SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934 For the Quarterly Period Ended September 30, 2000 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 Boulevard, Building I 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 Number of common shares outstanding ($.20 par value) at end of period: 5,054,661. - 1 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES INDEX Page No. Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets September 30, 2000 and December 31, 1999..............................3 Consolidated Statements of Income For the three and nine month periods ended September 30, 2000 and September 30, 1999.............................5 Consolidated Statements of Cash Flows For the three and nine month periods ended September 30, 2000 and September 30, 1999 . . . .. . . . . . . . . . .9 Notes to Consolidated Financial Statements....................................13 Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations.......................15 Item 3. Quantitative and Qualitative Disclosures About Market Risk ................................................20 Part II Other Information............................................................22 Signature Page...............................................................24 - 2 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) September 30, December 31, 2000 1999 (unaudited) ASSETS Investments other than investments in affiliate: Fixed maturities available for sale at market value (amortized cost of $78,667 and $78,252 at September 30, 2000 and December 31, 1999, respectively ) $ 78,840 $ 77,515 Equity securities at market (cost approximates $11 at September 30, 2000 and December 31, 1999) 4 4 Policy loans 3,676 3,595 Short-term investments 17,370 24,839 Total investments 99,890 105,953 Cash 1,613 692 Investment in affiliate 75,681 70,013 Accrued investment income 1,182 1,180 Agency advances and other receivables 6,534 6,885 Reinsurance receivables 16,781 14,848 Due and deferred premiums 12,541 12,392 Property and equipment, net 1,318 1,355 Deferred policy acquisition costs 55,447 52,490 Present value of future profits of acquired businesses 20,125 23,109 Other assets 4,778 4,758 Separate account assets 0 379 Total Assets $ 295,890 $ 294,054 The accompanying notes are an integral part of these consolidated financial statements - 3 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) September 30, December 31, 2000 1999 (unaudited) LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Policy liabilities and contract holder deposit funds: Future policy benefits $ 61,735 $ 59,783 Contract holder deposit funds 43,515 44,681 Unearned premiums 0 14 Other policy claims and benefits payable 3,111 4,282 108,361 108,760 Subordinated notes payable to affiliate 36,886 41,497 Deferred federal income taxes 23,200 23,222 Other liabilities 4,031 4,079 Separate account liabilities 0 ___ 379 Total Liabilities 172,478 177,937 Commitments and Contingencies Shareholders' equity: Common stock, $.20 par value, 10,000,000 shares authorized; 5,845,300 shares issued, 5,054,661 outstanding in 2000 and 1999 1,169 1,169 Additional paid-in capital 7,225 7,225 Accumulated other comprehensive income (838) (2,454) Retained earnings 123,231 117,552 130,787 123,492 Common treasury stock, at cost, 790,639 at 2000 and 1999. (7,375) (7,375) Total Shareholders" Equity 123,412 116,117 Total Liabilities and Shareholders' Equity $ 295,890 $ 294,054 The accompanying notes are an integral part of these consolidated financial statements. - 4 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended Sept. 30, 2000 1999 (unaudited) Revenues: Premiums $ 8,503 $ 8,516 Net investment income 1,780 1,733 Earned insurance charges 824 1,148 Other 3 324 11,110 11,721 Benefits and expenses: Policyholder benefits and expenses 3,528 3,557 Interest expense on contract holders deposit funds 496 345 Amortization of present value of future profits of acquired businesses 1,112 1,334 Amortization of deferred policy acquisition costs 1,417 1,354 Operating expenses 2,674 2,728 Interest expense 501 532 9,728 9,850 Income before federal income tax and equity in net earnings of affiliates 1,382 1,871 Provision for federal income taxes 256 181 Income before equity in net earnings of affiliates 1,126 1,690 Equity in net earnings of affiliate, net of taxes 1,041 786 Net Income $ 2,167 $ 2,476 The accompanying notes are an integral part of these consolidated statements. - 5 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended Sept. 30, 2000 1999 (unaudited) Net Income Per Share Basic: Average weighted shares outstanding 5,055 5,055 Basic earnings per share $ 0.43 $ 0.49 Diluted: Common stock and common stock equivalents 5,160 5,203 Diluted earnings