Of this premium, $122 million related to Medicare Part D business for which coverage began January 1, 2006. Excluding the Part D premium, premium increased 2%. Total net sales, including Medicare Part D, rose 126% in 2006 from $230 million to $520 million. Excluding the Part D net sales of $262 million, net sales in 2006 rose 12% to $258 million. First-year collected premium rose 52%. However, excluding Part D collections of $92 million, 2006 first-year collected premium increased 3% to $193 million.
Life insurance premium income grew 4% to $762 million. Life net sales declined 5% to $139 million and first-year collected life premium declined 6% to $108 million. Life underwriting margins increased 6% to $198 million due primarily to premium growth in two of the four major life distribution groups.
Health insurance premium income, excluding Medicare Part D premium, declined 1% to $513 million. Health net sales, excluding Part D, rose 41% to $119 million, reflective of increased supplemental limited-benefit product sales. First-year collected health premium, excluding Part D, rose 16% to $85 million.
As management views the Medicare Part D prescription drug business, policyholder premium was $92 million and underwriting income was $8.6 million in the 2006 six months. A reconciliation between how management views Medicare Part D business and GAAP is found under the caption Medicare Part D in this report. Medicare Part D is a component of Torchmark’s health insurance segment.
Excess investment income per diluted share increased 1% to $1.55, but excess investment income declined 3% or $5 million to $159 million in the period. Net investment income increased 3% or $9 million, but was offset by a $5 million increase in interest on net insurance policy liabilities and an $8 million increase in financing costs as a result of higher short-term rates. (For more information, refer to the discussion under the caption Investments (excess investment income)).
Excess investment income continues to be restrained as short-term financing costs have continued to rise while long-term yields available for investment have not increased accordingly. Because of the low interest environment over the last three years, Torchmark has made new investment acquisitions at yields lower than its average portfolio yield during that period. However, in the second quarter of 2006, interest rates ticked up resulting in higher new money yields. For the six months, the effective annual yield on new investments was 6.64%, but for the second quarter the yield was 6.98%, matching the
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average portfolio yield of 7.0%. The fixed-maturity portfolio at market value accounted for 95% of total investments at June 30, 2006.
Torchmark acquired 5.0 million shares of the Company’s common stock in the open market at a cost of $283 million ($56.85 average price per share) during the 2006 period. Of the $283 million, $267 million was from excess operating cash flow, which was used to repurchase 4.7 million shares, and $16 million was from the cash received from stock option exercises by current and former employees. Proceeds from these option exercises were used to repurchase 279 thousand shares in order to minimize dilution from the exercises. The Company has an on-going share repurchase program which began in 1986 and was reaffirmed at the July 27, 2006 Board of Directors’ meeting. With no specified authorization amount, management determines the amount of repurchases based on the amount of the Company’s excess cash flow, general market conditions, and other alternative uses.
A detailed discussion of Torchmark’s operations follows.
Life insurance, comparing the first six months of 2006 with the first six months of 2005. Life insurance is Torchmark’s predominant segment, representing 54% of premium income and 65% of insurance underwriting margin in the first six months of 2006. In addition, investments supporting the reserves for life business generate the majority of excess investment income attributable to the Investment segment. Torchmark’s life insurance premium income increased 4% to $761 million. The following table presents Torchmark’s life insurance premium by distribution method.
Life Insurance
Premium by Distribution Method
Increase
(Decrease)
Direct Response
American Income Exclusive Agency
Liberty National Exclusive Agency
Military Agency
Other Agencies
Total Life Premium
An indicator of new business production is net sales, as defined earlier in this report. Torchmark’s net sales of life insurance declined 5% from the same period of the prior year. An analysis of life net sales by distribution group is presented below.
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Net Sales by Distribution Method
Total Life Net Sales
First- year collected life premium, defined earlier in this report, was $108 million in the 2006 period, decreasing 6% from the prior-year period. First-year collected life premium by distribution group is presented in the table below.
First-Year Collected Premium by Distribution Method
Total
The Direct Response operation is conducted through direct mail, co-op mailings and television solicitations. Direct Response’s life premium income rose 7% to $230 million, representing 30% of Torchmark’s total life premium, the largest contribution of any distribution system. Both net sales of $61 million and first-year collected premium of $40 million increased slightly over the prior year period.
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A major market for the Direct Response channel is the sale of Direct Response life insurance to juveniles. Not only is the juvenile market an important source of sales, but it also is a vehicle to reach the parents and grandparents of the juvenile policyholders. Parents and grandparents of these juvenile policyholders are more likely to respond favorably to a Direct Response solicitation for life coverage on themselves than is the general adult population. Also, both the juvenile policyholders and their parents are low acquisition-cost targets for sales of additional coverage over time. Torchmark expects that sales to this demographic group will continue as one of Direct Response’s premier markets.
TheAmerican Income Exclusive Agency markets primarily to members of labor unions, but also to credit unions and other associations. This agency produced premium income of $201 million, an increase of 8%. Net sales were flat at $43 million while first-year collected premium declined 4% to $36 million. Growth in sales in Torchmark’s captive agencies is highly dependent on growing the size of the agency force. The American Income agent count was 2,312 at June 30, 2006, 14% higher than at 2005 year end (2,027) and 8% above the count a year earlier (2,138). This agency continues to emphasize the recruiting of new agents, focusing on a systematic, centralized internet recruiting program, and an incentive program to reward growth in both recruiting and production.
