================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) [x] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 1-10890 HORACE MANN EDUCATORS CORPORATION (Exact name of registrant as specified in its charter) Delaware 37-0911756 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1 Horace Mann Plaza, Springfield, Illinois 62715-0001 (Address of principal executive offices) (Zip Code) Registrant's Telephone Number, Including Area Code: 217-789-2500 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 --- --- As of October 31, 2001, 40,727,625 shares of Common Stock, par value $0.001 per share, were outstanding, net of 19,341,296 shares of treasury stock. ================================================================================
HORACE MANN EDUCATORS CORPORATION FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2001 INDEX Page ---- PART I - FINANCIAL INFORMATION Item 1. Financial Statements Independent Auditors' Review Report ........................ 1 Consolidated Balance Sheets as of September 30, 2001 and December 31, 2000 ................. 2 Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2001 and 2000 .. 3 Consolidated Statements of Changes in Shareholders' Equity for the Nine Months Ended September 30, 2001 and 2000 .... 4 Consolidated Statements of Cash Flows for the Three and Nine Months Ended September 30, 2001 and 2000 .. 5 Notes to Consolidated Financial Statements ................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................... 14 Item 3. Quantitative and Qualitative Disclosures about Market Risk ............................................ 32 PART II - OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders ...... 32 Item 6. Exhibits and Reports on Form 8-K ......................... 32 SIGNATURES ................................................................. 33
INDEPENDENT AUDITORS' REVIEW REPORT The Board of Directors and Shareholders Horace Mann Educators Corporation: We have reviewed the consolidated balance sheet of Horace Mann Educators Corporation and subsidiaries as of September 30, 2001, and the related consolidated statements of operations and cash flows for the three-month and nine-month periods ended September 30, 2001 and 2000, and the related consolidated statements of changes in shareholders' equity for the nine-month periods ended September 30, 2001 and 2000. These consolidated financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet of Horace Mann Educators Corporation and subsidiaries as of December 31, 2000, and the related consolidated statements of operations, changes in shareholders' equity, and cash flows for the year then ended (not presented herein); and in our report dated February 8, 2001, we expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP KPMG LLP Chicago, Illinois November 6, 2001 1
HORACE MANN EDUCATORS CORPORATION CONSOLIDATED BALANCE SHEETS (Dollars in thousands) <TABLE> <CAPTION> September 30, December 31, 2001 2000 ------------- ------------ ASSETS <S> <C> <C> Investments Fixed maturities, available for sale, at market (amortized cost, 2001, $2,700,120; 2000, $2,615,156).................................. $ 2,765,141 $ 2,607,738 Short-term and other investments............................................. 116,857 99,728 Short-term investments, loaned securities collateral......................... 405,076 204,881 ------------ ------------ Total investments........................................................ 3,287,074 2,912,347 Cash............................................................................ 23,516 21,141 Accrued investment income and premiums receivable............................... 112,471 101,405 Value of acquired insurance in force and goodwill............................... 85,357 92,260 Deferred policy acquisition costs............................................... 153,328 141,604 Other assets.................................................................... 115,401 116,756 Variable annuity assets......................................................... 850,468 1,035,067 ------------ ------------ Total assets............................................................. $ 4,627,615 $ 4,420,580 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Policy liabilities Fixed annuity contract liabilities........................................... $ 1,265,357 $ 1,217,756 Interest-sensitive life contract liabilities................................. 509,223 481,140 Unpaid claims and claim expenses............................................. 323,342 308,881 Future policy benefits....................................................... 181,650 180,049 Unearned premiums............................................................ 186,921 174,428 ------------ ------------ Total policy liabilities................................................. 2,466,493 2,362,254 Other policyholder funds........................................................ 123,410 122,233 Other liabilities............................................................... 555,150 324,312 Short-term debt................................................................. 49,000 49,000 Long-term debt.................................................................. 99,755 99,721 Variable annuity liabilities.................................................... 850,468 1,035,067 ------------ ------------ Total liabilities........................................................ 4,144,276 3,992,587 ------------ ------------ Preferred stock................................................................. - - Common stock.................................................................... 60 60 Additional paid-in capital...................................................... 341,024 338,243 Retained earnings............................................................... 460,660 452,624 Accumulated other comprehensive income (loss), net of taxes: Net unrealized gains (losses) on fixed maturities and equity securities........................................... 40,491 (4,038) Minimum pension liability adjustment......................................... (937) (937) Treasury stock, at cost......................................................... (357,959) (357,959) ------------ ------------ Total shareholders' equity............................................... 483,339 427,993 ------------ ------------ Total liabilities and shareholders' equity............................. $ 4,627,615 $ 4,420,580 ============ ============ </TABLE> See accompanying notes to consolidated financial statements. 2
HORACE MANN EDUCATORS CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except per share data) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ---------------------- ---------------------- 2001 2000 2001 2000 ---- ---- ---- ---- <S> <C> <C> <C> <C> Insurance premiums written and contract deposits......................... $224,307 $210,002 $650,304 $608,980 ======== ======== ======== ======== Revenues Insurance premiums and contract charges earned..................... $155,117 $150,220 $457,024 $448,149 Net investment income......................... 49,867 48,168 148,465 143,277 Realized investment losses.................... (1,853) (822) (2,888) (3,163) -------- -------- -------- -------- Total revenues 203,131 197,566 602,601 588,263 -------- -------- -------- -------- Benefits, losses and expenses Benefits, claims and settlement expenses...... 118,805 112,196 361,395 329,271 Interest credited............................. 24,034 23,308 72,351 68,818 Policy acquisition expenses amortized......... 14,688 13,498 42,002 40,816 Operating expenses............................ 31,064 31,078 87,356 89,505 Amortization of intangible assets............. 2,374 2,386 6,051 7,186 Interest expense.............................. 2,314 2,593 7,161 7,625 Restructuring reserve adjustment.............. - - (175) - Litigation charges............................ - - - 100 -------- -------- -------- -------- Total benefits, losses and expenses......... 193,279 185,059 576,141 543,321 -------- -------- -------- -------- Income before income taxes...................... 9,852 12,507 26,460 44,942 Income tax expense.............................. 2,064 3,100 6,900 13,127 Adjustment to the provision for prior years' taxes................................ (1,269) (2,800) (1,269) (2,800) -------- -------- -------- -------- Net income...................................... $ 9,057 $ 12,207 $ 20,829 $ 34,615 ======== ======== ======== ======== Net income per share Basic......................................... $ 0.22 $ 0.30 $ 0.51 $ 0.85 ======== ======== ======== ======== Diluted....................................... $ 0.22 $ 0.30 $ 0.51 $ 0.84 ======== ======== ======== ======== Weighted average number of shares and equivalent shares (in thousands) Basic....................................... 40,659 40,550 40,579 40,872 Diluted..................................... 40,977 40,708 40,834 41,040 </TABLE> See accompanying notes to consolidated financial statements. 3
HORACE MANN EDUCATORS CORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in thousands, except per share data) <TABLE> <CAPTION> Nine Months Ended September 30, ------------------- 2001 2000 ---- ---- <S> <C> <C> Common stock Beginning balance....................................................$ 60 $ 59 Options exercised, 2001, 188,575 shares; 2000, 555,000 shares; and shares awarded, 2000, 10,000 shares ..................................... - 1 Conversion of Director Stock Plan units, 2001, 10,293 shares......... - - -------- --------- Ending balance....................................................... 60 60 -------- --------- Additional paid-in capital Beginning balance.................................................... 338,243 333,892 Options exercised, conversion of Director Stock Plan units and shares awarded........................................... 3,494 5,276 Catastrophe-linked equity put option premium......................... (713) (713) -------- --------- Ending balance....................................................... 341,024 338,455 -------- --------- Retained earnings Beginning balance.................................................... 452,624 449,023 Net income........................................................... 20,829 34,615 Cash dividends, 2001, $0.315 per share; 2000, $0.315 per share............................................. (12,793) (12,985) -------- --------- Ending balance....................................................... 460,660 470,653 -------- --------- Accumulated other comprehensive income (loss), net of taxes: Beginning balance.................................................... (4,975) (40,016) Change in net unrealized gains (losses) on fixed maturities and equity securities........................... 44,529 7,737 (Increase) decrease in minimum pension liability adjustment............................................. - - -------- --------- Ending balance....................................................... 39,554 (32,279) -------- --------- Treasury stock, at cost Beginning balance, 2001, 19,341,296 shares; 2000, 18,258,896 shares............................................(357,959) (342,816) Purchase of 1,082,400 shares in 2000 (See note 5).................... - (15,143) -------- --------- Ending balance, 2001, 19,341,296 shares; 2000, 19,341,296 shares............................................(357,959) (357,959) -------- --------- Shareholders' equity at end of period...................................$483,339 $ 418,930 ======== ========= Comprehensive income Net income...........................................................$ 20,829 $ 34,615 Other comprehensive income, net of taxes: Change in net unrealized gains (losses) on fixed maturities and equity securities........................ 44,529 7,737 (Increase) decrease in minimum pension liability adjustment............................................. - - -------- --------- Other comprehensive income..................................... 44,529 7,737 -------- --------- Total........................................................$ 65,358 $ 42,352 ======== ========= </TABLE> See accompanying notes to consolidated financial statements. 4
