AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON OCTOBER 23, 1996
REGISTRATION NO. 333-
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
------------------------
ARM FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 63 61-1244251
(State or other jurisdiction of (Primary standard industrial (I.R.S. employer identification number)
incorporation or organization) classification code number)
------------------------
ARM FINANCIAL GROUP, INC.
515 WEST MARKET STREET
LOUISVILLE, KENTUCKY 40202
(502) 582-7900
(Address, including zip code, and telephone number, including area code, of
registrant's principal executive offices)
------------------------------
ROBERT H. SCOTT
ARM FINANCIAL GROUP, INC.
515 WEST MARKET STREET
LOUISVILLE, KENTUCKY 40202
(502) 582-7900
(Name, address, including zip code, and telephone number, including area code,
of agent for service for the registrant)
------------------------------
COPIES TO:
FAITH D. GROSSNICKLE PETER R. O'FLINN
SHEARMAN & STERLING LEBOEUF, LAMB, GREENE & MACRAE, L.L.P.
599 LEXINGTON AVENUE 125 WEST 55TH STREET
NEW YORK, NEW YORK 10022 NEW YORK, NEW YORK 10019-5389
(212) 848-4000 (212) 424-8000
------------------------
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as
practicable after this Registration Statement becomes effective.
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. / /
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. / /
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering.
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. / /
------------------------
CALCULATION OF REGISTRATION FEE
PROPOSED MAXIMUM
TITLE OF EACH CLASS OF AGGREGATE OFFERING AMOUNT OF REGISTRATION
SECURITIES TO BE REGISTERED PRICE(2) FEE
Class A Common Stock, par value $0.01 per share(1).......................... $115,000,000.00 $34,848.48
(1) Includes shares of Class A Common Stock that the Underwriters have an
option to purchase to cover over-allotments, if any.
(2) Estimated solely for the purpose of calculating the registration fee
pursuant to Rule 457 under the Securities Act of 1933.
--------------------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A),
MAY DETERMINE.
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INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A
REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY
OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES
EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE
SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES
IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR
TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE.
PROSPECTUS (SUBJECT TO COMPLETION)
ISSUED OCTOBER , 1996
SHARES
ARM FINANCIAL GROUP, INC.
CLASS A COMMON STOCK
---------------------
OF THE SHARES OF CLASS A COMMON STOCK BEING OFFERED HEREBY, SHARES
ARE BEING OFFERED BY THE COMPANY AND SHARES ARE BEING OFFERED BY THE
SELLING STOCKHOLDERS. SEE "PRINCIPAL AND SELLING STOCKHOLDERS." THE
COMPANY WILL NOT RECEIVE ANY PROCEEDS FROM THE SALE OF THE SHARES BEING
OFFERED BY THE SELLING STOCKHOLDERS.
THE COMPANY HAS TWO CLASSES OF AUTHORIZED COMMON STOCK, PAR VALUE $.01 PER
SHARE, CONSISTING OF THE CLASS A COMMON STOCK OFFERED HEREBY AND CLASS B
COMMON STOCK (COLLECTIVELY, THE "COMMON STOCK"). SEE "DESCRIPTION OF
CAPITAL STOCK." HOLDERS OF CLASS A COMMON STOCK ARE ENTITLED TO ONE
VOTE PER SHARE ON EACH MATTER SUBMITTED TO A VOTE OF STOCKHOLDERS.
THE CLASS B COMMON STOCK IS NON-VOTING EXCEPT UNDER CERTAIN
LIMITED CIRCUMSTANCES AND AS REQUIRED BY LAW. ALL HOLDERS OF
COMMON STOCK ARE ENTITLED TO RECEIVE SUCH DIVIDENDS AND
DISTRIBUTIONS, IF ANY, AS MAY BE DECLARED FROM TIME
TO TIME BY THE BOARD OF DIRECTORS.
PRIOR TO THIS OFFERING, THERE HAS BEEN NO PUBLIC MARKET FOR THE CLASS A COMMON
STOCK OF THE COMPANY. IT IS CURRENTLY ESTIMATED THAT THE INITIAL PUBLIC
OFFERING PRICE WILL BE BETWEEN $ AND $ PER SHARE. SEE
"UNDERWRITERS" FOR A DISCUSSION OF THE FACTORS TO BE CONSIDERED IN
DETERMINING THE INITIAL PUBLIC OFFERING PRICE.
------------------------
SEE "RISK FACTORS" BEGINNING ON PAGE 12 OF THIS PROSPECTUS FOR INFORMATION THAT
SHOULD BE CONSIDERED BY PROSPECTIVE INVESTORS.
------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
------------------------
PRICE $ A SHARE
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UNDERWRITING PROCEEDS TO
PRICE TO DISCOUNTS AND PROCEEDS TO SELLING
PUBLIC COMMISSIONS(1) COMPANY(2) STOCKHOLDERS(2)
--------------------- --------------------- --------------------- ---------------------
PER SHARE......... $ $ $ $
TOTAL(3).......... $ $ $ $
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(1) THE COMPANY AND THE SELLING STOCKHOLDERS HAVE AGREED TO INDEMNIFY THE
UNDERWRITERS AGAINST CERTAIN LIABILITIES, INCLUDING LIABILITIES UNDER THE
SECURITIES ACT OF 1933, AS AMENDED. SEE "UNDERWRITERS."
(2) BEFORE DEDUCTING EXPENSES PAYABLE BY THE COMPANY ESTIMATED AT
$ .
(3) THE SELLING STOCKHOLDERS HAVE GRANTED THE UNDERWRITERS AN OPTION,
EXERCISABLE WITHIN 30 DAYS OF THE DATE HEREOF, TO PURCHASE UP TO AN
AGGREGATE OF ADDITIONAL SHARES AT THE PRICE TO PUBLIC SHOWN ABOVE
LESS UNDERWRITING DISCOUNTS AND COMMISSIONS, FOR THE PURPOSE OF COVERING
OVER-ALLOTMENTS, IF ANY. IF THE UNDERWRITERS EXERCISE SUCH OPTION IN
FULL, THE TOTAL PRICE TO PUBLIC, UNDERWRITING DISCOUNTS AND COMMISSIONS,
PROCEEDS TO THE COMPANY AND PROCEEDS TO SELLING STOCKHOLDERS WILL BE
$ , $ , $ AND, $ , RESPECTIVELY. SEE
"UNDERWRITERS."
------------------------------
THE SHARES ARE OFFERED, SUBJECT TO PRIOR SALE, WHEN, AS AND IF ACCEPTED BY
THE UNDERWRITERS NAMED HEREIN AND SUBJECT TO APPROVAL OF CERTAIN LEGAL MATTERS
BY LEBOEUF, LAMB, GREENE & MACRAE, L.L.P., COUNSEL FOR THE UNDERWRITERS. IT IS
EXPECTED THAT DELIVERY OF THE SHARES WILL BE MADE ON OR ABOUT , 1996, AT
THE OFFICE OF MORGAN STANLEY & CO. INCORPORATED, NEW YORK, NEW YORK, AGAINST
PAYMENT THEREFOR IN IMMEDIATELY AVAILABLE FUNDS.
------------------------
MORGAN STANLEY & CO.
INCORPORATED
BEAR, STEARNS & CO. INC.
DEAN WITTER REYNOLDS INC.
MERRILL LYNCH & CO.
, 1996
NO PERSON IS AUTHORIZED IN CONNECTION WITH ANY OFFERING MADE HEREBY TO GIVE
ANY INFORMATION OR TO MAKE ANY REPRESENTATION NOT CONTAINED IN THIS PROSPECTUS
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY, THE SELLING STOCKHOLDERS OR BY
ANY UNDERWRITER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A
SOLICITATION OF AN OFFER TO BUY ANY SECURITY OTHER THAN THE SHARES OF CLASS A
COMMON STOCK OFFERED HEREBY, NOR DOES IT CONSTITUTE AN OFFER TO SELL OR A
SOLICITATION OF AN OFFER TO BUY ANY OF THE SECURITIES OFFERED HEREBY TO ANY
PERSON IN ANY JURISDICTION IN WHICH IT IS UNLAWFUL TO MAKE SUCH AN OFFER OR
SOLICITATION TO SUCH PERSON. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY
SALE MADE HEREUNDER SHALL UNDER ANY CIRCUMSTANCES CREATE ANY IMPLICATION THAT
THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY DATE SUBSEQUENT TO THE
DATE HEREOF.
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NO ACTION HAS BEEN OR WILL BE TAKEN IN ANY JURISDICTION BY THE COMPANY OR BY
ANY UNDERWRITER THAT WOULD PERMIT A PUBLIC OFFERING OF THE CLASS A COMMON STOCK
OR POSSESSION OR DISTRIBUTION OF THIS PROSPECTUS IN ANY JURISDICTION WHERE
ACTION FOR THAT PURPOSE IS REQUIRED, OTHER THAN IN THE UNITED STATES. PERSONS
INTO WHOSE POSSESSION THIS PROSPECTUS COMES ARE REQUIRED BY THE COMPANY AND THE
UNDERWRITERS TO INFORM THEMSELVES ABOUT AND TO OBSERVE ANY RESTRICTIONS AS TO
THE OFFERING OF THE CLASS A COMMON STOCK AND THE DISTRIBUTION OF THIS
PROSPECTUS.
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TABLE OF CONTENTS
PAGE
---------
Prospectus Summary............................. 4
Risk Factors................................... 12
Use of Proceeds................................ 19
Dividend Policy................................ 19
Dilution....................................... 21
Capitalization................................. 22
Selected Historical Financial Information...... 23
Management's Discussion and Analysis of
Financial Condition and Results of
Operations................................... 26
Business....................................... 42
Management..................................... 62
PAGE
---------
Certain Relationships and Related Party
Transactions................................. 78
Principal and Selling Stockholders............. 79
Description of Certain Indebtedness............ 82
Description of Capital Stock................... 83
Shares Eligible for Future Sale................ 90
Underwriters................................... 92
Legal Matters.................................. 93
Experts........................................ 93
Available Information.......................... 94
Glossary of Selected Insurance Terms........... 95
Index to Consolidated Financial Statements..... F-1A
------------------------
In this Prospectus, references to "dollar" and "$" are to United States
dollars, and the terms "United States" and "U.S." mean the United States of
America, its states, territories, possessions and all areas subject to its
jurisdiction.
"S&P 500-Registered Trademark- Price Index" is a trademark of The
McGraw-Hill Companies, Inc. and has been licensed for use by the Company. OMNI,
the Company's equity-indexed annuity product, is not sponsored, endorsed, sold
or promoted by Standard & Poor's, and Standard & Poor's makes no representation
regarding the advisability of investing in OMNI.
The principal executive offices of the Company are located at 515 West
Market Street, Louisville, Kentucky 40202, and the Company's telephone number is
(502) 582-7900.
2
IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVER-ALLOT OR EFFECT
TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF THE CLASS A COMMON
STOCK AT LEVELS ABOVE THOSE WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN MARKET.
SUCH TRANSACTIONS MAY BE EFFECTED ON THE NASDAQ STOCK MARKET, IN THE
OVER-THE-COUNTER MARKET OR OTHERWISE. SUCH STABILIZING, IF COMMENCED, MAY BE
DISCONTINUED AT ANY TIME.
FOR NORTH CAROLINA INVESTORS: THE COMMISSIONER OF INSURANCE OF THE STATE OF
NORTH CAROLINA HAS NOT APPROVED OR DISAPPROVED THIS OFFERING, NOR HAS SUCH
COMMISSIONER PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS.
STATE INSURANCE HOLDING COMPANY STATUTES APPLICABLE TO THE COMPANY DUE TO
ITS INSURANCE COMPANY SUBSIDIARIES GENERALLY PROVIDE THAT NO PERSON MAY ACQUIRE
CONTROL OF THE COMPANY, AND THUS INDIRECT CONTROL OF ITS INSURANCE SUBSIDIARIES,
WITHOUT PRIOR APPROVAL OF THE APPROPRIATE INSURANCE REGULATORS. GENERALLY, ANY
PERSON WHO ACQUIRES BENEFICIAL OWNERSHIP OF 10% OR MORE OF THE OUTSTANDING
SHARES OF THE COMPANY'S CLASS A COMMON STOCK WOULD BE PRESUMED TO HAVE ACQUIRED
SUCH CONTROL UNLESS THE APPROPRIATE INSURANCE REGULATORS UPON APPLICATION
DETERMINE OTHERWISE. BENEFICIAL OWNERSHIP INCLUDES THE ACQUISITION, DIRECTLY OR
INDIRECTLY (BY REVOCABLE PROXY OR OTHERWISE), OF VOTING STOCK OF THE COMPANY.
THE COMPANY CONTROLS INSURANCE COMPANY SUBSIDIARIES DOMICILED IN OHIO AND NEW
YORK. IF ANY PERSON ACQUIRES 10% OR MORE OF THE OUTSTANDING SHARES OF THE
COMPANY'S CLASS A COMMON STOCK IN VIOLATION OF SUCH PROVISIONS, THE INSURER OR
THE INSURANCE REGULATOR IS ENTITLED TO INJUNCTIVE RELIEF, INCLUDING ENJOINING
ANY PROPOSED ACQUISITION, OR SEIZING SHARES OWNED BY SUCH PERSON, AND SUCH
SHARES WOULD NOT BE ENTITLED TO BE VOTED.
3
PROSPECTUS SUMMARY
THE FOLLOWING INFORMATION IS QUALIFIED IN ITS ENTIRETY BY THE MORE DETAILED
INFORMATION AND FINANCIAL STATEMENTS APPEARING ELSEWHERE IN THIS PROSPECTUS.
PROSPECTIVE INVESTORS SHOULD CAREFULLY CONSIDER THE FACTORS SET FORTH HEREIN
UNDER THE CAPTION "RISK FACTORS" AND ARE URGED TO READ THIS PROSPECTUS IN ITS
ENTIRETY. PRIOR TO THE CONSUMMATION OF THE OFFERING, THE COMPANY WILL AMEND AND
RESTATE ITS CERTIFICATE OF INCORPORATION AND EFFECT A RECAPITALIZATION (THE
"RECAPITALIZATION") PURSUANT TO WHICH (I) EACH SHARE OF COMMON STOCK OF THE
COMPANY OUTSTANDING IMMEDIATELY PRIOR TO THE RECAPITALIZATION WILL BE CONVERTED
INTO ONE SHARE OF CLASS A COMMON STOCK; (II) THE MORGAN STANLEY STOCKHOLDERS (AS
DEFINED HEREIN) WILL CONVERT CERTAIN OF THEIR SHARES OF CLASS A COMMON STOCK
INTO CLASS B COMMON STOCK; AND (III) EACH SHARE OF COMMON STOCK OUTSTANDING WILL
BE SPLIT INTO SHARES. SEE "DESCRIPTION OF CAPITAL STOCK -- GENERAL."
UNLESS OTHERWISE INDICATED: (I) "COMPANY" MEANS ARM FINANCIAL GROUP, INC. AND,
WHERE APPROPRIATE, ITS SUBSIDIARIES; (II) "CLASS A COMMON STOCK" MEANS THE CLASS
A COMMON STOCK, PAR VALUE $.01 PER SHARE, OF THE COMPANY, "CLASS B COMMON STOCK"
MEANS THE CLASS B COMMON STOCK, PAR VALUE $.01 PER SHARE, OF THE COMPANY AND
"COMMON STOCK" MEANS, COLLECTIVELY, THE CLASS A COMMON STOCK AND THE CLASS B
COMMON STOCK; (III) "OFFERING" MEANS THE OFFERING OF SHARES OF CLASS A
COMMON STOCK IN THE UNDERWRITTEN PUBLIC OFFERING TO WHICH THIS PROSPECTUS
RELATES; AND (IV) NUMBERS AND PERCENTAGES OF SHARES OUTSTANDING ASSUME THAT THE
UNDERWRITERS' OVER-ALLOTMENT OPTION IS NOT EXERCISED AND HAVE BEEN ADJUSTED TO
GIVE EFFECT TO THE RECAPITALIZATION. CERTAIN OF THE INFORMATION CONTAINED IN
THIS SUMMARY AND ELSEWHERE IN THIS PROSPECTUS, INCLUDING INFORMATION RELATING TO
FUTURE DEMAND FOR LONG-TERM RETIREMENT AND SAVINGS PRODUCTS, INFORMATION
RELATING TO INCOME TAX BENEFITS AND INFORMATION RELATING TO INSURANCE REGULATORY
MATTERS IN THIS SUMMARY, UNDER "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND UNDER "BUSINESS," ARE
FORWARD-LOOKING STATEMENTS. FOR A DISCUSSION OF IMPORTANT FACTORS THAT COULD
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THE FORWARD-LOOKING STATEMENTS,
SEE "RISK FACTORS," "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS" AND "BUSINESS." SEE "GLOSSARY OF SELECTED INSURANCE
TERMS" FOR THE DEFINITIONS OF CERTAIN TERMS USED HEREIN.
UNLESS OTHERWISE INDICATED, FINANCIAL INFORMATION AND OPERATING STATISTICS
APPLICABLE TO THE COMPANY SET FORTH IN THIS PROSPECTUS ARE BASED ON UNITED
STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES ("GAAP") AND NOT STATUTORY
ACCOUNTING PRACTICES. IN CONFORMITY WITH INDUSTRY PRACTICE, DATA DERIVED FROM
A.M. BEST COMPANY, INC. ("A.M. BEST") AND THE NATIONAL ASSOCIATION OF INSURANCE
COMMISSIONERS ("NAIC") SOURCES, GENERALLY USED HEREIN FOR INDUSTRY COMPARISONS,
ARE BASED ON STATUTORY ACCOUNTING PRACTICES.
THE COMPANY
The Company specializes in the asset accumulation business, providing retail
and institutional customers with products designed to serve the growing
retirement and long-term savings markets as well as providing other asset
management services. The Company's earnings are derived from investment spread
(the difference between income earned on investments and interest credited on
customer deposits) and fee income. The Company's retail products include a wide
variety of fixed and variable annuities and face amount certificates sold
primarily through a broad spectrum of distribution channels including financial
planners, independent insurance agents (including those specializing in the
403(b) marketplace for teachers), stockbrokers and banks. The Company offers
asset management services and guaranteed investment contracts ("GICs") to its
institutional clients, which include defined benefit pension plans, defined
contribution or 401(k) pension plans and insurance companies. The Company
markets its institutional products and services directly to bank trust
departments, plan sponsors, cash management funds, other institutional funds and
insurance companies as well as through industry consultants.
The Company was established in July 1993 and completed its first acquisition
in November 1993, resulting in $2.3 billion of assets under management. Assets
under management have grown to $6.6 billion as of June 30, 1996. The Company
attributes this growth to internally generated sales, new product offerings
which are developed to meet the needs of its markets and opportunistic
acquisitions. Annual operating earnings (net income applicable to common
shareholders excluding the net effect of realized
4
investment gains and losses) have grown from $2.4 million in 1994 to $4.5
million in 1995 and operating earnings for the six month period ended June 30,
1996 were $8.9 million.
The Company believes that demographic trends favor strong consumer demand
for long-term savings and retirement products. According to U.S. Census Bureau
projections, the number of individuals between the ages of 45 to 64,
historically the primary holders of annuities, will grow from 55.7 million in
1996 to 71.1 million in 2005. Between 1990 and 1995, annual industry sales of
annuities increased from $65.1 billion to $99.1 billion.
The Company's strategy is focused on the following:
DEVELOP AND MARKET A BROAD ARRAY OF CUSTOMIZED PRODUCTS AND SERVICES. The
Company offers a diversified array of products and services and routinely seeks
to adapt those products and services to changes in the retail and institutional
marketplace. To minimize its dependence on any one product or distribution
channel and to capitalize on market developments, the Company's products, which
meet the needs of a variety of customers, are sold through a broad spectrum of
distribution channels. The Company's current range of products includes, for the
retail markets, fixed and variable annuities and face-amount certificates. For
the institutional markets, the Company's current range of products and services
includes GICs, defined benefit and 401(k) pension plan investment management
services and money management services for insurance companies and other
institutions. The Company's efforts are focused on developing new products to
fill the needs of less well served distribution channels, including financial
planners, independent insurance agents (including those specializing in the
403(b) marketplace for teachers), bank trust departments and regional banks. To
this end the Company works closely with its distributors to develop products and
services that are customized to suit their customers' particular needs. For
example, the Company was one of the first to recognize the market opportunity
for equity-indexed annuities and recently began offering a stand-alone
equity-indexed annuity, OMNI, that meets consumer demand for equity investments
with downside protection. The OMNI product appeals to both risk averse equity
investors and fixed income investors by allowing such investors to earn returns
tied to the S&P 500 Price Index with a return of principal guaranteed by the
issuing insurance company, and/or to earn a rate of return guaranteed by the
issuing insurance company. In the institutional market, the Company offers a
short-term floating rate GIC designed to meet the market demand for products
with attractive current yields and access to liquidity.
STRENGTHEN FINANCIAL CONDITION TO SUPPORT GROWTH. Since the Company
commenced operations in 1993, it has focused on building and maintaining a
strong capital base. Shareholders' equity, excluding the net effects of
unrealized gains and losses, has increased from $112.4 million at December 31,
1993 to $167.6 million at June 30, 1996. As of June 30, 1996, 93% of the
Company's total cash and investments of $3.0 billion were investment grade
securities. After giving effect to the Offering and application of the proceeds
as set forth under "Use of Proceeds," as of June 30, 1996, the Company had a pro
forma shareholders' equity of $ million and a pro forma long-term debt to
total capital ratio of %. In 1995, the ratings of the Company's insurance
subsidiaries were increased from "A- (Excellent)" to "A (Excellent)" by A.M.
Best, which rates insurers based upon factors relevant to policyholders. See
"Business -- Ratings" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Asset Portfolio Review." The Company
believes that its increase in financial strength as a result of the Offering
will enhance its ability to market and sell its products. The Company intends to
continue to strengthen its capital base to support new business growth.
ACTIVELY MANAGE INVESTMENT SPREAD WITH FIXED INCOME INVESTMENT MANAGEMENT
EXPERTISE. Through its acquisition of the assets and business operations of the
U.S. fixed-income unit of Kleinwort Benson Investment Management Americas Inc.
("KBIMA"), the Company acquired investment personnel recognized for their fixed
income investment management expertise. The KBIMA investment personnel brought
33 institutional clients to the Company, of which 27 remain clients, and the
Company has since added 26 institutional clients through June 30, 1996. In
addition, ARM Capital Advisors manages the
5
Company's investment portfolio, bringing its total combined assets under
management to $5.9 billion at June 30, 1996. The Company strives to actively
manage its investment portfolio to maximize investment spread by evaluating the
various asset sectors and individual securities in the Company's investment
portfolios and, based on market yield rates, repositioning holdings from sectors
perceived to be overvalued to sectors perceived to be undervalued in order to
improve cash flows without materially changing the overall credit, asset
duration and convexity characteristics of its portfolios. In order to manage its
investment spread, the Company uses an integrated functional process designed to
establish and maintain balanced investment and product strategies and which is
supported by an experienced management team and sophisticated computer system.
Total cash and investments in the Company's portfolio were 93% investment grade
or equivalent as of June 30, 1996, with the Company's investment portfolio
having minimal exposure to real estate, non-indemnified mortgage loans and
common equity securities.
CONTINUE SUCCESSFUL ACQUISITION RECORD. The Company's first acquisition was
of Integrity Life Insurance Company ("Integrity") and National Integrity Life
Insurance Company ("National Integrity" and, together with Integrity, the
"Integrity Companies") in 1993. Since that acquisition, the Company has
completed two additional acquisitions: the business operations of SBM Company
("SBM") and the business operations of the U.S. fixed-income unit of KBIMA, both
in 1995. These 1995 acquisitions met the Company's objectives of growing and
diversifying its product offerings and distribution channels and achieving
further economies of scale in its operations. For example, since the acquisition
of SBM, the Company has increased the investment yields of the SBM portfolio
while improving its associated risk profile through a restructuring of the
investment portfolio, reduced expenses by merging back-office operations into
the Company's existing operations and expanded the Company's distribution
channels. With the acquisition of the business operations of KBIMA, which had
provided investment management services to the Company since late 1993, the
Company not only brought the management of its own investment portfolio in-house
but also added assets managed for institutional clients that have since expanded
significantly and increased the Company's fee income, which is less sensitive to
interest rate changes than income derived from investment spreads. The Company
continues to pursue acquisitions and blocks of business, marketing partnerships
and reinsurance opportunities with other insurance companies, with the goal of
realizing additional economies of scale and enhanced profitability.
MINIMIZE FIXED COST STRUCTURE. The Company attempts to minimize fixed
distribution costs by marketing its products through fiduciaries and other third
parties. Unlike many of its competitors, the Company does not maintain its own
field sales force, and distributors are primarily paid based on production. As a
consequence, the Company has greater flexibility to shift the mix of its new
sales and distribution channels in order to respond to changes in market demand.
In addition, the Company believes that its administrative cost structure has
benefitted from the economies of scale achieved as a result of its strategic
acquisitions and its distribution and administrative personal computer
client/server network.
MAINTAIN FOCUS ON COMPANY PROFITABILITY. The Company focuses on
profitability on a firm-wide basis rather than a department-by-department basis.
This focus on profitability is supported by an integrated team approach to
developing products and operating the Company's business. Beginning with product
design and continuing through the product sale and eventual payout,
professionals in each functional area (such as marketing, actuarial,
investments, legal, finance and administration) work jointly with a common set
of risk/return profiles toward the goal of achieving the Company's liquidity and
profit objectives (rather than specific objectives of any particular functional
area). The Company's compensation system and equity investments made by certain
of the Company's employees further reinforce the Company's focus on the
objective of profitability. Employees at all levels of the Company receive
bonuses based on the Company's profitability, and as of September 30, 1996,
employees (including directors and executive officers and certain former
employees of the Company) owned, directly or indirectly, 9% of the Company's
Common Stock.
The Company conducts its different businesses through the following
subsidiaries:
6
- INTEGRITY LIFE INSURANCE COMPANY -- provides retail, fixed and variable
annuities (including the Company's new equity-indexed annuity) and institutional
GICs (both traditional and "synthetic") (acquired from The National Mutual Life
Association of Australasia Limited ("National Mutual") in 1993);
- NATIONAL INTEGRITY LIFE INSURANCE COMPANY -- provides retail, fixed and
variable annuities and institutional GICs, primarily in New York (wholly owned
subsidiary of Integrity acquired from National Mutual in 1993);
- ARM CAPITAL ADVISORS, INC. ("ARM CAPITAL ADVISORS") -- offers fixed income
asset management services to third party institutional clients (currently
consisting primarily of defined benefit pension plans) and the Company's
insurance subsidiaries as well as offering advisory services to investment
companies (operations acquired from KBIMA in early 1995);
- SBM CERTIFICATE COMPANY -- offers face-amount certificates
("Certificates") which guarantee a certain amount (the "face amount") to
investors at a future date. Certificates are similar to bank-issued certificates
of deposit (acquired from SBM in mid-1995);
- ARM FINANCIAL SERVICES, INC. ("ARM FINANCIAL SERVICES") -- supports the
Company's retail annuity operations and supports the Company's sales of
independent third party mutual funds which are conducted by representatives
registered with the National Association of Securities Dealers ("NASD"); and
- ARM TRANSFER AGENCY, INC. ("ARM TRANSFER AGENCY") -- provides transfer
agent services as needed to support the Company's retail business operations.
7
THE OFFERING
Class A Common Stock Offered:
By the Company................ --------- shares
By the Selling Stockholders... --------- shares
Total Class A Common Stock
offered................... --------- shares
---------
Common Stock to be outstanding
following the Offering.......... --------- shares
The net proceeds of the Offering will be used to
strengthen the Company's existing capital base, to repay
$25 million of outstanding indebtedness and for other
corporate purposes, which may include additions to working
capital and acquisitions. See "Use of Proceeds."
Use of Proceeds.................
Listing.........................
The Company currently intends to pay regular quarterly
cash dividends of $ per share on its Common Stock
subject to declaration by the Company's Board of
Directors. See "Dividend Policy."
Dividend Policy.................
8
SUMMARY HISTORICAL FINANCIAL INFORMATION
The following table sets forth summary historical consolidated financial
information of the Company for the six months ended June 30, 1996 and 1995, for
the years ended December 31, 1995 and 1994, for the period from November 27,
1993 through December 31, 1993, and for the period from January 1, 1993 through
November 26, 1993 (for the Historical Integrity Companies). The financial
information for the years ended December 31, 1995 and 1994 and for the periods
from January 1, 1993 through November 26, 1993 and November 27, 1993 through
December 31, 1993 have been derived from the consolidated financial statements
of the Company which were audited by Ernst & Young LLP, independent auditors,
whose report thereon appears elsewhere in this Prospectus. Effective May 31,
1995, the Company acquired substantially all of the assets and business
operations of SBM. The acquisition has been accounted for as a purchase, and the
results of operations of the acquired businesses are included in the Company's
historical information since the date of acquisition. Therefore, the results of
operations for 1995 and the six months ended June 30, 1996 are not completely
comparable to the results of the respective corresponding prior periods. See
"Index to Financial Statements -- Pro Forma Financial Information." "Historical
Integrity Companies" refers to operations, for accounting and reporting
purposes, prior to the Company's November 26, 1993 acquisition of the Integrity
Companies. The Historical Integrity Companies' results of operations for 1993
are presented for purposes of comparison with 1994; however, because of purchase
accounting adjustments, the new capital structure and new management team
resulting from that acquisition, the Company's results since November 26, 1993
have differed from the results of the Historical Integrity Companies.
The information presented for the interim periods was derived from the
Company's unaudited condensed consolidated financial statements and notes
thereto included elsewhere in this Prospectus. In the opinion of management, the
unaudited condensed consolidated financial statements include all adjustments,
consisting of normal recurring accruals, that are necessary for a fair
presentation of the financial position and results of operations for these
periods. Operating results for the six months ended June 30, 1996 are not
necessarily indicative of the results that may be expected for the entire year
ending December 31, 1996.
The summary historical financial information set forth below should be read
in conjunction with "Capitalization," "Selected Historical Financial
Information," "Management's Discussion and Analysis of Financial Condition and
Results of Operations," the Company's consolidated financial statements and the
notes thereto and other financial and operating information included elsewhere
in this Prospectus.
9
HISTORICAL
THE COMPANY INTEGRITY
------------------------------------------------------- COMPANIES(1)
PERIOD FROM -----------
NOVEMBER PERIOD FROM
27, JANUARY 1,
1993 1993
SIX MONTHS YEAR ENDED THROUGH THROUGH
ENDED JUNE 30, DECEMBER 31, DECEMBER NOVEMBER
-------------------- -------------------- 31, 26,
1996 1995 1995 1994 1993 1993
--------- --------- --------- --------- ----------- -----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA AMOUNTS)
INCOME STATEMENT DATA:
Investment income................... $ 117,863 $ 84,963 $ 196,024 $ 149,142 $ 16,260 $ 148,120
Interest credited on customer
deposits.......................... (86,012) (64,282) (146,867) (116,463) (13,563) (116,341)
--------- --------- --------- --------- ----------- -----------
Net investment spread............. 31,851 20,681 49,157 32,679 2,697 31,779
Fee income:
Variable annuity fees............. 5,024 3,158 7,238 4,291 91 1,000
Asset management fees............. 2,711 1,131 3,161 -- -- --
Other fee income.................. 628 228 949 4,100 369 1,258
--------- --------- --------- --------- ----------- -----------
Total fee income................ 8,363 4,517 11,348 8,391 460 2,258
Other income and expenses:
Surrender charges................. 2,890 1,115 3,339 2,356 145 1,615
Operating expenses................ (15,187) (10,369) (22,957) (21,484) (1,423) (30,663)
Commissions, net of deferrals..... (1,197) (490) (1,557) (2,551) (309) (4,877)
Interest expense on long-term
debt............................ (1,531) (1,673) (3,461) (3,136) (245) (133)
Amortization:
Deferred policy acquisition
costs........................... (3,105) (1,291) (2,932) (1,296) (12) (1,470)
Value of insurance in force....... (4,481) (2,486) (7,104) (3,830) (552) (6,444)
Acquisition-related deferred
charges......................... (251) (2,444) (9,920) (2,163) (249) --
Goodwill.......................... (244) (47) (358) -- -- --
Other, net........................ (2,640) (410) (687) 4,972 (46) --
--------- --------- --------- --------- ----------- -----------
Total other income and
expenses...................... (25,746) (18,095) (45,637) (27,132) (2,691) (41,972)
Realized investment gains
(losses).......................... (1,217) 2,694 4,048 (36,727) (79) (32,776)
--------- --------- --------- --------- ----------- -----------
Income (loss) before federal income
taxes............................. 13,251 9,797 18,916 (22,789) 387 (40,711)
Federal income tax benefit
(expense)......................... (2,763) (4,938) (7,026) 6,018 (508) --
--------- --------- --------- --------- ----------- -----------
Net income (loss)................... 10,488 4,859 11,890 (16,771) (121) $ (40,711)
-----------
-----------
Dividends on preferred stock........ (2,376) (2,376) (4,750) (4,750) (462)
--------- --------- --------- --------- -----------
Net income (loss) applicable to
common shareholders............... $ 8,112 $ 2,483 $ 7,140 $ (21,521) $ (583)
--------- --------- --------- --------- -----------
--------- --------- --------- --------- -----------
Net income (loss) per common
share............................. $ $ $ $ $
--------- --------- --------- --------- -----------
--------- --------- --------- --------- -----------
Average common shares outstanding
(in thousands)....................
--------- --------- --------- --------- -----------
--------- --------- --------- --------- -----------
OTHER OPERATING DATA:
Operating earnings (loss) (2)....... $ 8,903 $ 732 $ 4,509 $ 2,352 $ (532)
--------- --------- --------- --------- -----------
--------- --------- --------- --------- -----------
Operating earnings (loss) per common
share............................. $ $ $ $ $
--------- --------- --------- --------- -----------
--------- --------- --------- --------- -----------
10
JUNE 30, DECEMBER 31,
-------------------------- ----------------------------------------
1996 1995 1995 1994 1993
------------ ------------ ------------ ------------ ------------
(DOLLARS IN THOUSANDS)
BALANCE SHEET AND OTHER
DATA:
Total cash and investments(3).............. $ 3,048,571 $ 2,747,365 $ 2,798,027 $ 1,782,501 $ 2,103,856
Assets held in separate accounts........... 954,964 658,864 809,927 506,270 231,687
Total assets(3)............................ 4,234,918 3,699,684 3,793,580 2,447,888 2,427,886
Long-term debt............................. 40,000 40,000 40,000 40,000 40,000
Total liabilities.......................... 4,089,023 3,548,023 3,605,589 2,462,021 2,315,535
Shareholders' equity:
Carrying amount(3)....................... 145,895 151,661 187,991 (14,133) 112,351
Excluding the effects of
SFAS No. 115(4)........................ 167,604 154,804 159,461 90,816 n/a
Fair value(5)............................ 200,262 178,201 187,721 115,192 111,709
Assets under management(6)................. 6,618,800 4,767,500 5,404,100 2,582,600 2,476,000
- ------------------------
(1) The Company had no significant business activity until November 26, 1993,
when it acquired, the Integrity Companies from National Mutual. Results of
operations prior to the acquisition for the period from January 1, 1993
through November 26, 1993 are presented for comparative purposes.
(2) "Operating earnings" is defined as net income applicable to common
shareholders excluding realized investment gains and losses net of taxes.
(3) Total cash and investments, total assets and carrying amount shareholders'
equity for the periods ending subsequent to December 31, 1993 reflect a
change in accounting principle for the January 1, 1994 adoption of Statement
of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities."
(4) Excludes from total shareholders' equity the net unrealized gains and losses
on securities classified as available-for-sale, net of related amortization
and taxes.
(5) The methodologies used to estimate fair value are described in the notes to
the condensed consolidated financial statements contained elsewhere in this
Prospectus.
(6) Includes spread-based and fee-based customer deposits, off-balance sheet
assets managed on behalf of institutional clients on a fee basis, deposits
under marketing partnership arrangements and surplus assets.
11
RISK FACTORS
AN INVESTMENT IN THE CLASS A COMMON STOCK INVOLVES A SIGNIFICANT DEGREE OF
RISK. IN DETERMINING WHETHER TO MAKE AN INVESTMENT IN THE CLASS A COMMON STOCK,
PROSPECTIVE INVESTORS SHOULD CONSIDER CAREFULLY ALL OF THE INFORMATION SET FORTH
IN THIS PROSPECTUS AND, IN PARTICULAR, THE FOLLOWING FACTORS.
INTEREST RATE RISK
The Company's spread-based business is subject to several inherent risks
arising from movements in interest rates, especially if the Company fails to
anticipate or respond to such movements. First, interest-rate changes can cause
compression of the Company's net spread between interest earned on investments
and interest credited on customer deposits, thereby adversely affecting the
Company's results. Second, if interest-rate changes produce an unanticipated
increase in surrenders of the Company's spread-based products, the Company may
be forced to sell investment assets at a loss in order to fund such surrenders.
Finally, changes in interest rates can have significant effects on the
performance of the Company's portfolio of mortgage-backed securities ("MBSs"),
including its collateralized mortgage obligations ("CMOs"), as a result of
changes in the prepayment rate of the loans underlying such securities.
SPREAD COMPRESSION. The Company will experience spread compression when it
is unable or chooses not to maintain the same margin between its investment
earnings and its crediting rates. When interest rates rise, the Company may not
be able to replace the assets in its investment portfolio with the higher-
yielding assets that will be necessary to fund the higher crediting rates
necessary to keep its products competitive. As a result, the Company may
experience either a decrease in sales and an increase in surrenders (as
described below) if it chooses to maintain its spread by not raising its
crediting rates, or spread compression if it does increase its crediting rates.
Conversely, when interest rates fall, the Company would have to reinvest the
cash received from its investments (i.e., interest and payments of principal
upon maturity or redemption) in the lower-yielding instruments then available.
If the Company chose not to or was unable (i.e., due to guaranteed minimum or
fixed crediting rates or limitations on the frequency of crediting-rate resets)
to reduce the crediting rate on its spread-based products or acquire relatively
higher-risk securities yielding higher rates of return, spread compression would
occur.
INCREASE IN SURRENDERS. If, as a result of interest rate increases, the
Company was unable or chose not to raise its crediting rates to keep them
competitive, the Company may experience an increase in surrenders. If the
Company lacked sufficient liquidity, the Company might have to sell investment
securities to fund associated surrender payments. Because the value of such
securities would likely have decreased in response to the increase in interest
rates, the Company would realize a loss on the sales. Although certain of the
Company's products contain market value adjustment features which approximate
and transfer such loss to the customer if the selected time horizon for the
fixed return investment is terminated prior to maturity, there can be no
assurance that the Company would be fully insulated from realizing any losses on
sales of its securities. In addition, regardless of whether the Company realizes
an investment loss, the surrenders would produce a decrease in invested assets,
with an adverse effect on future earnings therefrom. Finally, premature
surrenders also cause the Company to accelerate amortization of deferred policy
acquisition costs and value of insurance in force which would otherwise be
amortized over a longer period, but the impact of such acceleration generally
would be offset to some extent by surrender charge fees. Policies issued by the
Company's insurance subsidiaries include lapse protection provisions that help
to deter surrenders when interest rates rise. Surrender charges are generally
assessable within the first five to seven years after a policy is issued. The
Company realized surrender charge income of $3.3 million on net surrenders of
$319.8 million in 1995. At June 30, 1996, approximately 66% of the Company's
insurance subsidiaries' customer deposits had surrender penalties or other such
restrictions or were not subject to withdrawal.
12
MBS PREPAYMENT AND EXTENSION. MBSs, including CMOs, are subject to
prepayment risks that vary with, among other things, interest rates. Such
securities accounted for approximately 43% of the Company's investment portfolio
as of June 30, 1996. As of that date, approximately 1.3% of the MBS portfolio
consisted of interest-only and residual securities. The Company acquired such
interest-only securities as a hedge against certain securities acquired in the
SBM acquisition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Asset Portfolio Review." During periods
of declining interest rates, MBSs generally prepay faster as the underlying
mortgages are prepaid and refinanced by the borrowers in order to take advantage
of the lower rates. MBSs that have an amortized cost that is greater than par
(i.e., purchased at a premium) will incur a reduction in yield or a loss as a
result of such prepayments. In addition, during such periods, the Company will
generally be unable to reinvest the proceeds of any such prepayment at
comparable yields. Conversely, during periods of rising interest rates,
prepayments generally slow. MBSs that have an amortized value that is less than
par (i.e., purchased at a discount) will incur a decrease in yield or a loss as
a result of slower prepayments. The gross unamortized premiums and unaccrued
discounts of MBSs were $27.1 million and $49.2 million, respectively, at June
30, 1996.
The Company follows asset/liability strategies that are designed to mitigate
the effect of interest rate changes on the Company's profitability. However,
there can be no assurance that management will be successful in implementing
such strategies and achieving adequate investment spreads. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Asset Portfolio Review" and "Business -- Asset/Liability Spread Management."
RECENT NET LOSSES; LIMITED OPERATING HISTORY; VARIABILITY OF OPERATING RESULTS
The Company has a limited operating history and sustained net losses for the
years ended December 31, 1994 and 1993 of $16.8 million and $40.8 million,
respectively (the results of operations for the year ended December 31, 1993
include those of the Historical Integrity Companies for the period from January
1, 1993 to November 26, 1993). In 1994, these losses principally related to
realized investment losses due to the sale of fixed-maturity securities during a
period of rising interest rates, and in 1993, these losses related primarily to
writedowns due to other-than-temporary impairments in the value of certain
investments in real estate and joint ventures that occurred prior to the
acquisition of the Integrity Companies. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Results of
Operations." Although the Company reported net income of $11.9 million for the
year ended December 31, 1995 and $10.5 million for the six months ended June 30,
1996, there can be no assurance that the Company will be able to sustain
profitable operations in the future. In addition, the Company may experience
substantial variability in its earnings from period to period, especially in
view of the Company's active management of its investment portfolio which may
produce significant realized investment gains or losses in a particular period
as a result of changes in prevailing interest rates.
COMPETITION; RATINGS
The Company operates in a highly competitive industry. The Company's
insurance subsidiaries compete in their markets with numerous major national
life insurance companies and insurance holding companies, many of which have
substantially greater capital and surplus, larger and more diversified
portfolios of life insurance policies and annuities, higher credit ratings and
greater access to distribution channels than the Company's subsidiaries. The
Company's insurance subsidiaries also encounter increasing competition from
banks, securities brokerage firms and other financial intermediaries marketing
insurance products, annuities and other forms of savings and pension products.
Competition in the insurance industry is based on many factors, including the
overall financial strength and reputation of the insurer, pricing and other
terms and conditions of the offered product, levels of customer service, access
to distributor channels and experience in the business, ratings assigned by A.M.
Best, and the claims-paying ability ratings assigned by nationally recognized
statistical rating organizations. Many financial institutions
13
and broker-dealers focus on the A.M. Best and claims paying ability ratings of
an insurer in determining whether to market the insurer's annuities. As a
result, if any of the Company's insurance subsidiaries' ratings were downgraded
from their current levels or if the ratings of the Company's competitors
improved and those of the Company's insurance subsidiaries did not, the ability
of the Company to distribute its products and the persistency of its existing
business could be adversely affected. Each of the rating agencies reviews its
ratings periodically, and there can be no assurance that the Company's insurance
subsidiaries' current ratings will be maintained in the future. See "Business --
Ratings and Rating Agencies."
ARM Capital Advisors competes with a large number of asset management firms
and mutual fund organizations, including banks and insurance companies.
Competition in the asset management service industry is based on many factors,
including investment performance, client service, product design, scope of
services and reputation. The ability of ARM Capital Advisors to compete with
other firms also is dependent, in part, on the relative attractiveness of the
types of investment services it offers and the relative success of its
investment styles and strategies under prevailing market conditions. The
Company's ability to retain and increase assets under management could be
adversely affected if client accounts underperform the market or those of the
Company's competitors. See "Business -- Competition."
HOLDING COMPANY STRUCTURE; DIVIDEND RESTRICTIONS
The Company is a holding company with no direct operations, and its
principal assets consist of the capital stock of Integrity Holdings, Inc.
("Integrity Holdings"), which owns Integrity and National Integrity (domiciled
in the States of Ohio and New York, respectively), ARM Capital Advisors and SBM
Certificate Company. The Company relies primarily on management fees, dividends
and other distributions from its insurance subsidiaries, its broker-dealer
subsidiary, ARM Financial Services, Inc. (previously known as SBM Financial
Services, Inc. and referred to herein as "ARM Financial Services"), and other
non-insurance operations to meet ongoing cash requirements, including amounts
required for payment of interest and principal on outstanding debt obligations,
preferred stock dividends and corporate expenses. The ability of the Integrity
Companies to pay dividends to the Company in the future is subject, among other
things, to regulatory restrictions of their respective states of domicile and
will depend on their statutory surplus and earnings. Because National Integrity
is a subsidiary of Integrity, dividend payments by National Integrity to
Integrity must be made in compliance with New York standards, and the ability of
Integrity to pass those dividends on to the Company is subject to compliance
with Ohio standards. From time to time, the NAIC and various state insurance
regulators have considered, and may in the future consider, proposals to further
restrict dividend payments that may be made by an insurance company without
regulatory approval. No assurance can be given that there will not be any
further regulatory action restricting the ability of the Company's insurance
subsidiaries to pay dividends. Inability on the part of Integrity or National
Integrity to pay dividends to the Company in an amount sufficient to enable the
Company to meet its debt service and other cash requirements (including dividend
payments on the Common Stock) could have a material adverse effect on the
Company. See "Business -- Regulation" and "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Liquidity and Capital
Resources."
The ability of the Company to pay dividends on the Common Stock is also
subject to the prior declaration and payment of accrued cumulative dividends on
the Company's 9 1/2% Cumulative Perpetual Preferred Stock (the "Perpetual
Preferred Stock"). See "Description of Capital Stock" and "Description of
Certain Indebtedness."
DEPENDENCE ON CERTAIN THIRD-PARTY RELATIONSHIPS
The Company uses third-party marketing organizations with sales networks to
distribute its retail, fixed and variable annuity products. A wholesaler
organization, Financial Marketing Group, Inc. ("FMG"), accounted for 72% and 68%
of total retail sales, and 8% and 17% of total retail and institutional sales
for the six months ended June 30, 1996 and for the year ended December 31, 1995,
14
respectively. No individual distributor affiliated with FMG accounted for more
than 2% and 4% of total retail sales for the six months ended June 30, 1996 and
the year ended December 31, 1995, respectively. The Company also relies on its
joint venture with General American Life Insurance Company ("General American")
for the issuance of GIC policies to institutional customers. In recent periods,
internal growth of the Company's spread-based business has been largely
dependent on the sales of GICs marketed by the Company and issued by General
American under the joint venture with the Company. Sales of GICs accounted for
93% and 55% of the Company's spread-based sales for the six months ended June
30, 1996 and the year ended December 31, 1995, respectively. If demand for GIC
products, or the Company's ability to market such products, were to decrease,
the Company's results of operations could be adversely affected. For the six
months ended June 30, 1996 and for the year ended December 31, 1995,
substantially all spread-based institutional product sales were made through
General American, or 31% and 12%, respectively, of total retail and
institutional sales. The loss of the wholesaler FMG or of General American as a
marketing partner, or the impairment of the reputation or creditworthiness of
either of them, could materially adversely affect the Company's ability to
market its retail products or GICs until another distribution source or
marketing partner could be found. There can be no assurance that the Company
would be able to find an alternate source of distribution in a timely manner.
See "Business -- Distribution."
REGULATION
The Company's businesses and operations are subject to various federal and
state laws and regulations which, among other things, grant supervisory agencies
broad administrative powers over such businesses and operations, including the
power to limit or restrict such businesses if they fail to comply with
applicable laws and regulations.
The Company's insurance subsidiaries are regulated by insurance regulators
in Ohio and New York as well as in other jurisdictions in which they are
licensed or authorized to do business. Insurance laws and regulations, among
other things, establish minimum capital requirements and limit the amount of
dividends and other payments insurance companies can make without prior
regulatory approval and impose restrictions on the amount and type of
investments such companies may hold. In addition, variable annuities and related
separate accounts of the Company's insurance subsidiaries are subject to
regulation by the Securities and Exchange Commission (the "Commission" or "SEC")
under the Securities Act of 1933, as amended (the "Securities Act"), and the
Investment Company Act of 1940, as amended (the "Investment Company Act"). The
Company's non-insurance operations are also subject to extensive regulation,
including regulation under the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), the Employee Retirement Income Security Act of 1974, as amended
("ERISA"), the Investment Advisers Act of 1940, as amended (the "Advisers Act"),
the Investment Company Act, various other federal and state securities laws and
regulations and by the National Association of Securities Dealers, Inc. (the
"NASD"). The Company cannot predict, and no assurance can be given as to, the
effect that any future regulation or changes in interpretation of existing
regulation may have on the financial condition or operations of the Company. See
"Business -- Regulation."
As required by the Investment Company Act and the Advisers Act, the
Company's standard investment management and investment advisory agreements
provide that such agreements may not be assigned by a party without the prior
written consent of the other party. The Investment Company Act and the Advisers
Act define the term "assignment" to include any "direct or indirect transfer" of
a "controlling block of the voting securities" of the Company's outstanding
voting securities. The Investment Company Act presumes that any person holding
more than 25% of the voting stock of any person "controls" such person.
Following completion of the Offering, sales by The Morgan Stanley Leveraged
Equity Fund II, L.P. ("MSLEF II") and Morgan Stanley Capital Partners III, L.P.,
Morgan Stanley Capital Investors, L.P and MSCP III 892 Investors, L.P.
(collectively, the "MSCP Funds" and, together with MSLEF II, the "Morgan Stanley
Stockholders") or other stockholders or issuances of Common Stock by the
Company, among
15
other things, may raise issues relating to assignments of the Company's
investment management and investment advisory agreements.
Under the insurance guaranty fund laws existing in each state, insurers
licensed to do business in such state can be assessed for certain obligations of
insolvent insurance companies to policyholders and claimants. Because such
assessments are typically not made for several years after an insurer fails and
depend upon the final outcome of liquidation or rehabilitation proceedings, the
Company cannot accurately determine the precise amount or timing of its exposure
to known insurance company insolvencies at this time. In connection with the
acquisition by the Company of the Integrity Companies from National Mutual,
National Mutual agreed to indemnify the Company with regard to guaranty fund
assessments levied in respect of companies declared insolvent or subject to
conservatorship prior to November 26, 1993. No assurance can be given that the
Company's reserve for assessments or such indemnity will be adequate in the
event of any loss suffered by the Company in respect of any assessment made
under state insurance guaranty fund laws. The Company estimates its reserve for
assessments using information provided by the National Organization of Life and
Health Guaranty Associations ("NOLHGA"). The reserve does not include any
provision for future assessments related to unknown failures or to known
failures for which no estimate of the Company's exposure can currently be made.
The insolvency of large life insurance companies in future years could result in
additional material assessments to the Company by state guaranty funds that
could have a material adverse impact on the Company's future earnings and
liquidity. See "Business -- Regulation."
SIGNIFICANT OWNERSHIP BY MORGAN STANLEY STOCKHOLDERS
After giving effect to the Offering, the Morgan Stanley Stockholders will
own approximately % of the outstanding Common Stock (approximately % of
the outstanding Class A Common Stock and approximately 100% of the outstanding
Class B Common Stock). If the Underwriters' over-allotment option is exercised
in full, the Morgan Stanley Stockholders will own approximately % of the
outstanding Common Stock (approximately % of the outstanding Class A Common
Stock and approximately 100% of the outstanding Class B Common Stock). The
Morgan Stanley Stockholders have informed the Company that they intend, upon
consummation of the Offering, to convert such number of their shares of
non-voting Common Stock so that, following such conversion, the Morgan Stanley
Stockholders will own, in the aggregate, 49% of the outstanding voting Common
Stock of the Company. The general partner of MSLEF II and the general partner of
the general partner of each of the MSCP Funds are wholly owned subsidiaries of
Morgan Stanley Group Inc. ("MS Group"). Currently, three of the nine directors
of the Company are employees of a wholly owned subsidiary of MS Group. Pursuant
to the terms of the Second Amended and Restated Stockholders' Agreement, to be
entered into prior to the consummation of the Offering (the "Stockholders'
Agreement"), among the Morgan Stanley Stockholders, the Company and certain
other stockholders of the Company, the Morgan Stanley Stockholders will have the
right to designate one-half of the members of the Board of Directors of the
Company for so long as the total number of shares of Common Stock of the Company
owned by the Morgan Stanley Stockholders constitutes at least 50% of the
outstanding Common Stock of the Company. See "Certain Relationships and Related
Party Transactions -- Stockholders' Agreement." As a result of their ownership
interest in the Company and certain rights pursuant to the Stockholders'
Agreement, the Morgan Stanley Stockholders have a substantial influence over the
affairs of the Company. See "Principal and Selling Stockholders" and "Certain
Transactions."
FEDERAL INCOME TAX TREATMENT OF ANNUITY PRODUCTS
Current federal income tax laws generally permit the tax-deferred
accumulation of earnings on the premiums paid by the holder of an annuity.
Taxes, if any, are payable on the accumulated tax-deferred earnings when these
earnings are paid to such holder. In the event that the federal income tax laws
are changed such that accumulated earnings on annuity products do not enjoy the
tax deferral described above
16
or that another product acquires such similar or preferred tax-advantaged
status, consumer demand for annuity products may decline substantially. In
addition, a reduction in the capital gains tax rate may reduce the product
demand for tax-deferred annuities. As a result, both the persistency of the
Company's existing products and the Company's ability to sell its products in
the future could be materially adversely affected. From time to time proposals
to this effect have been made and, although no such proposals are currently
pending, no assurance can be given that such a tax law change will not occur in
the future. The operations and business prospects of the Company could be
materially and adversely affected by any material decrease in the demand for its
annuity products.
DEPENDENCE ON KEY PERSONNEL
The success of the Company will depend, to a significant extent, upon the
continued services of the key executive officers of the Company. The loss or
unavailability of such key executive officers or the inability to attract or
retain key employees in the future could have an adverse effect upon the
Company's operations. See "Management -- Directors and Executive Officers."
RESTRICTIONS IN FINANCING DOCUMENTS
Certain provisions of the Credit Agreement dated as of November 14, 1993, as
amended (the "Credit Agreement"), among the Company, The Chase Manhattan Bank,
N.A., Chemical Bank and certain other parties, impose restrictions on the
Company's operations, including restrictions on its ability to pay dividends or
make distributions with respect to shares of the Common Stock absent compliance
with certain prepayment obligations under the Credit Agreement. On each date
that the Company pays a dividend in respect of any shares of Common Stock, the
Credit Agreement provides that the Company prepay, in an aggregate principal
amount equal to the aggregate amount of the dividends paid on such date, any
borrowings outstanding under the term loan facility and, to the extent such term
loan borrowings are fully prepaid, reduce any commitments to make revolving
loans under the revolving credit facility. Certain of the Company's assets and
all of the Company's interest in the securities of its subsidiaries, as well as
all of Integrity Holdings' interest in the capital stock of Integrity, have been
pledged under the Credit Agreement. Future indebtedness could contain similar or
additional covenants or security arrangements. If the Company fails to comply
with the covenants under the Credit Agreement or other senior credit facilities,
the lenders thereunder may accelerate the indebtedness and exercise remedies
under the pledge agreements and any other security document with respect to the
disposition of such collateral. See "Description of Certain Indebtedness." The
Company intends to amend the Credit Agreement to modify or eliminate certain of
the foregoing restrictions.
ANTI-TAKEOVER PROVISIONS
Under applicable state insurance laws and regulations, no person may acquire
control of any of the insurance subsidiaries of the Company or any corporation
controlling them unless such person has filed a statement containing specified
information with appropriate regulatory authorities and approval for such
acquisition is obtained. Under applicable laws and regulations, any person
acquiring, directly by stock ownership or indirectly (by revocable proxy or
otherwise), 10% or more of the voting stock of any other person is presumed to
have acquired control of such person, and a person who beneficially acquires 10%
or more of the Class A Common Stock of the Company without obtaining the
approval of the applicable state insurance regulator would be in violation of
such state's insurance holding company act and would be subject to injunctive
action requiring disposition or seizure of the shares and prohibiting the voting
of such shares, as well as other action determined by the applicable regulatory
authority.
Certain provisions of the Restated Certificate of Incorporation (the
"Certificate of Incorporation") and the Restated By-laws (the "By-laws") of the
Company that will be in effect upon the consummation of the Offering, certain
provisions of the Delaware General Corporation Law and the significant ownership
position of the Morgan Stanley Stockholders may also have the effect of
discouraging or making more
17
difficult a takeover attempt that a stockholder might consider in its best
interest. See "Description of Capital Stock -- Preferred Stock," "--Restated
Certificate of Incorporation and By-laws" and "-- Section 203 of the Delaware
General Corporation Law."
DILUTION
Based on an initial public offering price of $ per share of Class A
Common Stock, the Company's net tangible book value per share of Class A Common
Stock as of June 30, 1996, after giving effect to the Offering, would be
$ per share. Accordingly, purchasers of Class A Common Stock offered
hereby would suffer immediate dilution in the Company's net tangible book value
of $ per share. See "Dilution."
POTENTIAL DILUTION OF VOTING POWER UPON CONVERSION INTO CLASS A COMMON STOCK
After giving effect to the Offering and the Morgan Stanley Stockholders'
intended conversion of shares of Class B Common Stock into Class A Common Stock
such that, following such conversion, the Morgan Stanley Stockholders will own,
in the aggregate 49% of the outstanding voting Common Stock of the Company,
there will be shares of Class B Common Stock outstanding, representing, in
the aggregate approximately % of the total outstanding Common Stock.
Conversion of shares of Class B Common Stock into shares of Class A Common Stock
would result in a decrease in the voting power of the investors in the Class A
Common Stock offered hereby. If all such shares of Class B Common Stock were so
converted, the holders of such newly converted Class A Common Stock would own
approximately % of the outstanding Class A Common Stock. Upon any disposition
by the Morgan Stanley Stockholders of any of their Class B Common Stock, such
shares of Class B Common Stock will be automatically converted into shares of
Class A Common Stock. According to the terms of the Certificate of
Incorporation, the Morgan Stanley Stockholders may not, in the aggregate, own
more than 49% of the outstanding shares of Class A Common Stock. See
"Description of Capital Stock and "Principal and Selling Stockholders."
SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of the Offering, there will be shares of Common Stock
outstanding, of which the shares sold pursuant to the Offering and an
additional shares that were outstanding prior to the Offering will be
tradeable without restrictions by persons other than "affiliates" (as defined in
the Securities Act) of the Company. The remaining shares of Common Stock will be
"restricted" securities within the meaning of the Securities Act and may not be
sold in the absence of registration under the Securities Act or an exemption
therefrom, including the exemptions contained in Rule 144 under the Securities
Act.
The Company has reserved 3,445 shares of Class A Common Stock for issuance
upon exercise of options outstanding or to be granted pursuant to the Company's
stock option plans. As of September 30, 1996, options to purchase 2,680 shares
of Class A Common Stock were outstanding and unexercised.
Sales of substantial amounts of Common Stock (including shares issued upon
the exercise of stock options) in the public market, or the perception that such
sales may occur, could adversely affect the market price prevailing from time to
time of the Class A Common Stock in the public market and could impair the
Company's ability to raise additional capital through the sale of its equity
securities. Pursuant to the Stockholders' Agreement, the Company has granted the
Morgan Stanley Stockholders certain "demand" registration rights with respect to
the shares of Common Stock held by the Morgan Stanley Stockholders. See "Certain
Relationships and Related Party Transactions -- Stockholders' Agreement" and
"Shares Eligible for Future Sale."
18
ABSENCE OF PRIOR PUBLIC MARKET; POSSIBLE VOLATILITY OF STOCK PRICE AND OF THE
SECURITIES MARKET
Prior to the Offering, there has been no public market for the Class A
Common Stock. Although the Company has applied to have the Common Stock approved
for listing on the , there can be no assurance that an active
trading market for the Common Stock will develop or continue after the Offering
or that the Class A Common Stock offered hereby will trade at or above the
initial public offering price. The initial public offering price for the Class A
Common Stock will be determined by negotiations among the Company and the
Underwriters in accordance with the recommendation of , the "qualified
independent underwriter," as is required by Rule 2720 of the Conduct Rules of
the NASD, and may not be indicative of the market price for the Class A Common
Stock after the Offering.
The market price of the Class A Common Stock could be subject to significant
fluctuations in response to variations in the Company's quarterly financial
results and other factors such as announcements of new products by the Company
or by the Company's competitors, interest rate movements, the state of the
insurance and asset management industry, product pricing and developments in the
Company's relationships with its customers and distributors. In addition, the
stock market has in recent years experienced significant price fluctuations.
These fluctuations often have been unrelated to the operating performance of
specific companies and therefore have been due to factors which are beyond the
control of the Company. Broad market fluctuations as well as economic conditions
generally, and in the insurance and asset management and related industries
specifically, may adversely affect the market price or liquidity of the Class A
Common Stock and the price of securities generally.
USE OF PROCEEDS
The net proceeds of the Offering to the Company are estimated to be
approximately $ million, after deducting underwriting discounts and
commissions and other expenses of the Offering payable by the Company. The
Company intends to use the net proceeds of the Offering to strengthen the
Company's existing capital base, to repay $25 million of outstanding
indebtedness and for other corporate purposes, which may include additions to
working capital and acquisitions. The indebtedness bears a floating interest
rate equal to 7/8 of 1% over the London Interbank Offered Rate. The Company
maintains an interest rate cap related to this debt which expires on March 20,
1998 and currently caps the total rate of interest at approximately 6.2%. At
December 31, 1995, aggregate maturities of such indebtedness was: 1997 -- $4
million; 1998 -- $6 million; 1999 -- $8 million; 2000 -- $10 million and 2001 --
$12 million. Pending such uses, the net proceeds will be invested in highly
rated intermediate and short-term securities.
The Company will not receive any proceeds from the sale of the Common Stock
by the Selling Stockholders.
DIVIDEND POLICY
The Board of Directors of the Company currently intends to establish an
initial policy of declaring regular quarterly cash dividends of $ per
share on its Common Stock, commencing in the first quarter of 1997. There can be
no assurance, however, as to the payment or amount of future dividends, since
they will be at the discretion of the Board of Directors and will depend on
various factors, including the Company's results of operations, financial
condition, capital requirements, investment opportunities and legal and
regulatory restrictions on the payment of dividends to the Company by its
insurance subsidiaries. The payment of dividends will also be subject to
compliance with the financial covenants contained in the Company's debt
agreements. See "Description of Certain Indebtedness."
Under the terms of the Perpetual Preferred Stock, before dividends may be
declared or paid on the Common Stock, the Company must pay all accrued
cumulative quarterly dividends on the Perpetual Preferred Stock. Dividends
accrue on the Perpetual Preferred Stock at an annual rate of 9 1/2% or an
aggregate of $4.8 million annually.
19
The Company is a holding company with no direct operations, and its
principal assets are the capital stock of Integrity Holdings (which owns the
Integrity Companies), ARM Capital Advisors and SBM Certificate Company. The
Company relies primarily on management fees, dividends and other distributions
from its insurance subsidiaries, its broker-dealer subsidiary, ARM Financial
Services, and other non-insurance operations to meet ongoing cash requirements,
including amounts required for payment of interest and principal on outstanding
debt obligations, preferred stock dividends and corporate expenses. The
Integrity Companies are subject to the laws of the states in which they are
domiciled that limit the amount of dividends that an insurance company can pay.
The maximum dividend payments that may be made by the Integrity Companies to the
Company during 1996 are $17.6 million, of which $11.0 million have been made
during the six months ended June 30, 1996. See "Risk Factors -- Holding Company
Structure; Dividend Restrictions" and "Business -- Regulation."
20
DILUTION
The net tangible book value of the Company as of June 30, 1996 was $138.0
million or $ per share of outstanding Common Stock. After giving effect
to the sale of shares of Class A Common Stock offered by the Company
hereby at an assumed initial public offering price of $ per share, the
pro forma net tangible book value of the Company as of June 30, 1996 would have
been approximately $ million or $ per share, representing an
immediate dilution of $ per share to investors purchasing shares in the
Offering. The following table illustrates this per share dilution:
Assumed initial public offering price per common share...................... $
Net tangible book value per common share at June 30, 1996(1).............. $
Increase in net tangible book value per common share attributable to new
investors...............................................................
Pro forma net tangible book value per common share after the Offering.......
---------
Dilution of net tangible book value per share to new investors(2)(3)........ $
- ------------------------
(1) Net tangible book value per common share prior to the Offering has been
determined by dividing the net tangible book value (total assets less net
intangibles and less total liabilities) by the sum of the number of shares
of Common Stock outstanding as of June 30, 1996.
(2) Dilution per share to new investors would be $ if the net tangible
book value was determined with deferred policy acquisition costs and value
of insurance in force (which aggregated $117.1 million at June 30, 1996)
being considered intangible assets.
(3) Dilution per share to new investors would be $ if the net tangible
book value was determined based on fair values of assets and liabilities
determined in accordance with the methodologies used to estimate fair value,
which are described in the notes to the consolidated condensed interim
financial statements contained elsewhere in this Prospectus.
The following table sets forth on a pro forma basis as of June 30, 1996 the
number and percentage of total outstanding shares of Common Stock purchased from
the Company, the total consideration and percentage of total consideration paid
to the Company and the weighted average price paid per share by existing
stockholders and by purchasers of the Class A Common Stock offered by the
Company hereby. The calculations in this table with respect to Common Stock to
be purchased by new investors in the Offering reflect an assumed initial public
offering price of $ per share.
WEIGHTED
SHARES PURCHASED TOTAL CONSIDERATION AVERAGE
---------------------- ---------------------- PRICE PER
NUMBER PERCENT AMOUNT PERCENT SHARE
--------- ----------- --------- ----------- -----------
Existing stockholders......................................... % $ % $
New investors.................................................
--------- --- --------- ---
Total..................................................... 100% $ 100%
--------- --- --------- ---
--------- --- --------- ---
21
CAPITALIZATION
The following table sets forth the consolidated capitalization of the
Company as of June 30, 1996 and as adjusted to give effect to the sale by the
Company of shares of Class A Common Stock pursuant to the Offering at an
assumed initial public offering price of $ per share (less estimated
underwriting discounts and fees and expenses). This table should be read in
conjunction with the Company's consolidated financial statements and the notes
thereto and other financial and operating information included elsewhere in this
Prospectus.
AT JUNE 30, 1996
------------------------------------------------
CARRYING AMOUNT FAIR VALUE(C)
----------------------- -----------------------
ACTUAL AS ADJUSTED ACTUAL AS ADJUSTED
---------- ----------- ---------- -----------
(DOLLARS IN THOUSANDS)
Long-term debt................................................. $ 40,000 $ 40,000 $ 40,000 $ 40,000
Shareholders' equity:
Preferred Stock, $.01 par value, 7,000,000 shares authorized;
2,000,000 shares of Perpetual Preferred Stock, $25.00
stated value, issued and outstanding....................... 50,000 50,000
Common Stock, $.01 par value, 28,360 shares authorized,
24,796 shares issued and outstanding; no shares issued and
outstanding as adjusted.................................... (b)
Class A Common Stock, $.01 par value, shares
authorized, shares issued and outstanding as
adjusted(a)................................................ (b)
Class B Common Stock, $.01 par value, shares
authorized, shares issued and outstanding as
adjusted...................................................
Additional paid-in capital................................... 124,456
Net unrealized gains (losses) on available-for-sale
securities................................................. (21,709) -- --
Retained-earnings deficit.................................... (6,852)
---------- ----------- ---------- -----------
Total shareholders' equity................................. 145,895 200,262
---------- ----------- ---------- -----------
Total capitalization....................................... $ 185,895 $ $ 240,262 $
---------- ----------- ---------- -----------
---------- ----------- ---------- -----------
- ------------------------
(a) Excludes shares of Class A Common Stock issuable upon the exercise of
outstanding stock options as of June 30, 1996 at exercise prices ranging
from $ to $ per share. See "Management."
(b) Less than $1,000.
(c) The methodologies used to estimate fair value are described in the notes to
the consolidated condensed financial statements contained elsewhere in this
Prospectus.
22
SELECTED HISTORICAL FINANCIAL INFORMATION
The following table sets forth selected historical financial information of
the Company for the six months ended June 30, 1996 and 1995, for the years ended
December 31, 1995 and 1994, for the period from November 27, 1993 through
December 31, 1993, for the period from January 1, 1993 through November 26, 1993
(for the Historical Integrity Companies) and for the years ended December 31,
1992 and 1991 (for the Historical Integrity Companies). The financial
information for the years ended December 31, 1995 and 1994 and for the periods
from January 1, 1993 through November 26, 1993 and November 27, 1993 through
December 31, 1993 have been derived from consolidated financial statements of
the Company that have been audited by Ernst & Young LLP. The financial
information for the Integrity Companies for the years ended December 31, 1992
and December 31, 1991 have been derived from financial statements of the
Historical Integrity Companies. The information presented for the six months
ended June 30, 1996 and 1995 was derived from the Company's unaudited condensed
consolidated financial statements and notes thereto included elsewhere in this
Prospectus. In the opinion of management, the unaudited condensed consolidated
financial statements include all adjustments, consisting of normal recurring
accruals, that are necessary for a fair presentation of the financial position
and results of operations for these periods.
Effective May 31, 1995, the Company acquired substantially all of the assets
and business operations of SBM. This acquisition has been accounted for as a
purchase, and the results of operations of the acquired businesses are included
in the Company's historical financial information from the date of acquisition.
Therefore, the results of operations for 1995 and the six months ended June 30,
1996 are not completely comparable to the results of the respective
corresponding prior periods. See "Index to Consolidated Financial Statements --
Unaudited Pro Forma Financial Information." "Historical Integrity Companies"
refers to operations, for accounting and reporting purposes, prior to the
Company's November 26, 1993 acquisition of the Integrity Companies. The
Historical Integrity Companies' results of operations for 1993, 1992 and 1991
are presented for purposes of comparison; however, because of purchase
accounting adjustments, the new capital structure and new management team
resulting from that acquisition, the Company's results have differed from the
results of the Historical Integrity Companies.
The selected historical financial information set forth below should be read
in conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations," the Company's consolidated financial statements and
the notes thereto and other financial and operating information included
elsewhere in this Prospectus.
23
HISTORICAL
THE COMPANY INTEGRITY COMPANIES(1)
--------------------------------------------------------- ----------------------------------
PERIOD FROM
PERIOD FROM JANUARY 1,
SIX MONTHS YEAR ENDED NOVEMBER 27, 1993 YEAR ENDED
ENDED JUNE 30, DECEMBER 31, 1993 THROUGH THROUGH DECEMBER 31,
-------------------- -------------------- DECEMBER 31, NOVEMBER 26, --------------------
1996 1995 1995 1994 1993 1993 1992 1991
--------- --------- --------- --------- ------------- ------------ --------- ---------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
INCOME STATEMENT DATA:
Investment income.............. $ 117,863 $ 84,963 $ 196,024 $ 149,142 $ 16,260 $ 148,120 $ 158,037 $ 167,987
Interest credited on customer
deposits..................... (86,012) (64,282) (146,867) (116,463) (13,563) (116,341) (122,190) (136,072)
--------- --------- --------- --------- ------------- ------------ --------- ---------
Net investment spread...... 31,851 20,681 49,157 32,679 2,697 31,779 35,847 31,915
Fee income:
Variable annuity fees........ 5,024 3,158 7,238 4,291 91 1,000 1,405 1,300
Asset management fees........ 2,711 1,131 3,161 -- -- -- -- --
Other fee income............. 628 228 949 4,100 369 1,258 215 149
--------- --------- --------- --------- ------------- ------------ --------- ---------
Total fee income........... 8,363 4,517 11,348 8,391 460 2,258 1,620 1,449
Other income and expenses:
Surrender charges............ 2,890 1,115 3,339 2,356 145 1,615 2,403 4,936
Operating expenses........... (15,187) (10,369) (22,957) (21,484) (1,423) (30,663) (25,103) (25,921)
Commissions, net of
deferrals.................. (1,197) (490) (1,557) (2,551) (309) (4,877) (2,124) (2,042)
Interest expense on long-term
debt....................... (1,531) (1,673) (3,461) (3,136) (245) (133) (546) (546)
Amortization:
Deferred policy acquisition
costs...................... (3,105) (1,291) (2,932) (1,296) (12) (1,470) (1,045) (1,011)
Value of insurance in
force...................... (4,481) (2,486) (7,104) (3,830) (552) (6,444) (41,594) (18,310)
Acquisition-related deferred
charges.................... (251) (2,444) (9,920) (2,163) (249) -- -- --
Goodwill..................... (244) (47) (358) -- -- -- (8,978) (244)
Other, net................... (2,640) (410) (687) 4,972 (46) -- (6,434) (6,907)
--------- --------- --------- --------- ------------- ------------ --------- ---------
Total other income and
expenses................. (25,746) (18,095) (45,637) (27,132) (2,691) (41,972) (83,421) (50,045)
Realized investment gains
(losses)..................... (1,217) 2,694 4,048 (36,727) (79) (32,776) (9,759) (5,615)
--------- --------- --------- --------- ------------- ------------ --------- ---------
Income (loss) before federal
income taxes................. 13,251 9,797 18,916 (22,789) 387 (40,711) (55,713) (22,296)
Federal income tax benefit
(expense).................... (2,763) (4,938) (7,026) 6,018 (508) -- -- --
--------- --------- --------- --------- ------------- ------------ --------- ---------
Net income (loss).............. 10,488 4,859 11,890 (16,771) (121) $ (40,711) $ (55,713) $ (22,296)
------------ --------- ---------
------------ --------- ---------
Dividends on preferred stock... (2,376) (2,376) (4,750) (4,750) (462)
--------- --------- --------- --------- -------------
Net income (loss) applicable to
common shareholders.......... $ 8,112 $ 2,483 $ 7,140 $ (21,521) $ (583)
--------- --------- --------- --------- -------------
--------- --------- --------- --------- -------------
Net income (loss) per common
share........................ $ $ $ $ $
--------- --------- --------- --------- -------------
--------- --------- --------- --------- -------------
Average common shares
outstanding (in thousands)...
--------- --------- --------- --------- -------------
--------- --------- --------- --------- -------------
OTHER OPERATING DATA:
Operating earnings (loss)(2)... $ 8,903 $ 732 $ 4,509 $ 2,352 $ (532)
--------- --------- --------- --------- -------------
--------- --------- --------- --------- -------------
Operating earnings (loss) per
common share................. $ $ $ $ $
--------- --------- --------- --------- -------------
--------- --------- --------- --------- -------------
24
HISTORICAL
INTEGRITY
THE COMPANY COMPANIES(1)
----------------------------------------------------- --------------------
JUNE 30, DECEMBER 31, DECEMBER 31,
-------------------- ------------------------------- --------------------
1996 1995 1995 1994 1993 1992 1991
--------- --------- --------- --------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
BALANCE SHEET AND OTHER DATA:
Total cash and investments(3)............ $3,048,571 $2,747,365 $2,798,027 $1,782,501 $2,103,856 $1,838,435 $1,753,972
Assets held in separate accounts......... 954,964 658,864 809,927 506,270 231,687 38,952 25,065
Total assets(3).......................... 4,234,918 3,699,684 3,793,580 2,447,888 2,427,886 1,991,205 1,937,548
Long-term debt........................... 40,000 40,000 40,000 40,000 40,000 -- --
Total liabilities........................ 4,089,023 3,548,023 3,605,589 2,462,021 2,315,535 1,857,978 1,758,113
Shareholders' equity:
Carrying amount(3)..................... 145,895 151,661 187,991 (14,133) 112,351 133,227 179,435
Excluding the effects of SFAS No.
115(4)............................... 167,604 154,804 159,461 90,816 n/a n/a n/a
Fair value(5).......................... 200,262 178,201 187,721 115,192 111,709 n/a n/a
Assets under management(6)............... 6,618,800 4,767,500 5,404,100 2,582,600 2,476,000 1,906,817 1,805,295
- ------------------------
(1) The Company had no significant business activity until November 26, 1993,
when it acquired the Integrity Companies from National Mutual. Results of
operations prior to the acquisition for the period from January 1, 1993
through November 26, 1993 are presented for comparative purposes.
(2) "Operating earnings" is defined as net income applicable to common
shareholders excluding realized investment gains and losses net of taxes.
(3) Total cash and investments, total assets and carrying amount shareholders'
equity for the periods ending subsequent to December 31, 1993 reflect a
change in accounting principle for the January 1, 1994 adoption of SFAS No.
115, "Accounting for Certain Investments in Debt and Equity Securities."
(4) Excludes from total shareholders' equity the net unrealized gains and losses
on securities classified as available-for-sale, net of related amortization
and taxes.
(5) The methodologies used to estimate fair value are described in the notes to
the condensed consolidated financial statements contained elsewhere in this
Prospectus.
(6) Includes spread-based and fee-based customer deposits, off-balance sheet
assets managed on behalf of institutional clients on a fee basis, deposits
under marketing partnership arrangements and surplus assets.
25
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL
The Company specializes in the asset accumulation business, providing retail
and institutional customers with products designed to serve the growing
retirement and long-term savings markets as well as providing other asset
management services. At June 30, 1996, the Company had approximately $6.6
billion of assets under management.
The Company's revenues are derived from its spread-based business and its
fee-based business. The products and services comprising the spread-based and
fee-based businesses are sold in two principal markets, the retail and
institutional markets, through a broad spectrum of distribution channels. In the
spread-based line of business the Company earns a spread between what is earned
on invested assets and what is credited to customer accounts. In the fee-based
line of business the Company receives a fee for managing customers' deposits on
and off its balance sheet. The Company believes that market forces and
population demographics are producing and will continue to generate strong
consumer demand for long-term savings and retirement products, including
variable and equity-indexed annuity type products. Recent acquisitions by the
Company have provided it with the opportunity to leverage its resources and
enter into new markets in order to try to meet this demand. The Company
continues to focus on the development of its fee-based business to increase the
size of this business, which is less capital intensive than the spread-based
business and provides the Company with diversified sources of income. Although
the Company's objective is to achieve a better business mix with its
spread-based business, the business mix may vary from time to time, due to
opportunistic acquisitions of spread-based businesses.
The following discussion compares the results of operations for the Company
for the six months ended June 30, 1996 and for the three years ended December
31, 1995. As the Company acquired substantially all of the assets and business
operations of SBM effective May 31, 1995, the results for the six months ended
June 30, 1996 and for the year ended December 31, 1995 include the effects of
the operations of SBM for the period from June 1, 1995 to June 30, 1996.
Therefore, results for the six months ended June 30, 1996 and for the year ended
December 31, 1995 are not necessarily comparable with the results of the
respective prior periods. Additionally, the results of operations for the year
ended December 31, 1993 represent the results of the Historical Integrity
Companies for the period from January 1, 1993 through November 26, 1993 combined
with the results of operations of the Company for the period from November 27,
1993 through December 31, 1993. The combined results of operations for 1993 are
presented for purposes of comparison with 1994; however, because of purchase
accounting adjustments and the new capital structure and new management
resulting from that acquisition, the Company's results have differed from the
results of the Historical Integrity Companies.
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 1996 AND JUNE 30, 1995
Net income during the six months ended June 30, 1996 was $10.5 million
compared to $4.9 million for the six months ended June 30, 1995. Operating
earnings (net income applicable to common shareholders excluding realized
investment gains and losses net of taxes) were $8.9 million and $0.7 million for
the six months ended June 30, 1996 and 1995, respectively. The increase in
operating earnings is primarily attributable to an increase in net investment
spread due to ongoing asset/liability management and deposit growth from the
acquisition of the SBM business operations and, to a lesser extent, additional
sales of spread-based products. In addition, fee income increased as a result of
a growing base of variable annuity deposits and institutional assets under
management. Such increases in revenues were partially offset by increases in
operating and amortization expenses.
26
Annualized spread-based operating earnings were 1.01% and 0.92% of average
spread-based assets under management of $3.05 billion and $2.13 billion during
the six months ended June 30, 1996 and 1995, respectively. This increase in
spread-based margins is primarily attributable to ongoing asset/liability
management, which generated higher net investment spreads. Annualized fee-based
operating earnings were 0.18% and 0.20% of average fee-based assets under
management of $2.92 billion and $1.54 billion during the six months ended June
30, 1996 and 1995, respectively. Fee-based margins for the 1996 period were
essentially flat compared to the prior period as a result of a relatively
consistent mix of variable annuity deposits and other assets under management
which generate fee income.
Net investment spread, which is the difference between income earned on
investments and interest credited on customer deposits, increased to $31.9
million during the six months ended June 30, 1996 from $20.7 million during the
six months ended June 30, 1995. These amounts reflect the net investment spread
of 2.05% and 1.85% during the six months ended June 30, 1996 and 1995,
respectively, between the Company's annualized investment yield on average cash
and investments and the annualized average rate credited on customer deposits.
The Company's investment income increased to $117.9 million during the six
months ended June 30, 1996 from $85.0 million during the six months ended June
30, 1995. These amounts represent annualized investment yields of 7.70% and
7.89% on average cash and investments of $3.06 billion and $2.15 billion during
the six months ended June 30, 1996 and 1995, respectively. The decrease in
annualized investment yields on cash and investments primarily relates to a
significant increase in sales of GICs, the proceeds of which are invested in
securities of shorter duration (which generally have lower investment yields)
than many of the Company's other investments.
Interest credited on customer deposits increased to $86.0 million during the
six months ended June 30, 1996 from $64.3 million during the six months ended
June 30, 1995. These amounts represent annualized average rates of interest
credited on customer deposits of 5.65% and 6.04% on average customer deposits of
$3.04 billion and $2.13 billion during the six months ended June 30, 1996 and
1995, respectively. The decrease in annualized average rates of interest
credited on customer deposits resulted from the Company's decision to reset
crediting rates during the second half of 1995 consistent with an overall
declining interest rate environment during that period.
Fee income increased to $8.4 million during the six months ended June 30,
1996 from $4.5 million during the six months ended June 30, 1995. This increase
is in part attributable to variable annuity fees which are based on the market
value of assets supporting the investment portfolio options of variable annuity
customer deposits in separate accounts. Variable annuity fees increased to $5.0
million during the six months ended June 30, 1996 from $3.2 million during the
six months ended June 30, 1995 principally due to asset growth from the receipt
of variable annuity deposits and, to a lesser extent, from a market-driven
increase in the value of existing variable annuity deposits invested in
investment portfolio options. Fee-based variable annuity deposits increased to
$749.2 million at June 30, 1996 from $477.6 million at June 30, 1995. In
addition, asset management fees earned by ARM Capital Advisors on off-balance
sheet assets in private accounts increased to $2.7 million during the six months
ended June 30, 1996 from $1.1 million during the six months ended June 30, 1995.
This increase in asset management fees reflects a significant increase in the
average fair value of off-balance sheet assets managed due to sales. The average
fair value of off-balance sheet assets managed by the Company was $1.9 billion
during the six months ended June 30, 1996 compared to $1.1 billion during the
six months ended June 30, 1995.
27
Assets under management by type of product and service as of June 30, 1996
and December 31, 1995 were as follows:
JUNE 30, 1996 DECEMBER 31, 1995
---------------------- ----------------------
PERCENT PERCENT
AMOUNT OF TOTAL AMOUNT OF TOTAL
--------- ----------- --------- -----------
(DOLLARS IN MILLIONS)
Spread-based:
Retail (fixed annuity, guaranteed rate option and face-amount
certificate deposits)............................................... $ 2,634.8 40% $ 2,716.2 50%
Institutional (GIC deposits).......................................... 586.0 9 143.2 3
--------- --- --------- ---
Total spread-based.............................................. 3,220.8 49 2,859.4 53
Fee based:
Retail (investment portfolio options of variable annuity deposits and
off-balance sheet mutual fund assets managed)....................... 984.1 15 845.7 16
Institutional (off-balance sheet fee-based assets managed on behalf of
institutional clients and deposits under marketing partnerships).... 2,358.2 35 1,598.0 29
--------- --- --------- ---
Total fee-based................................................. 3,342.3 50 2,443.7 45
Corporate and other (primarily cash and investments in excess of
customer deposits).................................................... 55.7 1 101.0 2
--------- --- --------- ---
Total assets under management........................................... $ 6,618.8 100% $ 5,404.1 100%
--------- --- --------- ---
--------- --- --------- ---
The increase in spread-based deposits was attributable to sales of GICs to
institutional customers. The increase in the fee-based line of business was
primarily attributable to deposits under new investment management contracts
managed by ARM Capital Advisors. The Company continues to develop its fee-based
line of business, as reflected in its growth as a percentage of total assets
under management and, additionally, to diversify its spread-based and fee-based
products and services and their associated channels of distribution.
Sales for spread-based products include premiums and deposits received under
products issued by the Company's insurance and face-amount certificate
subsidiaries. Sales for fee-based products and services include premiums and
deposits for the investment portfolio options of variable annuity products
issued by the Company's insurance subsidiaries and the amount of new off-balance
sheet assets managed by ARM Capital Advisors.
Sales by market and type of business for the six months ended June 30, 1996
and 1995 were as follows:
SIX MONTHS ENDED
----------------------------
JUNE 30, 1996 JUNE 30, 1995
------------- -------------
(DOLLARS IN MILLIONS)
Retail:.........................................................
Spread-based................................................ $ 31.2 $ 64.0
Fee-based................................................... 127.5 65.4
------------- ------
Total retail............................................ 158.7 129.4
Institutional:
Spread-based................................................ 441.3 25.0
Fee-based................................................... 822.5 350.6
------------- ------
Total institutional..................................... 1,263.8 375.6
------------- ------
Total sales..................................................... $ 1,422.5 $ 505.0
------------- ------
------------- ------
28
The increase in retail sales is attributable to an increase in sales of
fee-based investment portfolio options of variable annuities due, in part, to
the continuing strong stock market returns during the first half of 1996 and
marketing efforts. This increase was somewhat offset by lower retail sales of
spread-based fixed annuity products due to greater industry-wide competition
from banks and other financial services institutions for savings products
primarily as a result of a U.S. Treasury yield curve (the "yield curve") that
was generally flatter during the first half of 1996 relative to the first half
of 1995. A flattened yield curve tends to weaken sales of retail spread-based
products due to increased competition from short-term instruments such as bank
certificates of deposit and money market funds because the difference between
short-term and intermediate-term market interest rates decreases. Expanded
distribution channels developed by the Company benefited sales of institutional
spread-based products (i.e., GICs), which accumulate interest based on
short-term rates. The Company's GIC products are issued mainly through a
marketing partnership with another insurance company. The increase in
institutional fee-based sales was primarily attributable to deposits in
off-balance sheet defined benefit pension plan accounts by new customers of ARM
Capital Advisors. The Company's strategy is to broaden its mix of products,
services and distribution channels to enable it to achieve its target sales
within different interest rate environments.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $173.5 million and $153.4 million during the six months ended
June 30, 1996 and 1995, respectively. Of these amounts, $54.4 million and $8.0
million, respectively, can be attributed to business acquired from SBM,
primarily fixed annuities. Surrender charge income increased to $2.9 million
during the six months ended June 30, 1996 from $1.1 million during the six
months ended June 30, 1995, due to higher average surrender charges associated
with SBM products compared to other products of the Company's insurance
subsidiaries and to the overall increase in the volume of surrenders. Policies
issued by the Company's insurance subsidiaries include lapse protection
provisions that provide a deterrent against surrenders when interest rates rise.
These provisions can include surrender charges and market value adjustments on
annuity withdrawals. During the period that surrender charges are assessable,
generally the first five to seven years after a policy is issued, surrenders are
relatively low. The surrender and withdrawal activity during the six months
ended June 30, 1995 and 1996 was generally expected by the Company due to the
level of customer deposits written several years ago that were subject to
declining or expiring surrender charges and the Company's strategy of
maintaining investment spreads. During the third quarter of 1994, and continuing
to date, the Company began implementing programs designed to reduce surrender
activity and improve persistency. During the six months ended June 30, 1996 and
1995, through one such program, $9.6 million and $9.8 million, respectively, of
new annuity contracts were issued to customers that had initiated a withdrawal
request. The Company excludes this activity from its net surrenders and sales
disclosures because such amounts have no impact on net cash flow. Other programs
involve direct contact with customers and are designed to inform customers of
the financial strength of the Company and its insurance subsidiaries and to
describe other product offerings available.
Operating expenses increased to $15.2 million during the six months ended
June 30, 1996 from $10.4 million during the six months ended June 30, 1995. The
increase was primarily attributable to the inclusion of six months of
incremental operating expenses related to the acquired SBM business operations
in the 1996 results versus one month for the comparable 1995 period, as well as
the expansion of distribution channels.
Commissions, net of deferrals were $1.2 million and $0.5 million during the
six months ended June 30, 1996 and 1995, respectively. The increase was
primarily attributable to the inclusion of six months' renewal commissions under
certain deferred annuity contracts acquired in the SBM acquisition in 1996
results versus one month for the comparable 1995 period.
Amortization of deferred policy acquisition costs related to operations was
$3.1 million and $1.3 million during the six months ended June 30, 1996 and
1995, respectively. This increase was the result of growth in the deferred
policy acquisition cost asset as variable costs of selling and issuing the
Company's
29
insurance subsidiaries' products (primarily first-year commissions) are deferred
and then amortized over the expected life of the policy.
Amortization of value of insurance in force related to operations increased
to $4.5 million during the six months ended June 30, 1996 from $2.5 million
during the six months ended June 30, 1995. The increase is primarily related to
amortization of the value of insurance in force established as an asset by the
Company on May 31, 1995 in connection with the acquisition of SBM's Life.
Amortization of acquisition-related deferred charges was $0.3 million and
$2.4 million during the six months ended June 30, 1996 and 1995, respectively.
The decrease was primarily attributable to the accelerated amortization during
the third quarter of 1995 of certain costs and charges deferred during 1993 and
1994. During the third quarter of 1995, Company management determined that
changes in facts and circumstances had resulted in a change in their original
estimate of the periods benefited by these costs and charges. As a result of
this change in estimate, the remaining unamortized balances of these deferred
costs and charges were fully amortized as of September 30, 1995, resulting in
lower amortization in future periods.
Other expenses, net increased $2.2 million during the six months ended June
30, 1996 compared to the same period in 1995. This increase is primarily
attributable to premiums paid in 1996 under a reinsurance agreement. Through
this reinsurance agreement, which commenced December 31, 1995, and an existing
agreement, substantially all mortality risks associated with single premium
endowment deposits have been reinsured.
Realized investment losses, which are reported net of related amortization
of deferred policy acquisition costs and value of insurance in force, were $1.2
million during the six months ended June 30, 1996 compared to realized
investment gains of $2.7 million during the six months ended June 30, 1995. Such
realized investment gains and losses were interest-rate related and attributable
to the ongoing management of the Company's fixed maturity securities classified
as available-for-sale which can result in period-to-period swings in realized
investment gains and losses since securities are sold during both rising and
falling interest rate environments. The ongoing management of securities is a
significant component of the Company's asset/liability management strategy. The
ongoing portfolio management process involves evaluating the various asset
sectors (i.e., security types and industry classes) and individual securities
comprising the Company's investment portfolios and, based on market yield rates,
repositioning holdings from relatively overvalued sectors to undervalued ones
with the aim of improving cash flows without materially changing the overall
credit, asset duration and convexity characteristics of its portfolios.
Federal income tax expense was $2.8 million and $4.9 million for the six
months ended June 30, 1996 and 1995, respectively, reflecting effective tax
rates of 20.9% and 50.4%. The lower effective tax rate in 1996 resulted
primarily from the recognition of benefits associated with certain deferred tax
assets established with the Company's acquisition of the Integrity Companies on
November 26, 1993 for which a full valuation allowance was originally provided.
These deferred tax benefits are being recognized based on the taxable income
generated by the Integrity Companies in the post-acquisition period and
projections of future taxable income.
YEARS ENDED DECEMBER 31, 1995 AND DECEMBER 31, 1994
During 1995, net income for the Company was $11.9 million compared to a net
loss of $16.8 million for 1994. Operating earnings were $4.5 million and $2.4
million for 1995 and 1994, respectively. The improvement in operating earnings
in 1995 was primarily attributable to an increase in net investment spread, the
acquired operations of SBM which generated operating earnings of approximately
$3.5 million during the period from June 1, 1995 to December 31, 1995 and an
increase in fee income from a growing base of variable annuity deposits and
institutional assets under management. Such increases in operating earnings were
partially offset by the accelerated amortization of certain acquisition-related
deferred charges.
30
Spread-based operating earnings were 0.90% and 0.81% of average spread-based
assets under management of $2.47 billion and $2.0 billion during 1995 and 1994,
respectively. This increase in spread-based margins was primarily attributable
to ongoing asset/liability management, which generated higher net investment
spreads. Fee-based operating earnings were 0.20% and 0.51% of average fee-based
assets under management of $1.84 billion and $421.7 million during 1995 and
1994, respectively. The decrease in fee-based margins was primarily attributable
to the growth in off-balance sheet fee-based assets managed by ARM Capital
Advisors for institutional clients, which generate lower margins than the
Company's other fee-based products, specifically variable annuities. For
example, margins on the Company's variable annuities were 0.64% and 0.66% during
1995 and 1994, respectively.
Net investment spread increased to $49.2 million in 1995 from $32.7 million
in 1994. These amounts reflect the net investment spread of 1.94% and 1.42% in
1995 and 1994, respectively, between the Company's investment yield on average
cash and investments and the average rate credited on customer deposits. The
Company's investment income increased to $196.0 million in 1995 from $149.1
million in 1994. These amounts represent investment yields of 7.84% and 7.30% on
average cash and investments of $2.50 billion and $2.04 billion in 1995 and
1994, respectively. This increase in yield was primarily attributable to
benefits from ongoing management of the Company's investment portfolios, the
rising interest rate environment during 1994 and lower amortization of invested
asset write-ups resulting from purchase accounting adjustments. Interest
credited on customer deposits increased to $146.9 million in 1995 from $116.5
million in 1994. These amounts represent average rates of interest credited on
customer deposits of 5.90% and 5.88% on average customer deposits of $2.49
billion and $1.98 billion in 1995 and 1994, respectively.
Fee income increased to $11.3 million in 1995 from $8.4 million in 1994.
This increase is in part attributable to variable annuity fees which are based
on the market value of assets supporting the mutual fund options of variable
annuity customer deposits in separate accounts. Variable annuity fees increased
to $7.2 million in 1995 from $4.3 million in 1994 principally due to asset
growth from the receipt of variable annuity deposits and from increased market
values. In addition, ARM Capital Advisors, which began operations in January
1995, added asset management fees earned on off-balance sheet assets in private
accounts and investment portfolios. Offsetting these increases was a reduction
in other fee income from $4.1 million in 1994 to $0.9 million in 1995 primarily
related to variable life insurance business which was effectively discontinued
in 1994.
31
Assets under management by type of product and service as of December 31,
1995 and 1994 were as follows:
1995 1994
---------------------- ----------------------
PERCENT PERCENT
AMOUNT OF TOTAL AMOUNT OF TOTAL
--------- ----------- --------- -----------
(DOLLARS IN MILLIONS)
Spread-based:...........................................................
Retail (fixed annuity, guaranteed rate option and face-amount
certificate deposits)............................................... $ 2,716.2 50% $ 1,990.0 77%
Institutional (GIC deposits).......................................... 143.2 3 -- --
--------- --- --------- ---
Total spread-based.............................................. 2,859.4 53% 1,990.0 77%
Fee-based:
Retail (investment portfolio options of variable annuity deposits and
off-balance sheet investment portfolio assets managed).............. 845.7 16 388.9 15
Institutional (off-balance sheet assets managed on behalf of
institutional clients on a fee basis and deposits under marketing
partnerships)....................................................... 1,598.0 29 121.0 5
--------- --- --------- ---
Total fee-based................................................. 2,443.7 45 509.9 20
--------- --- --------- ---
Corporate and other (primarily cash and investments in excess of
customer deposits).................................................... 101.0 2 82.7 3
--------- --- --------- ---
Total assets under management........................................... $ 5,404.1 100% $ 2,582.6 100%
--------- --- --------- ---
--------- --- --------- ---
The increase in the spread-based deposits was primarily attributable to the
SBM acquisition and sales of GICs. The increase in the fee-based line of
business is primarily due to funds managed by ARM Capital Advisors under
investment management and investment advisory contracts that were acquired on
January 5, 1995, assets managed under contract for the State Bond group of
mutual funds that were acquired effective May 31, 1995, and new sales.
Sales by market and type of business during 1995 and 1994 were as follows:
YEAR ENDED DECEMBER
31,
--------------------
1995 1994
--------- ---------
(DOLLARS IN
MILLIONS)
Retail:
Spread-based......................................................... $ 115.4 $ 131.1
Fee-based............................................................ 185.5 231.1
--------- ---------
Total retail..................................................... 300.9 362.2
--------- ---------
Institutional:
Spread-based......................................................... 142.2 --
Fee-based............................................................ 744.7 59.3
--------- ---------
Total institutional.............................................. 886.9 59.3
--------- ---------
Total sales.............................................................. $ 1,187.8 $ 421.5
--------- ---------
--------- ---------
The Company believes the decrease in retail sales is attributable to greater
industry-wide competition from banks and other financial services institutions
for savings products. However, the Company believes yield curve flattening
benefited sales of institutional spread-based products (i.e., GICs), resulting
in total overall sales growth of spread-based products. The increase in sales of
institutional fee-based products and
32
services is primarily attributable to deposits in third-party accounts by new
customers of ARM Capital Advisors.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $319.8 million (including $62.8 million from SBM Life) in
1995, compared to $221.8 million in 1994. This resulted in an increase in
surrender charge income to $3.3 million in 1995 from $2.4 million in 1994. The
surrender and withdrawal activity during 1994 and 1995 was expected by the
Company due to the level of customer deposits written several years ago that
were subject to declining or expiring surrender charges during 1994 and 1995,
and the Company's strategy of maintaining investment spreads. During the third
quarter of 1994 and continuing to-date, the Company began implementing programs
designed to reduce surrender activity and improve persistency. During 1995,
through one such program, $42.0 million of new annuity contracts were issued to
previous customers that had initiated a withdrawal request.
Commissions, net of deferrals were $1.6 million for the year ended December
31, 1995 consisting primarily of renewal commissions of approximately $1.3
million on fixed annuities of approximately $1.3 million acquired in connection
with the acquisition of SBM Life. Commissions, net of deferrals for the
corresponding period in 1994 were $2.6 million which included $2.5 million of
commissions on variable life insurance contracts. The majority of the variable
life block of business was sold in December 1994.
Operating expenses increased to $23.0 million in 1995 from $21.5 million in
1994. The increase was primarily attributable to additional expenses incurred in
connection with the operations of ARM Capital Advisors and the acquired SBM
businesses, offset by lower investment expenses incurred as a result of ARM
Capital Advisors managing the investment portfolios of the Company's
subsidiaries in 1995, a service that was provided by KBIMA in 1994.
Amortization of value of insurance in force related to operations increased
to $7.1 million in 1995 from $3.8 million in 1994 reflecting amortization of the
value of insurance in force established as an asset by the Company on May 31,
1995 in connection with the acquisition of SBM's insurance subsidiary.
Amortization of deferred policy acquisition costs related to operations was
$2.9 million and $1.3 million during 1995 and 1994, respectively. The increase
in amortization was related to growth in the deferred policy acquisition cost
asset.
Amortization of acquisition-related deferred charges was $9.9 million in
1995 compared to $2.2 million in 1994. The increase was primarily attributable
to the accelerated amortization of $4.3 million of certain costs and charges
deferred during 1993 and 1994. During the third quarter of 1995, Company
management determined that changes in facts and circumstances had resulted in a
change in their original estimate of the periods benefited by these costs and
charges. As a result of this change in estimate, the remaining unamortized June
30, 1995 balances of these deferred costs and charges were fully amortized as of
September 30, 1995.
Other expenses, net was $0.7 million for the year ended December 31, 1995
compared to other income, net of $5.0 million for the year ended December 31,
1994. The 1994 results include the benefits of favorable mortality experience
and a gain from the sale of the Company's variable life business.
Realized investment gains were $4.0 million in 1995, compared to realized
investment losses of $36.7 million in 1994. Such realized investment gains and
losses were primarily interest-rate-related and attributable to the ongoing
management of the Company's fixed maturity securities classified as available-
for-sale. The 1994 realized investment losses were a result of the market
interest rate environment at November 26, 1993 when the acquisition of the
Integrity Companies occurred. This acquisition was accounted for under the
purchase method which required that the Integrity Companies' investment
portfolio be marked-to-market on November 26, 1993, at which time the yield on
ten-year U.S. Treasury Notes was 5.74%. The yield on such notes increased
steadily during 1994 and at year-end was 7.83%. As a result of the acquisition
and mark-to-market occurring in a low interest rate environment and ongoing
33
portfolio management during the rising interest-rate environment of 1994,
realized investment losses of $36.7 million were generated.
Federal income tax expense during 1995 was $7.0 million compared to a
federal income tax benefit during 1994 of $6.0 million. This change was
attributable to income before federal income taxes of $18.9 million in 1995
compared to a loss before federal income taxes of $22.8 million in 1994.
YEARS ENDED DECEMBER 31, 1994 AND DECEMBER 31, 1993
Net loss for 1994 decreased to $16.8 million from a net loss of $40.8
million for 1993. The net loss for 1994 was primarily attributable to
interest-rate related realized investment losses as a result of ongoing
management of the Company's investment portfolios. The significant net loss in
1993 was primarily a result of writedowns due to other-than-temporary
impairments in the value of certain investments in real estate and joint
ventures. In accordance with the terms of the acquisition of the Integrity
Companies, these assets were replaced with cash by the seller, National Mutual.
Net investment spread decreased to $32.7 million in 1994 from $34.5 million
in 1993. These amounts reflect the net investment spread of 1.42% and 1.45% in
1994 and 1993, respectively, between the Company's investment yield on average
cash and investments and the average rate credited on customer deposits. The
Company's investment income decreased to $149.1 million in 1994 from $164.4
million in 1993. These amounts represent investment yields of 7.30% and 7.87% on
average cash and investments in 1994 and 1993, respectively. This decrease was
primarily attributable to (i) generally lower reinvestment rates available in
December 1993 when the Company completed a significant restructuring of its
insurance subsidiaries' investment portfolios, (ii) amortization resulting from
purchase accounting adjustments and
(iii) the Company's emphasis on higher quality investments with relatively lower
levels of credit risk than the Historical Integrity Companies' investment
portfolios. The impact of the lower reinvestment rates available in December
1993 was partially offset during the course of 1994 as a result of the Company's
ongoing management of its investment portfolios during 1994's rising interest
rate environment.
Although credited rates on new customer deposits were increased in 1994,
they remained modestly below rates in 1993. Interest credited on customer
deposits decreased to $116.5 million in 1994 from $129.9 million in 1993. These
amounts represent average rates of interest credited on customer deposits of
5.88% and 6.42% in 1994 and 1993, respectively, which resulted in the overall
decrease in interest credited on customer deposits.
Fee income increased to $8.4 million during 1994, as compared with $2.7
million during 1993. The increase was primarily attributable to a $3.2 million
increase in variable annuity fees resulting from fee-based variable annuity
sales of $230.2 million in 1994.
Sales by market and type of business during 1994 and 1993 were as follows:
YEAR ENDED
DECEMBER 31,
--------------------
1994 1993
--------- ---------
(DOLLARS IN
MILLIONS)
Retail:
Spread-based........................................................... $ 131.1 $ 144.6
Fee-based.............................................................. 231.1 188.1
--------- ---------
Total retail....................................................... 362.2 332.7
Institutional:
Fee-based.............................................................. 59.3 --
--------- ---------
Total sales................................................................ $ 421.5 $ 332.7
--------- ---------
--------- ---------
34
Sales, including off-balance sheet marketing partnership business, amounted
to $421.5 million, a 26.7% increase from 1993, and consisted primarily of sales
of variable annuity contracts and the guaranteed rate options available under
these contracts which were introduced in June 1994. Deposits into these options
are classified as spread-based deposits since the Company's insurance
subsidiaries guarantee a rate to the customer and accept the investment risk.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $221.8 million in 1994 compared to $132.3 million in 1993
resulting in an increase in surrender charge income to $2.4 million in 1994 from
$1.8 million in 1993. An increase in surrender and withdrawal activity during
1994 was expected by the Company due to the level of customer deposits written
several years ago that were subject to declining or expiring surrender charges
during 1994.
Operating expenses for 1994 were $21.5 million, a decrease of 33.0% from
$32.1 million in 1993. The decrease was attributable to the Company's cost
reduction efforts which included moving certain operations previously based in
New York City to Louisville, Kentucky and increasing the efficiency of back-
office administration.
Amortization of the value of insurance in force declined to $3.8 million in
1994 from $7.0 million in 1993, reflecting the lower amount of value of
insurance in force established as an asset by the Company in connection with the
acquisition of the Integrity Companies.
Other income, net was $5.0 million during 1994 compared to other expenses,
net of $46,000 during 1993. The 1994 results include the benefits of favorable
mortality experience and a gain from the sale of the Company's variable life
business.
Realized investment losses were $36.7 million in 1994, compared to realized
investment losses of $32.9 million in 1993. The 1994 realized investment losses
were primarily interest-rate related and attributable to the ongoing management
of the Company's fixed maturity securities classified as available-for-sale. The
1993 realized investment losses were primarily due to other-than-temporary
impairments of $39.3 million that were recognized for write-downs in the value
of certain investments in real estate and joint ventures which were replaced by
National Mutual with cash in connection with the acquisition of the Integrity
Companies.
A federal income tax benefit of $6.0 million and a federal income tax
expense of $0.5 million were recorded for 1994 and 1993, respectively, related
to losses before federal income taxes of $22.8 million and $40.7 million. In
1993, a federal income tax benefit was not recorded by the Historical Integrity
Companies on losses of $40.7 million in the pre-acquisition period because of
concerns relating to the ability of the Historical Integrity Companies to
recognize in the future any deferred tax asset related to such benefit.
35
ACQUISITION ACTIVITY
Effective November 26, 1993, the Company acquired N.M. U.S. Limited (the
holding company for National Mutual's U.S. operations) and its wholly owned
subsidiaries, Integrity and National Integrity, from National Mutual, for an
aggregate purchase price of $121.0 million. Immediately following the
acquisition, N.M. U.S. Limited changed its name to Integrity Holdings. The
Company financed the acquisition by issuing new common equity and its Perpetual
Preferred Stock for proceeds of approximately $70.0 million and $50.0 million,
respectively, and through $40.0 million of bank financing obtained under the
Credit Agreement.
On January 5, 1995, the Company completed the acquisition of substantially
all the assets and business of the U.S. fixed income unit of KBIMA, which had
provided investment management services to the Company commencing in late 1993.
The business acquired became part of the then newly-formed ARM Capital Advisors.
Pursuant to the purchase agreement, the Company paid to KBIMA $225,000 and will
pay KBIMA a commission through December 31, 1997 based on revenues received
under certain investment management and investment advisory contracts assigned
to ARM Capital Advisors by KBIMA. With the KBIMA transaction, the Company not
only brought the management of its own investment portfolio in-house but also
added a third-party asset management business that has since expanded
significantly, increasing the Company's fee income and adding a relatively
interest-insensitive source of revenue. Funds managed under such contracts have
increased from $0.8 billion as of January 5, 1995 to $1.2 billion as of December
31, 1995 and $2.0 billion as of June 30, 1996 due primarily to deposits under
new contracts executed since the acquisition and increased market values. This
acquisition enhanced the Company's fee-based business and provided a platform
for additional growth in the investment advisory sector, including services to
institutional clients in the pension, 401(k), insurance company and mutual fund
markets. ARM Capital Advisors specializes in the asset management field using
duration and yield curve analysis, sector allocation and security selection
techniques. ARM Capital Advisors primarily manages the assets of institutional
retirement and savings plans, in addition to assets supporting spread-based
products issued by the Company's insurance subsidiaries.
Effective May 31, 1995, the Company completed the acquisition of
substantially all of the assets and business operations of SBM, including all of
the issued and outstanding capital stock of SBM's subsidiaries, SBM Life and ARM
Financial Services (previously known as SBM Financial Services, Inc.), as well
as SBM's management contracts with the State Bond group of mutual funds. The
aggregate purchase price for the SBM acquisition was $38.8 million. The Company
financed the acquisition by issuing a total of 9,770 shares of the Company's
Common Stock to the MSCP Funds, and to New ARM, LLC (a limited liability company
owning 170 shares of Common Stock) and certain directors of the Company for an
aggregate sale price of $63.5 million. The Company used proceeds from the
issuance of the new common equity in excess of the adjusted purchase price for
the acquisition to (i) make a $19.9 million capital contribution to SBM Life;
(ii) acquire SBM Certificate Company from SBM Life for $3.3 million; and (iii)
along with approximately $1.0 million of additional cash from the Company,
provide for fees and expenses related to the acquisition of approximately $2.5
million. The capital contribution to SBM Life of $19.9 million was used to
strengthen SBM Life's financial position and allowed for a significant
investment portfolio restructuring immediately following the acquisition with no
net adverse effect on statutory adjusted capital and surplus. On December 31,
1995, SBM Life was merged with and into Integrity to create certain operating
efficiencies. The SBM acquisition provided the Company with expanded
distribution channels, as well as a new product base in the 403(b) tax-deferred
annuity marketplace.
The Company continues to pursue acquisitions of companies and blocks of
business, marketing partnerships and reinsurance opportunities with other
insurance companies, with the goal of realizing additional economies of scale
and enhanced profitability.
36
ASSET PORTFOLIO REVIEW
The Company primarily invests in securities with fixed maturities with the
objective of providing reasonable returns while limiting credit and liquidity
risks. At amortized cost, fixed maturities at June 30, 1996 totaled $2.9
billion, compared with $2.5 billion at December 31, 1995, representing
approximately 92% and 90%, respectively, of total cash and investments. The
increase primarily resulted from the investment of the proceeds from sales of
GIC products.
The Company's cash and investments as of June 30, 1996 are detailed as
follows:
AMORTIZED COST
----------------------
PERCENT ESTIMATED
AMOUNT OF TOTAL FAIR VALUE
--------- ----------- -----------
(DOLLARS IN MILLIONS)
Fixed maturities:
Corporate securities........................................................... $ 1,057.5 34% $ 1,030.2
U.S. Treasury securities and obligations of U.S. government agencies........... 130.7 4 129.6
Other government securities.................................................... 109.1 3 113.7
Asset-backed securities........................................................ 249.6 8 246.9
MBSs:
Agency pass-throughs......................................................... 109.0 3 109.1
CMOs:
Agency..................................................................... 455.0 15 447.9
Non-agency................................................................. 726.3 24 716.5
Interest only and residual................................................... 16.9 1 19.0
--------- --- -----------
Total fixed maturities........................................................... 2,854.1 92 2,812.9
Equity securities (i.e., non-redeemable preferred stock)......................... 16.3 1 16.3
Mortgage loans on real estate.................................................... 41.6 1 41.6
Policy loans..................................................................... 120.3 4 120.3
Cash and cash equivalents........................................................ 57.5 2 57.5
--------- --- -----------
Total cash and investments....................................................... $ 3,089.8 100% $ 3,048.6
--------- --- -----------
--------- --- -----------
Agency pass-through certificates are MBSs which represent an undivided
interest in a specific pool of residential mortgages. The payment of principal
and interest is guaranteed by the U.S. government or U.S. government agencies.
CMOs are pools of mortgages that are segregated into sections, or tranches,
which provide prioritized retirement of bonds rather than a PRO RATA share of
principal return in the pass-through structure. The underlying mortgages of
agency CMOs are guaranteed by the U.S. government or U.S. government agencies.
MBSs are subject to risks associated with prepayments of the underlying
mortgage loans. Prepayments cause these securities to have actual maturities
different from those expected at the time of purchase. Securities that have an
amortized cost that is greater than par (i.e., purchased at a premium) that are
backed by mortgages that prepay faster than expected will incur a reduction in
yield or a loss, versus an increase in yield or a gain if the mortgages prepay
slower than expected. Those securities that have an amortized cost that is less
than par (i.e., purchased at a discount) that are backed by mortgages that
prepay faster than expected will generate an increase in yield or a gain, versus
a decrease in yield or a loss if the mortgages prepay slower than expected. The
reduction or increase in yields may be partially offset as funds from prepayment
are reinvested at current interest rates. The degree to which a security is
susceptible to either gains or losses is influenced by the difference between
its amortized cost and par, the relative sensitivity of the underlying mortgages
backing the assets to prepayments in a changing interest rate environment and
the repayment priority of the securities in the overall securitization
structure. The
37
Company has limited its exposure during periods of accelerated prepayments, as
the gross unamortized premiums and unaccrued discounts of MBSs was $27.1 million
and $49.2 million, respectively, at June 30, 1996. Although the interest rate
environment has experienced significant volatility during 1995 and the first
half of 1996, prepayments and extensions of cash flows from MBSs have not
materially affected investment income of the Company.
The Company also manages prepayment exposure on CMO holdings by diversifying
not only within the more stable CMO tranches, but across alternative collateral
classes such as commercial mortgages and Federal Housing Administration project
loans, which are generally less volatile than agency-backed, residential
mortgages. Additionally, prepayment sensitivity is evaluated and maintained
giving full consideration to the collateral characteristics such as weighted
average coupon rate, weighted average maturity and the prepayment history of the
specific loan pool.
Total cash and investments were 93% investment grade or equivalent as of
June 30, 1996 and December 31, 1995. Investment grade securities are those
classified as 1 or 2 by the NAIC or, where such classifications are not
available, having a rating on the scale used by Standard & Poor's Corporation
("S&P") of BBB- or above. Yields available on non-investment grade securities
are generally higher than are available on investment grade securities. However,
credit risk is greater with respect to such non-investment grade securities. The
Company attempts to reduce the risks associated with non-investment grade
securities by limiting the exposure to any one issuer and by closely monitoring
the creditworthiness of such issuers. Additionally, the Company's investment
portfolio has minimal exposure to real estate, non-indemnified mortgage loans
and common equity securities, which represent less than 0.1% of cash and
investments as of June 30, 1996. As of June 30, 1996, the book value of
securities in the Company's investment portfolios which had defaulted on
principal or interest payments was $0.7 million. However, in July 1996 the
Company sold such securities at cost.
At June 30, 1996 the ratings assigned by the NAIC and comparable S&P ratings
on the Company's fixed maturity portfolio, and the percentage of total fixed
maturity investments classified in each category were as follows:
AMORTIZED COST
----------------------
PERCENT ESTIMATED
NAIC DESIGNATION (COMPARABLE S&P RATING) AMOUNT OF TOTAL FAIR VALUE
- --------------------------------------------------------------------------------- --------- ----------- -----------
(DOLLARS IN MILLIONS)
1 (AAA, AA, A)................................................................... $ 1,908.4 67% $ 1,886.1
2 (BBB).......................................................................... 719.5 25 707.2
3 (BB)........................................................................... 146.5 5 143.1
4 (B)............................................................................ 79.0 3 75.8
5 (CCC, CC, C)................................................................... -- -- --
6 (CI, D)........................................................................ 0.7 -- 0.7
--------- --- -----------
Total fixed maturities........................................................... $ 2,854.1 100% $ 2,812.9
--------- --- -----------
--------- --- -----------
As of January 1, 1994, the Company, adopted SFAS No. 115, "Accounting for
Certain Investments in Debt and Equity Securities." The Company classifies its
entire fixed maturities portfolio as available-for-sale. Fixed maturities
classified as available-for-sale are carried at fair value and changes in fair
value, net of related value of insurance in force and deferred policy
acquisition cost amortization and deferred income taxes, are charged or credited
directly to shareholders' equity.
The general decline in interest rates during 1995 and subsequent rise in
interest rates during the first half of 1996 resulted in unrealized losses on
available-for-sale securities which totaled $21.7 million (net of $7.9 million
of related amortization of deferred policy acquisition costs and value of
insurance in force and $11.6 million of deferred income taxes) at June 30, 1996,
compared to unrealized gains of $28.5 million (net of $14.2 million of related
amortization of deferred policy acquisition costs and value of insurance in
38
force and $15.4 million of deferred income taxes) at December 31, 1995. This
change in net unrealized gains and losses on available-for-sale securities for
the six months ended June 30, 1996 decreased reported shareholders' equity by
$50.2 million as compared to an increase of $133.5 million for the year ended
December 31, 1995. This volatility in reported shareholders' equity occurs as a
result of SFAS No. 115, which requires some assets to be carried at fair value
while all liabilities and other assets are carried at historical values. At June
30, 1996 and December 31, 1995, shareholders' equity excluding the effects of
SFAS No. 115 was $167.6 million and $159.5 million, respectively.
