UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
Commission File Number 0-4690
FINANCIAL INDUSTRIES CORPORATION
(Exact Name of Registrant as specified in its charter)
Texas 74-2126975
(State of Incorporation) (I.R.S. Employer Identification Number)
6500 River Place Blvd., Building One
Austin, Texas 78730
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (512) 404-5000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] NO [ ]
Number of common shares outstanding, $0.20 par value, as of June 30, 2003:
9,567,211.
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Forward-Looking Statements
Except for historical factual information set forth in this Quarterly Report on
Form 10-Q of Financial Industries Corporation (the "Company" or "FIC"), the
statements, analyses, and other information contained in this report relating to
trends in the Company's operations and financial results, the markets for the
Company's products, the future development of the Company's business, and the
contingencies and uncertainties to which the Company may be subject, as well as
other statements including words such as "anticipate," "believe," "path,"
"estimate," "expect," "intend" and other similar expressions constitute
forward-looking statements under the Private Securities Litigation Reform Act of
1995. Such statements are made based upon management's current expectations and
beliefs concerning the financial results, economic conditions and are subject to
known and unknown risks, uncertainties and other factors contemplated by the
forward-looking statements. Such factors include, among other things: (1)
general economic conditions and other factors, including prevailing interest
rate levels and stock market performance, which may affect the ability of FIC to
sell its products, the market value of FIC's investments and the lapse rate and
profitability of policies; (2) FIC's ability to achieve anticipated levels of
operational efficiencies and cost-saving initiatives; (3) customer response to
new products, distribution channels and marketing initiatives; (4) mortality,
morbidity and other factors which may affect the profitability of FIC's
insurance products; (5) changes in the Federal income tax laws and regulations
which may affect the relative tax advantages of some of FIC's products; (6)
increasing competition in the sale of insurance and annuities; (7) regulatory
changes or actions, including those relating to regulation of insurance products
and insurance companies; (8) ratings assigned to FIC's insurance subsidiaries by
independent rating organizations such as A.M. Best Company, which FIC believes
are particularly important to the sale of annuity and other accumulation
products; and (9) unanticipated litigation. There can be no assurance that other
factors not currently anticipated by management will not also materially and
adversely affect FIC.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
INDEX
Page No.
Part I - Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets
June 30, 2003 and December 31, 2002................................ 4
Consolidated Statements of Income
For the three and six month periods ended
June 30, 2003 and June 30, 2002, as restated....................... 6
Consolidated Statements of Cash Flows
For the six month periods ended
June 30, 2003 and June 30, 2002, as restated...................... 10
Notes to Consolidated Financial Statements................................. 12
Item 2. Management's Discussion and Analysis of
Financial Conditions and Results of Operations.................... 33
Item 3. Quantitative and Qualitative Disclosures
About Market Risk ............................................. 46
Item 4. Controls and Procedures........................................... 47
Part II
Other Information......................................................... 48
Signature Page............................................................ 51
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
June 30, December 31,
2003 2002
ASSETS (unaudited)
Investments:
Fixed maturities held to maturity, at
amortized cost (market value
approximates $31 and $1,069 at
June 30, 2003 and December 31, 2002,
respectively) $ 29 $ 1,090
Fixed maturities available for sale, at
market value (amortized cost of
$590,407 and $479,433 at June 30, 2003
and December 31, 2002,respectively) 604,220 493,827
Trading securities, at market value 19,995 0
Equity securities, at market value (cost
approximates $6,348 and $6,381 at June
30, 2003 and December 31, 2002, respectively) 7,023 6,351
Policy loans 45,033 46,607
Mortgage loans 0 17
Invested real estate 74,569 75,393
Short-term investments 29,349 137,944
Total investments 780,218 761,229
Cash and cash equivalents 9,239 24,975
Accrued investment income 8,802 8,308
Agency advances and other receivables 18,549 19,728
Reinsurance receivables 12,743 12,330
Due and deferred premiums 11,394 11,981
Real estate occupied by Company 19,495 19,702
Property and equipment, net 1,776 1,367
Deferred policy acquisition costs 76,375 77,210
Present value of future profits of
acquired businesses 21,764 23,796
Other assets 20,206 15,739
Separate account assets 348,194 334,637
Total Assets $ 1,328,755 $ 1,311,002
The accompanying notes are an integral part of
these consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
June 30, December 31,
2003 2002
LIABILITIES AND SHAREHOLDERS' EQUITY (unaudited)
Liabilities:
Policy liabilities and contractholder
deposit funds:
Contractholder deposit funds $ 562,616 $ 557,466
Future policy benefits 168,490 172,008
Other policy claims and benefits payable 14,027 17,035
745,133 746,509
Deferred federal income taxes 23,518 25,814
Notes payable 15,000 0
Other liabilities 26,574 29,400
Separate account liabilities 348,194 334,637
Total Liabilities 1,158,419 1,136,360
Commitments and Contingencies
Shareholders' equity:
Common stock, $.20 par value, 25,000
shares authorized in 2003 and 2002,
12,363 and 11,856 shares issued in
2003 and 2002, 9,566 and 9,601 shares
outstanding in 2003 and 2002 2,474 2,372
Additional paid-in capital 67,562 66,541
Unearned compensation (2,368) 0
Accumulated other comprehensive income 5,385 4,949
Retained earnings 121,275 123,046
194,328 196,908
Common treasury stock, at cost, 2,797
and 2,255 shares in 2003 and 2002 (23,992) (22,266)
Total Shareholders' Equity 170,336 174,642
Total Liabilities and Shareholders' Equity $ 1,328,755 $ 1,311,002
The accompanying notes are an integral part of these
consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share data, unaudited)
Three Months Ended June 30,
2003 2002
RESTATED
Revenues:
Premiums $ 7,612 $ 8,996
Net investment income 10,634 9,376
Real estate income 629 712
Net realized investment gains 360 4
Earned insurance charges 10,180 10,676
Other 631 238
30,046 30,002
Benefits and expenses:
Policyholder benefits and expenses 10,054 11,531
Interest expense on contract holders deposit funds 7,310 7,109
Amortization of present value of future profits
of acquired businesses 1,060 1,275
Amortization of deferred policy acquisition costs 2,641 2,310
Operating expenses 9,681 7,897
Interest expense 79 0
30,825 30,122
Loss before federal income tax (779) (120)
Provision for federal income taxes (272) 127
Net loss $ (507) $ (247)
The accompanying notes are an integral part of these
consolidated statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share data, unaudited)
Three Months Ended June 30,
2003 2002
Net Loss Per Share RESTATED
Basic:
Weighted average shares outstanding 9,593 9,541
Basic earnings per share:
Basic earnings per share $ (0.05) $ (0.03)
Diluted:
Common stock and common stock equivalents 9,593 9,541
Diluted earnings per share:
Diluted earnings per share $ (0.05) $ (0.03)
The accompanying notes are an integral part of these
consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share data, unaudited)
Six Months Ended June 30,
2003 2002
RESTATED
Revenues:
Premiums $ 15,551 $ 18,912
Net investment income 19,677 19,810
Real estate income 917 1,325
Net realized investment gains 1,990 5
Earned insurance charges 20,598 21,501
Other 889 690
59,622 62,243
Benefits and expenses:
Policyholder benefits and expenses 19,706 22,399
Interest expense on contract holders
deposit funds 14,649 15,094
Amortization of present value of future
profits of acquired business 2,174 2,361
Amortization of deferred policy acquisition
costs 5,273 4,320
Litigation settlement 2,915 0
Operating expenses 17,550 16,983
Interest expense 79 0
Total 62,346 61,157
Income (loss) before federal income tax and
cumulative effect of change in accounting principle (2,724) 1,086
Provision for federal income taxes (953) 751
Income (loss) before cumulative effect of
change in accounting principle (1,771) 335
Cumulative effect of change in accounting principle 0 10,429
Net (Loss) Income $ (1,771) $ 10,764
The accompanying notes are an integral part of
these consolidated statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share data, unaudited)
Six Months Ended June 30,
2003 2002
Net Income (Loss) Per Share RESTATED
Basic:
Weighted average shares outstanding 9,598 9,515
Basic earnings per share
Income (loss) per share before cumulative
effect of change in accounting principle $ (0.18) $ 0.03
Cumulative effect of change in accounting
principle 0 1.10
Basic earnings per share $ (0.18) $ 1.13
Diluted:
Common stock and common stock equivalents 9,598 9,594
Diluted earnings per share
Income (loss) per share before cumulative effect
of change in accounting principle $ (0.18) $ 0.03
Cumulative effect of change in accounting principle 0 1.09
Diluted earnings per share $ (0.18) $ 1.12
The accompanying notes are an integral part of these
consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands, unaudited)
Six Months Ended June 30,
2003 2002
RESTATED
CASH FLOWS FROM OPERATING ACTIVITIES
Net (Loss) Income $ (1,771) $ 10,764
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization of present value of future
profits of acquired business 2,174 2,361
Amortization of deferred policy acquisition costs 5,273 4,320
Depreciation 1,760 1,282
Cumulative effect of change in accounting principle 0 (10,429)
Realized gain on investments (1,990) 0
Changes in assets and liabilities:
(Increase) decrease in accrued investment income (494) 176
Decrease (increase) in agent advances and other
receivables 924 (5,152)
Decrease in due and deferred premiums 587 859
Increase in deferred policy acquisition costs (4,383) (5,006)
Increase in other assets (37) (2,489)
(Decrease) increase in policy liabilities
and accruals (243) 3,463
Increase in other liabilities 4,258 2,237
Decrease in deferred federal income taxes (2,285) (2,159)
Net activity from trading securities (19,995) 0
Other, net 540 916
Net cash (used in) provided by operating
activities $ (15,682) $ 1,143
The accompanying notes are an integral part of these
consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued
(in thousands, unaudited)
Six Months Ended June 30,
2003 2002
RESTATED
CASH FLOWS FROM INVESTING ACTIVITIES
Fixed maturities purchased $ (332,392) $ (106,587)
Real estate capitalized (439) (10,380)
Proceeds from sales and maturities of
fixed maturities 214,302 115,313
Net change in policy loans 1,574 1,597
Net change in short-term investments 108,595 11,840
Net change in property and equipment (411) (175)
Acquisition of subsidiaries, net of cash
acquired (4,037) 0
Net cash (used in) provided by investing
activities (12,808) 11,608
CASH FLOW FROM FINANCING
ACTIVITIES
Dividends Paid (483) (2,207)
Contractholder fund deposits 29,738 25,628
Contractholder fund withdrawals (30,871) (36,379)
Issuance of common capital stock 1,123 989
Purchase of treasury stock (1,753) (460)
Proceeds from bank borrowings 15,000 0
Net cash provided by (used in) financing
activities 12,754 (12,429)
Net (decrease) increase in cash (15,736) 322
Cash, beginning of year 24,975 7,094
Cash, end of period $ 9,239 $ 7,416
The accompanying notes are an integral part of these
consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued
(in thousands, unaudited)
Supplemental Schedule of Noncash Investing and Financing Activities
In June 2003, the Company purchased all of the capital stock of the New Era
Marketing companies (as defined and described in Note 6) for $4.2 million in
cash and consideration in the form of restricted FIC common stock of $0.6
million. In conjunction with the acquisition, assets were acquired and
liabilities were assumed as follows:
Estimated fair value of assets acquired $5.0 million
Estimated fair value of liabilities assumed $0.2 million
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The financial statements included herein have been presented to conform to the
requirements of Form 10-Q. This presentation includes year end balance sheet
data which was derived from audited financial statements. The notes to the
financial statements do not necessarily include all disclosures required by
generally accepted accounting principles (GAAP). The reader should refer to Form
10-K for the year ended December 31, 2002 previously filed with the Securities
and Exchange Commission for financial statements prepared in accordance with
GAAP. Management believes the financial statements reflect all adjustments
necessary to present a fair statement of interim results. Certain prior year
amounts have been reclassified to conform with current year presentation. All
adjustments made to the interim periods are of a normal recurring nature, except
for the 2002 restatement described in Note 9.