HORACE MANN EDUCATORS CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, ----------------------- ----------------------- 2001 2000 2001 2000 ---- ---- ---- ---- <S> <C> <C> <C> <C> Cash flows from operating activities Premiums collected................................ $ 162,778 $ 159,003 $ 479,236 $ 470,319 Policyholder benefits paid........................ (121,159) (108,429) (361,194) (346,440) Policy acquisition and other operating expenses paid................... (51,201) (46,854) (143,301) (138,550) Federal income taxes paid......................... - - - (16,101) Investment income collected....................... 52,238 48,677 146,837 145,978 Interest expense paid............................. (3,318) (4,206) (7,472) (9,156) Other............................................. (321) (176) (1,475) (2,860) --------- --------- --------- --------- Net cash provided by operating activities..... 39,017 48,015 112,631 103,190 --------- --------- --------- --------- Cash flows used in investing activities Fixed maturities Purchases....................................... (180,745) (292,735) (869,133) (588,679) Sales........................................... 92,405 235,345 563,337 382,423 Maturities...................................... 79,835 64,612 216,751 198,621 Net cash used for short-term and other investments........................... (22,031) (39,645) (14,945) (5,561) --------- --------- --------- --------- Net cash used in investing activities......... (30,536) (32,423) (103,990) (13,196) --------- --------- --------- --------- Cash flows used in financing activities Purchase of treasury stock........................ - (4,581) - (15,143) Dividends paid to shareholders.................... (4,275) (4,293) (12,793) (12,985) Principal repayments on Bank Credit Facility...... - - - - Exercise of stock options......................... 2,530 512 3,494 5,277 Catastrophe-linked equity put option premium...... (238) (238) (713) (713) Annuity contracts, variable and fixed Deposits........................................ 54,213 46,917 174,862 146,394 Maturities and withdrawals...................... (42,149) (78,344) (136,028) (244,333) Net transfer from (to) variable annuity assets.. (12,114) 16,543 (31,239) 33,672 Net decrease in life policy account balances...... (1,563) (1,238) (3,849) (3,513) --------- --------- -------- --------- Net cash used in financing activities......... (3,596) (24,722) (6,266) (91,344) --------- --------- -------- --------- Net increase (decrease) in cash...................... 4,885 (9,130) 2,375 (1,350) Cash at beginning of period.......................... 18,631 30,628 21,141 22,848 --------- --------- -------- --------- Cash at end of period................................ $ 23,516 $ 21,498 $ 23,516 $ 21,498 ========= ========= ======== ========= </TABLE> See accompanying notes to consolidated financial statements. 5
HORACE MANN EDUCATORS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2001 and 2000 (Dollars in thousands, except per share data) Note 1 - Basis of Presentation The accompanying unaudited consolidated financial statements of Horace Mann Educators Corporation ("HMEC"; and together with its subsidiaries, the "Company") have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. The Company believes that these financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the Company's consolidated financial position as of September 30, 2001 and December 31, 2000, the consolidated results of operations and cash flows for the three and nine months ended September 30, 2001 and 2000 and the consolidated changes in shareholders' equity for the nine months ended September 30, 2001 and 2000. The subsidiaries of HMEC sell and underwrite tax-qualified retirement annuities and private passenger automobile, homeowners, and life insurance products, primarily to educators and other employees of public schools and their families. The Company's principal operating subsidiaries are Horace Mann Life Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company, Horace Mann Property & Casualty Insurance Company (formerly Allegiance Insurance Company) and Horace Mann Lloyds. It is suggested that these financial statements be read in conjunction with the financial statements and the related notes included in the Company's December 31, 2000 Form 10-K. The results of operations for the three and nine months ended September 30, 2001 are not necessarily indicative of the results to be expected for the full year. Note 2 - Restructuring Charges In December 2000, the Company recorded restructuring charges of $2,236 pretax ($1,453, or $0.04 per share, after tax) reflecting two changes in the Company's operations. Specifically, the Company restructured the operations of its group insurance business, thereby eliminating 39 jobs, and its credit union marketing group, eliminating 20 additional positions. The changes will improve business results and more closely align these functions with the Company's strategic direction. Employee termination costs, for termination of an estimated 50 individuals, represented severance, vacation buy-out and related payroll taxes. The eliminated positions encompass management, professional and clerical responsibilities. As of September 30, 2001, 39 individuals have been terminated with two additional terminations scheduled later in 2001. Termination of lease agreements represented office space used by the credit union marketing group. The remaining charge was attributable primarily to the write-off of software related to these two areas. Restructuring charges were separately identified in the Statement of Operations for the year ended December 31, 2000. None of the cash restructuring costs were paid as of December 31, 2000. 6
Note 2 - Restructuring Charges-(Continued) The following table provides information about the components of the charge taken in December 2000, the balance of accrued amounts at December 31, 2000 and September 30, 2001, and payment activity during the nine months ended September 30, 2001. The adjustment to employee termination costs during the nine months ended September 30, 2001 reflected placement of nine individuals from terminated positions into other open positions within the Company. <TABLE> <CAPTION> Original Reserve at Reserve at Pretax December 31, September 30, Charge 2000 Payments Adjustments 2001 -------- ------------ -------- ----------- ------------- <S> <C> <C> <C> <C> <C> Charges to earnings: Employee termination costs ................... $1,827 $1,827 $(773) $(221) $ 833 Termination of lease agreements .............. 285 285 (50) - 235 Write-off of capitalized software ................ 106 - - - - Other ..................... 18 18 (44) 46 20 ------ ------ ----- ----- ------ Total ................... $2,236 $2,130 $(867) $(175) $1,088 ====== ====== ===== ===== ====== </TABLE> Note 3 - Debt Indebtedness outstanding was as follows: <TABLE> <CAPTION> September 30, December 31, 2001 2000 ------------- ------------ <S> <C> <C> Short-term debt: $65,000 Bank Credit Facility, commitment to December 31, 2001. (IBOR + 0.4%, 3.0% as of September 30, 2001) .............. $ 49,000 $ 49,000 Long-term debt: 6 5/8% Senior Notes, due January 15, 2006. Face amount less unaccrued discount of $245 and $279 (6.7% imputed rate) ........... 99,755 99,721 -------- -------- Total ..................................... $148,755 $148,721 ======== ======== </TABLE> The Company's earnings in the fourth quarter of 2000 could have caused a breach of a financial covenant of the Company's Bank Credit Facility in 2001 but, in the first quarter of 2001, the lender agreed to modify that covenant for the first, second and third quarters of 2001. As a result of earnings for the second quarter of 2001, and again based on third quarter 2001 earnings, the lender agreed to further modify that covenant. Prior to the determination of second quarter earnings, management had also begun discussions with representatives of the lender about a possible replacement credit facility to be implemented prior to the maturity of the existing Bank Credit Facility on December 31, 2001. At the time of this Report on Form 10-Q, management is in the final stages of negotiating an extension of the existing Bank Credit Facility through June 30, 2002. However, management believes that even if such discussions are not successful, the Company will be able to obtain replacement financing for the Bank Credit Facility elsewhere, but 7
Note 3 - Debt-(Continued) the Company cannot predict on what terms and conditions such financing would be available, and the availability of alternative financing is always subject to prevailing market conditions at the time of securing such financing. Note 4 - Investments The following table presents the composition and value of the Company's fixed maturity securities portfolio by rating category. The Company has classified the entire fixed maturity securities portfolio as available for sale, which is carried at market value. <TABLE> <CAPTION> Percent of Carrying Value September 30, 2001 ----------------------------- ------------------------ Rating of Fixed September 30, December 31, Carrying Amortized Maturity Securities(1) 2001 2000 Value Cost ---------------------- ------------- ------------ ---------- ---------- <S> <C> <C> <C> <C> AAA .................... 34.6% 42.9% $ 956,936 $ 915,090 AA ..................... 7.4 8.2 204,276 193,778 A ...................... 24.6 20.5 678,534 651,697 BBB .................... 28.8 22.8 797,393 783,185 BB ..................... 1.6 1.3 44,929 49,451 B ...................... 2.2 4.0 60,840 80,306 CCC or lower ........... 0.6 0.1 16,493 21,174 Not rated(2) ........... 0.2 0.2 5,740 5,439 ----- ----- ---------- ---------- Total .............. 100.0% 100.0% $2,765,141 $2,700,120 ===== ===== ========== ========== </TABLE> (1) Ratings are as assigned primarily by Standard & Poor's Corporation ("S&P") when available, with remaining ratings as assigned on an equivalent basis by Moody's Investors Service, Inc. ("Moody's"). Ratings for publicly traded securities are determined when the securities are acquired and are updated monthly to reflect any changes in ratings. (2) This category includes $89 of publicly traded securities not currently rated by S&P or Moody's and $5,651 of private placement securities not rated by either S&P or Moody's. The National Association of Insurance Commissioners (the "NAIC") has rated 98.0% of these private placements as investment grade. The following table presents a maturity schedule of the Company's fixed maturity securities. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. <TABLE> <CAPTION> Carrying Percent of Total Value ----------------------------- ------------- September 30, December 31, September 30, Scheduled Maturity 2001 2000 2001 ------------------ ------------- ------------ ------------- <S> <C> <C> <C> Due in 1 year or less....................... 3.9% 7.0% $ 108,760 Due after 1 year through 5 years............ 24.8 28.8 684,578 Due after 5 years through 10 years.......... 31.1 28.5 859,193 Due after 10 years through 20 years......... 14.2 15.6 393,566 Due after 20 years.......................... 26.0 20.1 719,044 ----- ----- ---------- Total................................... 100.0% 100.0% $2,765,141 ===== ===== ========== </TABLE> 8
