UNITED STATES
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 September 30, 2014
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
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 October 27, 2014
Common Stock,
$1.00 Par Value
Index of Exhibits (Page 58).
Total number of pages included are 59.
INDEX
PART I. FINANCIAL INFORMATION
Item 1.
Item 2.
Item 3.
Item 4.
PART II. OTHER INFORMATION
Item 1A.
Item 6.
PART I–FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(Dollar amounts in thousands except per share data)
Investments:
Fixed maturities, available for sale, at fair value (amortized cost: 2014–$12,728,196 ; 2013–$12,488,875)
Equity securities, at fair value (cost: 2014–$776 ; 2013–$875)
Policy loans
Other long-term investments
Short-term investments
Total investments
Cash
Accrued investment income
Other receivables
Deferred acquisition costs
Goodwill
Other 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
Current and deferred income taxes payable
Other liabilities
Short-term debt
Long-term debt (fair value: 2014–$1,144,199 ; 2013–$1,131,391)
Total liabilities
Shareholders’ equity:
Preferred stock, par value $1 per share–Authorized 5,000,000 shares; outstanding: -0- in 2014 and in 2013
Common stock, par value $1 per share–Authorized 320,000,000 shares; outstanding: (2014–139,218,183 issued, less 9,950,088 held in treasury and 2013–151,218,183 issued, less 16,965,802 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.
1
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-than-temporary impairments
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, premium taxes, and non-deferred acquisition costs
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
2
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
Reclassification adjustment for (gains) losses on securities included in net income
Reclassification adjustment for amortization of (discount) and premium
Foreign exchange adjustment on securities recorded at fair value
Unrealized gains (losses) on securities
Unrealized gains (losses) on other investments
Total unrealized investment gains (losses)
Less applicable taxes
Unrealized investment gains (losses), net of tax
Unrealized gains (losses) attributable to deferred acquisition costs
Unrealized gains (losses) attributable to deferred acquisition costs, net of tax
Foreign exchange translation adjustments, other than securities
Foreign exchange translation adjustments, other than securities, net of tax
Pension adjustments
Pension adjustments, net of tax
Other comprehensive income (loss)
Comprehensive income (loss)
3
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash provided from operations
Cash provided from (used for) investment activities:
Long-term investments sold or matured:
Fixed maturities available for sale—sold
Fixed maturities available for sale—matured, called, and repaid
Equity securities
Total long-term investments sold or matured
Long-term investments acquired:
Fixed maturities
Total long-term investments acquired
Net increase in policy loans
Net (increase) decrease in short-term investments
Net change in payable or receivable for securities
Disposition of properties
Additions to properties
Investment in low-income housing interests
Cash used for investment activities
Cash provided from (used for) financing activities:
Proceeds from exercise of stock options
Repayment of 7.375% Notes
Net borrowings (repayments) of commercial paper
Excess tax benefit from stock option exercises
Acquisition of treasury stock
Cash dividends paid to shareholders
Net receipts (withdrawals) from deposit-type products
Cash provided by (used for) financing activities
Effect of foreign exchange rate changes on cash
Net increase (decrease) in cash
Cash at beginning of year
Cash at end of period
4
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Note A—Accounting Policies
The accompanying condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q. Therefore, they do not include all of the annual 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 September 30, 2014, and the consolidated results of operations, comprehensive income, and cash flows for the periods ended September 30, 2014 and 2013. The interim period condensed consolidated financial statements should be read in conjunction with the Consolidated Financial Statements that are included in the Form 10-K filed on February 28, 2014.
Note B—Earnings Per Share
Stock Split: Torchmark declared a three-for-two stock split paid in the form of a 50% stock dividend on all of the Company’s outstanding common stock, having a record date of June 2, 2014. On July 1, 2014, the payment date, holders of Torchmark common stock received one additional share of stock for every two shares held. Upon completion of the transaction, Torchmark had 139,218,183 shares issued at a par value of $1 per share and 131,031,843 shares outstanding after giving effect to the purchase of $26 thousand in fractional shares on July 1, 2014. Shareholders’ equity component amounts as of December 31, 2013 were retrospectively adjusted to reflect this stock dividend. All share and per share amounts have been adjusted to reflect this stock split for all periods presented in these consolidated financial statements.
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
5
Note C—Postretirement Benefit Plans
The following tables present a summary of post-retirement benefit costs by component.
Components of Post-Retirement Benefit Costs
Service cost
Interest cost
Expected return on assets
Amortization:
Prior service cost
Actuarial (gain) loss
Actuarial valuation adjustment
Direct recognition of expense
Net periodic benefit cost
Actuarial (gain)/loss
6
Note C—Postretirement Benefit Plans (continued)
The following chart presents assets at fair value for the defined-benefit pension plans at September 30, 2014 and the prior-year end.
Pension Assets by Component
Corporate debt
Other fixed maturities
Guaranteed annuity contract
Other
Total
The liability for the funded defined-benefit pension plans was $342 million at September 30, 2014 and $322 million at December 31, 2013. Cash contributions of $12.8 million were made to the qualified pension plans during the nine months ended September 30, 2014. Torchmark does not expect to make further cash contributions to these plans during 2014. With respect to the Company’s non-qualified supplemental retirement plan, life insurance policies on the lives of plan participants have been established with an unaffiliated carrier to fund a portion of the Company’s obligations under the plan. These policies, as well as investments deposited with an unaffiliated trustee, were previously placed in a Rabbi Trust to provide for payment of the plan obligations. At September 30, 2014, the combined value of the insurance policies and investments in the Rabbi Trust to support plan liabilities were $70 million, compared with $66 million at year-end 2013. Since this plan is non-qualified, the values of the insurance policies and investments are recorded as other assets in the Consolidated Balance Sheets and are not included in the chart of plan assets above. The liability for the non-qualified pension plan was $61 million at September 30, 2014 and $58 million at December 31, 2013.
7
Note D—Investments
Portfolio Composition:
A summary of fixed maturities and equity securities available for sale by cost or amortized cost and estimated fair value at September 30, 2014 is as follows.
Portfolio Composition as of September 30, 2014
Fixed maturities available for sale:
Bonds:
U.S. Government direct, guaranteed, and government-sponsored enterprises
States, municipalities, and political subdivisions
Foreign governments
Corporates
Collateralized debt obligations
Other asset-backed securities
Redeemable preferred stocks
Total fixed maturities
Total fixed maturities and equity securities
8
Note D—Investments (continued)
A schedule of fixed maturities by contractual maturity date at September 30, 2014 is shown below on an amortized cost basis and on a fair value basis. Actual maturity dates could differ from contractual maturities due to call or prepayment provisions.
Due in one year or less
Due from one to five years
Due from five to ten years
Due from ten to twenty years
Due after twenty years
Mortgage-backed and asset-backed securities
Selected information about sales of fixed maturities is as follows.
For the nine months ended September 30,
Proceeds from sales
Gross realized gains
Gross realized losses
9
Fair Value Measurements:
The following table represents assets measured at fair value on a recurring basis.
Fair Value Measurements at September 30, 2014 Using:
Description
Percent of total
10
The following table represents an analysis of changes in fair value measurements using significant unobservable inputs (Level 3).
Analysis of Changes in Fair Value Measurements Using
Significant Unobservable Inputs (Level 3)
Balance at January 1, 2014
Total gains or losses:
Included in realized gains/losses
Included in other comprehensive income
Acquisitions
Sales
Amortization
Other (2)
Transfers in and/or out of Level 3 (3)
Balance at September 30, 2014
Percent of total fixed maturity and equity securities
Balance at January 1, 2013
Balance at September 30, 2013
11
Other-Than-Temporary Impairments:
During the first quarter of 2013, Torchmark wrote down investment real estate in the amount of $2.7 million pretax ($1.7 million after tax) because of other-than-temporary impairment. There were no additional other-than-temporary impairments during the nine-month periods ended September 30, 2014 or 2013.
Unrealized Loss Analysis:
The following table discloses unrealized investment losses by class of investment at September 30, 2014 for the period of time in a loss position. Torchmark considers these investments not to be other-than-temporarily impaired.