The Company manages assets and liabilities in a closely integrated manner,
with the aim of reducing the volatility of investment spreads during a changing
interest rate environment. As a result, adjusting shareholders' equity for
changes in the fair value of the Company's fixed maturities and equity
securities without reflecting offsetting changes in the value of the Company's
liabilities or other assets creates volatility in reported shareholders' equity
but does not always reflect the underlying economics of the Company's business.
The Company's accompanying consolidated financial statements include fair value
balance sheets which demonstrate that the general rise in interest rates during
the first half of 1996 did not have a material effect on the financial position
of the Company when all assets and liabilities are adjusted to fair values.
Mortgage loans on real estate represented 1% and 2% of total cash and
investments at June 30, 1996 and December 31, 1995, respectively. Pursuant to
the terms of the acquisition of certain of the Company's insurance operations,
National Mutual has indemnified the Company with respect to principal (up to
100% of the investments' year-end 1992 statutory book value) and interest with
respect to approximately 99% of these loans at June 30, 1996. In support of its
indemnification obligations, National Mutual placed $23.0 million into escrow in
favor of the Company's insurance subsidiaries, which will remain available until
the subject commercial and agricultural loans have been paid in full.
Assets held in separate accounts at June 30, 1996 totaled $955.0 million,
compared to $809.9 million at December 31, 1995. The $145.1 million increase
primarily resulted from the receipt of variable annuity deposits and from a
market-driven increase in the value of existing variable annuity deposits
invested in investment portfolios.
LIQUIDITY AND FINANCIAL RESOURCES
HOLDING COMPANY OPERATIONS
The Company's principal need for liquidity has historically consisted of
debt service obligations under its bank financing agreement, dividend payments
on its preferred stock and operating expenses not absorbed by management fees
charged to its subsidiaries. See "Description of Certain Indebtedness" for a
description of the terms of the Credit Agreement and "Description of Capital
Stock -- Preferred Stock -- Perpetual Preferred Stock" for a description of the
terms of the Perpetual Preferred Stock. The Company is dependent on dividends or
other distributions from its insurance subsidiaries and fee income generated by
ARM Capital Advisors, its asset management subsidiary, and other non-insurance
operations to meet ongoing cash needs, including amounts required to pay
dividends on its preferred stock.
The ability of the Company's insurance subsidiaries to pay dividends and
enter into agreements with affiliates is limited by state insurance laws. See
"Business -- Regulation -- Insurance Regulation -- Dividend Restrictions."
During the first half of 1996, the Company received dividends of $11.0 million
from Integrity. As of June 30, 1996, the amount that the Company's insurance
subsidiaries could transfer in the form of dividends to the Company in 1996 was
limited to $6.6 million. The Company had cash and unaffiliated investments at
the holding company level of $6.4 million at June 30, 1996. In addition, $20.0
million was available on unused bank lines of credit at June 30, 1996.
39
INSURANCE SUBSIDIARIES OPERATIONS
The sources of liquidity of the Company's insurance subsidiaries are
investment income and proceeds from maturities and redemptions of investments.
The principal uses of such funds are benefits, withdrawals and loans associated
with the various customer deposits, commissions, operating expenses and the
purchase of new investments.
The Company develops cash flow projections under a variety of interest rate
scenarios generated by the Company. The Company attempts to structure asset
portfolios so that the interest and principal payments, along with other fee
income, will be more than sufficient to cover the cash outflows for benefits,
withdrawals and expenses under the expected scenarios developed by the Company.
In addition, the Company maintains other liquid assets and aims to meet
unexpected cash requirements (with the projected cash inflows and liquid assets
being approximately double the expected cash outflows) without exposure to
material realized losses during a higher interest rate environment. These other
liquid assets include cash and cash equivalents and high-grade floating-rate
securities held by both the Company and its insurance subsidiaries. The Company
also has $20 million available on unused bank lines of credit.
During the six months ended June 30, 1996 and 1995, the Company met its
liquidity needs entirely by cash flows from operating activities and principal
payments and redemptions of investments. At June 30, 1996, cash and cash
equivalents totaled $57.5 million compared to $76.9 million at December 31,
1995. The Company's aim is to manage its cash and cash equivalents position so
as to satisfy short-term liquidity needs. In connection with this management of
cash and cash equivalents, the Company may invest idle cash in short-duration
fixed maturities to capture additional yield when short-term liquidity
requirements permit.
The Company generated cash flows of $88.6 million and $55.5 million from
operating activities during the six months ended June 30, 1996 and 1995,
respectively. These cash flows resulted principally from investment income, less
commissions and operating expenses. Proceeds from sales, maturities and
redemptions of investments generated $1,193.3 million and $686.0 million in cash
flows during the six months ended June 30, 1996 and 1995, respectively, which
were offset by purchases of investments of $1,559.3 million and $709.9 million,
respectively. An increase in investment purchases and sales activity during the
first half of 1996 compared to 1995 reflects the Company's ongoing management of
its fixed maturity portfolio which has increased in size due to the acquisition
of the SBM businesses.
INCOME TAXES
At June 30, 1996, the Company reported an asset for deferred federal income
taxes of $46.8 million on the carrying amount balance sheet. Such amount
reflects deferred tax assets of $72.9 million, net of valuation allowance of
$35.2 million, in excess of deferred tax liabilities of $26.1 million. The net
deferred tax assets represent deductible temporary differences and net operating
loss carryforwards. Based on historical operating results and projections of
future taxable ordinary income, management believes that the net tax benefit
recorded will be fully utilized.
DERIVATIVES
The Company has only limited involvement with derivative financial
instruments and does not use them for trading purposes. They are used to manage
well-defined interest rate risks. An interest rate cap agreement is used to
reduce the potential impact of increases in interest rates on the Company's
$40.0 million floating-rate long-term debt. The Company purchased an interest
rate cap agreement with a five-year term during 1994 for $1.1 million which
effectively limited interest payable, net of proceeds from the agreement, on
long-term debt outstanding to approximately 6% during the first six months of
1996.
Interest rate collar agreements are used to reduce the potential impact of
increases in interest rates on amounts credited on customer deposits. The
Company purchased two interest rate collar agreements at an
40
aggregate cost of $940,000 during 1994, each with a term of three years. If the
five-year U.S. Treasury rate increases to between 8.0% and 9.5% during the term
of the agreements, amounts receivable under these agreements will be used to
offset higher rates credited to customers on $100 million of single premium
deferred annuities and single premium endowment customer deposits.
The costs of the cap and collars are amortized over the terms of the
agreements and represent the Company's total exposure to loss under the
agreements.
EFFECTS OF INFLATION AND INTEREST RATE CHANGES
The Company believes that inflation will not have a material adverse effect
on results of operations. The Company manages its investment portfolios in part
to reduce its exposure to interest rate fluctuations. In general, the fair value
of the Company's fixed maturities portfolio increases or decreases inversely
with fluctuations in interest rates, and the Company's investment income
increases or decreases directly with interest rate changes. For example, if
interest rates decline, the Company's fixed maturity investments generally will
increase in fair value, while investment income will decrease as fixed income
investments are sold or mature and proceeds are reinvested at declining rates.
The converse will be true if interest rates rise.
41
BUSINESS
GENERAL
The Company specializes in the asset accumulation business, providing retail
and institutional customers with products designed to serve the growing
retirement and long-term savings markets as well as providing other asset
management services. The Company's earnings are derived from investment spread
(the difference between income earned on investments and interest credited on
customer deposits) and fee income. The Company's retail products include a wide
variety of fixed and variable annuities and face-amount certificates sold
primarily through a broad spectrum of distribution channels including financial
planners, independent insurance agents (including those specializing in the
403(b) marketplace for teachers), stockbrokers and banks. The Company offers
asset management services and GICs to its institutional clients, which include
defined benefit pension plans, defined contribution or 401(k) pension plans and
insurance companies. The Company markets its institutional products and services
directly to bank trust departments, plan sponsors, cash management funds, other
institutional funds and insurance companies as well as through industry
consultants.
The Company was established in July 1993 and completed its first acquisition
in November 1993, resulting in $2.3 billion of assets under management. Assets
under management have grown to $6.6 billion as of June 30, 1996. The Company
attributes this growth to internally generated sales, new product offerings
which are developed to meet the needs of its markets and opportunistic
acquisitions. Annual operating earnings (net income applicable to common
shareholders excluding the net effect of realized investment gains and losses)
have grown from $2.4 million in 1994 to $4.5 million in 1995 and operating
earnings for the six months ended June 30, 1996 were $8.9 million.
The Company believes that demographic trends favor strong consumer demand
for long-term savings and retirement products. According to U.S. Census Bureau
projections, the number of individuals between the ages of 45 to 64,
historically the primary holders of annuities, will grow from 55.7 million in
1996 to 71.1 million in 2005. Between 1990 and 1995, annual industry sales of
annuities increased from $65.1 billion to $99.1 billion.
The Company's strategy is focused on the following:
DEVELOP AND MARKET A BROAD ARRAY OF CUSTOMIZED PRODUCTS AND SERVICES. The
Company offers a diversified array of products and services and routinely seeks
to adapt those products and services to changes in the retail and institutional
marketplace. To minimize its dependence on any one product or distribution
channel and to capitalize on market developments, the Company's products, which
meet the needs of a variety of customers, are sold through a broad spectrum of
distribution channels. The Company's current range of products includes, for the
retail markets, fixed and variable annuities and face-amount certificates. For
the institutional markets, the Company's current range of products and services
includes GICs, defined benefit and 401(k) pension plan investment management
services and money management services for insurance companies and other
institutions. The Company's efforts are focused on developing new products to
fill the needs of less well served distribution channels, including financial
planners, independent insurance agents (including those specializing in the
403(b) marketplace for teachers), bank trust departments and regional banks. To
this end the Company works closely with its distributors to develop products and
services that are customized to suit their customers' particular needs. For
example, the Company was one of the first to recognize the market opportunity
for equity-indexed annuities and recently began offering a stand-alone
equity-indexed annuity, OMNI, that meets consumer demand for equity investments
with downside protection. The OMNI product appeals to both risk averse equity
investors and fixed income investors by allowing such investors to allocate
their funds to earn returns tied to the S&P 500 Price Index with a return of
principal guaranteed by the issuing insurance company, and/or to earn a rate of
return guaranteed by the issuing insurance company. In the institutional market,
the Company offers a short-term floating rate GIC designed to meet the market
demand for products with attractive current yields and access to liquidity.
42
STRENGTHEN FINANCIAL CONDITION TO SUPPORT GROWTH. Since the Company
commenced operations in 1993, it has focused on building and maintaining a
strong capital base. Shareholders' equity, excluding the net effects of
unrealized gains and losses, has increased from $112.4 million at December 31,
1993 to $167.6 million at June 30, 1996. As of June 30, 1996, 93% of the
Company's total cash and investments of $3.0 billion were investment grade
securities. After giving effect to the Offering and application of the proceeds
as set forth under "Use of Proceeds," as of June 30, 1996, the Company had a pro
forma shareholders' equity of $ million and a pro forma long-term debt
to total capital ratio of %. In 1995, the ratings of the Company's
insurance subsidiaries were increased from "A-(Excellent)" to "A (Excellent)" by
A.M. Best, which rates insurers based upon factors relevant to policyholders.
See "Business--Ratings" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Asset Portfolio Review." The Company
believes that its increase in financial strength as a result of the Offering
will enhance its ability to market and sell its products. The Company intends to
continue to strengthen its capital base to support new business growth.
ACTIVELY MANAGE INVESTMENT SPREAD WITH FIXED INCOME INVESTMENT MANAGEMENT
EXPERTISE. Through its acquisition of the assets and business operations of the
U.S. fixed-income unit of KBIMA, the Company acquired investment personnel
recognized for their fixed income investment management expertise. The KBIMA
investment personnel brought 33 institutional clients to the Company, of which
27 remain clients, and the Company has since added 26 institutional clients
through June 30, 1996. In addition, ARM Capital Advisors manages the Company's
investment portfolio, bringing its total combined assets under management to
$5.9 billion at June 30, 1996. The Company strives to actively manage its
investment portfolio to maximize investment spread by evaluating the various
asset sectors and individual securities comprising the Company's investment
portfolios and, based on market yield rates, repositioning holdings from sectors
perceived to be overvalued to sectors perceived to be undervalued in order to
improve cash flows without materially changing the overall credit, asset
duration and convexity characteristics of its portfolios. In order to manage its
investment spread, the Company uses an integrated functional process designed to
establish and maintain balanced investment and product strategies and which is
supported by an experienced management team and sophisticated computer system.
Total cash and investments in the Company's insurance subsidiaries' portfolio
were 93% investment grade or equivalent as of June 30, 1996, with the Company's
investment portfolio having minimal exposure to real estate, non-indemnified
mortgage loans and common equity securities.
CONTINUE SUCCESSFUL ACQUISITION RECORD. The Company's first acquisition was
of the Integrity Companies in 1993. Since that acquisition, the Company has
completed two additional acquisitions: the business operations of SBM and the
business operations of the U.S. fixed-income unit of KBIMA, both in 1995. These
1995 acquisitions met the Company's objectives of growing and diversifying its
product offerings and distribution channels and achieving further economies of
scale in its operations. For example, since the acquisition of SBM, the Company
increased the investment yields of the SBM portfolio while improving its
associated risk profile through a restructuring of the investment portfolio,
reduced expenses by merging back-office operations into the Company's existing
operations and expanded the Company's distribution channels. With the
acquisition of the business operations of KBIMA, which had provided investment
management services to the Company since late 1993, the Company not only brought
the management of its own investment portfolio in-house but also added assets
managed for institutional clients that have since expanded significantly and
increased the Company's fee income, which is less sensitive to interest rate
changes than income derived from investment spreads. The Company continues to
pursue acquisitions and blocks of business, marketing partnerships and
reinsurance opportunities with other insurance companies, with the goal of
realizing additional economies of scale and enhanced profitability.
MINIMIZE FIXED COST STRUCTURE. The Company attempts to minimize fixed
distribution costs by marketing its products through fiduciaries and other third
parties. Unlike many of its competitors, the Company does not maintain its own
field sales force, and distributors are primarily paid based on
43
production. As a consequence of its low fixed distribution costs the Company has
greater flexibility to shift the mix of its new sales and distribution channels
in order to respond to changes in market demand. In addition, the Company
believes that its administrative cost structure benefitted from the economies of
scale achieved as a result of its strategic acquisitions and its distribution
and administrative personal computer client/server network.
MAINTAIN FOCUS ON COMPANY PROFITABILITY. The Company focuses on
profitability on a firm-wide basis rather than a department-by-department basis.
This focus on profitability is supported by an integrated team approach to
developing products and operating the Company's business. Beginning with product
design and continuing through the product sale and eventual payout,
professionals in each functional area (such as marketing, actuarial,
investments, legal, finance and administration) work jointly with a common set
of risk/return profiles toward the goal of achieving the Company's liquidity and
profit objectives (rather than specific objectives of any particular functional
area). The Company's compensation system and equity investments made by certain
of its employees in the Company further reinforce the Company's focus on the
objective of profitability. Employees at all levels of the Company and certain
former employees receive bonuses based on the Company's profitability, and as of
September 30, 1996, employees (including directors and executive officers of the
Company) owned, directly or indirectly, 9% of the Company's Common Stock.
The Company conducts its different businesses through the following
subsidiaries:
- INTEGRITY--provides retail, fixed and variable annuities (including the
Company's new equity-indexed annuity) and institutional GICs (both
traditional and "synthetic") (acquired from National Mutual in 1993);
- NATIONAL INTEGRITY--provides retail, fixed and variable annuities and
institutional GICs primarily in New York (wholly owned subsidiary of
Integrity acquired from National Mutual in 1993);
- ARM CAPITAL ADVISORS--offers fixed income asset management services to
third party institutional clients (currently consisting primarily of
defined benefit pension plans) and the Company's insurance subsidiaries as
well as offering advisory services to investment companies (operations
acquired from KBIMA in early 1995);
- SBM CERTIFICATE COMPANY--offers Certificates which guarantee a certain
amount (the "face amount") to investors at a future date. Certificates are
similar to bank-issued certificates of deposit (acquired from SBM in
mid-1995);
- ARM FINANCIAL SERVICES--supports the Company's retail annuity operations
and supports the Company's sales of independent third party mutual funds
which are conducted by representatives registered with the NASD; and
- ARM TRANSFER AGENCY--provides transfer agent services as needed to support
the Company's retail business operations.
HISTORY
The Company was organized in July 1993 by MSLEF II, an investment fund
sponsored by MS & Co., and Analytical Risk Management, Ltd. (now known as Oldarm
L.P.) to acquire Integrity Holdings (formerly N.M. U.S. Limited) from National
Mutual. In connection with the acquisition, which occurred on November 26, 1993,
National Mutual replaced all equity securities, investments in real estate and
joint ventures and fixed maturity securities classified as "6" by the NAIC, with
cash in an amount equal to the statutory book value of such assets as of
December 31, 1992 adjusted for any additional cash investments or distributions
during the period from January 1, 1993 to November 26, 1993. In addition,
National Mutual (i) strengthened statutory policyholder reserves and surplus by
$24.3 million, (ii) indemnified the Integrity Companies with respect to the
payment of principal and interest due on $146.6 million of
44
commercial and agricultural mortgage loans (since reduced through repayments to
$41.3 million at June 30, 1996) and supported the indemnification with a $23.0
million escrow arrangement, (iii) provided indemnification as to the
availability of net operating and capital loss carryforwards and various tax
deductions, (iv) provided the Integrity Companies with indemnification as to
future claims for taxes, assessments from guaranty funds and claims from
litigation which arise from pre-closing events, (v) terminated all surplus
relief reinsurance arrangements, (vi) assumed all obligations under the
Integrity Companies' lease for certain office space and (vii) assumed all
obligations for retirement and severance benefits incurred by the Integrity
Companies prior to closing.
In January 1995, the Company completed the acquisition of the U.S. fixed
income unit of KBIMA. In addition to bringing their recognized fixed income
investment management expertise, the KBIMA team brought with them 33
institutional clients, of which 27 remain clients of the Company. Assets managed
by ARM Capital Advisors under contracts acquired from KBIMA and new contracts
with third parties have increased from $0.8 billion as of January 5, 1995 to
$2.0 billion as of June 30, 1996. In addition to providing asset management
services to institutional clients, ARM Capital Advisors manages the investment
portfolios of the Company's subsidiaries.
In June 1995, the Company completed the acquisition of substantially all of
the assets and business operations of SBM, including all of the issued and
outstanding capital stock of SBM's subsidiaries, SBM Life and ARM Financial
Services, and SBM's management contracts with the State Bond group of mutual
funds. By virtue of the acquisition, the Company also acquired SBM Certificate
Company, a wholly owned subsidiary of SBM Life. The Company issued 9,770 shares
of Common Stock, primarily to the MSCP Funds, and used the proceeds from the
issuance of new common equity to acquire the assets and business operations of
SBM and to make a $19.9 million capital contribution to SBM Life. On December
31, 1995, SBM Life was merged with and into Integrity to create certain
operating efficiencies.
PRODUCTS AND SERVICES
The Company offers a diversified array of products and services to meet the
needs of a variety of customers. The Company endeavors to adapt its products to
respond to changes in the retail and institutional marketplace and generally
seeks to have "a product for every market environment". The Company's retail
products include a wide variety of fixed and variable annuities and face-amount
certificates, and the Company offers participation in various investment
portfolios, some of which are offered on an exclusive basis to variable annuity
customers of the Company's insurance subsidiaries. In addition, the Company
offers asset management services and GICs to its institutional clients, which
include defined benefit pension plans, 401(k) plans and insurance companies.
The Company derives its earnings from its spread-based and fee-based
products and services. With spread-based products, the Company's insurance and
face-amount certificate subsidiaries agree to return customer deposits with
interest at a specified rate or based on a specified index. As a result, the
Company's insurance and face-amount certificate subsidiaries accept investment
risk in exchange for the opportunity to achieve a spread between what the
Company earns on invested assets and what it pays or credits on customer
deposits. With fee-based products and services, the Company's subsidiaries
receive a fee in exchange for managing deposits, and the customer accepts the
investment risk. Because the investment risk is borne by the customer, this line
of business requires significantly less capital support than the spread-based
business.
The Company has recently seen significant growth in its fee-based business.
At June 30, 1996, the Company's assets under management were equally balanced
between its spread-based and fee-based business, although the Company's
spread-based business is currently predominant in terms of earnings. Operating
earnings (net income applicable to common shareholders excluding the net effect
of realized investment gains and losses net of taxes) from spread-based products
represented 85.7%, 86.3% and 88.3% of total spread- and fee-based operating
earnings for the six months ended June 30, 1996 and the years
45
ended December 31, 1995 and 1994, respectively, whereas operating earnings from
fee-based products and services represented 14.3%, 13.7% and 11.7% of total
spread- and fee-based operating earnings for the same periods. The fee-based
business provides the Company with a stable source of income, since the revenues
from fee-based operations are relatively insensitive to changes in interest
rates.
The Company delivers its products and services through a variety of legal
entities. Retail fixed and variable annuities and institutional GICs are issued
by the Company's insurance subsidiaries. ARM Capital Advisors provides asset
management services for institutional clients in the pension, 401(k) and
insurance company markets and currently manages certain portfolios of The
Legends Funds, Inc. ("Legends"). ARM Financial Services, a registered
broker-dealer, provides a distribution channel for selling affiliated and
unaffiliated retail products. SBM Certificate Company is an issuer of
face-amount certificates, a retail product similar to certificates of deposit
issued by banks, but regulated by the Investment Company Act and not subject to
Federal Deposit Insurance Corporation ("FDIC") protection.
SPREAD-BASED BUSINESS
The Company seeks to maintain level investment spreads regardless of the
interest rate environment. To this end, management (i) structures investment
asset durations, convexity and liquidity characteristics in conjunction with
customer deposit characteristics, (ii) regularly trades investment assets to
improve yield while not disturbing other characteristics, (iii) offers an array
of products whose credited rates are based on differing points on the yield
curve and (iv) actively manages the trade-off between credited rates and
persistency.
The Company's spread-based products include retail single premium deferred
annuity ("SPDA") contracts, flexible premium deferred annuity ("FPDA")
contracts, single premium endowment ("SPE") contracts, guaranteed rate options
("GROs") of variable annuity contracts and certain FPDA contracts, single
premium immediate annuity ("SPIA") contracts, face-amount certificates and
institutional GICs as described below. Sales for spread-based business include
premiums and deposits received under these products. Spread-based sales for the
six months ended June 30, 1996 and for the years ended December 31, 1995 and
1994 were as follows:
SIX MONTHS YEAR ENDED
ENDED JUNE 30, DECEMBER 31,
--------------
1996 1995 1994
-------------- ------ ------
(DOLLARS IN MILLIONS)
Retail:
SPDA...................................................... $ 4.5 $ 44.3(1) $ 50.5
FPDA...................................................... 16.7 12.5(2) --
SPIA...................................................... 0.4 0.3 6.5
GRO....................................................... 6.0 47.1 73.4
Face-amount certificates.................................. 3.6 10.7(2) --
Other..................................................... -- 0.5 0.7
------ ------ ------
31.2 115.4 131.1
Institutional:
GIC....................................................... 441.3 142.2 --
------ ------ ------
Total spread-based sales.................................... $472.5 $257.6 $131.1
------ ------ ------
------ ------ ------
- ------------------------
(1) SPDA sales include $6.2 million which were attributable to the sale of SBM
products following the acquisition.
(2) Attributable to the sale of SBM products following the acquisition.
46
Spread-based assets under management at June 30, 1996 and at December 31,
1995, 1994 and 1993 were as follows:
DECEMBER 31,
-----------------------------------------------------
JUNE 30,
1996 1995 1994 1993
-------------------- -------------------- -------------------- ---------
PERCENT PERCENT PERCENT
AMOUNT OF TOTAL AMOUNT OF TOTAL AMOUNT OF TOTAL AMOUNT
--------- --------- --------- --------- --------- --------- ---------
(DOLLARS IN MILLIONS)
Retail:
SPDA............................................. $ 897.6 27.9% $ 969.8(*) 33.9% $ 804.7 40.4% $ 901.6
FPDA............................................. 428.4 13.3 436.2(*) 15.2 -- -- --
SPE.............................................. 397.0 12.3 403.3 14.1 409.3 20.6 422.2
SPIA............................................. 648.2 20.1 644.8 22.6 639.0 32.1 625.3
GRO.............................................. 166.4 5.2 164.5 5.8 92.6 4.7 5.3......
Face-amount certificates......................... 51.4 1.6 52.5(*) 1.8 -- -- --
Other............................................ 45.8 1.4 45.1 1.6 44.4 2.2 49.4
--------- --------- --------- --------- --------- --------- ---------
Total retail................................... $ 2,634.8 81.8% $ 2,716.2 95.0% $ 1,990.0 100.0% $ 2,003.8
Institutional:
GIC.............................................. 586.0 18.2 143.2 5.0 -- -- --
--------- --------- --------- --------- --------- --------- ---------
Total spread-based assets under management......... $ 3,220.8 100.0% $ 2,859.4 100.0% $ 1,990.0 100.0% $ 2,003.8
--------- --------- --------- --------- --------- --------- ---------
--------- --------- --------- --------- --------- --------- ---------
PERCENT
OF TOTAL
---------
Retail:
SPDA............................................. 45.0%
FPDA............................................. --
SPE.............................................. 21.1
SPIA............................................. 31.2
GRO.............................................. .3
Face-amount certificates......................... --
Other............................................ 2.4
---------
Total retail................................... 100.0%
Institutional:
GIC.............................................. --
---------
Total spread-based assets under management......... 100.0%
---------
---------
- ------------------------
(*) Includes amounts acquired in 1995 in connection with the SBM acquisition of
$297.7 million (SPDA), $436.2 million (FPDA) and $52.5 million (face-amount
certificates).
SINGLE PREMIUM DEFERRED ANNUITY CONTRACTS. Single premium deferred annuity
contracts are sold through investment brokerage firms, banks, financial
planners, and independent insurance general agents. Under these contracts, the
Company guarantees the customer's principal and credits the accumulated deposit
with a rate of interest that is guaranteed for a specified initial period and
reset annually or semi-annually thereafter, subject to guaranteed minimum
crediting rates set forth in the contracts (currently 3% or 4%). The Company
generally determines the crediting rate by reference to current yields along the
intermediate term section of the yield curve. No front-end sales charges are
imposed for purchases of such contracts, but all such contracts contain
surrender charges for withdrawals in excess of a specified amount during the
surrender charge period. These surrender charges vary depending upon the
guarantee periods in the contracts.
FLEXIBLE PREMIUM DEFERRED ANNUITY CONTRACTS. Flexible premium deferred
annuity contracts are marketed primarily through independent agents. Under these
contracts, principal is guaranteed by the issuing insurance company, and the
contracts are credited with a specified rate of interest that is guaranteed for
a period of time and reset annually thereafter. The Company generally determines
the crediting rate by reference to current yields along the intermediate term
section of the yield curve. Certain FPDA contracts, which were acquired as a
result of the SBM acquisition, are qualified under section 403(b) of the
Internal Revenue Code of 1986, as amended. These contracts are marketed to
qualified employers such as public school districts and churches. The Company
developed a new FPDA product, OMNI, in 1995, with sales commencing in February
1996. This new product furnishes customers with the ability to allocate assets
among equity index-based returns and guaranteed rates of return. The index-based
options offer the upside potential tied to a percentage of the appreciation in
the S&P 500 Price Index, but protect the customer against the related downside
risk through a guarantee of principal by the issuing insurance company. By
hedging the equity-based risk component of the product through the purchase of
call options, the Company is able to concentrate on managing the interest rate
spread component. OMNI has also allowed the Company to expand distribution of
FPDAs through stockbroker and bank distribution channels.
SINGLE PREMIUM ENDOWMENT CONTRACTS. Single premium endowment contracts once
represented a more material portion of the Company's insurance subsidiaries'
business in force, but, as a result of changes in applicable tax laws, are no
longer being sold. Under these contracts, principal is guaranteed, and the face
amount of the policy is paid upon the death of the insured. The contracts are
credited with a specified rate of interest that is guaranteed for a period of
time and that is reset annually thereafter,
47
subject to guaranteed minimums and certain other restrictions. The Company
generally determines the crediting rate by reference to current yields along the
intermediate term section of the yield curve. Due to changes in applicable tax
laws, and the consequential loss of tax benefits associated with SPEs in the
event of a withdrawal, and because the interest rate on SPEs is reset annually
based on the intermediate part of the yield curve, the Company believes that the
level of surrenders of SPEs associated with increases in interest rates will be
lower than would otherwise be the case.
SINGLE PREMIUM IMMEDIATE ANNUITY CONTRACTS. Single premium immediate
annuity contracts [were] [are] historically marketed by the Company to insurance
companies and defendants in connection with lawsuits involving structured
liability settlements. As a result of changes in the marketing environment for
this product and the increased competition in pricing, the Company's insurance
subsidiaries are not currently focusing on this segment of the immediate annuity
marketplace. SPIA contracts are not subject to surrender and rate resetting and
offer a fixed interest rate that is locked in over the term of the contract and
that the Company determines by reference to the long-term end of the yield
curve.
GUARANTEED RATE OPTIONS. Guaranteed rate options provide a fixed-rate
investment alternative for holders of the Company's variable annuity contracts
and are also issued as a separate product by the Company's insurance
subsidiaries. GROs, which were first introduced by the Company's insurance
subsidiaries in 1994, allow customers to lock in a fixed return for two, four,
six or ten years. There are no up-front or annual fees attached to these
options, but surrender charges apply to withdrawals in excess of a stated
maximum. Funds may be transferred to or from any of the guarantee periods (or
other investment options within the variable annuity contract) subject to a
market value adjustment ("MVA"). The MVA can be either positive or negative, but
the customer is guaranteed principal by the issuing insurance company plus a
return of 3%, before surrender charges. Transfers at the end of a guarantee
period are not subject to the MVA provision. The MVA provision tends to
virtually eliminate the gain or loss attributable to the impact of changes in
interest rates on the market value of assets that would be sold to fund
surrenders occurring prior to the end of the interest guarantee period. The
Company uses an immunized investment strategy which tends to provide a
consistent spread over the selected time horizon despite interest rate
volatility. Deposits into GROs are held in a separate account established by the
insurance company.
FACE-AMOUNT CERTIFICATES. Face-amount certificates are obligations of SBM
Certificate Company which require it to pay holders the original invested amount
of the certificate, plus a three-year fixed-rate return, at a given maturity
date. The Company selects the interest rate offered on the face-amount
certificates based on the short to intermediate term sections of the yield
curve. Face-amount certificates, which are similar to bank certificates of
deposit, generally compete with various types of individual savings products
offered by banks and insurance companies that provide a fixed rate of return on
investors' money. Face-amount certificates are regulated under the Investment
Company Act and, unlike bank certificates of deposit of less than $100,000, are
not guaranteed by the FDIC. The Company continues to investigate opportunities
to expand upon its face-amount certificate retail distribution channels.
GUARANTEED INVESTMENT CONTRACTS. Guaranteed investment contracts are issued
to institutional customers by the Company primarily through a joint venture with
General American, which originally dates to March 1993. Customers buy General
American product contracts which have been designed by the Company to meet their
specific needs. General American cedes 50% of the deposits to Integrity under a
coinsurance agreement entered into in September 1995. The interest rate on GICs
is typically based upon a short-term floating rate, such as LIBOR, which
periodically resets to provide current yields. GIC products offered by the
Company are designed and have historically been held by customers as long-term
core investments, even though under many contracts customers have the option to
liquidate their holdings with written notice of thirty days or less. The Company
has experienced withdrawals of annuity benefits by GIC customers of
approximately 3.1% and 2.5% on average GIC deposits for the year ended December
31, 1995 and for the six months ended June 30, 1996, respectively.
48
FEE-BASED BUSINESS
The Company's fee-based business is less capital intensive than the
spread-based business and generally provides the Company with a more diversified
source of income, due to the relative insensitivity of fee-based income to
changes in interest rates. However, significant decreases in price levels in the
securities market could adversely affect the level of fee income earned by the
Company from its asset management operations and, thereby, the Company's results
of operations. The Company's fee-based business allows for more rapid asset
growth by the Company than the spread-based business. The Company continues to
focus on the development of its fee-based business in order to increase the size
of this business and achieve an optimal business mix with its spread-based
business. Although the Company's objective is to achieve such a mix, in certain
periods, due to opportunistic acquisitions of spread-based businesses, the
business mix may shift temporarily.
Fee-based products and services include investment portfolio options of
variable annuity contracts, asset management services and marketing
partnerships. Sales for fee-based business represent premiums and deposits for
the investment portfolio options of variable annuity contracts, the amount of
new off-balance sheet deposits for asset management services, off-balance sheet
deposits under marketing partnerships and off-balance sheet deposits in
investment portfolios. The marketing partnership arrangement with General
American was converted from a fee-based to primarily a spread-based arrangement
in late 1995 through a reinsurance agreement executed with General American.
General American cedes 50% of new deposits to Integrity under the reinsurance
agreement which the Company reports in its spread-based line of business. The
Company receives nominal fee income for the 50% portion retained by General
American, which the Company reports as "other fee income." Fee-based sales for
the six months ended June 30, 1996 and for the years ended December 31, 1995 and
1994 were as follows:
YEAR ENDED
SIX MONTHS DECEMBER 31,
ENDED JUNE 30, --------------------
1996 1995 1994
--------------- --------- ---------
(DOLLARS IN MILLIONS)
Retail:
Investment portfolio options of variable annuities.................... $ 119.6 $ 177.7 $ 230.2
Mutual funds (1)...................................................... 7.9 7.8 --
Other................................................................. -- -- 0.9
------ --------- ---------
Total retail.......................................................... 127.5 185.5 231.1
Institutional:
Asset management (1).................................................. 822.5 471.8 --
Marketing partnerships (1)............................................ -- (2) 272.9 59.3
------ --------- ---------
Total institutional................................................... 822.5 744.7 59.3
------ --------- ---------
Total fee-based sales................................................... $ 950.0 $ 930.2 $ 290.4
------ --------- ---------
------ --------- ---------
- ------------------------
(1) Off-balance sheet item.
(2) The marketing partnership arrangement with General American was converted
from a fee-based to primarily a spread-based arrangement in late 1995
through a reinsurance agreement executed with General American. General
American cedes 50% of new deposits to Integrity under the reinsurance
agreement which the Company reports in its spread-based line of business.
The Company receives nominal fee income for the 50% portion retained by
General American, which the Company reports as "other fee income."
49
Fee-based assets under management at June 30, 1996 and at December 31, 1995,
1994 and 1993 were as follows:
DECEMBER 31,
------------------------------------------------
JUNE 30, 1996 1995 1994
---------------------- ---------------------- ------------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
--------- ----------- --------- ----------- ----------- -----------
(DOLLARS IN MILLIONS)
Retail:
Investment Portfolio options of variable
annuities.................................... $ 749.2 22.4% $ 617.3 25.3% $ 388.9 76.3%
Mutual funds(1)................................ 234.9 7.0 228.4(2) 9.3 -- --
Institutional:
Asset management(1)............................ 1,979.1 59.3 1,210.7(2) 49.5 -- --
Marketing partnerships(1)...................... 379.1 11.3 387.3 15.9 121.0 23.7
--------- ----- --------- ----- ----------- -----
Total fee-based assets under management.......... $ 3,342.3 100.0% $ 2,443.7 100.0% $ 509.9 100.0%
--------- ----- --------- ----- ----------- -----
--------- ----- --------- ----- ----------- -----
1993
------------------------
AMOUNT PERCENT
----------- -----------
Retail:
Investment Portfolio options of variable
annuities.................................... $ 199.0 69.9%
Mutual funds(1)................................ -- --
Institutional:
Asset management(1)............................ -- --
Marketing partnerships(1)...................... 85.5 30.1
----------- -----
Total fee-based assets under management.......... $ 284.5 100.0%
----------- -----
----------- -----
- ------------------------
(1) Off-balance sheet item.
(2) Includes amounts acquired in 1995 of $217.2 million (mutual funds) and
$843.6 million (asset management contracts) in connection with the SBM and
KBIMA acquisitions, respectively.
VARIABLE ANNUITY CONTRACTS. Variable annuity contracts issued by the
Company's insurance subsidiaries are distributed through financial planners,
investment brokerage firms and broker-dealers. Under variable annuity contracts,
customers may allocate all or a portion of their account values to a separate
account that invests in shares of one or more investment portfolios (registered
investment companies). Values in the separate account will vary with the
investment performance of the underlying investment portfolio. In addition, the
Integrity Companies also receive income in the form of mortality and expense
fees based primarily on the market value of the invested deposits and of
administrative expense charges in connection with variable annuity contract
deposits in investment portfolios. The Company reinsures most of the mortality
risk associated with its variable annuity contracts. The Integrity Companies
also receive spread income from funds allocated to the Company's GRO products.
Because the investment risk under the mutual investment portfolio options of
variable annuity products is borne by the customer, these products are treated
as securities under federal securities laws and, therefore, the salespeople are
both appointed as insurance agents for the Company's insurance subsidiaries and
registered as securities representatives with the applicable broker-dealer. In
addition, ARM Capital Advisors earns fee income by serving as an advisory
manager and by providing supervisory and administrative services to the
portfolios of Legends, a series-type registered investment company, the
investment portfolios of which are offered through one of the Company's variable
annuity products. Shares of Legends are offered only to the separate accounts of
Integrity and National Integrity.
ASSET MANAGEMENT SERVICES. ARM Capital Advisors earns fee income by
providing professional asset management services to institutional clients in the
pension markets. Beginning with an acquired base of $0.8 billion in funds under
management, the Company grew this segment of its fee-based business by
attracting new clients and receiving additional allocations from existing
clients. Third-party assets under management have grown from $0.8 billion to
$2.0 billion at June 30, 1996. ARM Capital Advisors is expanding into the
management of assets of other insurance companies and of pension funds under the
Company's recently developed "synthetic" GIC product. ARM Capital Advisors' goal
in the performance of its services is to preserve capital, while maintaining
liquid, quality securities and meeting or exceeding agreed upon performance
benchmarks without assuming undue risk.
MARKETING PARTNERSHIP ARRANGEMENTS. Marketing partnership arrangements are
strategic alliances or joint ventures with non-affiliated insurance companies.
The Company is currently party to one such arrangement with General American
(with respect to GICs) and, as part of such arrangement, the Company receives
fees for certain administrative, asset/liability, product development and
marketing support activities associated with GIC deposits that are recorded on
General American's balance sheet. In addition, the Company's fee-based marketing
and product development relationship with General
50
American has led to opportunities for spread-based business through reinsurance
of the products involved, currently GICs. During 1995 and 1996, the Company's
insurance subsidiaries entered into reinsurance agreements with General
American, assuming 50% of certain GIC business on a coinsurance basis.
DISTRIBUTION
The Company distributes its retail products through numerous channels,
including third-party marketing organizations with sales networks, which in turn
sell products through financial planners, banks, stockbrokers and independent
insurance agents (including those specializing in the 403(b) marketplace for
teachers). The Company currently relies to a large extent on a wholesaler
organization, FMG, to act as a channel for the distribution of its retail
products, although the Company intends to expand the depth and breadth of its
distribution channels. See "Risk Factors--Dependence on Certain Third-Party
Distributors." For the stockbrokerage channel, the Company brought the
third-party wholesaling process in-house in January 1996 by recruiting a team of
individuals to support the growing number of firms distributing its products and
to recruit new ones. The Company believes that this step may lessen some of the
risks associated with dependence on third-party distribution for the
stockbrokerage channel. Using this diverse group of channels, the Company has
access to retail product distribution dispersed throughout the United States.
Unlike many of its competitors, the Company does not maintain its own field
sales force, and distributors are primarily paid based on sales production.
Additional channels of annuity distribution include the bank market,
tax-qualified markets and a group of independent agents who were added with the
SBM acquisition. In addition to its reliance on FMG, the Company utilizes
PaineWebber for the distribution of certain of its fixed and variable annuity
products. For the six months ended June 30, 1996 and for the year ended December
31, 1995, approximately 10% and 16%, respectively, of the Company's retail sales
were made through PaineWebber.
For institutional distribution, the Company relies on a small group of
experienced in-house marketing professionals who work through industry
consultants or directly with plan sponsors, bank trust departments, cash
management funds and other insurance companies to promote products and services.
Retail and institutional sales by market and distribution channel for the
six months ended June 30, 1996 were as follows:
RETAIL INSTITUTIONAL
---------------------- ----------------------
PERCENT PERCENT
AMOUNT OF TOTAL AMOUNT OF TOTAL
--------- ----------- --------- -----------
(DOLLARS IN MILLIONS)
Distribution channel:
Financial planners................................................. $ 112.3 70.8% $ -- --
Stockbrokers....................................................... 16.8 10.6 -- --
Banks.............................................................. 0.4 0.2 -- --
Independent insurance agents....................................... 14.1 8.9 -- --
Other independents................................................. 15.1 9.5 -- --
In-house marketing professionals:
Institutional products........................................... -- -- 441.3 34.9
Institutional pension services................................... -- -- 822.5 65.1
--------- ----- --------- -----
Total sales.......................................................... $ 158.7 100.0% $ 1,263.8 100.0%
--------- ----- --------- -----
--------- ----- --------- -----
Strengthening existing relationships and building new relationships within
these distribution channels is essential for accelerated deposit growth. In
addition, by diversifying distribution channels, the Company can reduce the
impact of losing any one channel because of events outside of its control (such
as changes in tax laws). The Company seeks to expand the depth and breadth of
existing channels to capture additional market share without relying on the
capabilities and influence of just a few producers.
51
ASSET/LIABILITY SPREAD MANAGEMENT
The Company views asset/liability spread management as an integrated
process, rather than as a series of segregated functions, and integrates this
process into each aspect of its operations. The Company's overall goal is to
ensure that invested asset cash flows will be sufficient to meet all customer
obligations and to maximize investment spreads on a consistent basis. Beginning
with product design and continuing through the product sale and eventual payout,
professionals in each functional area (such as marketing, actuarial,
investments, legal, finance and administration) work jointly with a common set
of risk/return characteristics toward the goal of achieving the Company's
liquidity and profit objectives (rather than the specific objectives of any
particular functional area). The Company also conducts periodic thorough
analyses of its assets and liabilities using sophisticated software to model the
effect of changes in economic conditions on both its assets and liabilities.
During product development, the Company sets product features and rate
crediting strategies only after it has devised an appropriate investment
strategy that matches the product features. The Company employs an extensive
iterative modeling process to test various asset combinations against proposed
product features in randomly generated interest rate scenarios. The modeling
evaluates whether a particular investment strategy, when matched with the
product features under consideration, will provide adequate cash flow and
generate returns that exceed specified minimum targets consistently and without
significant fluctuations. If necessary, the Company then redesigns investment
strategies or product features until these objectives are met.
Once the Company has identified an asset portfolio having the desired
performance characteristics, the Company's investment professionals have the
flexibility to trade the portfolio in order to maximize yields while remaining
within well-defined risk parameters (such as duration, convexity, credit quality
and liquidity). In so doing, these professionals follow prescribed measures
designed to (i) minimize anticipated defaults, (ii) minimize anticipated call,
prepayment or extension losses and (iii) enhance yield through sector rotation
and security selection. In addition, the Company aims to generate and maintain
liquidity from scheduled interest and principal payments, projected prepayments
and early calls, cash on hand, floating rate public securities and lines of
credit (but not from new product sales), sufficient to cover approximately two
times expected cash needs (for benefits, withdrawals, expenses and dividends)
without having to sell any investments at a material loss.
Internal control measures are in place throughout the process to make any
necessary adjustments in the investment portfolio as promptly as possible. For
example, company personnel assess independently of portfolio managers whether
proposed trades would alter portfolio characteristics or how investment yields
or realized gains or losses are accounted for on a statutory and GAAP accounting
basis. The Company also remodels its assets and liabilities periodically to
determine whether any significant changes in assumptions or interest rates have
occurred or have been overlooked.
In pursuing its investment spread objectives, the Company focuses primarily
on calculable cash flows to expected maturities on its investments rather than
on estimated total returns to expected maturities or to some intermediate date.
This approach permits the Company to measure specifically the changes in yield
and cash flow on its investments at any given time. This approach emphasizes
securities which are liquid and easily tradeable. For certain investments, such
as common equities, real estate investments and direct mortgages, the fair
market value may be relatively difficult to determine, thereby further
increasing the difficulty of calculating total return. As a result, the Company
invests primarily in fixed-income securities, which can be more easily modelled
and hedged.
The Company's investment operations are conducted by ARM Capital Advisors.
The professionals staffing this operation have been managing the Company's fixed
income assets since December 1993 when they were employees of KBIMA. Their
expertise in developing and implementing immunization and duration-matched
portfolio strategies for fee-based pension fund accounts is also relevant to the
asset strategies supporting the Company's spread-based annuity and GIC products.
In addition, these asset
52
strategies can be used for an array of other products which the Company is
currently developing to serve the defined contribution plan and other
institutional markets.
See "Management's Discussion and Analysis of Financial Condition and Results
of Operations-- Asset Portfolio Review."
SURRENDERS
To encourage persistency and discourage withdrawals, the Company's spread-
and fee-based insurance products generally incorporate surrender charges, market
value adjustments and/or other features which may discourage or prevent such
surrenders or withdrawals. As of December 31, 1995, the Company had
approximately $896.5 million of customer deposits (25.9% of its total customer
deposits) which were no longer subject to surrender charges and approximately
$262.9 million and $188.0 million of customer deposits as to which the surrender
charge will cease to apply during 1996 and 1997, respectively. At June 30, 1996,
approximately 66% of the Company's insurance subsidiaries' customer deposits had
surrender penalties or other such restrictions or were not subject to
withdrawal. During the third quarter of 1994 and continuing to date, the Company
began implementing programs designed to improve persistency. Such programs
involve direct contact with customers and are designed to inform customers of
the financial strength of the Company and its insurance subsidiaries and to
describe other product offerings available. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Results of
Operations."
REINSURANCE CEDED
The Company's insurance subsidiaries reinsure risks under certain of their
products with other insurance companies through reinsurance agreements. Through
these reinsurance agreements substantially all mortality risks associated with
SPE deposits and substantially all risks associated with the variable life
business have been reinsured. The Company's primary reinsurers in respect of
mortality risks associated with SPE deposits are Swiss Reinsurance Company, RGA
Reinsurance Company and The Equitable Life Assurance Society, which are
respectively rated A+, A+ and A by A.M. Best. Phoenix Home Life Mutual and
American Franklin Life are the Company's principal reinsurers in respect of
risks associated with the variable life business and are respectively rated A
and A++ by A.M. Best. In addition, Integrity cedes a block of SBM Life SPDAs on
a coinsurance basis to Harbourton Reassurance, Inc., which was rated "FPR-4
(Average)" by A.M. Best for its financial performance. Reinsurance does not
fully discharge the Company's obligation to pay policy claims on the reinsured
business; the ceding reinsurer remains responsible for policy claims to the
extent the reinsurer fails to pay such claims.
RATINGS AND RATING AGENCIES
Insurance companies are rated by independent rating agencies to provide both
industry participants and insurance consumers meaningful information on specific
insurance companies. Higher ratings generally indicate a higher relative level
of financial stability and a stronger ability to pay claims. The basis for an
opinion on a particular rating includes such factors as capital resources,
financial strength, demonstrated management expertise, and stability of cash
flow as well as the quality of investment operations, administration and
marketing. These particular types of ratings are based upon factors relevant to
policyholders and are not directed toward protection of stockholders. Such
ratings are neither a rating of securities nor a recommendation to buy, hold or
sell any security. The Company's insurance subsidiaries currently hold ratings
from four such rating agencies: A.M. Best, S&P, Duff & Phelps and Moody's
Investors Service ("Moody's").
The Company's insurance subsidiaries are currently classified "A
(Excellent)" by A.M. Best, reflecting an upgrade from A- in October 1995. A.M.
Best's ratings are based upon an evaluation of the insurer's financial and
operating performance. A.M. Best's ratings range from "A++ (Superior)" to "C-
(Fair)," and some companies are not rated.
53
The Company's insurance subsidiaries currently hold an "A (Good)"
claims-paying ability rating from S&P. The rating is based on current
information provided by the Company and other reliable sources on a voluntary
basis. The S&P claims-paying ability rating categories range from "AAA
(Superior)" to "D (Liquidation)."
In addition, the Company's insurance subsidiaries currently hold an "A-1"
short-term rating from S&P. The short-term rating is used for any obligation
whose maturity is typically one year or less or would apply to a put option or
demand feature which would give the policyholder the right to receive their
funds within one year. The S&P short-term rating categories range from "A-1+" to
"D."
Duff & Phelps provides a claims-paying ability ratings which concerns only
the likelihood of timely payment of policyholder obligations, and not the
ability to pay non-policyholder obligations. The Company's insurance
subsidiaries currently have a claims-paying ability rating from Duff & Phelps of
"A+ (High)" and a short-term claims paying ability of "D-1." Duff & Phelps
claims-paying ability ratings range from "AAA" to "DD" and short-term claims
paying ability ratings range from "D-1+" to "D-5".
Moody's has currently assigned the Company's insurance subsidiaries a "Baa1
(Adequate)" insurance financial strength rating. Moody's financial strength
rating reflects an insurance company's ability to pay policyholder obligations
and claims. Moody's ratings range from "Aaa (Exceptional)" to "C (Lowest)," and
some companies are not rated.
Customers and many financial institutions and broker-dealers tend to focus
on the A.M. Best and claims-paying ability ratings of an insurer in determining
whether to buy or market the insurer's annuities. If any of the Company's
ratings were downgraded from their current levels or if the ratings of the
Company's competitors improved and the Company's did not, the ability of the
Company to distribute its products and the persistency of its existing business
could be adversely affected. Each of the rating agencies reviews its ratings
periodically, and there can be no assurance that the Company's current ratings
will be maintained in the future. See "Risk Factors--Competition; Ratings."
CUSTOMER SERVICE AND ADMINISTRATION
The Company seeks to build a strong customer base by offering high quality
and easily accessible service. To this end, the Company's objective is to
maintain an administrative infrastructure utilizing up-to-date technology,
efficient and effective work flow processes and well-trained personnel. This
infrastructure helps to bring new products to market quickly, enhance product
features and provide timely, accurate information to customers and management.
Sharing information across the organization supports the integrated nature
of the Company's business operations. Management believes that a personal
computer client/server data processing platform provides users with direct
access to information on a more efficient basis than a mainframe system. A wide
area network ("WAN") links all voice and data communications in the Company's
principal locations of Kentucky, Ohio, New York and, following the SBM
acquisition, Minnesota. With proper security clearances, employees may access
data bases on file servers at any location. In addition, the Company has
expanded automated interfaces between systems to help minimize the potential for
error from manual intervention, reduce costs and strengthen internal controls.
Some of these servers are owned and operated directly by the Company. Other
servers and some mainframe systems are operated by external entities with whom
the Company contracts to perform certain investment and administrative related
functions.
In addition to expanding its WAN during 1995, the Company completed a
restructuring of its organizational and work flow management processes with the
objective of creating additional operating efficiencies. The Company has
implemented an image management and automated workflow management system in
order to significantly reduce the amount of paper and manual work that is
required to process transactions and to perform customer service. Software
development efforts and systems migration projects underway in 1996 are intended
to eliminate computer processing redundancies in some lines of
54
business and enhance the Company's capability to bring increasingly complex and
competitive products and services to market. Customer service capabilities have
expanded with the Company's introduction in 1996 of an automated voice response
system for a majority of its retail customers. These customers now have
twenty-four hour access to account and unit values on their annuities and the
ability to reallocate assets among certain investment options. This alternative
supplements customers speaking directly with the Company's customer service
representatives or sending service requests through traditional mail services or
the Internet.
The Company's Customer Service unit, through direct customer contact, has
also achieved measurable success with the retention of business. As a result of
a new program implemented in 1995 to improve persistency, the Company was able
to retain over $42 million in annuity business during 1995 from customers who
had initiated requests to surrender their policies and were provided with
additional choices and incentives to keep their deposits with the Company. This
same unit proactively communicates with annuity customers to advise them of the
insurance subsidiaries' financial strength and recent activities.
The Company maintains current plans to recover its systems and operations
promptly in the event of a disaster. For critical WAN applications, redundant
servers with backed-up data are in place in New York City, Worthington, Ohio and
Louisville, Kentucky, the Company's primary operating sites. Key functions are
intended to be available within a matter of a few hours. For recovery of
computer systems accessed through external parties, these vendors provide their
own disaster recovery plans. Offsite storage of magnetic media ensures that data
processing systems and the imaging system can be restored in the event of a
disaster.
COMPETITION
The financial services industry is highly competitive, and each of the
Company's subsidiaries competes with companies that are significantly larger and
have greater access to financial and other resources.
The life insurance industry comprises approximately 2,000 companies in the
United States and is highly competitive, with no one company dominating any of
the principal markets in which the Company's insurance subsidiaries operate.
Many insurance companies and insurance holding companies have substantially
greater capital and surplus, larger and more diversified portfolios of life
insurance policies and annuities, higher ratings and greater access to
distribution channels than the Company's insurance subsidiaries. Competition is
based upon many factors, such as the form and content of annuity policies,
premiums charged, investment return, customer service, access to distribution
channels, financial strength and ratings of the company, experience and
reputation. The Company's insurance subsidiaries also encounter increasing
competition from banks, securities brokerage firms and other financial
intermediaries marketing insurance products, annuities and other forms of
savings and pension products. The Company believes that the fact that it is not
hampered with a large captive sales force like many insurance companies is an
advantage in enabling the Company to create strategic alliances with banking and
other industries.
The principal competitive factors in the sale of annuity products are
product features, perceived stability of the insurer, customer service, name
recognition, crediting rates, and commissions. The Company's insurance
subsidiaries compete in their markets with numerous major national life
insurance companies. Management believes that its ability to compete with other
insurance companies is dependent upon its ability to develop competitive
products with unique features and services that focus on the needs of targeted
market segments.
Competitors of ARM Capital Advisors include a large number of asset
management firms and mutual fund organizations, both independent and affiliated
with other financial services companies, including banks and insurance
companies. Competition in asset management services is based on investment
performance, service to clients, product design, size, scope of services, and
reputation of affiliates. The ability of the Company's investment management
subsidiary to compete with other firms also is dependent, in part, on the
relative attractiveness of the types of investment services such subsidiaries
offer and their
55
investment style and strategies under prevailing market conditions. See "Risk
Factors--Competition; Ratings."
REGULATION
The Company's business activities are subject to extensive regulation. Set
forth below is a summary discussion of the principal regulatory requirements
applicable to the Company.
INSURANCE REGULATION
The Company's insurance subsidiaries are subject to regulation and
supervision by the states in which they are organized and in the other
jurisdictions where they are authorized to transact business. State insurance
laws establish supervisory agencies with broad administrative and supervisory
powers related to granting and revoking licenses to transact business,
regulation of marketing and other trade practices, operating guaranty
associations, licensing agents, approving policy forms, regulating certain
premium rates, regulating insurance holding company systems, establishing
reserve requirements, prescribing the form and content of required financial
statements and reports, performing financial and other examinations, determining
the reasonableness and adequacy of statutory capital and surplus, regulating the
type and amount of investments permitted, limiting the amount of dividends that
can be paid without first obtaining regulatory approval, and other related
matters. The primary purpose of such supervision and regulation under the
insurance statutes of Ohio and New York, as well as other jurisdictions, is the
protection of policyholders rather than investors or shareholders of an insurer.
State insurance departments also conduct periodic examinations of the affairs of
insurance companies and require the filing of annual and other reports relating
to the financial condition of insurance companies.
In recent years, the insurance regulatory framework has been placed under
increased scrutiny by various states, the federal government and the NAIC.
Various states have considered or enacted legislation that changes, and in many
cases increases, the states' authority to regulate insurance companies.
Legislation has been introduced from time to time in Congress that could result
in the federal government assuming a role in the regulation of insurance
companies. Over the past few years, the NAIC has approved and recommended to the
states for adoption and implementation several regulatory initiatives designed
to reduce the risk of insurance company insolvencies. These initiatives include
new investment reserve requirements, spread-based capital standards and
restrictions on an insurance company's ability to pay dividends to its
stockholders. Specifically, the NAIC "Codification of Statutory Accounting
Principles" project may revamp the current statutory accounting practices for
the Company's insurance subsidiaries. Certain proposals under consideration may
have a negative impact on the statutory surplus of the Company's insurance
subsidiaries and thus their ability to pay dividends to the Company. Issue
papers have been released for industry review and a first draft of the
accounting practices manual is expected to be issued by the NAIC in 1997. This
project will not undermine the states' authority to make a final determination
on acceptable and appropriate accounting practices as the NAIC proposals are
subject to implementation only upon legislative enactment by the applicable
state legislature. The Company is monitoring developments in the regulatory area
and assessing the potential effects any changes would have on the Company.
Although the federal government currently does not directly regulate the
business of insurance generally, federal initiatives can significantly affect
the insurance business. Congress and certain federal agencies are investigating
the current condition of the insurance industry in the United States in order to
decide whether some form of federal regulation of insurance companies would be
appropriate. It is not possible to predict the outcome of any such congressional
activity, which could result in the federal government assuming some role in the
regulation of the insurance industry, or the potential effects thereof on the
Company.
