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 September 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 September 30, 2003:
9,689,198
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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, future results, 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," "plan," "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 financial results and 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) FIC's ability to develop and
maintain effective risk management policies and procedures and to maintain
adequate reserves for future policy benefits and claims; (6) changes in the
federal income tax laws and regulations that may affect the relative tax
advantages of some of FIC's products; (7) increasing competition in the sale of
insurance and annuities; (8) regulatory changes or actions, including those
relating to regulation of insurance products and insurance companies; (9)
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; (10) the
performance of our investment portfolios; (11) the effect of changes in
standards of accounting; (12) the effects and results of litigation; and (13)
other factors discussed in the Company's Annual Report on Form 10-K for the year
ended December 31, 2002 and in the Company's other filings with the SEC, which
are available free of charge on the SEC's website at www.sec.gov. Should one or
more of these risks or uncertainties materialize, or should underlying
assumptions prove incorrect, actual results may vary materially from those
indicated. Investors should not place undue reliance on forward-looking
statements. Each forward-looking statement speaks only as of the date of the
particular statement, and the Company undertakes no obligation to publicly
update or revise any forward-looking statements. 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
September 30, 2003 and December 31, 2002................................ 4
Consolidated Statements of Income
For the three and nine month periods ended
September 30, 2003 and September30, 2002, as restated................... 6
Consolidated Statements of Cash Flows
For the nine month periods ended
September 30, 2003 and September 30, 2002, as restated................. 10
Notes to Consolidated Financial Statements.................................. 13
Item 2. Management's Discussion and Analysis of
Financial Conditions and Results of Operations......................... 38
Item 3. Quantitative and Qualitative Disclosures
About Market Risk ..................................................... 55
Item 4. Controls and Procedures............................................ 57
Part II
Other Information........................................................... 58
Signature Page.............................................................. 62
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
September 30, December 31,
2003 2002
(unaudited)
Investments:
Fixed maturities held to maturity,
at amortized cost (market value
approximates $33 and $1,069 at
September 30, 2003 and December 31,
2002, respectively) $ 29 $ 1,090
Fixed maturities available for sale,
at market value (amortized cost of
$575,554 and $479,433 at September 30,
2003 and December 31, 2002, respectively) 572,479 493,827
Trading securities, at market value 6,101 0
Equity securities, at market value
(cost approximates $6,423 and $6,381 at
September 30, 2003 and December 31, 2002,
respectively) 7,145 6,351
Policy loans 44,361 46,607
Mortgage loans 0 17
Invested real estate 74,326 75,393
Short-term investments 62,300 137,944
Total investments 766,741 761,229
Cash and cash equivalents 6,312 24,975
Accrued investment income 9,070 8,308
Agency advances and other receivables 15,480 19,728
Reinsurance receivables 11,361 12,330
Due and deferred premiums 11,091 11,981
Property held for use 19,394 19,702
Property and equipment, net 1,891 1,367
Deferred policy acquisition costs 76,588 77,210
Present value of future profits of
acquired businesses 24,901 23,796
Goodwill 4,428 0
Other assets 13,786 15,739
Separate account assets 344,969 334,637
Total Assets $ 1,306,012 $ 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, Continued
(in thousands)
September 30, December 31,
2003 2002
LIABILITIES AND SHAREHOLDERS' EQUITY (unaudited)
Liabilities:
Policy liabilities and contractholder
deposit funds:
Contractholder deposit funds $ 564,613 $ 557,466
Future policy benefits 164,814 172,008
Other policy claims and benefits payable 15,322 17,035
744,749 746,509
Deferred federal income taxes 17,216 25,814
Notes payable 15,000 0
Other liabilities 23,582 29,400
Separate account liabilities 344,969 334,637
Total Liabilities 1,145,516 1,136,360
Commitments and Contingencies
Shareholders' equity:
Common stock, $.20 par value, 25,000
shares authorized in 2003 and 2002,
12,466 and 11,856 shares issued in
2003 and 2002, 9,689 and 9,601 shares
outstanding in 2003 and 2002 2,494 2,372
Additional paid-in capital 68,414 66,541
Unearned compensation (1,396) 0
Accumulated other comprehensive income (2,333) 4,949
Retained earnings 117,054 123,046
184,233 196,908
Common treasury stock, at cost, 2,777
and 2,255 shares at September 30, 2003
and December 31, 2002 (23,737) (22,266)
Total Shareholders' Equity 160,496 174,642
Total Liabilities and Shareholders' Equity $ 1,306,012 $ 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 September 30,
2003 2002
RESTATED
Revenues:
Premiums $ 7,392 $ 8,608
Net investment income 9,163 11,213
Real estate income 422 515
Net realized investment losses (244) (79)
Earned insurance charges 10,070 9,934
Other 1,321 329
28,124 30,520
Benefits and expenses:
Policyholder benefits and expenses 11,797 11,126
Interest expense on contractholders
deposit funds 6,740 7,423
Amortization of present value of
future profits of acquired businesses 1,025 1,109
Amortization of deferred policy
acquisition costs 2,744 2,852
Operating expenses 11,362 8,002
Interest expense 207 0
33,875 30,512
(Loss) income before federal income tax (5,751) 8
Federal income tax benefit (2,030) (369)
Net (loss) income $ (3,721) $ 377
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 September 30,
2003 2002
RESTATED
Net (Loss) Income Per Share
Basic:
Weighted average shares outstanding 9,615 9,597
Basic earnings per share $ (0.39) $ 0.04
Diluted:
Common stock and common stock equivalents 9,615 9,647
Diluted earnings per share $ (0.39) $ 0.04
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)
Nine Months Ended September 30,
2003 2002
RESTATED
Revenues:
Premiums $ 22,943 $ 27,520
Net investment income 28,735 31,023
Real estate income 1,339 1,840
Net realized investment gains (losses) 1,021 (74)
Earned insurance charges 30,668 31,435
Other 1,968 1,019
86,674 92,763
Benefits and expenses:
Policyholder benefits and expenses 31,503 33,525
Interest expense on contractholders
deposit funds 21,389 22,517
Amortization of present value of
future profits of acquired businesses 3,170 3,470
Amortization of deferred policy
acquisition costs 7,986 7,172
Litigation settlement 2,915 0
Operating expenses 28,644 24,986
Interest expense 286 0
Total 95,893 91,670
(Loss) income before federal income
tax and cumulative effect of change in
accounting principle (9,219) 1,093
(Benefit) provision for federal income taxes (3,227) 382
(Loss) income before cumulative
effect of change in accounting principle (5,992) 711
Cumulative effect of change in
accounting principle 0 10,429
Net (Loss) Income $ (5,992) $ 11,140
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)
Nine Months Ended September 30,
2003 2002
Net (Loss) Income Per Share RESTATED
Basic:
Weighted average shares outstanding 9,603 9,543
Basic earnings per share:
(Loss) income per share before cumulative
effect of change in accounting principle $ (0.62) $ 0.08
Cumulative effect of change in accounting
principle 0 1.09
Basic earnings per share $ (0.62) $ 1.17
Diluted:
Common stock and common stock equivalents 9,603 9,621
Diluted earnings per share:
(Loss) income per share before cumulative
effect of change in accounting principle $ (0.62) $ 0.07
Cumulative effect of change in
accounting principle 0 1.09
Diluted earnings per share $ (0.62) $ 1.16