Note 4 - Investments-(Continued) The Company's investment portfolio includes no derivative financial instruments (futures, forwards, swaps, option contracts or other financial instruments with similar characteristics). The Company reviews the market value of the investment portfolio on a monthly basis to determine if there are any securities that have fallen below 75% of book value. This review, in conjunction with the Company's investment managers' monthly credit reports and current market data, is the basis for determining if a security should be written down in value. A write-down is recorded when the decline in value is deemed to be other-than-temporary in nature. The Company lends fixed income securities to third parties, primarily major brokerage firms. As of September 30, 2001 and December 31, 2000, fixed maturities with a fair value of $405,076 and $204,881, respectively, were on loan. The Company separately maintains a minimum of 100% of the value of the loaned securities as collateral for each loan. Securities lending collateral is classified as investments with a corresponding liability included in Other Liabilities in the Company's consolidated balance sheet, in accordance with the applicable accounting guidance. Note 5 - Shareholders' Equity Share Repurchase Programs During the first nine months of 2001, the Company did not repurchase shares of its common stock under its stock repurchase program consistent with management's stated intention to utilize excess capital to support the Company's strategic growth initiatives. Since early 1997, 8,165,100 shares, or 17% of the shares outstanding on December 31, 1996, have been repurchased at an aggregate cost of $203,657, equal to an average cost of $24.94 per share. Including shares repurchased in 1995, the Company has repurchased 33% of the shares outstanding on December 31, 1994. The repurchase of shares was financed through use of cash and, when necessary, the Bank Credit Facility. However, the Company has not utilized the Bank Credit Facility for share repurchases since the second quarter of 1999. As of September 30, 2001, $96,343 remained authorized for future share repurchases. Note 6 - Income Taxes As previously reported, the Company has been contesting proposed additional federal income taxes relating to a settlement agreement with the Internal Revenue Service ("IRS") for prior years' taxes. In the third quarter of 1999, the Company recorded an additional federal income tax provision of $20,000 representing the maximum exposure of the Company to the IRS with regard to the issue for all of the past tax years in question (1994 through 1997). In 2000, the Company reached a final resolution with the IRS for the tax years 1994, 1995 and 1996 in an amount that was $8,682 less than was previously accrued. That amount was included in net income for the year ended December 31, 2000: $2,800 in the three months ended September 30, 2000 and $5,882 in the three months ended December 31, 2000. In the third quarter of 2001, the Company's liability for the 1997 tax year was resolved, resulting in a release of $1,269 that had previously been accrued for that tax year. That amount was included in net income for the three months ended September 30, 2001. 9
Note 7 - Reinsurance The Company recognizes the cost of reinsurance premiums over the contract periods for such premiums in proportion to the insurance protection provided. Amounts recoverable from reinsurers for unpaid claims and claim settlement expenses, including estimated amounts for unsettled claims, claims incurred but not reported and policy benefits, are estimated in a manner consistent with the insurance liability associated with the policy. The effect of reinsurance on premiums written; premiums earned; and benefits, claims and settlement expenses were as follows: <TABLE> <CAPTION> Ceded to Assumed Gross Other from State Amount Companies Facilities Net -------- --------- ----------- -------- <S> <C> <C> <C> <C> Three months ended September 30, 2001 --------------------------- Premiums written ................ $225,899 $ 7,499 $ 5,907 $224,307 Premiums earned ................. 156,722 7,471 5,866 155,117 Benefits, claims and settlement expenses ........... 120,651 6,086 4,240 118,805 Three months ended September 30, 2000 --------------------------- Premiums written ................ $211,571 $ 8,458 $ 6,889 $210,002 Premiums earned ................. 151,691 6,893 5,422 150,220 Benefits, claims and settlement expenses ........... 115,852 10,051 6,395 112,196 Nine months ended September 30, 2001 --------------------------- Premiums written ................ $657,133 $20,474 $13,645 $650,304 Premiums earned ................. 463,869 20,745 13,900 457,024 Benefits, claims and settlement expenses ........... 362,699 15,247 13,943 361,395 Nine months ended September 30, 2000 --------------------------- Premiums written ................ $613,764 $25,044 $20,260 $608,980 Premiums earned ................. 451,937 19,334 15,546 448,149 Benefits, claims and settlement expenses ........... 337,280 26,432 18,423 329,271 </TABLE> 10
Note 7 - Reinsurance-(Continued) The Company maintains an excess and catastrophe treaty reinsurance program. The Company reinsures 95% of catastrophe losses above a retention of $8,500 per occurrence up to $80,000 per occurrence for 48% of the coverage and above a retention of $7,500 per occurrence up to $80,000 per occurrence for the remaining 52% of the coverage. In addition, the Company's predominant insurance subsidiary for property and casualty business written in Florida reinsures 90% of hurricane losses in that state above a retention of $10,300 up to $50,300 with the Florida Hurricane Fund, based on the Fund's resources. These programs are augmented by a $100,000 equity put and reinsurance agreement. This equity put provides an option to sell shares of the Company's convertible preferred stock with a floating rate dividend at a pre-negotiated price in the event losses from catastrophes exceed the catastrophe reinsurance program coverage limit. Before tax benefits, the equity put provides a source of capital for up to $154,000 of catastrophe losses above the reinsurance coverage limit. For liability coverages, including the educator excess professional liability policy, the Company reinsures each loss above a retention of $500 up to $20,000. The Company also reinsures each property loss, including catastrophe losses that in the aggregate are less than the retention levels above, above a retention of $250 up to $2,500. The maximum individual life insurance risk retained by the Company is $200 on any individual life and $100 is retained on each group life policy. Excess amounts are reinsured. Note 8 - Contingencies Lawsuits and Legal Proceedings In December 2000, the Company recorded an after tax charge of $5,000, representing the Company's best estimate of the actual and anticipated costs of defending and ultimately resolving litigation brought against the Company in regards to its disability insurance product. The lawsuit is a class action on behalf of certain policyholders who purchased the Company's disability insurance product and allege that they were not adequately made aware of certain features. In July 2001, the Company submitted a settlement agreement to the court which was mutually agreed upon by all parties to this lawsuit. The settlement, which provides additional benefits for current policyholders and compensation to those who demonstrate they did not understand what they purchased, was approved by the court on October 31, 2001. While the actual costs incurred by the Company to resolve this litigation could be either less or more than the liability established in 2000, management believes that, based on facts and circumstances available at this time and on the settlement agreement approved by the court in October 2001, the amount recorded will be adequate to resolve the matter. Disability insurance represented less than 1% of the Company's insurance premiums written and contract deposits for the year ended December 31, 2000. There are various other lawsuits and legal proceedings against the Company. Management and legal counsel are of the opinion that the ultimate disposition of such other litigation will have no material adverse effect on the Company's financial position or results of operations. Assessments for Insolvencies of Unaffiliated Insurance Companies The Company is also contingently liable for possible assessments under regulatory requirements pertaining to potential insolvencies of unaffiliated insurance companies. Liabilities, which are established based upon regulatory guidance, have been insignificant. 11
Note 9 - Segment Information The Company conducts and manages its business through four segments. The three operating segments representing the major lines of insurance business are: property and casualty insurance, principally personal lines automobile and homeowners insurance; individual tax-qualified annuity products; and life insurance. The fourth segment, Corporate and Other, includes primarily debt service and realized investment gains and losses. Summarized financial information for these segments is as follows: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, -------------------- -------------------- 2001 2000 2001 2000 ---- ---- ---- ---- <S> <C> <C> <C> <C> Insurance premiums and contract charges earned Property and casualty ................................. $128,841 $123,044 $376,941 $366,681 Annuity ............................................... 3,834 4,378 11,353 13,097 Life .................................................. 22,763 23,120 69,690 69,305 Intersegment eliminations ............................. (321) (322) (960) (934) -------- -------- -------- -------- Total ............................................. $155,117 $150,220 $457,024 $448,149 ======== ======== ======== ======== Net investment income Property and casualty ................................. $ 9,453 $ 8,831 $ 27,636 $ 26,618 Annuity ............................................... 26,920 26,482 80,416 78,740 Life .................................................. 13,836 12,813 41,364 37,823 Corporate and other ................................... 15 342 90 996 Intersegment eliminations ............................. (357) (300) (1,041) (900) -------- -------- -------- -------- Total ............................................. $ 49,867 $ 48,168 $148,465 $143,277 ======== ======== ======== ======== Net income Operating income (loss) Property and casualty ............................... $ 1,920 $ 6,300 $ 115 $ 18,266 Annuity ............................................. 5,413 5,747 14,823 16,777 Life ................................................ 3,911 3,955 13,236 10,682 Corporate and other, including interest expense ..... (2,252) (6,061) (6,851) (11,789) -------- ------- ------- ------- Total operating income ............................ 8,992 9,941 21,323 33,936 Realized investment losses, after tax ................. (1,204) (534) (1,877) (2,056) Restructuring reserve adjustment, after tax ........... - - 114 - Litigation charges, after tax ......................... - - - (65) Adjustment to the provision for prior years' taxes .... 1,269 2,800 1,269 2,800 -------- -------- -------- -------- Total ............................................. $ 9,057 $ 12,207 $ 20,829 $ 34,615 ======== ======== ======== ======== Amortization of intangible assets Value of acquired insurance in force Annuity ............................................. $ 1,508 $ 1,486 $ 3,434 $ 4,463 Life ................................................ 461 495 1,403 1,509 -------- -------- -------- -------- Subtotal .......................................... 1,969 1,981 4,837 5,972 Goodwill .............................................. 405 405 1,214 1,214 -------- -------- -------- -------- Total ............................................. $ 2,374 $ 2,386 $ 6,051 $ 7,186 ======== ======== ======== ======== </TABLE> <TABLE> <CAPTION> September 30, December 31, 2001 2000 ------------- ------------ <S> <C> <C> Assets Property and casualty ................................ $ 771,477 $ 733,922 Annuity .............................................. 2,692,959 2,639,872 Life ................................................. 1,106,258 969,181 Corporate and other .................................. 96,554 115,584 Intersegment eliminations ............................ (39,633) (37,979) ---------- ---------- Total ............................................ $4,627,615 $4,420,580 ========== ========== </TABLE> 12