Analysis of Gross Unrealized Investment Losses
At September 30, 2014
Description of Securities
States, municipalities and political subdivisions
12
Additional information about investments in an unrealized loss position is as follows.
Number of issues (Cusip numbers) held:
As of September 30, 2014
As of December 31, 2013
Torchmark’s entire fixed-maturity and equity portfolio consisted of 1,604 issues at September 30, 2014 and 1,619 issues at December 31, 2013. The weighted average quality rating of all unrealized loss positions as of September 30, 2014 was A-. Although Torchmark’s fixed-maturity investments are available for sale, Torchmark’s management generally does not intend to sell and does not believe it will be required to sell any securities which are temporarily impaired before they recover due to the strong and stable cash flows generated by its insurance products.
13
Note E—Supplemental Information about Changes to Accumulated Other Comprehensive Income (continued)
An analysis of the change in balance by component of Accumulated Other Comprehensive Income is as follows for the three and nine month periods ended September 30, 2014 and 2013.
Components of Accumulated Other Comprehensive Income
Balance at July 1, 2014
Other comprehensive income (loss) before reclassifications, net of tax
Reclassifications, net of tax
Balance at July 1, 2013
14
15
Reclassifications out of Accumulated Other Comprehensive Income are presented below for the three and nine month periods ended September 30, 2014 and 2013.
Reclassification Adjustments
Affected line items in the
Statement of Operations
Unrealized investment gains (losses) on available for sale assets:
Realized (gains) losses
Amortization of (discount) premium
Total before tax
Tax
Total after tax
Pension adjustments:
Amortization of prior service cost
Amortization of actuarial gain (loss)
Total reclassifications (after tax)
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NOTE F—Business Segments
Torchmark is comprised of life insurance companies which primarily market individual life and supplemental health insurance products through niche distribution systems to middle income Americans. 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, Medicare Part D, and annuity. Effective January 1, 2014, Torchmark reorganized its segment structure to separate its Medicare Part D health insurance business from its other health insurance activities as a stand-alone segment. Management has concluded that Medicare Part D meets the criteria of a distinct segment. Previously, Part D was included in the health segment. Prior periods’ segment results have been retrospectively adjusted for comparability. Premium income for Medicare Part D health insurance is included with the premium for other health products in the Consolidated Statements of Operations. Annuity revenue is classified as “Other premium.” Management’s measure of profitability for each insurance segment is insurance underwriting margin, which is 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 (claims incurred and change in reserves), 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 agencies.
The investment segment 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 required interest on net policy liabilities and financing costs. Financing costs include the interest on Torchmark’s debt. Other income and insurance administrative expense are classified in a separate “Other” segment.
The majority of the Company’s required interest on net policy liabilities (benefit reserves less the deferred acquisition cost asset) is not credited to policyholder accounts. Instead, it is an actuarial assumption for discounting cash flows in the computation of benefit reserves and the amortization of the deferred acquisition cost asset. Required interest related to the net policy liabilities is not included in the various insurance underwriting segments but is shown in the investment segment as a reduction to net investment income. We believe this presentation facilitates a more meaningful analysis of the Company’s underwriting and investment performance as the underwriting results are based on premiums, claims, and expenses and are not affected by unanticipated fluctuations in investment yields.
17
NOTE F—Business Segments (continued)
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 concerns, calls by issuers, or other factors usually beyond the control of management.
Dispositions are sometimes required in order to maintain the Company’s investment policies and objectives. Investments are also occasionally written down as a result of other-than-temporary impairment. Torchmark does not actively trade investments. As a result, realized gains and losses from the disposition and write down of investments are generally incidental to operations and are not considered a material factor in insurance pricing or product profitability. While from time to time these realized gains and losses could be significant to net income in the period in which they occur, they generally have a limited 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.
Torchmark accounts for its stock options and restricted stock under current accounting guidance requiring stock options and stock grants to be expensed based on fair value at the time of grant. Management considers stock compensation expense to be an expense of the Parent Company. Therefore, stock compensation expense is treated as a corporate expense in Torchmark’s segment analysis.
18
Torchmark provides coverage under the Medicare Part D prescription drug plan for Medicare beneficiaries. In accordance with 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 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. In order to more closely match the benefit cost with the associated revenue for interim periods, Torchmark defers these excess benefits for segment reporting purposes. In addition, GAAP recognizes in each quarter a government risk-sharing premium adjustment consistent with the contract as if the quarter represented an entire contract period. These quarterly risk-sharing adjustments are removed in the segment analysis because the actual contract payments are based upon the experience of the full contract year, not the experience of interim periods. Generally, Torchmark expects its benefit ratio to be in line with pricing and generally does not expect to receive any government risk-sharing premium. Total premiums and benefits were the same for segment reporting purposes as they were under GAAP in 2013. For the year 2014, due to unexpected claims on Hepatitis C drugs, Torchmark expects its benefit ratio to exceed pricing and expects to receive government risk sharing premium. Total premiums and benefits for the full year 2014 are still anticipated to be the same under this alternative method as 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.
An analysis of the adjustments for the difference in the interim results as presented for segment purposes and GAAP for Medicare Part D is as follows.
Benefit costs deferred
Government risk-sharing premium adjustment
Pre-tax addition to segment interim period income
After tax amount
The significant increases in the risk-sharing adjustments in 2014 were caused by the increase in volume of business and certain benefit design changes.
19
Additionally, management does not view the risk-sharing premium for Medicare Part D as a component of premium income, and accordingly adjusts health premium income in its segment analysis. A reconciliation of health premium included in the segment analysis with health premium as reported in the Consolidated Statements of Operations is presented in the following table.
Premium per segment analysis:
Medicare Part D premium
Other health premium
Part D risk sharing adjustment
Health premium per Consolidated Statements of Operations
Torchmark has invested in various limited partnerships that provide investment returns through the provision of low-income housing tax credits and other related Federal income tax benefits to the Company. The investment returns from a portion of the interests are guaranteed by unrelated third-parties. Under GAAP, expenses associated with the amortization of the guaranteed interests are required to be reflected in income tax expense. In contrast, GAAP requires the expenses associated with the amortization of non-guaranteed interests to be reflected as a component of “Net investment income.” All of the investment returns from investing in these guaranteed and non-guaranteed limited partnerships interests are in the form of income tax benefits reflected in income tax expense. Management believes including the amortization expense associated with the non-guaranteed as well as the guaranteed interests in income tax expense provides a more appropriate matching of the expense with the related income. For this reason, amortization expense of the non-guaranteed interests is included in “Income taxes” and not “Net investment income” for segment reporting purposes. As described in Note G—New Unadopted Accounting Guidance, new accounting guidance related to low-income housing investments will conform more closely with Torchmark’s segment reporting once adopted in future periods.
20
During the first nine months of 2014, Torchmark accrued for certain litigation in the net amount of $3.7 million ($2.4 million after tax) that were not directly related to its insurance operations. Additionally, Torchmark received $1.3 million ($853 thousand after tax) in settlement of litigation regarding investments. Also in 2014, the Company recorded $8.2 million in administrative settlements ($5.3 million after tax) related to benefits paid for deaths occurring in prior years where claims had not been filed. These administrative settlements were included in “Policyholder benefits” in the Consolidated Statements of Operations in 2014.
During the first nine months of 2013, Torchmark incurred four non-operating charges: (1) a state guaranty fund assessment in the amount of $1.2 million ($751 thousand after tax), resulting from events in years prior to 2012, (2) a legal settlement related to a non-insurance matter in the amount of $500 thousand ($325 thousand after tax), (3) the settlement of a litigation matter related to prior years in the amount of $8.6 million ($5.6 million after tax), and (4) a one-time adjustment related to the finalization of accounting for the insurance assets and liabilities of the Family Heritage Life Insurance Company of America (Family Heritage) acquisition which closed on November 1, 2012. The Family Heritage adjustment increased after-tax earnings in the amount of $522 thousand. With the exception of the administrative settlements in the paragraph above, all of these items are included in “Other operating expense” in the Consolidated Statements of Operations for the appropriate year. The Company removes items related to prior years and non-operating items such as these from its segment analysis because management does not view such expenses as part of its ongoing core insurance operating results.
