Washington, D. C. 20549
Item 1. Business
Investors Heritage Capital Corporation was incorporated in 1963 and is the holder of 100% of the outstanding common stock of a life insurance company, a printing company and an insurance marketing company and is the sole member of two Kentucky limited liability companies.
Investors Heritage Capital owns 100% of Investors Heritage Life Insurance Company, Investors Heritage Printing, Inc. and Investors Heritage Financial Services Group, Inc. Investors Heritage Capital is the sole member of At Need Funding, LLC, and Heritage Funding, LLC, both Kentucky limited liability companies. We will be referring to Investors Heritage Printing, Investors Heritage Financial, At Need Funding and Heritage Funding as the "Non-insurance Subsidiaries". We will be referring to Investors Heritage Life, Investors Heritage Printing, Investors Heritage Financial and At Need Funding as the "Subsidiaries". We will also be referring to Investors Heritage Capital and its subsidiaries as “we”, “us”, “our” and as the "Company".
Investors Heritage Life owns 96% of Investors Underwriters, Inc., an investment holding company. Less than 1% of Investors Heritage Capital's total consolidated revenues were generated by the Non-insurance Subsidiaries for the year ended December 31, 2012. The Non-insurance Subsidiaries' total assets and stockholders’ equity comprised less than 1% in the aggregate of Investors Heritage Capital's reported total assets and stockholders’ equity as of December 31, 2012.
The business segments of Investors Heritage Life are identified and discussed on page 11 of the Annual Report to Stockholders for the year ended December 31, 2012 and are incorporated herein by reference. We offer a portfolio of the standard forms of participating and non-participating whole life, limited pay, endowments, split-funding, interest-sensitive whole life, guaranteed issue whole life, single premium whole life, universal life, term and group life, annuities and single premium immediate annuities. In addition, we write credit life and credit accident and health insurance (collectively "Credit Insurance”) on a group basis. The business of Investors Heritage Life is not seasonal.
Prior to being sold, all insurance products must be approved by the Departments of Insurance in each state where Investors Heritage Life is authorized to do business. In addition, the financial condition and market conduct condition of Investors Heritage Life are monitored and examined by the state regulatory agencies on a regular basis.
Traditional products consist of various forms of whole life and term insurance. During 2011, a new single premium whole life policy was introduced as well as a single premium immediate annuity which is sold in conjunction with a ten-pay whole life policy. These new products are marketed through a new distribution system which has exceeded production goals during the last year. We anticipate continued strong production in this area.
In addition to credit administration, this segment includes fees generated relative to our third party administrative relationships. We provide tailored administrative services for seven unaffiliated companies, comprised of five life insurance companies and two holding companies. Services provided to each company vary based on their needs and can include some or all aspects of back-office accounting, actuarial services and policy administration. We have been given notice of termination relative to two clients effective June 15, 2013. We are continuing to market our third party administrative services to prospective clients.
Preneed sales increased 3.3% during 2012 primarily due to increased marketing activity from our agency division in the preneed markets. Investors Heritage Life strives to continue to improve its marketing capability in this area. Our efforts and strategy to continue a successful ordinary insurance operation hinge on continuing to provide solid products and outstanding administrative service and on the personal relationships developed and fostered each year. Our preneed product, the Legacy Gold series, includes both single premium as well as multi-pay policies. Reaction to this product in our markets continues to be favorable. The performance of this product series has been in line with expectations and has improved product profitability in this segment. Our Preneed sales are generated primarily through independent funeral homes in fourteen states.
The preneed market is very competitive despite the recent conditions in the financial markets. There are more than twenty companies active in our preneed market and Investors Heritage ranks in the top 15 with respect to new sales. The principal methods of competition are product pricing including growth on preneed insurance products, commissions, and the quality and efficiency of service provided. Our competitive pricing and quality and efficient service as well as long term sustainability are positive factors in our competitive position. However, competitors introduce new products frequently and we strive to maintain and improve our offerings constantly as we ensure sales of sustainable and profitable business.
We also market a series of final expense whole life insurance policies known as the “Heritage Final Expense Products”. These products are non-participating whole life insurance issued with simplified underwriting. These products are offered outside of the preneed market and are performing in line with expectations. During 2011, we introduced a new final expense product which is marketed under a new distribution channel through a national general agent. We have carefully monitored sales of the new final expense product and are increasing production at a specified pace.
The final expense market is very competitive. There are numerous companies in this arena and Investors Heritage is not a top tier company in this market in terms of new sales. However, we have an agreement with a national agency which is producing business as projected. The principal methods of competition are product pricing and commissions. The quality and efficiency of service are also big factors.
Approximately 25% of total ordinary insurance in force is Traditional. These sales are built around a standard portfolio of life insurance policies with some of the contributions to in-force business being a participating ordinary life insurance policy, a guaranteed issue whole life policy and non-participating life policies. In addition, we offer term insurance products.
During the second quarter of 2011, we entered into an agreement with a small life company and its affiliated marketing organization to provide a unique product through their established distribution system. Our actuary redesigned the products and we launched new sales in April 2011.
The new products include a single premium whole life policy and a single premium immediate annuity sold in conjunction with a ten-pay whole life policy. The program has been very successful producing over $9 million in premiums for 2012. Under our agreement, the business will be produced by Investors Heritage Life for a period of no less than five years and will be partially reinsured with their life company on a coinsurance basis.
In addition, their life company has recently commenced marketing a similar product. Beginning January 1, 2013, Investors Heritage Life began accepting a portion of the risks on these policies sold by Puritan Life Insurance Company of America. This reinsured business includes single premium life insurance policies and a single premium immediate annuity sold in combination with a ten-pay whole life insurance policy. We anticipate this business to grow during 2013, which will increase revenue and will allow us to participate in certain markets where we are not currently licensed.
The single premium and 10-pay whole life/single premium immediate annuity markets are also very competitive but in conjunction with our marketing partner, Investors Heritage has established a middle market niche for the sale of lower volume products. Most of the major competitors are focused on much higher volume production. The principal methods of competition are product design, pricing and quality and efficiency of service.
Our ordinary products also include a Whole Life Policy, HLW Choice Whole Life. This Whole Life Policy is designed with numerous options and with flexibility to achieve our customer’s goals.
Ordinary premium production from financial institutions decreased by $84,424 to $151,353 in 2012. This 35.8% decrease over 2011 was primarily due to the tightening of consumer credit markets in light of the current economic situation.
Group life accounts for 3% of total in-force business. Investors Heritage Life has historically participated in the Federal Employees’ Group Life Insurance ("FEGLI") Program, which is administered by Metropolitan Life Insurance Company, and in the Servicemen's Group Life Insurance ("SEGLI") Program, which is administered by Prudential Insurance Company of America. During 2012, we terminated our participation in these programs due to the lack of profitability relative to other lines of business. As a result of the termination of our participation in FEGLI and SEGLI, the total amount of insurance in force has decreased approximately $2,900,000,000 from December 31, 2011.
Investors Heritage Life has reinsurance agreements for credit insurance with eight unaffiliated companies. Pursuant to those agreements, our credit insurance products sold by each company’s agents are then reinsured to each company, respectively. Investors Heritage Life and Investors Heritage Financial are paid an initiation fee and an administration fee for services provided. Investors Heritage Financial will continue to seek contracts to operate as an administrator for other companies that sell credit insurance.
Investors Heritage Financial continues to sell Investors Heritage Life’s credit insurance products through banks, finance companies and selected automobile dealerships. Only 8.3% of Investors Heritage Financial revenues for 2012 were derived from the sale of Investors Heritage Life's credit insurance products. The remaining revenues were primarily derived from service fees. Credit insurance gross written premiums were lower than in the prior year due primarily to lower loan demand related to the sluggish economy. As noted above, Investors Heritage Life has an exclusive marketing agreement with the KBA and its affiliated insurance agency, KenBanc Insurance Services, Inc., whereby KenBanc provides all marketing and sales management responsibilities for the sale of our credit insurance products through financial institutions in the Commonwealth of Kentucky.
In addition to selling credit insurance, Investors Heritage Life provides ongoing servicing of written credit business, generating fee income. Additionally, Investors Heritage Life bank agents may obtain an ordinary life license enabling them to sell mortgage life insurance that might be required in excess of the statutory credit life limitation enacted by each state where our credit insurance products are sold. The mortgage life insurance sales operations are also conducted through KenBanc. Investors Heritage Financial is licensed with other unaffiliated insurance companies to provide products that Investors Heritage Life does not offer to the financial institutions and other agents. These products include cancer, accident, second-to-die, large face amount term insurance, short term and long term disability and annuities. These relationships generated additional fee income in the amount of $197,110 during 2012 and management anticipates continued fee income from this area.
During 2012, we continued to market our third party administrative services to non-affiliated companies. We have an employee whose primary responsibility is to promote this aspect of our organization. This additional marketing focus has and is expected to generate fee income associated with providing these services. Our overall revenue is further enhanced by the fact that we generally incur minimal expense increases associated with the third party administrative services, which decreases our overall unit costs.
We have the capacity within our organization to handle the additional load and we have been successful in providing services without the need to add new employees. We currently provide administrative services for seven companies. These agreements are with a variety of companies that encompass different levels of services, including in some cases, full life insurance back office administration and accounting. We have been given notice of termination relative to two clients effective June 15, 2013.
As of December 31, 2012, approximately $53,996,000 or 11% of total benefit and unearned premium reserves was reinsured with non-affiliated, well-established insurance companies. Investors Heritage Life is party to reinsurance and coinsurance agreements with twenty-four non-affiliated companies. The reinsurers for Investors Heritage Life and amounts of insurance in force that are reinsured are as follows:
Investors Heritage Life reinsures all of the risk on the Credit Insurance products sold by its agents with Swiss Life Ltd. and KenBanc Reinsurance Company, Ltd. As explained above, some of these credit insurance risks are also reinsured to Transamerica, Universal Guaranty, Madison National, Minnesota Life, Plateau, Central States and St James.
The operation of Investors Heritage Financial generates additional revenue to Investors Heritage Capital Corporation. Although this additional revenue is not a significant factor in our overall business, Investors Heritage Financial generated revenue from its operations of approximately $217,000 in 2012 compared to $170,000 in 2011. The increase is primarily due to an increase in service fee income on credit insurance business.
At Need Funding is a single member, limited liability company organized under the laws of the Commonwealth of Kentucky. Investors Heritage Capital Corporation is the sole member of the LLC. Funding provided by At Need Funding is secured by assignments of verified incontestable life insurance policies issued by unaffiliated companies. The funds are advanced to funeral homes for services provided for the insured. Upon receipt of death benefits from the unaffiliated insurance company, the principal balance of the debt is reduced and interest and fees are recorded. This service is marketed primarily to funeral homes that do not have the manpower to timely complete necessary paperwork to process the insurance claim. Revenues from At Need Funding were approximately $78,000 in 2012, down $27,000 compared to 2011.
Dividends and distributions from the Non-insurance Subsidiaries for 2012 and 2011 amounted to $325,000 and $-0-, respectively.
Additionally, we earn fees for other services performed for our subsidiaries. The fees pay for the necessary supervision and coordination required to provide common policies and procedures for all the subsidiaries. The supervision results in a coordination of contracts with the various independent agents, common sales brochures, and a savings to each company in the area of printing and purchasing. We purchase director and officer liability coverage, employment practices liability insurance coverage, professional liability coverage and blanket fidelity bonds. All policies provide coverage for each of the subsidiaries and provide a cost savings when compared to purchases made by individual companies. These fees are not significant to our total revenue and are eliminated in consolidation. Investors Heritage Capital Corporation also has revenue from other investments, but it is not a significant factor in our business.
The principal markets for Investors Heritage Life's products are in Kentucky, North Carolina, Georgia, Indiana, Michigan, Ohio, Pennsylvania, South Carolina, Tennessee, Texas and Virginia. Investors Heritage Life has approximately 1,507 licensed ordinary agents and regional managers throughout these states and credit life agents in 264 banks and automobile dealerships.
Investors Heritage Life is also licensed in nineteen other states: Alabama, Arizona, Arkansas, Florida, Illinois, Louisiana, Mississippi and West Virginia in the South and Southeast; Colorado, Missouri, New Mexico, North Dakota, South Dakota, Oklahoma, Montana, Nebraska, Kansas and Utah in the West; and Maryland in the North. The business in these states is written mostly through general agents.
Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which are subject to change. These uncertainties and contingencies could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable factors and developments. Some of these may be national in scope, such as general economic conditions, changes in tax law and changes in interest rates. Some may be related to the insurance industry generally, such as pricing competition, regulatory developments, industry consolidation and the effects of competition in the insurance business from other insurance companies and other financial institutions operating in our market area and elsewhere. Others may relate to the Company specifically, such as credit, volatility and other risks associated with our investment portfolio. We caution that such factors are not exclusive. We disclaim any obligation to update forward-looking information.
Item 2. Properties
Our physical property consists of the home office building and grounds, owned in fee, at 200 Capital Avenue, Frankfort, Kentucky. Adjacent to the home office, we own additional property on Second Street and on Shelby Street in Frankfort, Kentucky. One building is used for agency and company meetings; one building is a print shop used by Investors Heritage Printing, one building is used for supplies and additional storage; one building is currently available for lease to a commercial tenant and one building is a residential apartment building. All of the properties are in good condition.
Item 3. Legal Proceedings
There are no legal proceedings to which Investors Heritage Capital Corporation is a party. There are no legal proceedings to which Investors Heritage Life is a party that are material to the overall financial condition or results of operations of Investors Heritage Capital Corporation.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The stock of Investors Heritage Capital Corporation is quoted on the OTCQB market. The quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, and may not represent actual transactions. The symbol for Investors Heritage Capital Corporation is IHRC. The following table shows the range of high and low closing sales prices of our shares on the OTCQB market quotations.
The 2013 cash dividend to be paid April 7, 2013, to stockholders of record March 15, 2013, is $.25 per share. Investors Heritage Capital Corporation paid an annual dividend totaling $265,129 to stockholders in 2012 representing $.23 per share. Investors Heritage Capital Corporation paid an annual dividend totaling $207,327 to stockholders in 2011 representing $.18 per share.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Management's Discussion and Analysis of Financial Condition and Results of Operations appears on pages 5-21 in the Annual Report to the Stockholders for the year ended December 31, 2012, and is incorporated herein by reference.
Item 8. Financial Statements
The consolidated financial statements and notes appear on pages 24-55 in the Annual Report to the Stockholders for the year ended December 31, 2012, and are incorporated herein by reference. See Part IV, Item 15.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Based on this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including our consolidated subsidiaries) required to be included in this Annual Report on Form 10-K.
In addition, based upon this evaluation, management concluded that, as of the end of the period covered by this annual report, our internal controls over financial reporting are effective. The standard measures adopted by management in making its evaluation are the measures in the Internal Control Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission.
During the fourth quarter of 2012, the Company converted its mainframe-based system to a PC-based system. The Company appropriately adjusted its control environment for this change. There were no other changes in our internal control over financial reporting during the three months ended December 31, 2012 that may have materially affected, or was reasonably likely to materially affect, the Company’s internal control over financial reporting.
None.
Item 10. Directors, Executive Officers and Corporate Governance
(b) Each of the Directors has occupied the position indicated for a period of more than five years with the exception of Gordon C. Duke. Since 2003, Mr. Duke has been an independent businessman. From November 1, 2008 to December, 2010, he served as a consultant and as a Vice President for Nucleus: Kentucky’s Life Science and Innovation Center, LLC. In January, 2013, George R. Burgess, Jr. was elected to the Board of Directors to fill the unexpired two year term of the deceased Jerry F. Howell, Jr. Mr. Burgess was employed by the Commonwealth of Kentucky, Cabinet for Economic Development from July, 2004 until December, 2012 when he retired. Mr. Burgess served in several capacities including Deputy Commissioner, Executive Director and Deputy Executive Director during his employment with the Cabinet. Mr. Burgess is currently an independent businessman.
There have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions material to the evaluation of the ability and integrity of any Director or Executive Officer during the past ten years.
Additional information regarding the Directors and leadership structure of the Board are shown on pages 3-7, respectively, of the Proxy Statement for the Annual Meeting of Shareholders to be held May 9, 2013 and is incorporated herein by reference.
Officers are appointed annually by the Board of Directors at the Board meeting immediately following the Annual Meeting of Shareholders. There are no arrangements or any understandings between any officer and any other person pursuant to which the officer was selected.
The Board of Directors has determined that Audit Committee members Harold G. Doran, Jr. and Gordon C. Duke are audit committee financial experts as defined by Item 407(d)(5) of Regulation S-K of the Exchange Act and are independent as that term is used in Item 7(d) of Schedule 14A under the Exchange Act. The Company has a designated Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. The members of the Audit Committee are Harold G. Doran, Jr., Gordon C. Duke, and David W. Reed. All members of the Audit Committee are independent.
Item 11. Executive Compensation
Information regarding compensation of executive officers and transactions with executive officers and directors is shown on pages 7-11 of the Proxy Statement for the Annual Meeting of Shareholders to be held May 9, 2013, and is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Security ownership by Officers, Directors, and management is shown on pages 5-6 of the Proxy Statement for the Annual Meeting of Shareholders to be held May 9, 2013, and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Certain relationships and related transactions are shown on page 12 of the Proxy Statement for the Annual Meeting of Shareholders to be held May 9, 2013, and are incorporated herein by reference.
Item 14. Principal Accounting Fees and Services
Information regarding accounting fees and services is shown on page 11-12 of the Proxy Statement for the Annual Meeting of Shareholders to be held May 9, 2013, and is incorporated herein by reference.
Item 15. Exhibits, Financial Statement Schedules
(a)1. The following financial statements incorporated herein by reference in Item 8 to the Company's Annual Report to Stockholders for the year ended December 31, 2012 (pages 23-55) are filed as Exhibit 1 thereto:
** XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.
*The material included in this Report shall not be deemed to be "filed" with the Commission or otherwise subject to the liabilities of Section 18 of the Act, except to the extent that this registrant specifically incorporates it in its Annual Report on this Form 10-K by reference.
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
/s/Robert M. Hardy, Jr.
Robert M. Hardy, Jr.
/s/Jimmy R. McIver
Jimmy R. McIver
/s/Raymond L. Carr
Raymond L. Carr
/s/Gordon C. Duke
Gordon C. Duke
/s/Helen S. Wagner
Helen S. Wagner
/s/Harold G. Doran
Harold G. Doran
/s/David W. Reed
David W. Reed
/s/ Howard L. Graham
Howard L. Graham
/s/Michael F. Dudgeon, Jr.
Michael F. Dudgeon, Jr.
| | investors Heritage |
| Capital Corporation |
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| | 2012 annual review |
| 3 | | | letter to our stockholders |
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| 5 | | | management's discussion and analysis |
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| 22 | | | management's report on internal control over financial reporting |
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| 23 | | | report of independent registered public accounting firm |
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| 24 | | | consolidated financial statements |
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| 29 | | | notes to consolidated financial statements |
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| 56 | | | corporate information |
LETTER
TO OUR STOCKHOLDERS
In last year’s letter I stated that “2011 was one of the most significant years in the history of our company”. This was due to the assumption of approximately 50,000 preneed policies from the Texas Life, Accident, Health and Hospital Guaranty Association in July 2011 and our partnership with Puritan Financial Group. I am pleased to announce that the work and accomplishments made in 2011 carried over into 2012 which led to another year of outstanding sales and financial results.
Net gain from operations for Investors Heritage Capital Corporation (the “Company”) was $2,098,762 compared to $552,129 in 2011. Per share earnings were $1.82 compared to $.48 a year ago. Your Board of Directors declared a 2013 dividend of $.25 per share, up $.02 from the prior year. As we did in 2012, the dividend will be paid from earnings of subsidiary units, but not from Investors Heritage Life Insurance Company. This enabled us to maximize the surplus growth of Investors Heritage Life Insurance Company and as such the surplus grew 5.3% during the year.