The Liberty National Exclusive Agency markets life insurance to middle-income customers primarily in the Southeast, but has recently expanded into several other states. Life premium income was $152 million, flat with the 2005 period. First-year collected premium declined 1% from the prior period, while net sales declined 6%, reflective of a decline in the number of agents in this agency. The Liberty Agency had 1,606 producing agents at June 30, 2006, declining 18% from 1,950 at June 30, 2005. As is the case with all of Torchmark’s captive agencies, building the size of the agency force is critical to increased sales and the growth in premium generated by those sales. The Liberty National agency is currently involved in a reorganization of its marketing leadership and has recently restructured its agent compensation system to provide greater reward to productive agents and to establish production minimums for agents. On May 1, 2006, Liberty terminated any agents not meeting those production minimums. Management believes that these changes will result in a more productive agency over the long-term.
The Military Agency is an independent agency comprised primarily of former military officers who sell primarily to commissioned and non-commissioned military officers and their families. Life premium in the Military Agency rose 3% to $102 million. This agency’s sales have been under pressure as it reorganizes its non-life (non-Torchmark) products. This reorganization included reduced commission rates on non-Torchmark investment products, and resulted in a loss of 43% of this agency’s producing agents appointed with Torchmark over the past two years (34% since June 30, 2005). As a result, sales in this agency have fallen sharply. Net sales of $6.8 million declined 32% and first-year collected premium of $7.8 million decreased 36% over the prior year period.
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The Other Agencies distribution systems offering life insurance include United American Independent and Branch Office Agencies (both of which predominately write health insurance), United Investors, and various minor distribution channels. The Other Distribution group contributed $78 million of life premium income to Torchmark, or 10% of Torchmark’s total.
Summary of Results
Premium and policy charges
Net policy obligations
Commissions and acquisition expense
Insurance underwriting income before other income and administrative expense
Life insurance underwriting income before insurance administrative expenses was $198 million, increasing 6%. As a percentage of life premium, underwriting margin rose 1% to 26%. Growth in life margins was due primarily to premium growth in the Direct Response Group and the American Income Agency.
Health insurance, comparing the first six months of 2006 with the first six months of 2005. Health premium accounted for 45% of Torchmark’s total premium in the 2006 quarter, while the health underwriting margin accounted for 33% of total underwriting margin, reflective of the lower underwriting margin as a percent of premium for health compared with life insurance. Torchmark’s health products are supplemental health plans that include a variety of limited-benefit health plans including hospital/surgical, cancer and accident plans sold to customers under age 65, as well as Medicare Supplements sold to Medicare enrollees. Beginning January 1, 2006, the Company also began providing coverage under a Medicare Part D prescription plan. Because Medicare Part D benefit loss ratios and underwriting ratios vary significantly from Torchmark’s other health products, Medicare Part D business will be shown as a separate health component and will be discussed separately in the analysis of the health segment.
Total health insurance premium for the 2006 period as management views it was $606 million, up 16%. Excluding Medicare Part D premium, it was $513 million, a 1% decline. A reconciliation between segment reporting for Part D and GAAP is discussed under the caption Medicare Part D in this report.
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The table below is an analysis of Torchmark’s health premium by distribution method.
Health Insurance
United American Independent Agency
United American Branch Office Agency
Medicare Part D
Total Health Premium
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Presented below is a table of health net sales by distribution method.
Total Health Net Sales
The following table presents health insurance first-year collected premium by distribution method.
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Below is an analysis of health net sales by product type.
Net Sales by Product Type
Limited-benefit plans
Medicare Supplement
The following table is an additional presentation of first-year collected health premium by product type.
First-Year Collected Premium by Product Type
Health insurance, excluding Medicare Part D. In recent periods, Torchmark has emphasized the sale of limited-benefit health insurance products rather than Medicare Supplement insurance, as customer demand for the limited-benefit hospital/surgical plans has increased and price competition and decreased demand for Medicare Supplements have caused reduced sales of that product. Even though Medicare Supplement remains Torchmark’s dominant health product in terms of premium income, the contribution to premium of other health products has increased rapidly. Medicare Supplement represented 56% of total health premium income for the six months through June 2006, compared with 61% a year earlier. In addition, first-year collected premium on limited-benefit plans was 80% of health collections in the 2006 period, compared with 70% in the 2005 period, reflecting the change in product mix in sales of health insurance business.
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Limited-benefit plans net sales accounted for 83% of sales, compared with 74% in the prior period.
The United American (UA) Branch Office and Independent Agencies are the predominant distributors of health products, primarily limited-benefit hospital/surgical plans. These agencies accounted for $389 million or 76% of Torchmark’s 2006 health premium income, exclusive of Part D premium. In recent periods, the focus of these agencies has been toward an increased emphasis on limited-benefit hospital/surgical policies sold to customers under age 65. Accordingly, these agencies have expanded their product lines as increased consumer demand for under-age-65 supplemental health products has resulted from the growing unavailability of individual major medical plans and decreased coverage offered by employers.
The UA Branch Office is a captive agency which focuses on sales of limited-benefit hospital/surgical plans. As is the case with all of Torchmark’s captive agency forces, growing the number of agents is critical to growth in sales. This agency has had ongoing recruiting initiatives, and as a result, this agency grew 44% over the prior year to 2,765 producing agents at June 30, 2006 from 1,915 agents a year earlier. The Agency opened 12 new branches in 2006 for a total of 110 at June 30. As a result of the growth in this agency, net sales rose 88% over the prior year to $75 million and first-year collected premium increased 51% to $48 million. Emphasis on sales of limited-benefit hospital/surgical plans resulted in premium growth of 58% in these products in 2006 to $69 million, surpassing the contribution of the UA Independent Agency. However, declines of 12% in premium for the Medicare Supplement product caused total health premium at this distribution channel to increase only 7%.