Note 10 - Subsequent Event - Massachusetts Automobile Business On October 18, 2001, Horace Mann announced that it had formed a marketing alliance with The Commerce Group, Inc. ("Commerce") for the sale of automobile insurance in the state of Massachusetts. Through this alliance, and beginning no later than January 1, 2002, Horace Mann will provide its Massachusetts customers with Commerce automobile insurance policies, while continuing to write other Horace Mann products, including property and life insurance and retirement annuities. Horace Mann will cease writing automobile insurance policies in Massachusetts no later than January 1, 2002, and on October 18, 2001 paid $6,438 to the Commonwealth Automobile Reinsurers ("C.A.R.") as full payment of its proportionate liability to C.A.R. for policy years 2002 and beyond. That payment and other related expenses of approximately $1,000, totaling approximately 12 cents per share, will be reflected as a restructuring charge in Horace Mann's financial statements for the fourth quarter of 2001. The Company expects that this transaction will have a positive impact on operating income of approximately 10 cents per share in 2003 and beyond. The improvement in 2002 earnings will be somewhat less reflecting the run-off of current policies in force. The Company plans to utilize the benefits of this transaction to invest in its marketing, customer service and technology infrastructures. On a full year basis, the Company's Massachusetts automobile business has represented premiums written and earned of approximately $28,000. In 2002, premiums written for this business will be reduced to zero, and premiums earned will be reduced significantly reflecting run-off of the policies in force at December 31, 2001. 13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in millions, except per share data) Forward-looking Information Statements made in the following discussion that state the Company's or management's intentions, hopes, beliefs, expectations or predictions of the future are forward-looking statements. It is important to note that the Company's actual results could differ materially from those projected in such forward-looking statements due to, among other risks and uncertainties inherent in the Company's business, the following important factors: . Changes in the composition of the Company's assets and liabilities through acquisitions or divestitures. . Prevailing interest rate levels, including the impact of interest rates on (i) unrealized gains and losses on the Company's investment portfolio and the related after-tax effect on the Company's shareholders' equity and total capital and (ii) the book yield of the Company's investment portfolio. . The impact of fluctuations in the capital markets on the Company's ability to refinance outstanding indebtedness or repurchase shares of the Company's outstanding common stock. . The frequency and severity of catastrophes such as hurricanes, earthquakes and storms, and the ability of the Company to maintain a favorable catastrophe reinsurance program. . Future property and casualty loss experience and its impact on estimated claims and claim adjustment expenses for losses occurring in prior years. . The Company's ability to develop and expand its agency force and its direct product distribution systems, as well as the Company's ability to maintain and secure product sponsorships by local, state and national education associations. . The competitive impact of new entrants such as mutual funds and banks into the tax-deferred annuity products markets, and the Company's ability to profitably expand its property and casualty business in highly competitive environments. . Changes in insurance regulations, including (i) those affecting the ability of the Company's insurance subsidiaries to distribute cash to the holding company and (ii) those impacting the Company's ability to profitably write property and casualty insurance policies in one or more states. . Changes in federal income tax laws and changes resulting from federal tax audits affecting corporate tax rates or taxable income, and regulations changing the relative tax advantages of the Company's life and annuity products to customers. . The impact of fluctuations in the financial markets on the Company's variable annuity fee revenues, valuations of deferred policy acquisition costs and value of acquired insurance in force, and the level of guaranteed minimum death benefit reserves. . The Company's ability to maintain favorable claims-paying ability ratings. . Adverse changes in policyholder mortality and morbidity rates. . The resolution of legal proceedings and related matters. 14
September 11, 2001 The September 11, 2001 terrorist attacks on the United States of America did not result in any material claims against the Company from either life or property and casualty policies. The Company has experienced some secondary short-term impacts. In the third quarter of 2001, financial market changes had an adverse impact on variable annuity fees, valuations of deferred policy acquisition costs and value of acquired insurance in force, and the level of a guaranteed minimum death benefit reserve established during the quarter. Also, in the weeks following the attack, the Company experienced a slowdown in new business volume for life insurance. However, during the same period of time, new business for the Company's other segments reflected an increase, compared to the same period last year. The credit quality of the Company's investment portfolio has not been materially impacted by the economic effects of the attack. The Company holds approximately $20 million of investment grade fixed maturity securities related to the aviation and leisure industries, and these securities had an unrealized loss of approximately $3 million at September 30, 2001. The high yield portion of the Company's fixed maturity securities portfolio has no exposure to the aviation, lodging or leisure industries. The Company is not immune to future secondary effects of this event such as those generated by additional fluctuations in variable annuity account values and anticipated increases in reinsurance costs. Management believes these impacts will be manageable. Results of Operations The Horace Mann Value Proposition In 2000, the Company's management announced steps to focus on the Company's core business and accelerate growth of the Company's revenues and profits. These initiatives are intended to make the Company's products more responsive to customer needs and preferences and expand the Company's product lines within the personal financial services segment; grow and strengthen the agent force and make the Company's agents more productive by improving the products, tools and support the Company provides to them; increase cross-selling and improve retention in the existing book of business; expand the Company's penetration of targeted geographic areas and new segments of the educator market; and broaden the Company's distribution options to complement and extend the reach of the Company's agent force. During the fourth quarter of 2000, management began implementing specific plans that address the initiatives above. New compensation and evaluation systems have been implemented to improve the performance of the Company's agents and agency managers. The Company has begun targeting high-priority geographic markets with dedicated staff teams. New approaches to customer service are being developed and tested that will free agents to spend more time selling. Additional distribution options are being initiated to capitalize fully on the value of the Company's payroll deduction slots in schools across the country. And, the Company will increase its use of technology to improve the efficiency of its agency force and its administrative operations. 15
The Horace Mann Value Proposition articulates the Company's overarching strategy and business purpose: Provide lifelong financial well-being for educators and their families through personalized service, advice and a full range of tailored insurance and financial products. Insurance Premiums and Contract Charges Insurance Premiums Written and Contract Deposits <TABLE> <CAPTION> Nine Months Ended Growth Over September 30, Prior Year ------------------- -------------------- 2001 2000 Percent Amount ------ ------ ------- ------ <S> <C> <C> <C> <C> Automobile and property (voluntary).... $371.7 $357.2 4.1% $14.5 Annuity deposits....................... 174.9 146.4 19.5% 28.5 Life................................... 86.1 88.5 -2.7% (2.4) ----- ------ ----- Subtotal - core lines............. 632.7 592.1 6.9% 40.6 Involuntary and other property & casualty.................. 17.6 16.9 4.1% 0.7 ------ ------ ----- Total............................. $650.3 $609.0 6.8% $41.3 ====== ====== ===== </TABLE> Insurance Premiums and Contract Charges Earned (Excludes annuity and life contract deposits) <TABLE> <CAPTION> Nine Months Ended Growth Over September 30, Prior Year ------------------- -------------------- 2001 2000 Percent Amount ------ ------ ------- ------ <S> <C> <C> <C> <C> Automobile and property (voluntary).... $361.0 $351.1 2.8% $ 9.9 Annuity................................ 11.4 13.1 -13.0% (1.7) Life................................... 68.7 68.4 0.4% 0.3 ------ ------ ----- Subtotal - core lines............. 441.1 432.6 2.0% 8.5 Involuntary and other property & casualty.................. 15.9 15.5 2.6% 0.4 ------ ------ ----- Total............................. $457.0 $448.1 2.0% $ 8.9 ====== ====== ===== </TABLE> Premiums written and contract deposits for the Company's core lines increased 6.9% compared to the first nine months of 2000, driven by double-digit growth in the annuity segment. This comparison includes the North Carolina settlement recorded in 2000 described below. At September 30, 2001, the Company's exclusive agent force totaled 853, a 13.7% decline from a year earlier. The number of experienced agents in the agent force, 566, was down 14.2% at September 30, 2001, compared to a year earlier. The total agent count decreased due primarily to terminations of less-productive agents. As a result, overall agent productivity continues to increase. The Company has changed what is expected from its agents. Historically, agent compensation and rewards focused on profitability, service and tenure with the Company. The new direction continues to focus on profitability but also places a greater emphasis on individual agent productivity, new premium growth, educator business, cross-selling and business retention. In addition, the Company's agency management team has been strengthened through the promotions of several of its most experienced and capable agents. Hiring of new agents during the first nine months of 2001 was within 15 agents of the prior year's first nine months, in spite of the Company's implementation of more stringent agent selection criteria to improve agent 16