The 2011 assumption of preneed business was the largest financial transaction in our history. It has proven to be a good investment, reducing our per policy maintenance cost by $6.16 in 2012 and adding significantly to Investors Heritage Life’s statutory profit and Investors Heritage Capital Corporation’s consolidated net income gain. Details are pointed out in the MD&A on page 6.
Our partnership with Puritan Financial Group, Inc. also grew and expanded during the year. First their premium production was much above the anticipated level. Also during the year, we entered into an agreement to perform Third Party Administrative (TPA) work for one of their affiliated companies and to reinsure a large percentage of the business written by that company. This will increase both our premium income and fee income.
Preneed life insurance sold through funeral homes continues to be the major focus of our sales management team. Sales were up 3.3% in 2012. During the spring of 2012 our Agency Vice President, Michael Dudgeon, resigned to pursue other interests. Thanks to our outstanding team of managers and home office staff, preneed sales continued at a good pace and other new partnerships performed well. We continue to be dedicated to this market as a vital part of our organization, marked by our continued sales development, recruitment of new accounts and assumption of blocks of preneed business.
We are fortunate to have found a new person to lead our sales organization. Jeff Crippen joined Investors Heritage as Agency Vice President on January 1, 2013. Jeff has an extensive and varied sales management background in life and health insurance. He also has a wealth of close contacts with agents and agencies throughout the country. We plan to use his extensive background and contacts to develop new insurance products, update existing products and recruit new sales personnel to the Company.
Our TPA work for non-affiliated companies continues to be an excellent source of revenue. Our outstanding home office staff enables us to make this a key profit center. Revenue from TPA contracts was $1,186,333 in 2012. We expect revenue from TPA activity to increase in 2013 with the addition of other clients contracted late in 2012. Through our Corporate Development Department we continue to look for new TPA clients and blocks of business to purchase.
This year we have taken advantage of the Securities and Exchange Commission rules that allow us to furnish our proxy materials and annual review on the Internet. The Notice of Internet Availability of Proxy Materials, with instructions on how to access our Proxy materials and Annual Review, as well as instructions to receive a paper copy of the documents, was mailed to you earlier. We are pleased to be able to offer these documents electronically as it will substantially reduce the costs associated with printing and distributing paper Proxy materials. We hope you will take advantage of this process and encourage each of our shareholders to vote.
LETTER
We were saddened by the death of our long-time friend and associate, H. Glenn Doran. Glenn died on November 5, 2012. He and his wife, Ann, were long-time friends of the Company and my family. He was an original stockholder in the Company (then Kentucky Investors, Inc.) and served on its Board of Directors from 1963 until resigning in 2001 and on the board of Investors Heritage Life Insurance Company from 1992 until 2001. His son, Harold, has been a board member of our two companies since Glenn’s departure from the Boards. Glenn Doran was a very successful businessman, farmer, community leader and leader in education through his many avenues of participation.
The home office staff of Investors Heritage Life enables us to provide great service to our policyholders, funeral homes, banks and other sales associates affiliated with us. They make it possible for us to assume and purchase blocks of business, to manage them effectively and to provide third party administrative work for other companies. Our sales managers and sales associates produce the premium income vital to a successful life insurance operation. Their dedicated efforts and accomplishments are greatly appreciated.
All of these categories of associates, past and present, as well as our current Board of Directors, and their predecessors, have helped our companies to succeed and to be a stable organization with a keen eye and positive outlook for the future. Thanks to all.
| | Respectfully submitted, | |
| | | |
| | Harry Lee Waterfield II | |
| | Chairman, Chief Executive Officer | |
MANAGEMENT’S
DISCUSSION & ANALYSIS
EXECUTIVE OVERVIEW
The following discussion highlights significant factors impacting the consolidated operating results and financial condition of Investors Heritage Capital Corporation (“Investors Heritage Capital”) and its subsidiaries (collectively referred to as “we”, “us”, “our” or the “Company”) as of and for the year ended December 31, 2012, as compared with the year ended December 31, 2011. This supplementary financial information should be read in conjunction with the Consolidated Financial Statements and related Notes, all of which are integral parts of the following analysis of our results of operations and financial position.
Investors Heritage Capital is the parent company of Investors Heritage Life Insurance Company (“Investors Heritage Life”), Investors Heritage Financial Services Group, Inc. (“Investors Heritage Financial”), Investors Heritage Printing, Inc., and is the sole member of At Need Funding, LLC and Heritage Funding, LLC. Investors Heritage Capital and each subsidiary are domiciled in the Commonwealth of Kentucky. Approximately 99% of Investors Heritage Capital’s consolidated revenue is generated by Investors Heritage Life.
MAJOR MARKETS AND NEW AFFILIATIONS
Investors Heritage Life offers a full line of life insurance products including, but not limited to, whole life, term life, single premium life, multi-pay life and annuities. Investors Heritage Life’s primary lines of business are insurance policies and annuities utilized to fund preneed funeral contracts, policies sold in the senior wealth transfer market, final expense insurance, credit life and credit disability insurance, and term life and reducing term life sold through financial institutions.
We continue to focus a significant amount of our sales efforts in the preneed funeral market. We have established a strong marketing base allowing us to maintain solid premium production in our core market while operating in the currently unfavorable economic and interest rate environment.
Investors Heritage Financial operates under marketing agreements with Investors Heritage Life. These arrangements have proven successful and enabled Investors Heritage Financial and Investors Heritage Life to utilize their expertise in the marketing and administration of credit insurance products. Further, Investors Heritage Financial enables Investors Heritage Life to offer mortgage protection and ordinary life insurance products through financial institutions. Additionally, Investors Heritage Financial has marketing relationships with other unaffiliated insurance companies to provide products not currently offered by Investors Heritage Life.
Investors Heritage Life continues to market its third party administrative (“TPA”) services as an additional revenue source. These agreements, for various levels of administrative services on behalf of each company, generate fee income for Investors Heritage Life. We currently have seven TPA clients for which we provide tailored services to meet each client’s individual business needs. We have been given notice of termination relative to two TPA clients effective June 15, 2013. We have been able to perform our TPA services using our existing in-house resources.
During the second quarter of 2011, we introduced two products geared toward wealth preservation in the senior market – the Heritage Solution, a single premium life policy, and the Heritage Provider, a ten pay whole life and single premium immediate annuity combination. These products are currently being sold exclusively through our partnership with Puritan Financial Group and are being underwritten and issued using a third party underwriter with significant experience in that market. This business is being reinsured under a 50% coinsurance arrangement with a life insurance company affiliated with Puritan Financial Group. Effective January 1, 2013, this coinsurance agreement was amended to reinsure 25% of new business with that life insurance company. The statutory reserves ceded under this agreement are secured by a trust account located within the Commonwealth of Kentucky. Premiums generated during the years ended December 31, 2012 and 2011 from this partnership totaled approximately $9,448,000 and $4,749,000, respectively.
MANAGEMENT’S
DISCUSSION & ANALYSIS
On November 5, 2012, the Company entered into a new loan agreement to borrow $2,000,000. The loan calls for interest to be paid quarterly at a rate of 0.25% under the prime rate and has a maturity date of November 5, 2017. The note requires quarterly principal payments of $45,000 beginning July 5, 2015 with a balloon payment upon maturity. There is no penalty for prepayment. This note is collateralized with 55,000 shares of Investors Heritage Life Insurance Company common stock.
The borrowed funds were utilized to fund a credit agreement to Puritan Financial Companies, Inc. for $2,000,000, with interest at a rate of 1.75% above the prime rate. The maturity date on this loan is April 1, 2016. This note requires quarterly payments of interest only beginning on January 5, 2013. The unpaid principal balance together with all accrued interest shall be due and payable with a balloon payment upon maturity. Under this credit agreement, Puritan Financial Companies, Inc. and its wholly-owned subsidiary Puritan Financial Group have committed to an increased level of new business production on behalf of the Company. Additionally, Puritan Financial Companies, Inc. has issued warrants for 2,000,000 shares of common stock to the Company in exchange for this funding. This note is further collateralized by all the stock and other assets of Puritan Financial Companies, Inc. and each of its affiliated companies. Puritan Financial Companies, Inc. has another credit facility with a senior lender and the Company has a subordinate interest to the senior lender in all of the collateral which is security for this loan.
Beginning January 1, 2013, Investors Heritage Life began assuming 75% of the risks on policies sold by Puritan Life Insurance Company of America. The products being assumed are identical to the Heritage Solution and Heritage Provider products currently being written by Investors Heritage Life. However, this reinsurance arrangement will allow us to participate in the profitability of these products in certain markets where we are not currently licensed.
During the third quarter of 2011, we assumed the covered obligations of the Texas Life, Accident, Health, and Hospital Service Insurance Guaranty Association related to a block of preneed policies originally issued by Memorial Service Life Insurance Company. We received cash in exchange for assuming the covered obligations. We assumed estimated net policy liabilities totaling approximately $93,904,000 in exchange for cash totaling approximately $93,909,000. Given that the liabilities assumed approximated the consideration received, we did not establish an asset for value of business acquired. We expect this acquisition to benefit us by lowering per policy fixed expenses as well as providing long-term profitability within the block of business. However, we encountered a short-term negative effect on net income during the third quarter of 2011 due to the challenges of investing this large amount of cash in the current investment market.
During 2011, we also entered into a sales agreement with a third party national master general agent to write a new final expense policy designed specifically for their sales organization. The master general agent has an established record and extensive experience in this market. The product is being issued using simplified tele-underwriting techniques through an experienced third party underwriting firm. Premiums generated on this product during 2012 and 2011 were approximately $1,271,000 and $239,000, respectively.
MANAGEMENT’S
DISCUSSION & ANALYSIS
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The discussion and analysis of our financial condition and results of operations is based on our Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. Preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We evaluate our estimates continually, including those related to investments, deferred acquisition costs, value of business acquired, policy liabilities, income taxes, employee benefit plans, regulatory requirements, contingencies and litigation. We base such estimates on historical experience and other assumptions believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following accounting policies, judgments and estimates are the most critical to the preparation of our Consolidated Financial Statements.
Investments in Fixed Maturities, Equity Securities, Mortgage Loans and State-Guaranteed Receivables
We hold fixed maturities and equity interests in a variety of companies. Additionally, we originate, underwrite and manage mortgage loans. During 2011, we also began purchasing investments in state-guaranteed receivables consisting of the future cash flow rights from lottery prize winners. We continuously evaluate all of our investments based on current economic conditions, credit loss experience and other developments. We evaluate the difference between the cost/amortized cost and estimated fair value of our investments to determine whether any decline in fair value is other-than-temporary in nature. This determination involves a degree of uncertainty. If a decline in the fair value of a security is determined to be temporary, the decline is recognized in other comprehensive income (loss) within stockholders’ equity. If a decline in a security’s fair value is considered to be other-than-temporary, we then determine the proper treatment for the other-than-temporary impairment. For fixed maturities, the amount of any other-than-temporary impairment related to a credit loss is recognized in earnings and reflected as a reduction in the cost basis of the security; and the amount of any other-than-temporary impairment related to other factors is recognized in other comprehensive income (loss) with no change to the cost basis of the security. For equity securities, the amount of any other-than-temporary impairment is recognized in earnings and reflected as a reduction in the cost basis of the security.
The assessment of whether a decline in fair value is considered temporary or other-than-temporary includes management’s judgment as to the financial position and future prospects of the entity issuing the security. It is not possible to accurately predict when it may be determined that a specific security will become impaired. Future adverse changes in market conditions, poor operating results of underlying investments and defaults on mortgage loan payments could result in losses or an inability to recover the current carrying value of the investments, thereby possibly requiring an impairment charge in the future. Likewise, if a change occurs in our intent to sell temporarily impaired securities prior to maturity or recovery in value, or if it becomes more likely than not that we will be required to sell such securities prior to recovery in value or maturity, a future impairment charge could result.
If an other-than-temporary impairment related to a credit loss occurs with respect to a bond, we amortize the reduced book value back to the security’s expected recovery value over the remaining term of the bond. We continue to review the security for further impairment that would prompt another write-down in the book value.
MANAGEMENT’S
DISCUSSION & ANALYSIS
We classify our fixed maturities and equity securities as available-for-sale and carry them at fair value on the balance sheet, with unrealized appreciation (depreciation) relating to temporary market value changes recorded as an adjustment to other comprehensive income (loss), net of deferred acquisition costs and federal income taxes. Fair value for these investments is determined using Accounting Standards Codification principles covering Level 1, Level 2 and Level 3 instruments as further discussed in Note 3 to the Consolidated Financial Statements.
The majority of our fixed maturities are Level 2 instruments, for which the fair value is derived from readily available pricing services utilizing recent trades and broker information. Certain liquid equity securities are considered Level 1 instruments and are valued based on publicly available market quotes in an active market. We hold approximately $4,861,000 in Level 3 financial instruments, comprising 1.1% of our total investments carried at fair value. Fair value for these instruments is derived from unobservable inputs such as non-binding broker quotes and internal models using unobservable assumptions about market participants.
Deferred Acquisition Costs
The recovery of deferred acquisition costs is dependent on the future profitability of the underlying business for which acquisition costs were incurred. Each reporting period, we evaluate the recoverability of the unamortized balance of deferred acquisition costs. We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable. If we determine a portion of the unamortized balance is not recoverable, it is immediately charged to amortization expense. The assumptions we use to amortize and evaluate the recoverability of the deferred acquisition costs involve significant judgment. A revision to these assumptions may impact future financial results.
Deferred acquisition costs related to annuities and universal life insurance products are deferred to the extent deemed recoverable and amortized in relation to the present value of actual and expected gross profits on the policies. To the extent that realized gains and losses on securities result in adjustments to deferred acquisition costs related to annuities, such adjustments are reflected as a component of the amortization of deferred acquisition costs.
Deferred acquisition costs related to annuities are also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in the change in net unrealized appreciation (depreciation) on available-for-sale securities, a component of "Accumulated Other Comprehensive Income (Loss)" in the stockholders' equity section of the balance sheet.
Policy Liabilities
Estimating liabilities for our long-duration insurance contracts requires management to make various assumptions, including policyholder persistency, mortality rates, investment yields, discretionary benefit increases, new business pricing, and operating expense levels. We evaluate historical experience for these factors when assessing the need for changing current assumptions. However, since many of these factors are interdependent and subject to short-term volatility during the long-duration contract period, substantial judgment is required. Actual experience may emerge differently from that originally estimated. Any such difference would be recognized in the current year’s consolidated statement of income. We utilize in-house actuaries in developing our actuarial assumptions and estimates and in monitoring such assumptions and estimates against actual experience.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Income Taxes
We evaluate our deferred income tax assets, which partially offset our deferred tax liabilities, for any necessary valuation allowances. In doing so, we consider our ability and potential for recovering income taxes associated with such assets, which involve significant judgment. Revisions to the assumptions associated with any necessary valuation allowances would be recognized in the Consolidated Financial Statements in the period in which such revisions are made.
Employee Benefit Plans
We maintain a defined benefit retirement plan on behalf of our employees. Measurement of the future benefit obligations associated with this plan involves significant judgment, particularly in regard to the expected long-term rate of return on plan assets and the current discount rate used to calculate the present value of future obligations. The long-term rate of return for plan assets is determined based on an analysis of historical returns on invested assets, anticipated future fixed income, equity investment markets, and diversification needs. Long term trends are evaluated relative to current market factors such as inflation, interest rates and investment strategies, including risk management, in order to assess the assumptions as applied to the plan. The discount rate utilized is determined based on reviews of market indices commonly used to measure such liabilities in the industry. Changes in our assumptions can significantly impact the accrued pension liability and net periodic benefit cost recorded in the Consolidated Financial Statements. Additionally, funding of plan liabilities is sensitive to changes in investment returns as well as regulatory changes, which can significantly impact our Consolidated Financial Statements.
On May 10, 2012, the Board of Directors of the Company authorized an amendment to the IHCC Employee Retirement Plan (the “Pension Plan”) which provides that all future benefit accruals and compensation increases under the Pension Plan shall automatically cease for all individuals who are participants under the Pension Plan as of June 30, 2012. The amendment also allows such participants to continue to earn vesting credit towards their Pension Plan benefit on and after June 30, 2012.
At December 31, 2012, our unfunded status with respect to our defined benefit pension plan was $7,211,519. The curtailment of the Pension Plan resulted in a reduction in our accrued pension liability of $1,760,623, net of deferred taxes of $598,612. The estimated net loss that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost in 2013 is $776,000. We currently expect to contribute $1,440,000 to our plan during 2013, although this contribution is subject to change based on the results of current year funding analyses to be performed by plan actuaries. We continually monitor the performance of plan assets and growth in liabilities and funding necessities, utilizing independent and experienced consultants to assist in plan management.
Additionally, on June 21, 2012, the Board of Directors of the Company authorized an amendment to the IHCC Retirement Savings Plan and Trust (the “Old 401(k) Plan”), under which, effective June 30, 2012, participants in the Old 401(k) Plan shall not be eligible to elect to defer and contribute compensation earned to the Old 401(k) Plan; the Company will not make any matching contributions to the Old 401(k) Plan; and the Old 401(k) Plan will not accept rollover contributions.
On June 21, 2012, the Board of Directors of the Company also adopted a new traditional 401(k) retirement plan, the IHCC 401(k) Retirement Plan (the “Retirement Plan”). Employees will be eligible to participate in the Retirement Plan on the first day of employment. Under the Retirement Plan, the Company will match employee contributions dollar for dollar up to 4% of employee compensation deferrals. Employees who have met certain employment criteria may also be eligible to receive an additional allocation after the end of each plan year. The Retirement Plan became effective July 1, 2012.
We expect these changes in our employee benefit plans to mitigate future uncertainty with respect to defined benefit pension plans while also maintaining a competitive benefit package for our employees.
MANAGEMENT’S
DISCUSSION & ANALYSIS
New Accounting Pronouncements
In October 2010, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. Under the new guidance, acquisition costs are to include only those costs that are directly related to the acquisition or renewal of insurance contracts by applying a model similar to the accounting for loan origination costs. An entity may defer incremental direct costs of contract acquisition that are incurred in transactions with independent third parties or employees as well as the portion of employee compensation and other costs directly related to underwriting, policy issuance and processing, medical inspection, and contract selling for successfully negotiated contracts. Additionally, an entity may capitalize as a deferred acquisition cost only those advertising costs meeting the capitalization criteria for direct-response advertising. This change became effective for fiscal years beginning after December 15, 2011 and interim periods within those years. We adopted this guidance effective January 1, 2012. The adoption of this guidance did not have any effect on the Company’s results of operations, financial position or liquidity.
In May 2011, the FASB issued new guidance concerning fair value measurements and disclosure. The new guidance is the result of joint efforts by the FASB and the International Accounting Standards Board to develop a single, converged fair value framework on how to measure fair value and the necessary disclosures concerning fair value measurements. This guidance became effective for interim and annual periods beginning after December 15, 2011. The Company’s adoption of this guidance resulted in a change in certain fair value footnote disclosures but did not have any effect on the Company’s results of operations, financial position or liquidity.
In June 2011, the FASB issued updated guidance to increase the prominence of items reported in other comprehensive income by eliminating the option of presenting components of comprehensive income as part of the statement of changes in stockholders’ equity. The updated guidance requires that all non-owner changes in stockholders’ equity be presented either as a single continuous statement of comprehensive income or in two separate but consecutive statements. The updated guidance is to be applied retrospectively and became effective for the quarter ending March 31, 2012. The Company adopted this guidance utilizing two separate but consecutive statements. The Company’s adoption of this guidance resulted in a change in the presentation of the Company’s consolidated financial statements but did not have any impact on the Company’s results of operations, financial position or liquidity.