The UA Independent Agency consists of over 28,000 independent agents who also sell for other companies. Historically, this agency group was dominated by one very large agency, producing the majority of sales of under-age-65 limited-benefit health products for Torchmark. In 2005, however, that agency experienced a disruption in recruiting and training programs resulting in a decline in producing agents. The disruption contributed to a decline in overall health premium and sales in the UA Independent Agency in both 2005 and early 2006. However, through the first six months of 2006, total net sales in the UA Independent Agency increased 2% to $29 million and limited-benefit health premium rose 5% to $53 million, respectively, over the prior year period. On the other hand, Medicare Supplement continues to decline, as Medicare Supplement premium income for this group fell 10% to $163 million from $181 million.
Other agencies. Certain of Torchmark’s other distribution channels market health products, although their main emphasis is on life insurance. On a combined basis, they account for 24% of health premium. The Liberty National Agency markets primarily limited-benefit cancer products. American Income also markets a variety of limited-benefit plans, primarily accident. The Direct Response group markets primarily Medicare Supplements to employer or union-sponsored groups.
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Medicare Part D. Coverage under Torchmark’s Medicare Part D prescription drug plan for Medicare beneficiaries began January 1, 2006. The enrollment period ended on May 15, 2006 for those who were eligible on January 1. At June 30, the Company had 200 thousand enrollees that had been confirmed by the Centers for Medicare and Medicaid Services (CMS). Details of the Company’s plan are at www.uamedicarepartd.com.
As described in Note E—Business Segments, Torchmark reports its Medicare Part D business for segment analysis purposes as it views the business, in which expected full-year benefits are matched with the related premium income which is received evenly throughout the policy year. At this time, management believes that 2006 full-year benefits will approximate 80% of premium. Also described in Note E are the differences between the segment analysis and GAAP. Due to the design of the Medicare Prescription Drug product, claims are expected to be heaviest early in the calendar year. Management believes that the use of the full-year loss ratio is an appropriate measure for interim results, and also that these reporting differences will arise only on an interim basis and will diminish at the end of a full year.
Actual Part D benefit costs for the year have been lower than expected; however, through June 30, 2006, the Company expensed benefits based on the original ultimate expected benefit ratio for the year because it is still unclear how benefit experience will trend in the last half of the contract year, which ends December 31, 2006. Should benefit costs continue to be lower than expected through the last half of 2006, health insurance underwriting income from Medicare Part D will be greater than was expected at the beginning of the year.
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Medicare Part D underwriting results are summarized in the following chart, with corresponding adjustments for GAAP.
Summary of Medicare Part D Results
Policy obligations
Pharmacy Benefit Manager fees
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The following table presents underwriting margin data for health insurance.
Underwriting margins for health insurance, excluding Part D margin, improved 1% to $91 million, even though premium declined 1%. As a percentage of health premium, underwriting margins rose from 17% to 18%. Liberty’s health margin rose 19% to $14 million. As a percentage of premium, Liberty’s health margin improved from 15% to 20% and was the primary contributor to margin growth. In the first quarter of 2005, Liberty settled a class-action lawsuit involving a closed block of Liberty National cancer policies. This settlement had the effect of reducing premiums on this closed block of cancer business going forward but also improved underwriting margins by reducing policy obligations on this block at the same time. The 7% decline in health premium at Liberty shown in the Health Premium Income chart above is also reflective of the implementation of that settlement.
Annuities, comparing the first six months of 2006 with the first six months of 2005. Torchmark markets both fixed and variable annuities. Annuity revenue represents less than 1% of Torchmark’s total premium income and annuity underwriting income
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represents less than 2% of the total. Torchmark has previously announced that the sale of annuities is not a major component of its marketing strategy.
Operating expenses, comparing the first six months of 2006 with the first six months of 2005. Operating expenses consist of insurance administrative expenses and parent company expenses. They also include stock option expense, which Torchmark views as a parent company expense. Insurance administrative expenses relate to premium income for a given period; therefore, Torchmark measures those expenses as a percentage of premium income. Total expenses are measured as a percentage of total revenues. An analysis of operating expenses is shown below.
Operating Expenses Selected Information
Insurance administrative expense
Parent company expense
Total operating expenses
Both insurance administrative expenses and total expenses increased over the prior year period. Administrative expenses of the Medicare Part D program added approximately $3.2 million of expense for which there was no expense in the prior period. Stock option expense, recorded in 2006 but not in 2005, accounted for $3.5 million of the increase in total operating expense. Litigation expense was approximately $7 million lower in 2006; however, most of this decline was offset by higher non-Medicare Part D salaries and other employee costs in 2006. Excluding both Medicare Part D expense and stock option expense, total expense would have declined 1.3%. Total expense, as a percentage of total revenue, would have remained at 5.1% if Medicare Part D activity and stock option expense were excluded from the ratio.
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Investments (excess investment income), comparing the first six months of 2006 with the first six months of 2005. The following table summarizes Torchmark’s investment income and excess investment income.