56
INSURANCE HOLDING COMPANY REGULATION. The Company and its affiliates are
subject to regulation under the insurance holding company statutes of Ohio, the
domiciliary state of Integrity, and of New York, the domiciliary state of
National Integrity, and under the insurance statutes of other states in which
Integrity and National Integrity are licensed to transact the business of
insurance. Most states have enacted legislation which regulates insurance
holding company systems, including acquisitions, extraordinary dividends, the
terms of affiliate transactions and other related matters. Integrity and
National Integrity are required to file certain reports in Ohio, New York and
certain other states, including information concerning their capital structure,
ownership, financial condition and general business operations. The Ohio and New
York insurance laws also require prior notice or approval of changes in control
of an insurer or its holding companies and of material intercorporate transfers
of assets and material agreements between an insurer and affiliates within the
holding company structure. Under the Ohio and New York insurance laws, any
person, corporation or other entity which seeks to acquire, directly or
indirectly, 10% or more of the voting securities of an Ohio or New York
insurance company or any of its parent companies is presumed to be seeking to
acquire "control" of such insurance company and must obtain the prior approval
of the Ohio Insurance Director and New York Insurance Superintendent,
respectively. Prior to acquiring such control, the proposed acquiror must either
file an application containing certain information including, but not limited
to, the identity and background of the acquiror and its affiliates and the
source and amount of funds to be used to effect the acquisition, or obtain an
exemption from the approval requirement.
In the event of a default on the Company's debt or the insolvency,
liquidation or other reorganization of the Company, the creditors and
stockholders of the Company will have no right to proceed against the assets of
Integrity or National Integrity or to cause their liquidation under federal or
state bankruptcy laws. Insurance companies are not subject to such insolvency
laws but are, instead, governed by state insurance laws relating to liquidation
or rehabilitation due to insolvency or impaired financial condition. Therefore,
if Integrity or National Integrity were to be liquidated or be the subject of
rehabilitation proceedings, such liquidation or rehabilitation proceedings would
be conducted by the Ohio Insurance Director and the New York Insurance
Superintendent, respectively, as the receiver with respect to all of Integrity's
or National Integrity's assets and business. Under the Ohio and New York
insurance laws, all creditors of Integrity or National Integrity, including
policyholders, would be entitled to payment in full from such assets before the
Company or Integrity Holdings, as indirect or direct stockholders, would be
entitled to receive any distribution therefrom.
DIVIDEND RESTRICTIONS. The Company's ability to declare and pay dividends
will be affected by Ohio and New York laws regulating the ability of National
Integrity to pay dividends to Integrity and the ability of Integrity to pay
dividends to the Company.
On December 30, 1994, Integrity redomesticated from Arizona to Ohio. Under
Ohio law, a domestic life insurance company may not make, without the prior
approval of the Ohio Insurance Director, dividend payments in excess of the
greater of (i) 10% of such insurance company's statutory capital and surplus as
of the preceding December 31, or (ii) such insurance company's statutory net
income for the preceding year. Under New York insurance law, National Integrity
may pay dividends to Integrity only out of its earnings and surplus and may not
distribute any dividends without at least 30 days' prior written notice to the
New York Insurance Superintendent, who may disapprove a proposed dividend upon a
determination that National Integrity's financial condition does not warrant
such distribution. Because National Integrity is a subsidiary of Integrity,
dividend payments made by National Integrity to Integrity must be made in
compliance with New York standards, and the ability of Integrity to pass those
dividends on to the Company is subject to compliance with Ohio standards.
The maximum dividend payments that may be made by Integrity to the Company
during 1996 are $17.6 million; dividends in the amount of $11.0 million have
been paid during the six months ended June 30, 1996.
57
MANDATORY INVESTMENT RESERVE. Under NAIC rules, life insurance companies'
must maintain an asset valuation reserve ("AVR"), supplemented by an interest
maintenance reserve ("IMR"). These reserves are recorded for purposes of
statutory accounting practices; they are not recorded under the provisions of
GAAP and therefore have no impact on the Company's reported results of
operations or financial position. These reserves affect the determination of
statutory policyholders' surplus, and changes in such reserves may impact the
ability of the Integrity Companies to pay dividends or other distributions to
the Company. The extent of the impact of the AVR will depend upon the future
composition of the investment portfolio of the Integrity Companies. The extent
of the impact of the IMR will depend upon the extent of the gains and losses of
the Integrity Companies' investment portfolio and the related amortization
thereof. Based on the current investment portfolio of the Company's insurance
subsidiaries, the Company does not anticipate that expected provisions for the
AVR and IMR will materially adversely affect the ability of the Integrity
Companies to pay dividends or other distributions to the Company.
RISK-BASED CAPITAL REQUIREMENTS. The NAIC Risk-Based Capital ("RBC")
requirements evaluate the adequacy of a life insurance company's adjusted
statutory capital and surplus in relation to investment, insurance and other
business risks. The RBC formula is used by the states as an early warning tool
to identify potential weakly capitalized companies for the purpose of initiating
regulatory action and is not designed to be a basis for ranking the financial
strength of insurance companies. In addition, the formula defines a minimum
capital standard which supplements the previous system of low fixed minimum
capital and surplus requirements. The RBC requirements provide for four
different levels of regulatory attention depending on the ratio of a company's
adjusted capital and surplus to its RBC.
The consolidated statutory-basis capital and surplus of the Company's life
insurance subsidiaries totalled $146.0 million and $107.9 million at December
31, 1995 and 1994, respectively, and were substantially in excess of the minimum
level of RBC that would require regulatory action. In addition, the consolidated
statutory-basis AVRs of the Company's insurance subsidiaries totaled $14.4
million and $5.2 million at December 31, 1995 and 1994, respectively (excluding
voluntary reserves of $5.0 million and $3.1 million at December 31, 1995 and
1994, respectively). These reserves, together with voluntary reserves, are
generally added to statutory capital and surplus for purposes of assessing
capital adequacy against various measures used by rating agencies and
regulators.
GUARANTY FUND ASSESSMENTS. Under the insurance guaranty fund laws existing
in each state, insurers licensed to do business in the state can be assessed for
certain obligations of insolvent insurance companies to policyholders and
claimants. In connection with the acquisition by the Company of the Integrity
Companies from National Mutual, National Mutual agreed to indemnify the Company
for guaranty fund assessments levied in respect of companies declared insolvent
or subject to conservatorship prior to November 26, 1993. The amounts actually
assessed to and paid by the Company's insurance subsidiaries for the years ended
December 31, 1994 and 1995 were approximately $1.0 million and $1.2 million,
respectively, and was approximately $0.7 million for the six months ended June
30, 1996. Of such amounts, approximately $0.9 million, $0.5 million and $0.3
million, respectively, were reimbursed by National Mutual under its indemnity
obligation to the Company. Because such assessments are typically not made for
several years after an insurer fails and depend upon the final outcome of
liquidation or rehabilitation proceedings, the Company cannot accurately
determine the precise amount or timing of its exposure to known insurance
company insolvencies at this time. During 1994 and 1995, and for the six months
ended June 30, 1996, the Company recorded provisions for state guaranty fund
association expenses of $0.4 million, $0.3 million, and $0.4 million,
respectively. At June 30, 1996, the Company's reserve for such assessments was
$5.7 million. No assurance can be given that the Company's reserve for
assessments or such indemnity will be adequate in the event of any loss suffered
by the Company in respect of any assessment made under state insurance guaranty
fund laws. The reserve does not include any provision for future assessments
related to unknown failures or to known failures for which no estimate of the
Company's exposure currently can be made. The Company estimates its reserve for
assessments using information provided by NOLHGA. The insolvency of large life
insurance companies in future years could
58
result in additional material assessments to the Company by state guaranty funds
that could have a material adverse impact on the Company's future earnings and
liquidity. See "Risk Factors--Regulation."
TRIENNIAL EXAMINATIONS. The Ohio and New York insurance departments usually
conduct an examination of Integrity and National Integrity, respectively, every
three years, and may do so at such other times as are deemed advisable by the
Ohio Insurance Director and New York Insurance Superintendent. The report with
respect to the most recent triennial examination of Integrity issued in 1994
covered the periods 1990 through 1992 and contained no material adverse
findings. The report with respect to the most recent triennial examination of
National Integrity issued in 1994 covered the periods 1990 through 1992 and also
contained no material adverse findings. National Integrity is currently
undergoing a triennial examination by the New York insurance department.
Integrity is also currently undergoing a triennial examination by the Ohio
insurance department.
INSURANCE REGULATORY INFORMATION SYSTEM. The NAIC has developed a set of
financial relationships or "tests" called the Insurance Regulatory Information
System ("IRIS") that were designed for early identification of companies that
may require special attention by insurance regulatory authorities. These tests
were developed primarily to assist state insurance departments in executing
their statutory mandate to oversee the financial condition of insurance
companies. Insurance companies submit data on an annual basis to the NAIC, which
in turn analyzes the data using ratios covering twelve categories of financial
data with defined "usual ranges" for each category.
Falling outside the usual range of IRIS ratios is not considered a failing
result; rather, unusual values are viewed as a part of the regulatory early
warning monitoring system. Furthermore, in some years, it may not be unusual for
financially sound companies to have several ratios with results outside the
usual ranges. An insurance company may fall outside of the usual range for one
or more ratios because of specific transactions that are in themselves
immaterial or eliminated at the consolidated level. Generally, an insurance
company will become subject to increased regulatory scrutiny if it falls outside
the usual ranges of four or more of the ratios. In normal years, 15% of the
companies included in the IRIS system are expected by the NAIC to be outside the
usual range on four or more ratios.
In 1995, the Company's insurance subsidiaries were each outside of the usual
range for three IRIS ratios. For Integrity, the net change in capital and
surplus ratio was -12%, as compared to a usual range of between +50% and -10%.
This ratio was below the usual range because the specific line items in the
financial statements used to prepare the ratios included a $15.3 million direct
charge to paid-in capital that SBM Life recognized as a result of
marking-to-market its bond portfolio in connection with its acquisition by the
Company, but did not include the $19.9 million capital contribution that the
Company made to offset that charge. Integrity's change in premium ratio was
- -25%, as compared to a usual range of between +50% and -10%. This ratio was
below the usual range because of a decrease in premiums caused by (i) greater
competition from banks and other financial institutions for savings products
primarily as a result of the flattening of the yield curve during 1995 (see
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Results of Operations") and (ii) lower SBM Life sales in 1995 due to
(a) termination of a modified coinsurance reinsurance agreement under which SBM
Life had assumed premiums of $18.2 million during 1994 and (b) a downgrade of
SBM Life's rating by A.M. Best at the end of 1994 from "A- (Excellent)" to "B+
(Very Good)" (although following the acquisition, this rating was upgraded in
October 1995 to "A (Excellent)"). Finally, Integrity's change in reserving ratio
was -99%, as compared with a usual range of between +20% and -20%. This ratio
measures the difference in reserves as a percentage of premiums from one year to
the next. The change in this ratio was below the usual range because premiums
(the denominator of the fraction), excluding deposits for deferred annuity and
GIC products, fell from $23.0 million in 1994 to approximately $1.5 million in
1995 largely as a result of the termination in 1995 of SBM Life's modified
coinsurance reinsurance agreement.
For National Integrity, the change in premium ratio was +68%, as compared to
a usual range of between +50% and -10%, and the change in product mix ratio was
9.9%, whereas the usual change does
59
not exceed 5%. The reason for both ratios being above the usual range was the
increase in sales of GICs in 1995 and the decrease in sales of deferred annuity
products, which events were primarily attributable to the relative advantage
enjoyed by shorter-maturity products in that year as a result of the flattening
of the yield curve (see "Management's Discussion and Analysis of Financial
Condition and Results of Operations-- Results of Operations"). Finally, National
Integrity's change in reserving ratio was -99%, as compared with a usual range
of between +20% and -20%. This ratio was below the usual range because National
Integrity reduced reserves for ordinary life business by $1.0 million in 1995 as
a consequence of an increase in death and surrender benefits of $0.9 million
paid on this closed block of business.
OTHER REGULATION
The Company's non-insurance activities are also subject to extensive
regulation. ARM Capital Advisors is registered with the SEC as an investment
adviser under the Advisers Act and is subject to regulation and examination
under ERISA by the U.S. Department of Labor and under the Advisers Act by the
SEC. In addition, variable annuities and the related separate accounts of the
Company's insurance subsidiaries are subject to regulation by the SEC under the
Securities Act and the Investment Company Act.
The Company's broker-dealer subsidiary, ARM Financial Services, is
registered with the SEC under the Exchange Act and is subject to regulation by
the SEC. ARM Financial Services is also subject to regulation, supervision and
examination by the states in which it transacts business, as well as by the
NASD. The NASD has broad administrative and supervisory powers relative to all
aspects of ARM Financial Services' business and may examine its business and
accounts at any time.
SBM Certificate Company is subject to regulation and supervision by federal
and state regulators. The Investment Company Act and rules issued by the SEC
thereunder specify certain terms applicable to face-amount certificates, the
method for calculating reserve liabilities on outstanding certificates, the
minimum amounts and types of investments to be deposited with a qualified
custodian to support such reserve liabilities, and a variety of other
restrictions on the operation and governance of a face-amount certificate
company. Pursuant to statutory authority, the Minnesota Department of Commerce
(the "MDC") exercises supervisory powers over SBM Certificate Company's
face-amount certificate business similar to those exercised by the SEC under the
Investment Company Act. In addition, the MDC conducts annual examinations of SBM
Certificate Company. The offer and sale of its face-amount certificates also are
subject to federal and state securities laws.
ARM Transfer Agency was established to provide transfer agent services to
the Company as needed. ARM Transfer Agency, a wholly owned subsidiary of the
Company, is registered with the SEC and is subject to examination by the SEC.
The securities laws and regulations referred to above generally grant
supervisory agencies and bodies broad administrative powers, including the power
to limit or restrict a firm from conducting its business in the event that it
fails to comply with such laws and regulations. In addition to maintaining
registrations, the regulatory requirements include reporting, maintaining books
and records in prescribed forms, maintaining certain mandatory custodial
arrangements, approving employees, representatives and, in some cases, owners,
and other compliance procedures. Possible sanctions that may be imposed in the
event of noncompliance include, without limitation, the suspension of individual
employees, limitations on the firm's engaging in business for specified periods
of time, revocation of the firm's registration as an investment advisor or
broker-dealer, censures and fines. The regulators make periodic examinations and
review annual, monthly and other reports on the operations of the Company or its
subsidiaries. Changes in these laws or regulations could have a material adverse
impact on the profitability and mode of operations of the Company.
The Company's standard investment management agreements expressly provide
that they may not be assigned by a party without the prior written consent of
the other party. Under the Advisers Act and the Investment Company Act, an
investment management agreement of any firm is deemed to have been assigned when
there is a "change in control" of the firm, either directly or indirectly, as
through a transfer of a "controlling block" of the firm's voting securities or,
under certain circumstances, upon the transfer of
60
a "controlling block" of the voting securities of its parent corporation. The
Investment Company Act presumes that any person holding more than 25% of the
voting stock of any person "controls" such person. If such a change in control
were to occur, all investment management agreements between the firm and its
clients would terminate, unless the clients consent to the continuation of the
agreements. Under the Investment Company Act, substantially similar change of
control principles apply with respect to investment management agreements with
mutual funds and mandate stockholder approval for deemed assignments of
investment management agreements. Following completion of the Offering, sales by
the Morgan Stanley Stockholders or other stockholders or issuances of Common
Stock by the Company, among other things, may raise issues relating to a deemed
assignment of the Company's investment management agreements under such
statutes. See "Risk Factors--Regulation."
EXAMINATIONS. The SEC conducts routine examinations of the Company's
registered investment adviser operations to ensure compliance with the
requirements prescribed by the Advisers Act. Similarly, the NASD regulates the
activities of the Company's broker-dealer operations and conducts routine
examinations thereof.
PROPERTIES
The Company leases approximately 31,010 square feet of office space in
Louisville, Kentucky under a lease agreement (the "Lease") which expires on
September 1, 2006, and which is subject to two five (5) year renewal options.
This office space accommodates the executive, marketing, product development,
actuarial, accounting, corporate finance and legal functions of the Company.
Pursuant to the Lease, the landlord (i) assumed the Company's former lease of
approximately 26,100 square feet of office space at another location in
Louisville, Kentucky and (ii) paid for certain relocation expenses and leasehold
improvement costs. In addition, the Company executed a $1.0 million standby
letter of credit with one of its lending institutions in favor of the landlord
to secure the Company's obligations under the Lease.
In addition to its headquarters, the Company and its subsidiaries lease
approximately 62,000 square feet of office space in the Columbus, Ohio vicinity
and approximately 8,000 square feet of office space in New York, New York. The
Columbus office space houses the Company's back-office transaction processing
operations including information systems, customer service and policy issuance
activities. The operations of the Company's asset management subsidiary, ARM
Capital Advisors, and New York insurance subsidiary, National Integrity, are
conducted from the New York facility. Additional office space owned in New Ulm,
Minnesota supports the distribution operations of SBM Certificate Company.
EMPLOYEES
At June 30, 1996, the Company and its subsidiaries had approximately 270
full-time employees, none of whom was represented by a labor union. The Company
believes that its relations with its employees are good.
LEGAL PROCEEDINGS
As a consequence of the acquisition of SBM Life and SBM Life's merger into
Integrity, Integrity became a party to a marketing agreement (the "Agreement")
with Multico Marketing Corporation ("Multico"). In reliance upon the Agreement,
Integrity eliminated commissions to Multico on new product sales on a
prospective basis effective July 1, 1995. Multico filed a lawsuit in the United
States District Court for the Western District of Kentucky against Integrity on
February 23, 1996, alleging breach of contract and breach of the covenant of
good faith and fair dealing, and seeking a trial by jury and damages of
approximately $61 million. Integrity filed a counterclaim against Multico
seeking a declaration that Integrity's actions in revising commissions did not
constitute a breach of contract, and the recovery of commissions, fees,
trailers, overwrites and bonuses paid to Multico in the amount of approximately
$9.3 million. Discovery is proceeding between the parties. On May 23, 1996,
Integrity filed a motion for summary judgment in the litigation. While the
Company believes that the Multico action is without merit, there can be no
assurance that Integrity will prevail in the litigation.
Except as described above, the Company is currently involved in no material
legal or administrative proceedings.
61
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of the Company, their ages as of
September 30, 1996 and positions with the Company are set forth below.
NAME AGE TITLE
- ------------------------------------------- --- -------------------------------------------
John Franco................................ 54 Co-Chairman of the Board and Co-Chief
Executive Officer
Martin H. Ruby............................. 46 Co-Chairman of the Board and Co-Chief
Executive Officer
Dennis L. Carr............................. 46 Executive Vice President--Chief Actuary
David E. Ferguson.......................... 49 Executive Vice President--Chief
Administrative Officer
John R. Lindholm........................... 47 Executive Vice President--Chief Marketing
Officer
Edward L. Zeman............................ 41 Executive Vice President--Chief Financial
Officer
Emad A. Zikry.............................. 47 Executive Vice President--Chief Investment
Officer
John R. McGeeney........................... 39 Co-General Counsel
Robert H. Scott............................ 49 Co-General Counsel and Secretary
Peter S. Resnik............................ 35 Treasurer
Barry G. Ward.............................. 35 Controller
James S. Cole.............................. 59 Director
Warren M. Foss............................. 49 Director
Dudley J. Godfrey, Jr...................... 70 Director
Edward D. Powers........................... 64 Director
David R. Ramsay............................ 32 Director
Frank V. Sica.............................. 45 Director
Irwin T. Vanderhoof........................ 68 Director
JOHN FRANCO has served as Co-Chairman of the Board and Co-Chief Executive
Officer of the Company since July 1993. From January 1993 until November 1993,
Mr. Franco served as Co-Chief Executive Officer of Oldarm L.P. and was Co-Chief
Executive Officer of its predecessor from March 1992 until December 1992. From
November 1989 to November 1991, Mr. Franco was the Chief Executive Officer and a
director of ICH Corporation. From 1979 to 1989, Mr. Franco was employed by
Capital Holding Corporation (now known as Providian Corporation) in various
positions, including Vice Chairman of the Board and President, Accumulation and
Investment Group (September 1987 to October 1989), President, Agency Group
(April 1984 to September 1987), and Executive Vice President and Chief Financial
Officer (September 1979 to April 1984).
MARTIN H. RUBY has served as Co-Chairman of the Board and Co-Chief Executive
Officer of the Company since July 1993. From its inception in March 1992 until
November 1993, Mr. Ruby served as Co-Chief Executive Officer of Oldarm L.P. From
May 1990 to January 1992, Mr. Ruby was President and Managing Director of the
ICH Capital Management Group, ICH Corporation, and the President of Constitution
Life Insurance Company, the accumulation product subsidiary of ICH Corporation.
From 1986 to 1989, Mr. Ruby was the Chief Executive Officer and Managing
Director of Capital Initiatives Corporation, a subsidiary of Providian
Corporation. From 1980 to 1986, Mr. Ruby held various other positions with
Providian Corporation.
62
DENNIS L. CARR has served as Executive Vice President--Chief Product
Development Officer of the Company since September 1993, and was appointed
Actuary in June 1995. Prior to joining the Company in September 1993, he was
Director of Product Development for the Accumulation and Investment Group of
Providian Corporation. From July 1983 to July 1988, Mr. Carr was a consulting
actuary for Tillinghast, being named a principal of that firm in 1987.
DAVID E. FERGUSON has served as Executive Vice President--Chief
Administrative Officer of the Company since July 1993. He served as Chief
Technology Officer of Oldarm L.P. from January 1993 until November 1993, and was
Chief Technology Officer of Franco Associates, Ltd. from its inception in March
1992 to its merger with Oldarm L.P. in December 1992. From 1990 to March 1992,
Mr. Ferguson was employed as the President and Chief Executive Officer of the
James Graham Brown Foundation, Inc., a private philanthropic association in
Louisville, Kentucky. From 1984 to 1990, Mr. Ferguson was a partner at Ernst &
Young LLP (or its predecessor Arthur Young) and National Director of their
Insurance Industry Consulting groups.
JOHN R. LINDHOLM has served as Executive Vice President--Chief Marketing
Officer of the Company since July 1993. Until November 1993, he served as the
Chief Marketing Officer of Oldarm L.P., a position he held since its inception
in March 1992. From June 1990 to February 1992, Mr. Lindholm was the Chief
Marketing Officer and a Managing Director of the ICH Capital Management Group,
ICH Corporation. From 1980 to 1990, Mr. Lindholm was employed by Providian
Corporation, first as Vice President-- Compensation and Benefits and then as
Chief Marketing Officer and Managing Director of its Accumulation and Investment
Group. Mr. Lindholm is also Chairman of the Board of Legends and of the State
Bond group of mutual funds.
EDWARD L. ZEMAN has been Executive Vice President--Chief Financial Officer
of the Company since September 1995. Prior to joining the Company, Mr. Zeman
served in various positions with SBM Company from June 1990 to June 1995, the
last of which was Vice President, Chief Operating Officer, Chief Financial
Officer and Treasurer. He also served in various positions with Deloitte &
Touche LLP, a certified public accounting firm, from 1977 through 1990, the last
of which was Senior Manager. Mr. Zeman currently serves on the Board of
Directors of Dotronix, Inc.
EMAD A. ZIKRY has served as Executive Vice President--Chief Investment
Officer of the Company since November 1994. Before joining the Company, Mr.
Zikry was President and Chief Investment Officer of KBIMA. From 1987 to 1992, he
served as Managing Director and Head of Fixed Income and Quantitative Services
at Mitchell Hutchins Institutional Investors, Inc., a subsidiary of PaineWebber
Incorporated. Prior to that time, he was a Director at Bankers Trust New York
Corporation.
JOHN R. MCGEENEY has served as Co-General Counsel of the Company since
January 1994. He was Assistant General Counsel of the Company from July 1993 to
December 1994 and served as Secretary from December 1993 to December 1995. From
February 1988 to October 1993, Mr. McGeeney served successively as Attorney,
Counsel and Assistant General Counsel for the Accumulation and Investment Group
of Providian Corporation. From 1986 to 1988, he was an associate with the law
firm of Middleton & Reutlinger. Mr. McGeeney is also Chairman of the Board of
SBM Certificate Company.
ROBERT H. SCOTT has served as Co-General Counsel of the Company since
January 1994, and was appointed Secretary of the Company in December 1995. He
was Assistant General Counsel of the Company from July 1993 to December 1994.
From June 1993 until November 1993, he served as Assistant General Counsel of
Oldarm L.P. Mr. Scott served as Deputy General Counsel for ICH Corporation from
June 1990 to March 1993. Prior to that time, he was employed by Providian
Corporation as Second Vice President--Tax from November 1976 to July 1990.
PETER S. RESNIK has been the Treasurer of the Company since December 1993.
From December 1992 to November 1993, he served in various financial and
operational positions for Oldarm L.P. From June 1986 through July 1992, he
served as Assistant Vice President of Commonwealth Life Insurance Company, a
63
subsidiary of Providian Corporation in various management positions, the last of
which was Director of Planning and Budgets in the Agency Group Division.
BARRY G. WARD has served as Controller of the Company since April 1996. From
October 1993 to April 1996, Mr. Ward served as financial officer directly
responsible for the Company's financial reporting function. From January 1989 to
October 1993, Mr. Ward served in various positions within Ernst & Young LLP's
Insurance Industry Accounting and Auditing Practice, the last of which was
Manager.
JAMES S. COLE has been a director of the Company since November 1993. He has
also served as Director of Finance of MS & Co.'s Merchant Banking Division since
1988. From 1980 to 1988, he served as Controller for North American Philips.
Prior to that time, Mr. Cole was Chief Financial Officer for GE Plastics from
1976 to 1980. He served in various positions from 1959 to 1976 within the
financial function of General Electric Company.
WARREN M. FOSS has been a director of the Company since June 1996. He has
been a Senior Managing Director of Bear, Stearns & Co. Inc. since September
1996. Mr. Foss had been self-employed as a financial consultant, handling
various assignments for corporate clients from April 1996 to August 1996. From
January 1993 until March 1996, Mr. Foss served as a Managing Director and
Principal of Donaldson, Lufkin & Jenrette Securities Corp. Prior to January
1993, Mr. Foss was a founding partner of Scully Brothers & Foss, an investment
banking firm founded in February 1988.
DUDLEY J. GODFREY has been a director of the Company since February 1994. He
has been a senior shareholder in the law firm of Godfrey & Kahn, S.C.,
Milwaukee, Wisconsin, since 1957. Mr. Godfrey serves on the Board of Directors
of Manpower, Inc., Clarcor, Inc., Fort Howard Corporation and other closely and
privately held corporations.
EDWARD D. POWERS has been a director of the Company since September 1994.
Mr. Powers currently serves as Chairman and Chief Executive Officer of Powers
Holding Co. He served as Chairman and Chief Executive Officer of Burnham Service
Co., Columbus, Georgia, from 1989 through 1993. Prior to 1989, he served as
Chairman and Chief Executive Officer of The Mueller Co., Decatur, Illinois. Mr.
Powers also serves on the Board of Directors of Red Roof Inn Inc.
DAVID R. RAMSAY has been a director and a Vice President of the Company
since July 1993. Mr. Ramsay has been a Vice President of MS & Co., working in
its Merchant Banking Division since January 1994. Prior to that, he had been an
associate at MS & Co. since 1989. Mr. Ramsay serves on the Board of Directors of
Consolidated Hydro, Inc., Jefferson Smurfit Corporation, Hamilton Services
Limited and Risk Management Solutions, Inc.
FRANK V. SICA has been a director of the Company since July 1993. He has
been a Managing Director of MS & Co. since 1988 and is a Vice Chairman and a
Director of Morgan Stanley Leveraged Equity Fund II, Inc. (the general partner
of MSLEF II), and of Morgan Stanley Capital Partners III, Inc. (the general
partner of the general partner of the MSCP Funds). Mr. Sica is also on the Board
of Directors of CSG Systems International, Inc., Consolidated Hydro, Inc., Fort
Howard Corporation, Kohl's Corporation, PageMart Wireless, Inc. and Sullivan
Communications, Inc.
IRWIN T. VANDERHOOF has been a director of the Company since November 1993.
Mr. Vanderhoof has been a clinical professor of Finance at the Stern School of
Business at New York University since 1989. He is the principal of Actuarial
Investment Consulting. Prior to 1988, Mr. Vanderhoof was the Chief Actuary and
Investment Officer for the individual lines of business of The Equitable Life
Assurance Company of the United States.
CLASSIFIED BOARD OF DIRECTORS
The Certificate of Incorporation that will be in effect upon the
consummation of the Offering provides that the Board of Directors will be
divided into three classes of directors serving staggered three-
64
year terms. The classes of directors will be as nearly equal in number as
possible. The initial division of the Board of Directors into classes shall be
made by the decision of a majority of the entire Board of Directors prior to the
consummation of the Offering. The term of the initial Class I directors shall
terminate on the date of the 1997 annual meeting of stockholders; the term of
the initial Class II directors shall terminate on the date of the 1998 annual
meeting of stockholders; and the term of the initial Class III directors shall
terminate on the date of the 1999 annual meeting of stockholders. At each annual
meeting of stockholders beginning in 1997, successors to the class of directors
whose term expires at that annual meeting shall be elected for a three-year
term. Accordingly, approximately one-third of the Company's Board of Directors
will be elected each year. See "Description of Capital Stock--Restated
Certificate of Incorporation and By-laws--Classified Board of Directors and
Related Provisions."
COMPENSATION OF DIRECTORS
The Company's four independent directors, Messrs. Vanderhoof, Powers,
Godfrey and Foss, are compensated annually in the amount of $10,000 plus $1,000
per Board meeting attended and their expenses of each attendance. Messrs.
Vanderhoof, Powers, Godfrey and Foss are also directors of National Integrity,
and each receive $20,000 annually plus $1,000 per Board meeting attended and the
expenses of attendance (unless such Board meeting is concurrent with a Board
meeting of the Company, in which case these directors receive a total of $1,000
and the expenses of attendance at the concurrent meetings). In addition, Messrs.
Vanderhoof, Powers, Godfrey and Foss serve on the Audit Committee for both the
Company and National Integrity and receive $1,000 per committee meeting attended
if held separate from the respective Board meetings.
65
EXECUTIVE COMPENSATION
The following table sets forth compensation information for the Co-Chief
Executive Officers of the Company and the four other most highly compensated
executive officers (the "Named Executive Officers") during the years ended
December 31, 1995 and 1994, and the period from November 27, 1993 to December
31, 1993:
SUMMARY COMPENSATION TABLE
LONG-TERM
COMPENSATION
AWARDS
-----------------
SECURITIES
ANNUAL COMPENSATION UNDERLYING
----------------------------------- OPTIONS ALL OTHER
NAME AND PRINCIPAL POSITION PERIOD SALARY(1) BONUS GRANTED(2) COMPENSATION(3)
- ------------------------------------------------ ----------- --------- ----------- ----------------- -----------------
John Franco..................................... 1995 $ 375,000 $ 224,300 309 $ 7,500(4)
Co-Chief Executive Officer and 1994 $ 375,000 $ 246,000 -- $ 7,500
Co-Chairman of the Board 1993 $ 31,250 -- 310 --
Martin H. Ruby.................................. 1995 $ 375,000 $ 224,300 309 $ 7,500(4)
Co-Chief Executive Officer and 1994 $ 375,000 $ 246,000 -- $ 7,500
Co-Chairman of the Board 1993 $ 31,250 -- 310 --
John R. Lindholm................................ 1995 $ 250,000 $ 146,400 159 $ 7,500(4)
Executive Vice President--Chief 1994 $ 250,000 $ 164,000 53 $ 7,500
Marketing Officer 1993 $ 20,833 -- 106 --
Emad A. Zikry................................... 1995 $ 250,000 $ 520,000(5) 159 $ 7,500
Executive Vice President--Chief 1994 $ 41,666 $ 1,000,000(5) 159 --
Investment Officer 1993 -- -- -- --
David E. Ferguson............................... 1995 $ 215,000 $ 133,900 113 $ 7,500
Executive Vice President--Chief 1994 $ 215,000 $ 141,000 -- $ 7,500
Administrative Officer 1993 $ 17,917 -- 106 --
Dennis L. Carr.................................. 1995 $ 160,000 $ 67,600 52 $ 7,500
Executive Vice President--Chief Actuary 1994 $ 160,000 $ 75,000 -- $ 6,000
1993 $ 13,333 -- 53 --
- ------------------------
(1) The 1993 salary figures for the Named Executive Officers (excluding Mr.
Zikry) reflect one month of compensation included in 1993 (December). The
1994 salary figure for Mr. Zikry reflects two months of compensation
included in 1994 (November and December).
(2) All stock options are for shares of Common Stock of the Company. The total
number of options granted to the Named Executive Officers in 1995 includes a
certain number of replacement options that were issued in exchange for
Series 2 Options (as defined below) originally granted in 1993 and 1994 as
part of the amendment and restatement of the ARM Financial Group, Inc. Stock
Option Plan effective as of June 14, 1995 (as amended through the date
hereof, the "Plan"), as more fully described below under the heading "Stock
Option Plan."
(3) The Company provides the Named Executive Officers with certain group life,
health, medical and other non-cash benefits generally available to all
salaried employees and not included in this column pursuant to the rules
promulgated by the SEC. The amounts presented in this column represent
matching contributions made by the Company under the ARM Financial Group,
Inc. Savings Plan (the "Savings Plan"). Under the Savings Plan, the Company
currently matches a participant's tax-deferred contributions by an amount
equal to 100% of such contribution for each year, subject to a maximum of 5%
of the participant's compensation for the year. Participants may allocate
their contributions among five investment funds.
(4) A portion of the matching contributions made by the Company under the
Savings Plan to the executive in 1994 (as reported in the Company's 1994
Form 10-K) exceeded the maximum percentage of contributions allowed as
promulgated by the rules of the Internal Revenue Code. As a result, the
amount in excess of the contributions permissible was refunded to the
Company.
(5) Pursuant to Mr. Zikry's employment agreement, he is entitled to a minimum
bonus and an initial bonus as more fully described herein under the heading
"Employment Agreements."
66
OPTION GRANTS
The following table sets forth information regarding those Named Executive
Officers who received stock option grants during fiscal year 1995:
OPTIONS GRANTED DURING 1995
INDIVIDUAL GRANTS
--------------------------------------------------------------
POTENTIAL
REALIZABLE
VALUE AT
ASSUMED
ANNUAL RATE
OF STOCK
PRICE
NUMBER OF APPRECIATION
SECURITIES % OF TOTAL FOR OPTION
UNDERLYING OPTIONS GRANTED TERM
OPTIONS EMPLOYEES IN BASE PRICE EXPIRATION -----------
NAME GRANTED(1) 1995 PER SHARE(2) DATE 0%
- -------------------------------------------------- ----------------- --------------- ------------- ----------- -----
John Franco
Old Options..................................... 73 5% $ 5,000 11/26/03 [ ]
New Options..................................... 236 16% $ 6,500 06/14/05 [ ]
Martin H. Ruby
Old Options..................................... 73 5% $ 5,000 11/26/03 [ ]
New Options..................................... 236 16% $ 6,500 06/14/05 [ ]
John R. Lindholm
Old Options..................................... 38 3% $ 5,000 11/26/03 [ ]
New Options..................................... 121 8% $ 6,500 06/14/05 [ ]
Emad A. Zikry
Old Options..................................... 38 3% $ 5,600 11/01/04 [ ]
New Options..................................... 121 8% $ 6,500 06/14/05 [ ]
David E. Ferguson
Old Options..................................... 29 2% $ 5,000 11/26/03 [ ]
New Options..................................... 84 6% $ 6,500 06/14/05 [ ]
Dennis L. Carr
Old Options..................................... 12 1% $ 5,000 11/26/03 [ ]
New Options..................................... 40 3% $ 6,500 06/14/05 [ ]
NAME 5% 10%
- -------------------------------------------------- ----- -----
John Franco
Old Options.....................................
New Options.....................................
Martin H. Ruby
Old Options.....................................
New Options.....................................
John R. Lindholm
Old Options.....................................
New Options.....................................
Emad A. Zikry
Old Options.....................................
New Options.....................................
David E. Ferguson
Old Options.....................................
New Options.....................................
Dennis L. Carr
Old Options.....................................
New Options.....................................
- ------------------------
(1) As more fully discussed below under the heading "Stock Option Plan," Old
Options (as defined below) were issued in exchange for Series 2 Options
originally granted in 1993 and 1994. Subject to certain rounding
calculations, the Old Options and the additional options granted during 1995
(the "New Options") will become exercisable in equal installments on the
first through fifth anniversaries of the date of the respective date of
grant.
(2) Prior to October , 1996, the Old Options and New Options had exercise
prices that increased at a rate of 12% per annum, compounded annually, from
their respective date of grant. Pursuant to an amendment to the Plan dated
October , 1996, (the "October Amendment") the exercise prices applicable
to the Old Options and New Options granted in fiscal year 1995 were fixed at
$ and $ , respectively, for each of the Named Executive
Officers (other than Mr. Zikry) and $ and $ , respectively,
for Mr. Zikry.
67
OPTION EXERCISES
The following table sets forth as to each of the Named Executive Officers
information with respect to options exercised during 1995 and the status of
their options on December 31, 1995:
AGGREGATED OPTION EXERCISES DURING 1995 AND OPTION VALUES
AT DECEMBER 31, 1995
VALUE OF UNEXERCISED
NUMBER OF UNEXERCISED IN-THE-MONEY
OPTIONS AT YEAR END OPTIONS AT YEAR END(*)
-------------------------- ------------------------
NUMBER OF SHARES
ACQUIRED UPON NON- NON-
NAME EXERCISE OF OPTIONS EXERCISABLE EXERCISABLE EXERCISABLE EXERCISABLE
- ------------------------------------------ ----------------------- ------------- ----------- ----------- -----------
John Franco
Old Options............................. -- 112 168 $ 25,536.00 $ 38,304
New Options............................. -- -- 236
Martin H. Ruby
Old Options............................. -- 112 168 $ 25,536.00 $ 38,304
New Options............................. -- -- 236
John R. Lindholm
Old Options............................. -- 57.60 86.40 $ 13,132.80 $ 19,699
New Options............................. -- -- 121 -- --
Emad A. Zikry
Old Options............................. -- 28.80 115.20 $ 6,566.40 $ 26,266
New Options............................. -- -- 121 -- --
David E. Ferguson
Old Options............................. -- 40 60 $ 9,120.00 $ 13,680
New Options............................. -- -- 84
Dennis L. Carr
Old Options............................. -- 19.20 28.80 $ 4,377.60 $ 6,566
New Options............................. -- -- 40 -- --
- ------------------------
(*) In accordance with the SEC's rules, values are calculated by subtracting the
exercise price from the fair market value of the underlying Common Stock.
For purposes of this table, fair market value is deemed to be $6,500, the
amount paid on June 14, 1995 by the MSCP Funds, New ARM, LLC and certain
directors of the Company, for newly issued shares. The Company believes that
none of the exercisable or nonexercisable New Options held at December 31,
1995 were in-the-money as of such date.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The full Board of Directors of the Company, including Mr. Franco and Mr.
Ruby, have approved the employment agreements described herein and will continue
to perform the functions of a compensation committee. Following the completion
of the Offering, the Board of Directors of the Company will appoint a
Compensation Committee, the members of which will be directors who are not
employees of the Company.
STOCK OPTION PLAN
The Plan provides for the grant of options to purchase Common Stock to
officers and other key employees of the Company. The maximum aggregate number of
shares of Common Stock that may be issued under the Plan is 3,445 (subject to
adjustment in accordance with the terms of the Plan), consisting of 1,765 Old
Options and 1,680 New Options. Approximately 46 individuals participate in the
Plan. As of September 30, 1996, an aggregate of 1,208 Old Options and 1,472 New
Options were outstanding and unexercised.
68
As originally adopted, the Plan provided for the grant of options to
purchase Common Stock of the Company with an exercise price that increased at a
rate equal to 12% per annum ("Series 1 Options") or 30% per annum ("Series 2
Options"), in each case compounded annually. As of June 14, 1995 (the "Amendment
Date"), outstanding Series 2 Options were replaced by a number of options with
an exercise price that increases at a rate of 12% per annum, compounded
annually. All options granted prior to the Amendment Date and all options
granted to replace Series 2 Options are referred to as "Old Options" and all
options that were or will be granted on or after the Amendment Date (other than
the options issued to replace Series 2 Options) are referred to as "New
Options."
Pursuant to the October Amendment, (i) the exercise prices applicable to Old
Options and New Options outstanding as of October , 1996 were fixed at
exercise prices ranging from $ per share to $ per share and (ii)
all unallocated Old Options were granted PRO RATA to existing holders of Old
Options with the exercise prices and vesting schedules being the average
weighted exercise prices and vesting percentages of the Old Options previously
held by such holders. As a result of such allocation, Old Options were
granted at exercise prices ranging from $ per share to $ per
share.
Pursuant to the terms of the Plan, the exercisability of the Old Options and
the New Options will be accelerated upon the occurrence of certain specified
events, including, without limitation, a Change in Control or a sale by the
Company of all or substantially all of its business to a third party. For
purposes of the Plan, a "Change in Control" means the acquisition of equity
securities of the Company, directly or indirectly, through a merger or
otherwise, in a single transaction or a series of transactions, by a person,
entity or group that is not, directly or indirectly, in control of, controlled
by, or under common control with the Company, MS & Co., MSLEF II or the MSCP
Funds, entitling such person, entity or group to elect a majority of the members
of the Board of Directors.
Following a holder's termination of employment by the Company for cause (as
defined in the Plan) on or prior to the fifth anniversary of the date on which
options were granted to the employee, such holder's vested and unvested options
are automatically forfeited and cancelled and must be surrendered without
payment and the shares previously issued upon exercise of the options will be
subject to repurchase by the Company at its discretion. In the event of such a
repurchase, Option Shares (as defined in the Plan and specifically including any
Option Shares transferred to permitted transferees under the Stockholders
Agreement) will be repurchased at a price based on their original purchase price
(or, if less, the then Applicable Value (as defined in the Plan) of the shares).
If, on or prior to the fifth anniversary of the date on which options were
granted, the holder resigns other than for good reason (as defined in the Plan),
such holder's unvested options will be forfeited and cancelled and must be
surrendered without payment, such holder's vested options will generally remain
exercisable for 30 days and the shares previously issued upon exercise of the
options will be subject to repurchase by the Company. In the event of such a
repurchase, Option Shares will be repurchased at a price equal to the then
Applicable Value. If a holder's employment is terminated by reason of death or
permanent disability, such holder's options will become 50%-vested if such
options were less than 50%-vested at the time of termination. If a holder's
employment is terminated due to his resignation for good reason, all unvested
options will vest. The Plan further provides that if a holder is terminated
without cause, resigns for good reason or terminates employment by reason of
death or permanent disability (or terminates employment for any other reason
following the fifth anniversary of the date on which options were granted to the
holder), (i) all vested options (including options that vest as a consequence of
such termination of employment) will generally remain exercisable for 90 days
(or one year in the event of death or permanent disability) following the date
of termination and (ii) no options or Option Shares shall be subject to
repurchase by the Company.
The Plan is administered by the Stock Option Committee of the Board of
Directors. Under certain circumstances, the Plan permits the holders to satisfy
the payment of the exercise price by delivery of shares of Class A Common Stock
previously owned by the holder for at least a six-month period and to
69
satisfy their withholding and exercise price obligations by delivery of such
shares or by having the Company retain a number of Option Shares that would
otherwise be issued upon the exercise of such holder's options.
All options are nontransferable except by will or the laws of descent and
distribution, and all shares of Common Stock issued upon exercise of any option
will be subject to the Stockholders' Agreement.
Upon completion of the Offering, all unallocated New Options will be granted
PRO RATA to existing holders of New Options with the exercise prices and vesting
schedules of such New Options being the average weighted exercise prices and
vesting percentages of the New Options previously held by such holders. Set
forth below is a chart summarizing the grants that will be made in accordance
with such allocation:
NEW PLAN BENEFITS
AMENDED AND RESTATED STOCK OPTION PLAN
DOLLAR VALUE
NAME ($) NUMBER OF NEW OPTIONS
- ----------------------------------------------------- --------------- ----------------------
John Franco..........................................
Martin H. Ruby.......................................
John R. Lindholm.....................................
Emad A. Zikry........................................
David E. Ferguson....................................
Dennis L. Carr.......................................
Executive Group......................................
Non-Employee Director Group..........................
Non-Executive Officer Employee Group.................
Upon consummation of the Offering and as a result of the allocation
described above, all options available for grant under the Plan will have been
granted and, accordingly, there are no further options available for grant
thereunder.
The federal income tax consequences of the options granted under the Plan
are substantially similar to those for nonqualified options to be granted under
the 1996 Equity Plan (as defined below). See "1996 Equity Incentive
Plan--Certain Federal Income Tax Consequences of Options".
EMPLOYMENT CONTRACTS
The Company has entered into employment agreements with Messrs. Franco,
Ruby, Lindholm, Zikry and Ferguson. Such agreements terminate on July 1, 1999
and will be extended automatically for additional one-year periods by means of
the Board of Directors giving written notice to such executive of its intention
to extend the term at least sixty days (in the case of Mr. Ruby and Mr. Franco,
twelve months) prior to the expiration of the then effective term. Each
employment agreement specifies salary levels and describes the bonus plan,
employee benefits and perquisites available. The present base salaries for
Messrs. Franco, Ruby, Lindholm, Zikry and Ferguson are $ , $ ,
$ , $ and $ , respectively.
The employment agreements with respect to Messrs. Franco and Ruby (i) fix
such executives' responsibilities and titles as Co-Chief Executive Officers and
directors of the Company and (ii) provide that such executives' base salary may
be increased by the Board of Directors at any time, but may not be decreased.
The employment agreement with respect to Mr. Zikry (i) establishes his
responsibilities and title as Executive Vice President and Chief Investment
Officer of the Company and as President of ARM Capital Advisors and (ii)
provides that his base salary may be increased at any time, but may not be
70
decreased, upon recommendation of the Company's Co-Chief Executive Officers and
review by the Board of Directors. The employment agreements with respect to
Messrs. Lindholm and Ferguson prohibit any decrease in base salary, but, in
contrast to the agreements for Messrs. Franco, Ruby and Zikry, do not fix such
executives' responsibilities or titles (other than providing that each will
serve the Company in a professional capacity). Each of the employment agreements
provides that the executives shall be entitled to participate in the Company's
bonus plan. In addition, Mr. Zikry's employment agreement provides for a
guaranteed bonus of $500,000 (the "Minimum Bonus") for the 1996 calendar year.
The benefits provided by the employment agreements include, to the extent
each executive is eligible, any plans, programs or arrangements of the Company
providing for retirement benefits, incentive compensation, profit sharing,
bonuses, disability benefits, health, dental and life insurance, or vacation and
paid holidays. The executives will also receive indemnification from the Company
to the fullest extent permitted by Delaware law and the Certificate of
Incorporation and By-Laws of the Company as currently in effect and the Company
will procure and maintain insurance policies, to the extent reasonably
available, for the benefit of its directors and officers, including the
executives.
Generally, the employment agreements provide that, upon a termination of an
executive's employment by the Company without "cause" or a resignation for "good
reason" (as such terms are defined in the employment agreements; among other
things, a termination by the executive following a Change in Control (as
previously defined under the heading "Stock Option Plan") is a resignation with
"good reason"), the executive will receive (i) severance pay in an amount equal
to the base salary for the greater of the remainder of the employment term or
two years and (ii) additional severance amounts for each full or partial
calendar year during the severance period in cash equal to the same percentage
of base salary as of the date of termination as the percentage of base salary
used in calculating the bonus paid to the executive for the year preceding the
year of termination. With respect to Mr. Zikry's employment agreement, if such
termination of employment occurs prior to the payment of bonuses in respect of
1996, he shall be entitled to receive the Minimum Bonus. In the event that his
employment is terminated prior to October 31, 1997, due to voluntary resignation
other than for good reason, or a termination by the Company for cause, he shall
be required to repay to the Company a PRO RATA portion of the $1,500,000 one-
time initial bonus he received upon accepting employment with the Company in
1994. Severance pay will be subject to each executive's compliance with certain
restrictive covenants. In the event an executive's employment is terminated by
the Company for cause or the executive resigns without good reason, he will be
entitled only to base salary through the relevant date of termination or
resignation of employment. In the event an executive dies or is permanently
disabled, he (or his beneficiary or estate in the event of his death) will be
entitled to receive base salary and benefits (including a PRO RATA cash bonus
for the year of death or disability) for the period ending on the date of death
or, in the case of disability, through the later of the date of termination or
the date (not later than one year following the date of termination) on which
the executive commences to receive disability benefits.
1996 EQUITY INCENTIVE PLAN
Prior to the consummation of the Offering, the Company intends to adopt the
1996 Equity Incentive Plan (the "1996 Equity Plan"). The 1996 Equity Plan will
be administered by the Compensation Committee upon establishment thereof, and by
the Board of Directors prior to that time (the "Committee"). The 1996 Equity
Plan provides for the granting of incentive stock options (within the meaning of
Section 422 of the Internal Revenue Code of 1986, as amended (the "Code")) and
nonqualified stock options, stock appreciation rights, restricted stock,
performance units and performance shares (individually, an "Award," or
collectively, "Awards") to those officers, and other key employees and
consultants with potential to contribute to the future success of the Company or
its subsidiaries; provided, that only employees may be granted incentive stock
options. The Committee has discretion to select the persons to whom Awards will
be granted (from among those eligible), to determine the type, size and terms
and conditions applicable to each Award and the authority to interpret, construe
and implement the
71
provisions of the 1996 Equity Plan; provided, that in accordance with the
requirements under Section 162(m) of the Code, no participant may receive a
grant of stock options or stock appreciation rights with respect to more than
shares of Common Stock in any Plan year. The Committee's decisions are
binding on the Company and persons eligible to participate in the 1996 Equity
Plan and all other persons having any interest in the 1996 Equity Plan. It is
presently anticipated that approximately individuals will initially
participate in the 1996 Equity Plan.
The maximum number of shares of Common Stock that may be subject to Awards
under the 1996 Equity Plan is shares, subject to adjustment in accordance
with the terms of the 1996 Equity Plan. Common Stock issued under the 1996
Equity Plan may be either authorized but unissued shares, treasury shares or any
combination thereof. Any shares of Common Stock subject to an Award which
lapses, expires or is otherwise terminated prior to the issuance of such shares
may become available for new Awards.
Set forth below is a description of the types of Awards which may be granted
under the 1996 Equity Plan:
STOCK OPTIONS. Options (each, an "Option") to purchase shares of Common
Stock, which may be nonqualified or incentive stock options, may be granted
under the 1996 Equity Plan at an exercise price (the "Option Price") determined
by the Committee in its discretion, provided that the Option Price of incentive
stock options may be no less than the fair market value of the underlying Common
Stock on the date of grant (110% of fair market value in the case of an
incentive stock option granted to a ten percent shareholder).
Options will expire not later than ten years after the date on which they
are granted (five years in the case of an incentive stock option granted to a
ten percent shareholder). Options become exercisable at such times and in such
installments as determined by the Committee; provided that all such Options will
be fully exercisable within five years after the date on which they are granted,
and such exercisability may be based on (i) length of service or (ii) the
attainment of performance goals established by the Committee. The Committee may
also accelerate the time or times at which any or all Options held by an
optionee may be exercised. Payment of the Option Price must be made in full at
the time of exercise in cash, certified or bank check, or other instrument
acceptable to the Committee. In the discretion of the Committee, payment in full
or in part may also be made by the optionee tendering to the Company shares of
Common Stock owned for at least a six-month period and having a fair market
value equal to the Option Price (or such portion thereof) or by means of a
"cashless exercise" procedure to be approved by the Committee.
STOCK APPRECIATION RIGHTS. A stock appreciation right ("SAR") is an Award
entitling the recipient to receive an amount equal to (or less than, if the
Committee so determines at the time of grant) the excess of the fair market
value of a share of Common Stock on the date of exercise over the exercise price
per share specified for the SAR, multiplied by the number of shares of Common
Stock with respect to which the SAR is then being exercised. An SAR granted in
connection with an Option will be exercisable to the extent that the related
Option is exercisable. Upon the exercise of an SAR related to an Option, the
Option related thereto will be cancelled to the extent of the number of shares
covered by such exercise and such shares will no longer be available for grant
under the 1996 Equity Plan. Upon the exercise of a related Option, the SAR will
be cancelled automatically to the extent of the number of shares covered by the
exercise of the Option. SARs unrelated to an Option will contain such terms and
conditions as to exercisability, vesting and duration as the Committee may
determine, but such duration will not be greater than ten years. The Committee
may accelerate the period for the exercise of an SAR. Payment upon exercise of
an SAR will be made, at the election of the Committee, in cash, in shares of
Common Stock or a combination thereof.
The Committee may grant limited stock appreciation rights (an "LSAR") under
the 1996 Equity Plan. An LSAR is an SAR which becomes exercisable only in the
event of a "change in control" (as defined below). Any such LSAR will be settled
solely in cash. An LSAR must be exercised within the 30-day period following a
change in control.
72
RESTRICTED STOCK. An Award of restricted stock ("Restricted Stock") is an
Award of Common Stock which is subject to such restrictions as the Committee
deems appropriate, including forfeiture conditions and restrictions against
transfer for a period specified by the Committee. Restricted Stock Awards may be
granted under the 1996 Equity Plan for or without consideration. Restrictions on
Restricted Stock may lapse in installments based on factors selected by the
Committee. The Committee, in its sole discretion, may waive or accelerate the
lapsing of restrictions in whole or in part. Prior to the expiration of the
restricted period, except as otherwise provided by the Committee, a grantee who
has received a Restricted Stock Award has the rights of a shareholder of the
Company, including the right to vote and to receive cash dividends on the shares
subject to the Award. Stock dividends issued with respect to shares covered by a
Restricted Stock Award will be treated as additional shares under such Award and
will be subject to the same restrictions and other terms and conditions that
apply to the shares with respect to which such dividends are issued.
PERFORMANCE SHARES; PERFORMANCE UNITS. A performance share Award (a
"Performance Share") is an Award which represents the right to receive a
specified number of shares of Common Stock upon satisfaction of certain
specified performance criteria, subject to such other terms and conditions as
the Committee deems appropriate. A performance unit (a "Performance Unit") is an
Award of a number of units entitling the recipient to receive an amount equal to
(or less than, if the Committee so determines at the time of grant) the excess
of the fair market value of a share of Common Stock on the relevant date over
the price per share specified for the Performance Unit, multiplied by the number
of Units, upon satisfaction of certain specified performance criteria, subject
to such other terms and conditions as the Committee deems appropriate.
Performance objectives will be established before, or as soon as practicable
after, the commencement of the performance period (the "Performance Period") and
may be based on net earnings, operating earnings or income, absolute and/or
relative return on equity or assets, earnings per share, cash flow, pre-tax
profits, earnings growth, revenue growth, comparisons to peer companies, any
combination of the foregoing and/or such other measures, including individual
measures of performance, as the Committee deems appropriate. Prior to the end of
a Performance Period, the Committee, in its discretion and only under conditions
which do not affect the deductibility of compensation attributable to
Performance Shares or Performance Units, as the case may be, under Section
162(m) of the Code, may adjust the performance objectives to reflect an event
which may materially affect the performance of the Company, a subsidiary or a
division, including, but not limited to, market conditions or a significant
acquisition or disposition of assets or other property by the Company, a
subsidiary or a division. The extent to which a grantee is entitled to payment
in settlement of a Performance Share Award or a Performance Unit Award at the
end of the Performance Period will be determined by the Committee in its sole
discretion, based on whether the performance criteria have been met.
Payment in settlement of a Performance Share Award or a Performance Unit
Award will be made as soon as practicable following the last day of the
Performance Period, or at such other time as the Committee may determine, in
shares of Common Stock or cash, respectively.
ADDITIONAL INFORMATION. Under the 1996 Equity Plan, if there is any change
in the outstanding shares of Common Stock by reason of any stock dividend,
recapitalization, merger, consolidation, stock split, combination or exchange of
shares or other form of reorganization, or any other change involving the Common
Stock, such proportionate adjustments as may be necessary (in the form
determined by the Committee) to reflect such change will be made to prevent
dilution or enlargement of rights with respect to the aggregate number of shares
of Common Stock for which Awards in respect thereof may be granted under the
1966 Equity Plan, the number of shares of Common Stock covered by each
outstanding Award and the price per share in respect thereof. Generally, an
individual's rights under the 1996 Equity Plan may not be assigned or
transferred (except in the event of death).
In the event of a change in control and except as the Committee (as
constituted prior to such change in control) may expressly provide otherwise:
(i) all Options or SARs then outstanding will become fully exercisable as of the
date of the change in control, whether or not then exercisable; (ii) all
restrictions and
73
conditions of all Restricted Stock Awards then outstanding will lapse as of the
date of the change in control; (iii) all Performance Share Awards and
Performance Unit Awards will be deemed to have been fully earned as of the date
of the change in control and (iv) in the case of a change in control involving a
merger of, or consolidation involving, the Company in which the Company is (A)
not the surviving corporation (the "Surviving Entity") or (B) becomes a wholly
owned subsidiary of the Surviving Entity or a parent thereof, each outstanding
Option granted under the Plan and not exercised (a "Predecessor Option") will be
converted into an option (a "Substitute Option") to acquire common stock of the
Surviving Entity or its parent, which Substitute Option will have substantially
the same terms and conditions as the Predecessor Option, with appropriate
adjustments as to the number and kind of shares and exercise prices. For
purposes of the 1996 Equity Plan, a "change in control" shall have occurred when
(A) any person or "group" within the meaning of Sections 13(d) or 14(d)(2) of
the Exchange Act (other than (x) the Company, any subsidiary of the Company, any
employee benefit plan of the Company or of any subsidiary of the Company, or any
person or entity organized, appointed or established by the Company or any
subsidiary of the Company for or pursuant to the terms of any such plans or (y)
MS & Co., MSLEF II or the MSCP Funds or any of their respective affiliates,
alone or together with its affiliates and associates (collectively, an
"Acquiring Person"), shall become the beneficial owner of [ ]% or more of
either (i) the then outstanding shares of Common Stock or (ii) the combined
voting power of the Company's then outstanding voting securities (except
pursuant to an offer for all outstanding shares of Common Stock at a price and
upon such terms and conditions as a majority of the Continuing Directors (as
defined below) determine to be in the best interests of the Company and its
shareholders (other than an Acquiring Person on whose behalf the offer is being
made)), (B) during any period of two consecutive years, individuals who at the
beginning of such period constitute the Board of Directors and any new director
(other than a director who is a representative or nominee of an Acquiring
Person) whose election by the Board of Directors or nomination for election by
the Company's shareholders was approved by a vote of at least a majority of the
directors then still in office who either were directors at the beginning of the
period or whose election or nomination for election was previously so approved
(collectively, the "Continuing Directors"), no longer constitute a majority of
the Board of Directors, (C) the shareholders of the Company approve a merger or
consolidation of the Company with any other corporation, other than a merger or
consolidation which would result in the voting securities of the Company
outstanding immediately prior thereto continuing to represent (either by
remaining outstanding or by being converted into voting securities of the
Surviving Entity or a parent thereof) at least [ ]% of the combined voting
power of the voting securities of the Company or such Surviving Entity or a
parent thereof outstanding immediately after such merger or consolidation; or
(D) the shareholders of the Company approve a plan of reorganization (other than
a reorganization under the United States Bankruptcy Code) or complete
liquidation of the Company or an agreement for the sale or disposition by the
Company of all or substantially all of the Company's assets; provided, however,
that a change in control shall not be deemed to have occurred in the event of
(x) a sale or conveyance in which the Company continues as a holding company of
an entity or entities that conduct all or substantially all of the business or
businesses formerly conducted by the Company or (y) any transaction undertaken
for the purpose of reincorporating the Company under the laws of another
jurisdiction, if such transaction does not materially affect the beneficial
ownership of the Company's capital stock.