In February 2013, the FASB issued updated guidance regarding the presentation of comprehensive income. Under the guidance, an entity would separately present information about significant items reclassified out of accumulated other comprehensive income by component as well as changes in accumulated other comprehensive income balances by component in either the financial statements or the notes to the financial statements. The guidance does not change the items that are reported in other comprehensive income, does not change when an item of other comprehensive income must be reclassified to net income, and does not amend any existing requirements for reporting net income or other comprehensive income. The guidance is effective for the first interim or annual reporting period beginning after December 15, 2012 and should be applied prospectively. We are currently assessing the impact of this guidance on the presentation of the Company’s consolidated financial statements and the notes to consolidated financial statements.
MANAGEMENT’S
DISCUSSION & ANALYSIS
BUSINESS SEGMENTS
FASB guidance requires a "management approach" in the presentation of business segments based on how management internally evaluates the operating performance of business units. Accordingly, our business segments are as follows:
| | § | Preneed and Burial Products segment includes both life and annuity products sold by funeral directors or affiliated agents to fund prearranged funerals or to provide for the insured’s final expenses. |
| | § | Traditional and Universal Life Products segment includes senior wealth transfer products, traditional life, group life, certain annuities and universal life products. |
| | § | Administrative and Financial Services segment includes the administration of credit life and credit accident and health insurance products as well as the fees generated from our third party administration arrangements. |
| | § | Corporate and Other segment consists of corporate accounts primarily including stockholders' paid-in capital, earned surplus, property and equipment, company-owned life insurance and other minor business lines which include group annuities and group and individual accident and health products. |
| | § | Please see Note 9 to the Consolidated Financial Statements for additional information regarding segment data. |
OPERATING RESULTS
Consolidated Operations
Excluding the effects of consideration on reinsurance assumed relative to the acquisition of the Texas blocks of business, consolidated revenues increased approximately $5,912,000. This increase was primarily driven by increases in earned premiums and net investment income.
We experienced an increase in net earned premiums of approximately $3,473,000, or 7.9%, during 2012. This increase was predominantly due to increased sales of our current product offerings, including our preneed products and the Puritan product offering introduced during the second quarter of 2011, in addition to premiums received on the recently acquired Texas blocks of business and through the sale of our new final expense policy. Our current product offerings are performing well, although current economic conditions continue to limit disposable income typically used as a source for new sales in many of our markets.
Net investment income increased approximately $2,520,000, or 13.8%, during 2012 due primarily to our larger invested asset base as a result of the recent acquisition of the Memorial Service block of life insurance policies. The cash received in this transaction was not fully invested until late in the third quarter of 2011, which contributed to slower growth in our investment income during 2011. The current economic environment continues to put pressure on new investment yields.
Net realized gains were $484,813 and $559,001 during 2012 and 2011, respectively. The activity during each of these periods was in the normal course of business, and we experienced no other-than-temporary impairments during these periods.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Consideration on reinsurance assumed totaled $16,225 and $93,942,509 for the years ended December 31, 2012 and 2011, respectively. The 2011 amount primarily represents the payments from the Texas Life, Accident, Health, and Hospital Service Insurance Guaranty Association in settlement of assumed policy liabilities on policies previously issued by Memorial Service Life Insurance Company. The 2012 amount represents additional payments from the Texas Life, Accident, Health and Hospital Service Insurance Guaranty Association in settlement of the assumed policy liabilities under this agreement.
Other income decreased approximately $7,000, or 0.4%, during 2012. This decrease is due to the loss of certain smaller TPA clients during the year. We entered into agreements with new TPA clients late in 2012 which partially offset the reduction in income during the current year.
Excluding the effect of net policy liabilities assumed totaling approximately $93,904,000 in 2011 relative to the Memorial Service block of life insurance policies, total benefits and expenses increased approximately $4,535,000 during 2012. This increase is primarily driven by increased claims and increased commissions associated with our higher sales volume and the larger policy count derived from our assumptions of both the Memorial Service and Texas Memorial blocks of life insurance policies.
After providing for federal income taxes, our net income was $2,098,762 with net income per share of $1.82 for 2012 as compared to net income of $552,129 and net income per share of $0.48 for 2011.
We declared a dividend of $0.23 per share on February 16, 2012 to shareholders of record on March 16, 2012. This dividend was paid on April 7, 2012.
Preneed & Burial Products
Excluding the effects of consideration on reinsurance assumed relative to the acquisition of the Texas blocks of business, revenues for the preneed and burial products business segment increased approximately $3,529,000, or 7.8%, in 2012 compared to 2011. This increase is predominantly due to the previously mentioned stronger sales of our existing preneed and final expense products and ongoing premium income generated as a result of the recent acquisitions, along with increased net investment income. Our pre-tax income (loss) increased approximately $1,734,000 in 2012 compared to prior year. The improvement in pre-tax income was driven by increased sales, increased premium and reduction of unit expenses due to recent acquisitions, and an adjustment to preneed death benefit crediting rates early in 2012. Additionally, while we continue to face crediting rate spread pressure due to lower investment income yields, our increased invested asset base has contributed to our improvement in pre-tax income. Finally, the reserve increases on the acquisition of the Memorial Service block of life insurance policies during the third quarter of 2011 were significantly larger than the associated earned investment income on that block during that quarter of 2011 due to the delay in investing the cash received in the acquisition.
MANAGEMENT’S
DISCUSSION & ANALYSIS
The table below provides the detail of premiums for the top ten producing states for this segment:
Preneed Premium Production First Year and Single Year Ended December 31 | |
| | | | | | | |
| | | 2012 | | | 2011 | |
| North Carolina | | $ | 7,344,795 | | | $ | 6,828,999 | |
| Kentucky | | | 5,503,080 | | | | 5,856,283 | |
| Tennessee | | | 3,786,330 | | | | 3,500,699 | |
| Georgia | | | 2,502,680 | | | | 1,927,586 | |
| Indiana | | | 1,659,096 | | | | 1,276,093 | |
| Virginia | | | 1,494,955 | | | | 1,541,029 | |
| Ohio | | | 1,004,634 | | | | 998,725 | |
| South Carolina | | | 487,353 | | | | 558,788 | |
| Michigan | | | 480,699 | | | | 357,879 | |
| Florida | | | 402,295 | | | | 278,387 | |
| All Other States | | | 1,092,581 | | | | 1,060,474 | |
| TOTAL | | $ | 25,758,498 | | | $ | 24,184,942 | |
We currently market the Legacy Gold and Heritage Final Expense II products within this segment. The Legacy Gold life insurance and annuity product series is sold in the preneed market in conjunction with prearranged funerals. The Legacy Gold series includes both single premium and multi-pay policies, and both underwritten and guaranteed options are available. The Heritage Final Expense II product is sold in the final expense market. This product is a non-participating whole life insurance product with simplified underwriting.
As noted previously, we launched the Heritage Advantage final expense product during 2011 for use through a third party national master general agent distribution system. The master general agent has an established record and extensive experience in this market. The product is being issued using simplified tele-underwriting techniques through an experienced third party underwriting firm.
Traditional & Universal Life Products
Revenues for 2012 increased approximately $2,482,000, or 14.7%, while pre-tax income increased approximately $64,000. The increase in revenue and pre-tax income is primarily due to strong sales, including sales of the Puritan product offering which was not introduced until the second quarter of 2011. We have also experienced a reduction in unit expenses that has contributed to our increase in pre-tax income.
During the second quarter of 2011, we introduced two products geared toward wealth preservation in the senior market – the Heritage Solution, a single premium life policy, and the Heritage Provider, a ten pay whole life and single premium immediate annuity combination. These products are currently being sold exclusively through our partnership with Puritan Financial Group and are being underwritten and issued using a third party underwriter with significant experience in that market. This business is being reinsured under a 50% coinsurance arrangement with a life insurance company affiliated with Puritan Financial Group. Effective January 1, 2013, this coinsurance agreement was amended to reinsure 25% of new business with that life insurance company. Additionally, these products were re-priced effective January 1, 2013 to account for lower required valuation rates and the current economic environment.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Beginning January 1, 2013, Investors Heritage Life began assuming 75% of the risks on policies sold by Puritan Life Insurance Company of America. The products being assumed are identical to the Heritage Solution and Heritage Provider products currently being written by Investors Heritage Life. However, this reinsurance arrangement will allow us to participate in the profitability of these products in certain markets where we are not currently licensed.
Our traditional and universal life products also include the HLW Choice Whole Life product and the Heritage Protector IV product. The HLW Choice Whole Life product is designed with numerous options and with flexibility to achieve our customers’ goals. The Heritage Protector IV product is a term product marketed primarily by banks and other financial institutions in conjunction with consumer credit.
Investors Heritage Financial markets traditional insurance products through banks and other financial institutions. Investors Heritage Financial markets Investors Heritage Life products and continues to expand the portfolio of products available to our regular ordinary insurance agents by offering products of other unaffiliated companies. For a number of years, we have provided outlets for our agents with substandard business that Investors Heritage Life will not accept. Investors Heritage Financial has provided “second to die” policies, substandard life policies, larger term policies and health insurance products through other unaffiliated insurance companies. Investors Heritage Financial receives a fee for providing those services.
We utilize a combination of yearly renewable term reinsurance and coinsurance to cede life insurance coverage in excess of our $25,000 per life retention limit. Most of our business is written in the smaller face amount markets and, in the past, claims on larger-case ordinary business caused income fluctuations. This lower retention level has stabilized earnings fluctuations in this segment. The lowered retention was achieved by maintaining the established reinsurance treaties and adding additional yearly renewable term treaties for amounts between $25,000 net amount at risk and the previous retention of $100,000.
During 2012, Investors Heritage Life terminated its participation in the Federal Employees’ Group Life Insurance (“FEGLI”) and Servicemen’s Group Life Insurance (“SGLI”) programs. The termination of our participation in FEGLI was effective September 30, 2012 while the termination of our participation in SGLI was effective July 1, 2012. These terminations did not have a significant impact on the results of our operations. However, the terminations did reduce certain items within the balance sheet, including the policy claims liability and due premiums for reinsurance assumed compared to the prior year.
Administrative & Financial Services
This segment includes the administration of credit life and credit accident and health insurance products. We reinsure 100% of the related underwriting risk on credit products currently produced within this segment. Accordingly, credit product revenue is generated primarily from initiation fees as well as fees for servicing and administering the credit business for our reinsurers. Because the credit product revenue is fee-based, performance is in direct relation to new premium production coupled with fees generated as premiums are earned. Premium production within this segment is also significantly affected by economic conditions within our credit markets, particularly Kentucky.
In addition to credit administration, this segment includes fees generated relative to our third party administrative relationships. We currently provide tailored administrative services for seven unaffiliated companies, comprised of five life insurance companies and two holding companies. Services provided to each company vary based on their needs and can include some or all aspects of back-office accounting, actuarial services and policy administration. We have been given notice of termination relative to two third party administration clients effective June 15, 2013.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Revenues for this segment decreased approximately $45,000, or 2.9%, in 2012 while pre-tax income increased approximately $37,000. The decrease in revenues is due to the loss of certain smaller TPA clients during the current year, the effects of which were partially offset by new TPA client agreements entered late in 2012. The increase in pre-tax income is primarily due to reductions in general expenses during the current year.
Corporate & Other
Corporate & Other consists of corporate accounts measured primarily by stockholders’ paid-in capital, contributed surplus, earned surplus, property and equipment, corporate-owned life insurance and other minor business lines which include group annuities and group and individual accident and health products. Revenues from this segment decreased approximately $53,000, or 6.7%, in 2012, while pre-tax income decreased $223,000. The decreases in revenues and pre-tax income are primarily due to the change in the mark-to-market adjustment on our investment in derivative. In 2012, this adjustment resulted in a decrease in revenue and pre-tax income of $110,100. In 2011, this adjustment increased revenue and pre-tax income by $107,700.
During 2012, Investors Heritage Financial's revenues were approximately $217,000, up $47,000 compared to 2011. Investors Heritage Financial paid dividends to Investors Heritage Capital totaling $225,000 during 2012. Revenues from Investors Heritage Printing were approximately $164,000 in 2012, down $39,000 compared to 2011. Investors Heritage Printing did not pay any dividends to Investors Heritage Capital. Revenues from At Need Funding were approximately $78,000 in 2012, down $27,000 compared to 2011. At Need Funding paid distributions to Investors Heritage Capital totaling $100,000 during 2012. Revenues from all non-Investors Heritage Life sources constitute less than 1% of total consolidated revenues in 2012, and management is working on the continued growth and profitability of each of the non-life subsidiaries.
INVESTMENTS, LIQUIDITY AND CAPITAL RESOURCES
Investments
Together with our outside investment advisor and portfolio manager, we manage the fixed income investment portfolio to achieve the Company’s investment goals, which include the diversification of credit risk, the maintenance of adequate portfolio liquidity, the management of interest rate risk and the maximization of investment returns. The primary investment objectives are to maintain the quality and integrity of the fixed income portfolio while improving the total return on investments.
We maintain a sound, conservative investment strategy. As of December 31, 2012, 92.2% of our total invested assets consisted of fixed income securities, compared to 92.0% at December 31, 2011. At December 31, 2012 and 2011, our fixed income investments were 95.8% and 96.8% investment grade, respectively, as rated by Standard & Poor's. The Standard & Poor's average quality rating of our fixed income portfolio holdings as of December 31, 2012 was A+. None of our investments are in default.
MANAGEMENT’S
DISCUSSION & ANALYSIS
The fixed income portfolio is diversified among sectors. At December 31, 2012 and 2011, the fixed income portfolio was allocated as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| Corporate: | | | | | | |
| Bank and finance | | | 15.8 | % | | | 15.5 | % |
| Industrial and miscellaneous | | | 37.0 | % | | | 37.6 | % |
| Government | | | 11.8 | % | | | 13.3 | % |
| Mortgage-backed securities | | | 9.5 | % | | | 12.8 | % |
| Foreign | | | 12.5 | % | | | 6.9 | % |
| Asset-backed securities | | | 1.1 | % | | | 1.3 | % |
| States and political subdivisions | | | 12.3 | % | | | 12.6 | % |
The fixed maturities and equity securities within our portfolio are in a net unrealized gain position of approximately $44,223,000 at December 31, 2012. Please see Note 3 to the Consolidated Financial Statements for additional information regarding these fair values.
The fixed income portfolio includes approximately $41,814,000 (at fair value) of mortgage-backed securities ("MBS"). MBS have historically added value to the portfolio and our outside investment advisor has provided the expertise to purchase MBS with confidence that the credit ratings have been properly analyzed and that the investment properly suits our asset and liability needs.
There have been concerns expressed by rating agencies, various regulators and other constituencies regarding investments in MBS by insurers and other financial institutions. Although these highly rated securities provide excellent credit quality, their liquidity risk must be monitored. Except for eight commercial-backed mortgages of approximately $6,837,000, all of the collateral of the MBS owned are guaranteed by the Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") or Federal Home Loan Mortgage Corporation ("FHLMC").
The FNMA and FHLMC securities are structured either as publicly traded collateralized mortgage obligations ("CMO") or pass-throughs. Unlike most corporate or real estate debt, the primary concern with MBS is the uncertainty of timing of cash flows due to prepayment assumptions rather than the possibility of loss of principal.
CMO holdings represent approximately 38% of the total MBS portfolio. In accordance with relevant accounting guidance, when these securities are purchased at a discount or premium, the income yield will vary with changes in prepayment speeds due to the change in accretion of discount or amortization of premium, as well as the timing of the basic principal and interest cash flows. The overall impact of the CMO’s variability in yields on the portfolio has not been significant in relation to the yield and cash flows of the total invested assets. More importantly, the investment portfolio has no exposure to more volatile, high-risk CMO’s, such as those structured to share in residual cash flows. Except for three sequential pay CMO’s totaling approximately $5,426,000, the CMO’s held are either planned amortization class bonds or support class bonds, both of which are structured to provide more certain cash flows to the investor and therefore have reduced prepayment risk. Based on our analysis of the investment portfolio, there are no impairment issues with respect to our CMO’s.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Pass-throughs comprise the remainder of MBS owned, representing approximately 62% of the total MBS portfolio. Pass-throughs are FNMA or FHLMC guaranteed MBS that, simply stated, pass through interest and principal payments to the investors in accordance with their respective ownership percentage.
We continuously monitor the investment risk within our portfolio, including the risk associated with subprime lending with our CMO investments. As of December 31, 2012, we have only one CMO, with a fair value of approximately $59,000, which has any level of direct subprime exposure. Based on our analysis, we believe this investment is of high quality and expect no losses as a result of the current subprime concerns. Additionally, we have no Alt-A bond exposure within our current holdings.
During 2012, we sold our investment in Farmers Bank Capital Corporation common stock. An other-than-temporary impairment had previously been recorded on this holding. The gain associated with this sale totaled $121,976. We have no remaining assets for which other-than-temporary impairments have been recorded.
We also engage in commercial and residential mortgage lending, with approximately 99.9% of these investments in commercial properties. All mortgage loans are either originated in-house or through two mortgage brokers, are secured by first mortgages on the real estate and generally carry personal guarantees by the borrowers. Loan to value ratios of 80% or less and debt service coverage from existing cash flows of 115% or higher are generally required. We minimize credit risk in our mortgage loan portfolio through various methods, including stringently underwriting the loan request, maintaining small average loan balances, and reviewing larger mortgage loans on an annual basis. The average loan balance is $386,518 and the average loan to value is 40%. The largest loan currently held is $795,129. Our mortgage loans are spread across properties located in 14 states primarily in the southeastern United States, with approximately 81.9% of our loans located in the states of Florida, Kentucky, Georgia, Texas, Ohio and Tennessee. At December 31, 2012 and 2011, 3.5% and 4.2% of invested assets consisted of mortgage loans, respectively.
The portfolio consists of the following property types:
| | | | December 31 | | |
| | | | 2012 | | | 2011 | | |
| | Office | | | 7.1 | % | | | 19.0 | % | |
| | Retail | | | 79.0 | % | | | 67.7 | % | |
| | Industrial | | | 3.7 | % | | | 3.6 | % | |
| | Medical | | | 3.7 | % | | | 3.4 | % | |
| | Apartments | | | 4.6 | % | | | 4.6 | % | |
| | Other | | | 1.9 | % | | | 1.7 | % | |
We are familiar with our mortgage loan markets and given our low loan-to-value ratios, we do not believe that current economic conditions will have a material negative impact on our mortgage loan portfolio. We have been successful in adding value to the total investment portfolio through mortgage loan originations due to the fact that yields realized from the mortgage loan portfolio are generally higher than yields realized from fixed income investments. Value has also been added because the mortgage loan portfolio has consistently performed well. As of December 31, 2012 and 2011, we had no non-performing mortgage loans, which would include loans past due 90 days or more, loans in process of foreclosure, restructured loans and real estate acquired through foreclosure.
MANAGEMENT’S
DISCUSSION & ANALYSIS
During the third quarter of 2011, we began purchasing investments in state-guaranteed receivables. These investments represent an assignment of the future rights to cash flows from lottery winners purchased at a discounted price. Payments on these investments are made by state run lotteries and guaranteed by the states. As these payment streams are secured by the states themselves, a key function of our due diligence is the assessment of the states’ ability to meet these obligations. Additionally, each state generally withholds income tax from each payment for which we must file for reimbursement of such tax annually. We carry the state-guaranteed receivables at their amortized cost basis on the balance sheet. As of December 31, 2012, we hold approximately $8,112,000 in state-guaranteed receivables, with the largest concentrations in the states of New York and Massachusetts totaling approximately $3,974,000 and $2,710,000, respectively. At December 31, 2012, 1.7% of invested assets consisted of state-guaranteed receivables compared to 1.4% at December 31, 2011.