per share $ 0.42 $ 0.48 The accompanying notes are an integral part of these consolidated financial statements. - 6 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Nine Months Ended Sept. 30, 2000 1999 (unaudited) Revenues: Premiums $ 25,347 $ 26,198 Net investment income 5,220 5,187 Earned insurance charges 3,196 3,733 Other 6 1,026 33,769 36,144 Benefits and expenses: Policyholder benefits and expenses 10,749 11,490 Interest expense on contract holders deposit funds 1,555 1,317 Amortization of present value of future profits of acquired businesses 2,984 3,946 Amortization of deferred policy acquisition costs 3,860 3,737 Operating expenses 8,612 8,450 Interest expense 1,513 1,782 Total 29,273 30,722 Income before federal income tax and equity in net earnings of affiliates 4,496 5,422 Provision for federal income taxes 834 954 Income before equity in net earnings of affiliates 3,662 4,468 Equity in net earnings of affiliate, net of tax 2,924 2,077 Net Income $ 6,586 $ 6,545 The accompanying notes are an integral part of these consolidated statements. - 7 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Nine Months Ended Sept. 30, 2000 1999 (unaudited) Net Income Per Share Basic: Average weighted shares outstanding 5,055 5,055 Basic earnings per share $ 1.30 $ 1.29 Diluted: Common stock and common stock equivalents 5,163 5,202 Diluted earnings per share $ 1.28 $ 1.26 The accompanying notes are an integral part of these consolidated financial statements. - 8 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Three Months Ended Sept. 30, 2000 1999 (unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 2,167 $ 2,476 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of present value of future profits of acquired business 1,112 1,334 Amortization of deferred policy acquisition costs 1,417 1,354 Equity in undistributed earnings of affiliate (1,534) (1,389) Changes in assets and liabilities: (Increase) decrease in accrued investment income 62 64 Increase in agent advances and other receivables (73) (456) (Increase) decrease in due and deferred premiums (26) 288 Increase in deferred policy acquisition costs (2,624) (2,555) Decrease in other assets 13 518 (Increase) decrease in policy liabilities and accruals (308) 928 Increase in other liabilities 281 456 Increase (decrease) in deferred federal income taxes 102 (122) Other, net (246) 1,155 Net cash (used in) provided by operating activities $ 343 $ 4,051 The accompanying notes are an integral part of these consolidated financial statements. - 9 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued (in thousands) Three Months Ended Sept. 30, 2000 1999 (unaudited) CASH FLOWS FROM INVESTING ACTIVITIES Fixed maturities purchased $ (500) $ (8,561) Proceeds from sales and maturities of fixed maturities 3,279 4,623 Increase in policy loans (73) (218) Net change in short-term investments (1,080) 2,837 Purchase & retirement of property and equipment 0 0 Net cash provided by (used in) investing activities 1,626 (1,319) CASH FLOW FROM FINANCING ACTIVITIES Dividends paid 0 0 Repayment of subordinated notes payable (1,537) (1,536) Net cash used in financing activities (1,537) (1,536) Net increase in cash 432 1,196 Cash, beginning of period 1,181 1,002 Cash, end of period $ 1,613 $ 2,198 The accompanying notes are an integral part of these consolidated financial statements. - 10 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Nine Months Ended Sept. 30, 2000 1999 (unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 6,586 $ 6,545 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of present value of future profits of acquired business 2,984 3,946 Amortization of deferred policy acquisition costs 3,860 3,737 Equity in undistributed earnings of affiliate (4,565) (3,867) Changes in assets and liabilities: (Increase) decrease in accrued investment income (2) 106 Increase in agent advances and other receivables (1,582) (1,283) (Increase) decrease in due and deferred premiums (149) 27 Increase in deferred policy acquisition costs (6,817) (7,063) (Increase) decrease in other assets (20) 1,039 (Decrease) increase in policy liabilities and accruals (399) 83 Decrease in other liabilities (48) (957) Decrease in deferred federal income taxes (22) (282) Other, net 59 1,084 Net cash (used in) provided by operating activities $ (115) $ 3,115 The accompanying notes are an integral part of these consolidated financial statements. - 11 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued (in thousands) Nine Months Ended Sept. 30, 2000 1999 (unaudited) CASH FLOWS FROM INVESTING ACTIVITIES Fixed maturities purchased $ (10,788) $ (18,557) Proceeds from sales and maturities of fixed maturities 9,917 17,878 Increase in policy