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)
Nine Months Ended September 30,
2003 2002
RESTATED
CASH FLOWS FROM OPERATING ACTIVITIES
Net (Loss) Income $ (5,992) $ 11,140
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization of present value of future
profits of acquired business 3,170 3,470
Amortization of deferred policy
acquisition costs 7,986 7,172
Depreciation 2,570 1,773
Cumulative effect of change in
accounting principle 0 (10,429)
Realized (gain) loss on investments (1,021) 74
Changes in assets and liabilities:
Increase in accrued investment income (762) (1,458)
Decrease in agent advances and other receivables 5,375 3,793
Decrease in due and deferred premiums 890 1,075
Increase in deferred policy acquisition costs (6,517) (7,802)
Decrease (increase) in other assets 1,384 (2,456)
Increase in policy liabilities and accruals 1,126 5,161
Increase (decrease) in other liabilities 1,748 (1,615)
Decrease in deferred federal income taxes (4,402) (1,109)
Net activity from trading securities (6,101) 0
Other, net 727 (41)
Net cash provided by operating activities $ 181 $ 8,748
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)
Nine Months Ended September 30,
2003 2002
RESTATED
CASH FLOWS FROM INVESTING ACTIVITIES
Fixed maturities purchased $ (428,024) $ (141,625)
Real estate capitalized (790) (11,399)
Proceeds from sales and maturities of
fixed maturities 323,758 189,999
Proceeds from payments received on mortgage
loans 17 3,649
Net change in policy loans 2,246 2,184
Net change in short-term investments 75,644 (34,370)
Net change in property and equipment (640) (1,043)
Acquisition of subsidiaries, net of cash
acquired (3,183) 0
Net cash (used in) provided by investing
activities (30,972) 7,395
CASH FLOW FROM FINANCING ACTIVITIES
Dividends Paid (483) (2,207)
Contractholder fund deposits 44,503 40,276
Contractholder fund withdrawals (47,389) (53,809)
Issuance of common capital stock 944 1,007
Sale of treasury stock 656 0
Purchase of treasury stock (1,103) (460)
Proceeds from bank borrowings 15,000 0
Net cash provided by (used in) financing
activities 12,128 (15,193)
Net (decrease) increase in cash (18,663) 950
Cash, beginning of year 24,975 7,094
Cash, end of period $ 6,312 $ 8,044
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
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
contingent 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
The accompanying notes are an integral
part of these consolidated financial statements.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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 that 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 September 30, 2002 and June 30, 2003
restatements described in Note 9.
The consolidated financial statements include the accounts of Financial
Industries Corporation ("FIC") and its subsidiaries. All significant
intercompany items and transactions have been eliminated.
1. Other Comprehensive Income
The following is a reconciliation of the change in accumulated other
comprehensive income from December 31, 2002 to September 30, 2003 (in
thousands):
Net unrealized Net Net
gain (loss) on Appreciation accumulated
investments in (depreciation) other
fixed maturities of equity comprehensive
available for securities income
sale Other (loss)
Balance at December 31, 2002 $ 6,601 $ (20) $ (1,632) $ 4,949
Current Period Change (8,026) 489 255 (7,282)
Balance at September 30, 2003 $ (1,425) $ 469 $ (1,377) $ (2,333)
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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 Nine months ended
September 30, September 30,
2003 2002 2003 2002
RESTATED RESTATED
BASIC:
Net (loss) income available to common
shareholders $ (3,721) $ 377 $ (5,992) $ 11,140
Weighted average common
shares outstanding 9,615 9,597 9,603 9,543
Basic earnings per share $ (0.39) $ 0.04 $ (0.62) 1.17
DILUTED:
Net (loss) income available to common
shareholders $ (3,721) $ 377 $ (5,992) $ 11,140
Weighted average common shares
outstanding 9,615 9,597 9,603 9,543
Common stock options 0 219 0 270
Repurchase of treasury stock 0 (169) 0 (192)
Common stock and common stock
equivalents 9,615 9,647 9,603 9,621
Diluted earnings per share $ (0.39) $ 0.04 $ (0.62) $ 1.16
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Options to purchase 873,020 shares of common stock at prices ranging from $8.18
to $16.42 were outstanding at September 30, 2003, but were not included in the
computation of diluted earnings per share for the three and nine months ending
September 30, 2003 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 Statement of Financial
Accounting Standards ("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, Accounting Principles Board ("APB") Opinion
No. 25, "Accounting for Stock Issued to Employees," 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. 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
(loss) per share):
Three months ended Nine months ended
September 30, September 30,
2003 2002 2003 2002
RESTATED RESTATED
Net (loss) income as reported $ (3,721) $ 377 $ (5,992) $ 11,140
Pro forma compensation expense,
net of tax benefits 0 39 0 115
Pro forma net (loss) income $ (3,721) $ 338 $ (5,992) $ 11,025
Net (loss) income per share:
Basic as reported $ (0.39) $ 0.04 $ (0.62) $ 1.17
Diluted as reported $ (0.39) $ 0.04 $ (0.62) $ 1.16
Basic - Pro Forma $ (0.39) $ 0.04 $ (0.62) $ 1.16
Diluted - Pro Forma $ (0.39) $ 0.04 $ (0.62) $ 1.15
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
4. Dividends Declared
The Board declared a dividend of $0.05 per common share payable on January 24,
2003 to shareholders of record as of January 3, 2003.
5. Trading Securities
FIC's trading securities consist of Collateralized Mortgage Obligations ("CMOs")
of the type 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 September 30, 2003 was $6.1 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 nine months ended September 30,
2003 is $ (630,000) and $131,000, respectively. FIC did not have any trading
securities at December 31, 2002.
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 that 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 was May 30, 2003.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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 whose restricted
common stock was valued at $756,842. 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 has been recorded as unearned compensation
as a component of shareholders' equity and is being 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 has been recorded as unearned compensation as a component of
shareholders' equity and is being 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 has been recorded as unearned compensation as a component of
shareholders' equity and is being 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):
Nine Months Ending Sept. 30, 2003
Revenues $ 88,068
Net Loss $ (6,045)
Basic Earnings Per Share $ (0.63)
Diluted Earnings Per Share $ (0.63)
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 SFAS No. 141, "Business Combinations." 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 adjusted 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. The Company previously reported in its 8-K filed on June 6, 2003,
that the purchase price was $6.9 million. However, a portion of that amount
($2.4 million) has been reclassified as contingent compensation, rather than as
part of the purchase price. FIC has not finalized the allocation of the purchase
price as of September 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: $116,000 to cash, $158,000 to agency advances and other
receivables, $288,000 to property, plant and equipment, $28,000 to other assets,
$182,000 to other liabilities and $4.4 million to goodwill and other
intangibles. While the Company has not completed its allocation of cost to other
intangibles, its preliminary assessment is that such amounts are not
significant, and accordingly, no amortization expense has been recorded.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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 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.