The 1996 Equity Plan will remain in effect until terminated by the Board of
Directors and thereafter until all Awards granted thereunder are either
satisfied by the issuance of shares of Common Stock or the payment of cash or
terminated pursuant to the terms of the 1996 Equity Plan or under any Award
agreements. Notwithstanding the foregoing, no Awards may be granted under the
1996 Equity Plan after the tenth anniversary of the effective date of the 1996
Equity Plan. The Board of Directors may at any time terminate, modify, suspend
or amend the 1996 Equity Plan; provided, however, that no such amendment,
modification, suspension or termination may adversely affect an optionee's or
grantee's rights under any Award theretofore granted under the 1996 Equity Plan,
except with the consent of such optionee or grantee, and no such amendment or
modification will be effective unless and until the same is approved by
74
the shareholders of the Company where such shareholder approval is required to
comply with Rule 16b-3 under the Exchange Act, Section 162(m) of the Code, or
other applicable law, regulation or Nasdaq National Market or stock exchange
rule.
CERTAIN FEDERAL INCOME TAX CONSEQUENCES OF OPTIONS. Certain of the Federal
income tax consequences to optionees and the Company of Options granted under
the 1996 Equity Plan should generally be as set forth in the following summary.
An employee to whom an incentive stock option ("ISO") which qualifies under
Section 422 of the Code is granted will not recognize income at the time of
grant or exercise of such Option. However, upon the exercise of an ISO, any
excess in the fair market price of the Common Stock over the Option Price
constitutes a tax preference item which may have alternative minimum tax
consequences for the employee. If the employee sells such shares more than one
year after the date of transfer of such shares and more than two years after the
date of grant of such ISO, the employee will generally recognize a long-term
capital gain or loss equal to the difference, if any, between the sale prices of
such shares and the Option Price. The Company will not be entitled to a federal
income tax deduction in connection with the grant or exercise of the ISO. If the
employee does not hold such shares for the required period, when the employee
sells such shares, the employee will recognize ordinary compensation income and
possibly capital gain or loss (long-term or short-term, depending on the holding
period of the stock sold) in such amounts as are prescribed by the Code and the
regulations thereunder and the Company will generally be entitled to a Federal
income tax deduction in the amount of such ordinary compensation income
recognized by the employee.
An employee to whom a nonqualified stock option ("NSO") is granted will not
recognize income at the time of grant of such Option. When such employee
exercises such NSO, the employee will recognize ordinary compensation income
equal to the excess, if any, of the fair market value, as of the date of Option
exercise, of the shares the employee receives upon such exercise over the Option
Price paid. The tax basis of such shares to such employee will be equal to the
Option Price paid plus the amount, if any, includible in the employee's gross
income, and the employee's holding period for such shares will commence on the
date on which the employee recognizes taxable income in respect of such shares.
Gain or loss upon a subsequent sale of any Common Stock received upon the
exercise of a NSO generally would be taxed as capital gain or loss (long-term or
short-term, depending upon the holding period of the stock sold). Certain
additional rules apply if the Option Price is paid in shares previously owned by
the participant. Subject to the applicable provisions of the Code and
regulations thereunder, the Company will generally be entitled to a Federal
income tax deduction in respect of a NSO in an amount equal to the ordinary
compensation income recognized by the employee. This deduction will, in general,
be allowed for the taxable year of the Company in which the participant
recognizes such ordinary income.
STOCK OPTION REPRICINGS
The following table sets forth information concerning the repricing of stock
options held by certain executive officers since the Company's inception,
including (i) the date of the repricing, (ii) the number of shares subject to
the repriced options, (iii) the market price at the time of repricing, (iv) the
exercise price at the time of repricing, (v) the new exercise price and (vi) the
original option term remaining at the date of repricing:
75
TEN-YEAR OPTION REPRICINGS
EXERCISE NEW EXERCISE
NUMBER OF PRICE OF PRICE OF LENGTH OF
DATE OF SECURITIES MARKET PRICE SERIES 2 REPLACEMENT ORIGINAL OPTION
REPRICING UNDERLYING OF STOCK AT OPTIONS AT OPTIONS AT TERM REMAINING
OF SERIES 2 OPTIONS TIME OF TIME OF TIME OF AT DATE OF
NAME AND PRINCIPAL POSITION OPTIONS(1) REPRICED REPRICING REPRICING(2) REPRICING(3) REPRICING
- -------------------------------------- ----------- --------------- ------------- ------------- ------------- ---------------
John Franco
Co-Chief Executive Officer and
Co-Chairman of the Board.......... 6/14/95 73 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
Martin H. Ruby
Co-Chief Executive Officer and
Co-Chairman of the Board.......... 6/14/95 73 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
John R. Lindholm
Executive Vice President-- Chief
Marketing Officer................. 6/14/95 38 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
Emad A. Zikry
Executive Vice President-- Chief
Investment Officer................ 6/14/95 38 $ 6,500 $ 6,440 $ 5,936 9 years, 5
months
David E. Ferguson
Executive Vice President-- Chief
Administrative Officer............ 6/14/95 29 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
Dennis L. Carr
Executive Vice President-- Chief
Actuary........................... 6/14/95 12 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
John R. McGeeney
Co-General Counsel.................. 6/14/95 10 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
Robert H. Scott
Co-General Counsel and Secretary.... 6/14/95 10 $ 6,500 $ 7,475 $ 5,936 8 years, 5
months
- ------------------------
(1) As more fully discussed herein under the heading "Stock Option Plan," Old
Options were issued, in exchange for Series 2 Options originally granted in
1993 and 1994, as a part of the amendment and restatement of the Plan
effective as of June 14, 1995.
(2) This reflects that the base price of the Series 2 Options issued under the
Plan prior to its amendment and restatement increased at a rate of 30% per
annum, compounded annually, from the original date of grant and continued
until exercise of the options.
(3) This reflects that the base price of the Old Options granted as replacement
options for the Series 2 Options under the Plan increased at the rate of 12%
per annum, compounded annually, from the original date of grant. Pursuant to
the October Amendment, the exercise prices applicable to Old Options were
fixed at prices ranging from $ per share to $ per share.
76
STOCK OPTION COMMITTEE REPORT ON REPRICING OF OPTIONS
On June 8, 1995, the Board of Directors of the Company approved the
amendment and restatement of the Plan effective as of June 14, 1995. As provided
by the Plan, Old Options, whose base price increases at a rate of 12% per annum,
compounded annually, were issued to the Plan participants as replacement options
for their respective Series 2 Options originally granted prior to the amendment
and restatement of the Plan, whose base price increased at a rate of 30% per
annum, compounded annually. The Company's Stock Option Committee (the
"Committee"), whose members consists of Messrs. Cole, Franco, Ramsay, Ruby, and
Sica, subsequently ratified the issuance of the Old Options in exchange for the
Series 2 Options. The number of Old Options granted to executive officers was
less than the number of Series 2 Options previously granted. All other terms and
conditions of these options, including vesting schedules and expiration dates,
remained unchanged.
Stock options are intended to provide incentives to the Company's officers
and employees. The Committee believes that such equity incentives are a
significant factor in the Company's ability to attract, retain and motivate key
employees who are critical to the Company's long term success. The Committee
believed that, at their original exercise price, the disparity between the
exercise price of the Series 2 Options and recent market prices for the Common
Stock did not provide meaningful incentives to the employees holding these
options. Inquiries conducted indicated that other companies in the insurance
industry have been confronted with this problem and have made similar
adjustments in option prices to motivate their employees. The Committee ratified
the issuance of the Old Options as replacement options for the Series 2 Options
as a means of ensuring that the optionees will continue to have meaningful
equity incentives to work toward the success of the Company. The adjustment was
deemed by the Committee to be in the best interest of the Company and its
stockholders.
John Franco, Co-Chairman
Martin H. Ruby, Co-Chairman
James S. Cole
David R. Ramsey
Frank V. Sica
77
CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
STOCKHOLDERS' AGREEMENT
The Company, MSLEF II, Oldarm L.P., Mr. Franco, Mr. Ruby, the MSCP Funds,
New ARM, LLC and the other stockholders of the Company prior to the Offering
will enter into the Stockholders' Agreement, which will set forth certain rights
and obligations of each such holder of Common Stock. Pursuant to the terms of
the Stockholders' Agreement, no stockholder may make or solicit the sale of, or
create, incur, solicit or assume the encumbrance of, any share of Common Stock
except in a public offering, in accordance with Rule 144 or otherwise in
compliance with the Securities Act and applicable state securities law.
The Stockholders' Agreement grants the Morgan Stanley Stockholders the right
on up to three occasions to require the Company to file a registration statement
under the Securities Act covering the registration of a number of shares at
least equal to million shares of Common Stock or a lesser number if such
number represents a majority of the shares of Common Stock then held by the
Morgan Stanley Stockholders. In addition to such demand rights, the other
parties to the Stockholders' Agreement are entitled, subject to certain
limitations, to register shares of Common Stock in connection with a
registration statement prepared by the Company. The Stockholders' Agreement
contains customary terms and provisions with respect to, among other things,
registration procedures and certain rights to indemnification granted by the
parties thereunder in connection with any such registration of Common Stock.
The Stockholders' Agreement also provides that the Morgan Stanley
Stockholders will have the right to designate one-half of the members of the
Board of Directors of the Company for so long as the total number of shares of
Common Stock of the Company owned by the Morgan Stanley Stockholders constitutes
at least 50% of the outstanding Common Stock of the Company. If such ownership
falls below 50%, the number of directors that the Morgan Stanley Stockholders
will have the right to designate will be reduced to the number of directors
which constitutes a percentage representation on the Board equal to the Morgan
Stanley Stockholders' aggregate percentage ownership of the outstanding Common
Stock of the Company; provided that so long as the Morgan Stanley Stockholders
own at least 5% of the outstanding Common Stock of the Company, the Morgan
Stanley Stockholders will have the right to designate at least one director.
After giving effect to the Offering, the Morgan Stanley Stockholders will own
% of the Common Stock of the Company ( % if the Underwriters'
over-allotment option is exercised in full) and % of the voting Common Stock
( % if the Underwriters' over-allotment option is exercised in full). The
Morgan Stanley Stockholders have informed the Company that they intend, upon
consummation of the Offering, to convert such number of their shares of
non-voting Common Stock so that, following such conversion, the Morgan Stanley
Stockholders will own, in the aggregate, 49% of the outstanding voting stock of
the Company.
OTHER TRANSACTIONS
The Company has entered into an agreement with MS & Co. for financial
advisory services in consideration for which the Company has agreed to pay MS &
Co. a base and contingency fee and to reimburse MS & Co. for all reasonable
expenses incurred in performance of the foregoing services. The Company paid
certain affiliates of MS Group approximately $13,000, $655,000 (in connection
with the SBM acquisition) and $3.1 million (in connection with the acquisition
of the Integrity Companies) for these and other miscellaneous services in the
first half of 1996 and in 1995 and 1994, respectively.
During 1995, in the ordinary course of business, certain of the Company's
insurance subsidiaries purchased debt and equity securities in public offerings
with an aggregate purchase price of approximately $16.5 million through MS & Co.
In addition, MS & Co. served as lead underwriter of the initial public offering
of the Company's Perpetual Preferred Stock in 1993, for which it received
approximately $487,000 in underwriting fees.
78
The Company entered into an interest rate collar agreement in 1994 with MS &
Co. under which MS & Co. was paid a one-time fee of $ .
Based on transactions of similar size and nature, the Company believes that
the foregoing fees received by MS & Co. were no less favorable to the Company
than would be available from unaffiliated third parties.
CERTAIN RELATIONSHIPS AND RELATED PARTIES
Four of the Named Executive Officers and certain of the directors of the
Company are limited partners of, or are the beneficial owners of limited
partnership interests in, Oldarm L.P. Two of the Named Executive Officers manage
New ARM LLC which owns 170 shares of Common Stock. Three of the Company's nine
directors are also employees of MS & Co. and officers (including, in one case, a
director) of affiliates of MS & Co. which control the Morgan Stanley
Stockholders. In addition, MS & Co.'s affiliates, the Morgan Stanley
Stockholders, beneficially own 49% of the Company's voting securities.
79
PRINCIPAL AND SELLING STOCKHOLDERS
The following table provides information, as of September 30, 1996,
concerning beneficial ownership of the Common Stock and Perpetual Preferred
Stock by (i) each person or entity known by the Company to beneficially own more
than 5% of the outstanding Class A Common Stock, (ii) each director of the
Company, (iii) each Named Executive Officer, (iv) each Selling Stockholder and
(v) all directors and executive officers of the Company as a group. The
information in the table is based on information from the named persons
regarding ownership of Common Stock. Unless otherwise indicated, each of the
stockholders has sole voting and investment power with respect to the shares
shown as beneficially owned by them.
CLASS A COMMON STOCK CLASS B COMMON STOCK
---------------------------------------------- ----------------------------------------------
OWNED PRIOR TO TO BE OWNED OWNED PRIOR TO TO BE OWNED
AFTER THE AFTER THE
THE OFFERING OFFERING THE OFFERING OFFERING
---------------------- ---------------------- ---------------------- ----------------------
NUMBER % NUMBER % NUMBER % NUMBER %
----------- --------- ----------- --------- ----------- --------- ----------- ---------
The Morgan Stanley Leveraged
Equity Fund II, L.P.(1)..... 12,896
1221 Avenue of the Americas
New York, New York 10020
Morgan Stanley Capital
Partners III, L.P.(1)....... 8,395.18
1221 Avenue of the Americas
New York, New York 10020
Morgan Stanley Capital
Investors, L.P.(1).......... 246.77
1221 Avenue of the Americas
New York, New York 10020
MSCP III 892 Investors,
L.P.(1)...................... 896.51
1221 Avenue of the Americas
New York, New York 10020
Oldarm L.P.(2)............... 1,000
239 S. Fifth Street, 12th
Floor
Louisville, Kentucky
40202-3271
Directors and Named Executive
Officers:
John Franco................ 1,670(3)
Martin H. Ruby............. 1,370(3)
Dennis L. Carr............. 40(3) (5)
David E. Ferguson.......... 1,039(3)
John R. Lindholm(5)........ 1,025(3)
Emad A. Zikry.............. -- --
James S. Cole.............. -- --
Warren M. Foss............. 21 (5)
Dudley J. Godfrey, Jr...... 50.77 (5)
Edward D. Powers........... 50.77 (5)
David R. Ramsay............ -- --
Frank V. Sica.............. -- --
Irwin T. Vanderhoof........ 10 (5)
All directors and executive
officers as a group.......... 2,312.54
TOTAL PERPETUAL
COMMON PREFERRED
STOCK STOCK
---------------------- --------------------
AFTER THE AFTER THE
OFFERING OFFERING
---------------------- --------------------
NUMBER % NUMBER %
----------- --------- --------- ---------
The Morgan Stanley Leveraged
Equity Fund II, L.P.(1).....
1221 Avenue of the Americas
New York, New York 10020
Morgan Stanley Capital
Partners III, L.P.(1).......
1221 Avenue of the Americas
New York, New York 10020
Morgan Stanley Capital
Investors, L.P.(1)..........
1221 Avenue of the Americas
New York, New York 10020
MSCP III 892 Investors,
L.P.(1)......................
1221 Avenue of the Americas
New York, New York 10020
Oldarm L.P.(2)...............
239 S. Fifth Street, 12th
Floor
Louisville, Kentucky
40202-3271
Directors and Named Executive
Officers:
John Franco................ 61,350(4)
Martin H. Ruby............. 1,600(4)
Dennis L. Carr............. 500(4)
David E. Ferguson.......... 3,800(4)
John R. Lindholm(5)........ 800
Emad A. Zikry..............
James S. Cole..............
Warren M. Foss.............
Dudley J. Godfrey, Jr......
Edward D. Powers...........
David R. Ramsay............
Frank V. Sica..............
Irwin T. Vanderhoof........
All directors and executive
officers as a group.......... 68,350
80
- ------------------------
(1) The general partner of which, in the case of MSLEF II, and the general
partner of the general partner of which, in the case of MSCP Funds, are
wholly owned subsidiaries of MS Group, the parent of MS & Co.
(2) Oldarm GP Partnership, the general partner of Oldarm L.P., has the power to
vote, or direct the voting of, the shares of Class A Common Stock owned by
Oldarm L.P. Messrs. Franco and Ruby may, by virtue of their positions as
Co-Chief Executive Officers of Oldarm GP Partnership, be deemed to be
beneficial owners of the Class A Common Stock owned by Oldarm L.P; however,
Messrs. Franco and Ruby disclaim any such beneficial ownership. As of the
date hereof, the Named Executive Officers, excluding Messrs. Carr and Zikry,
and certain of the directors of the Company were limited partners of, or
beneficial owners of, limited partnership interests in Oldarm L.P.
(3) All shares of Class A Common Stock are held directly with the following
exceptions: Mr. Ferguson beneficially owns 2 shares which are held in the
IRA account of his wife Jeanne Ferguson; Messrs. Ruby, Lindholm, and
Ferguson hold 200 shares, 4 shares, and 31 shares, respectively, in trust
for the purpose of securing personal loans, and over which they have full
voting, but limited investment power. In their capacity as managers of New
ARM, LLC, which is the direct owner of 170 shares of the Class A Common
Stock, Messrs. Franco and Ruby acting in concert would have voting and
limited investment power over, but no pecuniary interest in, the 170 shares
of Class A Common Stock (included above), of which they each disclaim
beneficial ownership. 1,000 shares of Class A Common Stock are directly
owned by Oldarm L.P. Despite the fact that the named beneficial owners of
Class A common stock as a group hold a majority of the stock of Oldarm GP
Partnership, the general partner of Oldarm L.P., and therefore may be deemed
to beneficially own such shares, each such individual disclaims any
beneficial ownership of the Class A Common Stock owned by Oldarm L.P.,
except to the extent of their pecuniary interest therein.
(4) Mr. Franco holds shared investment power over 25,400 shares of the Perpetual
Preferred Stock which are indirectly held by the John and Mary Franco Family
Foundation, Inc. Mr. Franco also disclaims beneficial ownership of such
shares of Perpetual Preferred Stock held by the John and Mary Franco Family
Foundation in accordance with the Foundation's 501(c)(3) tax-exempt status.
In addition, 3,650 shares of Perpetual Preferred Stock are owned indirectly
by Mr. Franco's minor daughter under the Uniform Transfer to Minors Act.
1600 shares of Perpetual Preferred Stock held by Mr. Ruby are indirectly
owned by his two minor daughters under the Uniform Transfer to Minors Act.
Mr. Ferguson owns 3,500 shares jointly with his wife. Dennis Carr owns 500
shares of Perpetual Preferred Stock jointly with his wife.
(5) Less than one percent.
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DESCRIPTION OF CERTAIN INDEBTEDNESS
The following summary of the Credit Agreement does not purport to be
complete and is qualified in its entirety by reference to the Credit Agreement,
a copy of which has been filed as an exhibit to the Registration Statement of
which this Prospectus is a part. Capitalized terms used but not defined herein
have the meanings given to them in the Credit Agreement.
Pursuant to the Credit Agreement, a syndicate of banks provides the Company
with a term loan facility in the principal amount of $40 million bearing a
floating interest rate equal to 7/8 of 1% over the London Interbank Offered Rate
(6.51% at September 30, 1996). By virtue of an interest rate cap agreement which
expires on March 20, 1998, the interest rate on the term loan facility was
effectively 6.2% at September 30, 1996. The loan, which is secured by a pledge
of the Company's assets and all of the Company's interest in the securities of
its subsidiaries, as well as all of Integrity Holdings' interest in the capital
stock of Integrity, matures September 30, 2001, is subject to optional
prepayment and requires compliance by the Company with various financial
covenants. At December 31, 1995, aggregate maturities of such indebtedness was:
1997--$4 million; 1998--$6 million; 1999--$8 million; 2000--$10 million and
2001--$12 million. The Company intends to use approximately $25 million of the
net proceeds of the Offering to reduce indebtedness under the term loan
facility.
The Credit Agreement also provides a revolving credit facility. The maximum
amount that the Company may borrow thereunder is $20 million. The facility is
available through September 30, 2001, and has an annual commitment fee equal to
0.25% on the unused portion. The Company has not made any borrowings under the
revolving credit facility to date.
The Credit Agreement contains certain negative covenants which impose
certain restrictions on the Company's operations, including the following:
restrictions on the Company's ability to pay dividends or make distributions
with respect to shares of Common Stock absent compliance with certain prepayment
obligations under the Credit Agreement, restrictions on capital expenditures in
excess of $2.0 million per year plus 50% of the amount of capital expenditures
permitted but not made in the previous fiscal year, prohibiting the ratio of
total funded indebtedness to total capital at the end of any fiscal quarter from
exceeding 0.35 to 1.00, prohibiting, at the last day of any fiscal quarter of
the Company, the fixed charge ratio from falling below 1.50 to 1.00 (1.75 to
1.00 after December 31, 1996) and prohibiting, at the last day of any fiscal
quarter of the Company, the surplus relief ratio (as such term is defined by the
NAIC and as computed and consolidated in accordance with IRIS) of the Integrity
Companies (taken together) for any period of four consecutive fiscal quarters of
the Company from exceeding 10% of the surplus of the Integrity Companies during
such period. The Company intends to amend the Credit Agreement to modify or
eliminate certain of the foregoing restrictions.
In addition, (i) the Company, SBM Certificate Company, ARM Capital Advisors
and ARM Financial Services may not permit, at any time, the aggregate amount of
their non-subsidiary investments (the "Non-Subsidiary Investments") and the
total admitted assets (other than separate account assets) of the Integrity
Companies (taken as a whole) (the "Total Admitted Assets"), in each case not
rated at least NAIC I at such time, to exceed the sum of 40% of the aggregate
amount of the Non-Subsidiary Investments and the aggregate amount of the Total
Admitted Assets and (ii) the Company, SBM Certificate Company, ARM Capital
Advisors and ARM Financial Services may not permit, at any time, the aggregate
amount of the Non-Subsidiary Investments and the Total Admitted Assets, in each
case that are not Investment Grade Securities, to exceed the sum of 10% of the
aggregate amount of the Non-Subsidiary Investments and the aggregate amount of
the Total Admitted Assets.
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DESCRIPTION OF CAPITAL STOCK
GENERAL
Prior to the Offering, the Company's authorized capital stock consisted of
27,280 shares of Class A Common Stock (the "Old Class A Common Stock"), 1,080
shares of Class B Common Stock (the "Old Class B Common Stock") and 2,300,100
shares of Preferred Stock, of which 2,300,000 shares were designated as
Cumulative Perpetual Preferred Stock. The Old Class A Common Stock had a
liquidation preference of $5,000 per share over the Old Class B Common Stock.
In connection with the Offering, the Company will amend and restate its
Certificate of Incorporation and By-laws. Upon such amendment and restatement,
the authorized capital stock of the Company will consist of shares of
Class A Common Stock, par value $.01 per share (the "Class A Common Stock"),
shares of Class B Common Stock (the "Class B Common Stock"; the Class A
Common Stock and the Class B Common Stock being, collectively, the "Common
Stock"), and shares of preferred stock, par value $.01 per share (the
"Preferred Stock"). In connection with such amendment and restatement of the
Certificate of Incorporation, the Company will effect the Recapitalization
pursuant to which (i) each outstanding share of Old Class A Common Stock and Old
Class B Common Stock will converted into one share of Class A Common Stock; (ii)
the Morgan Stanley Stockholders will convert shares of Class A Common Stock held
by them into Class B Common Stock such that, after giving effect to such
conversion, but not giving effect to the Offering, the Morgan Stanley
Stockholders will own, in the aggregate, 49% of the outstanding Class A Common
Stock; and (iii) each share of Common Stock outstanding will be split into
shares.
The following summary does not purport to be complete and is subject to the
detailed provisions of, and qualified in its entirety by reference to, the
Certificate of Incorporation and By-laws of the Company, forms of which have
been filed as exhibits to the Registration Statement of which this Prospectus is
a part, and to the applicable provisions of the General Corporation Law of the
State of Delaware (the "DGCL").
COMMON STOCK
Upon completion of the Offering, the Company will have shares of Class
A Common Stock and shares of Class B Common Stock outstanding.
CLASS A COMMON STOCK. Holders of Class A Common Stock are entitled to one
vote for each share of Class A Common Stock on each matter submitted to a vote
of stockholders, including the election of directors. Holders of Class A Common
Stock are not entitled to cumulative voting. Shares of Class A Common Stock have
no preemptive or other subscription rights and are convertible by the Morgan
Stanley Stockholders into an equal number of shares of Class B Common Stock.
CLASS B COMMON STOCK. Holders of Class B Common Stock have no right to vote
on matters submitted to a vote of stockholders, except (i) as otherwise required
by law; and (ii) that the holders of Class B Common Stock shall have the right
to vote as a class on any amendment, repeal or modification to the Certificate
of Incorporation that adversely affects the powers, preferences or special
rights of the holders of the Class B Common Stock. Shares of Class B Common
Stock have no preemptive or other subscription rights and are convertible into
an equal number of shares of Class A Common Stock (x) at the option of the
holder thereof to the extent that, following such conversion, the Morgan Stanley
Stockholders will not, in the aggregate, own more than 49% of the outstanding
shares of Class A Common Stock; and (y) automatically upon the transfer of such
shares by any Morgan Stanley Stockholder to a person that is not a Morgan
Stanley Stockholder or an affiliate of a Morgan Stanley Stockholder.
DIVIDENDS. All holders of Common Stock are entitled to receive such
dividends or other distributions, if any, as may be declared from time to time
by the Board of Directors in its discretion out of funds legally available
therefor, subject to the prior rights of any Preferred Stock then outstanding,
and to
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share equally, share for share, in such dividends or other distributions as if
all shares of Common Stock were a single class. Dividends or other distributions
declared or paid in shares of Common Stock, or options, warrants or rights to
acquire such stock or securities convertible into or exchangeable for shares of
such stock, are payable to all of the holders of Common Stock ratably according
to the number of shares held by them, in shares of Class A Common Stock to
holders of that class of Stock and in shares of Class B Common Stock to holders
of that class of stock. Delaware law generally requires that dividends be paid
only out of the Company's surplus or current net profits in accordance with the
DGCL. See "Dividend Policy."
LIQUIDATION. Subject to the rights of any holders of Preferred Stock
outstanding, upon the dissolution, liquidation or winding up of the Company, the
holders of Common Stock are entitled to share equally and ratably in the assets
available for distribution after payments are made to the Company's creditors.
FULL PAYMENT AND NONASSESSABILITY. All of the outstanding shares of Common
Stock are, and the Common Stock offered by the Company hereby will be, fully
paid and nonassessable.
PREFERRED STOCK
GENERAL
Under the Certificate of Incorporation, the Company's Board of Directors is
authorized, without further stockholder action, to issue any or all the
authorized Preferred Stock from time to time in one or more series, and for such
consideration, and with such voting powers (not to exceed one vote per share) as
the Board may determine and to determine the designations, preferences and
relative participating, optional or other special rights, and qualifications,
limitations, or restrictions thereon. Stockholders do not have any preemptive
rights with respect to any of the presently authorized but unissued shares of
authorized Preferred Stock. Other than the Perpetual Preferred Stock described
below, as of the date of this Prospectus, the Board of Directors of the Company
has not authorized any series of Preferred Stock and there are no plans,
agreements or understandings for the issuance of any shares of Preferred Stock.
PERPETUAL PREFERRED STOCK
The Company has designated 2,300,000 shares of authorized but previously
undesignated shares of Preferred Stock as the Perpetual Preferred Stock and has
issued 2,000,000 of such shares. The following description of the Perpetual
Preferred Stock is qualified in its entirety by reference to the Company's
Certificate of Incorporation and the Certificate of Designations, Preferences
and Rights relating to the Perpetual Preferred Stock (the "Certificate of
Designations") filed with the Secretary of State of the State of Delaware, which
is filed as an exhibit to the Registration Statement of which this Prospectus is
a part.
Holders of the Perpetual Preferred Stock do not have, by virtue of such
ownership, any preemptive rights with respect to any shares of capital stock of
the Company or any other securities of the Company convertible into or carrying
rights or options to purchase any such shares. The Perpetual Preferred Stock has
a perpetual maturity and is not subject to any sinking fund or other obligation
of the Company to redeem or retire the Perpetual Preferred Stock.
DIVIDENDS. Holders of shares of the Perpetual Preferred Stock are entitled
to receive, when, as and if declared by the Board of Directors of the Company,
cash dividends at a rate of 9 1/2% per annum per share, payable quarterly on the
fifteenth day of March, June, September and December of each year, or, if such
date is not a business day, on the next succeeding business day. Dividends are
cumulative, accrue from the date of original issue and are payable to holders of
record of the Perpetual Preferred Stock as they appear on the books of the
Company on such respective dates, not exceeding 60 days preceding such dividend
payment date, as may be fixed by the Board of Directors of the Company in
advance of the payment of
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each particular dividend. Dividends on the Perpetual Preferred Stock accrue
whether or not the Company has earnings, whether or not there are funds legally
available for the payment of such dividends and whether or not such dividends
are declared and will accumulate to the extent they are not paid on the dividend
payment date for the quarter for which they accrue. All dividends paid with
respect to shares of Perpetual Preferred Stock are paid PRO RATA to the holders
entitled thereto. Accruals of dividends do not bear interest.
The Perpetual Preferred Stock ranks prior to the Common Stock of the
Company. Before any dividends (other than dividends payable in Common Stock) on
any class or series of stock of the Company ranking junior to the Perpetual
Preferred Stock as to dividends or upon liquidation shall be declared or paid or
set apart for payment, the holders of shares of the Perpetual Preferred Stock
are entitled to receive full cumulative cash dividends, but only when and as
declared by the Board of Directors, at the annual rate set forth above. When
dividends are not paid in full upon the Perpetual Preferred Stock, any dividends
declared or paid upon shares of Perpetual Preferred Stock and any class or
series of stock ranking on a parity with the Perpetual Preferred Stock
("Dividend Parity Stock") shall be declared or paid, as the case may be, PRO
RATA so that the amount of dividends declared or paid, as the case may be, per
share on the Perpetual Preferred Stock and such Dividend Parity Stock in all
cases bear to each other the same ratio that accumulated and unpaid dividends
per share on the shares of Perpetual Preferred Stock and such Dividend Parity
Stock bear to each other. Unless full accumulated dividends on all outstanding
shares of the Perpetual Preferred Stock have been paid, the Company may not
declare or pay or set apart for payment any dividends or make any distribution
in cash or other property on, or redeem, purchase or otherwise acquire, any
other class or series of stock ranking junior to the Perpetual Preferred Stock
either as to dividends or upon liquidation.
The amount of dividends payable per share for each full quarterly dividend
period is computed by dividing the 9 1/2% annual rate by four and multiplying
the resulting rate by $25.00. The amount of dividends payable for the initial
dividend period or any period shorter than a full dividend period is computed on
the basis of a 360-day year of twelve 30-day months.
OPTIONAL REDEMPTION. The shares of Perpetual Preferred Stock may not be
redeemed prior to December 15, 1998. On or after December 15, 1998, the Company
may, at its option, redeem all or a part of the shares of Perpetual Preferred
Stock at any time and from time to time, upon at least 30 but not more than 60
days' notice, at a redemption price of $25.00 per share, plus an amount equal to
all accrued and unpaid dividends and distributions thereon (the "redemption
price"), whether or not declared, to the date fixed for redemption.
The Company shall, on or prior to the date fixed for redemption, but not
earlier than 45 days prior to the redemption date, deposit with its transfer
agent or other redemption agent, as a trust fund, a sum sufficient to redeem the
shares called for redemption, with irrevocable instructions and authority to
such agent to give or complete the required notice of redemption and to pay the
holders of such shares the redemption price upon surrender of their
certificates. Such deposit shall be deemed to constitute full payment of such
shares to their holders and from and after the date of such deposit,
notwithstanding that any certificates for such shares shall not have been
surrendered for cancellation, the shares represented thereby shall no longer be
deemed outstanding, the right to receive dividends and distributions shall cease
to accrue from and after the redemption date, and all rights of the holders of
the Perpetual Preferred Stock called for redemption as stockholders of the
Company will cease and terminate, except the right to receive the redemption
price, without interest, upon the surrender of their respective certificates.
Unless full accumulated dividends on all outstanding shares of the Perpetual
Preferred Stock shall have been or contemporaneously are declared and paid or
set apart for payment for all past dividend periods, the Perpetual Preferred
Stock may not be redeemed unless all the outstanding Perpetual Preferred Stock
is redeemed and neither the Company nor any subsidiary may purchase any shares
of the Perpetual Preferred Stock otherwise than pursuant to a purchase offer
made on the same terms to all
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holders of Perpetual Preferred Stock, provided that the Company may complete the
purchase or redemption of shares of Perpetual Preferred Stock for which a
purchase contract was entered into, or notice of redemption of which was
initially given, prior to any time at which the Company becomes in arrears with
respect to any dividends.
Notice of redemption shall be mailed to each holder of Perpetual Preferred
Stock to be redeemed at the address shown on the books of the Company not fewer
than 30 days nor more than 60 days prior to the redemption date. If less than
all of the outstanding shares of Perpetual Preferred Stock are to be redeemed,
the Company will select the shares to be redeemed by lot, PRO RATA (as nearly as
may be practicable), or in such other equitable manner as the Board of Directors
may determine.
VOTING RIGHTS. Except as indicated herein or provided by law, the holders
of Perpetual Preferred Stock are not entitled to vote.
Whenever dividends on the Perpetual Preferred Stock are in arrears for at
least six quarterly dividends, whether or not consecutive, the holders of
Perpetual Preferred Stock (voting as a class with all other series of authorized
Preferred Stock ranking on a parity with the Perpetual Preferred Stock either as
to dividends or upon liquidation and upon which like voting rights have been
conferred and are exercisable) will be entitled to vote for the election of two
additional directors on the terms set forth below until, in the case of the
Perpetual Preferred Stock, all past dividends in arrears on the Perpetual
Preferred Stock shall have been paid in full. Holders of all such series of
authorized Preferred Stock which are granted such voting rights (none of which
is currently outstanding), together with the Perpetual Preferred Stock, will
vote as a single class. In such case, the Board of Directors of the Company will
be increased by two directors, and the holders of all such series of authorized
Preferred Stock, together with the holders of Perpetual Preferred Stock, will
have the exclusive right as a class, as outlined above, to elect two directors
(the "Additional Directors") at the next annual meeting of stockholders or at a
special meeting of holders of all such series of authorized Preferred Stock and
the Perpetual Preferred Stock. At any time when such voting rights shall have
vested, a proper officer of the Company shall, upon written request of holders
of record of 10% of the shares of Perpetual Preferred Stock then outstanding,
call a special meeting of holders of all such series of authorized Preferred
Stock and the Perpetual Preferred Stock for the purpose of such election. For
purposes of the foregoing, each share of Perpetual Preferred Stock shall have
one vote per share, except that when any other series of authorized Preferred
Stock shall have the right to vote with the Preferred Stock as a single class on
any matter, then the Preferred Stock and such other series of authorized
Preferred Stock shall have with respect to such matters one vote per $25 of
stated liquidation preference. Upon termination of the right of the holders of
all such series of authorized Preferred Stock to vote for directors, the term of
office of all directors then in office elected by all such series of authorized
Preferred Stock voting as a class shall terminate. For so long as the holders of
all such series of authorized Preferred Stock shall have the right to vote for
directors, any vacancy in the office of an Additional Director may be filled
(except in the case of the removal of an Additional Director) by a person
appointed by the remaining Additional Director. In the case of the removal of an
Additional Director, or, if there is no remaining Additional Director, the
vacancy may be filled by a person elected by the holders of all such series of
authorized Preferred Stock.
The affirmative vote or consent of the holders of at least two-thirds of the
outstanding shares of the Perpetual Preferred Stock, voting as a class, will be
required to (i) authorize, create or issue, or increase the authorized or issued
amount of shares of, any class or series of stock ranking prior to the Perpetual
Preferred Stock, either as to dividends or upon liquidation, or (ii) amend,
alter or repeal (whether by merger, consolidation or otherwise) any provision of
the Certificate of Incorporation or of the Certificate of Designations so as to
materially and adversely affect the preferences, special rights or powers of the
Preferred Stock; provided, however, that any increase in the authorized
Preferred Stock or the creation and issuance of any other series of authorized
Preferred Stock ranking on a parity with or junior to the Perpetual Preferred
Stock shall not be deemed to materially and adversely affect such preferences,
special rights or powers.
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Except as set forth above or as required by law, the holders of Perpetual
Preferred Stock will not be entitled to vote on any merger or consolidation
involving the Company or a sale of all or substantially all of the assets of the
Company.
LIQUIDATION RIGHTS. In the event of any liquidation, dissolution or
winding-up of the Company, whether voluntary or involuntary, before any payment
or distribution of the assets of the Company or proceeds thereof (whether
capital or surplus) shall be made to or set apart for the holders of any class
or series of stock of the Company ranking junior to the Perpetual Preferred
Stock upon liquidation, holders of the Perpetual Preferred Stock shall be
entitled to receive $25.00 per share (the "stated liquidation preference"), plus
an amount equal to all dividends (whether or not earned or declared) accrued and
unpaid to the date of final distribution (together with the stated liquidation
preference, the "preferential amount"), but such holders shall not be entitled
to any further payment. If, upon any liquidation, dissolution or winding-up of
the Company the assets of the Company, or proceeds thereof, distributable among
the holders of shares of Preferred Stock and any other class or series of stock
ranking on a parity with the Preferred Stock as to payments upon liquidation,
dissolution or winding-up shall be insufficient to pay in full the preferential
amount payable on all such shares of stock, then such assets, or the proceeds
thereof, shall be distributed among such holders ratably in accordance with the
respective amounts that would be payable on such shares if all amounts payable
thereon were paid in full. The voluntary sale, conveyance, lease, exchange or
transfer (for cash, shares of stock, securities or other consideration) of all
or substantially all the property or assets of the Company to, or a
consolidation or merger of the Company with or into, one or more other
corporations (whether or not the Company is the corporation surviving such
consolidation or merger) will not be deemed to be a liquidation, dissolution or
winding-up, voluntary or involuntary.
TRANSFER AGENT. The transfer agent, dividend disbursing agent and registrar
for the Perpetual Preferred Stock is Chase Mellon Shareholder Services LLC.
RESTATED CERTIFICATE OF INCORPORATION AND BY-LAWS
Stockholders' rights and related matters are governed by the DGCL, the
Certificate of Incorporation and the By-laws. Certain provisions of the
Certificate of Incorporation and By-laws, which are summarized below, may have
the effect, either alone or in combination with each other, of discouraging or
making more difficult a tender offer or takeover attempt that is opposed by the
Company's Board of Directors but that a stockholder might consider to be in its
best interest. Such provisions may also adversely affect prevailing market
prices for the Common Stock. See "Risk Factors--Anti-Takeover Provisions."
CLASSIFIED BOARD OF DIRECTORS AND RELATED PROVISIONS. The Certificate of
Incorporation will provide that the Board of Directors be divided into three
classes of directors serving staggered three-year terms. The classes of
directors will be as nearly equal in number as possible. The initial division of
the Board of Directors into classes shall be made by the decision of a majority
of the entire Board of Directors. The term of the initial Class I directors
shall terminate on the date of the 1997 annual meeting of stockholders; the term
of the initial Class II directors shall terminate on the date of the 1998 annual
meeting of stockholders; and the term of the initial Class III directors shall
terminate on the date of the 1999 annual meeting of stockholders. At each annual
meeting of stockholders beginning in 1997, successors to the class of directors
whose term expires at that annual meeting shall be elected for a three-year
term. Accordingly, approximately one-third of the Company's Board of Directors
will be elected each year. See "Management--Directors and Executive Officers."
In addition, subject to certain limited exceptions, if the number of directors
is changed, any increase or decrease shall be apportioned among the classes so
as to maintain the number of directors in each class as nearly equal as
possible, and any additional director of any class elected to fill a vacancy
resulting from an increase in such class shall hold office for a term that shall
coincide with the remaining term of that class, but in no case will a decrease
in the number of directors shorten the term of any incumbent director. Subject
to the rights of holders of any outstanding
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preferred stock issued by the Company, vacancies on the Board of Directors may
be filled only by the Board of Directors, the stockholders acting at an annual
meeting or, if the vacancy is with respect to a director elected by a voting
group, by action of any other directors elected by such voting group or such
voting group.
The Certificate of Incorporation will also provide that, subject to the
rights of holders of any preferred stock then outstanding and any requirements
of law, directors may be removed only for cause.
ACTION BY WRITTEN CONSENT; SPECIAL MEETING. The Certificate of
Incorporation and By-laws will provide that so long as the Morgan Stanley
Stockholders own in the aggregate at least 25% of the voting Common Stock of the
Company, an action required or permitted to be taken at an annual or special
meeting of stockholders may be taken with the written consent of the holder or
holders of shares having not less than the minimum number of votes that would be
necessary to authorize or take such action at a meeting at which all shares
entitled to vote thereon were present and voted. From and after the time that
the Morgan Stanley Stockholders no longer own in the aggregate at least 25% of
the voting Common Stock of the Company, an action required or permitted to be
taken at an annual or special meeting of stockholders will not be permitted to
be taken by written consent in lieu of a meeting of stockholders, and, thus,
stockholders will only be permitted to take action at an annual or special
meeting called in accordance with the By-laws. The Certificate of Incorporation
and By-laws will provide that special meetings of stockholders may only be
called by one of the Co-Chief Executive Officers of the Company or by a majority
of the Board of Directors. Special meetings may not be called by the
stockholders.
ADVANCE NOTICE REQUIREMENTS FOR STOCKHOLDER PROPOSALS AND DIRECTOR
NOMINATIONS. The Certificate of Incorporation and By-laws will establish
advance notice procedures with regard to stockholder proposals and the
nomination, other than by or at the direction of the Board of Directors or a
committee thereof, of candidates for election as directors. These procedures
provide that the notice of stockholder proposals and stockholder nominations for
the election of directors at an annual meeting must be in writing and received
by the Secretary of the Company not less than 60 days nor more than 90 days
prior to the anniversary date of the previous year's annual meeting or, if the
date of the annual meeting is not within 30 days before or after the anniversary
date of the previous year's annual meeting, not later than the close of business
on the tenth day following the day on which notice of the date of such meeting
was mailed or public disclosure of the date of the meeting of stockholders was
made, whichever first occurs. The notice of stockholder nominations must set
forth certain information with respect to the stockholder giving the notice and
with respect to each nominee.
INDEMNIFICATION. The Certificate of Incorporation and By-laws will provide
that the Company shall advance expenses to and indemnify each director and
officer of the Company to the fullest extent permitted by law.
AMENDMENTS. Stockholders may adopt, alter, amend or repeal provisions of
the By-laws only by vote of the holders of 80% or more of the outstanding Common
Stock and any other voting securities. In addition, the affirmative vote of the
holders of 80% or more of the outstanding Common Stock and any other voting
securities is required to amend certain provisions of the Certificate of
Incorporation, including filling vacancies on the Board of Directors, removal of
directors only for cause, prohibiting stockholder action by written consent,
prohibiting the calling of special meetings by stockholders, approval of
amendments to the By-laws and the provisions referred to above relating to the
classification of the Company's Board of Directors.
LIMITATIONS ON DIRECTORS' LIABILITY
The Certificate of Incorporation will provide that no director of the
Company shall be personally liable to the Company or its stockholders for
monetary damages for any breach of fiduciary duty as a director, except for
liability: (i) for any breach of the director's duty of loyalty to the Company
or its
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stockholders; (ii) for acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law; (iii) in respect of
certain unlawful dividend payments or stock redemptions or purchases or (iv) for
any transaction from which the director derived an improper personal benefit.
The effect of these provisions will be to eliminate the rights of the Company
and its stockholders (through stockholders' derivative suits on behalf of the
Company) to recover monetary damages against a director for breach of fiduciary
duty as a director (including breaches resulting from grossly negligent
behavior), except in the situations described above. These provisions will not
limit the liability of directors under federal securities laws and will not
affect the availability of equitable remedies such as an injunction or
rescission based upon a director's breach of his duty of care.
SECTION 203 OF THE DELAWARE GENERAL CORPORATION LAW
Section 203 of DGCL prohibits certain transactions between a Delaware
corporation and an "interested stockholder," which is defined as a person who,
together with any affiliates and/or associates of such person, beneficially
owns, directly or indirectly, 15% or more of the outstanding voting shares of a
Delaware corporation. This provision prohibits certain business combinations
(defined broadly to include mergers, consolidations, sales or other dispositions
of assets having an aggregate value of 10% or more of the consolidated assets of
the corporation, and certain transactions that would increase the interested
stockholder's proportionate share ownership in the corporation) between an
interested stockholder and a corporation for a period of three years after the
date the interested stockholder acquired its stock, unless: (i) the business
combination is approved by the corporation's board of directors prior to the
date the interested stockholder acquired shares; (ii) the interested stockholder
acquired at least 85% of the voting stock of the corporation in the transaction
in which it became an interested stockholder or (iii) the business combination
is approved by a majority of the board of directors and by the affirmative vote
of two-thirds of the outstanding voting stock owned by disinterested
stockholders at an annual or special meeting. A Delaware corporation, pursuant
to a provision in its certificate of incorporation or by-laws, may elect not to
be governed by Section 203 of the DGCL. The Company anticipates that it will not
make such an election and, as a result, the Company will be subject to the
provisions of Section 203 of the DGCL following completion of the Offering.
LISTING
The Company intends to apply to have the Common Stock approved for listing
on under the symbol " ."
REGISTRAR AND TRANSFER AGENT
will act as Registrar and Transfer Agent for the Common
Stock.
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SHARES ELIGIBLE FOR FUTURE SALE
Upon the completion of the Offering, the Company will have shares of
Common Stock outstanding, assuming no exercise of any options granted by the
Company. Of these shares, the shares of Common Stock issued in the
Offering will be tradeable without restriction or further registration under the
Securities Act, except for any of such shares held by "affiliates" (as defined
under the Securities Act) of the Company. The remaining shares of Common
Stock will be deemed "restricted" securities within the meaning of Rule 144.
Neither shares held by an affiliate nor restricted securities may be publicly
sold in the absence of registration under the Securities Act unless an exemption
from registration is available, including the exemptions contained in Rule 144.
Generally, Rule 144 provides that a person who has owned restricted
securities for at least two years, or who may be deemed an "affiliate" of the
Company, is entitled to sell, within any three-month period, up to the number of
restricted securities that does not exceed the greater of (i) one percent of the
then outstanding shares of Common Stock or (ii) the average weekly trading
volume during the four calendar weeks preceding the date on which notice of sale
is filed with the SEC. Sales under Rule 144 are subject to certain restrictions
relating to manner of sale, volume of sales and the availability of current
public information about the Company. In addition, restricted securities that
have been held for at least three years by a person who has not been an
"affiliate" of the Company during the preceding three months may be sold under
Rule 144(k) without regard to the volume limitations or current public
information or manner of sale requirements of Rule 144. As defined in Rule 144,
an "affiliate" of an issuer is a person that directly, or indirectly through the
use of one or more intermediaries, controls, or is controlled by, or is under
the common control with such issuer.
The Company, its directors and executive officers, the Selling Stockholders
and the Company's other stockholders have agreed that, without the prior written
consent of , on behalf of the Underwriters, and subject to certain
limitations, they will not (a) offer, pledge, sell, contract to sell, sell any
option or contract to purchase, purchase any option or contract to sell, grant
any option, right or warrant to purchase or otherwise transfer or dispose of,
directly or indirectly, any shares of Common Stock or any securities convertible
into or exercisable or exchangeable for Common Stock or (b) enter into any swap
or other agreement that transfers, in whole or in part, any of the economic
consequences of ownership of the Common Stock, whether any such transaction
described in clause (a) or (b) of this sentence is to be settled by delivery of
Common Stock or such other securities, in cash or otherwise, for a period of 180
days after the date of this Prospectus, other than (i) the shares of Common
Stock to be sold hereby; (ii) any shares of Common Stock issued upon the
exercise of an option or warrant or the conversion of a security outstanding on
the date of this Prospectus; and (iii) any shares of Common Stock issued
pursuant to .
Pursuant to the Stockholders' Agreement, the Company has granted the Morgan
Stanley Stockholders certain "demand" registration rights with respect to the
shares of Common Stock held by the Morgan Stanley Stockholders. In addition to
such demand rights, the other parties to the Stockholders' Agreement are
entitled, subject to certain limitations, to register shares of Common Stock in
connection with a registration statement prepared by the Company to register
shares of Common Stock. See "Certain Relationships and Related Party
Transactions--Stockholders' Agreement."
Subject to the lock-up period described above, the Morgan Stanley
Stockholders may choose to dispose of the Common Stock owned by them. The timing
of such sales or other dispositions by such stockholders (which could include
distributions to the Morgan Stanley Stockholders limited partners) will depend
on market and other conditions, but could occur relatively soon after the
lock-up period, including pursuant to the exercise of their registration rights.
The Morgan Stanley Stockholders are unable to predict the timing of sales by any
of their limited partners in the event of a distribution to them. Such
dispositions could be privately negotiated transactions or public sales.
90
Prior to the Offering, there has been no public market for the Common Stock.
Although the Company intends to apply to have the Common Stock approved for
listing on the , there can be no assurance that an active trading market
for the Common Stock will develop or continue after the Offering or that the
Common Stock offered hereby will trade at or above the initial public offering
price. No prediction can be made as to the effect, if any, that future sales of
shares, or the availability of shares for future sale, will have on the market
price prevailing from time to time. Sales of substantial amounts of Common Stock
(including shares issued upon the exercise of stock options in the public
market, or the perception that such sales could occur), could adversely affect
the prevailing market price of the Common Stock in the public market or the
ability of the Company to raise additional capital through the sale of its
equity securities. See "Certain Risk Factors--Absence of Prior Public Market;
Possible Volatility of Stock Price and of the Securities Market."
As of September 30, 1996, the Company had granted 1,208 Old Options and
1,472 New Options under the Stock Option Plan and had reserved 3,445 shares of
Common Stock in connection with the exercise of such options or for the grant of
future options under the Stock Option Plan.
91
UNDERWRITERS
Under the terms and subject to the conditions contained in the Underwriting
Agreement dated the date hereof (the "Underwriting Agreement"), the Underwriters
named below have severally agreed to purchase, and the Company and Selling
Stockholders have agreed to sell to them, severally, the respective number of
shares of Common Stock set forth opposite their respective names below:
NUMBER OF
NAME SHARES
- ------------------------------------------------------------------------------- -------------
Morgan Stanley & Co. Incorporated..............................................
Bear, Stearns & Co. Inc........................................................
Dean Witter Reynolds Inc.......................................................
Merrill Lynch, Pierce, Fenner & Smith Incorporated.............................
-------------
Total..........................................................................
-------------
-------------
The Underwriting Agreement provides that the obligations of the several
Underwriters to pay for and accept delivery of the shares of Common Stock
offered hereby are subject to the approval of certain legal matters by their
counsel and to certain other conditions. The Underwriters are obligated to take
and pay for all of the shares of Common Stock offered hereby (other than those
shares covered by the Underwriters' over-allotment option described below) if
any such shares are taken.
The Underwriters initially propose to offer part of the Common Stock
directly to the public at the Price to Public set forth on the cover page hereof
and part to certain dealers at a price that represents a concession not in
excess of $ per share under the Price to Public. The Underwriters may
allow, and such dealers may reallow, a concession not in excess of $ a
share to other Underwriters or to certain dealers. After the initial offering of
the Common Stock, the offering price and other selling terms may be varied from
time to time by the Underwriters.
Pursuant to the Underwriting Agreement, the Selling Stockholders have
granted to the Underwriters an option, exercisable at any time for 30 days from
the date of the Underwriting Agreement, to purchase up to additional
shares of Common Stock at the Price to Public set forth on the cover page
hereof, less underwriting discounts and commissions. The Underwriters may
exercise such option to purchase solely for the purpose of covering
over-allotments, if any, incurred in the sale of the shares of Common Stock
offered hereby. To the extent such option is exercised, each Underwriter will
become obligated, subject to certain conditions, to purchase approximately the
same percentage of such additional shares as the number set forth next to such
Underwriter's name in the preceding table bears to the total number of shares of
Common Stock offered by the Underwriters hereby.
The Company intends to apply to have the Common Stock approved for listing
with the under the symbol " ."
The Company, its directors and executive officers, the Selling Stockholders
and the Company's other stockholders have agreed that, without the prior written
consent of , on behalf of the Underwriters, and subject to certain
exceptions, they will not (a) offer, pledge, sell, contract to sell, sell any
option or contract to purchase, purchase any option or contract to sell, grant
any option, right or warrant to purchase or otherwise transfer or dispose of,
directly or indirectly, any shares of Common Stock or any securities convertible
into or exercisable or exchangeable for Common Stock or (b) enter into any swap
or other agreement that transfers, in whole or in part, any of the economic
consequences of ownership of the Common Stock, whether any such transaction
described in clause (a) or (b) of this sentence is to be settled by delivery of
Common Stock or such other securities, in cash or otherwise, for a period of 180
days after
92
the date of this Prospectus, other than (i) the shares of Common Stock to be
sold hereby, (ii) any shares of Common Stock issued upon the exercise of an
option or warrant or the conversion of a security outstanding on the date of the
Underwriting Agreement and (iii) any shares of Common Stock issued pursuant to
.
Prior to the Offering, there has been no public market for the Common Stock.
The initial public offering price for the Common Stock will be determined by
negotiations among the Company and the Underwriters in accordance with the
recommendation of , the "qualified independent underwriter," as is required by
Rule 2720 of the Conduct Rules of the NASD. Among the factors considered in such
negotiations are the sales, earnings and certain other financial and operating
information of the Company in recent periods, the future prospects of the
Company and its industry in general, certain ratios, market prices and such
other factors as are deemed relevant, including the general condition of the
securities markets. The initial public offering price does not necessarily bear
any relationship to the Company's assets, book value, revenues or other
established criteria of value, and should not be considered indicative of the
actual value of the Common Stock. The Company has agreed to indemnify
against certain liabilities, including liabilities under the Securities Act.
Pursuant to the provisions of Rule 2720 of the Conduct Rules of the NASD,
NASD members may not execute transactions in the Common Stock offered hereby to
any accounts over which they exercise discretionary authority without prior
written approval of the customer.
At the request of the Company, the Underwriters have reserved shares
of the Common Stock for sale at the initial public offering price to employees
of the Company, to New ARM LLC and to certain partners of Oldarm L.P. The number
of shares available for sale to the public will be reduced to the extent such
individuals purchase such reserved shares. Reserved shares purchased by such
individuals will, except as restricted by applicable securities laws, be
available for resale following the Offering.
The Company, the Selling Stockholders and the Underwriters have agreed to
indemnify each other against certain liabilities, including liabilities arising
under the Securities Act.
From time to time, MS & Co. has provided, and continues to provide,
investment banking services to the Company and its affiliates. Three of the
Company's nine directors are employees of MS & Co. In addition, MS & Co. served
as lead underwriter of the initial public offering of the Company's Perpetual
Preferred Stock in 1993.
After giving effect to the Offering, affiliates of MS & Co. will own
approximately % of the outstanding shares of Common Stock ( % if the
Underwriters' over-allotment option is exercised in full). For a description of
certain transactions between the Company and MS & Co., see "Certain
Relationships and Related Party Transactions."
LEGAL MATTERS
Certain legal matters in connection with the Common Stock offered hereby are
being passed upon for the Company by Shearman & Sterling, New York, New York.
Shearman & Sterling regularly represents MS & Co., MS Group, MSLEF II and the
MSCP Funds on a variety of legal matters. Certain legal matters are being passed
upon for the Underwriters by LeBoeuf, Lamb, Greene & MacRae, L.L.P., a limited
liability partnership including professional corporations, New York, New York.
LeBoeuf, Lamb, Greene & MacRae, L.L.P. regularly represents the Company on
insurance related matters. Donald B. Henderson, Jr., a partner of LeBoeuf, Lamb,
Greene & MacRae, L.L.P., is a director of National Integrity.
EXPERTS
The consolidated financial statements of the Company at December 31, 1995
and 1994, for the years ended December 31, 1995 and 1994, and for the period
from November 27, 1993 (date operations commenced) through December 31, 1993,
and the consolidated statements of operations, shareholders'
93
equity and cash flows of Integrity Holdings and subsidiaries for the period from
January 1, 1993 through November 26, 1993, appearing in this Prospectus and
Registration Statement have been audited by Ernst & Young LLP, independent
auditors, as set forth in their report thereon appearing elsewhere herein, and
are included in reliance upon such report given upon the authority of such firm
as experts in accounting and auditing.
The consolidated balance sheet as of December 31, 1994 and the related
combined statements of operations, stockholder's deficit and cash flows for each
of the two years in the period ended December 31, 1994 of SBM included in this
Prospectus and Registration Statement have been audited by Deloitte & Touche
LLP, independent auditors, as stated in their report appearing herein, and are
included in reliance upon such report of such firm given upon the authority of
such firm as experts in accounting and auditing.