During the third quarter of 2011, we purchased a $3,000,000 position in a Morgan Stanley market-indexed note. The note pays 1% interest annually and matures in six years. In exchange for the reduced interest rate, the investment provides a protected level of equity market exposure. At the maturity date, we participate at 110% of any increase in the Dow Jones Industrial Average as compared to the purchase date, but our principal is guaranteed against market-related downside risk. We remain subject to counterparty credit risk associated with the issuer, Morgan Stanley, just as we would with any other fixed maturity or equity security within our portfolio. The equity-linked portion of the investment is classified as a derivative and bifurcated for reporting purposes. The derivative portion is reported as an investment in derivative on the balance sheet. This derivative is required to be marked-to-market through the income statement, with the change in value reported as a component of investment income on the income statement. As of December 31, 2012 and 2011, the derivative investment was valued at $642,600 and $752,700, respectively. We recognized a decrease in investment income of $110,100 during 2012 relative to the mark-to-market adjustment on this investment compared to an increase in investment income of $107,700 during 2011 relative to the mark-to-market adjustment.
Liquidity and Capital Resources
The quality of our investment portfolio and the current level of stockholders' equity continue to provide a sound financial base as we strive to expand our marketing system and to offer competitive, quality products. Our investment portfolio continues to provide financial stability. It is management's opinion that we have adequate cash flows both on a long-term and short-term basis as evidenced by the net cash flows provided by operating activities in the consolidated statements of cash flows presented in this Annual Review. Investors Heritage Life’s primary sources of cash flows are primarily insurance premiums, which include mortality and expense charges, investment income, administrative service fees, and cash received on the assumptions of blocks of business.
Investors Heritage Life’s short-term obligations consist primarily of policyholder benefits and operating expenses. Investors Heritage Life has historically been able to meet these obligations out of operating cash, premiums and investment income.
Investors Heritage Life’s principal long-term obligations are fixed contractual obligations incurred in the sale of its life insurance products. The premiums charged for these products are based on conservative and actuarially sound assumptions as to mortality, persistency and interest. We believe these assumptions will produce revenues sufficient to meet our future contractual benefit obligations and operating expenses, and provide an adequate profit margin.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Investors Heritage Capital’s principal sources of cash flow are rental income and dividends from its subsidiaries. Investors Heritage Capital’s principal long-term obligations are payments on long-term debt.
The stability of our liquidity is found in our conservative approach to product development and in the strength and stability of our fixed income portfolio and mortgage loans. Liquidity is also managed by laddering maturities of our fixed income portfolio. The average duration of our fixed income investments is 5.4 years with approximately $27,648,000 due within twelve months and approximately $62,167,000 due within the following four years. Historically, management has anticipated that all such investments will be held until maturity. However, one of the responsibilities of our independent portfolio manager is to constantly monitor the credit rating of our fixed income investments to determine if rating changes of any investment requires action by management. As explained in detail in Note 1 to the Consolidated Financial Statements, all fixed income securities and all marketable equity securities are classified as available-for-sale and are carried at fair value.
On November 5, 2012, the Company entered into a new loan agreement to borrow $2,000,000. The loan calls for interest to be paid quarterly at a rate of 0.25% under the prime rate and has a maturity date of November 5, 2017. The note requires quarterly principal payments of $45,000 beginning July 5, 2015 with a balloon payment upon maturity. There is no penalty for prepayment. This note is collateralized with 55,000 shares of Investors Heritage Life Insurance Company common stock. At December 31, 2012, the outstanding principal balance on the bank note was $2,000,000.
The borrowed funds were utilized to fund a credit agreement to Puritan Financial Companies, Inc. for $2,000,000, with interest at a rate of 1.75% above the prime rate. The maturity date on this loan is April 1, 2016. This note requires quarterly payments of interest only beginning on January 5, 2013. The unpaid principal balance together with all accrued interest shall be due and payable with a balloon payment upon maturity. Under this credit agreement, Puritan Financial Companies, Inc. and its wholly-owned subsidiary Puritan Financial Group have committed to an increased level of new business production on behalf of the Company. Additionally, Puritan Financial Companies, Inc. has issued warrants for 2,000,000 shares of common stock to the Company in exchange for this funding. This note is further collateralized by all the stock and other assets of Puritan Financial Companies, Inc. and each of its affiliated companies. Puritan Financial Companies, Inc. has another credit facility with a senior lender and the Company has a subordinate interest to the senior lender in all of the collateral which is security for this loan. This $2,000,000 note receivable is included within other invested assets on the balance sheet.
Effective September 29, 2011, we renewed for two years our line of credit for At Need Funding, which is used for the purpose of funding at-need funerals secured by the assignment of verified, incontestable life insurance policies. This line of credit was reduced from $2,000,000 to $1,000,000. Effective September 27, 2011, we also renewed for two years our $150,000 operating line of credit. These lines of credit require interest to be paid monthly at the prime rate, with a floor of 3.25%. At December 31, 2012, the outstanding principal balance on the At Need Funding line of credit was $490,220. At December 31, 2012, there was no amount outstanding on the operating line of credit.
On February 3, 2005, Investors Heritage Capital borrowed $3,650,000 to finance the purchase of certain home office property previously owned by Investors Heritage Life at a purchase price of $3,650,000. The note is an amortizing loan with a fixed interest rate of 5.05% and with a maturity date of March 1, 2015. The proceeds received by Investors Heritage Life were used to repay their surplus notes to Investors Heritage Capital. Additionally, Investors Heritage Capital used the proceeds to repay the $3,000,000 bank note outstanding at December 31, 2004. This transaction was approved by the Kentucky Department of Insurance. At December 31, 2012, $988,393 remained outstanding on this note.
MANAGEMENT’S
DISCUSSION & ANALYSIS
We are a member of the Federal Home Loan Bank of Cincinnati, Ohio by way of our investment in shares of their common stock. As a member, we have access to both short-term and long-term borrowings at below market rates. Borrowings under this program are collateralized by securities within our investment portfolio. To this point, we have not needed to access this borrowing capacity.
We assess our compliance with prescribed debt covenant requirements as outlined in the terms of each debt agreement at least annually, if not otherwise required in the debt agreement. Management has assessed our position as of December 31, 2012, and we are in compliance with all debt covenant requirements.
Management is not aware of any other commitments or unusual events that could materially affect our capital resources. We have the option to prepay certain notes payable at our discretion prior to their maturity dates.
Other than the items disclosed in Note 7 to the Consolidated Financial Statements and increased federal and state regulatory reporting requirements which generally increase administrative expenses, management is not aware of any current recommendations by any regulatory authority which, if implemented, would have any material effect on our liquidity, capital resources or operations.
We will continue to explore various opportunities, including mergers and acquisitions and purchasing blocks of business from other companies, which may dictate a need for either long-term or short-term debt. There are no restrictions as to use of funds except the restriction on Investors Heritage Life as to the payment of cash dividends to shareholders that is discussed in more detail in Note 7 to the Consolidated Financial Statements.
REGULATORY MATTERS
The statutory capital and surplus of Investors Heritage Life increased approximately $1,041,000 in 2012. The increase in statutory capital and surplus in 2012 is primarily related to current year net income and an increase in admissible deferred tax assets, which were partially offset by an increase in the asset valuation reserve and increases in certain non-admitted assets. Investors Heritage Life produced a statutory operating gain of approximately $1,677,000 and $1,103,000 in 2012 and 2011, respectively, before the effect of the realized gains (losses). For additional discussion on statutory accounting practices refer to Note 8 to the Consolidated Financial Statements.
OFF-BALANCE SHEET ARRANGEMENTS
We have no off-balance sheet arrangements as of December 31, 2012.
FORWARD LOOKING INFORMATION
We caution readers regarding certain forward-looking statements contained in this report and in any other statements made by us, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Statements using verbs such as "expect", "anticipate", "believe" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent our beliefs concerning future levels of sales and redemptions of our products, investment spreads and yields or the earnings and profitability of our activities.
MANAGEMENT’S
DISCUSSION & ANALYSIS
Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which are subject to change. These uncertainties and contingencies could cause actual results to differ materially from those expressed in any forward-looking statements made by us, or on our behalf. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable factors and developments. Some of these may be national in scope, such as general economic conditions, changes in tax laws and changes in interest rates. Some may be related to the insurance industry generally, such as pricing competition, regulatory developments, industry consolidation and the effects of competition in the insurance business from other insurance companies and other financial institutions operating in our market area and elsewhere. Others may relate to us specifically, such as credit, volatility and other risks associated with our investment portfolio. We caution that such factors are not exclusive. We disclaim any obligation to update forward-looking information.
MANAGEMENT’S REPORT ON INTERNAL
CONTROL OVER FINANCIAL REPORTING
Management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is designed to provide reasonable assurances regarding the reliability of financial reporting and the preparation of our Consolidated Financial Statements in accordance with U.S. generally accepted accounting principles. Our accounting policies and internal controls over financial reporting, established and maintained by management, are under the general oversight of our Audit Committee.
Our internal control over financial reporting includes those policies and procedures that:
| | § | pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; |
| | § | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of our management and directors; and |
| | § | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the financial statements. |
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management has assessed our internal control over financial reporting as of December 31, 2012. The standard measures adopted by management in making its evaluation are the measures in the Internal Control Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission.
Based upon its assessment, management has concluded that our internal control over financial reporting is effective at December 31, 2012, and that there were no material weaknesses in our internal control over financial reporting as of that date.
This annual report does not include an attestation report of our independent registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.
REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Investors Heritage Capital Corporation
We have audited the accompanying consolidated balance sheets of Investors Heritage Capital Corporation (“the Company”) as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for the years then ended. The Company’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Investors Heritage Capital Corporation as of December 31, 2012 and 2011, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Louisville, Kentucky
March 26, 2013
INVESTORS HERITAGE CAPITAL CORPORATION
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2012 AND 2011
| | | 2012 | | | 2011 | |
| ASSETS | | | | | | |
| Investments: | | | | | | |
| Securities available-for-sale, at fair value: | | | | | | |
| Fixed maturities (amortized cost: 2012 - $394,370,377; 2011- $389,789,791) | | $ | 438,323,413 | | | $ | 421,640,668 | |
| Equity securities (cost: 2012 - $1,117,051; 2011 - $1,099,678) | | | 1,386,637 | | | | 1,376,140 | |
| Mortgage loans on real estate | | | 16,620,290 | | | | 19,332,470 | |
| Policy loans | | | 6,781,751 | | | | 7,050,892 | |
| State-guaranteed receivables | | | 8,111,669 | | | | 6,468,912 | |
| Investment in derivative | | | 642,600 | | | | 752,700 | |
| Other invested assets | | | 3,420,189 | | | | 1,736,766 | |
| Total investments | | $ | 475,286,549 | | | $ | 458,358,548 | |
| | | | | | | | | |
| Cash and cash equivalents | | | 6,009,905 | | | | 6,534,616 | |
| Accrued investment income | | | 5,163,783 | | | | 4,978,676 | |
| Due premiums | | | 3,422,629 | | | | 3,697,869 | |
| Deferred acquisition costs | | | 16,654,246 | | | | 16,619,021 | |
| Value of business acquired | | | 513,667 | | | | 674,762 | |
| Leased property under capital leases | | | 577,839 | | | | 505,541 | |
| Property and equipment | | | 1,900,068 | | | | 1,751,706 | |
| Cash value of company-owned life insurance | | | 10,844,489 | | | | 9,899,557 | |
| Other assets | | | 1,835,666 | | | | 1,242,250 | |
| Amounts recoverable from reinsurers | | | 53,797,125 | | | | 47,582,367 | |
| Total assets | | $ | 576,005,966 | | | $ | 551,844,913 | |
| | | | | | | | | |
| LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | | | | |
| LIABILITIES | | | | | | | | |
| Policy liabilities: | | | | | | | | |
| Benefit reserves | | $ | 464,449,101 | | | $ | 451,421,904 | |
| Unearned premium reserves | | | 9,111,514 | | | | 9,568,125 | |
| Policy claims | | | 1,894,727 | | | | 2,098,959 | |
| Liability for deposit-type contracts | | | 3,147,458 | | | | 3,007,905 | |
| Reserves for dividends and endowments and other | | | 446,016 | | | | 526,480 | |
| Total policy liabilities | | $ | 479,048,816 | | | $ | 466,623,373 | |
| Deferred federal income tax liability | | | 13,189,478 | | | | 9,325,937 | |
| Obligations under capital leases | | | 568,214 | | | | 496,958 | |
| Notes payable | | | 3,478,613 | | | | 1,781,337 | |
| Accrued pension liability | | | 7,211,519 | | | | 9,547,038 | |
| Other liabilities | | | 4,276,542 | | | | 6,406,549 | |
| Total liabilities | | $ | 507,773,182 | | | $ | 494,181,192 | |
| | | | | | | | | |
| STOCKHOLDERS' EQUITY | | | | | | | | |
| Common stock (shares issued: 2012-1,141,886; 2011-1,152,737) | | $ | 1,141,886 | | | $ | 1,152,737 | |
| Paid-in surplus | | | 8,908,243 | | | | 8,832,222 | |
| Accumulated other comprehensive income | | | 22,539,724 | | | | 13,605,484 | |
| Retained earnings | | | 35,642,931 | | | | 34,073,278 | |
| Total stockholders' equity | | $ | 68,232,784 | | | $ | 57,663,721 | |
| Total liabilities and stockholders' equity | | $ | 576,005,966 | | | $ | 551,844,913 | |
See Notes to Consolidated Financial Statements.
INVESTORS HERITAGE CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011
| | | 2012 | | | 2011 | |
| REVENUE | | | | | | |
| Premiums and other considerations | | $ | 67,491,855 | | | $ | 59,877,767 | |
| Premiums ceded | | | (19,997,026 | ) | | | (15,855,869 | ) |
| Net premiums earned | | | 47,494,829 | | | | 44,021,898 | |
| | | | | | | | | |
| Investment income, net of expenses | | | 20,726,267 | | | | 18,206,256 | |
| Net realized gains on investments: | | | | | | | | |
| Total other-than-temporary impairment losses | | | - | | | | - | |
| Portion of loss recognized in other comprehensive income | | | - | | | | - | |
| Other net realized investment gains | | | 484,813 | | | | 559,001 | |
| Total net realized gains on investments | | | 484,813 | | | | 559,001 | |
| Consideration on reinsurance assumed | | | 16,225 | | | | 93,942,509 | |
| Other income | | | 1,707,589 | | | | 1,714,352 | |
| Total revenue | | $ | 70,429,723 | | | $ | 158,444,016 | |
| | | | | | | | | |
| BENEFITS AND EXPENSES | | | | | | | | |
| Death and other benefits | | $ | 41,866,578 | | | $ | 37,768,774 | |
| Guaranteed annual endowments | | | 446,190 | | | | 463,817 | |
| Dividends to policyholders | | | 418,273 | | | | 438,787 | |
| Increase in benefit reserves and unearned premiums | | | 9,777,951 | | | | 103,679,054 | |
| Acquisition costs deferred | | | (8,849,807 | ) | | | (6,267,513 | ) |
| Amortization of deferred acquisition costs | | | 8,489,322 | | | | 6,874,879 | |
| Commissions | | | 4,970,710 | | | | 3,130,715 | |
| Other general and administrative expenses | | | 11,215,041 | | | | 11,872,254 | |
| Total benefits and expenses | | $ | 68,334,258 | | | $ | 157,960,767 | |
| | | | | | | | | |
| INCOME BEFORE FEDERAL INCOME TAXES | | $ | 2,095,465 | | | $ | 483,249 | |
| | | | | | | | | |
| PROVISION (BENEFIT) FOR FEDERAL INCOME TAXES | | | | | | | | |
| Current | | $ | 757,918 | | | $ | 318,687 | |
| Deferred | | | (761,215 | ) | | | (387,567 | ) |
| Total federal income taxes | | $ | (3,297 | ) | | $ | (68,880 | ) |
| | | | | | | | | |
| | | | | | | | | |
| NET INCOME | | $ | 2,098,762 | | | $ | 552,129 | |
| | | | | | | | | |
| | | | | | | | | |
| BASIC AND DILUTED NET EARNINGS PER SHARE | | $ | 1.82 | | | $ | 0.48 | |
See Notes to Consolidated Financial Statements.
INVESTORS HERITAGE CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011
| | | 2012 | | | 2011 | |
| | | | | | | |
| NET INCOME | | $ | 2,098,762 | | | $ | 552,129 | |
| | | | | | | | | |
| OTHER COMPREHENSIVE INCOME: | | | | | | | | |
| Change in net unrealized gains on available-for-sale securities: | | | | | | | | |
| Unrealized holding gains arising during period | | | 12,580,096 | | | | 14,172,171 | |
| Reclassification adjustment for gains included in income | | | (484,813 | ) | | | (559,001 | ) |
| Adjustment for effects of deferred acquisition costs | | | (325,260 | ) | | | (224,440 | ) |
| Net unrealized gains on investments | | | 11,770,023 | | | | 13,388,730 | |
| Change in defined benefit pension plan: | | | | | | | | |
| Actuarial net loss on pension plan | | | (885,028 | ) | | | (4,856,491 | ) |
| Amortization of actuarial net loss in net periodic pension cost | | | 913,378 | | | | 705,713 | |
| Curtailment of defined benefit pension plan | | | 1,760,623 | | | | - | |
| Net change in defined benefit pension plan | | | 1,788,973 | | | | (4,150,778 | ) |
| | | | | | | | | |
| Other comprehensive income before income taxes | | | 13,558,996 | | | | 9,237,952 | |
| | | | | | | | | |
| Income tax expense | | | 4,624,756 | | | | 3,114,560 | |
| | | | | | | | | |
| OTHER COMPREHENSIVE INCOME, NET OF TAXES | | | 8,934,240 | | | | 6,123,392 | |
| | | | | | | | | |
| COMPREHENSIVE INCOME | | $ | 11,033,002 | | | $ | 6,675,521 | |
See Notes to Consolidated Financial Statements.
INVESTORS HERITAGE CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011
| | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | |
| BALANCE, JANUARY 1, 2011 | | $ | 1,151,817 | | | $ | 8,801,514 | | | $ | 7,482,092 | | | $ | 33,737,040 | | | $ | 51,172,463 | |
| | | | | | | | | | | | | | | | | | | | | |
| Net income | | | - | | | | - | | | | - | | | | 552,129 | | | | 552,129 | |
| Other comprehensive income, net | | | - | | | | - | | | | 6,123,392 | | | | - | | | | 6,123,392 | |
| Cash dividends | | | - | | | | - | | | | - | | | | (207,327 | ) | | | (207,327 | ) |
| Issuances of common stock, net | | | 920 | | | | 30,708 | | | | - | | | | (8,564 | ) | | | 23,064 | |
| BALANCE, DECEMBER 31, 2011 | | $ | 1,152,737 | | | $ | 8,832,222 | | | $ | 13,605,484 | | | $ | 34,073,278 | | | $ | 57,663,721 | |
| | | | | | | | | | | | | | | | | | | | | |
| Net income | | | - | | | | - | | | | - | | | | 2,098,762 | | | | 2,098,762 | |
| Other comprehensive income, net | | | - | | | | - | | | | 8,934,240 | | | | - | | | | 8,934,240 | |
| Cash dividends | | | - | | | | - | | | | - | | | | (265,129 | ) | | | (265,129 | ) |
| Issuances of common stock, net | | | (10,851 | ) | | | 76,021 | | | | - | | | | (263,980 | ) | | | (198,810 | ) |
| BALANCE, DECEMBER 31, 2012 | | $ | 1,141,886 | | | $ | 8,908,243 | | | $ | 22,539,724 | | | $ | 35,642,931 | | | $ | 68,232,784 | |
See Notes to Consolidated Financial Statements.