loans (81) (340) Net change in short-term investments 7,469 2,111 Purchase & retirement of property and equipment 37 0 Net cash provided by investing activities 6,554 1,092 CASH FLOW FROM FINANCING ACTIVITIES Dividends paid (907) 0 Repayment of subordinated notes payable (4,611) (4,610) Net cash used in financing activities (5,518) (4,610) Net increase (decrease) in cash 921 (403) Cash, beginning of year 692 2,601 Cash, end of period $ 1,613 $ 2,198 The accompanying notes are an integral part of these consolidated financial statements. - 12 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The financial statements included herein reflect all adjustments which are, in the opinion of management, necessary to present a fair statement of the interim results. The statements have been prepared to conform to the requirements of Form 10-Q and 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, 1999, previously filed with the Commission for financial statements prepared in accordance with GAAP. Certain prior year amounts have been reclassified to conform with current year presentation. The consolidated financial statements include the accounts of Financial Industries Corporation ("FIC") and its wholly-owned subsidiaries. The investment of FIC in InterContinental Life Corporation ("ILCO") is presented using the equity method. All significant intercompany items and transactions have been eliminated. Other Comprehensive Income The following is a reconciliation of accumulated other comprehensive income from December 31, 1999 to September 30, 2000 (in thousands): Net Total Net unrealized gain appreciation accumulated (loss) on investments (depreciation) other in fixed maturities of equity comprehensive available for sale securities income Balance at December 31, 1999 $ (2,454) $ (0) $ (2,454) Current Period Change 1,618 (2) 1,616 Balance at September 30, 2000 $ (836) $ (2) $ (838) Accumulated other comprehensive income of FIC includes approximately $943,000 of net unrealized losses from FIC"s affiliate, ILCO. - 13 - New Accounting Pronouncements In June 1998, the FASB issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS 133 is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000, as amended by FAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No.133." As the Company does not have significant investments in derivative financial instruments, the adoption of FAS No. 133 is not anticipated to have a material impact on the Company's results of operations, liquidity or financial position. Dividends Declared On January 17, 2000, FIC's Board of Directors approved a cash dividend in the amount of $.18 per common share. The dividend was paid on April 12, 2000 to shareholders of record on April 5, 2000. - 14 - Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operation The following discussion addresses the results of operations of Financial Industries Corporation ("FIC") for the nine months ended September 30, 2000 compared with the same nine-month period last year, and the financial condition of as of September 30, 2000, compared with December 31, 1999. For the nine-month period ended September 30, 2000, FIC's net income was $6,586,000 (basic earnings of $1.30 per common share, or diluted earnings of $1.28 per common share) as compared to $6,545,000 (basic earnings of $1.29 per common share, or diluted earnings of $1.26 per common share) in the first nine months of 1999. Earnings per share are stated in accordance with the requirements of FAS No. 128, which establishes two measures of earnings per share: basic earnings per share and diluted earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect the potential dilution that would occur if securities or other contracts to issue common stock were converted or exercised. Results of Operations FIC's income from operations - as determined before federal income tax and equity in net earnings of its affiliate, InterContinental Life Corporation - for the nine-month period ended September 30, 2000, was $4,496,000 (on revenues of $33,769,000), as compared to $5,422,000 (on revenues of $36,144,000) in the first nine months of 1999. Premiums for the first nine months of 2000, net of reinsurance ceded, were $25.3 million, as compared to $26.2 million in the first nine months of 1999. Policyholder benefits and expenses were $10.7 million in the third quarter of 2000, as compared to $11.5 million in the first nine months of 1999. As of September 30, 2000, the market value of the fixed maturities available for sale segment was $78.84 million as compared to an amortized cost of $78.67 million, or an unrealized gain of $.17 million. The increase reflects unrealized gains on such investments related to changes in interest rates subsequent