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.
21
Reconciliation of Segment Operating Information to the Consolidated Statement of Operations
Premium
Expenses:
Policy benefits
Required interest on:
Policy reserves
Amortization of acquisition costs
Insurance administrative expense (2)
Parent expense
Stock compensation expense
Total expenses
Subtotal
Nonoperating items
Amortization of low-income housing
Measure of segment profitability(pretax)
Deduct applicable income taxes
Segment profits after tax
Add back income taxes applicable to segment profitability
Add (deduct) realized investment gains (losses)
Deduct Part D adjustment (1)
Deduct amortization of low-income housing(4)
Deduct legal settlement expenses(5)
Deduct administrative settlements(6)
Pretax income per Consolidated Statement of Operations
22
Reconciliation of Segment Operating Information to the Consolidated Statement of Operations *
Deduct Guaranty Fund Assessment (5)
Deduct legal settlement expenses(6)
Add Family Heritage Life acquisition adjustments(7)
Pretax income from continuing operations per Consolidated Statement of Operations
23
Note F—Business Segments (continued)
The following table summarizes the measures of segment profitability for comparison. It also reconciles segment profits to net income.
Analysis of Profitability by Segment
Life
Health
Medicare Part D
Annuity
Investment
Other and corporate:
Administrative expense
Corporate
Pretax total
Applicable taxes
Reconciling items, net of tax:
Realized gains (losses) - Investments
Part D adjustment
Guaranty Fund assessment
Administrative settlements
Family Heritage acquisition adjustments and expense
Legal settlement expense
24
Note G—New Unadopted Accounting Guidance
Revenue recognition: The FASB issued Accounting Standard Update No. 2014-09 Revenue from Contracts with Customers (ASU 2014-09), to clarify the principles for recognizing revenue, to provide more consistency and comparability in revenue recognition practices, and to simplify recognition requirements along with other improvements. ASU 2014-09 will be effective for Torchmark beginning in calendar year 2017. The Company is currently evaluating this new guidance. Torchmark’s revenues consist of insurance premium and revenues related to financial instruments. These forms of revenue are not within the scope of ASC 2014-09 because they are addressed by other guidance. Therefore, Torchmark does not expect that the implementation of this guidance will result in any significant change in the manner the Company recognizes its revenue.
Low income housing tax credits: The FASB has issued new accounting guidance, Investments-Equity Method and Joint Ventures: Accounting for Investments in Qualified Affordable Housing Projects (ASU 2014-01). This accounting guidance replaces the effective yield method of accounting with respect to investments in qualified affordable housing projects and, if certain conditions are present, provides for a new method of accounting. The new method of accounting allows an investor to amortize the cost of its investment based on the proportion of the tax credits/benefits received during the year to the total expected tax credits/benefits to be received over the life of the investment and will be recognized in the Consolidated Statements of Operations as a component of “Income tax expense.” Additional disclosures are required concerning investments in qualified affordable housing.
The new guidance is effective for Torchmark beginning January 1, 2015, with early adoption permitted. The guidance continues to permit the effective-yield method for investments held as of the date of adoption. Adoption is required on a retrospective basis. Torchmark is currently evaluating the impact of adoption but does not expect that adoption will have a material impact on the consolidated financial statements.
Share-based performance awards: New accounting guidance has also been issued pertaining to share awards with performance targets. This standard, entitled Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could be Achieved After the Requisite Service Period (ASU 2014-12), is effective for Torchmark beginning in calendar year 2016, with early adoption permitted. The new guidance provides that the Company must take into account the performance target in the recognition of compensation expense once the achievement of the performance target is probable. Torchmark has a limited number of such awards, but currently accounts for these items consistent with the new guidance. Therefore, no material impact is expected from adoption.
25
Note G—New Unadopted Accounting Guidance (continued)
Going concern: The FASB has issued Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (ASU 2014-15). This new standard requires management to perform interim and annual assessments of the entity’s ability to continue its business operations within one year of the date of issuance of its financial statements. The Company must then provide certain disclosures if there is substantial doubt about its ability to continue as a going concern. ASU 2014-15 is effective for Torchmark for the year 2016 and for interim periods thereafter. Early adoption is permitted.
26
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Results of Operations
Summary of Operations. Torchmark’s operations are segmented into its insurance underwriting and investment operations as described in Note F—Business Segments. The measures of profitability described in Note F are useful in evaluating the performance of the segments and the marketing groups within each insurance segment, because each of our 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 F—Business Segments demonstrate how the measures of profitability are determined. Those tables also reconcile our revenues and expenses by segment to major income statement line items for the nine month periods ended September 30, 2014 and 2013. Additionally, a table in that note, Analysis of Profitability by Segment, provides a summary of the profitability measures that demonstrates year-to-year comparability and reconciles those measures to our net income. That summary represents our overall operations in the manner that management views the business, and is a basis of the following highlights discussion.
A discussion of operations by each segment follows later in this report. These discussions compare the first nine months of 2014 with the same period of 2013, unless otherwise noted. The following discussions are presented in the manner we view our operations, as described in Note F—Business Segments.
Highlights, comparing the first nine months of 2014 with the first nine months of 2013. Net income per diluted share increased 8% to $2.97 from $2.75. Included in net income in 2014 were after-tax realized investment gains of $10 million ($.08 per share) compared with gains of $3 million or $.02 per share in 2013. Realized investment gains and losses are presented more fully under the caption Realized Gains and Losses in this report.
We use three statistical measures as indicators of future premium growth: “annualized premium in force,” “net sales,” and “first-year collected premium.” Annualized premium in force is defined as the premium income that would be received over the following twelve months at any given date on all active policies if those policies remain in force throughout the twelve-month period. Annualized premium in force is an indicator of potential growth in premium revenue. Net sales is defined as annualized premium issued, net of cancellations in the first thirty days after issue, except for 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 that would be received during the policies’ first year in force, assuming that none of the policies lapsed or terminated. Although lapses and terminations will occur, we believe that net sales is a useful indicator of the rate of acceleration of premium growth. First-year collected premium is the premium collected during the reporting period for all policies in their first policy year.
27
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.
Total premium income rose 4% in 2014 to $2.4 billion. Total net sales rose 32% to $467 million. After removing the impact of sales of Medicare Part D, which increased significantly in 2014 as a result of the addition of automatic enrollees discussed later in this report, net sales rose 19% to $390 million. Automatic enrollees are individuals who are assigned by the Centers for Medicare and Medicaid Services (CMS) to Part D carriers because they are eligible for both Medicaid and Medicare and didn’t select a Part D plan on their own. First-year collected premium was $350 million for the 2014 period, compared with $323 million for the 2013 period. Excluding Part D, there was a 5% increase in first-year collected premium.
Life insurance premium income grew 4% to $1.5 billion. Life net sales increased 10% to $281 million. First-year collected life premium gained 4% to $201 million. Life underwriting margins were steady at 29% of premium, having increased to $421 million in 2014 from $408 million in 2013.
Health insurance premium income, excluding Medicare Part D premium, declined 1% to $645 million. Health net sales, led by sales of Medicare Supplement, rose 54% to $109 million for the nine-month period. First-year collected health premium rose 8% to $81 million. Health margins increased 1% to $148 million.
In the manner we view our Medicare Part D prescription drug business as described in Note F—Business Segments, policyholder premium was $258 million in 2014 compared with $227 million in 2013, an increase of 14%. As discussed under the caption Medicare Part D in this report, the increase in Part D premium resulted primarily from an increase in automatic enrollees. The increase in automatic enrollees, along with an increase in employer group activity, resulted in net sales increasing from $26 million to $77 million in 2014.
However, margins for the Medicare Part D product will be negatively affected by the requirement to cover two costly Hepatitis C drugs in 2014 which we were not able to include in our 2014 pricing. We anticipate reductions in 2014 Part D margins as a percentage of premium of 4% to 5% when compared with 2013, primarily due to the costs of the Hepatitis C drugs.