Excess Investment Income
Net investment income *
Required interest on net insurance policy liabilities
Interest rate swaps
Total financing costs
Excess investment income
Excess investment income per share
The Investment segment is responsible for the management of capital resources, including investments, debt, and cash flow. As defined in Note E - Business Segments, excess investment income is the profitability measure used by management to evaluate the performance of the Investment segment. Management also views excess investment income per diluted share as an important performance measure for this segment. It is defined as excess investment income divided by the total diluted weighted average shares outstanding, representing the contribution by the Investment segment to the consolidated earnings per share of the Company. Since 1986, Torchmark has used excess cash flow to repurchase Torchmark shares under its ongoing share repurchase program after determining that the repurchases provided a greater return than other investment alternatives. Share repurchases reduce excess investment income because of the potential earnings foregone on cash that could have otherwise been invested in interest-bearing assets, but the repurchases also reduce the number of shares outstanding. In order to put all capital resource uses on a comparable basis, management believes that excess investment income per diluted share is the most appropriate measure of the Investment segment.
Excess investment income declined 3% during the period from $164 million in 2005 to $159 million. On a per share basis, excess investment income per share rose 1% to $1.55. The largest component of excess investment income is net investment income,
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which rose $9 million, or 3%, to $308 million. As discussed below, the increase in net investment income was offset by increased financing costs and required interest on insurance liabilities. Financing costs rose $8 million or 33%, due to rising short-term rates and the associated reduced benefit of the interest-rate swaps. Required interest increased 4.9% or $5 million, correlating with the 4.3% growth in the average net insurance policy liability.
While net investment income rose 3%, the average size of the investment portfolio increased 5% from a year ago. The slower growth in income reflects the effect of acquisitions of investments in recent years with yields lower than the overall portfolio yield. Average invested assets, which include fixed maturities at amortized cost, were $9.2 billion in the 2006 period, compared with $8.7 billion a year earlier. The $464 million increase in average invested assets over the prior-year period was achieved even though Torchmark used $331 million of excess operating cash flows to repurchase the Company’s shares under its share repurchase program in the prior twelve months.
The following chart summarizes selected information for fixed-maturity purchases. Both yield and average life calculations on new purchases of noncallable bonds are based on the maturity date. In the case of callable bonds, the average life is based on the worst call date or maturity date, whichever produces the lowest yield (“yield to worst”).
Fixed Maturity Acquisitions Selected Information
(Dollar amounts in millions)
Cost of acquisitions:
Investment-grade corporate securities
Other investment-grade securities
Total fixed-maturity acquisitions
Effective annual yield (one year compounded) *
Average life (in years, to worst call)
In 2006, Torchmark continued to buy primarily investment-grade fixed-maturity corporate bonds and trust preferred securities (classified as redeemable preferred stocks) with a diversity of issuers and industry sectors. Year-to-date, new money was invested at an average yield of 6.6%, an average maturity of 20 years, and an average rating of A+.
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This compares to a yield of 6.3%, maturity of 22 years and rating of BBB+ for the first six months of 2005. However, in the second quarter of 2006, money was invested at 6.98% and an average maturity of 24 years.
The 6.98% yield on second quarter acquisitions matched the portfolio yield for the first time in three years. During this period of low interest rates, Torchmark has attempted to invest money as nearly as possible to 7%. From the second quarter of 2003 through the first quarter of 2005, the Company invested primarily in long-term bonds (20+ year maturities) yielding around 6 1/2%. With the flattening of the yield curve, Torchmark changed its strategy in the second quarter of 2005. Since the Company felt that it was no longer being adequately compensated for the risk of investing totally in long securities, Torchmark decided to invest long only in quality bonds yielding in excess of 6 1/2%; otherwise, the Company would invest in bonds with maturities around 5 years. In the second quarter of 2006, the rate environment changed again. Although the yield curve remained relatively flat, long-term interest rates ticked up. As a result, more quality bonds with yields in excess of 6 1/2% became available, which prompted the Company to invest exclusively in longer-term bonds.
Financing costs for the Investment segment primarily consist of interest on Torchmark’s various debt instruments. The following table reconciles interest expense per the Consolidated Statements of Operations to financing costs.
Reconciliation of Interest Expense to Financing Costs
(Amounts in thousands)
Interest expense per Consolidated Statements of Operations
Reclassification of interest amount due to deconsolidation
Benefit from interest-rate swaps
Financing costs
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The table below presents the components of financing costs.
Analysis of Financing Costs
Interest on funded debt
Interest on short-term debt
Financing costs increased 33% to $33 million from $25 million in the previous year’s six months, primarily because of the increase in short-term borrowing rates. The higher interest rates caused a reduction in the settlement benefit provided by Torchmark’s swap agreements to a benefit of $491 thousand in the 2006 period compared with a $5.2 million benefit in the 2005 period. Of this decline, $1.5 million of the 2005 benefit was the spread on two swaps sold in the third quarter of 2005. Please refer to the caption “Capital Resources” in this report for more information on Torchmark’s swaps. Additionally, the higher short-term borrowing rates along with a 7% increase in average commercial paper borrowings caused Torchmark’s interest on short-term debt to increase by $2.6 million or 67% in the 2006 period.
Lower long-term interest rates along with higher short-term rates have restricted the growth in excess investment income in the last two years. However, excess investment income will benefit from the higher new-money rates and the reduced exposure to short-term financing costs due to the termination, as discussed under the caption “Capital Resources,” of Torchmark’s fixed-to-floating interest-rate swaps. Of these two factors, higher investment rates will have the bigger impact because of the significant cash flow generated from operations.