productivity and retention in the future. A new compensation plan became effective January 1, 2001 for agency managers. The new compensation plan for all agents was implemented on August 1, 2001, and there were approximately 800 agents at the time of implementation. Management believes these actions, along with other strategic initiatives, will have a positive impact on agent productivity in the future. In March 2000, following lengthy negotiations, the North Carolina Rate Bureau and that state's Commissioner of Insurance agreed to settle the outstanding 1994, 1996 and 1999 private passenger automobile insurance rate filing cases resulting in an adverse impact of approximately $250 million for the insurance industry. For the nine months ended September 30, 2000, the Company recorded, in the first quarter, an estimate of its portion of the adverse settlement of $2.4 million pretax, comprised of $1.6 million premium refunds and $0.8 million interest charges. North Carolina is the Company's second largest property and casualty state representing approximately 7% of total premiums for the year ended December 31, 2000. Total voluntary automobile and homeowners premium written growth was 4.1% for the first nine months of 2001, including the effect of the North Carolina settlement in the prior year. The average premium per policy and the number of policies in force increased for both automobile and homeowners, compared to a year earlier. Voluntary automobile insurance premium written increased 2.7% ($7.3 million) compared to the first nine months of 2000 and homeowners premium increased 8.2% ($7.2 million). The property and casualty increase in premiums written resulted from growth in average premium per policy of 3% for automobile and 8% for homeowners, compared to a year earlier, as the impact of rate actions has begun to flow through policy renewals and new business. Over the prior 12 months, unit growth was 0.9%, bringing policies in force at September 30, 2001 to 888,000. Compared to December 31, 2000, total property and casualty policies in force increased 12,000 with an 8,000 unit increase in automobile and a 4,000 unit increase in homeowners. Based on policies in force, the property and casualty 12-month retention rate for new and renewal policies was 88%, equal to the 12 months ended September 30, 2000 despite implemented rate increases over the period. The Company's plans to implement tiered rating systems for automobile and homeowners business remain on track, which management expects will have a positive impact on both loss ratios and business growth in the educator market. Tiered rating, together with price increases implemented and planned, should return the Company to rate adequacy with average premium growth keeping pace with average loss experience. Growth in annuity contract deposits reached double-digit levels for the nine months ended September 30, 2001. In September 2000, the Company more than tripled the number of choices available to its customers by introducing 21 new investment options in its tax-deferred annuity product line. At the same time, the Company provided its agents with proprietary asset allocation software that helps agents assist educator customers in selecting the best retirement investment programs for their individual needs and circumstances. Compared to the first nine months of 2000, new annuity deposits increased 19.5%, reflecting a 62.2% increase in new single premium and rollover deposits and a 3.6% increase in scheduled deposits received. New deposits to variable annuities decreased 1.9%, or $1.7 million, and new deposits to fixed annuities were 52.5% higher than a year earlier. The Company offers a dollar cost averaging program for amounts systematically transferred from the fixed annuity option to the variable mutual fund investment options over a 12-month period. Variable annuity accumulated funds on deposit at September 30, 2001 were $0.9 billion, $195.0 million less than 17
a year earlier, an 18.7% decrease including the impact of financial market values. Variable annuity accumulated deposit retention improved 6.3 percentage points over the 12 months to 90.8%. Also, this retention improved 6.7 percentage points compared to the 12 months ended December 31, 2000 reflecting recent quarterly trends following the Company's expansion of variable investment options and implementation of proprietary asset allocation software. Fixed annuity cash value retention for the 12 months ended September 30, 2001 was 92.2%, 3.4 percentage points better than the same period last year. Reflecting recent quarterly trends, this showed improvement of 3.5 percentage points compared to retention of 88.7% for the 12 months ended December 31, 2000. The number of annuity contracts outstanding increased 8.8%, or 11,000 contracts, compared to September 30, 2000. In 2000, the Company took actions to increase the variable annuity options available to customers, as described above, and also took steps to improve the returns of its proprietary mutual funds. For the nine months ended September 30, 2001, the amount of variable annuity surrenders was 54% lower than for the same period last year. The amount of fixed annuity surrenders decreased 41% compared to the first nine months of 2000. For the nine months ended September 30, 2001, annuity segment contract charges earned decreased 13.0%, or $1.7 million, compared to the first nine months of 2000. The decline reflected the improvements in retention of variable and fixed accumulated values, as described above, as well as the impact of fluctuations in the financial markets on the Company's variable annuity fee revenues. The 13.0% decline recorded for the nine month period is comparable to the 13.8% decrease reported for the first six months of 2001. Life segment premiums and contract deposits for the first nine months of 2001 were 2.7% lower than a year earlier, reflecting a decline in disability income business. In 2001, the Company began ceding a larger portion of its disability income business as part of the group restructuring announced in the fourth quarter of 2000. Excluding the disability product from both years' results, life segment premiums written and contract deposits would be nearly equal to the first nine months of 2000. The life insurance in force lapse ratio was 8.5% for the twelve months ended September 30, 2001, compared to 8.8% for the same period last year. Net Investment Income Investment income of $148.5 million for the first nine months of 2001 increased 3.6%, or $5.2 million, (3.5% after tax) compared to the prior year due primarily to growth in the size of the investment portfolio. Average investments (excluding the securities lending collateral) increased 2.2% over the past 12 months. The average pretax yield on the investment portfolio was 7.2% (4.8% after tax) for the first nine months of 2001, compared to a pretax yield of 7.1% (4.8% after tax) last year. Realized Investment Gains and Losses Net realized investment losses were $2.9 million for the nine months ended September 30, 2001, compared to net realized investment losses of $3.2 million for the first nine months of 2000. The net realized losses in the current period primarily resulted from the sale, for credit reasons, of three fixed income securities and the impairment of one fixed income security, which were only partially offset by the first quarter full repayment of an impaired commercial mortgage loan and the release of a related reserve for uncollectible mortgages. For the prior year, nearly all of the net realized gains and losses occurred in the fixed income portfolios. 18
Benefits, Claims and Settlement Expenses <TABLE> <CAPTION> Nine Months Ended Growth Over September 30, Prior Year ------------------- -------------------- 2001 2000 Percent Amount ------ ------ ------- ------ <S> <C> <C> <C> <C> Property and casualty............. $328.7 $295.3 11.3% $33.4 Annuity........................... (0.5) - (0.5) Life.............................. 33.2 34.0 -2.4% (0.8) ------ ------ ----- Total........................... $361.4 $329.3 9.7% $32.1 ====== ====== ===== Property and casualty statutory loss ratio: Before catastrophe losses..... 84.3% 77.0% 7.3% After catastrophe losses...... 87.2% 80.5% 6.7% </TABLE> In the first nine months of 2001, the Company's benefits, claims and settlement expenses were affected adversely by strengthening of prior years' reserves for property and casualty claims and by a higher level of non-catastrophe weather-related losses. In the first nine months of 2000, the Company experienced a net release of prior years' property and casualty reserves. Net strengthening of reserves for property and casualty claims occurring in prior years, excluding involuntary business, was $11.1 million in the first nine months of 2001, compared to favorable development of $2.0 million for the same period in 2000. Total reserves for property and casualty claims occurring in prior years, including involuntary business, were strengthened $11.8 million in the current period, compared to favorable development of $2.0 million in the first nine months of 2000. During the first half of 2001, the Company continued to refine its process and methods for evaluating property and casualty reserves and selected a new independent property and casualty actuarial consulting firm. During the second quarter of 2001, a comprehensive review of property and casualty loss reserving methodologies and assumptions was completed in conjunction with the new actuarial firm. Based on this further enhanced analysis and the opinion of the new actuarial firm, prior years' net reserves - predominantly related to 1999 and prior accident years - were increased by $11 million at June 30, 2001. This consisted primarily of an $8 million reduction in reserves to be ceded by the Company to its reinsurers and reinsurance facilities, including $1.5 million related to the Company's automobile residual market business, primarily in Massachusetts; $2.0 million for its voluntary automobile ceded excess liability coverage; and approximately $4.5 million related to its educators excess professional liability product. No material changes to the Company's reserves for prior accident years were made during the third quarter of 2001. The Company's property and casualty net reserves were $275 million and $227 million at September 30, 2001 and 2000, respectively. In October 2001, the Company reached conclusion on its strategic direction for automobile business in the state of Massachusetts. For further discussion, see "Results of Operations -- Recent Developments -- Massachusetts Automobile Business." 19
In the first nine months of 2001, the higher level of non-catastrophe property losses included claims attributable to severe weather experienced in many areas of the country, including Tropical Storm Allison and wind and hail storms throughout the Midwest during the second quarter (with additional development related to these events recorded in the third quarter) as well as winter storms in the first quarter. The non-catastrophe property loss ratio by quarter and for the full years 2000 and 1999 was as follows: <TABLE> <CAPTION> 2001 2000 1999 ---- ---- ---- <S> <C> <C> <C> Non-catastrophe property loss ratio for the: Quarter ended March 31................ 85.1% 79.0% 81.9% Quarter ended June 30................. 99.4% 91.4% 72.8% Quarter ended September 30............ 99.7% 82.8% 78.1% Quarter ended December 31............. 80.7% 53.3% Year ended December 31................ 83.4% 71.0% </TABLE> After determining that the increase in non-catastrophe property losses experienced in the early months of 2000 was due to underlying loss trends, rather than the normal cyclicality of the property business, management began and has continued to implement pricing, underwriting and loss control initiatives. Although the Company's actions have begun to have a positive impact, with minimal effect on policy retention, management expects that the full impact of these changes will not be realized until 2002 and beyond. In light of experience and competitive actions in the first nine months of 2001, future rate increases are anticipated to be more aggressive than the Company's original plans. The Company has also initiated tightening of underwriting guidelines and additional reunderwriting programs and has implemented coverage and policy form restrictions in selected states. Management anticipates that these actions will enable the Company to improve the profitability of its existing book of homeowners business and attract new business that meets its profitability standards. For the first nine months of 2001, incurred catastrophe losses for all lines were $10.8 million including a net benefit of $1.4 million due to favorable development of reserves for 2000 catastrophe losses. Incurred catastrophe losses were $12.8 million in the first nine months of 2000. The voluntary automobile loss ratio excluding catastrophe losses was 77.9% for the first nine months of 2001, 3.5 percentage points higher than for the same period in 2000 due primarily to increases in prior years' reserves in 2001 versus releases in the first nine months of 2000, which represented approximately 2.5 percentage points of the increase in the loss ratio. Also, on a per-policy basis for the year, average voluntary automobile earned premium increased 1% and average current accident year loss costs increased 3% compared to the first nine months of 2000. The annuity benefits of $(0.5) million recorded in the first nine months of 2001 were comprised of three components. They were: 1) current period mortality experience on annuity contracts on payout status, 2) a guaranteed minimum death benefit reserve on variable annuity contracts established in the third quarter of 2001 as a result of fluctuations in the financial markets, and 3) a release of reserves for supplementary contracts, resulting from a systems conversion, recorded in the third quarter of 2001. 20