INVESTORS HERITAGE CAPITAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2012 AND 2011
| | | 2012 | | | 2011 | |
| OPERATING ACTIVITIES | | | | | | |
| Net income | | $ | 2,098,762 | | | $ | 552,129 | |
Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | | |
| Net realized gains on investments | | | (484,813 | ) | | | (559,001 | ) |
| Provision (benefit) for deferred federal income taxes | | | (761,215 | ) | | | (387,567 | ) |
| Amortization of deferred acquisition costs | | | 8,489,322 | | | | 6,874,879 | |
| Acquisition costs deferred | | | (8,849,807 | ) | | | (6,267,513 | ) |
| Net adjustment for premium and discount on investments | | | 269,479 | | | | 549,625 | |
| Depreciation and other amortization | | | 687,059 | | | | 488,727 | |
| Change in value of derivative investment | | | 110,100 | | | | (107,700 | ) |
| Changes in operating assets and liabilities: | | | | | | | | |
| Accrued investment income | | | (185,107 | ) | | | (1,052,085 | ) |
| Due premiums | | | 275,240 | | | | 74,200 | |
| Cash value of company-owned life insurance | | | (944,932 | ) | | | (878,125 | ) |
| Amounts recoverable from reinsurers | | | (6,214,758 | ) | | | (3,472,435 | ) |
| Benefit reserves | | | 15,919,314 | | | | 107,194,649 | |
| Policy claims | | | (204,232 | ) | | | 211,823 | |
| Liability for deposit-type contracts | | | 139,553 | | | | 216,644 | |
| Reserves for dividends and endowments and other | | | (80,464 | ) | | | (9,438 | ) |
| Other assets and other liabilities | | | (3,198,716 | ) | | | 3,904,070 | |
| NET CASH PROVIDED BY OPERATING ACTIVITIES | | $ | 7,064,785 | | | $ | 107,332,882 | |
| INVESTING ACTIVITIES | | | | | | | | |
| Purchases of available-for-sale securities | | $ | (39,049,112 | ) | | $ | (129,959,966 | ) |
| Sales of available-for-sale securities | | | 5,948,093 | | | | 5,328,369 | |
| Maturities of available-for-sale securities | | | 28,238,140 | | | | 33,132,620 | |
| Acquisitions of mortgage loans on real estate | | | (2,165,000 | ) | | | (3,227,500 | ) |
| Payments of mortgage loans on real estate | | | 4,870,367 | | | | 3,705,607 | |
| Purchases of state-guaranteed receivables | | | (1,750,727 | ) | | | (6,463,522 | ) |
| Payments of state-guaranteed receivables | | | 595,040 | | | | 87,260 | |
| Purchase of derivative investment | | | - | | | | (645,000 | ) |
| Acquisitions of short-term investments | | | (34,188 | ) | | | (24,028,034 | ) |
| Sales and maturities of short-term investments | | | 34,188 | | | | 24,519,075 | |
| Net additions in other investments | | | (1,414,282 | ) | | | (384,052 | ) |
| Net additions to property and equipment | | | (746,624 | ) | | | (897,436 | ) |
| NET CASH USED IN INVESTING ACTIVITIES | | $ | (5,474,105 | ) | | $ | (98,832,579 | ) |
| FINANCING ACTIVITIES | | | | | | | | |
Receipts from universal life policies credited to policyholder account balances | | $ | 5,335,141 | | | $ | 5,508,652 | |
| Return of policyholder account balances on universal life policies | | | (8,683,869 | ) | | | (9,185,256 | ) |
| Payments on notes payable | | | (4,112,642 | ) | | | (4,486,270 | ) |
| Proceeds from notes payable | | | 5,809,918 | | | | 3,733,652 | |
| Issuances of common stock, net | | | (198,810 | ) | | | 23,064 | |
| Dividends paid | | | (265,129 | ) | | | (207,327 | ) |
| NET CASH USED IN FINANCING ACTIVITIES | | $ | (2,115,391 | ) | | $ | (4,613,485 | ) |
| INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS | | $ | (524,711 | ) | | $ | 3,886,818 | |
| Cash and cash equivalents at beginning of year | | | 6,534,616 | | | | 2,647,798 | |
| CASH AND CASH EQUIVALENTS AT END OF YEAR | | $ | 6,009,905 | | | $ | 6,534,616 | |
See Notes to Consolidated Financial Statements.
NOTE 1 - Nature of Operations and Accounting Policies
Investors Heritage Capital Corporation is the holding company of Investors Heritage Life Insurance Company; Investors Heritage Printing, Inc., a printing company; Investors Heritage Financial Services Group, Inc., an insurance marketing company; is the sole member of At Need Funding, LLC, a limited liability company that provides advance funding of funerals in exchange for the irrevocable assignment of life insurance policies from other nonaffiliated companies; and is the sole member of Heritage Funding, LLC, a limited liability company that invests in various business ventures. These entities are collectively hereinafter referred to as the "Company". Approximately 99% of Investors Heritage Capital’s consolidated revenue is generated by Investors Heritage Life.
The Company's operations involve the sale and administration of various insurance and annuity products, including, but not limited to, participating and non-participating whole life, limited pay life, universal life, annuity contracts, credit life, credit accident and health and group insurance policies. The principal markets for the Company's products are in Kentucky, North Carolina, Georgia, Indiana, Michigan, Ohio, Pennsylvania, South Carolina, Tennessee, Texas and Virginia.
Basis of Presentation: The accompanying Consolidated Financial Statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”).
Principles of Consolidation: The Consolidated Financial Statements include the accounts of the wholly-owned subsidiaries of Investors Heritage Capital, which are Investors Heritage Life and its subsidiary, Investors Underwriters, Inc., Investors Heritage Printing, Investors Heritage Financial, At Need Funding and Heritage Funding. Intercompany transactions are eliminated in the Company's Consolidated Financial Statements.
Use of Estimates: The preparation of financial statements requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ from those estimates.
Reclassifications: Certain reclassifications have been made in the prior year Consolidated Financial Statements to conform to current year presentation. These reclassifications had no impact on previously reported net income or stockholders’ equity.
Investments: The Company classifies all fixed maturities and equity securities as available-for-sale. Securities classified as available-for-sale are carried at fair value with unrealized appreciation (depreciation) relating to temporary market value changes recorded as an adjustment to other comprehensive income (loss), net of deferred acquisition costs and federal income taxes.
Premiums and discounts on fixed maturity investments are amortized into income using the interest method. Anticipated prepayments on mortgage-backed securities are considered in the determination of the effective yield on such securities. If a difference arises between anticipated prepayments and actual prepayments, the carrying amounts of the investments are adjusted with a corresponding charge or credit to interest income.
Realized gains and losses on the sales of investments are determined based upon the specific identification method and include provisions for other-than-temporary impairments where appropriate, as discussed in further detail in Note 2 to the Consolidated Financial Statements.
If an other-than-temporary impairment occurs with respect to a bond, the reduced book value is amortized back to the security’s expected recovery value over the remaining term of the bond. The Company continues to review the security for further impairment that would prompt another write-down in the value.
Mortgage loans and policy loans are carried primarily at aggregate principal balance.
State-guaranteed receivables represent an assignment of the future rights to cash flows from lottery winners purchased at a discounted price. Payments on these investments are made by state run lotteries and guaranteed by the states. The state-guaranteed receivables are carried at their amortized cost basis.
Investment in derivative represents the derivative portion of the Company’s investment in a market-indexed note. The derivative portion of this investment is bifurcated and carried at fair value, with changes in the fair value of the derivative included within investment income in the consolidated statements of income.
Other invested assets include real estate investments and notes receivable. Real estate investments are carried at cost less accumulated depreciation. Notes receivable are carried at their aggregate principal balance.
Short-term investments represent securities with maturity dates within one year but exceeding three months. These securities are carried at amortized cost, which approximates fair value.
Cash equivalents include money market funds on deposit at various financial institutions with contractual maturity dates within three months at the time of purchase.
Deferred Acquisition Costs: Commissions and other acquisition costs, which vary with and are primarily related to the production of new business, are deferred and amortized over the life of the related policies (refer to Revenues and Expenses discussed later regarding amortization methods). Recoverability of deferred acquisition costs is evaluated periodically by comparing the current estimate of the present value of expected pretax future profits to the unamortized asset balance. If this current estimate is less than the existing balance, the difference is charged to expense.
Deferred acquisition costs related to annuities and universal life insurance products are deferred to the extent deemed recoverable and amortized in relation to the present value of actual and expected gross profits on the policies. To the extent that realized gains and losses on fixed income securities result in adjustments to deferred acquisition costs related to annuities, such adjustments are reflected as a component of the amortization of deferred acquisition costs.
Deferred acquisition costs related to annuities are also adjusted, net of tax, for the change in amortization that would have been recorded if the unrealized gains (losses) from securities had actually been realized. This adjustment is included in the change in net unrealized appreciation (depreciation) on available-for-sale securities, a component of "Accumulated Other Comprehensive Income (Loss)" in the stockholders' equity section of the balance sheet.
Value of Business Acquired: Value of business acquired represents the estimated value assigned to the insurance in force of the assumed policy obligations at the date of acquisition of a block of policies. Refer to Note 13 for details on recent acquisitions and their associated value of business acquired. Amortization of value of business acquired recognized in 2012 totaled $161,095. Amortization recognized in 2011 totaled $193,119. Accumulated amortization was $407,689 and $246,594 at December 31, 2012 and 2011, respectively. Estimated annual amortization will be approximately $128,000, $85,000, $76,000, $70,000, and $63,000 in 2013 through 2017, respectively.
Property and Equipment: Property and equipment is carried at cost less accumulated depreciation, using principally the straight-line method. Accumulated depreciation on property and equipment was $4,141,343 and $4,004,116 at December 31, 2012 and 2011, respectively.
Capital Leases: During 2012, the Company entered into two new capital leases totaling $292,872 at inception. Total lease payments for 2012 and 2011 relating to previously existing capital leases were $256,579 and $54,693, respectively. Future minimum lease payments for 2013 through 2017 are $347,216; $208,053; $56,544; $3,652; and $0, respectively. The present value of net minimum lease payments at December 31, 2012 was $568,214, which is equal to the total future minimum lease payments of $615,465 less imputed interest of $47,251. Accumulated amortization on the leased property was $280,367 and $394,166 at December 31, 2012 and 2011, respectively.
Cash Value of Company-Owned Life Insurance: The Company holds life insurance policies on key members of the organization. These policies are reported at the current cash surrender values of the policies.
Benefit Reserves and Policyholder Deposits: Reserves on traditional life and accident and health insurance products are calculated using the net level premium method based upon estimated future investment yields, mortality, withdrawals and other assumptions, including dividends on participating policies. The assumptions used for prior year issues are locked in. Current year issues are reserved using updated assumptions determined by reviewing the Company's past experience and include a provision for possible unfavorable deviation.
Benefit reserves and policyholder deposits on universal life and investment-type products are determined by using the retrospective deposit method and represent the policy account value before consideration of surrender charges. In addition, unearned revenues are included as a part of the benefit reserve.
The mortality assumptions for regular ordinary business are based on the 1955-60 Basic Table, Select and Ultimate, for plans issued prior to 1982; the 1965-70 Basic Table, Select and Ultimate, for plans issued in 1982 through 1984; the 1975-80 Basic Table, Select and Ultimate, for plans issued after 1984; the 2001 Valuation Basic Table, Select and Ultimate, for plans issued after 2008; and on the Company's experience for final expense and preneed plans.
Reinsurance: The Company assumes and cedes reinsurance under various agreements providing greater diversification of business, allowing management to control exposure to potential losses arising from large risks, and providing additional capacity for growth. Amounts recoverable from reinsurers are estimated in a manner consistent with the related liabilities associated with the reinsured policies. At December 31, 2012 and 2011, amounts recoverable from reinsurers were $53,797,125 and $47,582,367, respectively. These amounts included reserves ceded to reinsurers of $52,944,370 and $46,766,298 at December 31, 2012 and 2011, respectively.
Unearned Premium Reserves: Credit life unearned premium reserves are calculated for level and reducing coverage certificates using the monthly pro rata and Rule of 78's methods, respectively. Credit accident and health unearned premium reserves are determined based upon the Rule of 78's.
Policy Claims: Policy claims are based on reported claims plus estimated incurred but not reported claims developed from trends of historical data applied to current exposure.
Liability for Deposit-Type Contracts: Liability for deposit-type contracts consists of supplemental contracts without life contingencies, premium deposit funds and dividends and endowments left on deposit at interest.
Participating Policies: Participating business approximates 17% and 18% of ordinary life insurance in force at December 31, 2012 and 2011, respectively. Premiums relative to participating business comprised approximately 4% and 5% of net premiums earned for the years ended December 31, 2012 and 2011, respectively. Participating dividends are accrued as declared by the Board of Directors of Investors Heritage Life. For participating policies that are not a part of the Texas Memorial Life or Memorial Service Life policy acquisitions, the liability for future policy benefits for participating policies was determined based on the Net Level Premium Reserve Method, 3% interest, and the 1941 CSO Mortality and 1958 CSO Mortality tables. All guaranteed benefits were considered in calculating these reserves. Deferred acquisition costs are amortized in proportion to expected gross profits.
The increase in participating business during 2011 is due to the acquisition of the Memorial Service block of business (as discussed further in Note 13), which included a significant amount of participating business. While these policies are participating, no future dividends are anticipated on this block of policies. The liability for future policy benefits of the Texas Memorial Life and Memorial Service Life blocks of participating business was determined based on the 2001 CSO and 1980 CSO Mortality tables, respectively.
The average assumed investment yields used in determining expected gross profits ranged from 3.56% to 9.17% (for the current and all future years, an assumed investment yield of 5% was utilized).
Federal Income Taxes: The Company utilizes the liability method to account for income taxes. Under such method, deferred tax assets and liabilities are determined based on differences between the financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates.
Revenues and Expenses: Revenues on traditional life and accident and health insurance products consist of direct and assumed premiums reported as earned when due. Liabilities for future policy benefits, including unearned premium reserves on accident and health policies and unreleased profits on limited-pay life policies, are provided and acquisition costs are amortized by associating benefits and expenses with earned premiums to recognize related profits over the life of the contracts. Acquisition costs are amortized over the premium paying period using the net level premium method. Traditional life insurance products are treated as long duration contracts since they are ordinary whole life insurance products, which generally remain in force for the lifetime of the insured. The accident and health insurance products are treated as long duration contracts because they are non-cancelable.
Revenues for universal life and investment-type products consist of investment income and policy charges for the cost of insurance and policy initiation and administrative fees. Expenses include interest credited to policy account balances, actual administrative expenses and benefit payments in excess of policy account balances.
Other income consists principally of third party administrative service fees along with servicing and administration fees relative to credit insurance administered for our reinsurers.
Common Stock and Earnings per Share: The par value per share is $1.00 with 4,000,000 shares authorized. Earnings per share of common stock were computed based on the weighted average number of common shares outstanding during each year. The weighted average number of shares outstanding during 2012 and 2011 were 1,152,438 and 1,152,335 shares, respectively. The Company paid cash dividends per share of $0.23 and $0.18 in 2012 and 2011, respectively.
Subsequent Events: Management has evaluated all events subsequent to December 31, 2012 through the date that these Consolidated Financial Statements were available to be issued.
New Accounting Standards: In October 2010, the Financial Accounting Standards Board (“FASB”) issued authoritative guidance to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. Under the new guidance, acquisition costs are to include only those costs that are directly related to the acquisition or renewal of insurance contracts by applying a model similar to the accounting for loan origination costs. An entity may defer incremental direct costs of contract acquisition that are incurred in transactions with independent third parties or employees as well as the portion of employee compensation and other costs directly related to underwriting, policy issuance and processing, medical inspection, and contract selling for successfully negotiated contracts. Additionally, an entity may capitalize as a deferred acquisition cost only those advertising costs meeting the capitalization criteria for direct-response advertising. This change became effective for fiscal years beginning after December 15, 2011 and interim periods within those years. We adopted this guidance effective January 1, 2012. The adoption of this guidance did not have any effect on the Company’s results of operations, financial position or liquidity.
In May 2011, the FASB issued new guidance concerning fair value measurements and disclosure. The new guidance is the result of joint efforts by the FASB and the International Accounting Standards Board to develop a single, converged fair value framework on how to measure fair value and the necessary disclosures concerning fair value measurements. This guidance became effective for interim and annual periods beginning after December 15, 2011. The Company’s adoption of this guidance resulted in a change in certain fair value footnote disclosures but did not have any effect on the Company’s results of operations, financial position or liquidity.
In June 2011, the FASB issued updated guidance to increase the prominence of items reported in other comprehensive income by eliminating the option of presenting components of comprehensive income as part of the statement of changes in stockholders’ equity. The updated guidance requires that all non-owner changes in stockholders’ equity be presented either as a single continuous statement of comprehensive income or in two separate but consecutive statements. The updated guidance is to be applied retrospectively and became effective for the quarter ending March 31, 2012. The Company adopted this guidance utilizing two separate but consecutive statements. The Company’s adoption of this guidance resulted in a change in the presentation of the Company’s consolidated financial statements but did not have any impact on the Company’s results of operations, financial position or liquidity.
In February 2013, the FASB issued updated guidance regarding the presentation of comprehensive income. Under the guidance, an entity would separately present information about significant items reclassified out of accumulated other comprehensive income by component as well as changes in accumulated other comprehensive income balances by component in either the financial statements or the notes to the financial statements. The guidance does not change the items that are reported in other comprehensive income, does not change when an item of other comprehensive income must be reclassified to net income, and does not amend any existing requirements for reporting net income or other comprehensive income. The guidance is effective for the first interim or annual reporting period beginning after December 15, 2012 and should be applied prospectively. We are currently assessing the impact of this guidance on the presentation of the Company’s consolidated financial statements and the notes to consolidated financial statements.