AVAILABLE INFORMATION
The Company is subject to the informational requirements of the Exchange Act
and, in accordance therewith, is required to file reports, proxy statements and
other information with the SEC. Such reports, proxy statements and other
information can be inspected and copied at the Public Reference Section of the
SEC at Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549, and at the
SEC's regional offices at Citicorp Center, 500 West Madison Street, Suite 1400,
Chicago, Illinois 60661 and 7 World Trade Center, Suite 1300, New York, New York
10048. Copies of the reports, proxy statements and other information can be
obtained from the Public Reference Section of the SEC, Washington, D.C. 20549,
at prescribed rates. The SEC maintains a web site on the Internet at
http://www.sec.gov that contains reports, proxy and information statements and
other information regarding registrants that file electronically with the SEC.
The preferred stock of the Company is traded on the American Stock Exchange
(Symbol: ARM Pr). Such reports, proxy statements and other information
concerning the Company also can be inspected at the offices of the American
Stock Exchange, 86 Trinity Place, New York, New York 10006.
The Company has filed with the SEC a Registration Statement on Form S-1
under the Securities Act with respect to the securities offered by this
Prospectus. The Registration Statement has been filed electronically through the
SEC's Electronic Data Gathering, Analysis, and Retrieval System and may be
accessed electronically by means of the SEC's home page on the Internet at
http://www.sec.gov. As permitted by the rules and regulations of the SEC, this
Prospectus does not contain all of the information set forth in the Registration
Statement. For further information about the Company and the securities offered
hereby, reference is made to the Registration Statement and to the financial
statements, exhibits and schedules filed therewith. The statements contained in
this Prospectus about the contents of any contract or other document referred to
are not necessarily complete, and in each instance, reference is made to the
copy of such contract or other document filed as an exhibit to the Registration
Statement, each such statement being qualified in all respects by such
reference. Copies of each such document may be obtained from the SEC at its
principal office in Washington, D.C. upon payment of the charges prescribed by
the SEC.
94
GLOSSARY OF SELECTED INSURANCE TERMS
Adjusted capital and surplus................. The sum of statutory-basis capital and
surplus and asset valuation reserves and
asset valuation reserves of wholly owned
insurance subsidiaries.
Annuity...................................... A contract that provides for a fixed or
variable periodic payment for a specified
period of time.
Asset valuation reserve ("AVR").............. A formula-driven liability on an insurer's
statutory-basis financial statements designed
to provide over time for potential losses
associated with investments. The AVR
establishes statutory reserves for mortgage
loans, equity real estate and joint ventures
as well as for fixed maturities and common
and preferred stock. The AVR generally
captures all realized and unrealized gains
and losses on such assets, other than those
resulting from changes in interest rates, and
cushions surplus from large swings related to
capital gains or losses. The AVR has no
effect on financial statements prepared in
conformity with GAAP.
Assets under management...................... Spread-based and fee-based customer deposits,
off-balance sheet fee-based assets managed on
behalf of institutional clients and deposits
under marketing partnership arrangements and
surplus assets.
Capital and surplus.......................... Consists of capital stock, paid-in or
contributed surplus, special surplus funds
and unassigned surplus determined in
accordance with statutory accounting
practices.
Cede......................................... To transfer to a reinsurer all or part of the
insurance written by an insurance entity.
Crediting rates.............................. Interest rates applied to annuity contracts
and life insurance policies during the
accumulation period, whether a guaranteed
fixed rate or variable rate or some
combination thereof.
Customer deposits............................ Funds received from a customer under an
insurance contract which accumulate interest
or investment income performance, depending
on the contract.
Deferred annuity............................. An annuity purchased with a single premium or
a series of installment premiums that
provides for the income payments to begin at
some future date.
Deferred policy acquisition costs............ Policy acquisition costs (as defined
elsewhere in this Glossary) that are deferred
and amortized based on the present value of
estimated gross profits, for investment-type
products, related to the issued policy in
conformity with GAAP.
95
Fixed annuity................................ An annuity that guarantees the preservation
of the assets contributed to the contract and
the interest rate those contributions will
earn. The guaranteed rate can vary in
duration depending on whether the contract is
in the accumulation or pay-out phase. The
guaranteed rate may change periodically
during the accumulation phase depending on
financial market interest rates.
Flexible premium deferred annuities.......... Deferred annuities (as defined elsewhere in
this Glossary) that permit the contractholder
to vary the amounts and timing of premium
payments.
403(b) tax-deferred annuities................ Annuities issued by life insurance companies
that are available only to employees of
educational and charitable organizations.
Tax-deferred contributions are allowed for
such employees through voluntary salary
reduction or pursuant to an employer-funded
plan.
General account.............................. All of the assets of an insurance company
held for the purposes of the insurance
company's general business, as distinguished
from separate account assets (as defined
elsewhere in this Glossary).
Guaranteed investment contracts ("GICs")..... Contracts sold to the qualified and
non-qualified institutional markets for use
in public and private retirement plans,
municipal funds, endowment and foundation
funds, mutual funds, government funds and
trust funds. These contracts guarantee
principal and a stated interest rate for a
specified period of time.
Guaranteed rate options ("GROs")............. Fixed rate options within both fixed and
variable annuity contracts which allow
customers to lock in a fixed return for a
specified number of years. Deposits into GROs
are held in a separate account established by
the insurance company. Funds may be
transferred to or from any of the guarantee
period options (or to other investment
options within the annuity contract) subject
to a market value adjustment.
Immediate annuity............................ An annuity that begins payments to the
contractholder after a single premium payment
is made.
96
Interest maintenance reserve ("IMR")......... A liability on an insurer's statutory-basis
financial statements which is increased or
decreased with the portion of realized
capital gains or losses, respectively, from
the sale of fixed-income securities
attributable to changes in interest rates.
The IMR is required to be amortized against
earnings on a basis reflecting the remaining
period to maturity of the fixed-income
securities sold. The IMR has no effect on
financial statements prepared in accordance
with GAAP.
Investment spread............................ The difference between income earned on
investments and interest credited on customer
deposits.
Lapse or lapsation........................... The termination or forfeiture of an insurance
policy prior to maturity.
Market value adjustment ("MVA").............. For GROs, an adjustment, either positive or
negative, made to the contractholder's
account value for any transfer, partial
withdrawal in excess of the free withdrawal
amount or surrender (as defined elsewhere in
this Glossary).
Non-qualified annuities...................... Annuities which do not comply with the
requirements of tax qualified retirement
plans.
Off-balance sheet assets..................... Assets that are not recorded on the Company's
balance sheet and which the Company manages
for a fee.
Persistency.................................. The maintenance of insurance policies in full
force until completion of the term for which
the policy was written (with respect to life
insurance this includes death or maturity).
The term may also refer to continuance and
renewal of insurance and annuity contracts.
Policy acquisition costs..................... Costs incurred in the acquisition of new and
renewal insurance and annuity contracts.
Acquisition costs include those costs that
vary with and are primarily related to the
acquisition of insurance and annuity
contracts (for example, agent and broker
commissions and certain underwriting and
policy issue costs).
Premiums and deposits........................ The amount of money that the contractholder
pays to the insurance company for an
insurance policy or annuity. Deposits under
investment-type products are not recognized
as premium income under GAAP.
97
Reinsurance.................................. The acceptance by one or more insurers,
called reinsurers, of a portion of the risk
underwritten by another insurer, called the
ceding company, who has directly written the
coverage. However, the legal rights of the
insured generally are not affected by the
reinsurance transaction and the ceding
company remains liable to the insured for
payment of policy benefits.
Separate account............................. Investment account maintained by an insurer
to which funds have been allocated for
certain policies under provisions of relevant
state law. The investments in each separate
account are maintained separately from those
in other separate accounts and from the
general account. Separate account assets are
beneficially owned by the contractholders.
The investment results of the separate
account assets are credited directly to the
separate account contractholders, so that an
insurer derives management and other fees
from, but bears no investment risk on, these
assets, except the risk on products that
returns on separate account assets will not
meet the minimum rate guaranteed on these
products.
Single premium deferred annuities............ Annuities that require a one-time lump sum
premium payment upon the issuance of the
contract and that begin payments to the
holder at a specified later date.
Single premium endowment contracts........... Contracts under which principal is
guaranteed, and the face amount of the policy
is paid upon the death of the insured. The
contracts are credited with a specified rate
of interest that is guaranteed for a period
of time and reset periodically thereafter.
Single premium immediate annuities........... Annuities that require a one-time lump sum
premium payment upon the issuance of the
contract and that begin payments to the
holder immediately after issuance.
Statutory accounting practices............... Those accounting practices prescribed or
permitted by an insurer's domiciliary state
insurance regulatory authority for purposes
of recording transactions and preparing
financial statements. Statutory accounting
practices emphasize solvency rather than
matching revenues and expenses during an
accounting period.
98
Surplus...................................... As determined in accordance with statutory
accounting practices, the amount remaining
after all statutory liabilities are
subtracted from all admitted assets.
Statutory surplus includes common stock,
paid-in and contributed surplus, special
surplus funds and earned (unassigned)
surplus.
Surrender.................................... The act of terminating an annuity contract
during the accumulation period where the
contractholder receives the contract's
account value less any applicable surrender
charges (cash surrender value).
Surrender charge............................. The fee charged to a contractholder when an
annuity is surrendered for its cash value
during a specified term. Such charge is
intended to recover unamortized deferred
policy acquisition costs and to discourage
premature termination. Surrender charges
typically apply over a specified period of
time and decline over that period as a
percentage of the account value in relation
to the anticipated amortization of the
deferred policy acquisition costs.
Synthetic guaranteed investment contracts An investment product for the institutional
("Synthetic GICs")......................... defined contribution retirement plan market.
Synthetic GICs have two components: an
investment portfolio owned directly by the
plan and a book value "wrapper" which
promises to pay authorized plan benefits at
par value, regardless of the actual
investment experience of the fund. Under all
synthetic product structures, the
contractholder maintains direct ownership of
their assets held in a custodial trust.
Tax qualified annuities...................... Annuities which are issued pursuant to a tax
qualified retirement plan.
Underwriting................................. An insurer's process of examining, accepting
or rejecting insurance risks, and classifying
those accepted, in order to charge the
appropriate premium for each accepted risk.
Value of insurance in force ("VIF").......... An asset created on the GAAP-basis balance
sheet of an insurance company when it
acquires a block of insurance business, equal
to the actuarially determined present value
of the expected pretax future profits of
business acquired. VIF is amortized based on
the present value of estimated future gross
profits over the term of the underlying
policies.
99
Variable annuity............................. An annuity in which premium payments are used
to purchase accumulation units of separate
accounts. The value of a unit fluctuates in
accordance with the investment experience of
the related separate account. Variable
annuity contracts may include a general
account guaranteed interest investment option
or a GRO. At the time of benefit payments to
the annuitant, the annuitant can generally
elect from a number of payment options which
provide either fixed or variable benefit
payments.
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INDEX TO FINANCIAL STATEMENTS
PAGE
-----
ARM FINANCIAL GROUP, INC.:
Audited Financial Statements:
Report of Independent Auditors........................................................................... F-3
Consolidated Balance Sheets as of December 31, 1995 and 1994............................................. F-4
Consolidated Statements of Operations of ARM Financial Group, Inc. and Subsidiaries for the Years Ended
December 31, 1995 and 1994, and the Period from November 27, 1993 (Date Operations Commenced) through
December 31, 1993, and the Consolidated Statement of Operations of Integrity Holdings, Inc. (formerly
N.M. U.S. Limited) and Subsidiaries (Predecessor) for the Period from January 1, 1993 through November
26, 1993............................................................................................... F-5
Consolidated Statements of Shareholders' Equity of ARM Financial Group, Inc. and Subsidiaries for the
Years Ended December 31, 1995 and 1994, and the Period from November 27, 1993 (Date Operations
Commenced) through December 31, 1993, and the Consolidated Statement of Shareholders' Equity of
Integrity Holdings, Inc. (formerly N.M. U.S. Limited) and Subsidiaries (Predecessor) for the Period
from January 1, 1993 through November 26, 1993......................................................... F-6
Consolidated Statements of Cash Flows of ARM Financial Group, Inc. and Subsidiaries for the Years Ended
December 31, 1995 and 1994, and the Period from November 27, 1993 (Date Operations Commenced) through
December 31, 1993, and the Consolidated Statement of Cash Flows of Integrity Holdings, Inc. (formerly
N.M. U.S. Limited) and Subsidiaries (Predecessor) for the Period from January 1, 1993 through November
26, 1993............................................................................................... F-7
Notes to Consolidated Financial Statements............................................................... F-8
Unaudited Interim Financial Statements:
Condensed Consolidated Interim Financial Statements:
Condensed Consolidated Interim Balance Sheets at June 30, 1996 (Unaudited)............................... F-28
Condensed Consolidated Interim Statements of Operations for the Six Months Ended June 30, 1996 and 1995
(Unaudited)............................................................................................ F-29
Condensed Consolidated Interim Statements of Cash Flows for the Six Months Ended
June 30, 1996 and 1995 (Unaudited)..................................................................... F-30
Notes to Condensed Consolidated Interim Financial Statements............................................. F-31
SBM COMPANY AND SUBSIDIARIES:
Audited Financial Statements:
Independent Auditors' Report............................................................................. F-35
Consolidated Balance Sheet as of December 31, 1994....................................................... F-36
Consolidated Statements of Operations for the Years Ended December 31, 1994 and 1993..................... F-37
Consolidated Statements of Stockholders' Equity (Deficit) for the Years Ended December 31, 1994 and
1993................................................................................................... F-38
Consolidated Statements of Cash Flows for the Years Ended December 31, 1994 and 1993..................... F-39
Notes to Consolidated Financial Statements............................................................... F-40
Unaudited Interim Financial Statements:
Consolidated Balance Sheets at March 31, 1995 and December 31, 1994 (Unaudited).......................... F-65
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 1995 and 1994
(Unaudited)............................................................................................ F-66
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 1995 and 1994
(Unaudited)............................................................................................ F-67
F-1
PAGE
-----
Notes to Condensed Consolidated Financial Statements..................................................... F-68
UNAUDITED PRO FORMA FINANCIAL INFORMATION:
Pro Forma Condensed Consolidated Statement of Operations (Unaudited)..................................... F-74
Notes to Pro Forma Condensed Consolidated Statement of Operations (Unaudited)............................ F-75
F-2
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders
ARM Financial Group, Inc.
We have audited the accompanying consolidated carrying amount balance sheets
of ARM Financial Group, Inc. and subsidiaries as of December 31, 1995 and 1994,
the related consolidated statements of operations, shareholders' equity, and
cash flows for the years ended December 31, 1995 and 1994, and the period from
November 27, 1993 (date operations commenced) through December 31, 1993, and the
consolidated statements of operations, shareholder's equity and cash flows of
Integrity Holdings, Inc. (formerly N.M. U.S. Limited) and subsidiaries
(Predecessor) for the period from January 1, 1993 through November 26, 1993.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by the
Company's management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
We have also audited in accordance with generally accepted auditing
standards the supplemental fair value balance sheets of ARM Financial Group,
Inc. and subsidiaries as of December 31, 1995 and 1994. As described in Note 4,
the supplemental fair value balance sheets have been prepared by management to
present relevant financial information that is not provided by the carrying
amount balance sheets and is not intended to be a presentation in conformity
with generally accepted accounting principles. In addition, the supplemental
fair value balance sheets do not purport to present the net realizable,
liquidation or market value of ARM Financial Group, Inc. as a whole.
Furthermore, amounts ultimately realized by ARM Financial Group, Inc. from the
disposal of assets may vary significantly from the fair values presented. In our
opinion, the supplemental fair value balance sheets referred to above present
fairly, in all material respects, the information set forth therein as described
in Note 4.
In our opinion, the financial statements referred to in paragraph one above
present fairly, in all material respects, the consolidated financial position of
ARM Financial Group, Inc. and subsidiaries at December 31, 1995 and 1994, the
consolidated results of their operations and their cash flows for the years
ended December 31, 1995 and 1994, and the period from November 27, 1993 through
December 31, 1993 and the consolidated results of operations and cash flows of
Integrity Holdings, Inc. (formerly N.M. U.S. Limited) and subsidiaries
(Predecessor) for the period from January 1, 1993 through November 26, 1993, in
conformity with generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, in 1994 the
Company changed its method of accounting for certain debt securities.
/s/ Ernst & Young LLP
Louisville, Kentucky
February 23, 1996
F-3
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
CARRYING AMOUNT FAIR VALUE
-------------------------- --------------------------
DECEMBER 31, DECEMBER 31,
(IN THOUSANDS) 1995 1994 1995 1994
- --------------------------------------------------------- ------------ ------------ ------------ ------------
ASSETS
Cash and investments:
Fixed maturities:
Available-for-sale, at fair value (amortized cost:
1995-$2,490,843; 1994-$1,576,137).................. $ 2,547,909 $ 1,431,880 $ 2,547,909 $ 1,431,880
Held-to-maturity, at amortized cost.................. -- 135,347 -- 135,347
Equity securities, at fair value (cost: 1995-$10,756;
1994-$16,722)........................................ 11,751 16,635 11,751 16,635
Mortgage loans on real estate.......................... 43,943 64,298 43,943 64,298
Policy loans........................................... 117,528 88,486 117,528 88,486
Cash and cash equivalents.............................. 76,896 45,855 76,896 45,855
------------ ------------ ------------ ------------
Total cash and investments........................... 2,798,027 1,782,501 2,798,027 1,782,501
Separate account assets.................................. 809,927 506,270 809,927 506,270
Accrued investment income................................ 36,382 28,302 36,382 28,302
Value of insurance in force.............................. 51,051 31,760 98,977 92,016
Deferred policy acquisition costs........................ 43,113 26,667 -- --
Goodwill................................................. 8,124 -- 8,124 --
Deferred federal income taxes............................ 19,776 50,593 48,642 32,103
Other assets............................................. 27,180 21,795 27,180 21,795
------------ ------------ ------------ ------------
Total assets......................................... $ 3,793,580 $ 2,447,888 $ 3,827,259 $ 2,462,987
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits...................................... $ 2,708,260 $ 1,897,369 $ 2,742,209 $ 1,783,143
Separate account customer deposits..................... 808,345 503,871 808,345 503,871
Long-term debt......................................... 40,000 40,000 40,000 40,000
Accounts payable and accrued expenses.................. 15,496 7,176 15,496 7,176
Other liabilities...................................... 33,488 13,605 33,488 13,605
------------ ------------ ------------ ------------
Total liabilities.................................... 3,605,589 2,462,021 3,639,538 2,347,795
Contingencies
Shareholders' equity:
Preferred stock, $.01 par value, $25.00 stated value;
2,300,100 shares authorized; 2,000,000 shares issued
and outstanding...................................... 50,000 50,000
Class A common stock, $.01 par value; 27,100 and 16,700
shares authorized, respectively; 23,770 and 14,000
shares issued and oustanding, respectively........... * *
Class B common stock, $.01 par value; 1,080 shares
authorized; 1,000 shares issued and outstanding...... * *
Additional paid-in capital............................. 124,425 62,920
Net unrealized gains (losses) on available-for-sale
securities........................................... 28,530 (104,949)
Retained-earnings deficit................................ (14,964) (22,104)
------------ ------------ ------------ ------------
Total shareholders' equity........................... 187,991 (14,133) 187,721 115,192
------------ ------------ ------------ ------------
Total liabilities and shareholders' equity........... $ 3,793,580 $ 2,447,888 $ 3,827,259 $ 2,462,987
------------ ------------ ------------ ------------
------------ ------------ ------------ ------------
- ------------------------
* LESS THAN $1,000.
See accompanying notes.
F-4
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
ARM HISTORICAL
--------------------------------- INTEGRITY
PERIOD FROM COMPANIES
NOVEMBER -----------
27, PERIOD FROM
1993 JANUARY 1,
YEAR ENDED DECEMBER THROUGH 1993
31, DECEMBER THROUGH
-------------------- 31, NOVEMBER
(IN THOUSANDS, EXCEPT PER SHARE DATA) 1995 1994 1993 26, 1993
- --------------------------------------------- --------- --------- ----------- -----------
Investment income............................ $ 196,024 $ 149,142 $ 16,260 $ 148,120
Interest credited on customer deposits....... (146,867) (116,463) (13,563) (116,341)
--------- --------- ----------- -----------
Net investment spread.................... 49,157 32,679 2,697 31,779
Fee income:
Variable annuity fees...................... 7,238 4,291 91 1,000
Asset management fees...................... 3,161 -- -- --
Other fee income........................... 949 4,100 369 1,258
--------- --------- ----------- -----------
Total fee income......................... 11,348 8,391 460 2,258
Other income and expenses:
Surrender charges.......................... 3,339 2,356 145 1,615
Operating expenses......................... (22,957) (21,484) (1,423) (30,663)
Commissions, net of deferrals.............. (1,557) (2,551) (309) (4,877)
Interest expense on long-term debt......... (3,461) (3,136) (245) (133)
Amortization:
Deferred policy acquisition costs........ (2,932) (1,296) (12) (1,470)
Value of insurance in force.............. (7,104) (3,830) (552) (6,444)
Acquisition-related deferred charges..... (9,920) (2,163) (249) --
Goodwill................................. (358) -- -- --
Other, net................................. (687) 4,972 (46) --
--------- --------- ----------- -----------
Total other income and expenses.......... (45,637) (27,132) (2,691) (41,972)
Realized investment gains (losses), net...... 4,048 (36,727) (79) (32,776)
--------- --------- ----------- -----------
Income (loss) before federal income taxes.... 18,916 (22,789) 387 (40,711)
Federal income tax benefit (expense)......... (7,026) 6,018 (508) --
--------- --------- ----------- -----------
Net income (loss)............................ 11,890 (16,771) (121) $ (40,711)
-----------
-----------
Dividends on preferred stock................. (4,750) (4,750) (462)
--------- --------- -----------
Net income (loss) applicable to common
shareholders............................... $ 7,140 $ (21,521) $ (583)
--------- --------- -----------
--------- --------- -----------
Net income (loss) per common share........... $ 344.94 $(1,434.73) $ (38.87)
--------- --------- -----------
--------- --------- -----------
Average common shares outstanding............ 20,699 15,000 15,000
--------- --------- -----------
--------- --------- -----------
See accompanying notes.
F-5
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
NET
UNREALIZED
GAINS (LOSSES)
CLASS A CLASS B ADDITIONAL ON AVAILABLE-
PREFERRED COMMON COMMON COMMON PAID-IN FOR-SALE
(IN THOUSANDS) STOCK STOCK STOCK STOCK CAPITAL SECURITIES
- --------------------------------------------- ----------- ----------- ----------- ----------- ----------- --------------
HISTORICAL INTEGRITY COMPANIES:
Balance, January 1, 1993..................... $ -- $ -- $ -- $ 1 $ 253,817 $ --
Capital contributions from National
Mutual................................... 103,128
Net loss...................................
Change in unrealized investment gains
(losses).................................
Change in cumulative translation
adjustment...............................
----------- ----------- ----------- ----------- ----------- --------------
Balance, November 26, 1993................... $ -- $ -- $ -- $ 1 $ 356,945 $ --
----------- ----------- ----------- ----------- ----------- --------------
----------- ----------- ----------- ----------- ----------- --------------
ARM:
Balance, November 26, 1993................... $ -- $ -- $ -- $ -- $ --
Issuance of 2,000,000 shares of cumulative
perpetual preferred stock................ 50,000 (5,704)
Issuance of 14,000 shares of Class A common
stock.................................... * 69,000
Issuance of 1,000 shares of Class B common
stock.................................... * (376)
Net loss...................................
Dividends on preferred stock...............
Change in cumulative translation
adjustment...............................
----------- ----------- ----------- ----------- ----------- --------------
Balance, December 31, 1993................... 50,000 * * 62,920 --
Adjustment to beginning balance for change
in accounting method, net of income taxes
of $1,579................................ (7,445)
Net loss...................................
Dividends on preferred stock...............
Change in net unrealized losses on
available-for-sale securities............ (97,504)
Change in cumulative translation
adjustment...............................
----------- ----------- ----------- ----------- ----------- --------------
Balance, December 31, 1994................... 50,000 * * 62,920 (104,949)
Issuance of 9,770 shares of Class A common
stock.................................... * 61,505
Net income.................................
Dividends on preferred stock...............
Change in net unrealized losses on
available-for-sale securities............ 133,479
----------- ----------- ----------- ----------- ----------- --------------
Balance, December 31, 1995................... $ 50,000 $ * $ * $ 124,425 $ 28,530
----------- ----------- ----------- ----------- ----------- --------------
----------- ----------- ----------- ----------- ----------- --------------
RETAINED- TOTAL
EARNINGS SHAREHOLDERS'
(IN THOUSANDS) DEFICIT EQUITY
- --------------------------------------------- ----------- -------------
HISTORICAL INTEGRITY COMPANIES:
Balance, January 1, 1993..................... $(120,591) $ 133,227
Capital contributions from National
Mutual................................... 103,128
Net loss................................... (40,711) (40,711)
Change in unrealized investment gains
(losses)................................. (250) (250)
Change in cumulative translation
adjustment............................... (74) (74)
----------- -------------
Balance, November 26, 1993................... $(161,626) $ 195,320
----------- -------------
----------- -------------
ARM:
Balance, November 26, 1993................... $ -- $ --
Issuance of 2,000,000 shares of cumulative
perpetual preferred stock................ 44,296
Issuance of 14,000 shares of Class A common
stock.................................... 69,000
Issuance of 1,000 shares of Class B common
stock.................................... (376)
Net loss................................... (121) (121)
Dividends on preferred stock............... (462) (462)
Change in cumulative translation
adjustment............................... 14 14
----------- -------------
Balance, December 31, 1993................... (569) 112,351
Adjustment to beginning balance for change
in accounting method, net of income taxes
of $1,579................................ (7,445)
Net loss................................... (16,771) (16,771)
Dividends on preferred stock............... (4,750) (4,750)
Change in net unrealized losses on
available-for-sale securities............ (97,504)
Change in cumulative translation
adjustment............................... (14) (14)
----------- -------------
Balance, December 31, 1994................... (22,104) (14,133)
Issuance of 9,770 shares of Class A common
stock.................................... 61,505
Net income................................. 11,890 11,890
Dividends on preferred stock............... (4,750) (4,750)
Change in net unrealized losses on
available-for-sale securities............ 133,479
----------- -------------
Balance, December 31, 1995................... $ (14,964) $ 187,991
----------- -------------
----------- -------------
- ------------------------
* Less than $1,000.
See accompanying notes.
F-6
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
HISTORICAL
INTEGRITY
ARM COMPANIES
------------------------------------ ------------
PERIOD FROM PERIOD FROM
YEAR ENDED DECEMBER NOVEMBER 27, JANUARY 1,
31, 1993 THROUGH 1993 THROUGH
--------------------- DECEMBER 31, NOVEMBER 26,
(IN THOUSANDS) 1995 1994 1993 1993
- ---------------------------------------------------------- ---------- --------- ------------- ------------
CASH FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES:
Net income (loss)......................................... $ 11,890 $ (16,771) $ (121) $ (40,711)
Adjustments to reconcile net income (loss) to cash flows
provided by operating activities:
Interest credited on general account customer
deposits.............................................. 136,824 108,495 13,563 116,341
Realized investment (gains) losses, net................. (4,048) 36,727 79 32,776
Amortization of value of insurance in force and deferred
policy acquisition costs.............................. 10,036 5,126 564 7,913
Other amortization...................................... 12,406 9,402 2,049 (2,605)
Deferral of policy acquisition and other costs.......... (24,505) (25,273) (2,703) (17,885)
Deferred tax expense (benefit).......................... 6,385 (3,823) (1,960) --
Equity in income from real estate joint ventures and
limited partnerships.................................. -- -- -- (6,001)
(Increase) decrease in accrued investment income........ (1,609) 2,590 1,189 (2,729)
Changes in other assets and liabilities................. (9,020) (10,770) 5,548 (2,794)
---------- --------- ------------- ------------
Cash flows provided by operating activities............... 138,359 105,703 18,208 84,305
CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
Fixed maturity investments:
Purchases............................................... (1,498,623) (835,792) (829,396) (530,662)
Maturities and redemptions.............................. 205,319 159,684 41,894 171,863
Sales................................................... 1,197,468 522,175 782,751 252,945
Other investments:
Purchases............................................... (7,891) (18,562) (10,785) (11,465)
Maturities and redemptions.............................. 24,377 79,236 13,837 104,640
Sales................................................... 36,119 -- -- 14,760
Policy loans, net......................................... (6,428) (4,637) (1,601) (9,296)
Purchase of separate account assets....................... (226,812) (306,097) (36,761) (177,625)
Proceeds from sale of separate account assets............. 45,249 19,895 3,363 28,623
Cash and cash equivalents acquired in excess of purchase
price paid for:
Integrity Holdings, Inc................................. -- 3,250 102,911 --
Substantially all assets of SBM Company................. 36,490 -- -- --
---------- --------- ------------- ------------
Cash flows provided by (used in) investing activities..... (194,732) (380,848) 66,213 (156,217)
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Proceeds from issuance of common and preferred stock...... 63,505 -- 120,000 --
Proceeds from (redemption of) debt........................ -- -- 40,000 (5,573)
Organizational, debt and stock issuance costs............. (2,000) (2,104) (5,326) --
Preferred stock dividends................................. (4,750) (5,014) -- --
Amounts received from customers........................... 425,628 375,580 46,649 294,528
Amounts paid to customers................................. (406,977) (301,330) (31,876) (171,625)
Change in repurchase agreement liability.................. 12,008 -- -- --
Capital contributions..................................... -- -- -- 104,395
---------- --------- ------------- ------------
Cash flows provided by financing activities............... 87,414 67,132 169,447 221,725
---------- --------- ------------- ------------
Net change in cash and cash equivalents................... 31,041 (208,013) 253,868 149,813
Cash and cash equivalents at beginning of period.......... 45,855 253,868 -- 77,398
---------- --------- ------------- ------------
Cash and cash equivalents at end of period................ $ 76,896 $ 45,855 $ 253,868 $ 227,211
---------- --------- ------------- ------------
---------- --------- ------------- ------------
Supplemental cash flow information:
Interest paid on indebtedness........................... $ 2,736 $ 2,275 $ 168 $ 282
---------- --------- ------------- ------------
---------- --------- ------------- ------------
Income taxes paid....................................... $ -- $ 3,017 $ -- $ 183
---------- --------- ------------- ------------
---------- --------- ------------- ------------
See accompanying notes.
F-7
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
ARM Financial Group, Inc., (the "Company") is a financial services company
focusing on the long-term savings and retirement marketplace by providing retail
and institutional products and services throughout the United States. At
December 31, 1995, the Company had approximately $5.4 billion of customer
deposits and funds under management.
The Company was organized in July 1993 by The Morgan Stanley Leveraged
Equity Fund II, L.P. ("MSLEF II") and Analytical Risk Management, Ltd. (now
known as Oldarm, L.P.). MSLEF II is an investment fund sponsored by Morgan
Stanley Group Inc. ("Morgan Stanley"). As a result of an additional investment
(described in Note 2), certain other private equity funds sponsored by Morgan
Stanley, together with MSLEF II, own approximately 91% of the outstanding shares
of voting stock of the Company. Oldarm, L.P., New ARM, LLC and certain
employees, management and independent directors of the Company and its
subsidiaries own in the aggregate approximately 9% of the voting stock of the
Company. The Company had no significant business activity until November 26,
1993, when it acquired Integrity Life Insurance Company ("Integrity") and
National Integrity Life Insurance Company ("National Integrity") (collectively,
the "Integrity Companies").
NATURE OF OPERATIONS
The Company delivers its products and services through a variety of legal
entities. Retail fixed and variable annuities and institutional guaranteed
investment contracts are issued by the Company's insurance subsidiaries. ARM
Capital Advisors, Inc. ("ARM Capital Advisors"), an SEC-registered investment
advisor, provides asset management services for institutional clients in the
pension, 401(k), insurance company and mutual fund markets. SBM Financial
Services, Inc. ("SBM Financial Services"), a registered broker-dealer, provides
a distribution channel for selling affiliated and unaffiliated retail products.
SBM Certificate Company is an issuer of face-amount certificates, a retail
product similar to certificates of deposit issued by banks. The Legends Fund,
Inc. is a series-type mutual fund managed by Integrity, which offers various
investment portfolios exclusively to variable annuity customers of the Company's
insurance subsidiaries.
The Company derives its earnings from two major business segments:
spread-based and fee-based. With spread-based products, the Company's insurance
and face-amount certificate subsidiaries agree to return customer deposits with
interest at a specified rate. As a result, the Company's insurance and face-
amount certificate subsidiaries are accepting investment risk in exchange for
the opportunity to achieve a spread between what is earned on invested assets
and what is paid or credited to customer accounts. With fee-based products and
services, the Company's subsidiaries receive a fee in exchange for managing
deposits where the customer accepts the investment risk. Because the investment
risk is borne by the customer, this line of business requires significantly less
capital support than spread-based business. The Company's spread-based business
is currently its predominant segment in terms of customer deposits and earnings.
However, the fee-based business has grown, reflecting the Company's strategic
focus on developing this segment.
F-8
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
BASIS OF PRESENTATION
The consolidated financial statements are prepared in accordance with
generally accepted accounting principles ("GAAP") and include the accounts of
the Company from the date of its acquisition of the Integrity Companies, when it
began operations, and the accounts of its acquired subsidiaries following the
acquisition dates. The principal subsidiaries are Integrity, its wholly owned
subsidiary National Integrity, ARM Capital Advisors, SBM Financial Services, and
SBM Certificate Company. "Historical Integrity Companies" as shown in the
accompanying consolidated statements of operations and shareholders' equity
refers to operations, for accounting and reporting purposes, prior to the
Company's acquisition of the Integrity Companies. All significant intercompany
accounts and transactions have been eliminated in consolidation. Certain amounts
from prior years have been reclassified to conform to the current year's
presentation, including reclassifications to the statements of operations, as
discussed below. Such reclassifications had no effect on previously reported net
income or shareholders' equity.
The consolidated statements of operations represent a presentation of the
Company's results using the reporting format followed by banks and some
insurance companies whose products involve only minimal amounts of mortality
risk. The Company's focus on products and services for the long-term savings and
retirement marketplace creates many similarities to non-insurance financial
services companies. Management of the Company believes that these statements of
operations provide financial statement readers with more relevant information
than under the format generally followed by traditional life insurance
companies, which was used by the Company in prior years. These statements
highlight the Company's spread-based segment's net investment spread (primarily
interest earned in excess of interest credited) and provide details of the
sources of fee income for the Company's fee-based segment.
The consolidated balance sheets include a dual presentation of carrying
amount and fair value balances. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," fixed maturities classified as available-for-sale
are reported at fair value in the carrying amount balance sheets; however,
corresponding customer deposits are reported at historical values. In contrast,
in the fair value balance sheets both assets and liabilities are reported at
fair value. As permitted by SFAS No. 107, "Disclosures About Fair Value of
Financial Instruments," the fair value balance sheets are presented as a
supplemental disclosure to provide a more meaningful picture of the Company's
financial position. Note 4 describes the methods and assumptions used by the
Company in estimating fair value.
INVESTMENTS
Fixed maturities classified as held-to-maturity are stated at amortized
cost. Fixed maturities not classified as held-to-maturity and equity securities
are classified as available-for-sale. Available-for-sale securities are stated
at fair value. Unrealized gains and losses on available-for-sale securities are
reported as a separate component of shareholders' equity, net of adjustments to
value of insurance in force and deferred policy acquisition costs equal to the
change in amortization that would have been recorded if these securities had
been sold as of the balance sheet date, and net of deferred income taxes. The
amortized cost of fixed maturities classified as held-to-maturity or
available-for-sale is adjusted for amortization of premiums and accretion of
discounts to maturity, or in the case of mortgage-backed and asset-backed
securities, over the estimated life of the security. Such amortization and
accretion is computed using the interest method and is included in investment
income. Anticipated prepayments on mortgage-backed and asset-backed securities
are considered in determining the effective yield on such
F-9
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
securities. If a difference arises between anticipated and actual prepayments,
the carrying value of the investment is adjusted with a corresponding charge or
credit to investment income. Interest and dividends are included in investment
income. Mortgage loans on real estate and policy loans are carried at their
unpaid principal balances. Cash and cash equivalents consist of highly liquid
investments with maturities of three months or less at their time of purchase.
Realized gains and losses on the sale of investments are determined based
upon the specific identification method and include provisions for
other-than-temporary impairments where appropriate. In addition, the
amortization of value of insurance in force and deferred policy acquisition
costs are adjusted for gains and losses realized on sales of investments which
support customer deposits. The adjustment to amortization associated with such
realized gains and losses is included in Realized Investment Gains (Losses), Net
in the statement of operations.
The Company adopted the provisions of SFAS No. 115 for investments held as
of or acquired after January 1, 1994. In accordance with SFAS No. 115, prior
period financial statements have not been restated to reflect the change in
accounting principle. The January 1, 1994 opening balance of shareholders'
equity was decreased by $7,445,000 (net of $1,579,000 in deferred income tax
assets) to reflect the net unrealized holding losses on securities classified as
available-for-sale previously carried at amortized cost. The adoption of SFAS
No. 115 had no effect on net income. At the time of adoption, the Company
classified its portfolio of privately placed fixed maturity securities as
held-to-maturity. Although the Company had the ability to hold these securities
to maturity, its original intention of holding them as such changed during 1995.
Early in 1995, the Company developed an in-house investment operation to monitor
and manage the portfolio through its acquisition of substantially all the assets
and business of the U.S. fixed income unit of Kleinwort Benson Investment
Management Americas Inc. (described in Note 2). Accordingly, effective April 1,
1995, the Company transferred all of its fixed maturities classified as held-
to-maturity (i.e., its private placement portfolio) to the available-for-sale
category. The April 1, 1995 amortized cost of the fixed maturities transferred
was $129.7 million, resulting in an unrealized loss of $1.9 million, net of
deferred income tax assets.
VALUE OF INSURANCE IN FORCE, DEFERRED POLICY ACQUISITION COSTS AND GOODWILL
A portion of the purchase price paid for the insurance subsidiaries was
allocated to the value of insurance in force based on the actuarially-determined
present value of the expected pretax future profits from the business assuming a
discount rate of 13%. This present value amount was reduced to the extent that
the fair value of the net assets acquired including the value of insurance in
force exceeded the purchase price allocated to the insurance subsidiaries.
Interest is accrued on the balance annually at a rate consistent with the rate
credited on the acquired policies on the acquisition date. Recoverability of the
value of insurance in force is evaluated annually by comparing the current
estimate of the present value of expected pretax future profits to the
unamortized asset balance. If such current estimate is less than the existing
asset balance, the difference would be charged to expense. To the extent
recoverable from future gross profits, costs of producing new business
(primarily commissions and certain costs of policy issuance and underwriting)
which vary with and are primarily related to the production of new business are
deferred. Value of insurance in force and deferred policy acquisition costs are
amortized in proportion to the emergence of future gross profits, including
related realized investment gains and losses, over the estimated term of the
underlying policies. In addition, an adjustment is made to value of insurance in
force
F-10
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
and deferred policy acquisition costs equal to the change in amortization that
would have been recorded if unrealized gains and losses on available-for-sale
securities had been realized as of the balance sheet date.
A portion of the purchase price paid for subsidiaries was allocated to
goodwill representing the excess of the purchase price paid over the fair value
of net assets acquired. Goodwill currently recorded is amortized over a period
not exceeding twenty years using the straight-line method.
Incremental costs directly related to the integration of acquired companies
are deferred, to the extent recoverable from future gross profits of the
acquired companies. Deferred transition costs are amortized using the
straight-line method over the estimated term of the policies underlying the
acquired companies.
SEPARATE ACCOUNT ASSETS AND SEPARATE ACCOUNT CUSTOMER DEPOSITS
Separate account assets are segregated from other investments and are not
subject to claims that arise out of any other business of the Company. Separate
accounts include both spread-based and fee-based deposits representing
guaranteed and non-guaranteed business, respectively, primarily of variable
annuity customers. Assets held in separate accounts are carried at estimated
fair values. Separate account customer deposits are recorded at customer account
values before applicable surrender charges, which reflects the market value of
the underlying separate account investments. The Company receives administrative
fees for managing non-guaranteed deposits and other fees for assuming mortality
and certain expense risks. Such fees are included in Variable Annuity Fees in
the statement of operations. Investment income and interest credited on customer
deposits for guaranteed separate account deposits are included as such in the
statement of operations.
CUSTOMER DEPOSITS
For single and flexible premium deferred annuities, single premium
endowments, face-amount certificates, and guaranteed investment contracts,
customer deposits represent account values before applicable surrender charges.
Such account values represent premiums and deposits received, plus interest
credited, less withdrawals and assessed fees. For structured settlements and
immediate annuities, customer deposits represent the present value of future
benefit payments and maintenance expenses. The interest rate used in determining
such present value was approximately 7.3% for the year ended December 31, 1995.
RECOGNITION OF FEE INCOME AND EXPENSES
Variable annuity fees and asset management fees are recorded in income as
earned. Other fee income includes marketing partnership fees earned related to
ventures with other insurance companies and certain fees earned by SBM Financial
Services (primarily net retained commissions). Premiums and deposits received
from customers are not included in the statement of operations. Other expenses
include benefit payments paid in excess of a customer's account value.
FEDERAL INCOME TAXES
Deferred federal income taxes reflect the net tax effect of differences
between the financial reporting basis and tax basis of the Company's assets and
liabilities.
F-11
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NET INCOME PER SHARE OF COMMON STOCK
Net income per share is computed by dividing net income or loss, less
preferred stock dividend requirements, by the weighted average number of common
shares outstanding for the period, considering the effects of any dilutive
common stock equivalents. The rights of the holders of the Company's Class A and
Class B common stock are identical except that the Class A shares have a
liquidation preference over Class B.
DERIVATIVES
Premiums paid for interest rate cap and interest rate collar agreements are
amortized over the terms of the agreements. Unamortized premiums are included in
Other Assets in the balance sheet. Amounts received under the agreements are
recorded as a reduction of interest expense or interest credited.
USE OF ESTIMATES
The preparation of financial statements in conformity with GAAP requires
management of the Company to make estimates and assumptions that affect the
amounts reported in the consolidated financial statements and accompanying
notes. Actual results could differ from those estimates.
2. ACQUISITIONS
SBM COMPANY
On June 14, 1995, the Company completed the acquisition of substantially all
of the assets and business operations of SBM Company ("SBM"), including all of
the issued and outstanding capital stock of SBM's subsidiaries, State Bond and
Mortgage Life Insurance Company ("SBM Life") and SBM Financial Services, and
SBM's management contracts with the State Bond group of mutual funds. By virtue
of the acquisition, the Company acquired control of SBM Certificate Company, a
wholly owned subsidiary of SBM Life. Concurrent with the acquisition, the
Company acquired all outstanding shares of the authorized capital stock of SBM
Certificate Company from SBM Life for a purchase price of $3.3 million. The
designated effective date of the acquisition was May 31, 1995.
The acquisition was accounted for using the purchase method. The aggregate
purchase price for the acquisition was $38.8 million (including the net costs
associated with the purchase and subsequent redemption of SBM Series A preferred
stock and the cost of acquiring approximately 3% of the issued and outstanding
shares of SBM common stock required as part of the terms of the acquisition).
The Company financed the acquisition by issuing a total of 9,770 shares of the
Company's Class A common stock to Morgan Stanley Capital Partners III, L.P.,
Morgan Stanley Capital Investors, L.P., and MSCP III 892 Investors, L.P.
(collectively, the "MSCP Funds"), New ARM, LLC, and certain directors of the
Company for an aggregate sale price of $63.5 million. The MSCP Funds are private
equity funds sponsored by Morgan Stanley. The Company used proceeds from the
issuance of the new common equity in excess of the adjusted purchase price for
the acquisition to (i) make a $19.9 million capital contribution to SBM Life;
(ii) acquire SBM Certificate Company from SBM Life for $3.3 million; and (iii)
along with approximately $1.0 million of additional cash from the Company,
provide for fees and expenses related to the acquisition of approximately $2.5
million. Transition costs of $2.2 million directly related to the acquisition
were deferred.
F-12
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITIONS (CONTINUED)
The capital contribution to SBM Life of $19.9 million was used to strengthen
SBM Life's financial position and allowed for a significant investment portfolio
restructuring immediately following the acquisition with no net adverse effect
on statutory adjusted capital and surplus. On December 31, 1995, SBM Life was
merged with and into Integrity to create certain operating efficiencies which
are intended to benefit the Company and its customers.
The following unaudited pro forma consolidated results of operations for
1995 and 1994 give effect to the acquisition as though it had occurred at the
beginning of each year presented. The primary pro forma effects relate to the
amortization of fair value adjustments made to invested assets, the related
effects on realized investment gains and losses, and the amortization of values
assigned to the value of insurance in force and goodwill resulting from the
acquisition. As of January 1, 1995 and 1994, the amortized cost of SBM Life's
and SBM Certificate Company's pro forma invested assets was adjusted to reflect
their fair values. Accordingly, pro forma investment income was adjusted to
reflect the amortization of these adjustments computed in accordance with the
interest method. Pro forma realized investment gains and losses were also
adjusted as a result of marking the amortized cost of the invested assets to
fair value. These pro forma adjustments to invested assets and related accounts
are based upon interest rates at January 1, 1995 and 1994 and are not likely to
be reflective of future results since the actual fair value adjustments and
related future income statement effects are based upon the market interest rate
environment as of May 31, 1995. To illustrate, the five year treasury rate at
January 1, 1994, January 1, 1995 and May 31, 1995 was 5.20%, 7.83% and 6.05%,
respectively, which would result in different asset fair values at each of those
dates. Such differences in fair values, which are driven by the current market
rates, affect the timing of future earnings. Accordingly, the pro forma results
are not necessarily indicative of the consolidated results that actually would
have occurred or which will be obtained in the future.
(UNAUDITED)
PRO FORMA RESULTS FOR
THE
YEAR ENDED DECEMBER 31,
-----------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA) 1995 1994
---------- -----------
Revenues............................................................ $ 240,086 $ 222,775
Pretax operating income(1).......................................... 33,401 23,583
Income (loss) before federal income taxes........................... 40,588(2) (31,277)
Net income (loss) per share......................................... 859.02 (1,109.25)
- ------------------------
(1) Pretax income excluding amortization of acquisition-related deferred
charges, interest expense on long-term debt, and realized investment gains
and losses, net.
(2) Reflects a pro forma adjustment to increase realized investment gains, net
by $17.0 million.
ARM CAPITAL ADVISORS
On January 5, 1995, the Company completed the acquisition of substantially
all the assets and business of the U.S. fixed income unit of Kleinwort Benson
Investment Management Americas Inc. ("KBIMA"). KBIMA provided investment
advisory services to the Company during 1994 and received fees of $2.1 million
for such services. The business acquired became part of the then newly-formed
ARM Capital Advisors, a New York City-based money manager and wholly owned
subsidiary of the Company. Pursuant to the purchase agreement, the Company paid
$225,000 and will pay KBIMA a commission through December 31, 1997 based on
revenues received under the investment management and investment
F-13
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITIONS (CONTINUED)
advisory contracts assigned to ARM Capital Advisors by KBIMA. Assets managed
under acquired and new contracts with third parties have increased from $0.8
billion as of January 5, 1995 to $1.2 billion as of December 31, 1995. In
addition to providing asset management services to institutional clients, ARM
Capital Advisors manages the investment portfolios of the Company's
subsidiaries.
INTEGRITY COMPANIES
On November 26, 1993, the Company completed the acquisition of N.M. U.S.
Limited and its wholly owned subsidiaries, Integrity and National Integrity from
The National Mutual Life Association of Australasia Limited ("National Mutual")
for an adjusted purchase price of $121.0 million. Immediately following the
acquisition, N.M. U.S. Limited changed its name to Integrity Holdings, Inc.
In connection with the acquisition, National Mutual replaced all equity
securities, investment real estate and joint ventures and fixed maturity
investments classified as "6" by the National Association of Insurance
Commissioners ("NAIC") with cash in an amount equal to the statutory book value
of such assets as of December 31, 1992 adjusted for any additional cash
investments or distributions during the period from January 1, 1993 to November
26, 1993. In addition, National Mutual (i) strengthened Integrity's statutory
policyholder reserves and surplus by $24.3 million, (ii) indemnified principal
and interest on all commercial and agricultural mortgage loans and backed up the
indemnification with a $23.0 million escrow arrangement, (iii) provided
indemnification for the availability of net operating and capital loss
carryforwards and of Section 338(h)(10) tax deductions, (iv) provided
indemnification for future claims for taxes, assessments from guaranty funds,
and claims from litigation, which arise from preclosing events, and (v)
terminated all surplus relief reinsurance arrangements.
Income related to National Mutual indemnifications was $1.3 million and $2.3
million for the years ended December 31, 1995 and 1994, respectively. The
indemnification income is primarily related to indemnified guaranty fund
assessments and mortgage loan investment income.
Sources of funds for the acquisition consisted of $40 million of senior
debt, a $50 million public offering of the Company's preferred stock and the
sale of $70 million of privately held shares of the Company's Class A common
stock. The proceeds were used to pay the adjusted purchase price, transaction
fees and expenses; to establish reserves for debt service, preferred stock
dividends and restructuring costs; to make a capital contribution to Integrity;
and for general corporate purposes.
In connection with the acquisition, substantially all of the assets and
liabilities of Oldarm, L.P. having a net book value of approximately $0.3
million, were exchanged for 1,000 shares of the Company's Class B common stock.
Proceeds from the issuance of preferred and common stock were offset by stock
issuance costs of $7.4 million.
F-14
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENTS
The amortized cost and estimated fair values of available-for-sale
securities and held-to-maturity securities were as follows:
AVAILABLE-FOR-SALE SECURITIES
----------------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
(IN THOUSANDS) COST GAINS LOSSES FAIR VALUE
------------ ----------- ----------- ------------
DECEMBER 31, 1995:
Fixed Maturities:
U.S. treasury securities and obligations of U.S.
government agencies.................................... $ 248,838 $ 4,345 $ 32 $ 253,151
Obligations of state and political subdivisions.......... 10,126 29 467 9,688
Foreign governments...................................... 80,394 3,828 727 83,495
Corporate securities..................................... 951,893 38,320 17,776 972,437
Asset-backed securities.................................. 150,732 1,730 1,116 151,346
Mortgage-backed securities............................... 1,048,860 30,607 1,675 1,077,792
------------ ----------- ----------- ------------
Total fixed maturities..................................... 2,490,843 78,859 21,793 2,547,909
Equity securities.......................................... 10,756 995 -- 11,751
------------ ----------- ----------- ------------
Total available-for-sale securities...................... $ 2,501,599 $ 79,854 $ 21,793 $ 2,559,660
------------ ----------- ----------- ------------
------------ ----------- ----------- ------------
DECEMBER 31, 1994:
Fixed Maturities:
U.S. treasury securities and obligations of U.S.
government agencies.................................... $ 10,426 $ -- $ 538 $ 9,888
Obligations of state and political subdivisions.......... 4,635 -- 397 4,238
Foreign governments...................................... 111,831 -- 15,372 96,459
Corporate securities..................................... 800,711 1,007 91,071 710,647
Asset-backed securities.................................. 16,647 -- 2,737 13,910
Mortgage-backed securities............................... 631,887 1,310 36,459 596,738
------------ ----------- ----------- ------------
Total fixed maturities..................................... 1,576,137 2,317 146,574 1,431,880
Equity securities.......................................... 16,722 18 105 16,635
------------ ----------- ----------- ------------
Total available-for-sale securities...................... $ 1,592,859 $ 2,335 $ 146,679 $ 1,448,515
------------ ----------- ----------- ------------
------------ ----------- ----------- ------------
HELD-TO-MATURITY SECURITIES
----------------------------------------------------
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
(IN THOUSANDS) COST GAINS LOSSES FAIR VALUE
------------ ----------- ----------- ------------
DECEMBER 31, 1994:
Corporate securities..................................... $ 93,237 $ -- $ -- $ 93,237
Asset-backed securities.................................. 14,993 -- -- 14,993
Mortgage-backed securities............................... 27,117 -- -- 27,117
------------ ----------- ----------- ------------
Total fixed maturities held-to-maturity.................. $ 135,347 $ -- $ -- $ 135,347
------------ ----------- ----------- ------------
------------ ----------- ----------- ------------
The amortized cost and estimated fair value of available-for-sale
securities, by contractual maturity, are shown below. Expected maturities will
differ from contractual maturities because borrowers may have the right to call
or repay obligations with or without call or prepayment penalties and because
mortgage-
F-15
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENTS (CONTINUED)
backed and asset-backed securities (including floating-rate securities) provide
for periodic payments throughout their life.
DECEMBER 31, 1995
--------------------------
ESTIMATED
(IN THOUSANDS) COST FAIR VALUE
------------ ------------
Due in one year or less........................................... $ 26,197 $ 26,293
Due after one year through five years............................. 367,578 367,944
Due after five years through ten years............................ 243,542 247,812
Due after ten years............................................... 653,934 676,722
Asset-backed securities........................................... 150,732 151,346
Mortgage-backed securities........................................ 1,048,860 1,077,792
Equity securities................................................. 10,756 11,751
------------ ------------
Total available-for-sale securities............................. $ 2,501,599 $ 2,559,660
------------ ------------
------------ ------------
During 1995 and 1994, gross gains of $24,132,000 and $980,000, respectively,
and gross losses of $15,563,000 and $36,973,000, respectively, were realized on
sales of fixed maturities classified as available-for-sale. Gross gains of zero
and $21,678,000, and gross losses of $79,000 and $14,714,000 were realized on
sales of fixed maturities classified as held-to-maturity during the period from
November 27, 1993 to December 31, 1993 and the period from January 1, 1993 to
November 26, 1993, respectively. For the year ended December 31, 1995, the
recognition of the net realized gains during that year resulted in an increase
in the amortization of value of insurance in force and deferred policy
acquisition costs of $2,562,000 and $318,000, respectively.
For the period from January 1, 1993 to November 26, 1993, realized losses
due to other-than-temporary impairments of $39.3 million were recognized for
write-downs in the value of certain investments in real estate and joint
ventures. In accordance with the terms of the acquisition of the Integrity
Companies, these assets were replaced with cash by the seller, National Mutual,
in an amount equal to the statutory book value of such investments as of
December 31, 1992.
During 1994, the Company sold several issues of private placement fixed
maturities classified as held-to-maturity with a total amortized cost of $30.8
million. In all but one case, the issuer's historical financial performance and
forecasts pointed to a reasonable possibility that all amounts eventually due to
the Company would not be collected. In the remaining instance, a foreign
security was sold for compliance with an expected change in regulatory
requirements modifying what constituted a permissible investment. Net realized
gains of $805,000 resulted from the sales.
In accordance with SFAS No. 115, net unrealized gains and losses on
investments classified as available-for-sale were reduced by deferred federal
income taxes and adjustments to value of insurance in force and deferred policy
acquisition costs that would have been required had such gains and losses been
realized. Net unrealized gains and losses on available-for-sale securities
reflected as a separate component of shareholders' equity are summarized as
follows:
DECEMBER 31,
-----------------------
(IN THOUSANDS) 1995 1994
---------- -----------
Net unrealized gains (losses) on available-for-sale securities before adjustments for the
following:............................................................................. $ 58,061 $ (144,344)
Amortization of value of insurance in force and deferred policy acquisition costs...... (14,170) --
Deferred federal income taxes.......................................................... (15,361) 39,395
---------- -----------
Net unrealized gains (losses) on available-for-sale securities....................... $ 28,530 $ (104,949)
---------- -----------
---------- -----------
F-16
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENTS (CONTINUED)
Pursuant to the terms of the acquisition of the Integrity Companies,
National Mutual has indemnified principal (up to 100% of the investments'
year-end 1992 statutory book value) and interest with respect to $43.6 million
or 99.4% of the Company's investment in mortgage loans on real estate as of
December 31, 1995. In support of its indemnification obligations, National
Mutual has placed $23.0 million into escrow in favor of the Integrity Companies,
which will remain available until the subject commercial and agricultural loans
have been paid in full.