The consolidated financial statements include the accounts of Financial
Industries Corporation ("FIC") and its wholly-owned subsidiaries. All
significant intercompany items and transactions have been eliminated.
Certain prior year amounts have been reclassified to conform to the current year
presentation.
1. Other Comprehensive Income
The following is a reconciliation of the change in accumulated other
comprehensive income from December 31, 2002 to June 30, 2003 (in thousands):
Net
unrealized
gain (loss)
on invest-
ments in Total
fixed Net accumulated
maturities appreciation other com-
available of equity prehensive
for sale securities Other income
Balance at December 31, 2002 $ 6,601 $ (20) $ (1,632) $ 4,949
Current Period Change (250) 459 227 436
Balance at June 30, 2003 $ 6,351 $ 439 $ (1,405) $ 5,383
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
2. Earnings per Share
The following table reflects the calculation of basic and diluted earnings per
share (amounts in thousands, except per share amounts):
Three months ended Six months ended
June 30, June 30,
2003 2002 2003 2002
Restated Restated
BASIC:
Net (loss) income available to common
shareholders $ (507) $ (247) $ (1,771) $ 10,764
Weighted average common shares outstanding 9,593 9,541 9,598 9,515
Basic earnings per share $ (0.05) $ (0.03) $ (0.18) $ 1.13
DILUTED:
Net (loss) income available to common
shareholders $ (507) $ (247) $ (1,771) $ 10,764
Weighted average common shares outstanding 9,593 9,541 9,598 9,515
Common stock options 0 0 0 295
Repurchase of treasury stock 0 0 0 (216)
Common stock and common stock equivalents 9,593 9,541 9,598 9,594
Diluted earnings per share $ (0.05) $ (0.03) $ (0.18) $ 1.12
Options to purchase 202,250 shares of common stock at prices ranging from $8.18
to $14.30 were outstanding at June 30, 2003, but were not included in the
computation of diluted earnings per share because the inclusion would result in
an antidilutive effect in periods where a loss from continuing operations was
incurred.
3. Stock Option Plans and Other Equity Incentive Plans
The Company follows the disclosure-only provisions of SFAS No. 123, "Accounting
for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock
Based Compensation - Transition and Disclosure." SFAS No. 123 allows companies
to follow existing accounting rules (APB 25) provided that pro forma disclosures
are made of what net income and earnings per share would have been had the
company recognized expense for stock-based awards based on their fair value at
date of grant.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
For purpose of pro forma disclosures, the estimated fair value of the options is
amortized to expense over the options' vesting period. Pro forma income
information is as follows (in thousands except for net income per share) for the
three and six months ended June 30:
Three months ended Six months ended
June 30, June 30,
2003 2002 2003 2002
RESTATED RESTATED
Net (loss) income as reported $ (507) $ (247) $ (1,771) $ 10,764
Pro forma compensation expense,
net of tax benefits 0 39 0 76
Pro forma net (loss) income $ (507) $ (286) $ (1,771) $ 10,688
Net (loss) income per share:
Basic as reported, restated $ (0.05) $ (0.03) $ (0.18) $ 1.13
Diluted as reported, restated $ (0.05) $ (0.03) $ (0.18) $ 1.12
Basic - Pro Forma $ (0.05) $ (0.03) $ (0.18) $ 1.12
Diluted - Pro Forma $ (0.05) $ (0.03) $ (0.18) $ 1.11
4. Dividends Declared
The Board declared a dividend of $0.05 per common share payable on January 24,
2003 to record holders as of January 3, 2003.
5. Trading Securities
FIC's trading securities consist of Collateralized Mortgage Obligations
("CMO's") of the type which are generally referred to as "inverse floaters"
which have coupon rates that vary in an inverse relationship with a specified
benchmark rate. The value of FIC's trading securities as of June 30, 2003 was
$20.0 million. The change in the market value of trading securities during the
period is included in net realized investment income on the income statement.
The change in market value included in income during the three and six months
ended June 30, 2003 is $ 756,000 and $761,000, respectively. FIC did not have
any trading securities at December 31, 2002.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
6. Acquisition of Subsidiaries and Related Transactions
On June 5, 2003, FIC, through a subsidiary, acquired three companies in the
secondary education financial services market. Each of the three transactions is
described below. In connection with the acquisitions, FIC, or its subsidiaries,
entered into the transactions which are described below:
A. Acquisition of Marketing Companies:
A newly created subsidiary of FIC, FIC Financial Services, Inc. ("FICFS")
acquired all of the issued and outstanding capital stock of: (i) Total
Consulting Group, Inc. ("TCG"), (ii) JNT Group, Inc. ("JNT") and (iii) three
companies collectively referred to as "Paragon" - Paragon Benefits, Inc., The
Paragon Group, Inc., and Paragon National, Inc. (collectively the "New Era
Marketing Companies"). The Acquisitions were consummated pursuant to three
separate Stock Purchase Agreements by and among the parties. The effective date
of the acquisitions is May 30, 2003.
The consideration paid by FICFS for the purchase of TCG was $1,984,824 in cash
and 97,417 shares of restricted common stock of FIC. The value assigned to the
restricted common stock was $1,327,794 and was based on the 10-day average price
of FIC common stock as of two days prior to the effective date of the
acquisition. The restricted common stock is subject to a lock-up period of 12
months for shareholders other than two key employees of TCG. The restricted
common stock issued to two key employees of TCG is locked-up pursuant to a
three-year vesting schedule, which is subject to the continued employment of the
employees under employment agreements between the employees and FICFS. The value
of the restricted common stock issued to the two key employees will be
recognized as compensation expense over the vesting period.
The consideration paid by FICFS for the purchase of JNT was $514,583 in cash and
17,899 shares of restricted common stock of FIC. The value assigned to the
restricted common stock was $243,964 and was based on the 10-day average price
of FIC common stock as of two days prior to the effective date of the
acquisition. The restricted stock portion of the consideration is subject to a
three-year vesting restriction based on the three-year employment agreement
entered into by and between FICFS and one key employee of JNT. The value of the
restricted common stock issued to the key employee will be recognized as
compensation expense over the vesting period.
The consideration paid by FICFS for the purchase of Paragon was $1,410,750 in
cash and 105,593 shares of restricted common stock of FIC. The value assigned to
the restricted common stock was $1,439,233 and was based on the 10-day average
price of FIC common stock as of two days prior to the effective date of the
acquisition. A portion of the restricted stock consideration is subject to a
vesting restriction based on the employment agreements entered into by and
between FICFS and three key employees of Paragon. A portion of the restricted
stock is subject to forfeiture if certain business targets are not met. The
value of the restricted common stock issued to the key employees will be
recognized as compensation expense over the vesting period.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The results of operations of the New Era Marketing Companies are included in the
Consolidated Statement of Income from the effective date of the acquisitions
(May 30, 2003). The pro forma results as if FIC had acquired the New Era
Marketing Companies on January 1, 2003 are as follows (in thousands except per
share amounts):
Three Months Six Months
Ending June 30, Ending June 30,
2003 2003
- -------------------------- ------------------ ------------------------
Revenues $ 30,625 $ 60,774
Net income $ (525) $ (1,824)
Basic earnings per share $ (0.05) $ (0.19)
Diluted earnings per share $ (0.05) $ (0.19)
- -------------------------- ------------------ ------------------------
The pro forma information for the corresponding 2002 periods is not provided as
it is not practicable to obtain.
The acquisition of the New Era Marketing Companies has been accounted for in
accordance with Statement of Financial Accounting Standards No. 141, "Business
Combinations" ("SFAS No. 141"). This statement requires that FIC estimate the
fair value of assets acquired and liabilities assumed by the Company as of the
date of the acquisition and allocate the purchase price to those assets and
liabilities. The purchase price paid for the New Era Marketing Companies
(including transaction fees and excluding contingent consideration amounts
accounted for as compensation as described above) was $4,239,591 in cash and
41,889 shares of restricted common stock of FIC with an estimated value of
$570,947. FIC has not finalized the allocation of the purchase price as of June
30, 2003. An estimation of this allocation was prepared and included as part of
these financial statements. The purchase price has been allocated as follows:
$116 thousand to cash, $158 thousand to agency advances and other receivables,
$288 thousand to property, plant and equipment, $28 thousand to other assets,
$182 thousand to other liabilities and $4.4 million to goodwill and other
intangibles (included in other assets).
B. Marketing Agreement:
In addition to the acquisitions described above, and the establishment of FICFS
as a wholly-owned subsidiary of FIC, the life insurance company subsidiaries of
FIC (Investors Life Insurance Company of North America ("Investors Life"), and
Family Life Insurance Company ("Family Life") entered into a marketing agreement
with Equita Financial and Insurance Services of Texas, Inc. ("Equita"), a
Dallas-based company engaged in the marketing and sale of insurance policies,
annuity contracts and related financial products. Under the terms of the
agreement, Equita was granted an exclusive appointment to market products
underwritten by Investors Life and Family Life ("Products") to individuals in
the "senior market" (individuals over the age of fifty-five) (the "Exclusive
Market"). The appointment is for a ten-year period; however, the exclusive
rights of Equita terminate unless certain production targets are met.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
C. Stock Purchase and Option Agreement - American Physicians Service
Group, Inc. ("APS"):
In consideration of the role that APS served in having brought the opportunity
to acquire the New Era Marketing Companies to FIC and APS's intention to
actively assist FIC in promoting FIC's business plan; FIC sold 27,395 shares of
its common stock, par value $.20 ("Common Stock") per share to APS, at a
purchase price of $14.64 per share. These shares represent a portion of the
shares that FIC recently purchased from Roy F. Mitte (former Chairman and Chief
Executive Officer of FIC) pursuant to the provisions of the previously announced
settlement of the litigation between FIC, Mitte family members, and the Mitte
Foundation (the "Settlement Agreement"). In addition, FIC granted to APS an
option to acquire up to 323,000 shares of Common Stock at a per share exercise
price equal to $16.42 per share, but only if "Qualifying Premiums" for the
"Determination Period" exceed $200,000,000. The Qualifying Premiums requirement
refers, with certain exceptions, to the amount of premiums collected for life
insurance and annuity products marketed through FICFS, the newly-established
subsidiary of FIC which purchased the New Era Marketing Companies and includes
premiums received by FIC's life insurance subsidiaries in connection with the
Equita Marketing Agreement described above. The Determination Period means the
period beginning on July 1, 2003 and ending on December 31, 2005. Unless earlier
exercised, the option expires on December 31, 2006. The fair value of the
options at the date the Qualifying Premium targets, if met, are achieved will be
recognized as expense at that date in accordance with Statement of Financial
Accounting Standards No. 123, "Accounting for Stock Based Compensation" ("SFAS
No. 123") and Emerging Issues Task Force Issue No. 96-18 ("EITF 96-18"),
"Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services."