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 ("Common Stock"), par value $.20 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 for life insurance
and annuity products marketed through FICFS, the newly-established subsidiary of
FIC that 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 SFAS No. 123 and Emerging
Issues Task Force ("EITF") Issue No. 96-18, "Accounting for Equity Instruments
That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services."
- 19 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
D. Stock Purchase and Option Agreement - Equita Financial and Insurance
Services of Texas, Inc. ("Equita"):
In consideration of the role that 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 Issue No. 96-18 at that
date.
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 was included as an expense in
the Consolidated Income Statement for the nine months ended September 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
September 30, 2003 was $0.
- 20 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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 Opinion No. 25 and Financial Accounting
Standards Board ("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 and nine months ended
September 30, 2003.
In his capacity at the Company, Mr. Tedrow has participated during the current
year in the general supervision of investment activities. On October 29, 2003,
the Company announced that it is reviewing its investment activities during the
past year, including mark-ups and commissions paid during that time. The Company
is also investigating, among other things, relationships between a broker-dealer
used by the Company and William P. Tedrow. As stated above, Mr. Tedrow is the
president of the Company's FICFS subsidiary and a Vice President of the Company.
Mr. Tedrow has been placed on administrative leave pending the results of this
investigation.
F. Review of New Era Business
The Company is currently reviewing the business plans of the New Era Marketing
Companies in order to determine what changes, if any, may be needed in the
operation of the business entities which operate as part of the FICFS
subsidiary. In connection with its review of the operations of FICFS, the
Company evaluated the goodwill that was established in connection with the
acquisition of the New Era companies and has determined that, for the period
ended September 30, 2003, no adjustment to the carrying value that was
previously established is required.
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").
- 21 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The principal amount of the Senior Notes is to be paid on May 23, 2033 and
interest is to 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. 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
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.
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 Opinion No. 25 and
related interpretations as allowed by this statement. FIC has adopted the
disclosure provisions of SFAS No. 148.
- 22 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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. The FASB has deferred FIN 46 until the end of periods ending after
December 15, 2003 for VIEs created before February 1, 2003 that have not been
reported in accordance with FIN 46. FIN 46 is not expected to have a material
effect on the Company.
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.
- 23 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In April 2003, the FASB issued SFAS 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 No. 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 No. 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
instruments of a nonpublic entity, SFAS No. 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 No. 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 No. 150. At its October 29, 2003 meeting, the FASB
agreed to indefinitely defer the implementation of a portion of SFAS No. 150
regarding the accounting treatment for minority interests in finite life
partnerships. The provisions of SFAS No. 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 No. 150 on our consolidated
financial position and results of operations.
- 24 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In July 2003, the Accounting Standards Executive Committee ("AcSEC") of the
American Institute of Certified Public Accountants ("AICPA") issued Statement of
Position ("SOP") 03-01, "Accounting and Reporting by Insurance Enterprises for
Certain Nontraditional Long-Duration Contracts and for Separate Accounts." AcSEC
has developed the SOP to address the evolution of product designs since the
issuance of SFAS No. 60, "Accounting and Reporting by Insurance Enterprises,"
and SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain
Long-Duration Contracts and for Realized Gains and Losses from the Sale of
Investments," and the need for interpretive guidance to be developed in three
areas: separate account presentation and valuation; the accounting recognition
given sales inducements (bonus interest, bonus credits, persistency bonuses);
and the classification and valuation of certain long-duration contract
liabilities.
Significant accounting implications of the SOP are as follows: (1) reporting and
measuring assets and liabilities of separate account products as general account
assets and liabilities when specified criteria are not met; (2) reporting and
measuring seed money in separate accounts as general account assets based on the
insurer's proportionate beneficial interest in the separate account's underlying
assets; (3) capitalizing sales inducements that meet specified criteria and
amortizing such amounts over the life of the contracts using the same
methodology as used for amortizing deferred acquisition costs, but immediately
expensing those sales inducements accrued or credited if such criteria are not
met; (4) for contracts that have features that may result in more than one
potential account balance, recognizing contractholder liabilities based on the
highest contractually determinable balance that will be available in cash or its
equivalent at the contract maturity or reset date, without reduction for future
fees and charges; (5) recognizing contractholder liabilities for group pension
participating and similar general account "pass through" contracts that are not
accounted for under SFAS No. 133 at amounts based on the fair value of the
assets or index that determines the investment return pass through; (6)
establishing an additional liability for contracts determined to have mortality
and morbidity risk that is other than nominal when the risk charges made for a
period are not proportionate to the risk borne during that period; and (7) for
contracts containing an annuitization benefits contract feature, if such
contract feature is not accounted for under the provisions of SFAS No. 133
establishing an additional liability for the contract feature if the present
value of expected annuitization payments at the expected annuitization date
exceeds the expected account balance at the expected annuitization date.
- 25 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The provisions of the SOP are effective for fiscal years beginning after
December 15, 2003, and, as such, the Company will adopt the SOP effective
January 1, 2004. The effect of initially adopting this SOP will be reported as a
cumulative effect of a change in accounting principle except for the
requirements regarding capitalization of sales inducements, which is required to
be applied prospectively. The Company is currently completing an assessment of
the impact of the SOP on its operations; however, we do not believe that the
implementation of the SOP will have a material effect on the Company's
consolidated financial position.
9. Restatement
Restatement of Form 10-Q for period ending June 30, 2003
In connection with the preparation of its financial statements for the three and
nine-month periods ended September 30, 2003, the Company reviewed those
securities in its investment portfolio classified as fixed maturities available
for sale. That review was conducted in order to determine whether changes in the
carrying value of those securities should be considered as other than temporary.
As a result of that review, the Company incurred a $5.2 million charge to net
realized investment loss, of which approximately $725,000 relates to the quarter
ended June 30, 2003.
Realized investment losses of $725,000 and related adjustments to amortization
of present value of future profits of acquired businesses, deferred policy
acquisition costs and accumulated other comprehensive income have been recorded
as of June 30, 2003.
The Company also determined that $105,000 had been accrued and reported as
income in the period ended June 30, 2003 relating to amounts that were
anticipated to be due to ILG Securities Corporation, a broker-dealer subsidiary
of the Company, in connection with securities transactions involving the
investment portfolios of the Company's subsidiaries. This amount should have
been eliminated in consolidation. Moreover, the Company has not determined that
ILG Securities Corporation has a contractual right to receive such payments,
accordingly, such amounts are now reflected in liabilities pending resolution of
this issue.
The June 30, 2003 financial statements included in the previously filed Form
10-Q for the three and six months ended June 30, 2003 will be restated as shown
in the table below to correct the above impairments, reversal of commission
income and reflect the related effect of income taxes. The Company will file an
amended Form 10-Q for the three and six months ended June 30, 2003 to reflect
these restatements.