Investments (portfolio composition), comparing June 30, 2006 with June 30, 2005. Approximately 95% of Torchmark’s investments at fair market value are in a diversified fixed-maturity portfolio. Policy loans, which are secured by policy cash values, make up an additional 3%. The remaining balance is comprised of other investments including equity securities, mortgage loans, and other long-term and short-term investments. At June 30, 2006, fixed maturities had a fair value of $8.9 billion, compared with $8.8 billion at December 31, 2005 and $9.0 billion at June 30, 2005. An analysis of Torchmark’s fixed-maturity portfolio by component at June 30, 2006 is as follows.
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Fixed Maturities by Component
Fixed maturities available for sale:
Bonds:
U.S. Government direct obligations & agencies
GNMA pools and other mortgage-backed securities
Corporates
Other
Redeemable preferred stocks
Total fixed maturities
An analysis of the fixed-maturity portfolio by quality rating at June 30, 2006 is as follows.
Fixed Maturities by Rating*
AAA
AA
A
BBB
BB
B
Below B
The portfolio has an average quality rating of “A-.” Approximately 92% of the portfolio at amortized cost was considered investment grade.
The majority of fixed-maturity holdings are in corporate securities. Investments in corporate fixed maturities are diversified in a wide range of industry sectors. At fair value, the following table presents the largest twelve holdings of Torchmark’s corporate fixed maturities by industry sector at June 30, 2006.
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Industry
Insurance carriers
Depository institutions
Electric, gas, sanitation services
Nondepository credit institutions (finance)
Communications
Chemicals & allied products
Media (printing, publishing & allied lines)
Food & kindred products
Oil & gas extraction
Transportation equipment
Petroleum refining & related industries
Industrial, commercial machinery, computer equipment
All other sectors *
Additional information concerning the fixed-maturity portfolio is as follows.
Fixed Maturity Portfolio Selected Information
Amortized cost (millions)
Gross unrealized gains (millions)
Gross unrealized losses (millions)
Fair value (millions)
Average annual effective yield
Average life (in years, to worst call)(1)
Average life (in years, to maturity)(1)
Effective duration (to worst call)(1),(3)
Effective duration (to maturity)(1),(3)
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Realized Gains and Losses, comparing the first six months of 2006 with the first six months of 2005. As discussed in Note E—Business Segments, Torchmark’s core business of providing insurance coverage requires it to maintain a large and diverse investment portfolio to support its insurance liabilities. From time to time, investments are disposed of or written down prior to maturity for reasons generally beyond the control of management, resulting in realized gains or losses. As discussed in Note E, realized gains and losses are incidental to core insurance operating results, but can be significant in relation to the earnings from core insurance operations. As a result, these gains and losses can have a material positive or negative impact on net income and, if included in operating results, they might cause those results to not be indicative of the past or future performance of core operations. For these reasons, Torchmark management removes the effects of realized gains and losses when evaluating its overall operating results.
The following table summarizes Torchmark’s tax-effected realized gains (losses) by component.
Analysis of Realized Gains (Losses)
(Dollar amounts in thousands, except for per share data)
Realized gains (losses), net of tax, from:
Investment sales
Loss on redemption of debt
Valuation of interest rate swaps
Spread on interest rate swaps *
As noted under the caption “Capital Resources,” Torchmark acquired with the intent to retire $3.3 million principal amount of its 7 7/8% Notes during the second quarter of 2006, recording an after-tax loss of $270 thousand.
Accounting rules require Torchmark to value its interest-rate swaps at their fair value at the end of each accounting period. The fair values of these instruments fluctuate with interest rates in financial markets and diminish with the passage of time so that their value will be zero when they ultimately expire. These period-to-period fluctuations can be substantial. However, Torchmark management does not consider these period-to-period fluctuations in value in managing its ongoing operations because their cumulative result will be zero if held to expiration. These temporary unrealized changes in swap values are included as a component of “Realized Investment Gains (Losses)” on the Consolidated Statements of Operations. This fair value adjustment for all swaps on an after-tax basis
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was a negative $3.0 million in the six months of 2006, compared with a negative $604 thousand in the same period of 2005.
The Securities and Exchange Commission’s accounting guidance currently requires that all income and expenses related to a nonhedged derivative be recorded in the same line item on the income statement that the adjustment to fair value is recorded. Therefore, the cash settlements of the swaps are combined with the noncash unrealized fair value adjustments as a component of realized investment gains and losses. Torchmark’s after-tax interest cost reduction from the cash settlements included in realized investment gains and losses was a positive $319 thousand in 2006 and a positive $3.4 million in 2005. Torchmark reduces interest cost for this benefit in its segment analysis, because the segment analysis is required by GAAP to be as management evaluates the performance of the segment. Management views the benefit from lower interest rates as a reduction in its financing costs in its Investment segment.
Recent increases in short-term rates have had a negative impact on both the valuation of the swaps and the benefit from the cash settlements. As noted earlier and discussed under the caption “Capital Resources,” Torchmark disposed of both of its remaining interest-rate swaps in the second quarter of 2006.
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Financial Condition
Liquidity. Liquidity is evidenced by positive cash flow, a portfolio of marketable investments, and the availability of a line of credit facility. Torchmark’s insurance operations have historically generated cash flows well in excess of immediate requirements. Net cash inflows from operations were $432 million in the first six months of 2006 compared with $459 million in the same period of 2005. Cash flow in 2006 was negatively affected by a $32 million tax settlement paid during the first quarter, as well as approximately $26 million of net cash outflow due to the new Medicare Part D business. In addition to cash inflows from operations, Torchmark received $161 million in investment maturities or repayments during the 2006 six months.