As explained in Note F—Business Segments, differences in our estimate of interim results for Medicare Part D as we view this product for segment purposes and GAAP financial statement purposes resulted in a $11 million after-tax charge to earnings in 2014 ($.08 per share) and a $8 million charge in 2013 ($.06 per share). We expect our 2014 full year benefit ratios to be approximately the same as those for interim periods, as was the case in 2013 and prior years. For this reason, there should be no difference in our segment versus financial statement reporting by year end 2014, as it relates to Medicare Part D. The increase in this adjustment in 2014 resulted primarily from the increase in volume.
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Excess investment income per diluted share increased 9% in 2014 to $1.27 from $1.17, while the dollar amount of excess investment income rose 3% to $169 million. The greater increase in per share excess investment income in relation to the increase in dollar amount resulted from share purchases over the past twelve months, as discussed later in this report. Net investment income rose $18 million or 3% to $568 million, corresponding closely with the 3% growth in our average investment portfolio at amortized cost. The average effective yield on the fixed-maturity portfolio, which represented 96% of our investments at amortized cost, decreased slightly to 5.91% in the 2014 period from 5.95% in the prior period, as the impact of the low-interest-rate environment on average yield has moderated. Excess investment income is negatively impacted by the increase in required interest on net insurance policy liabilities. Required interest rose 5% or $16 million to $341 million, consistent with the growth in average net policy liabilities. Financing costs declined 7% in the period to $57 million, due to the maturity and repayment of our $94 million par amount 7.375% Notes during the third quarter of 2013. Please refer to the discussion under Capital Resources for more information on debt and interest expense.
In the first nine months of 2014, we invested new money in our fixed-maturity portfolio at an effective annual yield on new investments of 4.74%, compared with 4.37% in the same period of 2013. The portfolio had an average rating of A-, the same as of the previous year end. Approximately 96% of the portfolio at amortized cost was investment grade at September 30, 2014. Cash and short-term investments were $146 million at that date, compared with $114 million at December 31, 2013.
The net unrealized gain position in our fixed-maturity portfolio grew from $390 million at December 31, 2013 to $1.4 billion during the first nine months of 2014, largely due to a decline in market interest rates during 2014. The fixed-maturity portfolio contains no commercial mortgage-backed securities. We are not a party to any counterparty risk, with no credit default swaps or other derivative contracts. We do not engage in securities lending, and our only direct exposure to European sovereign debt is $9 million of German bonds.
We have an on-going share repurchase program which began in 1986 and was reaffirmed by the Board of Directors at their August, 2014 meeting. With no specified authorization amount, we determine the amount of repurchases based on the amount of our excess cash flow, general market conditions, and other alternative uses. These purchases are made at the Parent with excess cash flow. Share purchases are also made with the proceeds from option exercises by current and former employees, in order to reduce dilution. The following chart summarizes share purchases for the nine-month periods ended September 30, 2014 and 2013.
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Analysis of Share Purchases
(Amounts in thousands, except per share amounts)
Purchases with:
Excess cash flow
Option exercise proceeds
Throughout the remainder of this discussion, share purchases will only refer to those made from excess cash flow.
A detailed discussion of our operations by component segment follows.
Life insurance, comparing the first nine months of 2014 with the first nine months of 2013. Life insurance is our predominant segment, representing 62% of premium income and 71% of insurance underwriting margin in the first nine months of 2014. In addition, investments supporting the reserves for life business generate the majority of excess investment income attributable to the investment segment. Life insurance premium income increased 4% to $1.5 billion. The following table presents Torchmark’s life insurance premium by distribution method.
Life Insurance
Premium by Distribution Method
(Dollar amounts in thousands)
American Income Exclusive Agency
Direct Response
Liberty National Exclusive Agency
Other Agencies
Total Life Premium
Net sales, defined earlier in this report as an indicator of new business production, grew 10% to $281 million. 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 $201 million in the 2014 period, rising 4%. First-year collected life premium by distribution group is presented in the table below.
First-Year Collected Premium by Distribution Method
The American Income Exclusive Agency has historically marketed primarily to members of labor unions. While labor unions are still the core market for this agency, American Income has diversified in recent years by focusing heavily on other affinity groups and referrals to help to ensure sustainable growth. The life business of this agency is Torchmark’s highest margin life business and it is the largest contributor to life premium of any of Torchmark’s distribution systems at 39% of Torchmark’s total. This group produced premium income of $570 million, an increase of 7%. First-year collected premium was $99 million, an increase of 2%. Net sales increased 10% to $126 million. Sales growth in our captive agencies is generally dependent on growth in the size of the agency force. The American Income agent count rose 13% to 6,155 at September 30, 2014 over the count a year earlier (5,449), and rose 16% when
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compared with the count at December 31, 2013 (5,302). The average agent count for the nine months of 2014 was 5,716. The average agent count is based on the actual count at the end of each week during the period. The American Income Agency has been focusing on growing and strengthening middle management to support sustainable growth of the agency force. To accomplish this, we have placed an increased emphasis on agent training programs and financial incentives that appropriately reward agents at all levels for helping develop and train personnel. The agency has also begun providing more home-office and webinar training programs. These programs are designed to provide each agent, from new recruits to top level managers, coaching and instruction specifically designed for each individual’s level of experience and responsibilities.
The Direct Response Unit offers adult and juvenile life insurance through a variety of direct-to-consumer marketing approaches, which include direct mailings, insert media, and electronic media. These different approaches support and complement one another in the unit’s efforts to reach the consumer. The Direct Response Unit’s growth has been fueled by constant innovation. In recent years, electronic media production has grown rapidly as management has aggressively increased marketing activities related to internet and mobile technology, and has focused on driving traffic to the inbound call center. We have introduced certain new initiatives in this unit that have increased response rates. These initiatives include lower premium rates as well as offerings of higher face amounts on the adult products.
While the juvenile market is an important source of sales, it also is a vehicle to reach the parents and grandparents of the juvenile policyholders, who 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.
Direct Response’s life premium income rose 5% to $529 million, representing 36% of Torchmark’s total life premium in the first nine months of 2014. Net sales of $120 million for this group increased 9%. First-year collected premium increased 7% to $76 million.
The Liberty National Exclusive Agency markets individual and group life insurance to middle-income customers. Life premium income for this agency was $205 million in the 2014 period, a 2% decline from $208 million in the 2013 nine months. First-year collected premium declined 2% to $19 million.
Net sales for the Liberty Agency increased 9% to $25 million. Liberty had 1,604 producing agents at September 30, 2014, compared with 1,320 a year earlier, an increase of 22%. The agent count has increased 12% since December 31, 2013, when it stood at 1,430. The average agent count for the first nine months of 2014 was 1,482. Our long term plans to grow this agency involve expansion from small-town markets in the southeast to more densely populated areas with larger pools of potential agent recruits and customers. We believe that expansion of this Agency’s presence into more heavily populated, less-penetrated areas will help create long term agency growth. Additionally, a new prospecting training program has helped to improve the ability of agents to develop new worksite marketing business.
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The Other Agencies distribution systems offering life insurance include the Military Agency, the UA Independent Agency (which predominantly writes health insurance), and various smaller distribution channels. The Other Agencies distribution group contributed $169 million of life premium income, or 11% of Torchmark’s total in the first nine months of 2014, but contributed only 3% of net sales.
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 expense was $421 million, increasing 3%. Increases in margin were due in large part to growth in premium income. The percentage growth in margin was less than the growth in premium income due to slightly higher claims in 2014. As a percentage of premium, underwriting margins were stable at 29%.
Health insurance, comparing the first nine months of 2014 with the first nine months of 2013. Health insurance sold by Torchmark includes primarily Medicare Supplement insurance, cancer coverage, accident coverage, and other limited-benefit supplemental health products. In this discussion of health business, references to premium income, net sales, and underwriting will exclude our Medicare Part D health business, which will be discussed under another caption. In this analysis, all health coverage plans other than Medicare Supplement are classified as limited-benefit plans.
Health premium accounted for 27% of our total premium in the 2014 period, while the health underwriting margin accounted for 25% of total underwriting margin, reflective of the lower underwriting margin as a percent of premium for health compared with life insurance. As noted under the caption Life Insurance, we have emphasized life insurance sales relative to health, due to life’s superior profitability and its greater contribution to excess investment income.