Life mortality experience in the first nine months of 2001 was comparable to the same period in 2000. Interest Credited to Policyholders <TABLE> <CAPTION> Nine Months Ended Growth Over September 30, Prior Year ------------------- ------------------- 2001 2000 Percent Amount ------------------- ------------------- <S> <C> <C> <C> <C> Annuity........ $50.9 $49.1 3.7% $1.8 Life........... 21.5 19.7 9.1% 1.8 ----- ----- ---- Total....... $72.4 $68.8 5.2% $3.6 ===== ===== ==== </TABLE> The fixed annuity average annual interest rate credited increased to 5.1% for the nine months ended September 30, 2001, compared to 5.0% for the same period last year. In addition, the average accumulated fixed deposits increased 1.0% for the first nine months of 2001, compared to the same period in 2000. Life insurance interest credited increased as a result of continued growth in the interest-sensitive life insurance reserves. Operating Expenses Although operating expenses for the current period included increased costs to support business growth initiatives, for the first nine months of 2001, operating expenses decreased $2.3 million, or 2.6%, compared to last year, primarily as a result of three items. First, in the fourth quarter of 2000 the Company increased its capitalization threshold for software costs. Second, the current period included a lower level of profit-related incentive compensation. Third, expenses in the first nine months of 2000 included non-recurring charges of $0.8 million for interest on the North Carolina settlement and $2.5 million attributable to the chief executive officer transition. The total corporate expense ratio on a statutory accounting basis was 22.9% for the nine months ended September 30, 2001, 0.6 percentage points less than the same period in 2000. The property and casualty expense ratio, the 16th lowest of the 100 largest property and casualty insurance groups for 2000 (the most recent industry ranking available), was 20.5% for the nine months ended September 30, 2001, compared to 19.4% last year. Amortization of Policy Acquisition Expenses and Intangible Assets For the first nine months of 2001, the combined amortization of policy acquisition expenses and intangible assets was $48.1 million, compared to the $48.0 million recorded in the same period in 2000. Amortization of intangible assets decreased to $6.1 million for the nine months ended September 30, 2001, compared to $7.2 million for the same period in 2000. The decline reflected the lower level of amortization of the value of annuity business acquired in the 1989 acquisition of the Company ("Annuity VIF") consistent with the scheduled amortization reported in the Company's Form 10-K for the year ended December 31, 2000. 21
Policy acquisition expenses amortized for the nine months ended September 30, 2001 of $42.0 million were $1.2 million more than the same period last year primarily from the property and casualty segment. Over the past 12 months, this segment has experienced accelerated growth in business and the acquisition cost amortization period matches the terms of the insurance policies (six and twelve months). Income Tax Expense Excluding the benefits in both 2001 and 2000 related to the Company's dispute with the Internal Revenue Service ("IRS") regarding tax years 1994 through 1997, the effective income tax rate on income including realized investment gains and losses was 26.4% for the nine months ended September 30, 2001, compared to 29.2% for the same period last year. Income from investments in tax-advantaged securities reduced the effective income tax rate 11.1 and 6.7 percentage points for the nine months ended September 30, 2001 and 2000, respectively. While the amount of income from investments in tax-advantaged securities in the current period was comparable to the first nine months of 2000, the reduced level of income before income taxes in 2001 resulted in this having a more significant impact on the effective income tax rate. As previously reported, the Company has been contesting proposed additional federal income taxes relating to a settlement agreement with the Internal Revenue Service ("IRS") for prior years' taxes. In the third quarter of 1999, the Company recorded an additional federal income tax provision of $20 million representing the maximum exposure of the Company to the IRS with regard to the issue for all of the past tax years in question (1994 through 1997). In the third quarter of 2000, the 1994 and 1995 exposure was resolved for an amount that was $2.8 million less than was previously accrued and that amount was included in net income for the nine months ended September 30, 2000. (The 1996 exposure was resolved and reflected in the fourth quarter of 2000.) In the third quarter of 2001, the Company's liability for the 1997 tax year was resolved, resulting in a release of $1.3 million that had previously been accrued for that tax year. That amount was included in net income for the nine months ended September 30, 2001. The benefits of these dispute resolutions were excluded from the determination of reported operating income. Operating Income For the first nine months of 2001, operating income (net income before the after-tax impact of realized investment gains and losses and non-recurring items) was adversely affected primarily by strengthening of prior years' property and casualty claim reserves and by severe weather, compared to a year ago. Incorporating the unanticipated reserve actions taken in June 2001 and the Company's nine month results exclusive of those reserve actions, which reflect generally positive underlying trends, management anticipates that 2001 full year operating income will be within a range of $0.85 to $0.90 per share. And, while management is still refining the Company's 2002 plans, preliminary projections at the time of this Report on Form 10-Q indicate an operating earnings per share range of $1.15 to $1.30 for 2002. 22
Operating income by segment was as follows: <TABLE> <CAPTION> Nine Months Ended Growth Over September 30, Prior Year ------------------- --------------------- 2001 2000 Percent Amount ------ ----- ------- ------ <S> <C> <C> <C> <C> Property & casualty Before catastrophe losses................... $ 7.2 $26.6 -72.9% $(19.4) Catastrophe losses, after tax............... (7.0) (8.3) 1.3 ------ ----- ------ Total including catastrophe losses..... 0.2 18.3 -98.9% (18.1) Annuity....................................... 14.8 16.8 -11.9% (2.0) Life.......................................... 13.2 10.6 24.5% 2.6 Corporate and other expense................... (2.3) (6.8) 4.5 Interest expense, after tax................... (4.6) (5.0) 0.4 ----- ----- ------ Total.................................. $21.3 $33.9 -37.2% $(12.6) ===== ===== ====== Total before catastrophe losses........ $28.3 $42.2 -32.9% $(13.9) ===== ===== ====== Property and casualty statutory combined ratio: Before catastrophe losses................ 104.8% 96.4% 8.4% After catastrophe losses................. 107.7% 99.9% 7.8% </TABLE> Property and casualty segment operating income was lower than in the first nine months of 2000 due primarily to prior years' reserve increases of $7.7 million after tax in the current period, compared to releases of $1.3 million after tax for the same period last year. Also, the first nine months of 2001 was affected by a higher level of non-catastrophe weather-related losses. During the first nine months of 2001, the Company's average voluntary automobile insurance premium per policy increased 1% while average loss costs increased 3%, compared to the prior year. The Company's plans to implement tiered rating systems for automobile and homeowners business remain on track, which management expects will have a positive impact on both loss ratios and business growth for these products in the Company's target market. The Company is continuing to approach the pricing and underwriting of its homeowners products aggressively, to accelerate margin recovery. Actions include tightening of underwriting guidelines, reunderwriting existing policies, and implementing coverage and policy form restrictions in selected states. An adverse industry settlement of outstanding automobile insurance rate filing cases for 1994, 1996 and 1999 in North Carolina, including interest, reduced the Company's property and casualty segment operating income by $1.7 million after tax in the first quarter of 2000. The property and casualty combined ratio before catastrophes of 104.8% was 8.4 percentage points higher than the first nine months of 2000, reflecting the factors cited above. Catastrophe losses in the first nine months of 2001 were $7.0 million after tax, including a net benefit of $0.9 million after tax due to favorable development of reserves for 2000 catastrophe losses. Incurred catastrophe losses were $8.3 million after tax in the same period a year ago. Increases in reserves for property and casualty claims occurring in prior years, excluding involuntary business, were $7.2 million after tax in the first nine months of 2001, compared to favorable development of $1.3 million after tax for the same period in 2000. The current period reflected an increase in reserves of $7.7 million after tax, including involuntary business, for property and casualty claims occurring in prior years, compared to favorable development of $1.3 million after tax last year representing approximately 3.7 percentage points of the increase in the combined ratio including catastrophes. 23
Annuity segment operating income was below the year-earlier total as a result of reduced fee income related to decreases in both variable annuity market values and reduced surrender charges for fixed and variable annuities. In addition, operating expenses increased in the current period, reflecting the growth in annuity business volume. For the first nine months of 2001, the net interest margin was equal to the prior year and fees and contract charges earned decreased 13.0%. In the third quarter of 2001, financial market changes had an adverse impact on variable annuity fees, valuations of deferred policy acquisition costs and value of acquired insurance in force, and the level of a guaranteed minimum death benefit reserve established during the quarter. These factors were offset by the release of reserves for supplementary contracts, resulting from a systems conversion. Variable annuity accumulated deposits were $0.9 billion at September 30, 2001, $195.0 million, or 18.7%, less than 12 months earlier. Fixed annuity accumulated cash value of $1.4 billion was $51.4 million, or 3.9%, greater than September 30, 2000. Life insurance earnings increased compared to the first nine months of 2000 due primarily to an increase in margins in the Company's individual life business. In the first nine months of 2000, the Corporate and Other Expense category in the preceding table reflected higher holding company expenses, including charges related to the chief executive officer transition. Net Income Net Income Per Share, Diluted <TABLE> <CAPTION> Nine Months Ended Growth Over September 30, Prior Year ------------------- ------------------- 2001 2000 Percent Amount ------ ------- ------- ------ <S> <C> <C> <C> <C> Operating income .................... $ 0.52 $ 0.83 -37.3% $(0.31) Realized investment losses .......... (0.04) (0.06) 0.02 Restructuring reserve adjustment .... - - - Litigation charges .................. - - - Adjustment to the provision for prior years' taxes ................. 0.03 0.07 (0.04) ------ ------ ------ Net income ........................ $ 0.51 $ 0.84 -39.3% $(0.33) ====== ====== ====== </TABLE> Net income, which includes realized investment gains and losses and non-recurring items, for the first nine months of 2001 decreased by $13.8 million, or 39.9%, and net income per diluted share decreased by 39.3% compared to the same period in 2000. This change included the $12.6 million decline in operating income. As discussed above in "Income Tax Expense", net income reflected resolution of federal income tax exposures which increased net income by $1.3 million for the nine months ended September 30, 2001 and $2.8 million for the same period in 2000. After tax realized investment losses were comparable for the two periods. Return on shareholders' equity was 3% based on operating income and 2% based on net income for the 12 months ended September 30, 2001. 24