Cash and short-term investments were $83 million at June 30, 2006, compared with $138 million at December 31, 2005 and $46 million at the end of June, 2005. In addition to these liquid assets, the entire $8.9 billion (fair value at June 30, 2006) portfolio of fixed-income and equity securities is available for sale in the event of an unexpected need. Substantially all fixed-income and equity securities are publicly traded. Torchmark generally expects to hold fixed-income securities to maturity. Even though these securities are available for sale, the Company has the ability and intent to hold securities which are temporarily impaired until they are recoverable.
Torchmark has in place a line of credit facility with a group of lenders that allows unsecured borrowings and stand-by letters of credit up to $600 million. The five-year facility matures on November 18, 2009. The Company also has the ability to request up to $175 million in letters of credit to be issued against the facility. The line of credit is further designated as a back-up credit line for a commercial paper program not to exceed $600 million, whereby Torchmark may borrow from either the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed $600 million. Interest is charged at variable rates. At June 30, 2006, $115 million face amount of commercial paper was outstanding ($115 million book value), $163 million letters of credit were issued, and there were no borrowings under the line of credit. A facility fee is charged on the entire facility. There are also issuance and fronting fees related to the letters of credit and there is an additional usage fee if borrowing exceeds $300 million. The facility has no ratings-based acceleration triggers which would require early repayment. In accordance with the agreements, Torchmark is subject to certain covenants regarding capitalization and interest coverage. At June 30, 2006, Torchmark was in full compliance with these covenants.
Capital resources. The capital structure consists of short-term debt (including the commercial paper facility described above and maturities of long-term debt within one year), long-term funded debt, and shareholders’ equity. The outstanding long-term debt at book value, including Torchmark’s Junior Subordinated Debentures, was $870 million at June 30, 2006, compared with $508 million at December 31, 2005 and $691 million at June 30, 2005. An analysis of long-term debt issues outstanding is as follows at June 30, 2006.
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Long Term Debt at June 30, 2006
Instrument
Senior Debentures
Notes
Senior Notes
Issue expenses (1)
Total long-term debt
Junior Subordinated Debentures (2)
Junior Subordinated Debenture (2)
As reported in Note F – Capital Transactions in the Notes to Consolidated Financial Statements, Torchmark issued $123.7 million of 7.1% Junior Subordinated Debentures and $250 million principal amount of 6 3/8% Senior Notes due 2016 in June, 2006. The Junior Subordinated Debentures are payable to Torchmark Capital Trust III which in turn issued 4.8 million shares of 7.1% Trust Preferred Securities in a public offering in June, 2006. Issue expenses of $8.3 million were connected with these new issues and were deducted from long-term debt. More detailed information on these issues can be found in Note F.
In addition to these long-term issues, Torchmark had outstanding at June 30, 2006 its 6 1/4% Senior Notes, $180 million principal amount, which are scheduled to mature in December, 2006. These Notes were included in short-term debt at June 30, 2006 and long-term debt a year earlier.
During June, 2006, Torchmark acquired with the intent to retire $3.3 million par value of its 7 7/8% Notes due 2023 at a cost of $3.7 million. This transaction resulted in an after-tax realized loss of $270 thousand.
Torchmark sold its two remaining interest-rate swaps in June 2006, as rising short-term rates continued to reduce future prospects for positive interest-rate spreads. These swaps exchanged the fixed-interest commitments for floating rate commitments on Torchmark’s 6 1/4% Senior Notes due December, 2006 ($180 million notional amount) and 7 3/4% Trust Preferred Securities due November, 2041 ($150 million notional amount). Torchmark received $63 thousand in net proceeds from the sales of these swaps.
The swap related to the 6 1/4% Senior Notes qualified as a hedge under accounting rules. When a swap qualifies as a hedge, an adjustment corresponding but offsetting the fair value adjustment to the swap asset is made to the carrying value of the debt instrument
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and there is no earnings impact. The 6 1/4% Senior Note swap decreased the carrying value of the long-term debt instrument by $421 thousand as of the date of sale and increased the carrying value by $336 thousand at December 31, 2005.
Because the non-hedged swap was adjusted to fair value each period, there was no earnings impact at the time of the sale. However, the adjustment of value resulted in an after-tax loss of $3.0 million in 2006 compared with a gain of $122 thousand in 2005. During the third quarter of 2005, Torchmark sold two additional interest-rate swaps, one of which was a notional $99.4 million related to the 8.25% Senior Debentures and the other was a notional $100 million related to the 7.375% Notes.
The Company acquired 4.7 million of its outstanding common shares with excess cash flow on the open market at a cost of $267 million ($56.84 per share) during the first six months of 2006 under its ongoing share repurchase program. Please refer to the description of the Company’s share repurchase program under the caption Highlights in this report. The Company intends to continue the repurchase of its common shares when financial markets are favorable.
Shareholders’ equity was $3.13 billion at June 30, 2006. This compares with $3.43 billion at December 31, 2005 and $3.46 billion at June 30, 2005. Shareholder’s equity was reduced by the $331 million in share purchases made under the Company’s share repurchase program over the preceding twelve months and net after-tax unrealized losses in the fixed investment portfolio of $452 million over the same period.