- 26 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Net income for the three and six months ended June 30, 2003 was decreased from
amounts previously reported by $500,000 as a result of the restatement, as
follows (in thousands except per share data):
BALANCE SHEET As Reported As Restated
Other Assets $ 20,206 $ 20,101
Deferred policy acquisition costs $ 76,375 $ 76,369
Present value of future profits
of acquired businesses $ 21,764 $ 21,619
Deferred federal income taxes $ 23,518 $ 23,428
Accumulated other comprehensive income $ 5,385 $ 5,719
Retained Earnings $ 121,275 $ 120,775
INCOME STATEMENT Three months ended
Net loss $ (507) $ (1,007)
Basic earnings per share $ (0.05) $ (0.10)
Diluted earnings per share $ (0.05) $ (0.10)
Six months ended
Net loss $ (1,771) $ (2,271)
Basic earnings per share $ (0.18) $ (0.24)
Diluted earnings per share $ (0.18) $ (0.24)
- 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, 2003 was
due to the following adjustments that increased (decreased) net income (in
thousands):
Three and six months ended
June 30, 2003
Net investment income $ (105)
Net realized investment losses (725)
Amortization of present value of future
profits of acquired businesses 29
Amortization of deferred policy acquisition
costs 31
Provision for federal income taxes 270
Net Loss $ (500)
Restatement for period ending September 30, 2002
The financial statements as of and for the three and nine month periods ended
September 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.
- 28 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
B. Agency advances and other receivables had not been analyzed for
collectibility and contained balances pertaining 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.
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 date upon FIC's
acquisition of ILCO's remaining outstanding shares. ILCO's financial
statements also required adjustement for the following items:
- 29 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
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).
ii. Agency advances and other receivables 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 Janaury 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 difference 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 liabilites 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.
- 30 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Net income for the three and nine months ended September 30, 2002 was decreased
from amounts previously reported by $522,000 and $6,855,000, respectively, as a
result of the restatement, as follows (in thousands except per share data):
Three Months Ended Three Months Ended
September 30, 2002 September 30, 2002
As Previously Reported As Restated
Net Income $ 899 $ 377
Basic Earnings Per Share:
Net Income $ 0.09 $ 0.04
Diluted Earnings Per Share:
Net Income $ 0.09 $ 0.04
- 31 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Nine Months Ended Nine Months Ended
September 20, 2002 September 30, 2002
As Previously Reported As Restated
Net Income before cumulative
effect of change in accounting
principle $ 2,268 $ 711
Cumulative effect of change in
accounting principle $ 15,727 $ 10,429
Net Income $ 17,995 $ 11,140
Basic earnings per share:
Net income before cumulative effect
of change in accounting principle $ 0.24 $ 0.08
Cumulative effect of change in
accounting principle $ 1.65 $ 1.09
Net Income $ 1.89 $ 1.17
Diluted earnings per share:
Net income before cumulative effect of
change in accounting principle $ 0.24 $ 0.07
Cumulative effect of change in
accounting principle $ 1.63 $ 1.09
Net Income $ 1.87 $ 1.16
- 32 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The change in net income for the three and nine month ended September 30, 2002
was due to the following adjustments that increased (decreased) net income (in
thousands):
Three Months Ended Nine Months Ended
September 20, 2002 September 30, 2002
Premiums $ 1 $ 3
Policyholder benefits and expenses $ (503) $ (1,497)
Amortization of present value of
future profits $ (15) $ (46)
Amortization of deferred policy
acquisition costs $ (86) $ (259)
Provision for uncollectible
receivables $ (200) $ (597)
Provision for deferred federal
income taxes $ 281 $ 839
Cumulative effect of change in
accounting principle $ 0 $ (5,298)
Net Income $ (522) $ (6,855)
- 33 -
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 September 30, 2002 is as follows (in thousands):
As Previously As
Reported Restated
ASSETS
Equity securities $ 35 $ 5,994
Invested real estate 71,223 74,279
Total Investments 755,980 764,995
Agency advances and other
receivables 31,817 16,462
Property and equipment, net 3,604 790
Deferred policy acquisition costs 80,863 77,451
Present value of future profits
of acquired business 27,299 26,532
Other assets 17,214 18,335
Separate account assets 334,796 327,067
Total assets $ 1,313,466 $ 1,293,526
LIABILITIES AND SHAREHOLDERS' EQUITY
Deferred federal income taxes $ 34,640 $ 28,265
Other liabilities 7,689 15,531
Total liabilities 1,112,080 1,113,546
Accumulated other comprehensive
income 7,842 4,362
Retained earnings 147,251 129,325
Total shareholders' equity before
treasury stock 223,743 202,337
Total shareholders' equity 201,386 179,980
Total liability and shareholders'
equity $ 1,313,466 $ 1,293,526
- 34 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANICAL STATEMENTS (UNAUDITED)
The consolidated balance sheet as of September 30, 2002 was restated to reflect
the following:
* An increase of $6.0 million in FIC's investments in equity securities
to properly reflect the market value of the Company's investment in
the separate account;
* An increase of $3.1 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 $15.4 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 $3.4 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 $767,000 in present value of future profits of acquired
businesses due to an adjustment in the calculation of this asset;
* An increase of $1.1 million in other assets primarily related to the
establishment of unrecorded pre-paid pension assets related to Family
Life's and ILCO's pension plans;
* A decrease of $7.7 million in separate account assets due to a
reclassification of separate account assets to equity securities;
* A decrease of $6.4 million in the liability for deferred federal
income taxes as a result of the restatement adjustments described
herein;
- 35 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANICAL STATEMENTS (UNAUDITED)
* An increase of $7.8 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 $3.5 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 $17.9 million due to the
restatement adjustments described herein.
10. Commitments and Contingencies
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. Otter Creek and FIC have reached an agreement in principle to
settle the lawsuit, and are preparing the appropriate documentation to do so.
Under this proposed settlement, the Company will reimburse Otter Creek for
$250,000 in proxy expenses. An additional $299,000 of proxy expenses and
$190,000 of litigation expenses will be submitted to the Company's shareholders
for approval at a shareholder's meeting. The Board of Directors will recommend
that shareholders approve this reimbursement. The proposed settlement will also
provide for mutual releases between the Company and Otter Creek and certain of
its affiliates. The Company has accrued an expense of $250,000 for the
reimbursement to Otter Creek in the quarter ended September 30, 2003.
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.
- 36 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
11. Subsequent Events
As discussed in Note 6, on October 29, 2003, the Company announced that it is
reviewing its investment activities during the past year, including mark-ups and
commissions paid during that time. The Company is also investigating, among
other things, relationships between a broker-dealer used by the Company and
William P. Tedrow. Mr. Tedrow is the president of the Company's FIC Financial
Services, Inc. subsidiary and a Vice President of the Company. In his capacity
at the Company, Mr. Tedrow has participated during the current year in the
general supervision of investment activities. The Company's investigation of
these matters is ongoing. Mr. Tedrow has been placed on administrative leave
pending the results of this investigation. The Company has not reached any
conclusion with regard to Mr. Tedrow's role, if any, in the activities under
review.