Status of Litigation Regarding Disability Insurance In December 2000, the Company recorded an after tax charge of $5.0 million, representing the Company's best estimate of the actual and anticipated costs of defending and ultimately resolving litigation brought against the Company in regards to its disability insurance product. The lawsuit is a class action on behalf of certain policyholders who purchased the Company's disability insurance product and allege that they were not adequately made aware of certain features. In July 2001, the Company submitted a settlement agreement to the court which was mutually agreed upon by all parties to this lawsuit. The settlement, which provides additional benefits for current policyholders and compensation to those who demonstrate they did not understand what they purchased, was approved by the court on October 31, 2001. While the actual costs incurred by the Company to resolve this litigation could be either less or more than the liability established in 2000, management believes that, based on facts and circumstances available at this time and on the settlement agreement approved by the court in October 2001, the amount recorded will be adequate to resolve the matter. Disability insurance represented less than 1% of the Company's insurance premiums written and contract deposits for the year ended December 31, 2000. Recent Developments -- Massachusetts Automobile Business On October 18, 2001, Horace Mann announced that it had formed a marketing alliance with The Commerce Group, Inc. ("Commerce") for the sale of automobile insurance in the state of Massachusetts. Through this alliance, and beginning no later than January 1, 2002, Horace Mann will provide its Massachusetts customers with Commerce automobile insurance policies, while continuing to write other Horace Mann products, including property and life insurance and retirement annuities. Horace Mann will cease writing automobile insurance policies in Massachusetts no later than January 1, 2002, and on October 18, 2001 paid $6.4 million to the Commonwealth Automobile Reinsurers ("C.A.R.") as full payment of its proportionate liability to C.A.R. for policy years 2002 and beyond. That payment and other related expenses of approximately $1 million will be reflected in Horace Mann's financial statements for the fourth quarter of 2001 as a non-operating income restructuring charge of approximately 12 cents per share. The Company expects that this transaction will have a positive impact on operating income of approximately 10 cents per share in 2003 and beyond. The improvement in 2002 earnings will be somewhat less reflecting the run-off of current policies in force. The Company plans to utilize the benefits of this transaction to invest in its marketing, customer service and technology infrastructures. On a full year basis, the Company's Massachusetts automobile business has represented premiums written and earned of approximately $28 million. In 2002, premiums written for this business will be reduced to zero, and premiums earned will be reduced significantly reflecting run-off of the policies in force at December 31, 2001. 25
Liquidity and Financial Resources Investments The Company's investment strategy emphasizes investment grade, publicly traded fixed income securities. At September 30, 2001, fixed income securities represented 95.9% of investments excluding the securities lending collateral. Of the fixed income investment portfolio, 95.4% was investment grade and 99.8% was publicly traded. The average quality of the total fixed income portfolio was A+ at September 30, 2001. The duration of the investment portfolio is managed to provide cash flow to satisfy policyholder liabilities as they become due. The average option adjusted duration of total investments was 4.8 years at September 30, 2001 and 4.4 years at December 31, 2000. The Company has included in its annuity products substantial surrender penalties to reduce the likelihood of unexpected increases in policy or contract surrenders. All annuities issued since 1982 and approximately 78% of all outstanding fixed annuity accumulated cash values are subject in most cases to substantial early withdrawal penalties. Cash Flow The short-term liquidity requirements of the Company, within a 12-month operating cycle, are for the timely payment of claims and benefits to policyholders, operating expenses, interest payments and federal income taxes. Cash flow in excess of these amounts has been used to fund business growth, retire short-term debt, pay dividends to shareholders and repurchase shares of the Company's common stock. Long-term liquidity requirements, beyond one year, are principally for the payment of future insurance policy claims and benefits and retirement of long-term notes. Operating Activities As a holding company, HMEC conducts its principal operations in the personal lines segment of the property and casualty and life insurance industries through its subsidiaries. HMEC's insurance subsidiaries generate cash flow from premium and investment income, generally well in excess of their immediate needs for policy obligations, operating expenses and other cash requirements. Cash provided by operating activities primarily reflects net cash generated by the insurance subsidiaries. Net cash provided by operating activities was approximately $9 million more than the first nine months of 2000, primarily reflecting a reduction in federal income tax payments in the current period. Payment of principal and interest on debt, fees related to the catastrophe-linked equity put option and reinsurance agreement, dividends to shareholders and parent company operating expenses, as well as the share repurchase program, are dependent upon the ability of the insurance subsidiaries to pay cash dividends or make other cash payments to HMEC, including tax payments pursuant to tax sharing agreements. The insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. Dividends which may be paid by the insurance subsidiaries to HMEC during 2001 without prior approval are approximately $42 million. Although regulatory restrictions exist, dividend availability from subsidiaries has been, and is expected to be, adequate for HMEC's capital needs. 26
Investing Activities HMEC's insurance subsidiaries maintain significant investments in fixed maturity securities to meet future contractual obligations to policyholders. In conjunction with its management of liquidity and other asset/liability management objectives, the Company, from time to time, will sell fixed maturity securities prior to maturity and reinvest the proceeds in other investments with different interest rates, maturities or credit characteristics. Accordingly, the Company has classified the entire fixed maturity securities portfolio as available for sale. Financing Activities Financing activities include primarily payment of dividends, the receipt and withdrawal of funds by annuity contractholders, repurchases of the Company's common stock, and borrowings and repayments under the Company's debt facilities. Fees related to the catastrophe-linked equity put option and reinsurance agreement, which augments its other reinsurance program, have been charged directly to additional paid-in capital. For the first nine months of 2001, receipts from annuity contracts increased 19.5%. Annuity contract maturities and withdrawals decreased $108.3 million, or 44.3%, compared to the same period last year, including decreases of 54.0% and 40.8% in surrenders of variable and fixed annuities, respectively. Reflecting continued improvement in recent quarterly trends, cash value retention for variable and fixed annuities was 90.8% and 92.2%, respectively, for the 12 month period ended September 30, 2001. Net transfers to variable annuity assets increased $64.9 million compared to the same period last year reflecting the Company's expansion of its variable investment options. The Company did not repurchase shares of its common stock under its stock repurchase program during the first nine months of 2001, consistent with management's stated intention to utilize excess capital to support the Company's strategic growth initiatives. In the first nine months of 2000, 1,082,400 shares were repurchased at an aggregate cost of $15.1 million. The repurchase of shares was financed through use of cash and, when necessary, the Bank Credit Facility. However, the Company has not utilized the Bank Credit Facility for share repurchases since the second quarter of 1999. As of September 30, 2001, $96.3 million remained authorized for future share repurchases. Capital Resources The Company has determined the amount of capital which is needed to adequately fund and support business growth, primarily based on risk-based capital formulas including those developed by the National Association of Insurance Commissioners ("NAIC"). Historically, the Company's insurance subsidiaries have generated capital in excess of such needed capital. These excess amounts have been paid to HMEC through dividends. HMEC has then utilized these dividends and its access to the capital markets to service and retire long-term debt, increase and pay dividends to its shareholders, fund growth initiatives, repurchase shares of its common stock and for other corporate purposes. Management anticipates that the Company's sources of capital will continue to generate capital in excess of the needs for business growth, debt interest payments and shareholder dividends. 27
The NAIC has codified statutory accounting practices, which are expected to constitute the only source of prescribed statutory accounting practices and were effective January 1, 2001. Codification changed prescribed statutory accounting practices and resulted in changes to the accounting practices that insurance enterprises use to prepare their statutory financial statements. The states of domicile of the Company's principal operating subsidiaries, Illinois, California and Texas, have adopted the NAIC's codification. As a result of adopting the NAIC codification, the Company's statutory surplus of its insurance subsidiaries increased approximately $19 million. The total capital of the Company was $632.1 million at September 30, 2001, including $99.8 million of long-term debt and $49.0 million of short-term debt. Total debt represented 25.1% of capital (excluding unrealized investment gains and losses) at September 30, 2001, which was at the upper end of the Company's target operating range of 20% to 25%. Shareholders' equity was $483.3 million at September 30, 2001, including an unrealized gain in the Company's investment portfolio of $40.5 million after taxes and the related impact on deferred policy acquisition costs and the value of acquired insurance in force associated with annuity and interest-sensitive life policies. The market value of the Company's common stock and the market value per share were $718.6 million and $17.65, respectively, at September 30, 2001. Book value per share was $11.87 at September 30, 2001, $10.88 excluding investment market value adjustments. At September 30, 2000, book value per share was $10.34, $11.14 excluding investment market value adjustments. The increase over the 12 months included the effects of unrealized investment gains and losses. Excluding these items, book value per share was slightly lower than a year earlier. In January 1996, the Company issued $100.0 million face amount of 6 5/8% Senior Notes ("Senior Notes") at a discount of 0.5% which will mature on January 15, 2006. Interest on the Senior Notes is payable semi-annually. The Senior Notes are redeemable in whole or in part, at any time at the Company's option. The Senior Notes have an investment grade rating from Standard & Poor's Corporation ("S&P") (BBB+), Fitch, Inc. ("Fitch") (A-), and Moody's Investors Service, Inc. ("Moody's") (Baa1) and are traded on the New York Stock Exchange (HMN 6 5/8). As a result of factors impacting the Company's earnings for the three months ended December 31, 2000, S&P placed the Company's debt rating on "CreditWatch with negative implications" and Fitch placed the Company's debt rating on "Rating Watch Negative" in January 2001 and February 2001, respectively. Moody's issued a statement in February 2001 affirming their rating and identified the outlook for the rating as "Stable". In April 2001, Fitch reaffirmed their "A" rating and identified the outlook for the rating as "Stable". However, as a result of factors impacting the Company's earnings for the three months ended June 30, 2001, Fitch downgraded the rating to "A-" in August 2001 and identified the outlook for the rating as "Stable". In August 2001, S&P downgraded their rating to "BBB+" and identified the outlook for the rating as "Stable". As of both September 30, 2001 and December 31, 2000, the Company had short-term debt of $49.0 million outstanding under the Bank Credit Facility. The Bank Credit Facility allows unsecured borrowings of up to $65.0 million at Interbank Offering Rates plus 0.3% to 0.5% or Bank of America National Trust and Savings Association reference rates. The rate on the borrowings under the Bank Credit Facility was Interbank Offering Rate plus 0.4%, or 3.0%, as of September 30, 2001. The commitment for the Bank Credit Facility terminates on December 31, 2001. The Company's earnings in the fourth quarter of 2000 could have caused a breach of a financial covenant of the Company's Bank Credit Facility in 2001 but, in the first quarter of 2001, the lender agreed to modify that covenant for the first, second and third quarters of 2001. As a result of earnings for the second quarter of 2001, and again based on third quarter 2001 earnings, 28