The Company is required by an accounting rule (SFAS 115) to revalue its available-for-sale fixed-maturity portfolio to fair market value at the end of each accounting period. These changes, net of their associated impact on deferred acquisition costs and income tax, are reflected directly in shareholders’ equity. Changes in the fair value of the portfolio compared with prior periods result primarily from changes in interest rates in financial markets. While SFAS 115 requires invested assets to be revalued, it does not permit interest-bearing insurance policy liabilities to be valued at fair value in a consistent manner. If these liabilities were revalued in the same manner as the assets, the effect on equity would be largely offset. The size of both the investment portfolio and Torchmark’s policy liabilities are quite large in relation to its shareholders’ equity. Therefore, this inconsistency in measurement usually has a material impact on the reported value of shareholders’ equity. Fluctuations in interest rates cause volatility in the period-to-period presentation of Torchmark’s shareholders’ equity, capital structure, and financial ratios which would be essentially removed if interest-bearing liabilities were valued in the same manner as assets. For this reason, Company management, credit rating agencies, lenders, many industry analysts, and certain other financial statement users remove the effect of SFAS 115 when analyzing Torchmark’s balance sheet, capital structure, and financial ratios.
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The following table presents selected data related to capital resources. Additionally, the table presents the effect of SFAS 115 on relevant line items, so that investors and other financial statement users may determine its impact on the Company’s capital structure.
Selected Financial Data
Fixed maturities (millions)
Deferred acquisition costs (millions) **
Total assets (millions)
Short-term debt (millions)
Long-term debt (millions)
Shareholders’ equity (millions)
Book value per diluted share
Debt to capitalization ***
Diluted shares outstanding (thousands)
Actual shares outstanding (thousands)
Interest coverage was 12.2 times in the 2006 six months compared with 13.7 times in the prior period.
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Pension assets. The following chart presents assets at fair value for Torchmark’s defined-benefit pension plans at June 30, 2006 and the prior-year end.
Pension Assets by Component
Corporate debt
Other fixed maturities
Equity securities
The liability for qualified defined-benefit pension plans was $209 million at December 31, 2005. During the six months of 2006, Torchmark contributed $9 million to these plans. Torchmark estimates that it will contribute an amount not to exceed $20 million in total to these plans in 2006.
New Unadopted Accounting Rules
The FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) to clarify the accounting for income taxes by providing methodology for the financial statement recognition and measurement of uncertain income tax positions. This interpretation also requires disclosure and provides additional guidance on related topics. It is effective for fiscal years beginning after December 15, 2006. Torchmark is currently assessing the impact of the adoption of FIN 48, but does not believe at this time that it will be material.
Cautionary Statements
Torchmark cautions readers regarding certain forward-looking statements contained in the previous discussion and elsewhere in this document, and in any other statements made by, or on behalf of Torchmark whether or not in future filings with the Securities and Exchange Commission. Any statement that is not a historical fact, or that might otherwise be considered an opinion or projection concerning Torchmark or its business, whether express or implied, is meant as and should be considered a forward-looking statement. Such statements represent management’s opinions concerning future operations, strategies, financial results or other developments. Torchmark specifically disclaims any obligation to update or revise any forward-looking statement because of new information, future developments, or otherwise.
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Forward-looking statements are based upon estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond Torchmark’s control. If these estimates or assumptions prove to be incorrect, the actual results of Torchmark may differ materially from the forward-looking statements made on the basis of such estimates or assumptions. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments, which may be national in scope, related to the insurance industry generally, or applicable to Torchmark specifically. Such events or developments could include, but are not necessarily limited to:
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There have been no quantitative or qualitative changes with respect to market risk exposure during the six months ended June 30, 2006.
Torchmark, under the direction of the Chairman and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, has established disclosure controls and procedures that are designed to ensure that information required to be disclosed by Torchmark in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The disclosure controls and procedures are also intended to ensure that such information is accumulated and communicated to Torchmark’s management, including the Chairman and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
As of the end of the fiscal quarter completed June 30, 2006, an evaluation was performed under the supervision and with the participation of Torchmark management, including the Chairman and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, of Torchmark’s disclosure controls and procedures (as those terms are defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based upon their evaluation, the Chairman and Chief Executive Officer and the Executive Vice President and Chief Financial Officer have concluded that Torchmark’s disclosure controls and procedures are effective as of the date of this Form 10-Q. In compliance with Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350), each of these officers executed a Certification included as an exhibit to this Form 10-Q.
As of the date of this Form 10-Q for the quarter ended June 30, 2006, there have not been any significant changes in Torchmark’s internal control over financial reporting or in other factors that could significantly affect this control over financial reporting subsequent to the date of their evaluation which have materially affected, or are reasonably likely to materially affect, Torchmark’s internal control over financial reporting. No material weaknesses in such internal controls were identified in the evaluation and as a consequence, no corrective action was required to be taken.
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Part II – Other Information
Torchmark and its subsidiaries, in common with the insurance industry in general, are subject to litigation, including claims involving tax matters, alleged breaches of contract, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of Torchmark’s subsidiaries, employment discrimination, and miscellaneous other causes of action. A number of such actions involving Torchmark’s subsidiary Liberty also name Torchmark as a defendant. Based upon information presently available, and in light of legal and other factual defenses available to Torchmark and its subsidiaries, management does not believe that such litigation will have a material adverse effect on Torchmark’s financial condition, future operating results or liquidity; however, assessing the eventual outcome of litigation necessarily involves forward-looking speculation as to judgments to be made by judges, juries and appellate courts in the future. This bespeaks caution, particularly in states with reputations for high punitive damage verdicts such as Alabama and Mississippi.