D. Stock Purchase and Option Agreement - Equita Financial and Insurance
Services of Texas, Inc. ("Equita"):
In consideration of the role which Equita served in having brought the
opportunity to acquire the New Era Marketing Companies to FIC and Equita's
intention to assist FIC in the implementation of its business plan through the
marketing agreement described above, FIC granted to Equita an option to acquire
up to 169,000 shares of Common Stock at a per share exercise price equal to
$16.42 per share, but only if "Qualifying Premiums" for the "Determination
Period" exceed $200,000,000. The definitions of Qualifying Premiums and
Determination Period are the same as those for the option granted to APS with
respect to the base option only. In addition, FIC granted to Equita an
additional option to purchase up to 158,000 shares of Common Stock at a per
share exercise price equal to $16.42 per share, but only at the rate of 10,000
shares for each $10,000,000 increment by which Qualifying Premiums for the
Determination Period exceed $200,000,000. Unless earlier exercised, the options
granted to Equita expire on December 31, 2006. The fair value of the options at
the date the Qualifying Premium targets, if met, are achieved will be recognized
as expense in accordance with SFAS No. 123 and EITF 96-18 at that date.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
E. Employment Agreement and Option Agreement - William P. Tedrow:
In order to implement its business plan for the New Era Marketing Companies, FIC
appointed William P. Tedrow as President of FICFS and a Vice President of FIC.
FIC and Mr. Tedrow entered into an employment agreement, for a term ending March
31, 2009. In addition, the agreement provides Mr. Tedrow with a 6% stock
interest in FICFS subject to a right of repurchase by FIC and a lump sum payment
of $400,000 for Mr. Tedrow's efforts in organizing and integrating the New Era
Marketing Companies to FIC. The lump sum payment has been included as an expense
in the Consolidated Income Statement for the three months ended June 30, 2003.
The restricted stock interest is subject to repurchase by FIC on December 31,
2008, or earlier upon termination of the employment agreement or the termination
of the employment of Mr. Tedrow. The repurchase price is based upon the
valuation of FICFS and an actuarial valuation of the block of insurance and
annuity policies produced by or through FICFS; provided, however, if the
repurchase is made in connection with the termination of Mr. Tedrow's employment
for cause, or if Mr. Tedrow terminates his employment without good reason (as
defined in the agreement), the repurchase price is limited to $10. If the
repurchase price exceeds $5 million, FIC may, in lieu of paying such excess in
cash, deliver to Mr. Tedrow a subordinated note of FIC, such note to be for a
ten-year term, with equal payments of principal and interest on a semi-annual
basis, and bearing interest at the then- prevailing rate for ten-year
U.S.Treasury notes, plus 2.5%. A liability equal to the estimated fair value of
the repurchase obligation to Mr. Tedrow will be estimated at each reporting date
with changes in the fair value of the obligation recorded in earnings in each
reported period. The estimated fair value of the repurchase obligation at June
30, 2003 was $0.
In addition, FIC granted to Mr. Tedrow an option to purchase up to 150,000
shares of Common Stock at a per share exercise price of $13.07, but only if
"Qualifying Premiums" for the "Determination Period" exceed $200,000,000. The
definitions of Qualifying Premiums and Determination Period are the same as
those for the option granted to APS described above. Unless earlier exercised,
the options expire on December 31, 2006, or earlier in the event of the
termination of Mr. Tedrow's employment for cause or if he terminates his
employment without good cause. The options granted to Mr. Tedrow are being
accounted for in accordance with APB 25 and FASB Interpretation No. 28,
"Accounting for Stock Appreciation Rights and Other Variable Stock Option or
Award Plans, an interpretation of APB Opinions No. 15 and 25." No expense
related to the options granted to Mr. Tedrow was recognized in the three months
ended June 30, 2003.
- 19 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
7. Notes Payable
In May 2003, FIC issued $15,000,000 aggregate principal amount of Floating Rate
Senior Notes due 2033 (the "Senior Notes") and entered into a Senior Notes
Subscription Agreement ("Subscription Agreement") with InCapS Funding I, Ltd.
("InCapS"), wherein InCapS agreed to purchase the Senior Notes. The Senior Notes
were issued on May 22, 2003 pursuant to an indenture between FIC and Wilmington
Trust Company, as Trustee (the "Indenture"). Sandler O'Neill & Partners, L.P.
acted as the placement agent for the Senior Notes under the terms of a placement
agreement dated May 13, 2003 (the "Placement Agreement", and collectively the
Subscription Agreement, Indenture and Placement Agreement are referred to as the
"Operative Documents").
The principal amount of the Senior Notes is to be paid on May 23, 2033 and
interest shall be paid quarterly, beginning on August 23, 2003, at the rate of
4.20% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not
exceed 12.5% prior to May 2008). FIC may redeem the Senior Notes at any time on
or after May 23, 2008 by payment of 100% of the principal amount of the Senior
Notes being redeemed plus unpaid interest accrued to the payment date. In
accordance with the terms of the Operative Documents, the entire principal and
any interest accrued, but unpaid, may become immediately due and payable upon an
event of default, which includes: failure to pay interest within 30 days of any
due date; failure to pay principal when due; the bankruptcy or insolvency of
FIC; or the merger of FIC or sale of all or substantially all of FIC's assets
unless the successor entity to a merger is a United States corporation (or a
foreign corporation which agrees to be bound by certain tax provisions included
in the Indenture). The Operative Documents also place certain limitations on the
offer or sale of securities of FIC, if such offer or sale would render invalid
the Senior Notes' exemption from the registration requirements of the Securities
Act of 1933; and further restrict, for a two year period, purchases of senior
notes which are restricted securities.
Proceeds from the Senior Notes were used to fund the acquisition of the New ERA
Marketing Companies (See Note 6) and to pay down intercompany payables.
8. New Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," which addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies
Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. The adoption of SFAS No. 146 did not materially affect FIC's results of
operations, liquidity or financial position.
- 20 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure." The statement amends SFAS No.123 to
provide alternative methods of transition for voluntary change to the fair value
based method of accounting for stock-based employee compensation. In addition,
SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. SFAS No. 148 prescribes a specific tabular
format for the pro forma disclosures required by SFAS No. 123 and requires their
disclosure in the "Summary of Significant Accounting Policies" or its
equivalent. In addition, SFAS No. 148 requires inclusion of these pro forma
disclosures in financial reports for interim periods. SFAS No. 148 is effective
for financial statements for fiscal years ending after December 15, 2002. FIC
continues to account for its stock option plans under APB 25 and related
interpretations as allowed by this statement. FIC has adopted the disclosure
provisions of SFAS No. 148.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("FIN 45"). FIN 45 elaborates on the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. It also clarifies that
a guarantor is required to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken in issuing the
guarantee. The initial measurement provisions of FIN 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002. The
disclosure requirements of FIN 45 are effective for years ending after
December 15, 2002. FIN 45 did not have a material effect on the Company.
In January 2003, the FASB issued Interpretation No. 46 "Consolidation of
Variable Interest Entities, an interpretation of ARB 51" ("FIN 46"). The primary
objectives of FIN 46 are to provide guidance on the identification of entities
for which control is achieved through means other than through voting rights
("variable interest entities" or "VIEs") and how to determine when and which
business enterprise should consolidate the VIE (the "primary beneficiary"). This
new model for consolidation applies to an entity which either (1) the equity
investors (if any) do not have a controlling financial interest or (2) the
equity investment at risk is insufficient to finance that entity's activities
without receiving additional subordinated financial support from other parties.
In addition, FIN 46 requires that both the primary beneficiary and all other
enterprises with a significant variable interest in a VIE make additional
disclosures. FIN 46 is not expected to have a material effect on the Company.
- 21 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities". This statement amends SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities," for
decisions made (1) as part of the FASB's Derivatives Implementation Group
process that effectively required amendments to SFAS No. 133, (2) in connection
with other FASB projects dealing with financial instruments, and (3) in
connection with implementation issues raised in relation to the application of
the definition of a derivative. The adoption of SFAS No. 149 is not expected to
materially affect FIC's results of operations, liquidity or financial position.
In April 2003, the FASB issued Statement No. 133 Implementation Issue No. B36,
"Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments
That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially
Related to the Creditworthiness of the Obligor Under Those Instruments."
Implementation Issue No. B36 indicates that a modified coinsurance arrangement
("modco"), in which funds are withheld by the ceding insurer and a return on
those withheld funds is paid based on the ceding company's return on certain of
its investments, generally contains an embedded derivative feature that is not
clearly and closely related to the host contract and should be bifurcated in
accordance with the provisions of SFAS 133, "Accounting for Derivative
Instruments and Hedging Activities."
The effective date of Implementation Issue No. B36 is the first day of the first
fiscal quarter beginning after September 15, 2003. Beginning in the fourth
quarter of 2003, FIC intends to apply the guidance prospectively for existing
contracts and all future transactions. As permitted by SFAS No. 133, all
contracts entered into prior to January 1, 1999, were grandfathered and are
exempt from provisions of SFAS No. 133 that relate to embedded derivatives.
Based upon FIC's current level of modco and funds withheld reinsurance, the
application of Implementation Issue No. B36 is not expected to have a material
impact on consolidated financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150").
SFAS 150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity and is
effective for financial instruments entered into or modified after May 31, 2003
and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003, except for mandatorily redeemable financial
instruments of a nonpublic entity. For mandatorily redeemable financial
- 22 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
instruments of a nonpublic entity, SFAS 150 is effective for existing or new
contracts for fiscal periods beginning after December 15, 2003. For financial
instruments created before the issuance date of SFAS 150 and still existing at
the beginning of the interim period of adoption, transition is achieved by
reporting the cumulative effect of a change in an accounting principle by
initially measuring the financial instruments at fair value or other measurement
attribute required by SFAS 150. The provisions of SFAS 150, which we adopted in
2003, did not have a material impact on our consolidated financial statements.