the lender agreed to further modify that covenant. Prior to the determination of second quarter earnings, management had also begun discussions with representatives of the lender about a possible replacement credit facility to be implemented prior to the maturity of the existing Bank Credit Facility on December 31, 2001. At the time of this Report on Form 10-Q, management is in the final stages of negotiating an extension of the existing Bank Credit Facility through June 30, 2002. However, management believes that even if such discussions are not successful, the Company will be able to obtain replacement financing for the Bank Credit Facility elsewhere, but the Company cannot predict on what terms and conditions such financing would be available, and the availability of alternative financing is always subject to prevailing market conditions at the time of securing such financing. The Company's ratio of earnings to fixed charges for the nine months ended September 30, 2001 was 4.7x compared to 6.9x for the same period in 2000. Total shareholder dividends were $12.8 million for the nine months ended September 30, 2001. In February 2001, May 2001 and August 2001, the Board of Directors announced regular quarterly dividends of $0.105 per share. The Company reinsures 95% of catastrophe losses above a retention of $8.5 million per occurrence up to $80 million per occurrence for 48% of the coverage and above a retention of $7.5 million per occurrence up to $80 million per occurrence for the remaining 52% of the coverage. In addition, the Company's predominant insurance subsidiary for property and casualty business written in Florida reinsures 90% of hurricane losses in that state above a retention of $10.3 million up to $50.3 million with the Florida Hurricane Fund, based on the Fund's resources. These catastrophe reinsurance programs are augmented by a $100 million equity put and reinsurance agreement. This equity put provides an option to sell shares of the Company's convertible preferred stock with a floating rate dividend at a pre-negotiated price in the event losses from catastrophes exceed the catastrophe reinsurance program coverage limit. Before tax benefits, the equity put provides a source of capital for up to $154 million of catastrophe losses above the reinsurance coverage limit. While the Company anticipates that the cost of its reinsurance coverage will increase as a result of the effects on the reinsurance market of the September 11, 2001 terrorist attacks, 48% of the Company's coverage for catastrophe losses has rates which are fixed through 2003. Renewal of the remaining 52% of that coverage is being negotiated as of the time of this Report on Form 10-Q, and management believes that the rate increase which will be necessary on that remaining coverage will be manageable. Insurance Financial Ratings As disclosed in the 2000 Form 10-K, certain ratings of the Company's insurance subsidiaries were under review as a result of the Company's earnings for the three months ended December 31, 2000. Management also initiated discussions with each of the agencies rating its insurance subsidiaries as a result of earnings reported for the quarter ended June 30, 2001. At the time of this Report on Form 10-Q, these reviews have been completed by all agencies with the exception of A.M. Best's review of the Company's property and casualty subsidiaries. While A.M. Best has identified the outlook for the property and casualty subsidiaries' "A+" ratings as negative, it is not known what further actions, including possible downgrades of ratings, may occur. 29
Moody's Investors Service, Inc. ("Moody's") affirmed the Company's financial strength ratings following the Company's January 2001 preannouncement of earnings for the three months ended December 31, 2000, and in August 2001 issued an opinion update which again affirmed those ratings. In July 2001, Moody's assigned a financial strength rating of "A2 (Good)" to Horace Mann Property and Casualty Insurance Company (formerly Allegiance Insurance Company). HMLIC, HMIC and TIC are also rated "A2 (Good)" for financial strength by Moody's. Fitch, Inc. ("Fitch") placed the Company's financial strength ratings on "Rating Watch Negative" in February 2001. Although the Company's insurance subsidiaries remain in the "AA (very strong)" rating category, in April 2001, Fitch downgraded Horace Mann's financial strength ratings one notch from "AA" to "AA-". Fitch reaffirmed its "AA-" rating in August 2001 and identified the outlook for the rating as "Stable". Standard & Poor's Corporation ("S&P") placed the Company's financial strength ratings on "CreditWatch with negative implications" in January 2001. In August 2001, S&P downgraded the Company's financial strength ratings from "AA-" to "A+" and identified the outlook for the ratings as "Stable". As of 2001, Horace Mann is one of only two insurance groups that have been named to The Ward Financial Group's Top 50 for both its property and casualty and life subsidiaries in each of the last eight years. Market Risk Market risk is the risk that the Company will incur losses due to adverse changes in market rates. The Company's primary market risk exposure is the risk that the Company will incur economic losses due to adverse changes in interest rates. This risk arises as the Company's profitability is affected by the spreads between interest yields on investments and rates credited on insurance liabilities. The Company manages its market risk by coordinating the projected cash outflows of assets with the projected cash outflows of liabilities. For all its assets and liabilities, the Company seeks to maintain reasonable durations, consistent with the maximization of income without sacrificing investment quality and providing for liquidity and diversification. The risks associated with mutual fund investments supporting variable annuity products are assumed by those contractholders, and not by the Company. There have been no material changes during the first nine months of 2001 in the market risks the Company is exposed to and the management of those risks, which are described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 2000 Form 10-K. Recent Accounting Changes In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations", effective for all business combinations initiated after June 30, 2001, and No. 142, "Goodwill and Other Intangible Assets", effective for fiscal years beginning after December 15, 2001. SFAS No. 141 requires the purchase method of accounting be used for all business combinations. Goodwill and certain intangible assets will remain on the balance sheet and not be amortized. SFAS No. 142 30
establishes a new method of testing goodwill for impairment. On an annual basis, and when there is reason to suspect that their values may have been diminished or impaired, these assets must be tested for impairment. The amount of goodwill determined to be impaired will be expensed to current operations. The Company has not determined the impact, if any, that the goodwill impairment testing prescribed by these statements will have on its consolidated financial position or results of operations. Amortization of goodwill was $1.2 million for the nine months ended September 30, 2001 and 2000, and total goodwill amortization for the year ended December 31, 2000 was $1.6 million. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations", effective for fiscal years beginning after June 15, 2002. The accounting practices in this statement apply to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset. This statement will not have a material impact on the Company because it does not own a significant amount of property and equipment. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", effective for fiscal years beginning after December 15, 2001. This statement establishes a single accounting model, based on the framework established in SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", for long-lived assets disposed of by sale, including disposal of a segment of a business. This statement is not expected to have a material impact on the Company. 31
Item 3: Quantitative and Qualitative Disclosures About Market Risk The information required by Item 305 of Regulation S-K is contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in this Form 10-Q. PART II: OTHER INFORMATION Item 4: Submission of Matters to a Vote of Security Holders None. Item 6: Exhibits and Reports on Form 8-K Exhibit No. Description ------- ----------- (a) The following items are filed as Exhibits. Management contracts and compensatory plans are indicated by an asterisk (*). (10) Material contracts: 10.1 Credit Agreement dated as of December 31, 1996 (the "Bank Credit Facility") among HMEC, certain banks named therein and Bank of America National Trust and Savings Association, as administrative agent (the "Agent"), incorporated by reference to Exhibit 10.1 to HMEC's Annual Report on Form 10-K for the year ended December 31, 1996, filed with the Securities and Exchange Commission on March 26, 1997. 10.1(a) Waiver Relating to Credit Agreement, incorporated by reference to Exhibit 10.1(b) to HMEC's Quarterly Report on Form 10-Q for the quarter ended March 31, 2001, filed with the Securities and Exchange Commission on May 14, 2001. 10.1(b) Waiver Relating to Credit Agreement. 10.1(c) Waiver Relating to Credit Agreement. 10.2* Horace Mann Educators Corporation 2001 Stock Incentive Plan. 10.2(a)* Specimen Employee Stock Option Agreement under the Horace Mann Educators Corporation 2001 Stock Incentive Plan. 10.2(b)* Specimen Director Stock Option Agreement under the Horace Mann Educators Corporation 2001 Stock Incentive Plan. (11) Statement re computation of per share earnings. (b) No reports on Form 8-K were filed by the Company during the third quarter of 2001. 32
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HORACE MANN EDUCATORS CORPORATION (Registrant) Date November 13, 2001 /s/ Louis G. Lower II ------------------------- ----------------------------------------- Louis G. Lower II President and Chief Executive Officer Date November 13, 2001 /s/ Peter H. Heckman ------------------------- ----------------------------------------- Peter H. Heckman Executive Vice President and Chief Financial Officer Date November 13, 2001 /s/ Thomas K. Manion ------------------------- ----------------------------------------- Thomas K. Manion Senior Vice President and Controller 33