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Health premium declined 1% to $645 million in the 2014 period. Medicare Supplement premium declined 1% to $314 million, while other limited-benefit health premium declined 1% to $331 million. Limited-benefit premium now provides Torchmark with the greatest amount of non-Part D health premium, representing 51% of such premium for the 2014 period.
Health net sales increased 54% to $109 million. Medicare Supplement net sales increased 148% to $54 million in the 2014 period. The increase in Medicare Supplement net sales was primarily a result of stronger group sales, which vary significantly from period to period. Limited-benefit net sales increased 12% to $54 million. Health first-year collected premium rose 8% to $81 million.
The following table is an analysis of our health premium by distribution method.
Health Insurance
United American Independent Agency
Limited-benefit plans
Medicare Supplement
Family Heritage Agency
Total Health Premium
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Presented below is a table of health net sales by distribution method.
Total Net Sales
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The following table presents health insurance first-year collected premium by distribution method.
Total First-Year Collected Premium
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A discussion of health operations by distribution group follows.
The UA Independent Agency consists of independent agencies appointed with Torchmark who may also sell for other companies. The UA Independent Agency was Torchmark’s largest health agency in terms of health premium income. Premium income was $225 million, representing 35% of Torchmark’s total health premium. Net sales were $33 million, or 30% of Torchmark’s health sales. This agency is Torchmark’s largest producer of Medicare Supplement insurance, with Medicare Supplement premium income of $213 million. The UA Independent Agency represents approximately 68% of all Torchmark Medicare Supplement premium and 59% of Medicare Supplement net sales. Medicare Supplement premium in this agency rose 3%, while total health premium increased 1%. Net sales of these products rose 69% in 2014. As noted earlier, Group Medicare Supplement sales have historically fluctuated from period to period.
The Family Heritage Agency markets primarily limited-benefit supplemental health insurance in non-urban areas. Most of their policies include a cash-back feature, such as a return of premium whereby any excess of premiums over claims paid is returned to the policyholder at the end of a specified period stated within the insurance policy. Management expects to grow this agency through geographic expansion and incorporation of Torchmark’s recruiting programs. The Family Heritage Agency contributed $35 million in net sales in the nine months of 2014, compared with $32 million for the same period in 2013, an increase of 8%. Health premium income was $152 million for the nine month period of 2014, representing 24% of Torchmark’s health premium. This compared with $142 million or 22% of health premium in the prior year period. The producing agent count was 761 agents at September 30, 2014, compared with 695 at December 31, 2013, and 717 at September 30, 2013. The average agent count for the nine months of 2014 was 726.
The Liberty National Exclusive Agency represented 26% of all Torchmark health premium income at $168 million in the nine months of 2014. The Liberty Agency markets limited-benefit health supplemental products consisting primarily of cancer insurance. Much of Liberty’s health business is now generated through worksite marketing targeting small businesses of 10 to 25 employees. In 2014, health premium income in the Agency declined 8% from prior year premium of $183 million. Liberty’s health premium decline has been due primarily to the runoff of a block of discontinued hospital-surgical products and the declining Medicare Supplement block.
Other distribution. Certain of our other distribution channels market health products, although their main emphasis is on life insurance. On a combined basis, they accounted for 15% of health premium in the 2014 period. The American Income Exclusive Agency markets a variety of limited-benefit plans, primarily accident. The Direct Response group markets primarily Medicare Supplements to employer or union-sponsored groups. In 2014, Direct Response added $22 million of Medicare Supplement net sales compared with $3 million a year earlier, due to sales to a new large group. On a combined basis, the health net sales of these agencies more than tripled to $28 million in 2014 from $9 million in 2013, as a result of the Direct Response increase.
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The following table presents underwriting margin data for health insurance.
Underwriting income for health insurance increased 1% to $148 million in 2014. As a percentage of health premium, underwriting margins were stable at 23%. The improved benefit ratio was largely a result of normal claim fluctuations.
Medicare Part D, comparing the first nine months of 2014 with the first nine months of 2013. Coverage under Torchmark’s Medicare Part D prescription drug plan for Medicare beneficiaries is provided through United American. The Medicare Part D plan is a stand-alone prescription drug plan for Medicare beneficiaries which is regulated and partially funded by CMS for participating private insurers. These products are marketed through our Direct Response unit and to groups through our UA Independent Agency. As described in Note F—Business Segments, we report our Medicare Part D business for segment analysis purposes as we view 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, we have expensed benefits based on our expected benefit ratio of approximately 82% for the entire 2014 contract year. This ratio was also 82% for the full year 2013. We describe the differences between the segment analysis and the GAAP operating results in Note F. 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 be eliminated at the end of a full year, as they were in the full year of 2013.
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Selected Financial Information
Premium(1)
Net Sales(2)
First-Year Collected Premium (3)
Medicare Part D premium was $258 million in 2014, compared with $227 million in 2013, after removal of the risk-sharing adjustment in both periods. This represents an increase in premium of 14%. Net sales rose $51 million, due to an increase in new Part D auto-enrollees and an increase in employer group activity.
Medicare Part D underwriting results are presented in the following chart. The adjustments which reconcile Part D results in accordance with our health segment analysis to Part D results in accordance with GAAP are presented in the charts in Note F—Business Segments.
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Margins decreased 10% in 2014 to $23 million, even though premium rose 14%. Premiums were increased for 2014 to cover higher anticipated non-deferred acquisition expenses. As such, we expected significantly lower obligation ratios in 2014. However, due primarily to unexpected costs related to two Hepatitis C drugs approved by the U.S. Food and Drug Administration late in 2013, the obligation ratios for 2014 were only slightly lower than 2013. Non-deferred acquisition cost ratios were higher, as planned in our pricing, due to (1) new taxes imposed by the Affordable Care Act, (2) higher costs related to a change in structure of drug rebates, and (3) higher costs related to the increased volume of enrollees. As a percentage of premium, underwriting margin for the 2014 nine months was 9%, compared with 11% for 2013.
Medicare Part D claims will be higher than originally anticipated for the full year 2014 due to the cost of the new Hepatitis C drugs. We expect that Part D margin for the full year 2014 will decline primarily as a result of the impact of the new Hepatitis C drugs, causing 2014 margins to be in a range of approximately 6% to 9% of premium.
For 2015, we expect significantly less volatility in Part D and a return to higher margins at historical levels. We have addressed this issue by adjusting our 2015 pricing to reflect the impact of the Hepatitis C drugs. Additionally, we expect to have a significantly reduced number of auto-enrollees in 2015 than in 2014. Since auto-enrollees have accounted for nearly 85% of our Hepatitis C claims this year, our exposure to Hepatitis C claims should be much lower next year. This loss of auto-enrollees will result in lower Part D premium income in 2015, but we expect improved and more stable margins as a percentage of premium.
Since the Medicare Part D plan is a government-sponsored program, regulatory changes could further alter the outlook for this market.
Annuities. Annuities represent an insignificant part of our business and are not expected to be an important part of our marketing strategy going forward.
Operating expenses, comparing the first nine months of 2014 with the first nine months of 2013. Operating expenses consist of insurance administrative expenses and parent company expenses. Also included is stock compensation expense, which is viewed by us as a parent company expense. Insurance administrative expenses relate to premium income for a given period; therefore, we measure 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.
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Operating Expenses Selected Information
Insurance administrative expenses:
Salaries
Other employee costs
Other administrative costs
Legal expense
Total insurance administrative expenses
Parent company expense
New York Guaranty Fund Assessment
Total operating expenses, perConsolidated Statements of Operations
Increase (decrease) over prior year
Total operating expenses:
Insurance administrative expenses were up 1% in 2014 when compared with the prior year period. As a percentage of total premium, insurance administrative expenses declined from 5.8% in 2013 to 5.6%. Total operating expenses rose $8 million or 5%. In 2014, employee costs other than salaries declined 17% during the period, primarily as a result of decreased pension benefit costs. Stock compensation expense rose 30% to $25 million, primarily as a result of an increase in the market price of Torchmark stock in 2014 that resulted in higher grant prices for restricted stock and options, and positive Company performance that caused an increase in the expense related to performance share grants. As described in Note F in the Consolidated Financial Statements, we recorded legal accruals involving non-insurance matters, partially offset by proceeds for investment litigation. Litigation not related to our direct insurance operations is not considered an insurance administrative expense by Torchmark management and is removed from its analysis of core insurance operations in its segment reporting.