We will continue to evaluate the potential impact of SFAS 150 on our
consolidated financial position and results of operations.
9. Restatement
The financial statements as of and for the three and six month periods ended
June 30, 2002 have been restated. In the fourth quarter of 2002, the Company
identified uncollectible receivables for which adequate allowance had not been
made and policyholder benefits and expenses that were understated due to an
interface error between the policy administration system and the general ledger.
The Company extended its investigation to determine the years affected and
expanded the scope of its review to include other areas, including certain
adjustments that were deemed not material in prior years. As a result of this
review, the financial statements for 2001 and 2000 and previously reported
unaudited quarterly financial data were restated for the following items:
A. Family Life (a wholly owned subsidiary of the Company) did not properly
apply the accounting requirements of SFAS No. 87, "Employers' Accounting
for Pensions," in accounting for its defined benefit pension plan. The
Company had accounted for its pension expense on a cash basis. As a result,
the Company had not properly recognized pension expense or benefit and had
not recorded a prepaid pension asset in years prior to January 1, 2000.
B. Agency advances and other receivables had not been analyzed for
collectibility and contained balances pertaining to to agents that should
have been written off.
C. Depreciation on certain property and equipment had not been recorded since
purchase.
D. Certain lease incentives had been recognized in income as received in 1997
instead of being deferred and recognized over the lease period. Further,
certain other lease termination benefits had been deferred instead of being
recognized in income in the period the lease was terminated.
- 23 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
E. Deferred acquisition cost amortization for traditional life policies issued
prior to January 1, 2002 had been calculated using amortization factors
which did not properly take into account the pattern of commission expense
recognized on these policies, which understated amortization of these costs
in early years of the policies and overstated amortization of these costs
in later years of the policies. Also, deferred acquisition cost
amortization for universal life policies issued prior to January 1, 2002
was based on undiscounted estimates of future gross profits, which
overstated amortization of these costs.
F. Present value of future profits amortization had not reflected certain
adjustments that reduced the present value of future profits asset.
G. Certain death benefit and annuity benefit expenses incurred during the
years ended 1999, 2000, 2001 and 2002 were not recorded due to an interface
error between the Company's policy administration system and its general
ledger.
H. InterContinental Life Corporation ("ILCO") had been accounted for as an
investment of the Company under the equity method of accounting prior to
May 18, 2001 and consolidated after that upon FIC's acquisition of ILCO's
remaining outstanding shares. ILCO's financial statements also required
adjustment for the following items:
i. ILCO had not recorded dividend and capital gain distributions prior to
1998 on its investment in one of its variable annuity separate
accounts (which understated ILCO January 1, 2000 retained earnings)
and had not recorded unrealized gains or losses to adjust the carrying
value of its investment in the separate account to market value (which
understated ILCO January 1, 2000 accumulated other comprehensive
income).
- 24 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
ii. Agency advances and other receivables and and other assets had not
been analyzed for recoverability and contained balances that should
have been written off.
iii. Certain adjustments to reinsurance recoverables that related to
periods prior to January 1, 2000 were recorded during 2000.
iv. ILCO did not properly apply the accounting requirements of SFAS No.
87, "Employers' Accounting for Pensions," in accounting for its
defined benefit pension plan. ILCO had accounted for its pension
expense on a cash basis. As a result, the Company had not properly
recognized pension expense or benefit and had not recorded a prepaid
pension asset in years prior to January 1, 2000.
v. Certain lease incentives had been recognized in income as received in
1997 instead of being deferred and recognized over the lease period.
Further, certain other lease termination benefits had been deferred
instead of being recognized in income in the period the lease was
terminated.
vi. An unreconciled differnce between suspense account balances included
in the Company's general ledger and those included in its policy
administration system resulted in an unsupported net asset (included
in other liabilities on the consolidated balance sheet) that should
have been written off.
I. The negative goodwill recognized as a result of the Company's acquisition
of the remaining common shares of ILCO on May 18, 2001 and related
amortization of negative goodwill in 2001 was adjusted to reflect the
impact on ILCO of the above items.
J. Deferred federal income tax balances were adjusted for the above items.
Net income for the three and six months ended June 30, 2002 was decreased
from amounts previously reported by $462,000 and $6,334,000, respectively,
as a result of the restatement, as follows (in thousands except per share
data):
- 25 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Three
Months Ended Three
June 30, 2002 Months Ended
As Previously June 30, 2002
Reported As Restated
______________ ______________
Net income (loss) before cumulative
effect of change in accounting
principle $ 215 $ (247)
Net income $ 215 $ (247)
Basic earnings per share:
Net income (loss) before cumulative
effect of change in accounting
principle $ 0.02 $ (0.03)
Net income (loss) $ 0.02 $ (0.03)
Diluted earnings per share:
Net income (loss) before
cumulative effect of change
in accounting principle $ 0.02 $ (0.03)
Net income (loss) $ 0.02 $ (0.03)
- 26 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Six Months Ended Six
June 30, 2002 Months Ended
As Previously June 30, 2002
Reported As Restated
_____________ _____________
Net income before cumulative effect of
change in accounting principle $ 1,371 $ 335
Cumulative effect of change in
accounting principle $ 15,727 $ 10,429
Net income $ 17,098 $ 10,764
Basic earnings per share:
Net income before cumulative effect
of change in accounting principle $ 0.14 $ 0.03
Cumulative effect of change in
accounting principle 1.65 1.10
Net income $ 1.80 $ 1.13
Diluted earnings per share:
Net income before cumulative effect
of change in accounting principle $ 0.14 $ 0.03
Cumulative effect of change in
accounting principle 1.64 1.09
Net income $ 1.78 $ 1.12
- 27 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The change in net income for the three and six months ended June 30, 2002 was
due to the following adjustments that increased (decreased) net income (in
thousands):
Three Months Six Months
Ended Ended
June 30, 2002 June 30, 2002
______________ ____________
Premiums $ 0 $ 2
Policyholder benefits and expenses (410) (994)
Amortization of present value of
future profits (15) (31)
Amortization of deferred policy acquisition
costs (86) (173)
Provision for uncollectible receivables (200) (398)
Provision for deferred federal income taxes 249 558
Cumulative effect of change in
accounting principle 0 (5,298)
Net income $ (462) $ (6,334)
- 28 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
A summary of the effects of the restatement on the Company's consolidated
balance sheet as of June 30, 2002 is as follows (in thousands):
As
Previously As
Reported Restated
_____________ ______________
ASSETS
Equity securities $ 35 $ 7,263
Invested real estate 70,435 73,473
Total Investments 746,923 757,119
Agency advances and other receivables 36,251 21,774
Property and equipment, net 3,573 777
Deferred policy acquisition costs 81,232 77,907
Present value of future profits of
acquired businesses 28,735 27,984
Other assets 16,564 17,687
Separate account assets 364,060 356,261
Total Assets $ 1,340,922 $ 1,323,162
LIABILITIES AND SHAREHOLDERS' EQUITY
Deferred federal income taxes 31,857 26,183
Other liabilities 11,365 19,383
Total liabilities 1,143,250 1,145,594
Accumulated other comprehensive income 5,044 2,344
Retained earnings 146,353 128,949
Total shareholders' equity before
treasury stock 220,029 199,925
Total shareholders' equity 197,672 177,568
Total liabilities and shareholders' $ 1,340,922 $ 1,323,162
equity
- 29 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The consolidated balance sheet as of June 30, 2002 was restated to reflect the
following:
* An increase of $7.2 million in FIC's investments in equity securities to
properly refect the market value of the Company's investment in the
separate account;
* An increase $3.0 million in invested real estate primarily due to a
reclassification of certain real estate expenditures that were classified
as property and equipment;
* A decrease of $14.5 million in agency advances and other receivables
primarily due to a write-off of uncollectible agent balances, a write-off
of a reinsurance receivable, and a write-off of assets related to an
interface error between the Company's policy administration system and its
general ledger;
* A decrease of $2.8 million in property and equipment primarily due to a
reclassification of certain amounts classified as property and equipment to
invested real estate and a write-off of assets that had not been
depreciated since purchase;
* A decrease of $3.3 million in deferred policy acquisition costs due to a
revision of the factors used to calculate Family Life's deferred policy
acquisition costs;
* A decrease of $751,000 in present value of future profits of acquired
businesses due to an adjustment in calculation of this asset;
* An increase of $1.1 million in other assets primarily related to the
establishment of unrecorded prepaid pension assets related to Family Life's
and ILCO's pension plans;
* A decrease of $7.8 million in separate account assets due to a
reclassification of separate acount assets to equity securities;
* A decrease of $5.7 million in the liability for deferred federal income
taxes as a result of the restatement adjustments described herein;
* An increase of $8.0 million in other liabilities primarily related to an
unreconciled difference between suspense account balances included in the
Company's general ledger and those included in its policy administration
system.
* A decrease of $2.7 million of accumulated other comprehensive income due to
the changes in the accounting treatment for the pre-paid pension asset and
the separate account investment; and
* A decrease in retained earnings of $17.4 million due to the restatement
adjustments described herein.
- 30 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
10. Commitments and Contingencies
The Company and its subsidiaries are defendants in certain legal actions related
to the normal business operations of the Company. Management believes that the
resolution of such matters will not have a material impact on the financial
statements.
Litigation Relating to the FIC/ILCO Merger. On the day that FIC and ILCO each
publicly announced the formation of a special committee to evaluate a potential
merger, two class action lawsuits were filed against ILCO, FIC and the officers
and directors of ILCO. The actions allege that a cash consideration in the
proposed merger is unfair to the shareholders of ILCO, that it would prevent the
ILCO shareholders from realizing the true value of ILCO, and that FIC and the
named officers and directors had material conflicts of interest in approving the
transaction. In their initial pleadings, the plaintiffs sought certification of
the cases as calass actions and the named plaintiffs as class representatives,
and among other relief, requested that the merger be enjoined (or, if
consummated, rescinded and set aside) and that the defendants account to the
class members for their damages. The defendants believe that the lawsuits are
without merit and intend to vigorously contest the lawsuits. Management is
unable to determine the impact, if any, that the lawsuits may have on the
results of operations of the Company. There have been no material developments
since the Company's filing of its Annual Report on Form 10-K for the year ended
December 31, 2002.
Litigation Relating to Former Chairman and CEO. As previously reported in its
Annual Report on Form 10-K for the year ended December 31, 2002, the Company
filed a lawsuit against Roy F. Mitte ("Mitte"), The Roy F. and Joann Cole Mitte
Foundation (the "Foundation") and Joann Mitte (collectively referred to as the
"Defendants"). Mitte was the Chairman, President and Chief Executive Officer of
FIC until he was placed on administrative leave in August, 2002. The
administrative leave, and the subsequent action by the Board of Directors in
October, 2002 to terminate the employment agreement between FIC and Mitte,
resulted from an investigation conducted by the FIC Audit Committee. Subsequent
to the filing of the lawsuit, Mr. Mitte filed a counterclaim against the Company
alleging that the Company breached the employment agreement between the Company
and Mr. Mitte by refusing to pay Mitte the severance benefits and compensation
provided for under the employment agreement and amendment thereto.