Investments, aggregated by issuer, in excess of 10% of shareholders' equity
(before net unrealized gains and losses on available-for-sale securities) at
December 31, 1995 and 1994, other than investments in affiliates and investments
issued or guaranteed by the United States government are as follows:
CARRYING
(IN MILLIONS) AMOUNT
-----------
1995
Fixed maturities:
ABN AMRO Bank.................................................... $ 18.5
AETNA Life & Casualty............................................ 16.5
American President Company....................................... 19.7
CNA Financial.................................................... 21.3
Commonwealth Edison Company...................................... 21.2
Conseco Commercial Mortgage...................................... 20.7
Contimortgage Home Equity Loan Trust............................. 27.2
Countrywide Mortgage Backed...................................... 36.7
General Electric Capital Mortgage................................ 39.6
Georgia Pacific.................................................. 22.3
Home Holdings.................................................... 19.3
Hydro-Quebec..................................................... 23.0
Korea Electric & Power........................................... 17.1
Nationwide CSN Trust............................................. 17.2
Nomura Asset Security Corporation................................ 24.2
Pohang Iron and Steel............................................ 16.0
RJR Nabisco, Incorporated........................................ 16.6
Ryland Mortgage Securities Corporation........................... 20.5
Salomon, Incorporated............................................ 18.8
Structured Asset Securities Corporation.......................... 73.3
Swedish Export Credit............................................ 19.9
Telephone & Data Systems, Incorporated........................... 18.7
Time Warner Incorporated......................................... 22.5
Torchmark Corporation............................................ 17.2
Western Financial Grantor Trust.................................. 17.3
1994
Fixed maturities:
American Brands Incorporated..................................... $ 11.7
American President Company....................................... 16.3
Boeing Company................................................... 10.3
F-17
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENTS (CONTINUED)
CARRYING
(IN MILLIONS) AMOUNT
-----------
CBS Incorporated................................................. 11.1
Champion International........................................... 14.3
Chase Mortgage Financial Corporation............................. 12.1
Circus Circus.................................................... 12.0
Citicorp......................................................... 11.5
Commonwealth Edison Company...................................... 18.1
Conseco Commercial Mortgage...................................... 19.4
Countrywide Mortgage Backed...................................... 20.3
DLJ Acceptance Corporation....................................... 23.9
FedEx Corporation................................................ 16.9
Florida Power & Light............................................ 16.8
Ford Motor Company............................................... 12.5
Fruit of the Loom................................................ 17.0
General Electric Capital Mortgage................................ 35.3
General Motors Corporation....................................... 14.6
Harcourt General Incorporated.................................... 9.8
Home Holdings.................................................... 19.3
Hydro-Quebec..................................................... 18.6
IBM Corporation.................................................. 12.5
Republic of Italy................................................ 12.6
James River Corporation.......................................... 13.8
Kidder Peabody................................................... 13.4
Korea Electric & Power........................................... 15.8
LUC Incorporated................................................. 13.1
Marine Midland................................................... 9.5
Newfoundland Province............................................ 10.7
Newmont Gold..................................................... 9.1
Nomura Asset Security Corporation................................ 9.9
Nova Scotia Province............................................. 15.1
Ohio Edison...................................................... 15.8
Pohang Iron & Steel.............................................. 21.8
Potomac Electric Power Company................................... 11.0
Prudential Home Mortgage......................................... 12.6
Quebec Province.................................................. 17.1
Residential Funding.............................................. 19.9
Ryland Mortgage Securities Corporation........................... 9.7
Southern California Edison....................................... 16.1
Structured Asset Securities Corporation.......................... 30.1
TeleCommunications Incorporated.................................. 18.4
Telephone & Data Systems, Incorporated........................... 15.3
Time Warner Incorporated......................................... 28.6
Republic of Turkey............................................... 12.9
MORTGAGE LOANS ON REAL ESTATE:
BJW Associates................................................... 9.5
F-18
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENTS (CONTINUED)
The components of investment income were:
HISTORICAL
ARM INTEGRITY
--------------------------------- COMPANIES
PERIOD FROM -----------
NOVEMBER PERIOD FROM
27, JANUARY 1,
1993 1993
YEAR ENDED DECEMBER THROUGH THROUGH
31, DECEMBER NOVEMBER
-------------------- 31, 26,
(IN THOUSANDS) 1995 1994 1993 1993
--------- --------- ----------- -----------
Fixed maturities............................ $ 177,123 $ 129,211 $ 11,261 $ 113,874
Policy loans................................ 7,579 6,767 626 5,553
Mortgage loans on real estate............... 6,712 9,379 1,474 12,420
Cash and cash equivalents................... 3,096 3,222 656 1,418
Income from other investments............... 1,514 563 2,243 14,855
--------- --------- ----------- -----------
Investment income......................... $ 196,024 $ 149,142 $ 16,260 $ 148,120
--------- --------- ----------- -----------
--------- --------- ----------- -----------
4. FAIR VALUE BALANCE SHEETS
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments",
requires disclosure of fair value information about all financial instruments,
including insurance liabilities classified as investment contracts, unless
specifically exempted. The accompanying fair value balance sheets reflect fair
values for those financial instruments specifically covered by SFAS No. 107,
along with fair value amounts for other assets and liabilities for which
disclosure is permitted but not required.
The fair value of a financial instrument is the amount at which the
instrument could be exchanged in a current transaction between willing parties,
other than in a forced or liquidation sale. In cases where quoted market prices
are not available, fair values are based on estimates using present value or
other valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. Accordingly, the aggregate fair value amounts presented do not
necessarily represent the underlying value of the Company.
The Company's management of interest rate risk reduces its exposure to
changing interest rates through a close matching of duration, convexity and cash
flow characteristics of both assets and liabilities while maintaining liquidity
redundancies. As such, the Company believes that it will have only limited
volatility in its "fair value" adjusted shareholders' equity, although
volatility cannot be completely eliminated.
The following methods and assumptions were used in estimating fair values:
FIXED MATURITIES AND EQUITY SECURITIES
Fair values for fixed maturities and equity securities are based on quoted
market prices, where available. For fixed maturities for which a quoted market
price is not available, fair values are estimated using internally calculated
estimates or quoted market prices of comparable instruments.
MORTGAGE LOANS ON REAL ESTATE
Pursuant to the terms of the acquisition of the Integrity Companies,
payments of principal and interest on mortgage loans acquired on November 26,
1993 are guaranteed by National Mutual. Principal
F-19
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. FAIR VALUE BALANCE SHEETS (CONTINUED)
received in excess of statutory book value is to be returned to National Mutual.
Accordingly, book value is deemed to be fair value for these mortgage loans.
POLICY LOANS
The carrying amount of policy loans approximates their fair value.
CASH AND CASH EQUIVALENTS AND ACCRUED INVESTMENT INCOME
The carrying amount of cash and cash equivalents and accrued investment
income approximates their fair value given the short-term nature of these
assets.
SEPARATE ACCOUNT ASSETS AND SEPARATE ACCOUNT CUSTOMER DEPOSITS
Fair values of separate account assets are based on the quoted market prices
of the underlying mutual funds for assets invested in variable options. The fair
value of separate account assets invested in guaranteed rate options is
primarily based on quoted market prices of fixed maturity securities. The fair
value of separate account customer deposits is based on the account values of
the underlying policies, plus or minus market value adjustments applicable to
certain customers who are guaranteed a fixed rate of return.
GOODWILL
The carrying amount of goodwill approximates fair value.
DEFERRED FEDERAL INCOME TAXES
Deferred federal income tax assets and related valuation allowance were
adjusted for federal income tax which may be incurred as a result of the
differences between the estimated fair values and carrying amounts of the assets
and liabilities.
CUSTOMER DEPOSITS AND VALUE OF INSURANCE IN FORCE
The fair value of customer deposits for structured settlements and immediate
annuities is based on discounted cash flow calculations using a current market
yield rate for assets with similar durations (i.e., indexed to the U.S. Treasury
yield curve). The fair value of customer deposits for structured settlements and
immediate annuities represents the fair values of those insurance policies as a
whole which implicitly eliminates the corresponding value of insurance in force.
The fair value amounts of the remaining customer deposits, primarily deferred
annuities, single premium endowments, and guaranteed investment contracts,
represent the account values of the underlying contracts before applicable
surrender charges. The fair value of the value of insurance in force represents
the estimated present value of future profits for accumulation business,
including variable annuities, assuming a discount rate of 13%. Deferred policy
acquisition costs do not appear on the fair value presentation because those
values are implicitly considered in the determination of the fair value of the
corresponding customer deposits and value of insurance in force.
LONG-TERM DEBT
The carrying amount of long-term debt approximates fair value.
F-20
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. FAIR VALUE BALANCE SHEETS (CONTINUED)
OTHER ASSETS AND LIABILITIES
The fair values of other assets and liabilities are reported at their
financial statement carrying amounts.
5. VALUE OF INSURANCE IN FORCE
The following provides information on the value of insurance in force during
1995, 1994 and 1993:
HISTORICAL
ARM INTEGRITY
--------------------------------- COMPANIES
PERIOD FROM -----------
NOVEMBER PERIOD FROM
27, JANUARY 1,
1993 1993
YEAR ENDED DECEMBER THROUGH THROUGH
31, DECEMBER NOVEMBER
-------------------- 31, 26,
(IN THOUSANDS) 1995 1994 1993 1993
--------- --------- ----------- -----------
Amortization excluding effects of realized and
unrealized investment gains and losses...... $ (10,490) $ (5,874) $ (792) $ (9,071)
Interest accrued on unamortized balance....... 3,386 2,044 240 2,627
--------- --------- ----------- -----------
Net amortization as reported in the statement
of operations............................... (7,104) (3,830) (552) (6,444)
Amortization related to realized investment
gains and losses(1)......................... (2,562) -- -- --
Amortization related to unrealized gains and
losses on available-for-sale
securities(2)............................... (14,170) -- -- --
Addition resulting from the acquisition of SBM
Life........................................ 61,131 -- -- --
Recognition of acquired tax benefits.......... (18,004) (5,415) -- --
--------- --------- ----------- -----------
Net change in value of insurance in force..... 19,291 (9,245) (552) (6,444)
Balance at beginning of period................ 31,760 41,005 41,557 39,813
--------- --------- ----------- -----------
Balance at end of period...................... $ 51,051 $ 31,760 $ 41,005 $ 33,369
--------- --------- ----------- -----------
--------- --------- ----------- -----------
- ------------------------
(1) Included in Realized Investment Gains (Losses), Net in the statement of
operations.
(2) Included in Net Unrealized Gains (Losses) on Available-for-Sale Securities
in shareholders' equity of the balance sheet.
The value of insurance in force of the Historical Integrity Companies at
November 26, 1993 was eliminated as a result of the Company's acquisition of the
Integrity Companies. The interest rates used to accrue interest on the
unamortized value of insurance in force are consistent with the rates credited
on acquired policies and range from 5% to 8%. Net amortization of the value of
insurance in force, excluding the effects of realized and unrealized investment
gains and losses, in each of the following years is estimated to be: 1996--$5.3
million; 1997--$5.6 million; 1998--$5.2 million; 1999--$4.7 million; and
2000--$4.5 million.
F-21
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. ACQUISITION-RELATED DEFERRED CHARGES
During 1993 and 1994, certain costs and charges incurred by the Company in
connection with acquisitions of companies or business units were deferred, and
then amortized using a systematic allocation procedure over estimated useful
lives determined at the time the costs or charges were incurred. During the
third quarter of 1995, Company management determined that changes in facts and
circumstances had resulted in a change in their original estimate of the periods
benefited by these deferred costs and charges. As a result of this change in
estimate, the unamortized balances of these deferred costs and charges were
fully amortized during the third quarter of 1995, thereby increasing
amortization of acquisition-related deferred charges by $4.3 million and
decreasing net income by $2.7 million ($130.44 per share) during 1995.
7. DEBT
LONG-TERM DEBT
In connection with the acquisition of the Integrity Companies, the Company
entered into a Credit Agreement, as amended, providing a term loan facility in
the principal amount of $40 million bearing a floating interest rate indexed to
the London Interbank Offered Rate. The loan matures September 30, 2001, subject
to optional prepayment and contingent upon the Company's compliance with various
financial covenants. The loan amount is secured by a pledge of the shares of
common stock of the Company's subsidiaries (except National Integrity). At
December 31, 1995, aggregate maturities of such debt were as follows: 1997 -- $4
million; 1998 -- $6 million; 1999 -- $8 million; 2000 -- $10 million; 2001 --
$12 million.
The Company has only limited involvement with derivative financial
instruments, as defined by SFAS No. 119, "Disclosures about Derivative Financial
Instruments and Fair Value of Financial Instruments," and has not used them for
trading purposes. They are used to manage well-defined interest rate risks. An
interest rate cap agreement is used to reduce the potential impact of increases
in interest rates on the Company's $40 million floating-rate, long-term debt.
Such interest rate cap, with a five year term, was purchased during 1994 for
$1.1 million which effectively limited interest payable, net of proceeds from
the agreement, on long-term debt outstanding to approximately 6% in 1995. During
1995, the Company received proceeds under the interest rate cap agreement of
$378,000.
REVOLVING CREDIT FACILITY
The Credit Agreement, as amended, also provides a revolving credit facility.
The maximum borrowing allowed under this facility is $20 million. The facility
is available through September 30, 2001, and has an annual commitment fee of
0.25% on the unused portion. There have been no borrowings under this facility.
F-22
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. FEDERAL INCOME TAXES
The components of the provision for federal income tax benefit (expense)
consist of the following:
ARM
--------------------------------- HISTORICAL
PERIOD FROM INTEGRITY
NOVEMBER COMPANIES
27, -------------
1993 PERIOD FROM
YEAR ENDED DECEMBER THROUGH JANUARY 1,
31, DECEMBER 1993 THROUGH
-------------------- 31, NOVEMBER 26,
(IN THOUSANDS) 1995 1994 1993 1993
- ---------------------------------------------------- --------- --------- ----------- -------------
Current............................................. $ (641) $ 2,195 $ (2,468) $ --
Deferred............................................ (6,385) 3,823 1,960 --
--------- --------- ----------- -----
Total federal income tax benefit (expense).......... $ (7,026) $ 6,018 $ (508) $ --
--------- --------- ----------- -----
--------- --------- ----------- -----
The significant components of the asset for deferred federal income taxes as
of December 31, 1995 and 1994 were:
(IN THOUSANDS) 1995 1994
- ---------------------------------------------------------------------- ---------- ----------
Deferred tax assets:
Difference between GAAP and tax reserves............................ $ 68,708 $ 45,166
Value of insurance in force......................................... -- 11,977
Capital loss carryforward........................................... 4,483 --
Net operating loss carryforward..................................... 15,341 16,462
Intangibles......................................................... 1,618 228
Alternative minimum tax credit carryforward......................... 1,209 246
Net unrealized losses on available-for-sale securities.............. -- 50,520
Other............................................................... 5,399 2,601
---------- ----------
Total deferred tax assets......................................... 96,758 127,200
Valuation allowance for deferred tax assets......................... (37,336) (66,489)
---------- ----------
Net deferred tax assets........................................... 59,422 60,711
Deferred tax liabilities:
Deferred policy acquisition costs................................... 10,848 5,720
Value of insurance in force......................................... 8,891 --
Fixed maturities.................................................... 1,727 2,403
Other investments................................................... 2,819 1,995
Net unrealized gains on available-for-sale securities............... 15,361 --
---------- ----------
Total deferred tax liabilities.................................... 39,646 10,118
Total deferred federal income taxes................................... $ 19,776 $ 50,593
---------- ----------
---------- ----------
In the event that deferred tax assets are recognized on deductible temporary
differences for which a valuation allowance was provided at the date of an
acquisition, such benefits will be applied to first reduce the balance of
intangible assets related to the acquisition, such as value of insurance in
force and goodwill. During 1995 and 1994, the value of insurance in force was
reduced by $18,004,000 and $5,415,000, respectively, as a result of realizing
such benefits. During 1995, the balance of goodwill was reduced by $980,000 as a
result of realizing such benefits.
F-23
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. FEDERAL INCOME TAXES (CONTINUED)
A full valuation allowance was provided on the difference between deferred
tax assets and liabilities of the Integrity Companies as of November 26, 1993,
resulting in zero deferred federal income taxes at that date. Based on the
Integrity Companies' ability to generate taxable income in the post-acquisition
period and projections of future taxable income, approximately 50% of the
remaining December 31, 1995 valuation allowance was released at year end.
Intangibles associated with the acquisition of Integrity were reduced by
$10,588,000 to zero at December 31, 1995, resulting from the year end valuation
allowance release for that subsidiary, and $4,864,000 was recorded through the
1995 consolidated tax provision as a deferred tax benefit. Additionally, the
Company has established a full valuation allowance on its non-life net operating
loss carryforwards. Realization of these carryforward benefits is dependent on
future non-life earnings.
The Company files a consolidated federal income tax return with its non-life
insurance subsidiaries, but is not currently eligible to file with its life
insurance subsidiaries. Accordingly, Integrity and National Integrity file a
consolidated federal income tax return. SBM Life merged with and into Integrity
on December 31, 1995 and will file a final federal income tax return on a
separate company basis for 1995.
Federal income taxes differ from that computed using the federal income tax
rate of 35% for 1995 and 1994, and 34% for 1993 as follows:
HISTORICAL
INTEGRITY
COMPANIES
-----------
ARM PERIOD FROM
----------------------------------- JANUARY 1,
PERIOD FROM 1993
YEAR ENDED DECEMBER NOVEMBER 27, THROUGH
31, 1993 THROUGH NOVEMBER
-------------------- DECEMBER 31, 26,
(IN THOUSANDS) 1995 1994 1993 1993
- --------------------------------------------------- --------- --------- ------------- -----------
Income tax benefit (expense) at statutory rate..... $ (6,621) $ 7,976 $ (132) $ 13,841
(Increase) decrease in valuation allowance......... (1,052) (1,977) (376) 2,506
Net operating losses not currently deductible...... 271 -- -- (5,264)
Basis difference in investments.................... -- -- -- (10,505)
Capital losses not currently deductible............ -- -- -- (577)
Other, net......................................... 376 19 -- (1)
--------- --------- ----- -----------
Total federal income tax benefit (expense)......... $ (7,026) $ 6,018 $ (508) $ --
--------- --------- ----- -----------
--------- --------- ----- -----------
The Company had net operating loss carryforwards of approximately $43.8
million, $47.0 million and $3.6 million at December 31, 1995, 1994 and 1993,
respectively, expiring in years 2005 to 2010.
F-24
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STATUTORY INFORMATION
Following is a reconciliation of income (loss) based on statutory accounting
practices prescribed or permitted by insurance regulatory authorities for the
Company's insurance subsidiaries with GAAP net income (loss) reported in the
accompanying statements of operations:
YEAR ENDED DECEMBER 31,
---------------------------------
(IN THOUSANDS) 1995 1994 1993
- ------------------------------------------------------------------------------- --------- ---------- ----------
Insurance subsidiaries (statutory-basis)(1).................................... $ 31,179 $ 27,079 $ (15,983)
Non-insurance companies(2)..................................................... 255 (1,909) (612)
--------- ---------- ----------
Statutory-basis operating income (loss)(3)................................... 31,434 25,170 (16,595)
Reconciling items:
Deferred policy acquisition costs, net of amortization....................... 16,650 23,976 19,106
Adjustments to customer deposits............................................. (5,994) (15,773) (20,205)
Adjustments to invested asset carrying values at acquisition date............ (769) (3,726) 7,022
Amortization of value of insurance in force.................................. (7,104) (3,830) (6,996)
Amortization of interest maintenance reserve................................. (3,905) (5,796) (578)
Amortization of goodwill..................................................... (358) -- --
Surplus relief reinsurance................................................... -- -- 10,223
Other........................................................................ (1,705) (784) 1,048
--------- ---------- ----------
GAAP operating income (loss)............................................... 28,249 19,237 (6,975)
Amortization of acquisition-related deferred charges........................... (9,920) (2,163) (249)
Interest expense on long-term debt............................................. (3,461) (3,136) (245)
Realized investment gains (losses), net........................................ 4,048 (36,727) (32,855)
Federal income tax benefit (expense)........................................... (7,026) 6,018 (508)
--------- ---------- ----------
GAAP net income (loss)..................................................... $ 11,890 $ (16,771) $ (40,832)
--------- ---------- ----------
--------- ---------- ----------
- ------------------------
(1) Insurance company general account and separate account statutory-basis
pretax income (loss) excluding realized gains and losses, as reported to
insurance regulatory authorities.
(2) Non-insurance company pretax income (loss) excluding amortization of
acquisition-related deferred charges, interest expense on long-term debt,
and realized investment gains and losses, net.
(3) Includes the results of operations of the SBM subsidiaries for the seven
months ended December 31, 1995.
On December 30, 1994, Integrity redomesticated from Arizona to Ohio.
Dividends that the Company may receive from Integrity in any year without prior
approval of the Ohio insurance commissioner are limited by statute to the
greater of (i) 10% of Integrity's statutory capital and surplus as of the
preceding December 31, or (ii) Integrity's statutory net income for the
preceding year. The maximum dividend payments that may be made by Integrity to
the Company during 1996 are $17.6 million.
The consolidated statutory-basis capital and surplus of the Company's
insurance subsidiaries totaled $146.0 million and $107.9 million at December 31,
1995 and 1994, respectively. In addition, the consolidated statutory-basis asset
valuation reserves of the Company's insurance subsidiaries totaled $19.4 million
and $8.3 million at December 31, 1995 and 1994, respectively. These reserves are
generally added
F-25
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STATUTORY INFORMATION (CONTINUED)
to statutory capital and surplus for purposes of assessing capital adequacy
against various measures used by rating agencies and regulators.
The NAIC has adopted Risk-Based Capital ("RBC") requirements which became
effective December 31, 1993, that attempt to evaluate the adequacy of a life
insurance company's statutory-basis adjusted capital and surplus in relation to
investment, insurance and other business risks. The RBC formula is used by the
states as an early warning tool to identify possible weakly capitalized
companies for the purpose of initiating regulatory action and is not designed to
be a basis for ranking the financial strength of insurance companies. In
addition, the formula defines a new minimum capital standard which supplements
the prevailing system of low fixed minimum capital and surplus. The RBC
requirements provide for four different levels of regulatory attention depending
on the ratio of the company's adjusted capital and surplus to its RBC. As of
December 31, 1995 and 1994, the adjusted capital and surplus of Integrity and
National Integrity are substantially in excess of the minimum level of RBC that
would require regulatory response.
10. PREFERRED STOCK
During 1993, the Company issued 2,000,000 shares of non-voting 9.5%
Cumulative Perpetual Preferred Stock, stated value $25, in connection with the
acquisition of the Integrity Companies. Cash dividends at a rate of 9.5% per
annum per share are payable quarterly. The shares of preferred stock may not be
redeemed prior to December 15, 1998. On or after December 15, 1998, the Company
may, at its option, redeem all or part of the shares at a redemption price of
$25 per share.
11. STOCK OPTIONS
In June 1995, the Company amended and restated the Stock Option Plan for key
employees initially adopted in December 1993. The plan provides for granting of
options to purchase up to 3,265 shares of Class A common stock. A total of 2,388
options were granted through December 31, 1995, of which 434 were exercisable,
and all of which were outstanding at year end. Each option has an exercise price
set initially at fair market value on the date of the grant, as determined by
the Board of Directors of the Company. The option price will increase at the end
of every three month period following the date of grant at a rate of 12% per
annum, compounded annually, while the option remains issued but unexercised (or
if shorter, up to the date of a public offering, a sale of the Company or a
change in control). Such options will become exercisable in equal installments
on the first through fifth anniversary of the date of grant.
The Company has elected to follow Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations in accounting for its employee stock options. Because the
exercise price of the Company's stock options, after considering the 12%
increase mentioned above, is greater than the fair market value of the
underlying stock on December 31, 1995, no compensation expense has been
recognized.
12. CONTINGENCIES
The Company is a defendant in various lawsuits in connection with the normal
conduct of its operations. Company management believes the ultimate resolution
of such litigation will not result in any material adverse impact to operations
or financial condition of the Company.
F-26
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. CONTINGENCIES (CONTINUED)
The number of insurance companies that are under regulatory supervision has
resulted in and is expected to continue to result in assessments by state
guaranty funds to cover losses to policyholders of insolvent or rehabilitated
companies. The Company has accrued for expected non-indemnified assessments net
of estimated future premium tax deductions.
13. SEGMENT INFORMATION
The Company classifies its products and services as either spread-based or
fee-based and manages these two distinct segments separately. Assets and related
investment income are allocated to each segment based on their respective
liabilities. Realized investment gains and losses are reported in corporate and
other. The Historical Integrity Companies made no such distinction between
segments. Accordingly, segment information is presented for periods subsequent
to November 26, 1993 as follows:
CORPORATE
(IN THOUSANDS) SPREAD-BASED FEE-BASED AND OTHER CONSOLIDATED
- ------------------------------------------------------------- ------------ ---------- ---------- ------------
YEAR ENDED DECEMBER 31, 1995:
Revenues................................................... $ 188,476 $ 10,682 $ 8,214 $ 207,372
Pretax operating income.................................... 22,060 2,988 3,201 28,249
Net income (loss) before federal income taxes.............. 22,060 2,988 (6,132) 18,916
Assets..................................................... 3,031,076 647,132 115,372 3,793,580
Amortization............................................... 8,422 1,837 10,055 20,314
YEAR ENDED DECEMBER 31, 1994:
Revenues................................................... $ 143,890 $ 4,459 $ 9,184 $ 157,533
Pretax operating income.................................... 13,092 2,472 3,673 19,237
Net income (loss) before federal income taxes.............. 13,092 2,472 (38,353) (22,789)
Assets..................................................... 1,948,240 409,291 90,357 2,447,888
Amortization............................................... 3,956 900 2,433 7,289
PERIOD FROM NOVEMBER 27, 1993 TO DECEMBER 31, 1993:
Revenues................................................... $ 14,976 $ 274 $ 1,470 $ 16,720
Pretax operating income (loss)............................. 1,288 30 (358) 960
Net income (loss) before federal income taxes.............. 1,288 30 (931) 387
Amortization............................................... 557 7 249 813
F-27
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
CARRYING
AMOUNT FAIR VALUE
------------ ------------
JUNE 30, JUNE 30,
(IN THOUSANDS) 1996 1996
- -------------------------------------------------------------------------------------- ------------ ------------
(UNAUDITED) (UNAUDITED)
ASSETS
Cash and investments:
Fixed maturities available-for-sale, at fair value (amortized cost: June 30,
1996-$2,854,061; December 31, 1995-$2,490,843).................................... $ 2,812,843 $ 2,812,843
Equity securities, at fair value (cost: June 30, 1996-$16,345; December 31,
1995-$10,756)..................................................................... 16,331 16,331
Mortgage loans on real estate....................................................... 41,593 41,593
Policy loans........................................................................ 120,315 120,315
Cash and cash equivalents........................................................... 57,489 57,489
------------ ------------
Total cash and investments............................................................ 3,048,571 3,048,571
Assets held in separate accounts...................................................... 954,964 954,964
Accrued investment income............................................................. 35,513 35,513
Value of insurance in force........................................................... 66,165 118,715
Deferred policy acquisition costs..................................................... 50,947 --
Goodwill.............................................................................. 7,880 7,880
Deferred federal income taxes......................................................... 46,845 44,599
Other assets.......................................................................... 24,033 24,033
------------ ------------
TOTAL ASSETS.......................................................................... $ 4,234,918 $ 4,234,275
------------ ------------
------------ ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits................................................................... $ 3,062,628 $ 3,007,618
Customer deposits in separate accounts.............................................. 949,052 949,052
Long-term debt...................................................................... 40,000 40,000
Payable for investment securities purchased......................................... 12,856 12,856
Accounts payable and accrued expenses............................................... 11,699 11,699
Other liabilities................................................................... 12,788 12,788
------------ ------------
Total liabilities..................................................................... 4,089,023 4,034,013
Contingencies
Shareholders' equity:
Preferred Stock, $25.00 Stated value................................................ 50,000
Class A common stock, $.01 par value, 23,775 and 23,770 shares issued,
respectively...................................................................... *
Class B common stock, $.01 par value, 1,000 shares issued........................... *
Additional paid-in capital.......................................................... 124,456
Net unrealized gains (losses) on available-for-sale securities...................... (21,709)
Retained-earnings deficit........................................................... (6,852)
------------
Total shareholders' equity............................................................ 145,895 200,262
------------ ------------
Total liabilities and shareholders' equity............................................ $ 4,234,918 $ 4,234,275
------------ ------------
------------ ------------
- ------------------------
* Less than $1,000.
SEE ACCOMPANYING NOTES.
F-28
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
SIX MONTHS ENDED JUNE
30,
----------------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1996 1995
- ------------------------------------------------------------------------------------------ ---------- ----------
Investment income......................................................................... $ 117,863 $ 84,963
Interest credited on customer deposits.................................................... (86,012) (64,282)
---------- ----------
Net investment spread................................................................... 31,851 20,681
Fee income:
Variable annuity fees................................................................... 5,024 3,158
Asset management fees................................................................... 2,711 1,131
Other fee income........................................................................ 628 228
---------- ----------
Total fee income...................................................................... 8,363 4,517
Other income and expenses:
Surrender charges....................................................................... 2,890 1,115
Operating expenses...................................................................... (15,187) (10,369)
Commissions, net of deferrals........................................................... (1,197) (490)
Interest expense on long-term debt...................................................... (1,531) (1,673)
Amortization:
Deferred policy acquisition costs..................................................... (3,105) (1,291)
Value of insurance in force........................................................... (4,481) (2,486)
Acquisition-related deferred charges.................................................. (251) (2,444)
Goodwill.............................................................................. (244) (47)
Other, net.............................................................................. (2,640) (410)
---------- ----------
Total other income and expenses....................................................... (25,746) (18,095)
---------- ----------
Realized investment gains (losses)........................................................ (1,217) 2,694
---------- ----------
Income before federal income taxes........................................................ 13,251 9,797
Federal income tax expense................................................................ (2,763) (4,938)
---------- ----------
Net income................................................................................ 10,488 4,859
Dividends on preferred stock.............................................................. (2,376) (2,376)
---------- ----------
Net income applicable to common shareholders.............................................. $ 8,112 $ 2,483
---------- ----------
---------- ----------
Net income per common share............................................................... $ 327.44 $ 149.33
---------- ----------
---------- ----------
Average common shares outstanding......................................................... 24,774 16,628
---------- ----------
---------- ----------
SEE ACCOMPANYING NOTES.
F-29
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE SIX MONTHS ENDED JUNE 30, 1996 AND 1995
(IN THOUSANDS) 1996 1995
- -------------------------------------------------------------------------------------- ------------- -----------
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES........................................... $ 88,554 $ 55,456
CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
Fixed maturity investments:
Purchases........................................................................... (1,526,142) (704,791)
Maturities and redemptions.......................................................... 118,596 45,315
Sales............................................................................... 1,044,921 622,198
Other investments:
Purchases........................................................................... (33,153) (5,133)
Maturities and redemptions.......................................................... 2,351 18,513
Sales............................................................................... 27,394 --
Policy loans, net..................................................................... (2,787) (2,633)
Purchase of assets held in separate accounts.......................................... (132,932) (101,912)
Proceeds from sale of assets held in separate accounts................................ 40,272 18,127
Cash and cash equivalents acquired in excess of purchase price paid for substantially
all assets of SBM Company........................................................... -- 36,490
------------- -----------
Cash flows used in investing activities............................................... (461,480) (73,826)
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Proceeds from issuance of common stock................................................ -- 63,505
Stock issuance costs.................................................................. -- (2,000)
Amounts received from customers....................................................... 597,998 155,368
Amounts paid to customers............................................................. (230,095) (188,105)
Increase (decrease) in repurchase agreement liability................................. (12,008) 24,007
Preferred stock dividends............................................................. (2,376) (2,376)
------------- -----------
Cash flows provided by financing activities........................................... 353,519 50,399
------------- -----------
Net change in cash and cash equivalents............................................... (19,407) 32,029
Cash and cash equivalents at beginning of period...................................... 76,896 45,855
------------- -----------
Cash and cash equivalents at end of period............................................ $ 57,489 $ 77,884
------------- -----------
------------- -----------
SEE ACCOMPANYING NOTES.
F-30
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
JUNE 30, 1996
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles
("GAAP") for interim financial information and with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the six months ended June 30, 1996 are not
necessarily indicative of those to be expected for the year ended December 31,
1996. For further information, refer to the consolidated financial statements
and footnotes thereto included in the annual report on Form 10-K of ARM
Financial Group, Inc. (the "Company") for the year ended December 31, 1995.
Certain amounts from prior periods have been reclassified to conform to the
current period presentation. These reclassifications had no effect on previously
reported net income or shareholders' equity.
2. FAIR VALUE BALANCE SHEETS
The consolidated balance sheets include a dual presentation of carrying
amount and fair value balances. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," fixed maturities classified as available-for-sale
are reported at fair value in the carrying amount balance sheets; however,
corresponding customer deposits are reported at historical values. In contrast,
in the fair value balance sheets both assets and liabilities are reported at
fair value. As permitted by SFAS No. 107, "Disclosures About Fair Value of
Financial Instruments," the fair value balance sheets are presented as a
supplemental disclosure to provide a more meaningful picture of the Company's
financial position.
SFAS No. 107 requires disclosure of fair value information about all
financial instruments, including insurance liabilities classified as investment
contracts, unless specifically exempted. The accompanying fair value balance
sheets reflect fair values for those financial instruments specifically covered
by SFAS No. 107, along with fair value amounts for other assets and liabilities
for which disclosure is permitted but not required.
The fair value of a financial instrument is the amount at which the
instrument could be exchanged in a current transaction between willing parties,
other than in a forced or liquidation sale. In cases where quoted market prices
are not available, fair values are based on estimates using present value or
other valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. Accordingly, the aggregate fair value amounts presented do not
necessarily represent the underlying value of the Company.
The Company seeks to reduce its exposure to changing interest rates through
the management of duration, convexity and cash flow characteristics of both
assets and liabilities while maintaining liquidity redundancies (i.e., sources
of liquidity in excess of projected liquidity needs). As a result, fair values
of the Company's assets and liabilities will tend to respond similarly to
changes in interest rates.
F-31
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
JUNE 30, 1996
2. FAIR VALUE BALANCE SHEETS (CONTINUED)
The following methods and assumptions were used in estimating fair values:
FIXED MATURITIES AND EQUITY SECURITIES
Fair values for fixed maturities and equity securities are based on quoted
market prices, where available. For fixed maturities for which a quoted market
price is not available, fair values are estimated using internally calculated
estimates or quoted market prices of comparable instruments.
MORTGAGE LOANS ON REAL ESTATE
Pursuant to the terms of the acquisition of certain of the Company's
insurance operations, payments of principal and interest on substantially its
entire current mortgage loan portfolio are guaranteed by The National Mutual
Life Association of Australasia Limited ("National Mutual"). Principal received
in excess of statutory book value is to be returned to National Mutual.
Accordingly, book value is deemed to be fair value for these mortgage loans.
POLICY LOANS
The carrying amount of policy loans approximates their fair value.
CASH AND CASH EQUIVALENTS AND ACCRUED INVESTMENT INCOME
The carrying amount of cash and cash equivalents and accrued investment
income approximates their fair value given the short-term nature of these
assets.
ASSETS HELD IN SEPARATE ACCOUNTS AND CUSTOMER DEPOSITS IN SEPARATE ACCOUNTS
Fair value of assets held in separate accounts is based on the quoted market
prices of the underlying mutual funds for assets invested in variable options.
The fair value of assets held in separate accounts invested in guaranteed rate
options is primarily based on quoted market prices of fixed maturity securities.
The fair value of customer deposits in separate accounts is based on the account
values of the underlying policies, plus or minus market value adjustments
applicable to certain customers who are guaranteed a fixed rate of return.
GOODWILL
The carrying amount of goodwill approximates fair value.
DEFERRED FEDERAL INCOME TAXES
The deferred federal income tax asset and related valuation allowance were
adjusted for federal income tax which may be incurred as a result of the
differences between the estimated fair values and carrying amounts of the assets
and liabilities.
F-32
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
JUNE 30, 1996
2. FAIR VALUE BALANCE SHEETS (CONTINUED)
CUSTOMER DEPOSITS AND VALUE OF INSURANCE IN FORCE
The fair value of customer deposits for structured settlements and immediate
annuities is based on discounted cash flow calculations using a current market
yield rate for assets with similar durations (i.e., indexed to the U.S. Treasury
yield curve). The fair value of customer deposits for structured settlements and
immediate annuities represents the fair values of those insurance policies as a
whole which implicitly eliminates the corresponding value of insurance in force.
The fair value amounts of the remaining customer deposits, primarily deferred
annuities, single premium endowments, and guaranteed investment contracts
("GICs"), represent the account values of the underlying contracts before
applicable surrender charges. The fair value of the value of insurance in force
represents the estimated present value of future profits for all customer
deposits, excluding those related to structured settlements and immediate
annuities, assuming a discount rate of 13%. Deferred policy acquisition costs do
not appear on the fair value presentation because those values are implicitly
considered in the determination of the fair value of the corresponding customer
deposits and value of insurance in force.
LONG-TERM DEBT
The carrying amount of long-term debt approximates fair value.
OTHER ASSETS AND LIABILITIES
The fair values of other assets and liabilities are reported at their
financial statement carrying amounts.
3. FEDERAL INCOME TAXES
Federal income taxes are different from the amount determined by multiplying
pretax earnings by the expected federal income tax rate of 35%. The differences
are primarily attributable to changes in valuation allowances related to
deferred federal income tax assets.
F-33
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
JUNE 30, 1996
4. STATUTORY INFORMATION
Following is a reconciliation of income based on statutory accounting
practices prescribed or permitted by insurance regulatory authorities for the
Company's insurance subsidiaries with net income reported in the accompanying
condensed consolidated statements of operations:
SIX MONTHS ENDED
JUNE 30,
--------------------
(IN THOUSANDS) 1996 1995
- -------------------------------------------------------------------------------------------- --------- ---------
Insurance subsidiaries (statutory-basis) (1)................................................ $ 18,680 $ 14,116
Non-insurance companies(2).................................................................. (608) (628)
--------- ---------
Consolidated statutory-basis pretax operating income.................................... 18,072 13,488
Reconciling items:
Deferral of policy acquisition costs, net of amortization................................. 7,071 7,304
Adjustments to customer deposits.......................................................... (329) (4,137)
Adjustments to invested asset carrying values at acquisition date......................... (435) (247)
Amortization of value of insurance in force............................................... (4,481) (2,486)
Amortization of interest maintenance reserve.............................................. (2,165) (2,070)
Amortization of goodwill.................................................................. (244) (47)
Amortization of acquisition-related deferred charges...................................... (251) (2,444)
Interest expense on long-term debt........................................................ (1,531) (1,673)
Realized investment gains (losses)........................................................ (1,217) 2,694
Federal income tax expense................................................................ (2,763) (4,938)
Other..................................................................................... (1,239) (585)
--------- ---------
Consolidated GAAP-basis net income...................................................... $ 10,488 $ 4,859
--------- ---------
--------- ---------
- ------------------------
(1) Insurance company general account and separate account statutory-basis
pretax income excluding realized gains and losses as reported to insurance
regulatory authorities.
(2) Non-insurance company pretax loss excluding amortization of
acquisition-related deferred charges, interest expense on long-term debt and
realized investment gains and losses.
F-34
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
SBM Company and Subsidiaries
Minneapolis, Minnesota
We have audited the accompanying consolidated balance sheet of SBM Company
and subsidiaries as of December 31, 1994 and the related consolidated statements
of operations, stockholders' deficit, and cash flows for each of the two years
in the period ended December 31, 1994. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of SBM Company
and subsidiaries as of December 31, 1994 and the results of their operations and
their cash flows for each of the two years in the period ended December 31, 1994
in conformity with generally accepted accounting principles.
As discussed in Note A to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standards No. 115, ACCOUNTING FOR
CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES, in 1994.
As discussed in Note B to the consolidated financial statements, the Company
has agreed to sell substantially all of the business operations and assets of
the Company, subject to a number of contingencies, including the obtaining of
regulatory and shareholder approvals. As soon as practicable after the
consummation of the sale, the Company intends to wind up and liquidate the
Company. The accompanying financial statements have been prepared on a
historical basis of accounting and do not include any purchase accounting,
liquidation accounting or other adjustments which would result upon completion
of the proposed sale and resulting liquidation.
/s/ Deloitte & Touche LLP
Minneapolis, Minnesota
March 29, 1995
F-35
SBM COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
DECEMBER 31,
1994
--------------
ASSETS
Investments:
Debt securities available-for sale at market (cost $732,262,541)--Note C........................ $ 653,207,076
Debt securities held-to-maturity at amortized cost (market $11,913,328)--Note C................. 13,944,234
Marketable equity securities at market (cost $1,068,525)--Note C................................ 683,089
Mortgage loans--Note D.......................................................................... 36,257,214
Policy loans.................................................................................... 22,153,936
Other invested assets........................................................................... 1,694,506
Short-term investments.......................................................................... 37,602,490
--------------
Total investments........................................................................... 765,542,545
Cash.............................................................................................. 3,565,693
Accrued investment income......................................................................... 8,470,103
Receivable from reinsurer--Notes A and I.......................................................... 105,806,093
Deferred policy acquisition costs, less accumulated amortization--Note E.......................... 76,950,470
Land, building and equipment, at cost less accumulated depreciation of $2,470,302-- Note H........ 1,417,796
Deferred income taxes--Note J..................................................................... 3,091,000
Refundable income taxes........................................................................... 3,003,386
Other assets...................................................................................... 1,517,067
--------------
Total Assets................................................................................ $ 969,364,153
--------------
--------------
LIABILITIES AND STOCKHOLDERS' (DEFICIT)
Future policy benefits............................................................................ $ 910,104,179
Face amount certificate reserves--Note G.......................................................... 60,355,015
Accounts payable and other liabilities............................................................ 9,252,047
Deferred compensation and retirement benefits for officers--Note L................................ 1,227,284
--------------
Total liabilities........................................................................... 980,938,525
--------------
Mandatory redeemable voting convertible preferred stock, par value $1,000 (1994 includes
$760,000 dividends in arrears). Authorized 19,000 shares, issued 19,000 shares, liquidation
value $19,000,000 plus dividends in arrears--Note L........................................... 18,485,868
Common stock held by employee benefit plans; 304,693 and 305,693 shares, respectively--Note L..... 1,916,519
Commitments and contingencies--Notes I, K, L and M................................................
Common stock, no par value. Authorized 20,000,000 shares; issued and outstanding 2,179,714 shares,
less 304,693 shares held by employee benefit plans.............................................. 2,945,606
Unrealized losses on marketable equity securities--Notes C and J.................................. (254,388)
Unrealized losses on debt securities--Notes A, C and J............................................ (59,691,765)
Retained earnings................................................................................. 25,023,788
--------------
Total stockholders' (deficit)--Note L........................................................... (31,976,759)
--------------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT..................................................... $ 969,364,153
--------------
--------------
See notes to consolidated financial statements.
F-36
SBM COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31
----------------------------
1994 1993
------------- -------------
Revenues:
Net investment income............................................................ $ 62,887,722 $ 60,884,031
Underwriting, sales service and distribution fees................................ 3,124,299 3,618,848
Life insurance premiums.......................................................... 392,801 415,141
Advisory and other fees from affiliated mutual funds............................. 1,481,074 1,486,052
Realized investment (losses) gains, net.......................................... (9,799,377) 3,828,598
Other income..................................................................... 1,845,231 1,814,676
------------- -------------
Total revenues............................................................... 59,931,750 72,047,346
------------- -------------
Benefits and expenses:
Provisions for benefits:
Annuities and life insurance..................................................... 42,466,335 44,659,544
Face amount certificate reserves (interest)--Note G.............................. 3,575,075 4,089,905
Loan and real estate losses--Notes C and D....................................... 320,000 718,908
Death and other benefits......................................................... 471,419 489,768
Commissions, wages and benefits.................................................. 7,148,918 6,795,909
Interest expense................................................................. 124,363 598,450
Amortization of deferred policy acquisition costs--Note E........................ 4,275,361 4,076,736
Occupancy of equipment........................................................... 1,370,685 1,433,732
State guaranty association assessments........................................... 1,791,617 1,463,441
Other expenses................................................................... 3,259,408 2,173,256
------------- -------------
Total benefits and expenses.................................................. 64,803,181 66,499,649
------------- -------------
Income (loss) from continuing operations before income taxes................. (4,871,431) 5,547,697
Income taxes (benefit)--Note J................................................... (1,267,000) 1,800,000
------------- -------------
Net income (loss)................................................................ $ (3,604,431) $ 3,747,697
------------- -------------
------------- -------------
Discount accretion of preferred stock............................................ $ 136,188 $ --
Mandatory redeemable voting convertible preferred stock dividends................ $ 1,520,000 $ 657,802
------------- -------------
------------- -------------
Net income (loss) applicable to common stock..................................... $ (5,260,619) $ 3,089,895
------------- -------------
------------- -------------
Earnings per common share:
Primary:
Net income (loss).............................................................. $ (2.40) $ 1.35
------------- -------------
------------- -------------
Fully diluted:
Net income (loss).............................................................. $ (2.40) $ 1.32
------------- -------------
------------- -------------
Weighted average common shares outstanding (primary)............................. 2,187,481 2,281,673
Weighted average common shares outstanding (fully diluted)....................... 2,187,481 2,971,923
See notes to consolidated financial statements.
F-37
SBM COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
UNREALIZED
LOSSES ON UNREALIZED TOTAL
MARKETABLE LOSSES ON STOCKHOLDERS'
EQUITY DEBT RETAINED EQUITY
COMMON STOCK SECURITIES SECURITIES EARNINGS (DEFICIT)
-------------- --------------- ------------- ---------- -------------
Balances as of December 31, 1992............. $3,101,197 $ (213,024) $ -- $27,031,218 $29,919,391
Net income................................. -- -- -- 3,747,697 3,747,697
Dividends declared:
Common stock $.40 per share.............. -- -- -- (911,925) (911,925)
Mandatory redeemable voting convertible
preferred stock, 8%...................... -- -- -- (657,802) (657,802)
Decrease in unrealized loss on marketable
equity securities, net of income tax
benefit.................................. -- 47,282 -- -- 47,282
Accretion of discount mandatory redeemable
voting convertible preferred stock....... -- -- -- (38,994) (38,994)
Allocation of net income in excess of
dividends to common stock held by
employee benefit plans................... -- -- -- (146,175) (146,175)
-------------- --------------- ------------- ---------- -------------
Balances at December 31, 1993................ 3,101,197 (165,742) -- 29,024,019 31,959,474
Net loss................................... -- -- -- (3,604,431) (3,604,431)
Dividends declared:
Common stock, $.10 per share............. -- -- -- (217,971) (217,971)
Mandatory redeemable voting convertible
preferred stock, 8%.................... -- -- -- (760,000) (760,000)
Dividends in arrears on mandatory
redeemable voting convertible preferred
stock, 8%................................ -- -- -- (760,000) (760,000)
Adoption of SFAS No. 115 -
Note A..................................... -- -- 3,800,000 -- 3,800,000
Increase in unrealized loss on marketable
equity securities, net of income tax
benefit.................................. -- (88,646) -- -- (88,646)
Accretion of discount on mandatory
redeemable voting convertible preferred
stock.................................... -- -- -- (136,188) (136,188)
Allocation of net loss, dividends and
carrying value to common stock held by
employee benefit plans................... -- -- -- 2,876,307 2,876,307
Increase in unrealized loss on debt
securities............................... -- -- (63,491,765) -- (63,491,765)
Purchases of 100,041 shares including
acquisition costs of $42,193............. (155,591) -- -- (1,397,948) (1,553,539)
-------------- --------------- ------------- ---------- -------------
Balances at December 31, 1994.............. $2,945,606 $ (254,388) $(59,691,765) $25,023,788 $(31,976,759)
-------------- --------------- ------------- ---------- -------------
-------------- --------------- ------------- ---------- -------------
See notes to consolidated financial statements.
F-38
SBM COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31
----------------------------
1994 1993
------------- -------------
Cash flows from operating activities:
Net income (loss)................................................................. $ (3,604,431) $ 3,747,697
------------- -------------
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Provisions for losses and benefits:
Annuities and life insurance.................................................. 42,466,335 44,659,544
Face amount certificate reserves (interest)................................... 3,575,075 4,089,905
Loan and real estate losses................................................... 320,000 718,908
Depreciation.................................................................... 302,491 318,025
Amortization of deferred policy acquisition costs............................... 4,275,361 4,076,736
Deferred income taxes........................................................... (786,000) (252,000)
Premium amortization, net....................................................... (4,537,537) (4,396,269)
Realized investment (gains) losses, net......................................... 9,799,377 (3,828,598)
Decrease (increase) in operating assets:
Accrued investment income....................................................... (2,764,904) (120,792)
Receivable from reinsurer....................................................... (300,934) 363,943
Deferred policy acquisition costs capitalized................................... (5,205,762) (7,932,570)
Refundable income taxes......................................................... (2,648,568) 282,256
Other assets.................................................................... (160,953) 991,081
Increase (decrease) in operating liabilities:
Accounts payable and other liabilities:......................................... 899,236 1,388,655
Deferred compensation and retirement benefits for officers...................... (8,764) (68,268)
------------- -------------
Net cash provided by operating activities......................................... 41,620,022 44,038,253
------------- -------------
Cash flows from investing activities:
Proceeds from maturities and repayments of debt securities:
Available-for-sale.............................................................. 67,792,568 --
Held-to-maturity................................................................ 22,833,787 311,637,232
Proceeds from other investments sold.............................................. 314,979 --
Proceeds from sales of debt securities:
Available-for-sale.............................................................. 176,422,655 --
Held-to-maturity................................................................ 11,983 103,871,141
Cost of debt securities acquired:
Available-for-sale.............................................................. (242,280,515) --
Held-to-maturity................................................................ (16,678,534) (513,801,212)
Cost of other investments purchased............................................... (2,880) --
Sales (purchases) of short-term investments, net.................................. (28,729,158) 6,710,632
Loan principal repayments......................................................... 17,472,582 22,503,776
Loans funded...................................................................... (11,142,529) (10,654,812)
Proceeds from (additions to) land, building and equipment, net.................... 2,170,973 (203,697)
------------- -------------
Net cash used in investing activities........................................... (11,814,089) (79,936,940)
------------- -------------
Cash flows from financing activities:
Payments to face amount certificate holders....................................... (15,615,986) (9,596,304)
Reserve payments from face amount certificate holders............................. 5,332,840 5,984,921
Deposit received from annuitants, net............................................. 73,987,946 99,636,112
Payments to annuitants............................................................ (86,284,317) (65,545,851)
Sale of preferred stock........................................................... -- 11,000,000
Expenses of issuance of preferred stock........................................... -- (1,299,314)
Purchase of common stock.......................................................... (1,569,268) (193,375)
Dividends on common stock......................................................... (217,971) (683,925)
Dividends on preferred stock...................................................... (760,000) (657,802)
Principal payments on notes payable............................................... (2,012,210) (3,175,575)
------------- -------------
Net cash (used in) provided by financing activities............................. (27,138,966) 35,468,887
------------- -------------
Net increase (decrease) in cash..................................................... 2,666,967 (429,800)
Cash at beginning of year........................................................... 898,726 1,328,526
------------- -------------
Cash at end of year................................................................. $ 3,565,693 $ 898,726
------------- -------------
------------- -------------
See notes to consolidated financial statements.
F-39
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of SBM Company
(the "Company") and all wholly owned subsidiaries. All significant intercompany
accounts and transactions have been eliminated in consolidation. For
comparability, certain prior year amounts have been reclassified to conform with
the current year presentation.
INVESTMENTS
Effective January 1, 1994, the Company adopted Financial Accounting
Standards Board Statement of Financial Accounting Standards (SFAS) No. 115,
ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES. The primary
impact of SFAS 115 is to require the Company to classify its debt securities
into categories based upon the Company's intent relative to the eventual
disposition of the securities. SFAS 115 establishes three categories of
securities: (1) Held-to-maturity securities are comprised of securities which
the Company has the positive intent and ability to hold to maturity. These
securities are carried at amortized cost. SFAS 115 prevents the Company from
classifying a security as held-to-maturity if the security might be sold for
liquidity needs or based on changes in interest rates. (2) Available-for-sale
securities may be sold to address liquidity and other needs of the Company.
These securities are held at "fair value" on the balance sheet with an increase
or decrease to stockholders' equity for unrealized gains or losses after the
recording of deferred income taxes. (3) Trading securities would be securities
acquired for the purpose of selling them in the near term. The Company does not
intend to classify any of its securities as trading securities.
Upon adoption of SFAS 115, the Company analyzed its debt securities and
determined that to maintain flexibility in its investment portfolio it would
classify a significant portion of its investment portfolio as available-for-sale
even though management did not have the intention of selling these securities.
As such, as of January 1, 1994, approximately $505.6 million of its debt
securities were classified as available-for-sale with approximately $254.2
million classified as held-to-maturity. The fair value of the available-for-sale
securities created a net unrealized after tax gain of $3.8 million, after
adjustment for deferred acquisition costs, at January 1, 1994. Due to an
investment portfolio repositioning program in mid 1994, the Company's life
insurance subsidiary transferred approximately $234 million of securities
classified as held-to-maturity into the available-for-sale category with an
unrealized loss of $15.9 million. With the significant increase in interest
rates in 1994, the market value of the available-for-sale securities at December
31, 1994 resulted in a net pretax unrealized loss of $79.1 million and a
deferred tax benefit of approximately $6.6 million. A tax valuation allowance of
approximately $20.3 million has been established for the additional tax benefit
that cannot be recognized at this time. In addition, deferred policy acquisition
costs have been increased by $12.8 million, net of a deferred tax liability of
$6.5 million, in conjunction with SFAS 115. This amount is included in the
stockholders' equity section for unrealized losses on debt securities
available-for-sale. During 1994, changes in market interest rates and other
factors have caused fluctuations in the value of securities classified as
available-for-sale which has created volatility in the Company's stockholders'
equity.
Marketable equity securities are carried at fair value, and any change in
unrealized losses, net of deferred income taxes, is recorded directly against
stockholders' equity (deficit).
F-40
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The fair values for actively traded bonds, such as GNMA and FNMA
Certificates, are based on quoted market prices. The fair values of
collateralized mortgage obligations (CMOs) are based on quotes from independent
brokers. Considerable judgment is required in interpreting market data to
develop estimates of fair value for CMOs; accordingly, these quotes are not
necessarily indicative of the amounts that could be realized or would be paid in
a current sale of the security. The fair values of equity securities are based
on closing market quotations or on estimates from independent broker-dealers and
pricing services. When evidence indicates there is an other than temporary
decline in the underlying value of individual investments, such investments are
written down to reflect such impairment by a charge to realized gains (losses)
in the consolidated statements of income. Realized gains or losses on the sale
of investments are computed on the basis of specific identification of
investment costs.
Mortgage loans on real estate are carried at amortized cost less an
allowance for loan losses.
Real estate acquired in satisfaction of loans is stated at the lower of cost
or fair value, less cost of disposition, at the date acquired. If there are
subsequent declines in market value, the property is adjusted to fair value
through current earnings. Foreclosed real estate is included as a component of
other invested assets.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses provides for potential losses when other than
temporary declines have occurred in the value of the real estate and other
assets securing the loans. The allowance is based upon management's evaluation
of a number of factors, including loan loss experience, a continuing review of
problem loans and current and anticipated economic conditions that may affect
the borrower's ability to repay the loan. The allowance is increased by
provisions charged to operating expense and reduced by net chargeoffs. Loans are
placed on nonaccrual status when management believes the collection of interest
is uncertain, generally when payments are past due more than three months.
DEFERRED POLICY ACQUISITION COSTS
The costs of acquiring and issuing new life insurance policies, annuity
contracts and face amount certificates, principally commissions, expenses of
issuance and underwriting and certain sales expenses have been deferred.
Deferred policy acquisition costs applicable to annuity contracts are amortized
over the lives of the policies in relation to the present value of estimated
gross profits from investment and expense margins. The deferred policy
acquisition costs applicable to traditional life insurance policies are
amortized to income over the premium-paying periods of the related policies in
proportion to the ratio of the expected annual premium revenues to total
anticipated premium revenues from the life insurance policies. Expected premium
revenue was estimated using the same actuarial assumptions as were used in
calculating the liabilities for future policy benefits. Deferred acquisition
costs applicable to face amount certificates are amortized on a straight-line
basis over three years.
LAND, BUILDING AND EQUIPMENT
Depreciation is computed using the straight-line method over estimated
useful lives of thirty-three years for the building and related improvements and
from three to twenty years for equipment.
F-41
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FUTURE POLICY BENEFITS
The liability for future policy benefits for traditional life insurance has
been computed by a net level premium method based on assumptions as to
investment yields, mortality, withdrawals and dividends. The assumptions are
based on projections of past experience and include provisions for possible
unfavorable deviation. These assumptions are made at the time the contract is
issued.
The liability for future policy benefits for flexible premium and single
premium deferred annuities represents accumulated account values with interest
currently at 4.50% to 8.0%.
The Company records ceded reinsurance receivables, including amounts related
to paid and unpaid benefits and amounts related to liabilities for future policy
benefits, as assets and liabilities on the Company's consolidated balance sheet.
As of December 31, 1994, receivable from reinsurer and future policy benefits on
the consolidated balance sheet include reinsurance receivables of $105,428,796.
FACE AMOUNT CERTIFICATE RESERVES
Face amount certificates issued by the Company's subsidiary entitle
certificate holders, who have made either single or installment payments, to
receive a definite sum of money at maturity. Certificate reserves earn interest
and cash surrender values are less than accumulated certificate reserves prior
to maturity dates. Certificate reserves are maintained for advance payments by
certificate holders and accrued interest thereon and for interest earned and
accrued due to additional interest rates declared. The reserve accumulation
rates, cash surrender values and certificate reserves, among other matters, are
governed by the Investment Company Act of 1940.
EARNINGS PER SHARE
Primary earnings per share were computed by dividing net income (loss) less
dividends on mandatory redeemable voting convertible preferred stock by the
weighted average number of common shares outstanding during each year. The
mandatory redeemable voting convertible preferred stock is not considered to be
a common stock equivalent. Fully diluted earnings per share for 1993 assumes
conversion of the mandatory redeemable voting convertible preferred stock into
690,250 weighted average common shares and a $180,000 adjustment for interest,
net of tax, paid on the convertible promissory note. For 1994, the warrant (Note
K) and the assumed conversion of the mandatory redeemable voting convertible
preferred stock would have been anti-dilutive and are not considered in primary
or fully diluted common shares, respectively.
MANDATORY REDEEMABLE VOTING CONVERTIBLE PREFERRED STOCK
The discount on the mandatory redeemable voting convertible preferred stock
is being accreted through a charge against retained earnings over ten years
using the effective interest method.
UNDERWRITING, SALES SERVICE AND DISTRIBUTION FEES
Sales service fees for selling and servicing life insurance policies and
annuity contracts are recognized at the time a new policy or contract is written
and as premiums are collected from policy and contract holders thereafter.
Underwriting fees for sale of mutual fund shares and other products are
recognized at the time of sale. All significant intercompany transactions have
been eliminated with no effect on net
F-42
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
income since fees received by the Company's sales subsidiary approximate the
costs incurred by the Company and its other subsidiaries.
PREMIUM REVENUE
Life insurance premiums are reported as earned when due. Benefits and
expenses are associated with earned premiums in a manner that results in
recognition of policy profits over the lives of the related policies.
Annuity contracts which do not subject the Company to significant risks
arising from policyholder mortality or morbidity are considered
interest-sensitive insurance contracts. Amounts received as payments for such
contracts are not reported as revenues. Revenues for investment products consist
of investment income and policy administration charges. Contract benefits that
are charged to expense include benefit claims incurred in the period in excess
of related contract values and interest credited to contract values.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Supplemental Cash Flow Information:
Cash paid for interest during the years ended December 31, 1994 and 1993,
was $4,062,114 and $4,784,118, respectively. Cash paid for income taxes, net of
refunds received, for the years ended December 31, 1994 and 1993, was $2,062,899
and $2,057,832, respectively.
Noncash Investing and Financing Activities:
At December 31, 1994, the Company was $760,000 in arrears for dividends on
the mandatory redeemable voting convertible preferred stock.
During 1993, the Company sold real estate owned properties and financed
$2,235,000 of the purchase prices. During 1993, the Company foreclosed on
certain mortgage loans and acquired the underlying real estate collateral. This
real estate was then transferred to other invested assets at the lower of cost
or fair value less cost of disposition of $2,374,951 in 1993.