Many of these lawsuits involve claims for punitive damages in state courts of Alabama and Mississippi. Torchmark’s management recognizes that large punitive damage awards continue to occur bearing little or no relation to actual damages awarded by juries in jurisdictions in which Torchmark has substantial business, particularly Alabama and Mississippi, creating the potential for unpredictable material adverse judgments in any given punitive damage suit. As of June 30, 2006, Liberty was a party to approximately 50 active lawsuits (which included 5 employment-related cases and excluded interpleaders), 32 of which were Alabama proceedings and 3 of which were Mississippi proceedings in which punitive damages were sought.
As previously reported, on March 15, 1999, Torchmark was named as a defendant in consolidated derivative securities class action litigation involving Vesta Insurance Group, Inc. filed in the U.S. District Court for the Northern District of Alabama (In re Vesta Insurance Group, Inc. Securities Litigation. Master File No. 98-AR-1407-S). The amended consolidated complaint in this litigation alleges violations of Section 10(b) of the Securities Exchange Act of 1934 by the defendants Vesta, certain present and former Vesta officers and directors, KPMG, LLP (Vesta’s former independent public accountants) and Torchmark and of Section 20(a) of the Exchange Act by certain former Vesta officers and directors and Torchmark acting as “controlling persons” of Vesta in connection with certain accounting irregularities in Vesta’s reported financial results and filed financial statements. Unspecified damages and equitable relief are sought on behalf of a purported class of purchasers of Vesta equity securities between June 2, 1995 and June 29, 1998. A class was certified in this litigation on October 25, 1999. In September, 2001, Torchmark filed a motion for summary judgment, which was denied by the District Court on January 10, 2002. On April 9, 2003, the District Court issued an order denying the class plaintiffs’ motion to strike certain of Torchmark’s affirmative defenses, holding that Torchmark cannot be held jointly and severally liable with Vesta under the securities law without an affirmative jury determination that Torchmark knowingly committed a violation of the securities laws.
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Vesta, its officers and directors, its insurance carriers and KPMG settled their portions of the litigation with class plaintiffs in 2001; Torchmark did not. Subsequently, in May 2003, Torchmark instituted separate litigation against KPMG which was resolved in March, 2006. In April, 2006, class plaintiffs in Vesta Insurance Group Securities Litigation filed a motion in U.S. District Court for the Northern District of Alabama renewing their claims against Torchmark based upon an allegation of control person liability. This matter has been set for trial in the District Court on October 2, 2006.
As previously reported, United American Insurance Company has been named as a defendant in purported class action litigation filed on January 7, 2005, in the District Court of Starr County, Texas on behalf of the Texas purchasers of association group health insurance policies or certificates issued by United American through Heartland Alliance of America and Farm & Ranch Healthcare, Inc. (Rodriguez v. Burdine, et al, DC-05-8). The plaintiffs assert claims of civil conspiracy, conversion and theft, violations of the Texas Insurance and Administrative Codes, breach of fiduciary duties, fraud and gross negligence and breach of contract as well as filing a members representative action on behalf of all the members of the Heartland Association. The plaintiffs allege excessive and unauthorized association dues payments that the defendants have collected from policyholders. A declaratory judgment, monetary damages, imposition of a constructive trust, equitable forfeiture and attorney’s fees are sought by the plaintiffs.
On February 17, 2005, named defendant Martha Burdine filed an amended answer and a complaint (the cross complaint) against various other defendants including United American (the cross defendants) on behalf of a purported class of former agents and managers of those cross defendants (the cross plaintiffs). These cross plaintiffs assert a pattern of contract breaches and misconduct by the cross defendants including claims for breach of contract, intentional and negligent misrepresentation, fraud, negligence, breach of duties of trustees, trespass to chattels, conversion, intentional interference with a business relationship and intentional interference with a valid business expectancy. The cross plaintiffs seek actual, punitive and exemplary damages, attorneys’ fees and costs and other legal and equitable relief. A class certification hearing has been set for August 31, 2006, at which time the Court will consider approval of a proposed settlement agreement between the parties.
Additional information regarding these cases can be found in the Company’s prior Forms 10-K and Forms 10-Q.
Torchmark has had no material changes to its risk factors.
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Period
April 1-30, 2006
May 1-31, 2006
June 1-30, 2006
On July 27, 2006, Torchmark’s Board reaffirmed its continued authorization of the Company’s stock repurchase program in amounts and with timing that management, in consultation with the Board, determined to be in the best interest of the Company. The program has no defined expiration date or maximum shares to be purchased.
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At the 2006 Annual Meeting of Shareholders held April 27, 2006:
David L. Boren
M. Jane Buchan
Robert W. Ingram
Harold T. McCormick
Paul J. Zucconi
The following directors have continuing terms of office:
Lloyd W. Newton was also elected by the Board of Directors at their April 27, 2006 meeting for a one year term, filling a newly created directorship.
FOR
AGAINST
ABSTAIN
90,888,036
BROKER NON-VOTE
67,504,380
7,534,676
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SIGNATURES
Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
Date: August 7, 2006
/s/ Mark S. McAndrew
Mark S. McAndrew
Chairman and Chief Executive Officer
/s/ Gary L. Coleman
Gary L. Coleman, Executive Vice
President and Chief Financial Officer
(Chief Accounting Officer)
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