On May 15, 2003, the Company entered into a settlement agreement with the
Defendants and Scott Mitte (a director of the Company and the son of Roy Mitte)
(the "Mitte Parties"). Under the terms of the agreement the Mitte Parties
released the Company from any past, present or future claims which they may have
against the Company, including any claims which Roy Mitte may assert under the
employment agreement. In addition, the Company agreed to release the Mitte
Parties from any past, present or future claims which the Company may have
against the Mitte Parties.
- 31 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The settlement provides for payments by the Company to Roy Mitte of $1 million
on June 1, 2003, $1 million on June 1, 2004 and $1 million on June 1, 2005, with
a provision for acceleration of payments in the event of a change in control.
The settlement agreement also includes provisions whereby, the Company agrees
(i) to use commercially reasonable efforts to locate a purchaser or purchasers
of specified installments over a two year period of the 1,552,206 shares of FIC
common stock owned by the Foundation during future periods set forth in the
settlement agreement, at a price of $14.64 per share, (ii) to purchase (or,
alternatively, locate a purchaser) on or before June 1, 2003 of the 39, 820
shares of FIC common stock owned by Roy Mitte and the 35,502 shares of common
stock held in the ESOP account of Roy Mitte, at a price of $14.64 per share. The
agreement also includes provisions related to the continuation of health
insurance of Roy and Joann Mitte and payment for the cancellation of options
held by Roy Mitte to purchase 6,600 shares of FIC common stock. The Company has
recognized a charge of $2.9 million (before tax) in the first quarter of 2003
for amounts to be paid under the settlement agreement, representing the
discounted amount of the non-interest bearing settlement.
As a condition of the obligations of the Company under the settlement agreement,
the Mitte Parties agreed to grant a limited proxy to the persons named as
proxies by FIC in any proxy statement filed by FIC with the SEC. With respect to
the future shareholders meetings, the proxy may be voted "for" all nominees for
the Board of Directors named on FIC's proxy statement, "against" any proposal by
a person other than FIC for the removal of any members of the Board of
Directors, "withheld" as to nominees for the Board of Directors proposed by any
person other than FIC and "against" any proposal by any person other than FIC to
amend the bylaws or articles of FIC. The proxy also extends to certain matters
which may be proposed by FIC at the 2004 annual meeting of shareholders, or any
later annual or special meeting, regarding changes in the ownership percentage
required in order for a shareholder to call a special meeting of shareholders
and the elimination of cumulative voting. The granting of the proxy is generally
conditioned upon the performance of the scheduled purchases of the shares of FIC
common stock owned by the Foundation.
Litigation with Otter Creek Partnership I, L.P.
On June 13, 2003, Otter Creek Partnership I, L.P. ("Otter Creek") filed a civil
action lawsuit against FIC in the District Court in Travis County, Texas, Cause
No. GN302872, for the purpose of seeking an injunction against the Company to
compel the Company to schedule and hold an Annual Meeting of Shareholders and
either not to exercise the proxy it acquired from the Mitte Parties in
connection with the settlement of the litigation referenced under the caption
"Litigation Relating to the Former Chairman and CEO" or to vote such shares in
the same proportion as the other outstanding shares of the Company are voted.
The court refused to order the Company to set a specific record date or meeting
date for the 2003 Annual Meeting. However, the 2003 Annual Meeting of
Shareholders of FIC was, in fact, held on July 31, 2003.
- 32 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
On July 29, 2003, FIC released the proxy acquired from the Mitte Parties, with
respect to 312,484 shares acquired prior to the record date for the 2003 Annual
Meeting from the Mitte Foundation by American Physicians Service Group Inc.
("APS") and 204,918 shares acquired from the Mitte Foundation by M&W Insurance
Services, Inc. ("M&W"). Said release was granted at the request of APS and M&W.
Accordingly, APS and M&W each voted their respective shares directly at the 2003
Annual Meeting. The proxy granted to management by the Mitte Parties with
respect to the remaining shares was voted at the 2003 Annual Meeting by the
persons named as Proxies in FIC's Proxy Statement. Otter Creek has objected to
the release of proxy to APS and M&W.
FIC believes that the provisions of the settlement agreement with the Mitte
Parties pertaining to the grant of proxy, and the conditions set forth in the
settlement agreement pertaining to said grant, are consistent with applicable
legal requirements. Accordingly, FIC intends to defend its right to vote the
shares subject to the proxy from the Mitte Parties and the partial release of
said proxy to APS and M&W.
A trial date has been set for the second week of September, 2003.
Item 2. Management's Discussion and Analysis of Financial Conditions and
Results of Operations
The following discussion addresses the financial condition of Financial
Industries Corporation ("FIC") as of June 30, 2003, compared with December 31,
2002, and its results of operations for the six months ended June 30, 2003,
compared with the same period last year. This discussion should be read in
conjunction with Management's Discussion and Analysis included in FIC's 10-K for
the year ended December 31, 2002, to which the reader is directed for additional
information.
Restatement
In this Item 2, references to results for the three and six-month periods ended
June 30, 2002 are to restated results. See the Notes to the Consolidated
Financial Statements.
- 33 -
Transactions Affecting Comparability of Results of Operations
In the first six months of 2002, net income and earnings per share were affected
by the cumulative effect of a change in accounting principle of $10.4 million.
This amount represents the excess of fair value of net assets acquired over cost
as of the beginning of 2002 related to the merger of InterContinental Life
Corporation ("ILCO") with and into a subsidiary of FIC on May 18, 2001. The
Company recorded this cumulative effect in conjunction with adopting Statement
of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations,"
in the first quarter of 2002, as required by SFAS 141.
In the first six months of 2003, net income was affected by a $2.9 million
expense related to the settlement of the litigation between FIC, Roy F. Mitte
(the former Chairman and Chief Executive Officer of the Company), and the Roy F.
and Joann Cole Mitte Foundation (see Registrant's Quarterly Report on Form 10-Q
for the three-month period ended March 31, 2003 for a further description of
this settlement, referred to therein as the "Mitte Settlement"). Net income in
the first six months of 2003 was also affected by the following operating
expenses including: (i) a $476,000 expense accrual for payments to be made to
Jeffrey Demgen pursuant to his employment agreement; (ii) a $400,000 payment to
William P. Tedrow; (iii) legal and other expenses related to litigation and
proxy matters; and (iv) fees paid to Salomon Smith Barney. "Benefits and
Expenses" below for a further explanation of these items.
Results of Operations - Six Months Ended June 30, 2003 and 2002
For the six-month period ended June 30, 2003, FIC's net loss was $1.8 million
(basic and diluted loss of $0.18 per common share) on revenues of $59.6 million
as compared to net income of $10.8 million (basic earnings of $1.13 per common
share, or diluted earnings of $1.12 per common share) on revenues of $62.2
million in the first six months of 2002. Net income for the first six months of
2002, before the cumulative effect of change in accounting principle, was $0.3
million (basic and diluted earnings of $0.03 per common share).
Revenues.
Premium revenues reported for traditional life insurance products are recognized
when due. Premium income for the first six months of 2003, net of reinsurance
ceded, was $15.6 million, as compared to $18.9 million in the first six months
of 2002. This source of revenues is related to the traditional life insurance
book of business of FIC's insurance subsidiaries. The level of net collected
premiums for traditional life insurance products at Family Life for the six
months ending June 30, 2003 was $11.0 million, as compared to $14.0 million in
the same period in 2002. The decrease in net collected premium is attributable
to the decrease in the traditional life insurance book of business.
- 34 -
Income from universal life and annuity charges for the first six months of 2003
was $20.6 million, as compared to $21.5 million in the same period of 2002. The
face amount of in force universal life policies was $4.8 billion at June 30,
2002 as compared to $5.2 billion at June 30, 2003.
Net investment income for the first six months of 2003 was $19.7 million as
compared to $19.8 million in the same period of 2002. Net investment income in
the first six months of 2003 has been adversely affected by the current interest
rate environment.
Real estate income is primarily earned from the leases on the buildings at River
Place Pointe, an office complex in Austin, Texas which is owned by Investors
Life. Real estate income was $0.9 for the six-month period ended June 30, 2003,
as compared to $1.3 million for the same period in 2002. The decrease in real
estate income from the six months ended June 30, 2003 to the same period ended
June 30, 2002 is due to the completion of the remainder of the buildings in
River Place Pointe and the related expenses and depreciation of those buildings.
These three buildings did not generate rental income in the first six months of
2003.
Net realized investment gains were $2.0 million in the first six months of 2003,
as compared to $0.005 million in the first six months of 2002. This gain is
related to sales of fixed maturity securities which were sold in anticipation of
the securities being called.
Other income was $0.9 million in the first six months of 2003, as compared to
$0.7 million in the first six months of 2002. Other income includes income from
FIC's non-insurance subsidiaries, Actuarial Risk Consultants, Inc. and FIC
Financial Services, Inc. ("FICFS"). During the second quarter of 2003, FICFS
acquired three companies in the secondary education financial services market:
(i) Total Consulting Group, Inc. ("TCG") (a consulting firm and registered
investment advisor with clients in the secondary education marketplace), (ii)
JNT Group, Inc. ("JNT") (an independent fee-based third party administrator
operating principally in Texas and California) and (iii) three companies
collectively referred to as "Paragon" - Paragon Benefits, Inc., The Paragon
Group, Inc., and Paragon National, Inc. (a provider of employee benefit products
and services to the secondary education marketplace). FICFS intends to continue
the business operations of each company and believes that the synergies created
by the acquisitions will help position FICFS and FIC to become an industry
leader in the secondary education financial services market. Because the income
attributable to the subsidiaries of FICFS was only included on FIC's
consolidated statements of income from May 30, 2003 through June 30, 2003, there
was not a significant impact to other income for the six-month period ended June
30, 2003. For a further description of FICFS and the acquisitions, see FIC's
Current Report on Form 8-K filed with the Securities and Exchange Commission on
June 10, 2003.
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Benefits and Expenses.
Policyholder benefits and expenses were $19.7 million in the first six months of
2003, as compared to $22.4 million in the first six months of 2002. The decrease
in policyholder benefits and expenses from June 30, 2002 to the same period in
2003 was due primarily to a decrease in death benefits claims as well as reserve
adjustments related to lower premiums received and withdrawal payments at a less
than expected level.
Interest expense on contract holders deposit funds was $14.6 million in the
first six months of 2003, as compared to $15.1 million in the same period of the
year 2002. This expense is related to crediting of interest to policyholders for
cash values accumulated in their accounts. This decrease was due primarily to
the lowering of credited rates on these accounts starting in the fourth quarter
of 2002.