to the purchase of such investments. The net of tax effect of this increase ($.11 million at September 30, 2000) has been recorded as an increase in shareholders' equity. The operating strategy of the Company's management emphasizes several key objectives: expense management; marketing of competitively priced insurance products which are designed to generate an acceptable level of profitability; maintenance of a high quality portfolio of investment grade securities; and the provision of quality customer service. - 15 - Equity in Net Income of InterContinental Life Corporation General For the nine-month period ended September 30, 2000, the Company's equity in the net earnings of InterContinental Life Corporation ("ILCO"), net of federal income tax, was $2,924,000, as compared to $2,077,000 for the first nine months of 1999. As of September 30, 2000, FIC owned 3,590,292 shares of ILCO's common stock. In addition, FIC's wholly-owned life insurance subsidiary, Family Life Insurance Company ('Family Life"), owned 342,400 shares of ILCO common stock. As a result, as of September 30, 2000, FIC owned, directly and indirectly through Family Life, 3,932,692 shares (approximately 48.4 %) of ILCO's common stock. As of September 30, 2000, the market value of ILCO's fixed maturities available for sale segment was $445.61 million as compared to an amortized cost of $448.89 million, or an unrealized loss of $3.28 million. The decrease reflects unrealized losses on such investments related to changes in interest rates subsequent to the purchase of such investments. Since FIC owns approximately 48 % of the common stock of ILCO, the net of tax effect of this decrease (approximately $1.0 million at September 30, 2000) is included in "Accumulated other comprehensive loss" on the Consolidated Balance Sheets and has been recorded as a decrease in shareholders' equity. Liquidity and Capital Resources of ILCO ILCO is a holding company whose principal assets consist of the common stock of Investors Life Insurance Company of North America ("Investors-NA") and its subsidiary, Investors Life Insurance Company of Indiana ("Investors-IN"). Prior to June 30, 2000, ILCO's primary source of funds consisted of payments under the surplus debentures from Investors-NA. Prior to June 30, 2000, ILCO's principal source of liquidity consisted of the periodic payment of principal and interest to it by Investors-NA, pursuant to the terms of two surplus debentures (the "Surplus Debentures"). The Surplus Debentures were originally issued by Standard Life Insurance Company and their terms were previously approved by the Mississippi Insurance Commissioner. In connection with the 1993 merger of Standard Life into Investors-NA, the obligations of the Surplus Debentures were assumed by Investors-NA. As of June 30, 2000, the outstanding principal balance of the Surplus Debentures was completely paid off. For periods subsequent to June 30, 2000, ILCOs available source of liquidity would be from dividends paid to it from its subsidiaries, Investors-NA and Investors-IN. Applicable state insurance laws may limit the ability of such subsidiaries to pay dividends to ILCO. Investors-NA is domiciled in the State of Washington. The Washington insurance law includes the "greater of" standard for payment of dividends to shareholders, but has a requirement that prior notification of a proposed dividend be given to the Washington Insurance - 16 - Commissioner and that cash dividends may 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. As of September 30, 2000, Investors-NA had earned surplus of $ 52.9 million. Investors-IN is domiciled in the State of Indiana. Under the Indiana insurance law, a domestic insurer may make dividend distributions upon proper notice to the Department of Insurance, as long as the distribution is reasonable in relation to adequate levels of policyholder surplus and quality of earnings. Under Indiana law the dividend must be paid from earned surplus. Extraordinary dividend approval would be required where a dividend exceeds the greater of 10% of surplus or the net gain from operations for the prior fiscal year. Investors-IN had earned surplus of $20.86 million at September 30, 2000. In June, 1999, Investors- IN paid a dividend in the amount of $3 million to its sole shareholder, Investors-NA. The amount of the dividend was less than the net gain from operations for the prior fiscal year; accordingly, no prior approval was required for the payment of the dividend. Advance notice of the payment was provided to the Indiana Department of Insurance, in accordance with the provisions of the Indiana Insurance Code. The Form 10-Qs of ILCO for the nine-month periods ended September 30, 2000 and September 