Following a review of the investment portfolios of the life insurance
subsidiaries of the Company, the Investment Committee of the Company's Board of
Directors recommended the engagement of a third- party investment manager to
provide on-going, professional management of the portfolios. In October, 2003,
the life insurance subsidiaries entered into investment management agreements
with Conning Asset Management Company ("Conning"). Under these agreements,
Conning will manage the investment security portfolios of the Company's life
insurance subsidiaries in accordance with investment policies set by the
Company's Board of Directors. In addition, Conning will provide such other
investment advisory and investment accounting and reporting services to the
Company's life insurance subsidiaries as may be reasonably requested and agreed
to by Conning.
The Company also revised the investment policies of its insurance subsidiaries.
Conning has begun to realign the Company's life insurance subsidiaries'
portfolios. As part of this realignment, Conning identified eight securities
purchased earlier in 2003 that they felt had significant future principal risk.
While all of these securities were investment grade when purchased, six of the
eight have had ratings downgrades since purchase. Conning recommended that these
securities be sold in the near future. Five of the eight had been sold by
November 20, 2003. All eight were treated as other than temporarily impaired as
of September 30, 2003.
- 37 -
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 September 30, 2003, compared with December
31, 2002, and its results of operations for the three and nine months ended
September 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 nine-month periods ended
September 30, 2002 are to restated results. See the Notes to the Consolidated
Financial Statements.
Transactions Affecting Comparability of Results of Operations
In the first nine 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 SFAS No.
141, "Business Combinations," in the first quarter of 2002, as required by SFAS
No. 141.
In the first nine 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 nine months of 2003 was also affected by certain operating expenses
such as: (i) a $476,000 expense 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,
including the accrual of $250,000 of proxy expenses to be reimbursed to Otter
Creek in connection with the settlement of the litigation between the Company
and Otter Creek; (iv) $212,175 paid to Salomon Smith Barney; (v) a $5.2 million
charge related to other than temporary impairments of securities. This
adjustment resulted from an analysis of the investment portfolio that was made
by the Company with the assistance of the Company's recently-appointed
investment manager, Conning Asset Management Company. A portion of this
adjustment (approximately $725,000) relates to the quarter ended June 30, 2003;
and (vi) an expense of $360,000 for payments to be made to Eugene E. Payne
pursuant to an amendment to his employment agreement.
- 38 -
Results of Operations - Nine Months Ended September 30, 2003 and 2002
For the nine-month period ended September 30, 2003, FIC's net loss was $6.0
million (basic and diluted loss of $ 0.62 per common share) on revenues of $86.7
million as compared to net income of $11.1 million (basic earnings of $1.17 per
common share, or diluted earnings of $1.16 per common share) on revenues of
$92.8 million in the first nine months of 2002. Net income for the first nine
months of 2002, before the cumulative effect of change in accounting principle,
was $0.7 million (basic and diluted earnings of $0.08 and $0.07 per common
share, respectively).
Revenues.
Premium revenues reported for traditional life insurance products are recognized
when due. Premium income for the first nine months of 2003, net of reinsurance
ceded, was $22.9 million, as compared to $27.5 million in the first nine 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 nine
months ending September 30, 2003 was $16.0 million, as compared to $20.3 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
due to the runoff of policies in force.
Income from universal life and annuity charges for the first nine months of 2003
was $30.7 million, as compared to $31.4 million in the same period of 2002. The
face amount of in force universal life policies was $4.7 billion at September
30, 2003 as compared to $5.1 billion at September 30, 2002.
Net investment income for the first nine months of 2003 was $28.7 million as
compared to $31.0 million in the same period of 2002. Net investment income in
the first nine months of 2003 was adversely affected by the interest rate
environment during that period.
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 $1.3 million for the nine-month period ended
September 30, 2003, as compared to $1.8 million for the same period in 2002. The
decrease in real estate income from the nine months ended September 30, 2003 to
the same period ended September 30, 2002 is due to the completion of the last
three buildings in River Place Pointe project and the depreciation related to
those buildings. These three buildings did not generate rental income in the
first nine months of 2003.
- 39 -
Net realized investment gain was $1.0 million in the first nine months of 2003,
as compared to a net realized investment loss of $74,000 in the first nine
months of 2002. These gains and losses are related to sales of fixed maturity
securities. In addition, net realized investment gain was adversely affected by
a $5.2 million charge resulting from the impairments in the value of certain
securities. A portion of this charge (approximately $725,000) pertains to the
quarter ended June 30, 2003. The Company has restated its results for the three
and six- month periods ended June 30, 2003 to reflect the effect of this charge.
The charge resulted from a review that was conducted by the Company and its
newly-appointed investment manager, Conning Asset Management Company, in
connection with the preparation of its financial statements for the three and
nine- month periods ended September 30, 2003. That review was conducted in order
to determine whether changes in the carrying value of certain securities
classified as fixed maturities available for sale should be considered as other
than temporary. Under applicable accounting rules, declines in value which are
considered as other than temporary require that the decrease in value be treated
as an investment loss and that a new cost basis be established for such
investments.
Other revenue was $2.0 million in the first nine months of 2003, as compared to
$1.0 million in the first nine months of 2002. Other income includes income from
FIC's non-insurance subsidiaries, Actuarial Risk Consultants, Inc. ("ARC") and
FIC Financial Services, Inc. ("FICFS"). For the nine-month period ended
September 30, 2003, ARC had revenues of $220,000 on business conducted with
third-party clients and revenues of $476,000 on business conducted with
subsidiaries of the Company. Revenue with the Company's subsidiaries is
eliminated against operating expenses in consolidation. The revenues of FICFS
(including the revenues of its subsidiaries) for the period from June 1, 2003 to
September 30, 2003 were $1.0 million. At the end of 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). 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 and Note 6 of
the Notes to Consolidated Financial Statements.
- 40 -
Benefits and Expenses.
Policyholder benefits and expenses were $31.5 million in the first nine months
of 2003, as compared to $ 33.5 million in the first nine months of 2002. The
decrease in policyholder benefits and expenses from September 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.
Interest expense on contractholders deposit funds was $21.4 million in the
first nine months of 2003, as compared to $22.5 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 $8.0 million in the first nine months of 2003, as
compared to $7.2 million in the first nine 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 from the nine-month period ended September 30, 2002 to
the same period in 2003 reflects the level of policyholder withdrawals
experience during the current period.
In the first nine months of 2003, the expense related to the amortization of
present value of future profits of acquired business was $3.2 million as
compared to $3.5 million in the first nine months of 2002.
Operating expenses for the first nine months of 2003 were $28.6 million, as
compared to $25.0 million in the first nine months of 2002. The level of
operating expenses for the nine-month period ending September 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 in the amount of $2.9 million related to
litigation with the former Chairman and CEO, Roy F. Mitte;
(iii)$925,000 of legal and other expenses for proxy matters and litigation
related to the 2003 Annual Meeting of Shareholders;
(iv) the accrual of a payment in the amount of $250,000 to be made to Otter
Creek in connection with the settlement of litigation related to the
2003 Annual Meeting of Shareholders;
- 41 -
(v) $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);
(vi) $212,175 paid to Salomon Smith Barney related to the matter as set
forth in the Company's Current Report on Form 8-K filed with the
Securities and Exchange Commission ("SEC") on January 28, 2003; and
(vii)an expense of $360,000 for payments to be made to Eugene E. Payne
pursuant to an amendment to his employment agreement.