NOTE 2 - Investments
The Company limits credit risk by investing primarily in investment grade securities and by diversifying its investment portfolio among government and corporate bonds and mortgage loans. The Company manages its fixed income portfolio to diversify between and within industry sectors. Investments in available-for-sale securities at December 31 are summarized as follows:
| 2012 | | | | | Gross Unrealized Gains | | | Gross Unrealized Losses | | | | |
| Available-for-sale securities: | | | | | | | | | | | | |
| U.S. government obligations | | $ | 47,634,952 | | | $ | 4,263,920 | | | $ | - | | | $ | 51,898,872 | |
| States and political subdivisions | | | 46,323,487 | | | | 7,522,997 | | | | - | | | | 53,846,484 | |
| Corporate | | | 207,553,209 | | | | 23,818,640 | | | | 93,765 | | | | 231,278,084 | |
| Foreign | | | 50,000,420 | | | | 4,748,130 | | | | 11,680 | | | | 54,736,870 | |
| Asset-backed securities | | | 4,460,090 | | | | 289,373 | | | | 529 | | | | 4,748,934 | |
| Mortgage-backed securities (MBS): | | | | | | | | | | | | | | | | |
| Commercial MBS | | | 6,429,641 | | | | 407,386 | | | | - | | | | 6,837,027 | |
| Residential MBS | | | 31,968,578 | | | | 3,008,564 | | | | - | | | | 34,977,142 | |
| | | | | | | | | | | | | | | | | |
| Total fixed maturity securities | | $ | 394,370,377 | | | $ | 44,059,010 | | | $ | 105,974 | | | $ | 438,323,413 | |
| Equity securities: | | | | | | | | | | | | | | | | |
| U.S. agencies | | | 681,300 | | | | - | | | | - | | | | 681,300 | |
| Mutual funds | | | 318,283 | | | | 3,054 | | | | - | | | | 321,337 | |
| Corporate common stock | | | 117,468 | | | | 266,532 | | | | - | | | | 384,000 | |
| Total equity securities | | | 1,117,051 | | | | 269,586 | | | | - | | | | 1,386,637 | |
| | | | | | | | | | | | | | | | | |
| Total | | $ | 395,487,428 | | | $ | 44,328,596 | | | $ | 105,974 | | | $ | 439,710,050 | |
| 2011 | | | | | Gross Unrealized Gains | | | Gross Unrealized Losses | | | | |
| Available-for-sale securities: | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| U.S. government obligations | | $ | 52,208,593 | | | $ | 4,134,415 | | | $ | - | | | $ | 56,343,008 | |
| States and political subdivisions | | | 47,104,054 | | | | 6,067,945 | | | | - | | | | 53,171,999 | |
| Corporate | | | 208,379,560 | | | | 15,791,790 | | | | 603,218 | | | | 223,568,132 | |
| Foreign | | | 26,931,549 | | | | 2,531,890 | | | | 447,179 | | | | 29,016,260 | |
| Asset-backed securities | | | 5,041,278 | | | | 438,652 | | | | 735 | | | | 5,479,195 | |
| Mortgage-backed securities (MBS): | | | | | | | | | | | | | | | | |
| Commercial MBS | | | 7,893,233 | | | | 414,233 | | | | - | | | | 8,307,466 | |
| Residential MBS | | | 42,231,524 | | | | 3,523,084 | | | | - | | | | 45,754,608 | |
| | | | | | | | | | | | | | | | | |
| Total fixed maturity securities | | $ | 389,789,791 | | | $ | 32,902,009 | | | $ | 1,051,132 | | | $ | 421,640,668 | |
| Equity securities: | | | | | | | | | | | | | | | | |
| U.S. agencies | | | 552,800 | | | | - | | | | - | | | | 552,800 | |
| Mutual funds | | | 318,283 | | | | 52,253 | | | | - | | | | 370,536 | |
| Corporate common stock | | | 228,595 | | | | 234,535 | | | | 10,326 | | | | 452,804 | |
| Total equity securities | | | 1,099,678 | | | | 286,788 | | | | 10,326 | | | | 1,376,140 | |
| | | | | | | | | | | | | | | | | |
| Total | | $ | 390,889,469 | | | $ | 33,188,797 | | | $ | 1,061,458 | | | $ | 423,016,808 | |
The following table summarizes, for all securities in an unrealized loss position at December 31, 2012 and 2011, the estimated fair value, pre-tax gross unrealized loss and number of securities by length of time that those securities have been continuously in an unrealized loss position.
| | | December 31, 2012 | | | December 31, 2011 |
| | | | | | | | | | | | | | | | | | | |
| Fixed Maturities: | | | | | | | | | | | | | | | | | | |
| Less than 12 months: | | | | | | | | | | | | | | | | | | |
| Corporate | | $ | 4,648,363 | | | $ | 88,805 | | | | 5 | | | $ | 20,516,939 | | | $ | 603,218 | | | | 20 | |
| Foreign | | | 988,320 | | | | 11,680 | | | | 1 | | | | 1,875,940 | | | | 122,315 | | | | 1 | |
| Asset-backed securities | | | - | | | | - | | | | - | | | | 58,892 | | | | 735 | | | | 1 | |
| Greater than 12 months: | | | | | | | | | | | | | | | | | | | | | | | | |
| Corporate | | | 243,040 | | | | 4,960 | | | | 1 | | | | - | | | | - | | | | - | |
| Foreign | | | - | | | | - | | | | - | | | | 653,350 | | | | 324,864 | | | | 1 | |
| Asset-backed securities | | | 59,097 | | | | 529 | | | | 1 | | | | - | | | | - | | | | - | |
| Total fixed maturities | | | 5,938,820 | | | | 105,974 | | | | 8 | | | | 23,105,121 | | | | 1,051,132 | | | | 23 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Equities: | | | | | | | | | | | | | | | | | | | | | | | | |
| Less than 12 months: | | | | | | | | | | | | | | | | | | | | | | | | |
| Corporate common stock | | | - | | | | - | | | | - | | | | 100,804 | | | | 10,326 | | | | 1 | |
| Total equities | | | - | | | | - | | | | - | | | | 100,804 | | | | 10,326 | | | | 1 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Total | | $ | 5,938,820 | | | $ | 105,974 | | | | 8 | | | $ | 23,205,925 | | | $ | 1,061,458 | | | | 24 | |
As of December 31, 2012, all of the above fixed maturity securities had a fair value to cost ratio equal to or greater than 96% and all of our equity securities had a fair value to cost ratio equal to or greater than 100%. As of December 31, 2011, except for one fixed maturity security with a fair value to cost ratio of 67%, all of the above fixed maturity securities had a fair value to cost ratio equal to or greater than 89% and the equity securities noted above had a fair value to cost ratio of over 90%.
The Company’s decision to record an impairment loss is primarily based on whether the security’s fair value is likely to remain significantly below its book value in light of all the factors considered. Factors that are considered include the length of time the security’s fair value has been below its carrying amount, the severity of the decline in value, the credit worthiness of the issuer, and the coupon and/or dividend payment history of the issuer. The Company also assesses whether it intends to sell or whether it is more likely than not that it may be required to sell the security prior to its recovery in value. For any fixed maturity securities that are other-than-temporarily impaired, the Company determines the portion of the other-than-temporary impairment that is credit-related and the portion that is related to other factors. The credit-related portion is the difference between the expected future cash flows and the amortized cost basis of the fixed maturity security, and that difference is charged to earnings. The non-credit-related portion representing the remaining difference to fair value is recognized in other comprehensive income (loss). Only in the case of a credit-related impairment where management has the intent to sell the security, or it is more likely than not that it will be required to sell the security before recovery of its cost basis, is a fixed maturity security adjusted to fair value and the resulting losses recognized in realized gains/losses in the consolidated statements of income. Any other-than-temporary impairments on equity securities are recorded in the consolidated statements of income in the periods incurred as the difference between fair value and cost. Based on our review, the Company experienced no other-than-temporary impairments during the years ended December 31, 2012 or 2011.
Management believes that the Company will fully recover its cost basis in the securities held at December 31, 2012, and management does not have the intent to sell nor is it more likely than not that the Company will be required to sell such securities until they recover or mature. The temporary impairments shown herein are primarily the result of the current interest rate environment rather than credit factors that would imply other-than-temporary impairment.
During 2012, the Company sold its investment in Farmers Bank Capital Corporation common stock. An other-than-temporary impairment had previously been recorded on this holding. The pre-tax gain associated with this sale totaled $121,976. During the fourth quarter of 2011, the Company liquidated its equity positions in three Fifth Third mutual funds, including two for which the Company had previously recognized other-than-temporary impairment losses during 2008. These sales generated a pre-tax gain of $495,272. We have no remaining assets for which other-than-temporary impairments have been recorded.
Net unrealized gains for investments classified as available-for-sale are presented below, net of the effect on deferred income taxes and deferred acquisition costs assuming that the appreciation had been realized.
| | | December 31 | |
| | | 2012 | | | 2011 | |
| | | | | | | |
Net unrealized appreciation on available-for sale securities | | $ | 44,222,622 | | | $ | 32,127,339 | |
| Adjustment to deferred acquisition costs | | | (1,312,922 | ) | | | (987,662 | ) |
| Deferred income taxes | | | (14,821,597 | ) | | | (10,805,092 | ) |
Net unrealized appreciation on available-for sale securities | | $ | 28,088,103 | | | $ | 20,334,585 | |
The amortized cost and fair value of debt securities at December 31, 2012, by contractual maturity, are presented below. 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.
| | | Available-for-Sale | |
| | | | | | | |
| Due in one year or less | | $ | 27,648,176 | | | $ | 28,229,124 | |
| Due after one year through five years | | | 62,166,593 | | | | 68,927,640 | |
| Due after five years through ten years | | | 181,162,569 | | | | 202,192,902 | |
| Due after ten years | | | 84,994,820 | | | | 97,159,578 | |
| Due at multiple maturity dates | | | 38,398,219 | | | | 41,814,169 | |
| Total | | $ | 394,370,377 | | | $ | 438,323,413 | |
Proceeds for the years ended December 31, 2012 and 2011 from sales and maturities of investments in available-for-sale securities, as well as gross gains and gross losses realized, are presented below.
| | | 2012 | | | 2011 | |
| Proceeds from sales and maturities | | $ | 34,186,233 | | | $ | 38,460,989 | |
| Gross realized gains | | | 513,989 | | | | 567,280 | |
| Gross realized losses | | | (29,176 | ) | | | (8,279 | ) |
Presented below is investment information, including the accumulated and annual change in net unrealized investment gains or losses. Additionally, the table shows the annual change in net unrealized investment gains (losses) and the amount of realized investment gains (losses) on debt and equity securities for the years ended December 31, 2012 and 2011.
| | | 2012 | | | 2011 | |
| Change in unrealized investment gains (losses): | | | | | | |
| Available-for-sale: | | | | | | |
| Fixed maturities | | $ | 12,102,159 | | | $ | 13,983,704 | |
| Equity securities | | | (6,876 | ) | | | (370,534 | ) |
| Realized investment gains: | | | | | | | | |
| Available-for-sale: | | | | | | | | |
| Fixed maturities | | $ | 362,837 | | | $ | 53,730 | |
| Equity securities | | | 121,976 | | | | 505,271 | |
The Company is required to hold assets on deposit for the benefit of policyholders in accordance with statutory rules and regulations. At December 31, 2012 and 2011, these required deposits had a total amortized cost of $22,860,625 and $22,821,430, respectively.
Approximately 99.9% of the Company’s mortgage loans involve commercial properties. Mortgage loans are generally issued at loan to value ratios not exceeding 80 percent and are generally secured by personal guarantees. All loans are secured by a first mortgage on the property. Although approximately 81.9% of the loans outstanding at December 31, 2012 were located in six states (Florida, Kentucky, Georgia, Texas, Ohio and Tennessee), the Company believes the risk of loss due to concentrations is low as a result of the remaining loans being dispersed across the southeastern United States, our stringent underwriting requirements, maintaining small average loan balances, and consistent positive performance of the portfolio as a whole. This is evidenced by the fact that as of December 31, 2012 and 2011, there were no non-performing loans, loans on nonaccrual status, loans 90 days past due or more, loans in process of foreclosure, or restructured loans. The Company experienced no mortgage loan defaults during 2012 or 2011.
At December 31, 2012, the Company held various real estate investments for the production of income totaling $614,578, net of accumulated depreciation of $497,101. At December 31, 2011, the Company’s real estate investments totaled $670,317, net of accumulated depreciation of $467,485.
During the third quarter of 2011, the Company began purchasing investments in state-guaranteed receivables. These investments represent an assignment of the future rights to cash flows from lottery winners purchased at a discounted price. Payments on these investments are made by state run lotteries and guaranteed by the states. At December 31, 2012, the amortized cost and estimated fair value of state-guaranteed receivables, by contractual maturity, are summarized as follows:
| | | State-Guaranteed Receivables | |
| | | | | | | |
| Due in one year or less | | $ | 575,361 | | | $ | 583,835 | |
| Due after one year through five years | | | 2,514,595 | | | | 2,744,150 | |
| Due after five years through ten years | | | 2,727,678 | | | | 3,449,385 | |
| Due after ten years | | | 2,294,035 | | | | 3,408,856 | |
| Total | | $ | 8,111,669 | | | $ | 10,186,226 | |
The outstanding balance of state-guaranteed receivables, by state, as of December 31, 2012 and 2011 is summarized as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| New York | | $ | 3,973,862 | | | $ | 4,247,490 | |
| Massachusetts | | | 2,709,704 | | | | 1,611,607 | |
| Georgia | | | 659,540 | | | | - | |
| Pennsylvania | | | 270,657 | | | | 106,417 | |
| California | | | 202,563 | | | | 209,073 | |
| Texas | | | 198,260 | | | | 185,021 | |
| Ohio | | | 97,083 | | | | 109,304 | |
| Total | | $ | 8,111,669 | | | $ | 6,468,912 | |
During the third quarter of 2011, the Company purchased a $3,000,000 position in a Morgan Stanley market-indexed note. The note pays 1% interest annually and matures in six years. At maturity, the Company participates at 110% of any increase in the Dow Jones Industrial Average since the purchase date, but is guaranteed against market-related downside risk. Accordingly, a portion of the investment is classified as a derivative and bifurcated for reporting purposes. The derivative portion, having a cost basis of $645,000 calculated at 21.5% of the total value of the purchase price of the note, is reported as an investment in derivative on the balance sheet. The remaining non-derivative portion of the note is reported within fixed maturities on the balance sheet. This derivative is marked-to-market through the income statement, with the change in value reported as a component of investment income on the income statement. As of December 31, 2012 and 2011, the derivative investment was valued at $642,600 and $752,700, respectively. We recognized a decrease in investment income of $110,100 during 2012 relative to the mark-to-market adjustment on this investment compared to an increase in investment income of $107,700 during 2011 relative to the mark-to-market adjustment.
Major categories of net investment income are summarized as follows:
| | | 2012 | | | 2011 | |
| Fixed maturities | | $ | 19,456,710 | | | $ | 16,890,435 | |
| Equity securities | | | 58,972 | | | | 141,660 | |
| Mortgage loans on real estate | | | 1,317,826 | | | | 1,317,523 | |
| Policy loans | | | 489,824 | | | | 489,876 | |
| State-guaranteed receivables | | | 487,070 | | | | 92,652 | |
| Gain (loss) on investment in derivative | | | (110,100 | ) | | | 107,700 | |
| Other | | | 116,380 | | | | 169,925 | |
| Gross investment income | | $ | 21,816,682 | | | $ | 19,209,771 | |
| Investment expenses | | | 1,090,415 | | | | 1,003,515 | |
| Net investment income | | $ | 20,726,267 | | | $ | 18,206,256 | |
NOTE 3 - Fair Values of Financial Instruments
The fair value of a financial instrument is the estimated amount at which the instrument could be exchanged in an orderly transaction between knowledgeable, unrelated, willing parties, i.e., not in a forced transaction. The estimated fair value of a financial instrument may differ from the amount that could be realized if the security was sold in an immediate sale, e.g., a forced transaction. Additionally, the valuation of investments is more subjective when markets are less liquid due to the lack of market based inputs, which may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur.
The Company holds fixed maturities and equity securities that are measured and reported at fair market value on the balance sheet. The Company is also required to disclose fair value estimates for other financial instruments not required to be carried at market value on the balance sheet. The Company determines the fair market values of its financial instruments based on the fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value, as follows:
Level 1 - Quoted prices in active markets for identical assets or liabilities.
Level 2 - Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The unobservable inputs reflect the Company’s own assumptions about the inputs that market participants would use.
The Company has categorized its financial instruments, based on the priority of the inputs to the valuation technique, into the three-level fair value hierarchy. If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument. A review of fair value hierarchy classifications is conducted on a quarterly basis. Changes in the valuation inputs, or their ability to be observed, may result in a reclassification for certain financial assets or liabilities. Reclassifications impacting Level 3 of the fair value hierarchy are reported as transfers in/out of the Level 3 category as of the beginning of the period in which the reclassifications occur.
Valuation of Investments Reported at Fair Value in Financial Statements
The Company’s Level 1 investments include equity securities that are traded in an active exchange market, as well as one U.S. agency equity security whose value is set by government statute.
The Company’s Level 2 investments include fixed maturities with quoted prices that are traded less frequently than exchange-traded instruments or instruments whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data. This category generally includes the majority of our fixed maturities, where fair values are obtained from a nationally recognized, third-party pricing service.
The Company’s Level 3 investments include financial instruments whose value cannot be obtained through a pricing service and must be determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. This category currently includes one private equity investment and four fixed maturities where independent pricing inputs were not able to be obtained for a significant portion of the underlying assets. For the fixed maturities within this level, the Company utilizes the assistance of its third-party investment advisor to estimate the fair value based on non-binding broker quotes and internal models using unobservable assumptions about market participants. For the private equity investment, the Company establishes fair value based on the most recent trading activity as well as a review of the underlying financial statements of the entity. The Company’s Level 3 segment also includes the investment in derivative related to the bifurcated equity-indexed portion of a market-indexed note. The value of the derivative portion of this investment was derived from an option pricing model that utilizes the current Dow Jones Industrial Average compared to the strike price in the note, along with various other market assumptions including those regarding volatility and dividend yields.
The following table presents the Company’s fair value hierarchy for those financial instruments measured and reported at fair value on a recurring basis as of December 31, 2012 and 2011.
| | | December 31, 2012 | |
| | | Level 1 | | | Level 2 | | | Level 3 | | | Total | |
| Fixed maturities: | | | | | | | | | | | | |
| U.S. government obligations | | $ | - | | | $ | 51,898,872 | | | $ | - | | | $ | 51,898,872 | |
| States and political subdivisions | | | - | | | | 53,846,484 | | | | - | | | | 53,846,484 | |
| Corporate | | | - | | | | 227,443,614 | | | | 3,834,470 | | | | 231,278,084 | |
| Foreign | | | - | | | | 54,736,870 | | | | - | | | | 54,736,870 | |
| Asset-backed securities | | | - | | | | 4,748,934 | | | | - | | | | 4,748,934 | |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | |
| Commercial MBS | | | - | | | | 6,837,027 | | | | - | | | | 6,837,027 | |
| Residential MBS | | | - | | | | 34,977,142 | | | | - | | | | 34,977,142 | |
| Total fixed maturities | | $ | - | | | $ | 434,488,943 | | | $ | 3,834,470 | | | $ | 438,323,413 | |
| | | | | | | | | | | | | | | | | |
| Equity securities: | | | | | | | | | | | | | | | | |
| U.S. agencies | | $ | 681,300 | | | $ | - | | | $ | - | | | $ | 681,300 | |
| Mutual funds | | | 321,337 | | | | - | | | | - | | | | 321,337 | |
| Corporate common stock | | | - | | | | - | | | | 384,000 | | | | 384,000 | |
| Total equity securities | | $ | 1,002,637 | | | $ | - | | | $ | 384,000 | | | $ | 1,386,637 | |
| | | | | | | | | | | | | | | | | |
| Investment in derivative | | $ | - | | | $ | - | | | $ | 642,600 | | | $ | 642,600 | |
| | | December 31, 2011 | |
| | | Level 1 | | | Level 2 | | | Level 3 | | | Total | |
| Fixed maturities: | | | | | | | | | | | | | | | | |
| U.S. government obligations | | $ | - | | | $ | 56,343,008 | | | $ | - | | | $ | 56,343,008 | |
| States and political subdivisions | | | - | | | | 53,171,999 | | | | - | | | | 53,171,999 | |
| Corporate | | | - | | | | 221,435,053 | | | | 2,133,079 | | | | 223,568,132 | |
| Foreign | | | - | | | | 29,016,260 | | | | - | | | | 29,016,260 | |
| Asset-backed securities | | | - | | | | 5,479,195 | | | | - | | | | 5,479,195 | |
| Mortgage-backed securities: | | | | | | | | | | | | | | | | |
| Commercial MBS | | | - | | | | 8,307,466 | | | | - | | | | 8,307,466 | |
| Residential MBS | | | - | | | | 45,754,608 | | | | - | | | | 45,754,608 | |
| Total fixed maturities | | $ | - | | | $ | 419,507,589 | | | $ | 2,133,079 | | | $ | 421,640,668 | |
| | | | | | | | | | | | | | | | | |
| Equity securities: | | | | | | | | | | | | | | | | |
| U.S. agencies | | $ | 552,800 | | | $ | - | | | $ | - | | | $ | 552,800 | |
| Mutual funds | | | 370,536 | | | | - | | | | - | | | | 370,536 | |
| Corporate common stock | | | 100,804 | | | | - | | | | 352,000 | | | | 452,804 | |
| Total equity securities | | $ | 1,024,140 | | | $ | - | | | $ | 352,000 | | | $ | 1,376,140 | |
| | | | | | | | | | | | | | | | | |
| Investment in derivative | | $ | - | | | $ | - | | | $ | 752,700 | | | $ | 752,700 | |
The following table provides a summary of changes in fair value of our Level 3 financial instruments for the years ended December 31, 2012 and 2011.
| | | Year Ended December 31, 2012 | |
| | | Corporate | | | | | | | | | | | | Total | |
| Beginning balance | | $ | 2,133,079 | | | $ | - | | | $ | 352,000 | | | $ | 752,700 | | | $ | 3,237,779 | |
| Transfers into Level 3 | | | - | | | | - | | | | - | | | | - | | | | - | |
| Transfers out of Level 3 | | | - | | | | - | | | | - | | | | - | | | | - | |
| Purchases | | | 1,748,750 | | | | - | | | | - | | | | - | | | | 1,748,750 | |
| Sales | | | (102,137 | ) | | | - | | | | - | | | | - | | | | (102,137 | ) |
| Total gains or losses: | | | | | | | | | | | | | | | | | | | | |
| Included in earnings | | | - | | | | - | | | | - | | | | (110,100 | ) | | | (110,100 | ) |
Included in other comprehensive income | | | 54,778 | | | | - | | | | 32,000 | | | | - | | | | 86,778 | |
| Ending balance | | $ | 3,834,470 | | | $ | - | | | $ | 384,000 | | | $ | 642,600 | | | $ | 4,861,070 | |
| | | Year Ended December 31, 2011 | |
| | | Corporate | | | | | | | | | | | | Total | |
| Beginning balance | | $ | - | | | $ | 387,863 | | | $ | 344,000 | | | $ | - | | | $ | 731,863 | |
| Transfers into Level 3 | | | 1,701,785 | | | | - | | | | - | | | | - | | | | 1,701,785 | |
| Transfers out of Level 3 | | | - | | | | (387,863 | ) | | | - | | | | - | | | | (387,863 | ) |
| Purchases | | | 400,000 | | | | - | | | | - | | | | 645,000 | | | | 1,045,000 | |
| Sales | | | (74,051 | ) | | | - | | | | - | | | | - | | | | (74,051 | ) |
| Total gains or losses: | | | | | | | | | | | | | | | | | | | | |
| Included in earnings | | | - | | | | - | | | | - | | | | 107,700 | | | | 107,700 | |
Included in other comprehensive income | | | 105,345 | | | | - | | | | 8,000 | | | | - | | | | 113,345 | |
| Ending balance | | $ | 2,133,079 | | | $ | - | | | $ | 352,000 | | | $ | 752,700 | | | $ | 3,237,779 | |
The Company experienced no transfers between Level 1 and Level 2 during the years ended December 31, 2012 or 2011. The Company experienced no transfers between Level 2 and Level 3 during the year ended December 31, 2012. The Company had one asset-backed security that transferred from Level 3 to Level 2 during the year ended December 31, 2011. The Company had two corporate fixed maturities that transferred from Level 2 to Level 3 during the year ended December 31, 2011. Transfers in and/or (out) of Level 3 are primarily attributable to changes in the availability of market observable information and re-evaluation of the observability of pricing inputs.