The costs related to acquiring new business, including certain costs of issuing
policies and certain other variable selling expenses (principally commissions),
are deferred policy acquisition costs ("DAC"). The expense related to the
amortization of DAC was $5.3 million in the first six months of 2003, as
compared to $4.3 million in the first six months of 2002. See "Critical
Accounting Policies, Deferred Policy Acquisition Costs and Present Value of
Future Profits of Acquired Business" herein for a further discussion of
capitalization of expenses related to acquiring new business. The increase in
the amortization of DAC of $1.0 million from the six-month period ended June 30,
2002 to the same period in 2003 reflects the withdrawal experience during this
period.
In the first six months of 2003, the expense related to the amortization of
present value of future profits of acquired business was $2.2 million as
compared to $2.4 million in the first six months of 2002.
Operating expenses for the first six months of 2003 were $17.6 million, as
compared to $17.0 million in the first six months of 2002. The level of
operating expenses for the six-month period ending June 30, 2003 included: (i)
$476,000 related to payments to be made to retired chief marketing officer,
Jeffrey Demgen, pursuant to his employment agreement; (ii) legal and other
expenses related to litigation and proxy matters; (iii) $400,000 paid to William
P. Tedrow for his efforts in organizing and integrating the New Era Marketing
Companies to FIC (see Notes to Consolidated Financial Statements, note 6E,
herein for information regarding the payment to and employment agreement of
William P. Tedrow); and (iv) fees paid to Salomon Smith Barney related to the
matter set forth in the Company's Current Report on Form 8-K filed with the
Securities and Exchange Commission ("SEC") on January 28, 2003. Operating
expenses for the six-month period ended June 30, 2002 included approximately
$1.5 million of executive bonus payments and the repurchase of James M. Grace's
employment contract, as well as a $1 million donation to the Roy F. and Joann
Cole Mitte Foundation.
- 36 -
Expenses for the six-month period ended June 30, 2003 also include an expense of
$2.9 million related to the Mitte Settlement (see Registrant's Quarterly Report
on Form 10-Q for the quarter period ended March 31, 2003 for a further
description of the Mitte Settlement).
The provision for federal income taxes was ($1.0) million in the first six
months of 2003 as compared to $0.8 million in the first six months of 2002. The
decrease was due to the decrease in income for the six month period ended June
30, 2003 compared to the same period in 2002.
Results of Operations - Three Months Ended June 30, 2003
as compared to the Three Months Ended June 30, 2002
For the three-month period ended June 30, 2003, FIC's net loss was $0.5 million
(basic and diluted loss of $0.05 per common share) on revenues of $30.0 million
as compared to a net loss of $0.2 million (basic and diluted loss of $0.03 per
common share) on total revenues of $30.0 million in the same three month period
of 2002.
Liquidity and Capital Resources
Liquidity describes the ability of a company to generate sufficient cash flows
to meet the cash requirements of business operations. FIC is an insurance
holding company whose principal assets consist of the outstanding capital stock
of its insurance subsidiaries, Family Life Insurance Company ("Family Life") and
Investors Life Insurance Company of North America ("Investors Life"), as well as
the outstanding capital stock of Actuarial Risk Consultants, Inc. ("ARC"), its
actuarial subsidiary, and 94% of the outstanding capital stock of FIC Financial
Services, Inc.("FICFS"), a subsidiary which concentrates on the secondary
education financial services market. As a holding company, FIC's ability to meet
its cash requirements, pay interest on any debt, pay expenses related to its
affairs and pay dividends on its common stock substantially depends upon
dividends from its subsidiaries.
Applicable state insurance laws generally restrict the ability of insurance
companies to pay cash dividends in excess of prescribed limitations without
prior approval. The ability of Family Life and Investors Life to pay shareholder
dividends is and will continue to be subject to restrictions set forth in the
insurance laws and regulations of Washington, their domiciliary state.
Washington limits how and when Family Life and Investors Life can pay
shareholder dividends by (a) including the "greater of" standard for payment of
dividends to shareholders, (b) requiring that prior notification of a proposed
dividend be given to the Washington Insurance Commissioner and (c) requiring
that cash dividends be paid only from earned surplus. Under the "greater of"
standard, an insurer may pay a dividend in an amount equal to the greater of :
(i) 10% of the policyholder surplus or (ii) the insurer's net gain from
operations for the previous year. For the year ended December 31, 2002,
Investors Life had earned surplus of $35.4 million and a net gain from
- 37 -
operations of $1.4 million, and Family Life had earned surplus of $0.4 million
and a net gain from operations of $3.3 million. Neither Investors Life nor
Family Life paid any dividends during the first six months of 2003. For the six
month period ended June 30, 2003, Investors Life had earned surplus of $36.7
million and a net gain from operations of $.34 million, and Family Life had
earned surplus of $2.5 million and a net gain from operations of $1.2 million.
Sources of cash for FIC's insurance subsidiaries consist of premium payments
from policyholders and annuity holders, charges on policies and contracts,
investment income, and proceeds from sales, maturities and calls of invested
assets. These funds are applied primarily to provide for the payment of claims
under insurance and annuity policies, payment of policy withdrawals, surrenders
and loans, operating expenses, taxes, investments in portfolio securities, and
shareholder dividends.
FIC expects to have the ability to receive unrestricted dividends from its newly
created subsidiary, FICFS, of which FIC owns 94% of the outstanding stock, as
well as dividends from ARC.
FIC's cash and cash equivalents at June 30, 2003 was $9.2 million as compared to
$25.0 million at December 31, 2002. The decrease in cash and cash equivalents at
June 30, 2003 from December 31, 2002 was due primarily to reinvestment of cash
into purchases of fixed maturity securties. Cash and cash equivalents at June
30, 2002 was $7.4 million.
FIC's net cash flow used in operating activities was $15.7 million for the six
month period ending June 30, 2003, as compared to $1.1 million provided by
operating activities for the same period in the year 2002. The decrease in cash
flows provided by operating activities is due primarily to net activity from
trading securities, which are required to be reported in cash flows from
operations.
Net cash flow used in investing activities was $12.8 million in the six month
period ending June 30, 2003, as compared to $11.6 million provided by investing
activities in the same period of 2002. The $24.4 million increase in cash used
in investing activities in 2003 from 2002 was due primarily to investment of
cash into fixed maturity securities. Additionally, $4.0 million was used to
invest in the acquisition of the above-mentioned subsidiaries of FICFS.
Net cash flow provided by financing activities was $12.8 million in the first
six months of 2003, as compared to $12.3 million used in financing activities in
the first six months of 2002. The increase in cash provided by financing
activities of $25.1 million is primarily attributable to the issuance of the
Senior Notes (see description of Senior Notes below) and a reduction in
surrender benefits paid on certain contractholder balances.
- 38 -
A primary liquidity consideration with respect to life insurance and annuity
products is the risk of early policyholder and contractholder withdrawal.
Deposit fund liabilities for universal life and annuity products as of June 30,
2003 were $562.6 million, as compared to $557.5 million at December 31, 2002.
Individual life insurance policies are less susceptible to withdrawal than are
annuity contracts because policyholders may incur surrender charges and undergo
a new underwriting process in order to obtain a new insurance policy. At June
30, 2003, the bulk of the liabilities for contractholder deposit funds on FIC's
balance sheet, $414.3 million, were related to insurance products, as compared
to only $148.4 million of annuity product liabilities.
The cash requirements of FIC, and its holding company subsidiary, Family Life
Corporation, consist primarily of (i) its service of the indebtedness created in
connection with FIC's ownership of Family Life; and (ii) service of the
indebtedness created by the Senior Notes (see description of Senior Notes in
"Liquidity and Capital Reserves", below).
The indebtedness created in connection with FIC's ownership of Family Life
includes $18.44 million of notes payable to FIC's subsidiary, Investors Life
(the "Affiliate Notes"), represented by (i) a loan of $30 million by Investors
Life to Family Life Corporation made in July 1993, in connection with the
prepayment of indebtedness which had been previously issued to Merrill Lynch as
part of the 1991 acquisition of Family Life by a wholly-owned subsidiary of FIC,
and (ii) a loan of $4.5 million by Investors Life to Family Life Insurance
Investment Company made in July 1993, in connection with the same transaction
described above.
The Affiliate Notes owned by Investors Life include the following provisions:
(a) the $30 million note provides for quarterly principal payments, in the
amount of $1,336,458; the final quarterly principal payment is due on September
12, 2006; the interest rate on the note is 9%, and (b) the $4.5 million note
provides for quarterly principal payments, in the amount of $200,469; the final
quarterly principal payment is due on September 12, 2006; the interest rate on
the note is 9%.
On June 30, 2003, Investors Life exercised its option to purchase 500,411 shares
of FIC's common stock, which were granted to Investors Life in connection with
the Affiliate Notes (see FIC's 10-K for the year ended December 31, 2002, "Item
1. Business - Investors Life Loans"). Pursuant to the Affiliate Notes, and
subsequent amendments thereto, Investors Life paid FIC $1.05 million to purchase
the FIC shares.
- 39 -
Due to the merger of InterContinental Life Corporation (which owns 100% of the
outstanding stock of Investors Life) with a subsidiary of FIC on May 18, 2001,
the indebtedness created by the Affiliate Notes is not included as a liability
on the consolidated financial statements of FIC. Additionally, the 500,411
shares obtained by Investors Life pursuant to the option exercise are held as
treasury shares and do not affect the consolidated balance sheet of FIC.
In May, 2003, FIC issued $15,000,000 aggregate principal amount of Floating Rate
Senior Notes due 2033 (the "Senior Notes") and entered into a Senior Notes
Subscription Agreement ("Subscription Agreement") with InCapS Funding I, Ltd.
("InCapS"), wherein InCapS agreed to purchase the Senior Notes. The Senior Notes
were issued on May 22, 2003 pursuant to an indenture between FIC and Wilmington
Trust Company, as Trustee (the "Indenture"). Sandler O'Neill & Partners, L.P.
acted as the placement agent for the Senior Notes under the terms of a placement
agreement dated May 13, 2003 (the "Placement Agreement", and collectively the
Subscription Agreement, Indenture and Placement Agreement are referred to as the
"Operative Documents").