Operating expenses for the nine-month period include $544,000 of expenses at ARC
and $1.2 million of expenses at FICFS. The operating expenses FICFS (including
the expenses of its subsidiaries) are for the period from June 1, 2003 to
September 30, 2003. Since the results of FICFS are below the expectations of
management, the Company is currently reviewing the business plans of these
entities in order to determine what changes, if any, may be needed in the
operation of the business entities that operate as part of the FICFS subsidiary.
In connection with its review of the operations of FICFS, the Company evaluated
the goodwill that was established in connection the acquisition of the New Era
companies and has determined that, for the period ended September 30, 2003, no
adjustment to the carrying value that was previously established is required.
The Company expects to continue to monitor this item.
Operating expenses for the nine-month period ended September 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.
The provision (benefit) for federal income taxes was ($3.2) million in the first
nine months of 2003 as compared to $0.4 million in the first nine months of
2002. The change is attributable to the decrease in income for the nine month
period ended September 30, 2003 compared to the same period in 2002.
- 42 -
Results of Operations - Three Months Ended September 30, 2003
as compared to the Three Months Ended September 30, 2002
For the three-month period ended September 30, 2003, FIC's net loss was $3.7
million (basic and diluted loss of $0.39 per common share) on revenues of $28.1
million as compared to net income of $377,000 (basic and diluted earnings of
$0.04 per common share) on total revenues of $30.5 million in the same
three-month period of 2002.
Revenues
Premium income for traditional life insurance products, net of reinsurance
ceded, was $7.4 million, as compared to $8.6 million for the quarter ended
September 30, 2002. Income from universal life and annuity charges increased
from $9.9 million for the quarter ended September 30, 2002 to $10.1 million for
the quarter ended September 30, 2003.
Net investment income was $9.2 million for the three-month period ended
September 30, 2003, as compared to $11.2 million in the same period of 2003.
This decrease is primarily attributable to the interest rate environment during
that period.
Net realized investment losses were $244,000 in the quarter ended September 30,
2003, as compared to a net realized investment loss of $79,000 in the same
period in 2002. This loss is related to sales of fixed maturity securities. In
addition, net realized investment loss was adversely affected by a $4.5 million
charge resulting from the impairments in the value of certain securities. The
charge resulted from a review that was conducted by the Company and its
newly-appointed investment manager (Conning Asset Management Company), as
previously described.
Other revenue was $1.3 million in the quarter ended September 30, 2003, as
compared to $329,000 in the same period in 2002. Other income includes income
from FIC's non-insurance subsidiaries, ARC and FICFS. For the three-month period
ended September 30, 2003, ARC had revenues of $37,000 on business conducted with
third-party clients and revenues of $234,000 on business conducted with
subsidiaries of the Company. Revenue with the Company's subsidiaries is
eliminated against operating expenses in consolidation. The revenues of FICFS
(including the revenues of its subsidiaries) for the quarter ended September 30,
2003 were $813,000. ARC and FICFS were established by the Company during the
current year; accordingly, the results of operations for the quarter ended
September 30, 2002 do not reflect income from those businesses.
- 43 -
Benefits and Expenses
Policyholder benefits and expenses were $11.8 million in the quarter ended
September 30, 2003, as compared to $ 11.1 million in the same period of 2002.
The slight increase was due primarily to an increase in death benefits claims
between the two periods.
Interest expense on contractholders deposit funds was $6.7 million in the
quarter ended September 30, 2003, as compared to $7.4 million in the same period
of 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 $2.7 million for the quarter, as compared to $2.9
million in three-month period ended September 30, 2002.
Operating expenses for the three-month period September 30, 2003 were $11.4
million, as compared to $8.0 million in the same period in 2002. The level of
operating expenses for the 2003 quarter were affected by: (i) $925,000 of legal
and other expenses for proxy matters and litigation related to the 2003 Annual
Meeting of Shareholders; (ii) the accrual of a payment in the amount of $250,000
to be made to Otter Creek in connection with the settlement of litigation
related to the 2003 Annual Meeting of Shareholders; (iii) an expense of $360,000
for payments to be made to Eugene E. Payne pursuant to an amendment to his
employment agreement; and (iv) $1.2 million related to the operations of ARC and
FICFS.
The provision (benefit) for federal income taxes was $2.0 million in the three
months ended September 30, 2003 as compared to a benefit of $369,000 in the
three months ended September 30, 2002. The increase in the benefit was due to
the $5.8 million decrease in income (before federal income tax) for the three
month period ended September 30, 2003 compared to the three month period ended
September 30, 2002. The benefit has been calculated based on an effective tax
rate equal to the statutory rate of 35% for the three months ended September 30,
2003 and 2002. Additionally, the Company was able to credit $350,000 in the
third quarter 2002 provision for federal income taxes related to the
compensation of its former president and chief executive officer, Roy F. Mitte.
In the first two quarters of 2002, the Company expected to incur federal income
taxes related to non-deductible compensation. However, since Mr. Mitte was not
an executive with the company on December 31, 2002, which is the relevant date
for measuring deductibility of compensation under Section 162(m) of the Code,
his entire compensation for 2002 is deductible and thus the Company will not
incur the $350,000 in federal income taxes which had been reflected in the
provision for federal income taxes in the first and second quarter of 2002.
- 44 -
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 that 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 primarily its life insurance 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
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 nine months of 2003. For the
nine month period ended September 30, 2003, Investors Life had earned surplus of
$35.7 million and a net gain from operations of $ 1.4 million, and Family Life
had earned surplus of $2.9 million and a net gain from operations of $1.6
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.
- 45 -
FIC expects to have the ability to receive 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 September 30, 2003 amounted to $6.3 million
as compared to $25.0 million at December 31, 2002. The decrease in cash and cash
equivalents at September 30, 2003 from December 31, 2002 was due primarily to
reinvestment of cash into purchases of fixed maturity securties.
FIC's net cash flow provided by operating activities was $181,000 for the nine
month period ending September 30, 2003, as compared to $8.7 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 $31.0 million in the nine month
period ending September 30, 2003, as compared to $7.4 million provided by
investing activities in the same period of 2002. The $38.4 million increase in
cash used in investing activities in 2003 from 2002 was due primarily to
investment of cash into fixed maturity securities. Additionally, $4.2 million
was used to invest in the acquisition of the above-mentioned subsidiaries of
FICFS.
Net cash flow provided by financing activities was $12.1 million in the first
nine months of 2003, as compared to $15.2 million used in financing activities
in the first nine months of 2002. The increase in cash provided by financing
activities of $27.3 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.
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 September
30, 2003 were $564.6 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
September 30, 2003, the bulk of the liabilities for contractholder deposit funds
on FIC's balance sheet, $412.3 million, were related to insurance products, as
compared to only $152.3 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,
below).