The unrealized gains (losses) on Level 3 investments, other than the investment in derivative, are recorded as a component of accumulated other comprehensive income (loss), net of tax, in accordance with required accounting for our available-for-sale portfolio. The unrealized gains (losses) on the investment in derivative are reported in earnings as a component of investment income.
Financial Instruments Disclosed, but not Carried, at Fair Value
The following disclosure presents the carrying values and estimated fair values of the Company’s financial instruments disclosed, but not carried, at fair value as of December 31, 2012 and 2011, and the level within the fair value hierarchy at which such assets and liabilities are measured on a recurring basis. The fair values for insurance contracts other than investment-type contracts are not required to be disclosed. The estimated fair value amounts have been determined using available market information and appropriate valuation methodologies. However, considerable judgment was required to interpret market data to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the fair value amounts.
| | | December 31, 2012 | |
| | | | | | | | | Level 1 | | | Level 2 | | | Level 3 | |
| Assets: | | | | | | | | | | | | | | | |
| Mortgage loans on real estate: | | | | | | | | | | | | | | | |
| Commercial | | $ | 16,604,183 | | | $ | 17,365,363 | | | $ | - | | | $ | 17,365,363 | | | $ | - | |
| Residential | | | 16,107 | | | | 18,068 | | | | - | | | | 18,068 | | | | - | |
| Policy loans | | | 6,781,751 | | | | 6,781,751 | | | | - | | | | - | | | | 6,781,751 | |
| State-guaranteed receivables | | | 8,111,669 | | | | 10,186,226 | | | | - | | | | 10,186,226 | | | | - | |
| Other invested assets | | | 3,420,189 | | | | 3,420,189 | | | | - | | | | - | | | | 3,420,189 | |
| Cash and cash equivalents | | | 6,009,905 | | | | 6,009,905 | | | | 6,009,905 | | | | - | | | | - | |
| Accrued investment income | | | 5,163,783 | | | | 5,163,783 | | | | - | | | | - | | | | 5,163,783 | |
Cash value of company-owned life insurance | | | 10,844,489 | | | | 10,844,489 | | | | - | | | | - | | | | 10,844,489 | |
| | | | | | | | | | | | | | | | | | | | | |
| Liabilities: | | | | | | | | | | | | | | | | | | | | |
Policyholder deposits (Investment-type contracts) | | | 54,602,229 | | | | 58,704,154 | | | | - | | | | - | | | | 58,704,154 | |
| Policy claims | | | 1,894,727 | | | | 1,894,727 | | | | - | | | | - | | | | 1,894,727 | |
| Obligations under capital leases | | | 568,214 | | | | 568,214 | | | | - | | | | - | | | | 568,214 | |
| Notes payable | | | 3,478,613 | | | | 3,485,503 | | | | - | | | | - | | | | 3,485,503 | |
| | | December 31, 2011 | |
| | | | | | | | | Level 1 | | | Level 2 | | | Level 3 | |
| Assets: | | | | | | | | | | | | | | | | | | | | |
| Mortgage loans on real estate: | | | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 19,311,670 | | | $ | 20,050,148 | | | $ | - | | | $ | 20,050,148 | | | $ | - | |
| Residential | | | 20,800 | | | | 23,593 | | | | - | | | | 23,593 | | | | - | |
| Policy loans | | | 7,050,892 | | | | 7,050,892 | | | | - | | | | - | | | | 7,050,892 | |
| State-guaranteed receivables | | | 6,468,912 | | | | 7,924,353 | | | | - | | | | 7,924,353 | | | | - | |
| Other invested assets | | | 1,736,766 | | | | 1,736,766 | | | | - | | | | - | | | | 1,736,766 | |
| Cash and cash equivalents | | | 6,534,616 | | | | 6,534,616 | | | | 6,534,616 | | | | - | | | | - | |
| Accrued investment income | | | 4,978,676 | | | | 4,978,676 | | | | - | | | | - | | | | 4,978,676 | |
| | | | | | | | | | | | | | | | | | | | | |
Cash value of company-owned life insurance | | | 9,899,557 | | | | 9,899,557 | | | | - | | | | - | | | | 9,899,557 | |
| | | | | | | | | | | | | | | | | | | | | |
| Liabilities: | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | |
Policyholder deposits (Investment-type contracts) | | | 54,545,769 | | | | 57,795,323 | | | | - | | | | - | | | | 57,795,323 | |
| Policy claims | | | 2,098,959 | | | | 2,098,959 | | | | - | | | | - | | | | 2,098,959 | |
| Obligations under capital leases | | | 496,958 | | | | 496,958 | | | | - | | | | - | | | | 496,958 | |
| Notes payable | | | 1,781,337 | | | | 1,782,661 | | | | - | | | | - | | | | 1,782,661 | |
The following methods and assumptions were used in estimating the fair value disclosures for financial instruments in the accompanying Consolidated Financial Statements and Notes thereto:
Mortgage loans on real estate: The fair values for mortgage loans are estimated using discounted cash flow analyses, using the actual spot rate yield curve in effect at the end of each period, as determined by recent new loan activity.
State-guaranteed receivables: The fair values for state-guaranteed receivables are estimated using discounted cash flow analyses, using the average Citigroup Pension Liability Index in effect at the end of each period.
Cash and cash equivalents: The carrying amounts reported for these financial instruments approximate their fair values given the highly liquid nature of the instruments.
Cash value of company-owned life insurance: The carrying values and fair values for these policies are based on the current cash surrender values of the policies.
Investment-type contracts: The fair value for liabilities under investment-type insurance contracts (accumulation annuities) is calculated using a discounted cash flow approach. Cash flows are projected using actuarial assumptions and discounted to the valuation date using risk-free rates adjusted for credit risk and the nonperformance risk of the liabilities.
Notes payable: The fair values for notes payable on commercial loans with fixed interest rates are estimated using discounted cash flow analyses, assuming current interest rate assumptions for similar borrowings based on information gathered from market loan brokers. The fair value for notes payable with floating interest rates approximate the unpaid principal balances on such notes.
Policy loans, other invested assets, accrued investment income, policy claims and obligations under capital leases: The carrying values of these instruments approximate their fair values and are disclosed in Level 3 of the hierarchy.
NOTE 4 - Federal Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax liabilities and assets as of December 31 are as follows:
| | | 2012 | | | 2011 | |
| Deferred tax liabilities: | | | | | | |
| Policy acquisition costs | | $ | 3,117,299 | | | $ | 3,303,307 | |
| Net unrealized gain on available-for-sale securities | | | 14,821,597 | | | | 10,805,092 | |
| Due premiums | | | 1,164,289 | | | | 1,288,335 | |
| Other | | | 904,492 | | | | 865,299 | |
| Total deferred tax liabilities | | $ | 20,007,677 | | | $ | 16,262,033 | |
| | | | | | | | | |
| Deferred tax assets: | | | | | | | | |
| Benefit reserves | | $ | 3,167,947 | | | $ | 2,507,315 | |
| Other policyholder funds | | | 348,010 | | | | 362,143 | |
| AMT credit carryforwards | | | 543,033 | | | | 494,094 | |
| Accrued pension liability | | | 2,451,916 | | | | 3,245,993 | |
| Other-than-temporary impairments | | | - | | | | 36,153 | |
| Other | | | 307,293 | | | | 290,398 | |
| Total deferred tax assets | | $ | 6,818,199 | | | $ | 6,936,096 | |
| Net deferred tax liabilities | | $ | 13,189,478 | | | $ | 9,325,937 | |
The Company periodically reviews its gross deferred tax assets for recoverability. At December 31, 2012 and 2011, the Company is able to demonstrate that the benefit of its gross deferred tax assets is fully recoverable.
The reconciliation of income tax attributable to operations computed at the federal statutory tax rate to income tax expense is as follows:
| | | 2012 | | | 2011 | |
| | | | | | | |
| Statutory federal income tax rate | | | 34.0 | % | | | 34.0 | % |
| Small life insurance company deduction | | | (28.2 | ) | | | (50.8 | ) |
| Dividends-received deduction | | | (0.9 | ) | | | (4.5 | ) |
| Defined contribution plan dividend | | | (1.3 | ) | | | (4.3 | ) |
| Book vs tax basis bond difference | | | 0.7 | | | | (13.0 | ) |
| Nondeductible COLI expense | | | (4.6 | ) | | | (15.6 | ) |
| Rate differential on realized loss | | | - | | | | 16.6 | |
| Nondeductible travel & meals expense | | | 0.8 | | | | 3.1 | |
| Implied interest on structured note | | | 2.0 | | | | 2.9 | |
| NOL utilized in carryback return | | | - | | | | 15.0 | |
| Other | | | (2.7 | ) | | | 2.3 | |
| | | | | | | | | |
| Effective income tax rate | | | (0.2 | ) % | | | (14.3 | ) % |
We file U.S. federal income tax returns and income tax returns in various state jurisdictions. Our 2009 through 2012 U.S. federal tax years remain subject to income tax examination by tax authorities. We have no known uncertain tax benefits within our provision for income taxes. In addition, we do not believe the Company will be subject to any penalties or interest relative to any open tax years and, therefore, have not accrued any such amounts. However, should such a circumstance arise, it is our policy to classify any interest and penalties (if applicable) as income tax expense in the Consolidated Financial Statements.
The Company made income tax payments of $863,191 and $338,410 relative to the 2012 and 2011 tax years, respectively.
NOTE 5 - Notes Payable
On November 5, 2012, the Company entered into a new loan agreement to borrow $2,000,000. The loan calls for interest to be paid quarterly at a rate of 0.25% under the prime rate and has a maturity date of November 5, 2017. The note requires quarterly principal payments of $45,000 beginning July 5, 2015 with a balloon payment upon maturity. There is no penalty for prepayment. This note is collateralized with 55,000 shares of Investors Heritage Life Insurance Company common stock.
The borrowed funds were utilized to fund a credit agreement to Puritan Financial Companies, Inc. for $2,000,000, with interest at a rate of 1.75% above the prime rate. The maturity date on this loan is April 1, 2016. This note requires quarterly payments of interest only beginning on January 5, 2013. The unpaid principal balance together with all accrued interest shall be due and payable with a balloon payment upon maturity. Under this credit agreement, Puritan Financial Companies, Inc. and its wholly-owned subsidiary Puritan Financial Group have committed to an increased level of new business production on behalf of the Company. Additionally, Puritan Financial Companies, Inc. has issued warrants for 2,000,000 shares of common stock to the Company in exchange for this funding. This note is further collateralized by all the stock and other assets of Puritan Financial Companies, Inc. and each of its affiliated companies. Puritan Financial Companies, Inc. has another credit facility with a senior lender and the Company has a subordinate interest to the senior lender in all of the collateral which is security for this loan. This $2,000,000 note receivable is included within other invested assets on the balance sheet.
Effective September 29, 2011, the Company renewed its line of credit for At Need Funding, maturing on September 29, 2013. The line of credit was reduced from $2,000,000 to $1,000,000 under the renewal. This line of credit is used for the purpose of funding at-need funerals secured by the assignment of verified, incontestable life insurance policies. Effective September 27, 2011, the Company renewed its $150,000 operating line of credit, maturing on September 27, 2013. These lines of credit require interest to be paid monthly at the prime rate, with a floor of 3.25%.
On February 3, 2005, Investors Heritage Capital borrowed $3,650,000 to finance the purchase of certain home office property previously owned by Investors Heritage Life at a purchase price of $3,650,000. The note is an amortizing loan with a fixed interest rate of 5.05% and with a maturity date of March 1, 2015. The proceeds received by Investors Heritage Life were used to repay their surplus notes to Investors Heritage Capital. Additionally, Investors Heritage Capital used such proceeds to repay the $3,000,000 bank note outstanding at December 31, 2004. This transaction was approved by the Kentucky Department of Insurance.
Information relative to the Company’s notes payable at December 31, 2012 and 2011 is as follows:
| 2012 | | | | | | | | | | | | | |
| Mortgage note | | $ | 988,393 | | | | 5.05 | % | 3/1/2015 | | $ | 59,363 | | | $ | 61,066 | |
| At Need Funding line of credit | | | 490,220 | | | | 3.25 | % | 9/29/2013 | | | 8,298 | | | | 8,320 | |
| Bank note | | | 2,000,000 | | | | 3.00 | % | 11/5/2017 | | | 9,333 | | | | - | |
| 2011 | | | | | | | | | | | | | |
| Mortgage note | | $ | 1,392,966 | | | | 5.05 | % | 3/1/2015 | | $ | 79,330 | | | $ | 80,949 | |
| At Need Funding line of credit | | | 388,371 | | | | 3.25 | % | 9/29/2013 | | | 7,647 | | | | 7,645 | |
NOTE 6 - Employee Benefit Plans
The Company sponsors a noncontributory defined benefit pension plan which covers substantially all employees. Benefits are based on years of service and the highest consecutive 60 months average earnings within the last 120 months of credited service. Benefits are funded based on actuarially-determined amounts. On May 10, 2012, the Board of Directors of the Company authorized an amendment to the IHCC Employee Retirement Plan (the “Pension Plan”) which provides that all future benefit accruals and compensation increases under the Pension Plan shall automatically cease for all individuals who are participants under the Pension Plan as of June 30, 2012. The amendment also allows such participants to continue to earn vesting credit towards their Pension Plan benefit on and after June 30, 2012. The curtailment of the Pension Plan resulted in a reduction in our accrued pension liability of $1,760,623, net of deferred taxes of $598,612.
The following table provides additional details for the Company on a consolidated basis as of December 31.
| | | 2012 | | | 2011 | |
| Change in projected benefit obligation: | | | | | | |
| Benefit obligation at beginning of year | | $ | 24,098,408 | | | $ | 18,811,475 | |
| Service cost | | | 293,544 | | | | 498,989 | |
| Interest cost | | | 1,010,630 | | | | 1,123,196 | |
| Actuarial (gain) loss | | | 1,184,013 | | | | 4,209,766 | |
| Benefits paid | | | (953,328 | ) | | | (545,018 | ) |
| Curtailment | | | (1,760,623 | ) | | | - | |
| Benefit obligation at end of year | | $ | 23,872,644 | | | $ | 24,098,408 | |
| | | | | | | | | |
| Change in plan assets: | | | | | | | | |
| Fair value of plan assets at beginning of year | | $ | 14,551,370 | | | $ | 13,204,844 | |
| Actual return on plan assets | | | 1,571,883 | | | | 451,544 | |
| Employer contributions | | | 1,491,200 | | | | 1,440,000 | |
| Benefits paid | | | (953,328 | ) | | | (545,018 | ) |
| Fair value of plan assets at end of year | | $ | 16,661,125 | | | $ | 14,551,370 | |
| | | | | | | | | |
| Funded status | | $ | (7,211,519 | ) | | $ | (9,547,038 | ) |
| Unrecognized net actuarial loss | | | - | | | | - | |
| Accrued pension liability | | $ | (7,211,519 | ) | | $ | (9,547,038 | ) |
| | | | | | | | | |
| Components of net periodic benefit cost: | | | | | | | | |
| Service cost | | $ | 293,544 | | | $ | 498,989 | |
| Interest cost | | | 1,010,630 | | | | 1,123,196 | |
| Expected return on plan assets | | | (1,272,898 | ) | | | (1,098,269 | ) |
| Recognized actuarial net loss | | | 913,378 | | | | 705,713 | |
| Net periodic benefit cost | | $ | 944,654 | | | $ | 1,229,629 | |
| | | | | | | | | |
| Accumulated benefit obligation | | $ | 23,872,644 | | | $ | 22,090,615 | |
The portion of the accrued pension liability included in accumulated other comprehensive loss at December 31, 2012 is $8,406,635, which has been recorded net of related tax of $2,858,256. The portion of the accrued pension liability included in accumulated other comprehensive income at December 31, 2011 is $10,195,608, which has been recorded net of related tax of $3,466,507. These amounts are solely the result of unamortized actuarial net losses not yet amortized into income.
Amounts recognized in other comprehensive income (loss) for the year ended December 31 are as follows:
| | | 2012 | | | 2011 | |
| Actuarial net loss | | $ | (885,028 | ) | | $ | (4,856,491 | ) |
| Amortization of actuarial net loss | | | 913,378 | | | | 705,713 | |
| Curtailment | | | 1,760,623 | | | | - | |
| | | | 1,788,973 | | | | (4,150,778 | ) |
| Deferred federal income tax | | | (608,251 | ) | | | 1,411,265 | |
| Total recognized in other comprehensive income | | $ | 1,180,722 | | | $ | (2,739,513 | ) |
The estimated net loss that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost during 2013 is $776,000.
Weighted-average actuarial assumptions used at December 31, 2012 and 2011 to determine benefit obligations and net periodic benefit cost are as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| Discount rate | | | 4.00 | % | | | 4.50 | % |
| Expected return on plan assets | | | 8.50 | % | | | 8.50 | % |
| Rate of compensation increases | | | 3.00 | % | | | 3.00 | % |
The long-term rate of return for plan assets is determined based on an analysis of historical returns on invested assets, anticipated future fixed income, equity investment markets, and diversification needs. Long term trends are evaluated relative to current market factors such as inflation, interest rates and investment strategies, including risk management, in order to assess the assumptions as applied to the plan.