Investments (excess investment income), comparing the first nine months of 2014 with the first nine months of 2013. We manage our capital resources including investments, debt, and cash flow through the investment segment. Excess investment income represents the profit margin attributable to investment operations. It is the measure that we use to evaluate the performance of the investment segment as described in Note F—Business Segments in the Notes to the Consolidated Financial Statements. It is defined as net investment income less the required interest on net policy liabilities and the interest cost associated with capital funding or “financing costs.”
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We also view excess investment income per diluted share as an important and useful measure to evaluate the performance of the investment 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 implementing our share repurchase program in 1986, we have used $6.0 billion of cash flow to repurchase Torchmark shares (average price per share of $14.16) after determining that the repurchases provided a greater return than other investment alternatives. Share repurchases reduce excess investment income because of the foregone earnings on the cash that would otherwise have been invested in interest-bearing assets, but they also reduce the number of shares outstanding. In order to put all capital resource uses on a comparable basis, we believe that excess investment income per diluted share is an appropriate measure of the investment segment.
The following table summarizes Torchmark’s investment income, excess investment income, and excess investment income per diluted share.
Excess Investment Income
Net investment income *
Required interest on net insurance policy liabilities
Financing costs:
Interest on funded debt
Interest on short-term debt
Total financing costs
Excess investment income
Excess investment income per diluted share
Average invested assets (at amortized cost)
Average net insurance policy liabilities **
Average debt and preferred securities (at amortized cost)
Excess investment income for the 2014 period increased 3% to $169 million. On a per share basis, excess investment income increased an even greater 9% as a result of our share purchases over the past 12 months. While excess investment income has been pressured in recent years as a result of the impact that lower interest rates have had on net investment income, it has increased in 2014 as the impact of portfolio turnover has moderated. The increase in excess investment income was also due, in part, to the decline in financing costs related to the August, 2013 maturity and repayment of our $94 million principal amount 7 3/8% Notes.
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Net investment income rose $18 million or 3% in 2014, while average invested assets (with fixed maturities at amortized cost) also rose 3% year over year. The effective annual yield on the fixed maturity portfolio was 5.91% in the first nine months of 2014, compared with 5.95% a year earlier. The reduction in the average portfolio yield rate was primarily a result of investing new money at rates lower than the portfolio average yield and reinvesting proceeds from bonds that were called or matured in 2013 at yield rates less than the rates we earned on the bonds before they were called or matured. At current new money rates, we would expect to see only modest declines in the average portfolio yield rate over the next few years compared with the larger declines in recent years, as only 1% to 2% of fixed maturities on average are expected to run off each year over the next five years.
In recent years, investment income has been negatively impacted as the proceeds from fixed maturity assets that matured, were called, or were otherwise disposed of were reinvested in lower yielding assets. However, during 2014, the proceeds from dispositions have been reinvested at yield rates closer to the yield rates earned on the assets disposed of. There would be no material negative impact on investment income in the foreseeable future if the assets currently callable are called and the proceeds from such calls and the proceeds from assets expected to mature are reinvested at expected future new money rates.
Net investment income has also been negatively affected in 2014 by the CMS requirement for us to cover Medicare Part D claim costs in the current period that are ultimately the responsibility of the government, but are not reimbursed until the following year. Because Part D claims have been unusually high in 2014, due to the approval of new Hepatitis C drugs discussed earlier in this report and higher generic drug costs, we have incurred extensive upfront costs that will not be reimbursed by CMS until late 2015. This delay has caused a decrease in investable cash flows that will cause us to lose approximately $4 million in investment income in 2014 and approximately $6 million in 2015. See the discussion on Consolidated Liquidity later in this report for more information.
Should interest rates rise, especially long-term rates, Torchmark would benefit due to higher net investment income on new purchases. Even a sudden, significant increase in interest rates would be beneficial because Torchmark has very little disintermediation risk. Also, we are not concerned with potential interest-rate driven unrealized losses in our fixed maturity portfolio because we have the intent, and more importantly, the ability to hold our fixed maturities to maturity.
Required interest on net insurance policy liabilities reduces excess investment income because we consider these amounts to be components of the profitability of our insurance segments. Required interest is based on the actuarial interest assumptions used in discounting the benefit reserve liability and the
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amortization of deferred acquisition costs for our insurance policies in force. The great majority of our life and health insurance policies are fixed interest-rate protection policies, not investment products, and are accounted for under current accounting guidance for long-duration insurance products under ASC 944-20-05 (formerly SFAS 60) which mandates that interest rate assumptions be “locked in” for the life of that block of business. Each calendar year, we set the discount rate to be used to calculate the benefit reserve liability and the amortization of the deferred acquisition cost asset for all insurance policies issued that year. That rate is based on the new money yields that we expect to earn on premiums received in the future from policies of that issue year, and cannot be changed. The discount rate used for policies issued in the current year has no impact on the in force policies issued in prior years as the rates of all prior issue years are also locked in. As such, the overall discount rate for the entire in force block is a weighted average of the discount rates being used from all issue years. Changes in the overall weighted-average discount rate over time are caused by changes in the mix of the reserves and the deferred acquisition cost asset by issue year on the entire block of in force business. Business issued in the current year has very little impact on the overall weighted-average discount rate due to the size of our in force business.
Required interest on net insurance policy liabilities increased $16 million or 5% to $341 million. The increase in required interest correlated with the 5% growth in average net interest-bearing insurance policy liabilities.
Financing costs declined 7% or $4 million to $57 million, as a result of a decline in interest cost from the previously-mentioned maturity of our $94 million 7 3/8% Notes in August, 2013. More information concerning debt can be found in the Capital Resources section of this report.
Investments (acquisitions), comparing the first nine months of 2014 with the first nine months of 2013. Torchmark’s investment policy calls for investing in fixed maturities that are investment grade and meet our quality and yield objectives. We generally prefer to invest in securities with longer maturities because they more closely match the long-term nature of our policy liabilities. We believe this strategy is appropriate because our cash flows are generally stable and predictable. If available longer-term securities do not meet our quality and yield objectives, new money is generally invested in shorter-term fixed maturities.
The following table summarizes selected information for fixed-maturity purchases. The effective annual yield shown is the yield calculated to the “worst call date.” For non-callable bonds, the worst-call date is always the maturity date. For callable bonds, the worst-call date is the call date that produces the lowest yield (or the maturity date, if the yield calculated to the maturity date is lower than the yield calculated to each call date).
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Fixed Maturity Acquisitions Selected Information
(Dollar amounts in millions)
Cost of acquisitions:
Investment-grade corporate securities
Total fixed-maturity acquisitions
Effective annual yield *
Average life, in years to:
Next call
Maturity
Average rating
Acquisitions in both periods consisted primarily of corporate bonds, with securities spanning a diversified range of issuers, industry sectors, and geographical regions. All of the acquired securities were investment grade.
Investments (portfolio composition). The composition of the investment portfolio at book value on September 30, 2014 was as follows:
Invested Assets At September 30, 2014
Fixed maturities(at amortized cost)
Equities (at cost)
Approximately 96% of our investments at book value are in a diversified fixed-maturity portfolio. Policy loans, which are secured by policy cash values, make up approximately 4% of our investments. We also have insignificant investments in equity securities and other long-term investments. Because fixed maturities represent such a significant portion of our investment portfolio, the remainder of the discussion of portfolio composition will focus on fixed maturities.
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Fixed Maturities. The following table summarizes certain information about our fixed-maturity portfolio by component at September 30, 2014.