- 46 -
The current balance of the indebtedness related to FIC's ownership of Family
Life is $18.44 million, consisting of notes payable to FIC's subsidiary,
Investors Life (the "Affiliate Notes"), represented by (i) a loan 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 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"). Investors Life paid FIC $1.05 million to
purchase the FIC shares.
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").
- 47 -
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.
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.
- 48 -
Investments
As of September 30, 2003, FIC's invested assets, excluding separate accounts,
totalled $766.7 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
September 30, 2003 as compared to December 31, 2002 are: (i) the addition of
trading securities, which comprise 0.8% of the investment portfolio at September
30, 2003 as compared to 0% at December 31, 2002; (ii) fixed maturities available
for sale comprise 74.7% at September 30, 2003 compared to 64.9% at December 31,
2002; and (iii) short-term investments comprise 8.1% at September 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.
The allocation of assets is determined primarily on the basis of cash flow and
return requirements of FIC's products and secondarily by the level of investment
risk. In order to ensure that investments are sufficient to satisfy cash flow
needs, FIC established a level of cash and securities that, 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.
Beginning in the first quarter of 2003, the Company took steps to diversify its
selection of new investments, with the expectation of increasing the overall
yield on the portfolio. As part of these efforts, the Company increased the
percentage of its assets invested in collateralized mortgage obligations
("CMOs"), asset- backed securities and private placements. These investments
were classified as "investment grade" at the time of purchase, which adhered to
the investment guidelines of the Company at the time.
- 49 -
During the first nine months of 2003, FIC invested $438.1 million of its assets,
of which $341.9 million consisted of reinvestments of matured and called fixed
maturities, and $94.3 million consisted of investments from cash, cash
equivalents and short-term investments. These investments were primarily made in
short and medium-term securities. CMOs comprised $209.9 million of new
investments, corporate securities comprised $57.2 million, asset-backed
securities comprised $49.3 million, private placements comprised $54.8 million,
taxable municipals comprised $23.8 million and agency bonds comprised $43.0
million.
Management believes that the asset allocation is sufficient to satisfy current
projected cash flow requirements.
Following a review of the investment portfolios of the life insurance
subsidiaries of the Company, the Investment Committee of the Company's Board of
Directors recommended the engagement of a third- party investment manager to
provide ongoing, professional management of the portfolios. In October, 2003,
the life insurance subsidiaries entered into investment management agreements
with Conning Asset Management Company ("Conning"). Under these agreements,
Conning will manage the investment security portfolios of the Company's life
insurance subsidiaries in accordance with investment policies set by the
Company's Board of Directors. In addition, Conning will provide such other
investment advisory and investment accounting and reporting services to the
Company's life insurance subsidiaries as may be reasonably requested and agreed
to by Conning.
The Company also revised the investment policies of its insurance subsidiaries.
Conning has begun to realign the Company's life insurance subsidiaries'
portfolios. As part of this realignment, Conning identified eight securities
purchased earlier in 2003 that they felt had significant future principal risk.
While all of these securities were investment grade when purchased, six of the
eight have had ratings downgrades since purchase. Conning recommended that these
securities be sold in the near future. Five of the eight had been sold by
November 20, 2003. All eight were treated as other than temporarily impaired as
of September 30, 2003.
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
September 30, 2003, the market value fixed maturities available for sale was
$572.5 million as compared to an amortized cost of $575.6 million or an
unrealized loss of $3.1 million. This reflects unrealized losses 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.
- 50 -
The investments of FIC's insurance subsidiaries in mortgage-backed securities
included CMOs of $208.7 million as of September 30, 2003 as compared to $175.4
million at December 31, 2002, and mortgage- backed pass-through securities of
$88.6 million as of September 30, 2003 and $29.6 million at December 31, 2002.
Mortgage-backed pass-through securities, sequential CMOs and support bonds,
which comprised approximately 50.62% of the book value of FIC's mortgage-backed
securities at September 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 September 30, 2003, PAC and
TAC instruments and scheduled bonds represented approximately 34.48% of the book
value of FIC's mortgage-backed securities. Sequential and support classes
represented approximately 20.83% of the book value of FIC's mortgage-backed
securities at September 30, 2003. Additionally, the insurance subsidiaries make
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 that 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 anticipated
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.
Trading Securities
FIC's trading securities consist of CMOs of the type that 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 September 30, 2003 was $6.1 million. The increase in the market
value of trading securities during the period, $0.131 million, is included in
net realized investment income on the consolidated income statement. FIC did not
have any trading securities at December 31, 2002.
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Equity Securities
FIC's equity securities consist primarily of its investment in the separate
account of Investors Life. As of September 30, 2003, the market value of FIC's
equity securities was $7.1 million, as compared to $6.4 million at December 31,
2002. The increase is related to an increase in the value of the underlying
funds in the separate account.
Policy Loans
Policy loans totaled $44.4 million at September 30, 2003, as compared to $46.6
million at December 31, 2002.
Mortgage Loans
As of September 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 September 30, 2003 was $74.3 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 September 30, 2003, Investors Life had invested $92.7 million in the
construction of River Place Pointe, of which $19.4 million is recorded on FIC's
balance sheet as property held for use. As of the date of this filing, 250,113
rentable square feet of office space was leased to third party tenants, 92,609
square feet of office space was occupied by the Company and its subsidiaries and
241,550 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.
- 52 -
The Company views the River Place Pointe investment as a long-term investment.
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 September 30, 2003 was $62.3 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.
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 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.
- 53 -
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.
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), is 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 attempts to match these costs against the associated revenues.
For a further discussion of accounting standards, see New Accounting
Pronouncements beginning on page 21, herein.
- 54 -
Subsequent Events
The life insurance subsidiaries of the Company currently maintain an office and
records storage facility in Seattle, Washington. The office facility provides
premium processing services and is staffed by approximately 28 employees.
Management has determined that cost savings may be achieved by consolidating
those functions in Austin, Texas. The estimated annual expenses savings, once
the move has been completed, are estimated to be approximately $800,000
annually. The estimated cost of moving the facility is approximately $530,000,
including the cost of severance payments to employees. In connection with that
move, the life insurance subsidiaries have filed applications with the insurance
departments of Texas and Washington to authorize the redomestication of the
companies from Washington to Texas. As of the date of this report, the
applications are under review by the insurance departments.
On October 29, 2003, the Company announced that it is reviewing its investment
activities during the past year, including mark-ups and commissions paid during
that time. The Company is also investigating, among other things, relationships
between a broker-dealer used by the Company and William P. Tedrow. Mr. Tedrow is
the president of the Company's FIC Financial Services, Inc. subsidiary and a
Vice President of the Company. In his capacity at the Company, Mr. Tedrow has
participated during the current year in the general supervision of investment
activities.
The Company's investigation of these matters is ongoing. Mr. Tedrow has been
placed on administrative leave pending the results of this investigation. The
Company has not reached any conclusion with regard to Mr. Tedrow's role, if any,
in the activities under review.
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."
- 55 -
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 $6.1 million of "inverse
floater" CMOs. These contain a derivative which is "embedded" in the financial
instrument.