The Company employs a conservative investment strategy whereby the majority of invested assets are held in appropriate investments for defined benefit pension plans, including a small portion of plan assets held in common stock of the Company. The Company uses an independent third party to administer its retirement plan. Plan assets are held in a trust account and include a diversified assortment of pooled separate accounts as well as Company common stock. The fair value of plan assets as of December 31, 2012 and 2011 are as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| | | | | | | |
| Pooled separate accounts | | $ | 16,113,355 | | | $ | 14,055,370 | |
| Company common stock - 31,000 shares | | | 547,770 | | | | 496,000 | |
Pooled separate accounts held by the Pension Plan at December 31, 2012 and 2011 are considered Level 2 assets and are valued at the net asset value (“NAV”) of units held by the Pension Plan at year end. The NAV is determined by dividing the net assets, at fair value, of the fund by the number of units outstanding on the day of valuation. Pooled separate accounts are comprised, primarily, of shares of registered investment companies held through subaccounts of a separate account of an insurance company. The NAV as adjusted (for mutual fund dividends, mutual fund splits and administrative maintenance charges and other items) and reported by the insurance company approximates fair value of the investments. The investments are redeemable at the adjusted NAV under agreements with the insurance company. However, it is possible that the redemptions rights may be restricted or eliminated in the future. Due to the nature of the investments, changes in the market conditions, liquidity requirements, and the economic environment may significantly affect the NAV of the registered investment companies and, consequently, the fair value of the Pension Plan's investments.
Shares of Company common stock held by the plan at December 31, 2012 and 2011 are considered Level 2 assets and are valued based on observable inputs, such as quoted prices in markets with limited activity. Dividends of $7,130 and $5,580 were paid to the plan in 2012 and 2011, respectively, on the Company common stock. The plan made no purchases or sales of Company common stock during 2012 or 2011.
A summary of the allocation of plan assets by investment type as of December 31, 2012 and 2011 is as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| Equity pooled separate accounts | | | 48 | % | | | 44 | % |
| Debt pooled separate accounts | | | 49 | % | | | 53 | % |
| Company common stock | | | 3 | % | | | 3 | % |
The Company expects to contribute approximately $1,440,000 to its pension plan in 2013.
The following estimated future benefit payments are expected to be paid:
| | | Pension Benefits | |
| | | | |
| 2013 | | $ | 845,000 | |
| 2014 | | | 2,365,000 | |
| 2015 | | | 1,317,000 | |
| 2016 | | | 2,078,000 | |
| 2017 | | | 1,312,000 | |
| 2018-2022 | | | 7,557,000 | |
The Company also sponsors a 401(k) defined contribution plan known as the IHCC Retirement Savings Plan and Trust (the “Old 401(k) Plan”). On June 21, 2012, the Board of Directors of the Company authorized an amendment to the Old 401(k) Plan, under which, effective June 30, 2012, participants in the Old 401(k) Plan shall not be eligible to elect to defer and contribute compensation earned to the Old 401(k) Plan; the Company will not make any matching contributions to the Old 401(k) Plan; and the Old 401(k) Plan will not accept rollover contributions.
On June 21, 2012, the Board of Directors of the Company also adopted a new traditional 401(k) retirement plan, the IHCC 401(k) Retirement Plan (the “Retirement Plan”). Employees will be eligible to participate in the Retirement Plan on the first day of employment. Under the Retirement Plan, the Company will match employee contributions dollar for dollar up to 4% of employee compensation deferrals. Employees who have met certain employment criteria may also be eligible to receive an additional allocation after the end of each plan year. The Retirement Plan became effective July 1, 2012.
The funds previously invested in mutual funds in the Old 401(k) Plan were rolled into the Retirement Plan in conjunction with the plan amendments, leaving only Company stock in the Old 401(k) Plan.
Information relative to the assets within both the Old 401(k) Plan and the Retirement Plan as of December 31, 2012 and 2011, along with matching contributions expensed and dividends paid on Company stock for the years then ended, are as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| | | | | | | |
| Old 401(k) Plan | | | | | | |
| Company common stock: | | | | | | |
| Shares held | | | 345,145 | | | | 343,370 | |
| Fair value | | $ | 6,098,714 | | | $ | 5,493,923 | |
| Mutual funds - fair value | | | - | | | | 586,379 | |
| | | | | | | | | |
| Retirement Plan | | | | | | | | |
| Mutual funds - fair value | | $ | 844,941 | | | $ | - | |
| | | For the Year Ended December 31 | |
| | | | 2012 | | | | 2011 | |
| | | | | | | | | |
| Old 401(k) Plan | | | | | | | | |
| Employer matching contributions | | $ | 133,970 | | | $ | 279,348 | |
| Dividends on Company stock | | | 79,621 | | | | 60,514 | |
| | | | | | | | | |
| Retirement Plan | | | | | | | | |
| Employer matching contributions | | $ | 88,654 | | | $ | - | |
In addition, the Company sponsors a deferred compensation plan for selected executive officers. Information relative to the assets within the deferred compensation plan as of December 31, 2012 and 2011, along with matching contributions expensed and dividends paid on Company stock for the years then ended, are as follows:
| | | December 31 | |
| | | 2012 | | | 2011 | |
| | | | | | | |
| Company common stock: | | | | | | |
| Shares held | | | 20,881 | | | | 19,585 | |
| Fair value | | $ | 368,976 | | | $ | 313,360 | |
| Mutual funds - fair value | | | 13,939 | | | | - | |
| Cash and cash equivalents | | | 5,012 | | | | 7,736 | |
| | | For the Year Ended December 31 | |
| | | | 2012 | | | | 2011 | |
| | | | | | | | | |
| Employer matching contributions | | $ | 18,212 | | | $ | 17,750 | |
| Dividends on Company stock | | | 4,659 | | | | 3,309 | |
NOTE 7 - Stockholders' Equity and Dividend Restrictions
Statutory restrictions limit the amount of dividends which may be paid by Investors Heritage Life. Generally, dividends during any year may not be paid, without prior regulatory approval, in excess of the lesser of (a) 10 percent of statutory surplus as of the preceding December 31, or (b) statutory net gain from operations for the preceding year. For 2013, the maximum dividend that Investors Heritage Life can pay to Investors Heritage Capital without regulatory approval is $1,676,705.
NOTE 8 - Statutory Accounting Practices
Investors Heritage Life's statutory-basis capital and surplus was $20,579,141 and $19,538,234 at December 31, 2012 and 2011, respectively. Statutory-basis net income was $1,905,812 and $1,690,216 for 2012 and 2011, respectively.
Principal adjustments to statutory amounts to derive GAAP amounts include: a) costs of acquiring new policies are deferred and amortized; b) benefit reserves are calculated using more realistic investment, mortality and withdrawal assumptions; c) changes in deferred taxes associated with timing differences are recorded in net income rather than directly to equity; d) value of business acquired and goodwill established for acquired companies differ from admitted statutory goodwill; e) accounting for certain investments in debt securities is at fair value with unrealized gains and losses reported as a separate component of equity; and f) statutory asset valuation reserves and interest maintenance reserves are eliminated.
NOTE 9 - Segment Data
The Company operates in four segments as shown in the following table. All segments include both individual and group insurance. Identifiable revenues, expenses and assets are assigned directly to the applicable segment. Net investment income, realized gains and losses, and invested assets are generally allocated to the insurance and the corporate segments in proportion to policy liabilities and stockholders' equity, respectively. Certain assets, such as property and equipment and leased property under capital leases, are allocated between the Administrative and financial services segment and the Corporate and other segment. Investors Heritage Financial revenue and income associated with credit administrative services is assigned to the Administrative and financial services segment, along with fees relative to third party administrative services. Any remaining revenue and income is assigned to the Corporate and other segment. Results for the parent company, Investors Heritage Printing, At Need Funding and Heritage Funding, after elimination of intercompany amounts, are allocated to the Corporate and other segment.
| | | 2012 | | | 2011 | |
| | | (000's omitted) | |
| Revenue: | | | | | | |
| Preneed and burial products | | $ | 48,863 | | | $ | 139,261 | |
| Traditional and universal life products | | | 19,336 | | | | 16,854 | |
| Administrative and financial services | | | 1,491 | | | | 1,536 | |
| Corporate and other | | | 740 | | | | 793 | |
| | | $ | 70,430 | | | $ | 158,444 | |
| | | | | | | | | |
| Pre-tax income (loss) from operations: | | | | | | | | |
| Preneed and burial products | | $ | 993 | | | $ | (741 | ) |
| Traditional and universal life products | | | 921 | | | | 857 | |
| Administrative and financial services | | | 366 | | | | 329 | |
| Corporate and other | | | (185 | ) | | | 38 | |
| | | $ | 2,095 | | | $ | 483 | |
| | | | | | | | | |
| Assets: | | | | | | | | |
| Preneed and burial products | | $ | 378,142 | | | $ | 378,882 | |
| Traditional and universal life products | | | 91,142 | | | | 79,704 | |
| Administrative and financial services | | | 10,757 | | | | 10,771 | |
| Corporate and other | | | 95,965 | | | | 82,488 | |
| | | $ | 576,006 | | | $ | 551,845 | |
| | | | | | | | | |
| Amortization and depreciation expense: | | | | | | | | |
| Preneed and burial products | | $ | 5,427 | | | $ | 5,023 | |
| Traditional and universal life products | | | 3,223 | | | | 2,045 | |
| Administrative and financial services | | | 213 | | | | 100 | |
| Corporate and other | | | 313 | | | | 199 | |
| | | $ | 9,176 | | | $ | 7,367 | |
NOTE 10 - Reinsurance
The Company ceded 100% of the risks associated with its credit life and accident insurance written during 2012 and 2011 through coinsurance agreements with various companies. The Company administers the ceded credit life and accident insurance for an agreed-upon fee. During 2012 and 2011, the Company received $299,843 and $280,406, respectively, of fee income associated with these reinsurance arrangements, which is recognized in the administrative and financial services segment in the preceding table in Note 9. Ceded benefit and claim reserves associated with these reinsurance arrangements at December 31, 2012 and 2011 were $9,737,123 and $9,707,159, respectively. Additionally, unearned premium reserves were reduced by $9,107,458 and $9,563,857 at December 31, 2012 and 2011, respectively, for credit-related reinsurance transactions. The Company utilizes yearly renewable term reinsurance to cede life insurance coverage in excess of its retention limit, which is set at $25,000.
Investors Heritage Life cedes 85% of life and annuity policy obligations assumed from Franklin American Life Insurance Company to Scottish Annuity and Life Insurance Company (Cayman) Ltd. Benefit reserves ceded to Scottish and included in the amounts recoverable from reinsurers approximated $22,627,000 and $23,783,000 at December 31, 2012 and 2011, respectively. An escrow account has been established by Scottish to secure Investors Heritage Life's ceded benefit obligations.
Investors Heritage Life cedes 50% of policy obligations written through its relationship with Puritan Financial Group to Puritan Life Insurance Company (“Puritan”), an affiliate of Puritan Financial Group. Benefit reserves ceded to Puritan and included in the amounts recoverable from reinsurers approximated $11,141,000 and $3,741,000 at December 31, 2012 and 2011, respectively. Puritan maintains a trust account in Kentucky to secure Investors Heritage Life's ceded benefit obligations. At December 31, 2011, the Company held $3,630,175 as a payable to Puritan until such time that the trust account was established. This liability was included within other liabilities on the balance sheet at December 31, 2011.
Reinsurance ceded and assumed amounts included in the consolidated statements of income are as follows:
| | | 2012 | | | 2011 | |
| | | | | | | |
| Premiums ceded | | $ | 19,997,026 | | | $ | 15,855,869 | |
| Premiums assumed | | | 3,834,907 | | | | 5,869,332 | |
| Commission and expense allowances | | | 4,596,452 | | | | 4,138,849 | |
| Benefit recoveries | | | 7,288,897 | | | | 6,495,183 | |
During 2012, the Company terminated its participation in the Federal Employees’ Group Life Insurance (“FEGLI”) and Servicemen’s Group Life Insurance (“SGLI”) programs. The termination of our participation in FEGLI was effective September 30, 2012 while the termination of our participation in SGLI was effective July 1, 2012. These terminations did not have a significant impact on the results of our operations. However, the terminations did reduce certain items within the balance sheet, including the policy claims liability and due premiums for reinsurance assumed compared to the prior year.
The Company remains contingently liable on all ceded insurance should any reinsurer be unable to meet their obligations.
NOTE 11 – Other Comprehensive Income
The following tables present the pretax components of the Company’s other comprehensive income, and the related income tax expense (benefit) for each component, for the years ended December 31, 2012 and 2011.
| | | Year Ended December 31, 2012 | |
| | | Pretax | | | | | | Net of Tax | |
| Other comprehensive income: | | | | | | | | | |
Change in net unrealized gains on available-for-sale securities: | | | | | | | | | |
Unrealized holding gains arising during period | | $ | 12,580,096 | | | $ | 4,219,487 | | | $ | 8,360,609 | |
Reclassification adjustment for gains included in income | | | (484,813 | ) | | | (92,394 | ) | | | (392,419 | ) |
Adjustment for effect of deferred acquisition costs | | | (325,260 | ) | | | (110,588 | ) | | | (214,672 | ) |
| Net unrealized gains on investments | | | 11,770,023 | | | | 4,016,505 | | | | 7,753,518 | |
| Actuarial net loss on pension plan | | | (885,028 | ) | | | (300,910 | ) | | | (584,118 | ) |
Amortization of actuarial net loss in net periodic pension cost | | | 913,378 | | | | 310,549 | | | | 602,829 | |
Curtailment of defined benefit pension plan | | | 1,760,623 | | | | 598,612 | | | | 1,162,011 | |
| Net change in defined benefit pension plan | | | 1,788,973 | | | | 608,251 | | | | 1,180,722 | |
| | | | | | | | | | | | | |
| Total other comprehensive income | | $ | 13,558,996 | | | $ | 4,624,756 | | | $ | 8,934,240 | |
| | | Year Ended December 31, 2011 | |
| | | Pretax | | | | | | Net of Tax | |
| Other comprehensive income: | | | | | | | | | | | | |
Change in net unrealized gains on available-for-sale securities: | | | | | | | | | | | | |
Unrealized holding gains arising during period | | $ | 14,172,171 | | | $ | 4,570,687 | | | $ | 9,601,484 | |
Reclassification adjustment for (gains) losses included in income | | | (559,001 | ) | | | 31,448 | | | | (590,449 | ) |
Adjustment for effect of deferred acquisition costs | | | (224,440 | ) | | | (76,310 | ) | | | (148,130 | ) |
| Net unrealized gains on investments | | | 13,388,730 | | | | 4,525,825 | | | | 8,862,905 | |
| Actuarial net loss on pension plan | | | (4,856,491 | ) | | | (1,651,207 | ) | | | (3,205,284 | ) |
Amortization of actuarial net loss in net periodic pension cost | | | 705,713 | | | | 239,942 | | | | 465,771 | |
| Net change in defined benefit pension plan | | | (4,150,778 | ) | | | (1,411,265 | ) | | | (2,739,513 | ) |
| | | | | | | | | | | | | |
| Total other comprehensive income | | $ | 9,237,952 | | | $ | 3,114,560 | | | $ | 6,123,392 | |
Realized gains and losses on the sales of investments are determined based upon the specific identification method and include provisions for other-than-temporary impairments where appropriate.
The change in the components of the Company’s accumulated other comprehensive income for the years ended December 31, 2012 and 2011 are as follows:
| | | | | | | | | | |
| For the year ended December 31, 2012: | | | | | | | | | |
| Beginning balance | | $ | 20,334,585 | | | $ | (6,729,101 | ) | | $ | 13,605,484 | |
| Other comprehensive income | | | 7,753,518 | | | | 1,180,722 | | | | 8,934,240 | |
| Ending balance | | $ | 28,088,103 | | | $ | (5,548,379 | ) | | $ | 22,539,724 | |
| | | | | | | | | | | | | |
| For the year ended December 31, 2011: | | | | | | | | | | | | |
| Beginning balance | | $ | 11,471,680 | | | $ | (3,989,588 | ) | | $ | 7,482,092 | |
| Other comprehensive income | | | 8,862,905 | | | | (2,739,513 | ) | | | 6,123,392 | |
| Ending balance | | $ | 20,334,585 | | | $ | (6,729,101 | ) | | $ | 13,605,484 | |
NOTE 12 - Contingent Liabilities
The Company is named as a defendant in several legal actions arising primarily from claims made under insurance policies. Management and its legal counsel are of the opinion that the settlement of those actions will not have a material adverse effect on the financial position or results of operations.
In most of the states in which the Company is licensed to do business, guaranty fund assessments may be taken as a credit against premium taxes over a five-year period. These assessments, brought about by the insolvency of life and health insurers, are levied at the discretion of the various state guaranty fund associations to cover association obligations. It is management's opinion that the effect of any future assessments would not be material to the financial position or results of operations of the Company because of the use of premium tax offsets.
NOTE 13 - Acquisitions
During the third quarter of 2011, we assumed the covered obligations of the Texas Life, Accident, Health, and Hospital Service Insurance Guaranty Association related to a block of preneed policies originally issued by Memorial Service Life Insurance Company. We received cash in exchange for assuming the covered obligations. We assumed estimated net policy liabilities totaling approximately $93,904,000 in exchange for cash totaling approximately $93,909,000. Given that the liabilities assumed approximated the consideration received, we did not establish an asset for value of business acquired. The total consideration received from this assumption is shown on the income statement as “Consideration on reinsurance assumed” while the associated policy liabilities are included within “Increase in benefit reserves and unearned premiums.”
HARRY LEE WATERFIELD II | | | Chairman of the Board President Chief Executive Officer | Executive Committee Finance Committee Nominating Committee Frankfort, Kentucky |
GEORGE R. BURGESS, JR. | | | Frankfort, Kentucky | HOWARD L. GRAHAM | | | Retired Vice President, Corporate Services Finance Committee Nominating Committee Frankfort, Kentucky |
| | | | | | | | |
HAROLD G. DORAN, JR. | | | Audit Committee Executive Committee Finance Committee Murray, Kentucky | ROBERT M. HARDY, JR. | | | Vice President, General Counsel Executive Committee Finance Committee Frankfort, Kentucky |
| | | | | | | | |
GORDON C. DUKE | | | Audit Committee Finance Committee Frankfort, Kentucky | DAVID W. REED | | | Audit Committee Nominating Committee Gilbertsville, Kentucky |
| | | | | | | | |
MICHAEL F. DUDGEON, JR. | | | Frankfort, Kentucky | HELEN S. WAGNER | | | Executive Committee Nominating Committee Owensboro, Kentucky |
| CORPORATE OFFICERS |
| |
| | | | | | | | |
RAYMOND L. CARR | | | Vice President, Chief Financial Officer Frankfort, Kentucky | JANE S. JACKSON | | | Corporate Secretary Frankfort, Kentucky |
| | | | | | | | |
JIMMY R. McIVER | | | Treasurer Frankfort, Kentucky | | | | |
MOUNTJOY CHILTON MEDLEY LLP | | | Independent Registered Public Accounting Firm Louisville, Kentucky |
| |
ANNUAL MEETING | | | The 2013 annual meeting of shareholders of Investors Heritage Capital Corporation is scheduled for 11:00 a.m. on May 9, 2013 at the Company auditorium, Second and Shelby Streets, Frankfort, Kentucky. |
| | | | |
| FORM 10-K | | | A copy of the Form 10-K Annual Report to the Securities and Exchange Commission for the Company can be obtained at www.investorsheritage.com or upon request to the Secretary. |
| | | | |
TRANSFER AGENT | | | Investors Heritage Life Insurance Company Stock Transfer Department P.O. Box 717 Frankfort, KY 40602-0717 Phone: 800.422.2011 502.209.1009 |
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