Fixed Maturities by Component
Redeemable preferred stock
Municipals
Government-sponsored enterprises
Governments & agencies
Residential mortgage-backed*
At September 30, 2014, fixed maturities had a fair value of $14.2 billion, compared with $12.9 billion at December 31, 2013. The net unrealized gain position in the fixed-maturity portfolio increased from a net gain of $390 million at December 31, 2013 to a net gain of $1.4 billion at September 30, 2014, as a result of a decrease in market interest rates. The September 30, 2014 net unrealized gain consisted of gross unrealized gains of $1.5 billion offset by $120 million of gross unrealized losses, compared with the December, 2013 net unrealized gain which consisted of a gross unrealized gain of $801 million and a gross unrealized loss of $411 million.
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Investments in fixed-maturity securities are diversified over a wide range of industry sectors. The following table summarizes certain information about our fixed-maturity portfolio by sector at September 30, 2014.
Fixed Maturities by Sector
Financial - Life/Health/PC Insurance
Financial - Bank
Financial - Other
Subtotal Financial
Utilities
Energy
Government (US, municipal, and foreign)
Basic Materials
Consumer, Non-cyclical
Other Industrials
Communications
Transportation
Consumer, Cyclical
Mortgage-backed Securities
At September 30, 2014, approximately 42% of the fixed-maturity assets at amortized cost and fair value were in the financial and utility sectors. The balance of the portfolio is spread among 398 issuers in a wide variety of sectors. The financial sector had a net unrealized gain of $391 million at September 30, 2014, compared with a gain of $180 million at December 31, 2013. We expect our investment in temporarily impaired securities to be fully recoverable.
An analysis of the fixed-maturity portfolio at September 30, 2014 by a composite quality rating is shown in the table below. The composite rating for each security is the average of the security’s ratings as assigned by Moody’s Investor Service, Standard & Poor’s, Fitch Ratings, and Dominion Bond Rating Service, LTD. The ratings assigned by these four nationally recognized statistical rating organizations are evenly weighted when calculating the average.
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Fixed Maturities by Rating
Investment grade:
AAA
AA
A
BBB+
BBB
BBB-
Investment grade
Below investment grade:
BB
B
Below B
Below investment grade
Of the $12.7 billion of fixed maturities at amortized cost as of September 30, 2014, $12.2 billion or 96% were investment grade with an average rating of A-. Below-investment-grade bonds were $570 million with an average rating of B+. Below-investment-grade bonds at amortized cost were 16% of our shareholders’ equity, excluding the effect of unrealized gains and losses on fixed maturities as of September 30, 2014. Overall, the total portfolio was rated A- based on amortized cost, the same as at the end of 2013.
An analysis of the changes in our portfolio of below-investment-grade bonds at amortized cost during the first nine months of 2014 is as follows:
Balance as of December 31, 2013
Downgrades by rating agencies
Upgrades by rating agencies
Disposals
Amortization and other
Balance as of September 30, 2014
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Our investment policy is to acquire only investment-grade obligations. Thus, any increases in below-investment-grade issues are a result of ratings downgrades of existing holdings. Our investment portfolio contains no commercial mortgage-backed securities. We have no direct investments in residential mortgages, nor do we have any counterparty risks as we are not a party to any credit default swaps or other derivative contracts. We do not participate in securities lending, we have no off-balance sheet investments, and we have only insignificant exposure to European Sovereign debt consisting of $9 million in German bonds.
Additional information concerning the fixed-maturity portfolio is as follows.
Fixed Maturity Portfolio Selected Information
Average annual effective yield (1)
Average life, in years, to:
Next call(2)
Maturity(2)
Effective duration to:
Next call (2), (3)
Maturity (2), (3)
Realized Gains and Losses, comparing the first nine months of 2014 with the first nine months of 2013. As discussed in Note F—Business Segments, our core business of providing insurance coverage requires us to maintain a large and diverse investment portfolio to support our insurance liabilities. From time to time, investments are disposed of or written down prior to maturity, resulting in realized gains or losses. Because these dispositions and writedowns are outside the course of our normal operations, management removes the effects of such gains and losses when evaluating its overall core operating results.
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The following table summarizes our tax-effected realized gains (losses) by component.
Analysis of Realized Gains (Losses), Net of Tax
(Dollar amounts in thousands, except for per share data)
Fixed maturities and equities:
Investment sales
Investments called or tendered
Real estate:
Sold
Other investments
Financial Condition
Liquidity. Liquidity provides Torchmark with the ability to meet on demand the cash commitments required by our business operations and financial obligations. Our liquidity is evidenced by positive cash flow, a portfolio of marketable investments, and the availability of a line of credit facility.
Insurance subsidiary liquidity. The operations of our insurance subsidiaries have historically generated substantial cash inflows in excess of immediate cash needs. Sources of cash flows for the insurance subsidiaries include primarily premium and investment income. Cash outflows from operations include policy benefit payments, commissions, administrative expenses, and taxes. The funds to provide for policy benefits, the majority of which are paid in future periods, are invested primarily in long-term fixed maturities to meet these long-term obligations. In addition to investment income, maturities and scheduled repayments in the investment portfolio are sources of cash. Excess cash available from the insurance subsidiaries’ operations is generally distributed as a dividend to the parent company, subject to regulatory restriction. The dividends are generally paid in amounts equal to the subsidiaries’ prior year statutory net income excluding realized capital gains.
Parent Company liquidity. An important source of Parent Company liquidity is the dividends from the insurance subsidiaries noted above. These dividends are used by the Parent Company to pay dividends on common and preferred stock, interest and principal repayment requirements on Parent Company debt, and operating expenses of the Parent Company. In the first nine months of 2014, the Parent Company received $345 million of cash dividends from subsidiaries, compared with $392 million in 2013. For the full year 2014, cash dividends from subsidiaries are expected to total approximately $479 million.
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Additional sources of liquidity for the Parent Company are cash, intercompany receivables, and a credit facility. At September 30, 2014, the Parent Company had $105 million of invested cash and net intercompany receivables. The credit facility is discussed below under the caption “Short-term borrowings.”
Short-term borrowings. As of July 16, 2014, we entered into a new credit facility with a group of lenders allowing for unsecured borrowings and stand-by letters of credit up to $750 million, replacing our previous facility that had a maximum limitation of $600. Up to $250 million in letters of credit can be issued against the new facility. The facility is further designated as a back-up credit line for a commercial paper program under which we may either borrow from the credit line or issue commercial paper at any time, with total commercial paper outstanding not to exceed the facility maximum, less any letters of credit issued. Interest is charged at variable rates. The facility has no ratings-based acceleration triggers which would require early repayment. The new facility terminates July 16, 2019. In accordance with the agreement, we are subject to certain covenants regarding capitalization, as was the case with our previous credit facility. As of September 30, 2014, we were in full compliance with these covenants.
Short-term debt consists of our commercial paper outstanding as noted above. The following table presents certain information about our commercial paper borrowings.
Short-term Borrowings - Commercial Paper
Balance at end of period (par value)
Annualized interest rate
Letters of credit outstanding
Remaining amount available under credit line
Average balance outstanding during period (par value)
Daily-weighted average interest rate (annualized)
Maximum daily amount outstanding during period (par value)
Our balance of commercial paper outstanding at September 30, 2014 was $291 million compared with $229 million at the previous year end. We have had no difficulties in accessing the commercial paper market under this facility during the nine-month periods ended September 30, 2014 and 2013.
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In summary, Torchmark expects to have readily available funds for the foreseeable future to conduct its operations and to maintain target capital ratios in the insurance subsidiaries through internally generated cash flow and the credit facility. In the unlikely event that more liquidity is needed, the Company could generate additional funds through multiple sources including, but not limited to, the issuance of debt, an additional short-term credit facility, and intercompany borrowing.
Consolidated liquidity. Consolidated net cash inflows from operations were $644 million in the first nine months of 2014, compared with $771 million in the same period of 2013. The decline in cash provided from operations was caused primarily by the increase in the Medicare Part D receivable from CMS resulting from our required coverage of Hepatitis C drug claims discussed earlier in this report and higher than expected generic drug costs. In addition to cash inflows from operations, our companies have received $123 million in investment calls and tenders and $95 million in scheduled maturities or repayments during the 2014 period. As previously noted under the caption Short-term borrowings, we have in place a line of credit facility. The insurance companies have no additional outstanding credit facilities.