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 $42.4 million at September 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 $640.9 million at September 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 $297.2 million at September
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 $21.3
million at September 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 CMOs at September 30, 2003 described above have a
coupon rate which varies in an inverse relationship with a specified benchmark
rate.
- 56 -
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
(a) 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 September 30, 2003. Based upon their evaluation, the
principal executive officer and principal financial officer concluded
that the Company's disclosure controls and procedures, as modified
following implementation of the procedure described in paragraph (b),
below, 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.
(b) In connection with the preparation of its financial statements for the
nine and three-month periods ended September 30, 2003, the Company
reviewed those securities in its investment portfolio classified as
fixed maturities available for sale. That review was conducted in
order to determine whether changes in the carrying value of those
securities should be considered as other than temporary. As a result
of that review, the Company incurred a $5.2 million charge to net
realized investment loss, of which a portion (approximately $725,000)
relates to the quarter ended June 30, 2003. In addition, a review is
in progress with respect to mark-ups and commissions paid on
investments made during the past year, which review has not been
completed as of the date of this report. In October, 2003, the Company
retained Conning Asset Management Company ("Conning") to manage the
investment security portfolios of the Company's life insurance
subsidiaries in accordance with investment policies set by the
Company's Board of Directors. The Company believes that the engagement
of a third-party investment manager to provide ongoing, professional
management of the portfolios will enhance the effectiveness of its
controls with respect to investment transactions.
- 57 -
In addition, the Company is conducting a review of the accounting
systems used by JNT Group, Inc., one of the companies purchased in the
New Era transaction, in connection with the processing of funds which
it receives from various employee benefit plans. That review, which
was commenced in early October, 2003, indicates that the accounting
procedures in use at JNT were not sufficient to provide for the timely
reconciliation of funds received by JNT for remittance to third-party
providers of benefits to plan participants.
(c) Except as described above, 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 September 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 with Otter Creek Partnership I, L.P.
On June 13, 2003, Otter Creek Partnership I, L.P. filed a civil action
lawsuit against FIC in the District Court in Travis County, Texas, Cause
No. GN302872. Otter Creek and FIC have reached an agreement in principle to
settle the lawsuit, and are preparing the appropriate documentation to do
so. Under the proposed settlement, the Company will reimburse Otter Creek
for $250,000 in proxy expenses. An additional $299,000 of proxy expenses
and $190,000 of litigation expenses will be submitted to the Company's
shareholders for approval at a shareholder's meeting. The Board of
Directors will recommend that shareholders approve the reimbursement. The
proposed settlement will also provide for mutual releases between the
Company and Otter Creek and its affiliates. The Chairman of the Board of
Directors of the Company, R. Keith Long, is the President and owner of the
General Partner of Otter Creek Partners I, L.P. Other Litigation.
Additionally, the Company and its 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.
- 58 -
Item 2. Changes in Securities and Use of Proceeds
On June 30, 2003, a subsidiary of the Company, Investors Life Insurance
Company of North America, exercised its option to purchase 500,411 shares
of FIC's common stock, at a price of $2.10 per share. In connection with
the option exercise, Investors Life paid FIC $1.05 million in cash to
purchase the shares. The shares so issued are treated as treasury stock on
the consolidated balance sheets of the Company. The sale of securities was
exempt under section 4(2) of the Securities Act of 1933.
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
The 2003 Annual Meeting of Shareholders of the Company was held on July 31,
2003. At the annual meeting, shareholders were asked to elect ten
directors. In addition to the management slate of ten nominees, a slate of
seven nominees was presented by Otter Creek Management, Inc. The meeting
was adjourned on successive dates in order to provide for the counting of
votes, the application of the cumulative voting procedure which had been
requested in connection with the annual meeting and the receipt of the
final report of the inspector of elections. The following table represents
the tabulation of votes by the inspector of elections for each of the
seventeen nominees prior to the application of cumulative voting:
Name For Withheld
John D. Barnett ** 3,128,489.490 333,474.340
J. Bruce Boisture * 3,925,841.354 52,429.089
Salvador Diaz-Verson, Jr. * 3,925,159.354 53,111.089
Patrick E. Falconio * 3,925,541.354 52,729.089
Theodore A. Fleron ** 3,123,337.053 338,626.777
W. Lewis Gilcrease ** 3,115,064.806 346,899.024
Richard H. Gudeman * 3,925,841.354 52,429.089
Steven A. Haxton * 3,925,716.354 52,554.089
Richard Kosson ** 3,135,381.819 326,582.011
Fred W. Lazenby ** 3,136,341.071 325,622.759
R. Keith Long * 3,925,375.354 52,895.089
Elizabeth T. Nash ** 3,125,137.541 336,825.289
Frank Parker ** 3,116,937.470 345,026.360
Eugene E. Payne ** 3,129,658.143 332,305.687
Lonnie L. Steffen * 3,925,841.354 52,429.089
Kenneth S. Shifrin ** 3,220,052.975 241,910.855
Eugene J. Woznicki ** 3,420,330.694 41,633.136
* = Otter Creek nominee
** = Management nominee
- 59 -
Following application of the cumulative voting process, the following ten
nominees were elected as directors. The following table reflects the
results of the cumulative voting process:
Name Number of Votes
John D. Barnett 8,654,909.575
J. Bruce Boisture 7,353,085.738
Salvador Diaz-Verson, Jr. 7,353,085.738
Patrick E. Falconio 7,353,085.738
Richard H. Gudeman 7,353,085.738
R. Keith Long 7,353,085.738
Eugene E. Payne 8,654,909.575
Lonnie L. Steffen 7,353,085.738
Kenneth S. Shifrin 8,654,909.575
Eugene J. Woznicki 8,654,909.575
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
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
- 60 -
(b) Reports on Form 8-K
(i) On July 10, 2003, the Registrant filed a Current Report on Form
8-K. The report describes a modification in the membership of the
Nominations/Governance Committee of the Board of Directors.
(ii) On July 14, 2003, the Registrant filed a Current Report on Form
8-K. The report included a copy of a letter from the Registrant
to Institutional Shareholders Services (information furnished,
not filed).
(iii)On July 29, 2003, the Registrant filed a Current Report on Form
8-K, announcing the release by the Registrant of the proxy with
respect to shares of FIC common stock acquired by third parties
from the Mitte Foundation.
(iv) On August 13, 2003, the Registrant filed a Current Report on Form
8-K. The report referred to a press release issued on August 13,
2003, announcing the Registrant's financial results for the
quarter ended June 30, 2003 (information furnished, not filed).
(v) On August 22, 2003, the Registrant filed a Current Report on Form
8-K. The report announced the results of the 2003 Annual Meeting
of Shareholders.
(vi) On August 25, 2003, the Registrant filed a Current Report on Form
8-K, announcing the election of Keith Long as Chairman of the
Board. The release also announced the resignation of Eugene E.
Payne as Chairman and the agreement of Dr. Payne to continue as
President and CEO, until a replacement is hired by the Board of
Directors.
- 61 -
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: November 25, 2003
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