30,1999, set forth the business operations and financial results of ILCO and its life insurance subsidiaries. Such 10-Q reports of ILCO, including the discussion by ILCO's management under the caption "Management's Discussion and Analysis of Financial Conditions and Results of Operations" are incorporated herein by reference. Liquidity and Capital Resources FIC is a holding company whose principal assets consist of the common stock of Family Life and its equity ownership in ILCO. FIC's primary sources of capital consists of cash flow from operations of its subsidiaries. The cash requirements of FIC and its subsidiaries consist primarily of its service of the indebtedness created in connection with its ownership of Family Life. As of September 30, 2000, the outstanding balance of such indebtedness was $36.9 million on the Subordinated Notes granted by Investors-NA. The principal source of liquidity for FIC's subsidiaries consists of the periodic payment of principal and interest by Family Life pursuant to the terms of a Surplus Debenture. The terms of the Surplus Debenture were previously approved by the Washington Insurance Commissioner. Under the provisions of the Surplus Debenture and current law, no prior approval of the Washington Insurance Department is required for Family Life to pay interest or principal on the Surplus Debenture; provided that, after giving effect to such payments, the statutory surplus of Family Life is in excess of 6% of assets (the 'surplus floor"). However, Family Life has voluntarily agreed with the Washington Insurance Commissioner that it will provide at least five days advance notice of payments which it will make under the surplus debenture. As of September 30, 2000, the statutory capital and surplus of Family Life was $24.1 million, an - 17 - amount substantially in excess of the surplus floor. As of September 30, 2000, the principal balance of the Surplus Debenture was $7.88 million. The funds required by Family Life to meet its obligations under the terms of the Surplus Debenture are generated primarily from premium payments from policyholders, investment income and the proceeds from the sale and redemption of portfolio investments. Washington's insurance code includes the "greater of" standard for dividends but has requirements that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. Family Life does not presently have earned surplus as defined by the regulations adopted by the Washington Insurance Commissioner and, therefore, is not permitted to pay cash dividends. However, since the new law applies only to dividend payments, the ability of Family Life to make principal and interest payments under the Surplus Debenture is not affected. The Company does not anticipate that Family Life will have any difficulty in making principal and interest payments on the Surplus Debenture in the amounts necessary to enable Family Life Corporation to service its indebtedness for the foreseeable future. The sources of funds for Family Life consist of premium payments from policyholders, investment income and the proceeds from the sale and redemption of portfolio investments. These funds are applied primarily to provide for the payment of claims under insurance and annuity policies, operating expenses, taxes, investments in portfolio securities, shareholder dividends and payments under the provisions of the Surplus Debenture. FIC's net cash flow provided by operating activities was $(0.115 million in the first nine months of 2000, as compared to $3.1 million in the first nine months of 1999. Net cash flow used in financing activities was $5.5 million in the first nine months of 2000, as compared to $4.6 million in the first nine months of 1999. The guaranty commitments of FIC under the loans incurred in connection with the acquisition of Family Life (after taking into account the repayments and new loans which occurred in July, 1993) relate to: (i) the $22.5 million note issued by Family Life Corporation to Investors Life Insurance Company of North America and (ii) the $34.5 million loaned by Investors-NA to two subsidiaries of FIC. Management believes that its cash, cash equivalents and short term investments are sufficient to meet the needs of its business and to satisfy debt service. There are no trends, commitments or capital asset requirements that are expected to have an adverse effect on the liquidity of FIC. Investments As of September 30, 2000, the Company's investment assets totaled $99.9 million, as compared to $105.95 million as of December 31, 1999. - 18 - The level of short-term investments at September 30, 2000 was $17.4 million, as compared to $24.8 million as of December 31, 1999. The fixed maturities available for sale portion represents $78.84 million of investment assets as of September 30, 2000, as compared to $77.5 million at December 31, 1999. The amortized cost of fixed maturities available for sale as of September 30, 2000 was $78.67 million representing a net unrealized gain of $.17 million. This unrealized gain principally reflects changes in interest rates from the date the respective investments were purchased. To reduce the exposure to interest rate changes, portfolio investments are selected so that diversity, maturity and liquidity factors approximate the duration of associated policyholder liabilities. The assets held by Family Life must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the Company's 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 fixed maturities portfolio of Family Life, as of September 30, 2000, consisted solely of fixed maturities investments which, in the annual statements of the companies, as filed with state insurance departments, were designated under the National Association of Insurance Commissioners ("NAIC" rating system as a "1" (highest quality). The investments of Family Life and ILCO's insurance subsidiaries in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $22.0 million and $176.2 million, respectively, and mortgage-backed pass-through securities of $28.8 million and $44.4 million, respectively, at September 30, 2000. Mortgage-backed pass-through securities, sequential CMO's and support bonds, which comprised approximately 50.3 % of the book value of FIC's mortgage-backed securities and 55.5 % of the book value of ILCO's mortgage-backed securities at September 30, 2000, are sensitive to prepayment and extension risks. ILCO and FIC 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, 2000, PAC and TAC instruments and scheduled bonds represented approximately 49.7% of the book value of FIC's mortgage-backed securities and approximately 44.5 % of the book value of ILCO's mortgage-backed securities. Sequential and support classes represented approximately 21.5 % of the book value of FIC's mortgage-backed securities and approximately 35.3 % of the book value of ILCO's mortgage-backed securities at September 30, 2000. In addition, FIC and ILCO limit the risk of prepayment of CMOs by not paying a premium for any CMOs. ILCO and FIC do not invest in mortgage-backed securities with increased prepayment risk, such as interest-only stripped pass-through securities and inverse floater bonds. Neither FIC nor ILCO had any z-accrual bonds as of September 30, 2000. The prepayment risk that certain mortgage-backed securities are subject to is prevalent in periods of declining interest rates, when mortgages may be repaid - 19 - 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. Neither FIC nor ILCO made additional investments in CMOs during 1999. For the year 2000, the investment objectives of FIC and ILCO include the making of selected investments in CMOs. Management believes that the absence of "high-yield" or "non-investment grade" investments (as defined above) in the portfolios of its life insurance subsidiary enhances the ability of the Company to service its debt, provide security to its policyholders and to credit relatively consistent rates of return to its policyholders. Cautionary Statements for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995 Except for historical factual information set forth in this Management's Discussion and Analysis, certain statements made in this report are forward looking and contain information about financial results, economic conditions and other risks and known uncertainties. The Company cautions the reader that actual results could differ materially from those anticipated by the Company, depending upon the eventual outcome of certain factors, including: (1) heightened competition for new business, (2) significant changes in interest rates and (3) adverse regulatory changes affecting the business of insurance. Accounting Developments In June, 1998, the FASB issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133 applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000, as amended by FAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No. 133". As the Company does not have significant investments in derivative financial instruments, the adoption of FAS No. 133 is not anticipated to have a material impact on the Company's results of operations, liquidity or financial position. 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. - 20 - 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 Item 2, "Management's Discussion and Analysis of Financial Conditions and Results of Operation - Investments" of this report. 