Cash and short term investments were $146 million at September 30, 2014, compared with $114 million at December 31, 2013. In addition to these liquid assets, the entire $14.2 billion (fair value at September 30, 2014) portfolio of fixed-income and equity securities is available for sale in the event of an unexpected need. Substantially all of our fixed-income and equity securities are publicly traded. We generally expect to hold fixed-income securities to maturity, and even though these securities are classified as available for sale, we have the ability and intent to hold any securities which are temporarily impaired until they mature. Our strong cash flows from operations, investment maturities, and credit line availability make any need to sell securities for liquidity highly unlikely.
Capital Resources. Our insurance subsidiaries maintain capital at a level adequate to support their current operations and meet the requirements of the regulatory authorities and the rating agencies. Our insurance subsidiaries generally target a capital ratio of around 325% of Company Action Level required regulatory capital under Risk-Based Capital (RBC), a measure established by insurance regulatory authorities to monitor the adequacy of capital. The 325% target is considered sufficient because of the insurance companies’ strong reliable cash flows, the relatively low risk of their product mix, and because that ratio exceeds regulatory requirements and has been in line with rating agency expectations for Torchmark. As of December 31, 2013, our insurance subsidiaries had a consolidated RBC ratio of 341%. In the event of a decline in the RBC ratios of the insurance companies due to ratings downgrades in the investment portfolios, impairments, or other circumstances, we have available cash on hand and credit availability at the Parent Company to make additional contributions as necessary to maintain the ratio at or above 325%.
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During the third quarter, Standard and Poor’s (S&P’s) revised their outlook on Torchmark to negative. This revised outlook was due to a change in S&P’s view of certain components of Torchmark’s existing capital position, rather than a change in the capital position itself. There has not been any significant change recently in the level or components of Torchmark’s capital position. We do not expect S&P’s action to cause any change in our share repurchase program.
On a consolidated basis, Torchmark’s capital structure consists of short-term debt (comprised of the commercial paper outstanding discussed above), long-term funded debt, and shareholders’ equity. The outstanding long-term debt at book value was $992 million at September 30, 2014, versus $991 million at December 31, 2013. An analysis of long-term debt issues outstanding is as follows at September 30, 2014.
Long Term Debt at September 30, 2014
Instrument
Senior Notes
Senior Notes(1)
Notes
Junior Subordinated Debentures
Total long-term debt
As previously noted under the caption Highlights in this report, we acquired 5.5 million of our outstanding common shares under our share repurchase program during the first nine months of 2014. These shares were acquired at a cost of $288 million (average of $52.32 per share), compared with purchases of 6.4 million shares at a cost of $265 million in the first nine months of 2013.
Shareholders’ equity was $4.5 billion at September 30, 2014. This compares with $3.8 billion at both December 31, 2013 and September 30, 2013. During the nine months since December 31, 2013, shareholders’ equity was increased by $668 million of after-tax unrealized gains in the fixed-maturity portfolio, as interest rates have declined over the period. Net income added another $396 million for the nine months, but the share purchases of $288 million noted above during the period reduced shareholders’ equity.
We are required by GAAP to revalue our 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.
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While GAAP requires our fixed-maturity assets to be revalued, it does not permit interest-bearing insurance policy liabilities supported by those assets to be valued at fair value in a consistent manner, with changes in value applied directly to shareholders’ equity. However, due to the size of both the investment portfolio and our policy liabilities, this inconsistency in measurement can have a material impact on shareholders’ equity. Because of the long-term nature of our fixed maturities and liabilities and the strong cash flows generated by our insurance subsidiaries, we have the intent and ability to hold our securities to maturity. As such, we do not expect to incur realized gains or losses due to fluctuations in the market value of fixed maturities caused by interest rate changes or losses caused by temporarily illiquid markets. Accordingly, management removes the effect of this rule when analyzing Torchmark’s balance sheet, capital structure, and financial ratios in order to provide a more consistent and meaningful portrayal of the Company’s financial position from period to period.
The following table presents selected data related to capital resources. Additionally, the table presents the effect of this GAAP requirement on relevant line items, so that investors and other financial statement users may determine its impact on our capital structure.
Selected Financial Data
Fixed maturities (millions)
Deferred acquisition costs (millions) (2)
Total assets (millions)
Short-term debt (millions)
Long-term debt (millions)
Shareholders’ equity (millions)
Book value per diluted share
Debt to capitalization (3)
Diluted shares outstanding (thousands)
Actual shares outstanding (thousands)
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Interest coverage was 10.9 times in the 2014 nine months, compared with10.1 times in the 2013 period. Interest coverage is computed by dividing interest expense into the sum of pretax income and interest expense.
Cautionary Statements
We caution 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. We specifically disclaim any obligation to update or revise any forward-looking statement because of new information, future developments, or otherwise.
Forward-looking statements are based upon estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond our 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:
Changing general economic conditions leading to unexpected changes in lapse rates and/or sales of our policies, as well as levels of mortality, morbidity, and utilization of health care services that differ from Torchmark’s assumptions;
Regulatory developments, including changes in governmental regulations (particularly those impacting taxes and changes to the Federal Medicare program that would affect Medicare Supplement and Medicare Part D insurance);
Market trends in the senior-aged health care industry that provide alternatives to traditional Medicare (such as Health Maintenance Organizations and other managed care or private plans) and that could affect the sales of traditional Medicare Supplement insurance;
Interest rate changes that affect product sales and/or investment portfolio yield;
General economic, industry sector or individual debt issuers’ financial conditions that may affect the current market value of securities we own, or that may impair an issuer’s ability to make principal and/or interest payments due on those securities;
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Changes in pricing competition;
Litigation results;
Levels of administrative and operational efficiencies that differ from our assumptions;
Our inability to obtain timely and appropriate premium rate increases for health insurance policies due to regulatory delay;
The customer response to new products and marketing initiatives; and
Reported amounts in the financial statements which are based on management’s estimates and judgments which may differ from the actual amounts ultimately realized.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
There have been no quantitative or qualitative changes with respect to market risk exposure during the nine months ended September 30, 2014.
Item 4. Controls and Procedures
Torchmark, under the direction of the Co-Chairmen and Chief Executive Officers 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 Co-Chairmen and Chief Executive Officers 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 September 30, 2014, an evaluation was performed under the supervision and with the participation of Torchmark management, including the Co-Chairmen and Chief Executive Officers 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 Co-Chairmen and Chief Executive Officers 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.
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As of the date of this Form 10-Q for the quarter ended September 30, 2014, there have not been any 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.
Part II – Other Information
Item 1. Legal Proceedings
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. 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. Torchmark’s management recognizes that large punitive damage awards bearing little or no relation to actual damages continue to be awarded by juries in jurisdictions in which Torchmark and its subsidiaries have substantial business, creating the potential for unpredictable material adverse judgments in any given punitive damage suit.
Torchmark subsidiaries are currently the subject of audits regarding the identification, reporting and escheatment of unclaimed property arising from life insurance policies and a limited number of annuity contracts. These audits are being conducted by private entities that have contracted with forty-seven various states through their respective Departments of Revenue, and have not resulted in any financial assessment from any state nor indicated any liability. The audits are wide-ranging and seek large amounts of data regarding claims handling, procedures, and payments of contract benefits arising from unreported death claims. No estimate of range can be made at this time for loss contingencies related to possible administrative penalties or amounts that could be payable to the states for the escheatment of abandoned property.
Item 1A. Risk Factors
Torchmark has had no material changes to its risk factors.
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Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
Period
July 1-31, 2014
August 1-31, 2014
September 1-30, 2014
On July 14, 2014, 2,700 shares of unvested restricted stock, valued at $55.25 per share on that date, were forfeited to the Company by an executive upon termination.
At its August 6, 2014 meeting, the Board of Directors reaffirmed the Company’s share repurchase program in amounts and with timing that management, in consultation with the Board, determines to be in the best interest of the Company. The program has no defined expiration date or maximum shares to be repurchased.
Item 6. Exhibits
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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: November 7, 2014
Gary L. Coleman
Executive Vice President and Chief Financial Officer
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