The principal amount of the Senior Notes is to be paid on May 23, 2033 and
interest shall be paid quarterly, beginning on August 23, 2003, at the rate of
4.20% over LIBOR (LIBOR is recalculated quarterly and the interest rate may not
exceed 12.5% prior to May 2008). FIC may redeem the Senior Notes at any time on
or after May 23, 2008 by payment of 100% of the principal amount of the Senior
Notes being redeemed plus unpaid interest accrued to the payment date. In
accordance with the terms of the Operative Documents, the entire principal and
any interest accrued, but unpaid, may become immediately due and payable upon an
event of default, which includes: failure to pay interest within 30 days of any
due date; failure to pay principal when due; the bankruptcy or insolvency of
FIC; or the merger of FIC or sale of all or substantially all of FIC's assets
unless the successor entity to a merger is a United States corporation (or a
foreign corporation which agrees to be bound by certain tax provisions included
in the Indenture). The Operative Documents also place certain limitations on the
offer or sale of securities of FIC, if such offer or sale would render invalid
the Senior Notes' exemption from the registration requirements of the Securities
Act of 1933; and further restrict, for a two year period, purchases of senior
notes which are restricted securities. (See Note 7 for description on use of
proceeds)
FIC's other liquidity requirements relate principally to the need for cash flow
to meet operating expenses, as well as the liabilities associated with its
insurance subsidiaries' various life insurance and annuity products. In order to
ensure that cash flow is sufficient to meet these needs, management monitors
benefits and surrenders of insurance products to provide projections of future
cash requirements. As part of this monitoring process, FIC performs cash flow
testing of assets and liabilities to evaluate the adequacy of reserves. There
can be no assurance that future experience regarding benefits and surrenders
will be similar to historic experience since withdrawal and surrender levels are
influenced by such factors as the interest rate environment and general economic
conditions as well as the claims-paying and financial strength ratings of FIC's
insurance subsidiaries.
- 40 -
In 2002, management reviewed the Company's liquidity to determine whether the
cash, cash equivalents and short term investments of the Company were sufficient
to meet the Company's needs for cash for operations, capital requirements and
commitments. Management has reduced the amount of dividends paid to
shareholders, discontinued donations to the Roy F. and Joann Cole Mitte
Foundation, and implemented plans to streamline the operations of the Company.
Management believes that the cash, cash equivalents and short term investments
of FIC and its subsidiaries are sufficient to meet the needs of its business and
to satisfy debt service. There are no trends, commitments or capital asset
requirements that are expected to have an adverse effect on the liquidity of
FIC.
Investments
As of June 30, 2003, FIC's invested assets, excluding separate accounts,
totalled $780.2 million, compared to $761.2 million at December 31, 2002. The
increase is primarily attributable to investments of cash into fixed maturity
securities. The significant differences between the portfolio composition as of
June 30, 2003 as compared to December 31, 2002 are: (i) the addition of trading
securities, which comprise 3.2% of the investment portfolio at June 30, 2003 as
compared to 0% at December 31, 2002; (ii) fixed maturities available for sale
comprise 77.4% at June 30, 2003 compared to 64.9% at December 31, 2002; and
(iii) short-term investments comprise 3.8% at June 30, 2003 compared to 18.1% at
December 31, 2002.
The assets held by FIC's life insurance subsidiaries must comply with applicable
state insurance laws and regulations. In selecting investments for the
portfolios of its life insurance subsidiaries, the emphasis is to obtain
targeted profit margins, while minimizing the exposure to changing interest
rates. This objective is implemented by selecting primarily short- to
medium-term, investment grade fixed income securities. In making such portfolio
selections, the Company generally does not select new investments which are
commonly referred to as "high yield" or "non-investment grade". The general
investment objective of the Company emphasizes the selection of short to medium
term high quality fixed income securities, rated Baa-3 (investment grade) or
better by Moody's Investors Service, Inc.
FIC determines the allocation of our assets primarily on the basis of cash flow
and return requirements of our products and secondarily by the level of
investment risk. In order to ensure that investments are sufficient to satisfy
cash flow needs, FIC establishes a level of cash and securities which, combined
with expected net cash inflows from operations, maturities of fixed maturity
investments and principal payments on mortgage-backed securities, are believed
adequate to meet anticipated short-term and long-term benefit and expense
payment obligations.
- 41 -
During the first six months of 2003, FIC invested $342.5 million of its assets,
of which $218.2 million consisted of reinvestments of matured and called fixed
maturities, and $124.3 million consisted of investments from cash, cash
equivalents and short-term investments. The $342.5 million was primarily
invested in short- and medium- term securities. Collateralized mortgage
obligations ("CMOs") comprised $179.8 million of new investments, corporate
securities comprised $62.1 million, asset-backed securities comprised $57.6
million, and agency bonds comprised $43.0 million. Management believes that the
asset allocation is sufficient to satisfy current projected cash flow
requirements.
Another key element of the Company's investment strategy is to avoid large
exposure in other investment categories which the Company believes carry higher
credit or liquidity risks, including private placements, partnerships and bank
participations. These categories accounted for only $17,107 of invested assets
as of June 30, 2003 and $26,049 of invested assets at December 31, 2002.
Fixed Maturity Securities
The Company's fixed maturity securities portfolio is predominately comprised of
low risk, investment grade, available for sale publicly traded corporate
securities, mortgage-backed securities and United States Government bonds. As of
June 30, 2003, the market value fixed maturities available for sale was $604.2
million as compared to an amortized cost of $590.4 million or an unrealized gain
of $13.8 million. The increase reflects unrealized gains on such investments
related to changes in interest rates subsequent to the purchase of such
investments. At December 31, 2002, the market value of the fixed maturities
available for sale segment was $493.8 million as compared to an amortized cost
of $479.4 million.
The investments of FIC's insurance subsidiaries in mortgage-backed securities
included CMOs of $267.1 million as of June 30, 2003 as compared to $175.4
million at December 31, 2002, and mortgage-backed pass-through securities of
$95.1 million as of June 30, 2003 and $29.6 million at December 31, 2002.
Mortgage-backed pass-through securities, sequential CMO's and support bonds,
which comprised approximately 42.4% of the book value of FIC's mortgage-backed
securities at June 30, 2003, are sensitive to prepayment and extension risks.
FIC's insurance subsidiaries have reduced the risk of prepayment associated with
mortgage-backed securities by investing in planned amortization class ("PAC"),
target amortization class ("TAC") instruments and scheduled bonds. These
investments are designed to amortize in a predictable manner by shifting the
risk of prepayment of the underlying collateral to other investors in other
tranches ("support classes") of the CMO. At June 30, 2003, PAC and TAC
instruments and scheduled bonds represented approximately 41.2% of the book
value of FIC's mortgage-backed securities. Sequential and support classes
represented approximately 16.2% of the book value of FIC's mortgage-backed
securities at June 30, 2003. Additionally, the insurance subsidiaries make
- 42 -
selected investments in CMOs of the inverse floater category. Such instruments,
which are subject to strict quantitative and qualitative standards, carry a
higher current interest rate which varies in an inverse relationship with a
specified benchmark interest rate. The investment guidelines do not permit the
purchase of CMOs which are interest only or principal only instruments. The
prepayment risk that certain mortgage-backed securities are subject to is
prevalent in periods of declining interest rates, when mortgages may be repaid
more rapidly than scheduled as individuals refinance higher rate mortgages to
take advantage of the lower current rates. As a result, holders of
mortgage-backed securities may receive large prepayments on their investments
which cannot be reinvested at an interest rate comparable to the rate on the
prepaying mortgages. Conversely, in periods of rising interest rates mortgages
are generally not repaid as rapidly which would adversely affect the
anticipation duration of the CMO. For the year 2003, the investment objectives
of FIC's insurance subsidiaries include a strategy of reducing the concentration
in short-term investments by making selected investments in a variety of
medium-term CMO instruments.
The securities valuation office (SVO) of the National Association of Insurance
Commissioners evaluates all public and private bonds purchased as investments by
insurance companies. The SVO assigns one of six investment categories to each
security it reviews. Category 1 is the highest quality rating, and Category 6 is
the lowest. As of June 30, 2003, the majority of our bonds are investment grade
(Category 1 and 2). The Company's fixed maturities portfolio (including
short-term investments), included only a non-material amount of debt securities
which, in the annual statements of the companies as filed with state insurance
departments, were designated by the SVO as "3" (medium quality) or below.
Trading Securities
FIC's trading securities consist of Collateralized Mortgage Obligations
("CMO's") of the type which are generally referred to as "inverse floaters"
which have coupon rates that vary in an inverse relationship with a specified
benchmark rate. The value of FIC's trading securities as of June 30, 2003 was
$19.9 million. The change in the market value of trading securities during the
period, $0.761 million, is included in net realized investment income on the
consolidated income statement. FIC did not have any trading securities at
December 31, 2002.
Equity Securities
FIC's equity securities consist primarily of its investment in the separate
account of Investors Life. As of June 30, 2003, the market value of FIC's equity
securities was $7.0 million, as compared to $6.3 million at December 31, 2002.
The increase is related to an increase in the value of the underlying funds in
the separate account.
- 43 -
Policy Loans
Policy loans totaled $45.2 million at June 30, 2003, as compared to $46.6
million at December 31, 2002.
Mortgage Loans
As of June 30, 2003, the Company did not have any investments in mortgage loans,
as compared to $17,000 at December 31, 2002. The Company does not make new
mortgage loans on commercial properties.
Real Estate
Invested real estate at June 30, 2003 was $74.6 million as compared to $75.4
million at December 31, 2002. The real estate investment is primarily related to
the development of the River Place Pointe project ("River Place Pointe") by
Investors Life. In October 1998, Investors Life purchased River Place Pointe,
which consisted of two adjoining tracts of land located in Austin, Texas
totaling 47.995 acres. The aggregate purchase price for these tracts was $8.1
million. Investors Life obtained a Site Development Permit for the tracts from
the City of Austin allowing for the construction of seven office buildings
totaling 600,000 square feet, with associated parking, drives and related
improvements. Construction on the first section of the project, which consists
of four office buildings, an associated parking garage, and related
infrastructure was completed during 2000 and 2001. Construction on the second
section of the project, which consists of three office buildings, an associated
parking garage, and related infrastructure was completed in 2002.
As of June 30, 2003, Investors Life had invested $92.7 million in the
construction of River Place Pointe, of which $19.5 million is recorded on FIC's
balance sheet as real estate occupied by the Company. As of June 30, 2003,
307,403 rentable square feet of office space was leased to third party tenants
and 276,869 rentable square feet was available for lease. According to the
Federal Deposit Insurance Corporation's ("FDIC") National Edition of Regional
Outlook, Fourth Quarter, 2002, the Austin office market vacancy rate (including
sublease space available) was 27.2% as of September 30, 2002, the highest in the
nation.
The Company views the River Place Pointe investment as a long term commitment.
Based on this assumption, the Company has examined future anticipated cash flow
on the development and has determined that the investment is not impaired.
Short-term investments
FIC's short-term investments consist primarily of U.S. Government bonds. The
level of short-term investments at June 30, 2003 was $29.3 million, as compared
to $137.9 million as of December 31, 2002. The decrease in short-term
investments was due to reinvestments of short-term assets into primarily
medium-term fixed maturity securities and trading securities.
- 44 -
Critical Accounting Policies
The financial statements contain a summary of FIC's critical accounting
policies, including a discussion of recently-issued accounting pronouncements.
Certain of these policies are considered to be important to the portrayal of
FIC's financial condition, since they require management to make difficult,
complex or subjective judgments, some of which may relate to matters that are
inherently uncertain. These policies include accounting for acquisitions, as
well as valuation of investments and deferred acquisition costs and present
value of future profits. For the year 2002, the Company's critical accounting
policies also included the cumulative effect of accounting changes regarding the
goodwill acquired from the merger with ILCO.