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 which 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 which 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. Since the Company own approximately 48.4 % of the common stock of ILCO, the interest rate risk of ILCO's fixed income portfolio has an effect on the value of FIC's "investment in affiliate". The Company does not use derivative financial instruments. Interest Rate Risk (a) FIC's Fixed Income Investments 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 $ 3.2 million at September 30, 2000 and $9.7 million at December 31, 1999. For purposes of the foregoing estimate, the following categories of the Company's fixed income investments were taken into account: (i) fixed maturities, including fixed maturities available for sale and (ii) short-term investments. The market value of such assets was $ 96.2 million at September 30, 2000 and $102.4 million at December 31, 1999. The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $30.9 million at September 30, 2000 and $ 27.3 million at December 31, 1999. 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 $ 1.3 million at September 30, 2000 and $ 1.9 million at December 31, 1999. (b) FIC's Investment in Affiliate The value of FIC's investment in affiliate is affected by the amount of unrealized gains and losses, net of tax, in the investment portfolio of its affiliate, ILCO. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in value, net of tax, related to the Company's investment in affiliate is estimated to be $6.5 million at September 30, 2000 and $6.3 million at December 31, 1999. - 21 - 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. 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 upon the financial statements. ILCO and Investors-NA are defendants in a lawsuit which was filed in October, 1996, in Travis County, Texas. CIGNA Corporation, an unrelated Company, is also a named defendant in the lawsuit. The named plaintiffs in the suit (a husband and wife), allege that the universal life insurance policies sold to them by INA Life Insurance Company (a company which was merged into Investors-NA in 1992) utilized unfair sales practices. The named plaintiffs seek reformation of the life insurance contracts and an unspecified amount of damages. The named plaintiffs also seek a class action as to similarly situated individuals. No certification of a class has been granted as of the date hereof. The Company believes that the suit is without merit and intends to vigorously defend this matter. In August, 1997, another individual filed a similar action in Travis County, Texas against the corporate entities identified above. The lawsuit involved the same type of policy and includes allegations which are substantially identical to the allegations in the first action. In July, 2000, the court, on its own motion, moved to dismiss the action for failure on the part of the plaintiff to prosecute the matter. The plaintiff did not file a motion to retain the case and the matter has been removed from the court's docket. Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None - 22 - Item 5. Other Information a. As previously reported in a press release dated October 13, 2000, the Board of Directors of the Company has established a Special Committee of outside directors of the Board to explore a merger with InterContinental Life Corporation ("ILCO"). FIC owns approximately 48% of the common stock of ILCO. The Board and the Special Committee have received a report on an actuarial evaluation of the Company and ILCO, which was performed by an independent actuarial consulting firm. The Special Committee will review the actuarial evaluation and other pertinent information and furnish a recommendation on the merger proposal to the Board. As of the date of this report on Form 10-Q, no date has been set for the next meeting of the Board of Directors of the Company. b. On October, 10, 2000, Charles K. Chacosky submitted his resignation as a director and officer of the Company and its life insurance company subsidiaries. Mr. Chacosky advised the Board that his resignation was for personal reasons. c. On October 5, 2000, Dale E. Mitte submitted his resignation as a director of the Company, since his health condition does not permit him to actively participate in the work of the Board. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Form 10-K Annual Report of Registrant for the year ended December 31, 1999 heretofore filed by Registrant with the Securities and Exchange Commission, which is hereby incorporated by reference. (b) Reports on Form 8-K None. - 23 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SIGNATURE 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/ James M. Grace James M. Grace, Treasurer Date: November 14, 2000 - 24 -