Cumulative Effect of Accounting Changes. During the first quarter of 2002, the
Company adopted Statement of Financial Accounting Standards (SFAS) No. 141,
"Business Combinations." SFAS No. 141 eliminates the practice of amortizing and
deferring excess of net assets acquired over costs and requires unallocated
negative goodwill to be recognized immediately. In accordance with the standard,
FIC ceased negative goodwill amortization on January 1, 2002 and recognized the
unamortized balance of $10.4 million of negative goodwill acquired in the
Merger.
Accounting for Business Combinations. The Company accounts for business
combinations using the purchase method of accounting. The cost of an acquired
entity is allocated to the assets acquired (including identified intangible
assets)and liabilities assumed based on their estimated fair values. The excess
of the cost of an acquired entity over the net total of the amounts assigned to
assets acquired and liabilities assumed is an asset referred to as "goodwill".
Indirect and general expenses related to business combinations are expensed as
incurred.
Investments. The Company's investments primarily consist of fixed maturity
securities, which include bonds, notes and redeemable preferred stocks. Fair
values of investments in fixed securities are based on quoted market prices or
dealer quotes. Fixed maturities classified as "available for sale" are reported
at fair value, with unrealized investment gains and losses, net of income taxes,
credited or charged directly to shareholder's equity. Securities classified as
trading are reported at fair value with changes in fair value credited or
charged directly to income. Generally accepted accounting principles require
that investments be written down to fair value when declines in value are
considered other than temporary. When such impairments occur, the decrease in
value is reported in net income as a realized investment loss and a new cost
basis is established.
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Deferred Policy Acquisition Costs and Present Value of Future Profits of
Acquired Business.
The costs of acquiring new business, including certain costs of issuing policies
and certain other variable selling expenses (principally commissions), included
in deferred policy acquisition costs ("DAC"). DAC is capitalized and then
amortized to reflect an expense in relation to the projected stream of profits
(for universal life and annuity products) or to the premium revenue (for
traditional life products). Such projections require use of certain assumptions,
including interest margins, product loads, mortality rates, persistency rates,
and maintenance expense levels. Effective with respect to new business issued on
and after January 1, 2002, the Company has capitalized DAC based on an updated
analysis of its cost structure and assumptions as to product performance.
Management periodically reviews the assumptions associated with the amortization
models prospectively.
Present value of future profits of acquired business ("PVFP") are the costs
associated with acquiring blocks of insurance from other companies or through
the acquisition of other companies. PVFP is capitalized and amortized in a
manner that matches these costs against the associated revenues.
For a further discussion of accounting standards, see New Accounting
Pronouncements beginning on page 12, herein.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
General. FIC's principal assets are financial instruments, which are
subject to market risks. Market risk is the risk of loss arising from adverse
changes in market rates, principally interest rates on fixed rate investments.
For a discussion of the Company's investment portfolio and the management of
that portfolio to reflect the nature of the underlying insurance obligations of
the Company's insurance subsidiaries, please refer to the information set forth
in "Management's Discussion and Analysis of Financial Condition and Operations -
Investments".
The following is a discussion of the Company's primary market risk sensitive
instruments. It should be noted that this discussion has been developed using
estimates and assumptions. Actual results may differ materially from those
described below. Further, the following discussion does not take into account
actions that could be taken by management in response to the assumed changes in
market rates. In addition, the discussion does not take into account other types
of risks that may be involved in the business operations of the Company, such as
the reinsurance recoveries on reinsurance treaties with third party insurers.
The primary market risk to the Company's investment portfolio is interest rate
risk. The Company's investment portfolio includes $20.0 million of "inverse
floater" CMOs. These contain a derivative which is "embedded" in the financial
instrument.
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Interest Rate Risk. The Company manages the interest rate risk inherent in
our assets relative to the interest rate risk inherent in our liabilities.
Generally, we manage interest rate risk based on the application of a commonly
used model. The model projects the impact of interest rate changes on a range of
factors, including duration and potential prepayment. For example, assuming an
immediate increase of 100 basis points in interest rates, the net hypothetical
loss in fair market value related to the financial instruments segment of the
Company's balance sheet is estimated to be $34.6 million at June 30, 2003 and
$16.6 million at December 31, 2002. For purposes of the foregoing estimate,
fixed maturities, including fixed maturities available for sale and trading
securities, and short-term investments were taken into account. The market value
of such assets was $664 million at June 30, 2003 and $632.8 million at December
31, 2002.
The fixed income investments of the Company include certain mortgage-backed
securities. The market value of such securities was $362.1 million at June 30,
2003 and $205.4 million at December 31, 2002. Assuming an immediate increase of
100 basis points in interest rates, the net hypothetical loss in the fair market
value related to such mortgage-backed securities is estimated to be $19.6
million at June 30, 2003 and $4.7 million at December 31, 2002.
Separate account assets have not been included, since gains and losses on those
assets generally accrue to the policyholders.
The Company generally does not use derivative financial instruments to manage
our exposure to fluctuations in interest rates. However, the Company's
investments in inverse floater CMO's at June 30, 2003 described above have a
coupon rate which varies in an inverse relationship with a specified benchmark
rate.
The hypothetical effect of the interest rate risk on fair values was estimated
by applying a commonly used model. The model projects the impact of interest
rate changes on a range of factors, including duration and potential prepayment.
Item 4. Controls and Procedures
The Company's principal executive officer and principal financial officer have
evaluated the effectiveness of the Company's "disclosure controls and
procedures," as such term is defined in Rule 13a-15(e) under the Securities
Exchange Act of 1934, as amended, (the "Exchange Act") as of June 30, 2003.
Based upon their evaluation, the principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures are effective to provide reasonable assurance that information
required to be disclosed by the Company in the reports filed or submitted by it
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and forms, and to provide
reasonable assurance that information required to be disclosed by the Company in
such reports is accumulated and communicated to the Company's management,
including its principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.
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There was no change in the Company's "internal control over financial reporting"
(as such term is defined in Rule 13a-15(f) under the Exchange Act) that occurred
during the quarter ended June 30, 2003, that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.
Part II. Other Information
Item 1. Legal Proceedings
The Company and its subsidiaries are defendants in certain legal actions related
to the normal business operations of the Company. Management believes that the
resolution of such legal actions will not have a material impact on the
financial statements.
Litigation Relating to the FIC/ ILCO Merger. There have been no material
developments since the Company's filing of its Annual Report on Form 10-K for
the year ended December 31, 2002.
Litigation Relating to Former Chairman and CEO. There have been no material
developments in this matter since the Company's filing of its Quarterly Report
on Form 10-Q for the quarterly period ended March 31, 2003.
Litigation with Otter Creek Partnership I, L.P.
On June 13, 2003, Otter Creek Partnership I, L.P. ("Otter Creek") filed a civil
action lawsuit against FIC in the District Court in Travis County, Texas, Cause
No. GN302872, for the purpose of seeking an injunction against the Company to
compel the Company to schedule and hold an Annual Meeting of Shareholders and
either not to exercise the proxy it acquired from the Mitte Parties in
connection with the settlement of the litigation referenced under the caption
"Litigation Relating to Former Chairman and CEO" or to vote such shares in the
same proportion as the other outstanding shares of the Company are voted. The
court refused to order the Company to set a specific record date or meeting date
for the 2003 Annual Meeting. However, the 2003 Annual Meeting of Shareholders of
FIC was, in fact, held on July 31, 2003.
On July 29, 2003, FIC released the proxy acquired from the Mitte Parties, with
respect to 312,484 shares acquired prior to the record date for the 2003 Annual
Meeting from the Mitte Foundation by American Physicians Service Group Inc.
("APS") and 204,918 shares acquired from the Mitte Foundation by M&W Insurance
Services, Inc. ("M&W"). Said release was granted at the request of APS and M&W.
Accordingly, APS and M&W each voted their respective shares directly at the 2003
Annual Meeting. The proxy granted to management by the Mitte Parties with
respect to the remaining shares was voted at the 2003 Annual Meeting by the
persons named as Proxies in FIC's Proxy Statement. Otter Creek has objected to
the release of proxy to APS and M&W.
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FIC believes that the provisions of the settlement agreement with the Mitte
Parties pertaining to the grant of proxy, and the conditions set forth in the
settlement agreement pertaining to said grant, are consistent with applicable
legal requirements. Accordingly, FIC intends to defend its right to vote the
shares subject to the proxy from the Mitte Parties and the partial release of
said proxy to APS and M&W.
A trial date has been set for the second week of September, 2003.
Other Litigation. Additionally, FIC's insurance subsidiaries are regularly
involved in litigation, both as a defendant and as plaintiff. The litigation
naming the insurance subsidiaries as defendant ordinarily involves our
activities as a provider of insurance protection products. Management does not
believe that such litigation, either individually or in the aggregate, will have
a material adverse effect on the Company's business, financial condition or
results of operations.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during
the second quarter of 2003.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of
1934
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of
1934
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32.1 Certification of Chief Executive Officer of Financial Industries
Corporation pursuant to Rule 13a-14(b) or Rule 15-14(b) and 18
U.S.C. Section 1350
32.2 Certification of Chief Financial Officer of Financial Industries
Corporation pursuant to Rule 13a-14(b) or Rule 15-14(b) and 18
U.S.C. Section 1350
(b) Reports on Form 8-K
(i) On April 21, 2003 the Registrant filed a Current Report on Form
8-K. The current report referred to a press release issued by FIC
on April 17, 2003 announcing the Registrant's financial results
for the year ended December 31, 2002 and restated financial
results for the years ended December 31, 2001 and 2000.
(ii) On May 16, 2003 the Registrant filed a Current Report on Form
8-K. The current report referred to a press release issued by FIC
on May 15, 2003 announcing the Registrant's financial results for
the three-month period ended March 31, 2003.
(iii)On June 10, 2003 the Registrant filed a Current Report on Form
8-K. The current report referred to (a) FIC's acquisition of
marketing companies; (b) a marketing agreement entered into by
and among FIC and certain of its subsidiaries, and Equita
Financial and Insurance Services of Texas, Inc. ("Equita"); (c) a
stock purchase and option agreement entered into with American
Physicians Service Group, Inc. ("APS"); (d) a stock purchase and
option agreement entered into with Equita; (e) a registration
rights agreement entered into with APS and Equita; (f) an
employment agreement and option agreement entered into with
William P. Tedrow; and (g) the issuance, by FIC, of $15,000,000
senior notes.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FINANCIAL INDUSTRIES CORPORATION
/s/ Eugene E. Payne
_____________________________________
Eugene E. Payne
President and Chief Executive Officer
/s/ George M. Wise, III
_____________________________________
George M. Wise, III
Chief Financial Officer
Date: August 14, 2003
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