During 1993, the Company's $4,000,000 Convertible Promissory Note was
converted into 4,000 shares of the Company's Series A Mandatory Redeemable
Voting Convertible Preferred Stock.
IMPACT OF ACCOUNTING PRONOUNCEMENTS TO BE ADOPTED IN THE FUTURE
In May 1993, the Financial Accounting Standards Board issued SFAS No. 114
(SFAS 114), ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN. SFAS 114 is
effective for fiscal years beginning after December 15, 1994. The primary effect
of the statement for the Company will be related to the accounting for impaired
commercial mortgage loans. The significant issue addressed is the utilization of
fair value in establishing allowances for impaired loans. The Company estimates
that the effect of adoption of SFAS 114 will not be material.
F-43
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
B. SALE AND LIQUIDATION OF THE COMPANY
Pursuant to a Stock and Asset Purchase Agreement dated February 16, 1995,
between the Company and ARM Financial Group, Inc., (ARM), the Company has agreed
to sell substantially all of the business operations and assets of the Company
to ARM (the Proposed Transaction) for a purchase price of $38.6 million, subject
to certain adjustments. As part of the Proposed Transaction, ARM will acquire
all of the outstanding stock of the subsidiaries and certain assets of the
Company and assume certain liabilities of the Company. Additionally, the
agreement requires ARM to contribute between $15-20 million in additional
capital to the subsidiaries (See Note L regarding Stockholders' Equity and
Regulatory Matters). The completion of the Proposed Transaction is subject to a
number of contingencies, including the obtaining of regulatory and shareholder
approvals.
As soon as practicable after consummation of the Proposed Transaction, the
Company intends to wind up and liquidate the Company. The Company anticipates
adopting a Plan of Dissolution, such Plan to be effective upon consummation of
the Proposed Transaction. In the liquidation, distributions to the holders of
common stock will be subject to the senior rights of the holders of the Series A
Preferred Stock (Note L) and the Series B Preferred Stock (no Series B shares
are outstanding as of December 31, 1994).
At the Company's regular meeting of shareholders, expected to be held in
April or May 1995, the Company's shareholders will vote on the above matters. A
proxy statement will be sent to all shareholders with detailed information
concerning the Proposed Transaction and the Plan of Dissolution.
The Proposed Transaction and the Plan of Dissolution each require the
affirmative vote of the holders of a majority of the voting power of all shares
entitled to vote, voting together as a single class. Approval of the Proposed
Transaction also requires the affirmative vote of the holders of 66 2/3% of the
outstanding shares of Series A Preferred Stock, voting separately as a class.
The accompanying consolidated financial statements have been prepared on an
historical basis of accounting and do not include any purchase accounting,
liquidation accounting or other adjustments which would result upon completion
of the Proposed Transaction and the Plan of Dissolution.
F-44
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
C. INVESTMENTS
Investment securities by type and gross unrealized gains and losses at
December 31, 1994 are presented below:
GROSS UNREALIZED
--------------------------
AMORTIZED COST GAINS LOSSES FAIR VALUE
-------------- ---------- -------------- --------------
Debt securities available-for-sale:
CMOs.............................................. $ 444,647,746 $ -- $ (70,647,798) $ 373,999,948
GNMA certificates................................. 88,584,779 224,202 (2,399,982) 86,408,999
FNMA certificates................................. 19,483,095 11,277 (958,581) 18,535,791
Corporate bond obligations........................ 78,968,327 77,713 (1,580,342) 77,465,698
U.S. Government obligations....................... 100,578,894 -- (3,782,254) 96,796,640
-------------- ---------- -------------- --------------
$ 732,262,841 $ 313,192 $ (79,368,957) $ 653,207,076
-------------- ---------- -------------- --------------
-------------- ---------- -------------- --------------
Debt securities held-to-maturity:
CMOs.............................................. $ 13,108,720 $ -- $ (1,987,005) $ 11,121,715
GNMA certificates................................. -- -- -- --
FNMA certificates................................. -- -- -- --
Corporate bond obligations........................ -- -- -- --
State and municipal obligations................... 667,053 5,601 (34,254) 638,400
U.S. Government obligations....................... 168,461 -- (15,248) 153,213
-------------- ---------- -------------- --------------
$ 13,944,234 $ 5,601 $ (2,036,507) $ 11,913,328
-------------- ---------- -------------- --------------
-------------- ---------- -------------- --------------
Marketable equity securities:
Preferred stocks.................................. $ 1,065,645 $ 6,932 $ (392,368) $ 680,209
Common stocks..................................... 2,880 -- -- 2,880
Affiliated mutual funds........................... -- -- -- --
-------------- ---------- -------------- --------------
$ 1,068,525 $ 6,932 $ (392,368) $ 683,089
-------------- ---------- -------------- --------------
-------------- ---------- -------------- --------------
CMOs are a discreet pool of mortgage-backed securities which are generally
issued in several classes. Each such class bears or accrues any interest to
which it is entitled at a specified rate or at a rate calculated in a specified
manner. Principal on the mortgage loans ultimately underlying a series of CMOs
may be allocated among the several classes within such series in a variety of
ways, resulting in classes of CMOs which return principal based on a specified
or scheduled order. By varying the rates or methods of calculating interest on
several classes within a series of CMOs and the allocations of principal among
such classes, a CMO issuer can create "derivative" securities with a wide range
of payment characteristics. These securities include the inverse floaters and
the two-tier index bonds held by the Company. All of the CMOs held by the
Company are collateralized by mortgage pass-through certificates which are
guaranteed by either FNMA or FHLMC.
F-45
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
C. INVESTMENTS (CONTINUED)
As of December 31, 1994 the Company's CMO portfolio consisted of the
following classes based on carrying value:
AVAILABLE- HELD-TO-
FOR-SALE MATURITY
----------- -----------
Planned amortization class (PACs)....................................... 70.5% 38.1%
Two-tiered index bonds (TTIBs).......................................... 8.3 20.4
Accrual bond (Z bond)................................................... 7.9 12.3
Targeted amortization class (TACs)...................................... 3.8 19.1
Inverse floating rate................................................... 3.6 .6
Companion bonds (SUPs).................................................. 3.5 9.5
Sequential.............................................................. 1.1 --
Very accurately determined maturity (VADMs)............................. .8 --
Floating rate........................................................... .5 --
----- -----
100.0% 100.0%
----- -----
----- -----
A PAC CMO has a fixed interest rate and is a class that is designed to
receive fixed principal payments using a predetermined schedule over a
predetermined time period under a wide range of prepayment scenarios which makes
the average life of the security more predictable. A sequential pay class
("Sequential") has a fixed interest rate and receives principal payments in a
prescribed sequence continuously from the first payment date until the class is
paid off. The average life of the class will shorten or lengthen based on
prepayments.
A TTIB is a CMO class whose coupon is fixed until the applicable index such
as the Cost of Funds Index ("COFI") reaches a specified level known as the first
strike. When the index is higher than a first strike, the TTIB becomes an
inverse floater whose coupon declines to its floor at the second strike. The
floor at the second strike typically will be zero. On initial purchase date the
first strike on a TTIB is generally two to three hundred basis points (2-3%)
above the current level of the applicable index. Consequently, it is unlikely at
the date of purchase that the first strike would be reached in the near future.
At December 31, 1994, the weighted average first strike on the TTIBs held by the
Company was 2.41% above the applicable index and, accordingly, none of these
securities have become inverse floaters. The Company would purchase TTIBs in
anticipation of an interest rate and prepayment environment in which prepayments
would remain at moderate to high levels, in which event the TTIBs generally
would pay off before the first strike is reached. Nevertheless, if the index
applicable to a TTIB reaches its first strike, the value of the TTIB would be
expected to decline. The average life of a CMO TTIB can vary greatly, depending
upon prepayments.
An accrual bond class of CMOs, also known as Z bond, does not pay periodic
interest, but rather accumulates interest at a specified rate until the
principal of the class becomes payable. The accumulated interest then is paid
when the principal is repaid. An accrual bond class of CMOs enables the holder
to avoid reinvestment risk. However, in a period of increasing interest rates,
an accrual bond class of CMOs is likely to experience a greater decline in value
than a current-interest class with the same interest rate and principal payment
schedule.
A TAC is similar to a PAC, in that they both have a schedule of principal
repayments. TACs provide more protection against call risk, but offer less
protection against extension risk.
F-46
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
C. INVESTMENTS (CONTINUED)
A floating rate security has an interest rate that is based on a known index
such as COFI and is adjusted periodically, typically monthly, as such index rate
changes. The interest rate of the security moves in the same direction as the
index. Inverse floating rate classes are securities with a coupon that moves in
the reverse direction to an applicable index such as COFI. Accordingly, the
coupon rate thereon will increase as interest rates decrease and decrease as
rates increase, in some cases by a greater amount than the amount of change in
the related index rate. Inverse floating rate securities are typically more
volatile than fixed or floating rate securities. The current yield on the
Company's inverse floating rate securities was approximately 10.4% at December
31, 1994. Inverse floating securities would be purchased by the Company to
attempt to protect against a reduction in the income earned on the Company's
investments due to a decline in interest rates and a corresponding increase in
prepayments. The Company would be adversely affected by the purchase of such
securities in the event of an increase in interest rates since the coupon rates
thereon will decrease as interest rates increase, and, like other fixed income
securities, the value will decrease as interest rates increase.
The Companion (Support) Class acts as a shock absorber. It takes excess cash
flow or does not get a payment so that the PAC and TAC classes can be paid. This
is a CMO class that receives principal payments on any payment date only if
scheduled payments have been made on specific PAC and TAC classes.
VADMs or Accretion Directed class pays principal from specified accretions
of accrual bonds. VADM's may, in addition, receive principal from the collateral
paydowns. This class is a CMO that has a very stable average life because the
cashflows are directed from the Z bonds, which receive no principal payments.
The amortized cost and fair value of debt securities at December 31, 1994,
by contractual maturity are shown below. Actual maturities may differ from
contractual maturities because the borrower may have the right to call or prepay
with or without call or prepayment penalties.
AMORTIZED COST FAIR VALUE
-------------- --------------
Debt securities available-for-sale:
Due in one year or less.................................... $ 33,491,503 $ 33,111,737
Due after one year through five years...................... 141,053,572 136,436,774
Due after five years through ten years..................... 4,950,702 4,665,156
Due after ten years........................................ 51,444 48,671
-------------- --------------
179,547,221 174,262,338
Mortgage-backed securities................................. 552,715,620 478,944,738
-------------- --------------
$ 732,262,841 $ 653,207,076
-------------- --------------
-------------- --------------
F-47
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
C. INVESTMENTS (CONTINUED)
AMORTIZED COST FAIR VALUE
-------------- -------------
Debt securities held-to-maturity:
Due in one year or less..................................... $ 50,000 $ 50,000
Due after one year through five years....................... 110,000 109,153
Due after five years through ten years...................... 217,228 214,576
Due after ten years......................................... 458,286 417,884
-------------- -------------
835,514 791,613
Mortgage-backed securities.................................. 13,108,720 11,121,715
-------------- -------------
$ 13,944,234 $ 11,913,328
-------------- -------------
-------------- -------------
The weighted average stated maturity of mortgage-backed securities was in
excess of 20 years as of December 31, 1994. However, after factoring in
estimated prepayments of the underlying loans, the weighted average duration of
the Company's GNMA and FNMA Certificates and CMO portfolio, in the aggregate, is
8.5 years. Changes in interest rates would affect the prepayment speed of the
underlying mortgages and the average lives of the securities. If interest rates
increased, it would be expected that the average life of these securities would
increase and correspondingly, if interest rates decreased, the average life
would decrease.
Gross gains and (losses) in 1994 from debt securities available-for-sale
were $852,201 and $(10,193,636), respectively. Gross gains from debt securities
held-to-maturity in 1994 were $1,864. Gross gains of $3,976,052 and gross losses
of $0 were recognized in 1993.
At December 31, 1994, debt securities of the life insurance subsidiary
carried at $14,845,594 were on deposit with various states pursuant to legal
deposit requirements.
Investments in affiliated mutual funds include shares of the Company's
affiliated tax-free income fund. This investment primarily represents "seed"
money for the start-up of the fund. Under regulations of the Investment Company
Act of 1940, the investments may not be liquidated until all organization costs
of the fund are amortized, unless the fund is reimbursed for unamortized
organization costs at the time of sale. This investment was liquidated in 1994
after organization costs were fully amortized.
Short-term investments consist of commercial paper with maturities of less
than 35 days.
Real estate acquired in satisfaction of loans included in other invested
assets was $1,462,149 at December 31, 1994. During 1994 and 1993, the Company
recognized losses on real estate owned of $320,000 and $258,908, respectively.
F-48
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
C. INVESTMENTS (CONTINUED)
Net investment income summarized by investment category for the two years
ended December 31, 1994 is as follows:
1994 1993
------------- -------------
Debt securities available-for-sale............................. $ 54,509,734 $ --
Debt securities held-to-maturity............................... 953,519 55,147,353
Marketable equity securities................................... 60,154 66,328
Mortgage loans................................................. 4,586,675 5,019,123
Policy loans................................................... 851,780 717,164
Short-term investments......................................... 2,412,970 654,426
------------- -------------
Total investment income........................................ 63,374,832 61,604,394
Less investment expenses....................................... (487,110) (720,363)
------------- -------------
$ 62,887,722 $ 60,884,031
------------- -------------
------------- -------------
D. MORTGAGE LOAN
A summary of the changes in the allowance for loan losses as of December 31
is as follows:
1994 1993
------------ ------------
Balance at beginning of year...................................... $ 1,609,000 $ 1,617,000
Provision for loan losses......................................... -- 460,000
Less loans charged off............................................ (18,000) (468,000)
------------ ------------
Balance at end of year............................................ $ 1,591,000 $ 1,609,000
------------ ------------
------------ ------------
At December 31, 1994, nonperforming loans (past due three months or more)
totaled $0 and restructured loans totaled $6,380,264. Had such loans been
accruing interest in accordance with the original terms, interest income would
have been $706,129 for the year ended December 31, 1994. Interest income
received on restructured and nonperforming loans was $595,296 for the year ended
December 31, 1994.
As of December 31, 1994, approximately 51% of the mortgage loan property was
in Minnesota and 12% was located in Arizona with the remainder in various
geographic areas of the United States. Mortgage loans by significant types as of
December 31, 1994, were as follows: industrial/warehouse--41%; office/
warehouse--35%; office--12%; multifamily housing--5%.
F-49
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
E. DEFERRED POLICY ACQUISITION COSTS
The changes in deferred acquisition costs for the two years ended December
31, 1994 are summarized as follows:
1994 1993
-------------------------- --------------------------
ANNUITIES AND FACE- ANNUITIES AND FACE-
LIFE AMOUNT LIFE AMOUNT
INSURANCE CERTIFICATES INSURANCE CERTIFICATES
------------- ----------- ------------- -----------
Balance at beginning of year.............................. $ 56,399,696 $ 320,373 $ 52,419,951 $ 444,284
Acquisition costs deferred during the year (primarily
commission)............................................. 4,697,766 507,996 7,555,104 377,466
Acquisition costs amortized during the year............... 3,756,579 518,782 3,575,359 501,377
SFAS 115 adjustment....................................... 19,300,000 -- -- --
------------- ----------- ------------- -----------
Balance at end of year.................................... $ 76,640,883 $ 309,587 $ 56,399,696 $ 320,373
------------- ----------- ------------- -----------
------------- ----------- ------------- -----------
F. DEPOSITS OF ASSETS AND MAINTENANCE OF QUALIFIED ASSETS
Under the provisions of its face amount certificates and the Investment
Company Act of 1940 (the "Act"), the Company's face amount certificate
subsidiary was required to have qualified assets (as defined in Section 28(b) of
the Act) of $60,605,015 at December 31, 1994. The Company had qualified assets
of $64,729,182 as of that date (such amount is before reduction of $385,437 for
net unrealized pretax losses on marketable equity securities and net unrealized
pretax losses on debt securities of $4,890,270).
For purposes of determining compliance with the foregoing provisions,
qualified assets are valued in accordance with such provisions of the Code of
the District of Columbia (the "Code") as are applicable to life insurance
companies as required by the Act. Qualified assets for which no provision for
valuation is made in such Code are valued in accordance with rules, regulations
or orders prescribed by the Securities and Exchange Commission. These values are
the same as the financial statement carrying value, except that for financial
statement purposes, marketable equity securities and debt securities classified
as available-for-sale are carried at fair value. For qualified asset purposes,
marketable equity securities are carried at cost and debt securities classified
as available-for-sale are carried at amortized cost.
Pursuant to the requirements of various states, the provisions of the
certificates, depository agreements and the Act, qualified assets were deposited
with custodians to meet certificate liability requirements as follows at
December 31:
1994
-------------
Assets on deposit with:
State governmental authority................................................. $ 170,435
Bank--central depository..................................................... 64,092,848
-------------
Total deposits............................................................. $ 64,263,283
-------------
-------------
Required deposits............................................................ $ 60,266,136
-------------
-------------
Certificate loans, secured by applicable certificate reserves, are deducted
from certificate reserves in computing deposit requirements.
F-50
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
F. DEPOSITS OF ASSETS AND MAINTENANCE OF QUALIFIED ASSETS (CONTINUED)
Assets on deposit consisted of the following at December 31:
1994
-------------
Investment securities, at cost plus accrued interest........................... $ 58,871,273
Mortgage loans, at cost less allowances for loan losses........................ 4,281,089
Other assets on deposit, at cost............................................... 1,110,921
-------------
$ 64,263,283
-------------
-------------
Investment securities consist mainly of GNMA and FNMA certificates, CMOs,
and commercial paper.
G. FACE AMOUNT CERTIFICATE RESERVES
TOTAL RESERVES
AT
DECEMBER 31, MINIMUM INTEREST
1994 (A)
--------------- -----------------
Installment certificates:
Reserves to mature, by series:
120, 215 and 220................................................... $ 554,466 3.25(b)(c)
315................................................................ 425,412 3.50(c)
---------------
979,878
Advance payments....................................................... 384,282 (d)
Fully paid certificates:
Installment.......................................................... 2,311,547 2.50--3.50(c)(e)
Optional settlement.................................................. 615,811 2.50--3.00(c)
Single-payment series 503............................................ 56,056,890 2.50(f)
Due to unlocated certificate holders................................... 6,607 None
---------------
$ 60,355,015
---------------
---------------
- ------------------------
(a) The amount of interest accrued on installment certificates is reduced by
delays in certificate holders making specified payments. After a nonpayment
period of six months, the certificate is converted to an optional settlement
certificate.
(b) Series 120 certificates provide for additional interest at a rate dependent
upon the Company earning in excess of rates specified in the certificates.
Such additional interest is credited to the certificate holder's account
upon attainment of the annual anniversary date.
F-51
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
G. FACE AMOUNT CERTIFICATE RESERVES (CONTINUED)
(c) As of December 31, 1994, the Board of Directors has declared additional
interest to be credited on anniversary dates through 1995 and 1996 as
follows:
1995 1996
--------- ---------
Series 215 and 220:
Installment certificates................................................. 2.25% 2.75%
Optional settlements elected at maturity................................. 2.25% 2.75%
Unapplied advance payments............................................... 2.25% 2.75%
Series 315:
Installment certificates................................................. 1.75% 2.25%
Optional settlements elected at maturity................................. 1.75% 2.25%
Unapplied advance payments............................................... 1.75% 2.25%
(d) Minimum interest rates on advance payments are generally the same as the
rates on scheduled installment payments. Interest on advance payments,
however, is accruing at 5.25% and will continue at this rate through 1995.
(e) Effective July 1, 1980, the rate of reserve accumulation on fully paid
installment certificates having loans outstanding is limited to the greater
of the minimum interest, as set forth in the certificate, or the interest
rate applicable to the loan.
(f) The Company's Executive Committee declares interest rates for Series 503
certificates purchased during the designated time periods. Additional
interest rates are assigned based on the three-year life of the certificate
and vary between first, second and third anniversary dates. Since 503
certificates were first issued on July 17, 1986, the combined minimum and
additional interest rates have ranged from 4.20% to 9.50%.
H. NOTES PAYABLE
The Company had a note payable secured by an airplane with interest at 8.5%
through December 2000. The airplane was sold at a loss of approximately $490,000
and the related note was retired in 1994.
I. REINSURANCE
The Company retains up to $50,000 of life insurance and waiver of premium
benefits on any one life, depending on age and classification of the risk. The
excess over the maximum retention is reinsured with other life insurance
companies. Reinsurance ceded could become a liability in the event that the
reinsurers become unable to meet the obligations assumed under the reinsurance
agreements. Life insurance in force on direct business aggregated approximately
$105,929,000 at December 31, 1994, of which $25,284,000 was ceded.
In a prior year, the Company entered into an annuity coinsurance agreement
in which it ceded a 90% interest in a block of annuity contracts to a reinsurer.
As of December 31, 1994, the account value and statutory value of the ceded
annuities was $105,428,796 and $117,417,617, respectively. Provision for
benefits for annuities excludes interest credited on coinsured annuities of
approximately $6.4 million and $7.2 million for the years ended December 31,
1994 and 1993, respectively.
F-52
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
I. REINSURANCE (CONTINUED)
Under the coinsurance agreement, the reinsurer is required to maintain
assets with a statutory value equal to or greater than the statutory value of
the annuities in a trust with the Company as the beneficiary to secure the
obligations of the reinsurer under the coinsurance agreement. As of December 31,
1994, the statutory value of the assets securing the coinsurance agreement was
$103,487,006.
J. INCOME TAXES
The provision for income taxes (benefit) for the years ended December 31 was
as follows:
1994 1993
------------- ------------
Current:
Federal............................................................................ $ (675,000) $ 2,069,000
State.............................................................................. 86,000 29,000
Deferred federal and state......................................................... (678,000) (298,000)
------------- ------------
$ (1,267,000) $ 1,800,000
------------- ------------
------------- ------------
The components of deferred income taxes as of December 31 are summarized as
follows:
1994
--------------------------------------------
ASSETS LIABILITIES TOTAL
------------- -------------- -------------
Future policy benefits............................................. $ 21,002,000 $ (590,000) $ 20,412,000
Unrealized losses on debt securities available-for-sale............ 26,879,000 -- 26,879,000
Deferred acquisition costs (DAC)................................... -- (19,496,000) (19,496,000)
DAC recovery on SFAS 115 unrealized losses......................... -- (6,500,000) (6,500,000)
Depreciation on building and equipment............................. -- (98,000) (98,000)
Write down on investments not currently deductible for taxes....... 625,000 -- 625,000
Guaranty fund assessments accrual.................................. 1,088,000 -- 1,088,000
Deferred compensation.............................................. 444,000 -- 444,000
Real estate limited partnership.................................... -- (189,000) (189,000)
Premium capitalization............................................. 464,000 -- 464,000
Unrealized losses on marketable equity securities.................. 131,000 -- 131,000
Other.............................................................. 260,000 (214,000) 46,000
------------- -------------- -------------
Total.............................................................. 50,893,000 (27,087,000) 23,806,000
Valuation allowance................................................ (20,715,000) -- (20,715,000)
------------- -------------- -------------
$ 30,178,000 $ (27,087,000) $ 3,091,000
------------- -------------- -------------
------------- -------------- -------------
F-53
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
J. INCOME TAXES (CONTINUED)
Federal income tax expense (benefit) in the consolidated financial
statements is different than the federal statutory rate of 35% in 1994 and 1993
applied to pretax income. The reasons for these differences are summarized as
follows:
1994 1993
------------- ------------
Federal income tax expense (benefit) at statutory rate............................... $ (1,705,000) $ 1,942,000
Change in estimate of valuation allowance............................................ 400,000 --
Tax-exempt income.................................................................... (10,000) (46,000)
State income taxes, net of federal benefit........................................... 22,000 17,000
Benefit of graduated income tax rates................................................ 37,000 (56,000)
Other, net........................................................................... (11,000) (57,000)
------------- ------------
$ (1,267,000) $ 1,800,000
------------- ------------
------------- ------------
Prior to January 1, 1984, the life insurance subsidiary was entitled to
exclude certain amounts from taxable income and accumulate such amounts in a
"policyholder surplus" account. The balance in this account at December 31, 1994
of approximately $1,738,000 will be taxed if distributed to SBM Company (the
"Parent"). The life insurance subsidiary has no plans to distribute amounts from
the "policyholder surplus" account and no further additions to the account are
allowed by the Tax Reform Act of 1984.
K. PROFIT SHARING PLANS, COMPENSATION AND COMMITMENTS FOR FUTURE RETIREMENT
BENEFITS
The Company has a non-contributory employee profit sharing plan whereby
contributions are made to a trust based on percentages of participants' annual
compensation. The Company also has a non-contributory profit sharing stock plan
whereby employees can participate in the ownership of the Company. Under this
plan, the contributions are used by the trustee primarily to purchase common
shares of the Company. During 1994 and 1993, the Company purchased 1,000 and
12,500 shares respectively from the plan.
The two plans generally cover all full-time employees age twenty-one and
over with six months of service. Total employer contributions to the two plans
cannot exceed 15% of the total compensation of the participants. Profit sharing
expense for these plans aggregated $197,851 in 1994 and $270,587 in 1993.
Directors' fees were $200,367 and $79,957 in 1994 and 1993, respectively,
and aggregate salaries of executive officers for the respective years was
$1,187,087 and $1,043,870 excluding amounts under the agreements described in
the following paragraphs.
Under employment agreements with two retired officers, the Company is
required to make payments after retirement to each individual until death and,
thereafter, reduced payments during the lifetimes of their spouses. The required
payments are adjusted for the annual change in the Consumer Price Index.
Required payments by the Company for the two retired officers for 1995 will be
$144,288. The estimated present value, using a 6% discount rate, of the
retirement benefits of the retired officers at December 31, 1994 was $913,865.
The Company has been accruing the liability for such deferred retirement
benefits over remaining active employment periods by annual charges to expense.
In addition, deferred compensation related to other agreements for certain
officers is $313,419 at December 31, 1994. One of the employment agreements also
contains provisions for consultation and non-compete restrictions for an
aggregate compensation of $66,000 annually through December 31, 1999.
F-54
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
K. PROFIT SHARING PLANS, COMPENSATION AND COMMITMENTS FOR FUTURE RETIREMENT
BENEFITS (CONTINUED)
Total expense provisions for deferred compensation and future retirement
benefits under these agreements aggregated $83,772 in 1994 and $93,252 in 1993.
During 1994, the Company entered into an employment agreement with the
Company's Chief Executive Officer (CEO). The agreement requires the Company to
make a bonus payment of $135,000 if the CEO is terminated for other than cause
or $270,000 if for constructive termination or due to a change in control of the
Company. In addition, the agreement provides for a bonus of 1% of the net amount
of value received by the Company in any new capital financing which includes
substantial sale of assets by the Company or any subsidiary, issuance of shares
or securities by the Company or any tender offer for shares of the Company, if
such transaction is commenced during the CEO's tenure.
In connection with execution of the employment agreement, the Company issued
the CEO a warrant to purchase five percent of the fully-diluted outstanding
stock of the Company at $6.29 per share. The warrant provides that the CEO may
require the Company to repurchase the warrant if employment is terminated prior
to December 31, 1996 other than for cause at a redemption price of $300,000 if
notice is given before a change in control and $500,000 if the notice is given
subsequent to a change in control. The Company may also repurchase the warrant
subsequent to the termination of employment at the same terms as described
above.
L. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS
MANDATORY REDEEMABLE VOTING CONVERTIBLE PREFERRED STOCK AND CONVERTIBLE
PROMISSORY NOTE
On December 20, 1992, the Company entered into a Preferred Stock and Note
Purchase Agreement (the "Agreement") with SBM Partners L.P. (of which Head
Insurance Investors L.P. and Jupiter Industries, Inc. are general partners)
("SBM Partners") and Integon Life Insurance Corporation ("Integon") (SBM
Partners and Integon are referred to herein as the "Purchasers") regarding a
sale to the Purchasers of an aggregate of 19,000 shares of the Company's Series
A Mandatory Redeemable Voting Convertible Preferred Stock (the "Preferred
Stock") at a purchase price of $19,000,000.
The closing of the transaction occurred in two stages. At the first closing,
which occurred on December 23, 1992, the Company issued 4,000 shares of its
Preferred Stock to SBM Partners at a purchase price of $4,000,000. In addition,
the Company issued to Integon a $4,000,000 Convertible Promissory Note (the
"Note"). At the second closing, which occurred on September 21, 1993, the Note
was converted into 4,000 shares of Preferred Stock, and the Company sold an
additional 11,000 shares of Preferred Stock to the Purchasers for $11,000,000.
The Preferred Stock will initially pay a cumulative preferred dividend of
8%; however, if the National Association of Insurance Commissioners (NAIC)
rating assigned to the Preferred Stock is increased to a two, the dividend rate
will be lowered to 6%. Each share of Preferred Stock is convertible at the
option of the holder into 62.5 shares of the Company's common stock, which
represents a conversion price of $16.00 per common share.
The terms of the Preferred Stock prohibit the payment of common stock
dividends or redemptions of common stock by the Company at any time when a
dividend on the Preferred Stock is in arrears. As of December 31, 1994, the
Company was $760,000 in arrears on its Preferred Stock dividends. In addition,
common stock dividends and redemptions of common stock are restricted to a
maximum amount equal to
F-55
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
L. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS (CONTINUED)
the sum of $3 million plus 50% of the Company's consolidated net income
subsequent to January 1, 1993. As of December 31, 1994, the aggregate amount
available for common stock dividends and redemptions was $219,257.
The Preferred Stock provides that the shares will be redeemed by the Company
on January 1, 2004, unless the shares are converted earlier into shares of the
Company's common stock. Starting in 1998, the Company has the option to redeem
the Preferred Stock at a price of 105% decreasing to 100% in 2003. The Preferred
Stock also gives the holders of the Preferred Stock the right to have such
shares redeemed prior to such date upon the occurrence of certain events of
default at a price of 105% until 1998 decreasing to 100% in 2003.
The Purchasers own shares representing approximately 34% (assuming
conversion to common stock) of the voting power of all outstanding shares of the
Company's voting stock and are entitled as a class to elect at least 34% of the
Company's directors or four of the ten member Board of Directors. The holders of
Preferred Stock have voting rights on matters other than election of directors
that are based upon the number of shares of the Company's common stock into
which the Preferred Stock is convertible. In addition, upon the occurrence of
certain significant defaults by the Company, the Preferred Stockholders would be
permitted to elect a majority of the Board Directors of the Company.
The Company and the Purchasers also have entered into a Registration Rights
Agreement and an Exchange Right Agreement. Under the terms of the Registration
Rights Agreement, the Purchasers have been given the right to require the
Company to publicly register the Preferred Stock and any shares of the
Registrant's common stock issued upon conversion of such Preferred Stock. The
Exchange Right Agreement gives the Purchasers the right to exchange shares of
common stock of the Company held or acquired by them for shares of the Company's
Series B Voting Convertible Participating Preferred Stock (the "Series B
Preferred Stock"). Unless and until any shares of the Preferred Stock are
redeemed, repurchased or converted, the Series B Preferred Stock will vote as a
class with the Preferred Stock for purposes of election of directors, and
together with the Preferred Stock, will elect a number of directors of the
Company proportionate to the aggregate ownership interest of the holders of the
Preferred Stock and Series B Preferred Stock in the Company.
COMMON STOCK HELD BY EMPLOYEE BENEFIT PLANS
The Company's two employee benefit plans own 304,693 shares of Company
common stock at December 31, 1994 (see Note K). The Company has entered into a
written trustee agreement whereby the Company has agreed to purchase common
shares tendered to it by the trustee from either benefit plan at a price equal
to the higher of adjusted book value or fair market value. Adjusted book value
is defined as the consolidated net assets of the Company plus unrealized losses
on marketable equity securities plus the deferred income tax liability (if any)
of the Company's life insurance subsidiary. Historically, adjusted book value of
Company common stock in the two plans has been computed based upon amortized
cost value of debt securities. However, as is discussed in Note A, effective
January 1, 1994, SFAS 115 requires that debt securities classified as
available-for-sale be valued on a mark-to-market basis rather than at amortized
cost. Accordingly, with the required adoption of SFAS 115, common stockholders'
equity is in a deficit position. The Company has determined that in connection
with the adoption of SFAS 115 the adjusted book value of Company common stock
held by employee benefit plans for purposes of the trustee agreement must be
computed based upon market value of available-for-sale debt securities. As such,
the adjusted book value for the common stock held by the plans is currently
negative.
F-56
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
L. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS (CONTINUED)
However, as is discussed above, under the terms of the trustee agreement the
Company is required to repurchase Company common stock from the plans at a price
equal to the higher of adjusted book value or fair market value. In the past,
for purposes of the trustee agreement, the Company has regarded adjusted book
value of Company stock as being equivalent to the fair market value of such
stock. With the adoption of SFAS 115, adjusted book value of Company stock
frequently will be greater or less than the fair market value of such stock.
Accordingly, the Company has obtained an independent determination of the fair
market value of its common stock as of June 30, 1994, for purposes of valuing
the Company's stock pursuant to the trustee agreement. The fair market value of
the Company stock held by the plans was determined by the valuation to be $6.29
per common share. As this amount exceeds the adjusted book value of Company
stock, it has been used by management to determine the value of the stock in the
plans as of December 31, 1994. Because the valuation was performed as of June
30, 1994, it may not precisely reflect the value of SBM common stock held by the
plans as of December 31, 1994. Further, the value determined by the independent
valuation does not reflect the value of the Company's common stock held by the
Company's other shareholders. In as much as interest rates have continued to
rise in the third and fourth quarters of 1994, it is possible that the value of
the Company stock held by the plans has decreased.
Subsequent to year-end, the trustee of the plans notified the Company that
it was tendering all shares held by the plans to the Company under the trustee
agreement. The tender indicated that the value of the stock should be based on
amortized cost adjusted book value in that it was the trustee's interpretation
that this was the appropriate method of valuing the stock under the trustee
agreement. The Company believes the trustee's tender of all shares is not
consistent with the trustee agreement and the valuation of the common stock held
by the Plans should not be based upon amortized cost but rather based on the
methodology described above. The Company has subsequently commenced a lawsuit
against the trustee to obtain a declaratory judgment as to the appropriate
interpretation of the trustee agreement.
While the Company believes its interpretation of the trustee agreement is
appropriate, if it were determined that, for the limited purpose of establishing
the adjusted book value of the Company common stock in the two plans under the
trustee agreement, the plans should use amortized cost value of portfolio
securities rather than market value, this would have the effect at December 31,
1994 of increasing the value of the stock held by the plans by approximately
$2.5 million or $1.33 per share and reducing stockholders' equity by an equal
amount.
As the common stock held by employee benefit plans is subject to the trustee
agreement as described above, the Company has classified those shares of common
stock held by the Company's employee benefit plans outside of Stockholders'
Equity on the consolidated balance sheet.
COMMON STOCK AND STOCK OPTIONS
The Company has a stock option plan which allows for incentive stock
options, nonstatutory options and stock appreciation rights. The Company has
reserved 350,000 shares for issuance under the plan. No options have been
granted under the plan.
TENDER OFFER
During January 1994, the Company purchased 98,296 shares of its common stock
for approximately $1.5 million, $15.26 per share, pursuant to a cash tender
offer initiated by the Company during December 1993.
F-57
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
L. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS (CONTINUED)
DIVIDENDS
The ability of the Company to pay cash dividends to shareholders may be
dependent upon the amount of dividends received from subsidiaries. The following
is a summary of dividend restrictions and capital requirements for each
subsidiary.
As of December 31, 1994 the life insurance subsidiary is required to obtain
written approval prior to payment of all dividends in accordance with an
administrative order issued by the Minnesota Department of Commerce ("MDC")--see
"Regulatory Matters" below. Exclusive of the administrative order, pursuant to
Minnesota legal requirements, dividend payments must be paid solely from the
adjusted earned surplus of the life insurance subsidiary. Adjusted earned
surplus means the earned surplus as determined in accordance with statutory
accounting practices (unassigned funds), less 25% of the amount of such earned
surplus which is attributable to unrealized capital gains. Further, the life
insurance subsidiary may not pay in any calendar year any dividend which, when
combined with other dividends paid within the preceding 12 months, exceeds the
greater of (i) 10% of the life insurance subsidiary's statutory surplus at the
prior year-end or (ii) 100% of the life insurance subsidiary's statutory net
gain from operations (not including realized capital gains) for the prior
calendar year. The limitation for 1995 would be $3,262,671. Furthermore,
distributions to the Parent by the life insurance subsidiary in excess of
$26,896,170 as of December 31, 1994, would result in an additional income tax
liability to the subsidiary.
The Company's life insurance subsidiary prepares its statutory basis
financial statements in accordance with accounting practices prescribed or
permitted by the MDC. Prescribed statutory accounting practices include a
variety of publications of the NAIC, as well as state laws, regulations and
general administrative rules. The Company's life insurance subsidiary has
strengthened its reserves on five policy forms in accordance with Proposed
Actuarial Guideline GGG. The Minnesota Department of Commerce and the California
Insurance Department, the Company's domiciliary and commercially domiciliary
states, respectively, have approved the reserve strengthening over a three-year
period beginning in 1994. The strengthening totals $12.3 million and according
to the three year phase-in provision, one-third of this total, or $4.1 million,
is included in reserves in the 1994 statutory basis financial statements of the
subsidiary with the remaining two-thirds to be reflected equally in 1995 and
1996. The life insurance subsidiary's statutory capital and surplus as of
December 31, 1994 was $32,626,711. Statutory operating income was $3,102,341 and
$1,460,216 for 1994 and 1993, respectively.
The Company's sales subsidiary is subject to the Securities and Exchange
Commission's uniform net capital rule (Rule 15c3-1) which requires that the
ratio of aggregate indebtedness to net capital, both as defined, shall not
exceed 15 to 1. In addition, restrictions may be imposed to prohibit the Company
from expanding its business or declaring dividends if its ratio of aggregate
indebtedness to net capital is greater than 10 to 1. Net capital and the related
net capital ratio fluctuate on a daily basis; however, at December 31, 1994, the
net capital ratio was .78 to 1 and net capital was $562,500, which exceeded the
minimum capital requirement by $533,053.
The Company's face amount certificate subsidiary is subject to two principal
restrictions relating to its regulatory capital requirements. First, under the
Investment Company Act of 1940, the subsidiary is required to establish and
maintain minimum capital in an amount of certificate reserves plus $250,000.
Second, the MDC has historically recommended to the Company that face amount
certificate companies should maintain a ratio of stockholder's equity to total
assets at a minimum of 5% based upon a valuation of available-for-sale
securities reflected at amortized cost. Under this formula, the subsidiary's
capital level
F-58
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
L. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS (CONTINUED)
was 6.9% at December 31, 1994. In November 1994, the MDC notified the subsidiary
that, based on the decline in the value of the subsidiary's investment portfolio
resulting from increasing interest rates in 1994 and the subsidiary's decreasing
liquidity resulting from reduced principal prepayments on the subsidiary's CMO
portfolio, the MDC recommended that the subsidiary increase its capital level.
The MDC's concern was influenced by the subsidiary's capital ratio, calculated
including the effects of SFAS 115 (see Note C), which would have been 0.31% at
December 31, 1994. On March 29, 1995, the life insurance subsidiary, parent of
the face amount certificate subsidiary, contributed $1.5 million to the capital
of the certificate subsidiary. The certificate subsidiary is now in compliance
with the MDC's recommendation. The certificate subsidiary's shareholder's equity
on a proforma basis at December 31, 1994, adjusted to reflect the $1.5 million
capital contribution and the change in unrealized losses through February 28,
1995, would have been approximately $3 million. SBM Company is guarantor of
approximately 65% of the certificates issued by the certificate company. The
subsidiary has not paid dividends in the past and has no present intention to
pay dividends in the near future, in order to increase capital resources.
REGULATORY MATTERS
On November 16, 1994, the Commissioner of the MDC issued an administrative
order to the Company's life insurance subsidiary (SBM Life). The order restricts
the following types of material transactions without approval of the
Commissioner: merging or consolidating with another company; paying dividends;
entering into new reinsurance agreements; making material changes in management;
increasing salaries and benefits of officers or directors or making payment of
bonuses; entering into any transactions with officers and directors, including
employment agreements, or making other payments determined preferential by the
commissioner; disposing of, conveying, or encumbering its assets or its business
in force; or amending or entering into new contracts with the holding company or
other affiliated companies.
The issuance of the order was influenced by the SBM Life's A.M. Best rating
reduction and the significant unrealized depreciation in its investment
portfolio (Note C). An additional capital infusion to SBM Life will be necessary
to address the issues of the MDC and for possible re-evaluation of its rating.
M. COMMITMENTS AND CONTINGENCIES
The Company leases office space under two noncancelable operating leases
expiring on July 14, 1998, and on June 30, 1999. In addition to the minimum
rental payments, the Company is required to pay as additional rent its pro rata
share of all operating costs as defined. Rent expense under these and former
leases was $443,209 and $425,285 for 1994 and 1993, respectively. The leases
require minimum annual rental payments as follows:
1995............................................................ $ 305,785
1996............................................................ 320,993
1997............................................................ 336,201
1998............................................................ 321,169
1999............................................................ 145,465
---------
Total....................................................... $1,429,613
---------
---------
F-59
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
M. COMMITMENTS AND CONTINGENCIES (CONTINUED)
The Company's life insurance subsidiary is subject to state guaranty
association assessments. The assessments are made by the associations to obtain
funds to pay off policyholders of insolvent insurance companies. In 1994 and
1993, the Company recorded approximately $1.8 million and $1.5 million of
assessments, respectively. At December 31, 1994, accounts payable and other
liabilities includes accrued guaranty fund assessments of $3.2 million, which
are reflected at present value using a discount rate of 8%. The Company has no
control over these assessments and additional assessments in future years are
probable, but undeterminable at this time.
The Company and its subsidiaries are involved in various litigation in the
ordinary course of business. In the opinion of management, the ultimate
resolution of such litigation will not have a material adverse effect upon the
financial condition or results of operations of the Company.
The Internal Revenue Service (the "IRS") has conducted examinations of the
Company's income tax returns for the years 1986 through 1990 and has proposed
several adjustments to increase taxable income relating to the timing of certain
deductions. Based on these adjustments, additional tax due would be
approximately $1.3 million plus interest. However, additional taxes currently
payable would be principally offset by deductions to taxable income in future
periods. The Company has filed a protest with the Appellate Division of the IRS
and is vigorously contesting all of the proposed adjustments. The Company
believes the ultimate resolution of this matter will not have a material adverse
effect on the Company's consolidated results of operations or financial
position.
N. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosures are made in accordance with the requirements of
SFAS 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS and SFAS 119,
DISCLOSURES ABOUT DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL
INSTRUMENTS. SFAS 107 requires disclosure of fair value information about
financial instruments, whether or not recognized in the balance sheet, for which
it is practicable to estimate that value. In cases where quoted market prices
are not available, fair values are based on estimates using present value or
other valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. In that regard, the derived fair value estimates cannot be substantiated
by comparison to independent markets and, in many cases, could not be realized
in immediate settlement of the instrument.
SFAS 107 excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate fair
value amounts presented do not represent the underlying value of the Company.
SFAS 119 requires fair value disclosures to be presented together with the
related carrying amount in a summary table. The fair value estimates presented
herein are based on pertinent information available to the Company as of
December 31, 1994. Although the Company is not aware of any factors that would
significantly affect the estimated fair value amounts, such amounts have not
been comprehensively revalued for purposes of these financial statements since
that date; therefore, current estimates of fair value may differ significantly
from the amounts presented herein.
The following methods and assumptions were used by the Company in estimating
its fair value disclosures for financial instruments:
F-60
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
N. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Debt Securities: The estimated market value disclosures for debt securities
satisfy the fair value disclosure requirements of SFAS 107. (See Note
C--Investments.)
Marketable Equity Securities: Fair value equals carrying value as these
securities are carried at quoted market value.
Mortgage Loans: The fair values for mortgage loans are estimated using
discounted cash flow analyses, using interest rates currently being offered in
the marketplace for similar loans to borrowers with similar credit ratings.
Loans with similar characteristics are aggregated for purposes of the
calculations.
Policy Loans, Other Invested Assets, Cash and Short-Term Investments: The
carrying amounts for these assets approximate the assets' fair values.
Other Financial Instruments Reported as Assets: The carrying amounts for
these financial instruments (receivable from reinsurer and accrued investment
income) approximate those assets' fair values.
Future Policy Benefits: The fair value of future policy benefits,
principally deferred annuities, was determined to be the customers' account
balance as management has the ability to reprice the deferred annuities on an
annual basis.
Face Amount Certificate Reserves: The fair value for face amount certificate
reserves was determined from discounted cash flow analyses of the certificates
included in the reserve. The interest rates used in the analyses were based on
interest rates currently being offered on the Company's certificates.
Other Financial Instruments Reported as Liabilities: The carrying amounts
for other financial instruments (normal payables of a short-term nature, notes
payable and deferred compensation and retirement benefits) approximate those
liabilities' fair values.
Mandatory Redeemable Voting Convertible Preferred Stock: The fair value for
mandatory redeemable voting convertible preferred stock equals the liquidation
value plus any dividends in arrears.
Common Stock Held by Employee Benefit Plans: The fair value equals the most
recent appraised value for 1994.
F-61
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
N. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
The carrying amounts and estimated fair values of the Company's financial
instruments are as follows:
DECEMBER 31, 1994
------------------------------
CARRYING
VALUE FAIR VALUE
-------------- --------------
Financial Instruments Recorded as Assets:
Debt securities available-for-sale............................................. $ 653,207,076 $ 653,207,076
Debt securities held-to-maturity............................................... 13,944,234 11,913,328
Equity securities.............................................................. 683,089 683,089
Mortgage loans................................................................. 36,257,214 37,373,864
Policy loans................................................................... 22,153,936 22,153,936
Other invested assets.......................................................... 1,694,506 1,694,506
Cash and short-term investments................................................ 41,168,183 41,168,183
Other financial instruments reported as assets................................. 114,276,196 114,276,196
Financial Instruments Recorded as Liabilities:
Future policy benefits......................................................... 899,709,020 899,709,020
Face amount certificate reserves............................................... 60,355,015 60,050,268
Other financial instruments reported as liabilities............................ 10,479,331 10,479,331
Mandatory Redeemable Voting Convertible Preferred Stock.......................... 18,485,868 19,760,000
Common Stock Held by Employee Benefit Plans...................................... 1,916,519 1,916,519
Fair value estimates are made at a specific point in time, based on relevant
market information and information about the financial instrument. These
estimates do not reflect any premium or discount that could result from offering
for sale at one time the Company's holdings of a particular financial
instrument. These estimates are subjective in nature and involve uncertainties
and matters of significant judgment and, therefore, cannot be determined with
precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing financial instruments without
attempting to estimate the value of anticipated future business and the value of
assets and liabilities that are not considered financial instruments. In
addition, the tax ramifications related to the realization of the unrealized
gains and losses can have a significant effect on fair value estimates and have
not been considered in the estimates.
F-62
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
O. INDUSTRY SEGMENT DATA
The Company's principal business activities consist of four distinct
business segments. SBM Company (the "Parent") manages six mutual fund companies.
SBM Certificate Company currently issues single payment face amount
certificates. SBM Financial Services, Inc. is registered as a broker and dealer
in securities under the Securities and Exchange Act of 1934 and performs sales
functions for SBM Certificate Company, affiliated mutual funds and State Bond
and Mortgage Life Insurance Company. State Bond and Mortgage Life Insurance
Company is licensed as a life insurer and issues a variety of ordinary life
insurance policies and flexible premium and single premium deferred annuities.
SBM Company segment data is as follows:
SBM COMPANY
------------------------------
STATE BOND
SBM AND MORTGAGE
SBM FINANCIAL LIFE ADJUSTMENTS
MUTUAL GENERAL CERTIFICATE SERVICES, INSURANCE AND
FUND OPERATIONS CORPORATE COMPANY INC. COMPANY ELIMINATIONS CONSOLIDATED
----------------- ----------- ----------- ----------- ------------- ------------ ------------
(DOLLAR AMOUNTS IN THOUSANDS)
1994:
Total revenues............ $ 1,399 $ (258) $ 5,336 $ 9,191 $ 55,598 $ (11,334) $ 59,932
Pretax income (loss)...... 240 (1,260) 555 -- (4,406) -- (4,871)
Income (loss)............. 158 (1,208) 383 -- (2,937) -- (3,604)
Identifiable assets....... -- (8,085) 60,563 1,004 906,449 9,433 969,364
Liabilities............... -- 3,235 60,376 441 917,486 (599) 980,939
1993:
Total revenues............ $ 1,401 $ 337 $ 5,413 $ 11,797 $ 60,642 $ (7,543) $ 72,047
Pretax income (loss)...... 302 (642) 56 -- 5,832 -- 5,548
Income (loss)............. 199 (415) 101 -- 3,863 -- 3,748
Identifiable assets....... -- 60,198 70,939 992 949,800 (57,019) 1,024,910
Liabilities............... -- 5,675 67,058 495 897,852 (527) 970,553
The Company's capital expenditures and related depreciation expenses are
incurred by the Parent and SBM Certificate Company. For the two years ended
December 31, 1994, total capital expenditures for the Parent were $161,330 and
$266,284, respectively, and depreciation expense for the Parent and SBM
Certificate Company was $248,474 and $54,017 and $259,347 and $58,678,
respectively.
Income (loss) of each industry segment includes a provision for income taxes
calculated on a separate return basis (except for the Parent's segments, which
are allocated taxes (credits) based on the segments' percentage of pretax income
(loss) to the Parent's total), modified to the extent that benefits from
operating losses are recognizable for SBM Company on a consolidated basis.
The adjustments and eliminations required to determine consolidated amounts
shown above consist principally of elimination of intersegment financial income,
investments in consolidated subsidiaries and intersegment receivables or
payables. Intersegment income is related primarily to commissions earned by SBM
Financial Services, Inc. on the sale of the other subsidiaries' products to
outside customers.
The Parent received dividends from its life insurance subsidiary of $650,000
in 1994 and $1,855,000 in 1993.
F-63
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
P. SUBSEQUENT EVENTS (UNAUDITED)
A Plan of Liquidation and Dissolution was adopted by the Company's Board of
Directors and approved by the holders of a majority of the Company's outstanding
shares of common stock at the annual meeting on May 18, 1995. On June 14, 1995,
the Company closed the sale of the business operations and assets of the Company
to ARM Financial Group, Inc., pursuant to the Amended and Restated Stock and
Asset Purchase Agreement dated February 16, 1995 between the Company and ARM.
As a result of the sale, the Company changed its name to 1150 Liquidating
Corporation. The Company also adopted a liquidation basis of accounting
effective January 1, 1995.
F-64
SBM COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
MARCH 31, DECEMBER 31,
1995 1994
-------------- --------------
(UNAUDITED)
ASSETS
Investments
Debt securities available-for-sale at market--Note C........................... $ 648,317,303 $ 653,207,076
Debt securities held-to-maturity at amortized cost............................. 13,923,608 13,944,234
Marketable equity securities at market......................................... 714,866 683,089
Mortgage loans................................................................. 33,636,210 36,257,214
Policy loans................................................................... 22,427,287 22,153,936
Other invested assets.......................................................... 1,693,006 1,694,506
Short-term investments......................................................... 59,786,533 37,602,490
-------------- --------------
Total investments.......................................................... 780,498,813 765,542,545
Cash............................................................................. 1,675,579 3,565,693
Accrued investment income........................................................ 6,113,194 8,470,103
Receivable from reinsurer........................................................ 93,466,912 105,806,093
Deferred policy acquisition costs, less accumulated amortization................. 70,835,753 76,950,470
Land, building and equipment, at cost less accumulated depreciation of $2,530,418
and $2,470,302, respectively................................................... 1,394,625 1,417,796
Deferred income taxes............................................................ 3,165,534 3,091,000
Refundable income taxes.......................................................... 2,510,594 3,003,386
Other assets..................................................................... 2,043,731 1,517,067
-------------- --------------
$ 961,704,735 $ 969,364,153
-------------- --------------
-------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Future policy benefits........................................................... $ 877,947,462 $ 910,104,179
Face amount certificate reserves................................................. 57,176,977 60,355,015
Accounts payable and other liabilities........................................... 13,306,016 9,252,047
Deferred compensation and retirement benefits for officers....................... 1,200,516 1,227,284
-------------- --------------
Total liabilities.......................................................... 949,630,971 980,938,525
-------------- --------------
Mandatory redeemable voting convertible preferred stock, par value $1,000
(includes dividends in arrears:
March 31, 1995--$1,162,952, December 31, 1994--$760,000). Authorized 19,000
shares; issued 19,000 shares, liquidation value $19,000,000, plus dividends
in arrears................................................................... 18,923,031 18,485,868
Common stock held by employee benefit plans; 304,693 shares--Note E.............. 1,916,519 1,916,519
Commitments and contingencies--Note D
Common stock, no par value. Authorized 20,000,000 shares; issued and outstanding
2,179,714 shares; less 304,693 shares held by employee benefit plans........... 2,945,606 2,945,606
Unrealized losses on marketable equity securities, net of income tax benefit of
$120,244 and $131,048, respectively............................................ (233,415) (254,388)
Unrealized losses on debt securities, net--Note C................................ (36,063,460) (59,691,765)
Retained earnings................................................................ 24,585,483 25,023,788
-------------- --------------
Total stockholders' equity (deficit)....................................... (8,765,786) (31,976,759)
-------------- --------------
$ 961,704,735 $ 969,364,153
-------------- --------------
-------------- --------------
See notes to consolidated financial statements.
F-65
SBM COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
THREE MONTHS ENDED
MARCH 31
----------------------------
1995 1994
------------- -------------
Revenues:
Net investment income............................................................ $ 15,104,765 $ 15,767,869
Underwriting, sales service and distribution fees................................ 732,943 975,238
Life insurance premiums.......................................................... 100,840 104,323
Advisory and other fees from affiliated mutual funds............................. 370,501 371,650
Realized investment (losses) gains, net.......................................... (451,613) 10,552
Other income..................................................................... 617,492 449,748
------------- -------------
Total revenues............................................................... 16,474,928 17,679,380
------------- -------------
Benefits and expenses:
Provisions for benefits:
Annuities and life insurance................................................... 10,880,260 10,808,005
Face amount certificate reserves (interest).................................... 735,938 958,456
Loan and real estate losses...................................................... -- 150,000
Death and other benefits......................................................... 120,934 80,566
Commissions, wages and benefits.................................................. 1,851,756 1,939,361
Interest expense................................................................. -- 42,401
Amortization of deferred policy acquisition costs................................ 1,778,235 1,152,534
Occupancy and equipment.......................................................... 315,345 347,680
State guaranty association assessments........................................... 75,550 226,210
Other expenses................................................................... 727,051 527,734
------------- -------------
Total benefits and expenses.................................................. 16,485,069 16,232,947
------------- -------------
Income (loss) from operations before income taxes.................................. (10,141) 1,446,433
Income taxes (benefits)............................................................ (9,000) 493,000
------------- -------------
Net income (loss)............................................................ $ (1,141) $ 953,433
------------- -------------
------------- -------------
Mandatory redeemable voting convertible preferred stock dividends.................. $ 402,952 $ 380,000
Discount accretion on preferred stock.............................................. 34,212 33,948
------------- -------------
Net income (loss) applicable to common stock....................................... $ (438,305) $ 539,485
------------- -------------
------------- -------------
Earnings per common share:
Primary.......................................................................... $ (.20) $ .24
------------- -------------
------------- -------------
Fully diluted.................................................................... $ (.20) $ .24
------------- -------------
------------- -------------
Weighted average common shares outstanding (primary)............................... 2,179,714 2,211,212
Weighted average common shares outstanding (fully diluted)......................... 2,179,714 3,398,712
See notes to consolidated financial statements.
F-66
SBM COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS ENDED
MARCH 31
------------------------------
1995 1994
-------------- --------------
Net cash provided by operating activities......................................... $ 16,582,530 $ 9,803,057
Cash flows from investing activities:
Proceeds from maturities and repayment of debt securities:
Available-for-sale............................................................ 3,999,043 32,198,402
Held-to-maturity.............................................................. 51,500 20,610,604
Proceeds from sales of debt securities available-for-sale....................... 29,887,528 685,515
Cost of debt securities acquired:
Available-for-sale............................................................ -- (48,252,588)
Held-to-maturity.............................................................. -- (13,486,952)
Sales (purchases) of short term investments, net................................ (21,537,220) 3,130,438
Loan principal repayments....................................................... 5,625,316 4,040,234
Loans funded.................................................................... (3,277,477) (2,353,952)
Proceeds from (additions to) land, building and equipment, net.................. (36,944) (64,681)
-------------- --------------
Net cash provided by (used in) investing activities......................... 14,711,746 (3,492,980)
Cash flows from financing activities:
Payments to face amount certificate holders..................................... (7,823,103) (6,348,692)
Reserve payments from face amount certificate holders........................... 3,957,062 4,596,360
Deposits received from annuitants, net.......................................... 15,468,103 18,727,251
Payments to annuitants.......................................................... (44,786,452) (20,619,547)
Purchase of common stock........................................................ -- (1,511,346)
Dividends on common stock....................................................... -- (228,000)
Dividends on preferred stock.................................................... -- (380,000)
Principal payments on notes payable............................................. -- (46,171)
-------------- --------------
Net cash used in financing activities....................................... (33,184,390) (5,810,145)
-------------- --------------
Net increase (decrease) in cash................................................... (1,890,114) 499,932
Cash at beginning of period....................................................... 3,565,693 898,726
-------------- --------------
Cash at end of period............................................................. $ 1,675,579 $ 1,398,658
-------------- --------------
-------------- --------------
See notes to consolidated financial statements.
F-67
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
A. BASIS OF PRESENTATION
The consolidated balance sheets as of March 31, 1995 and the condensed
consolidated statements of income and condensed consolidated statements of cash
flows for the three month periods ended March 31, 1995 and 1994, have been
prepared by the Company without audit. In the opinion of management, all
adjustments (consisting only of normal recurring accruals) necessary to present
fairly the financial positions, results of operations and cash flows at March
31, 1995, and for all periods presented have been made.
The consolidated financial statements include the accounts of SBM Company
(the "Company") and its wholly owned subsidiaries: State Bond and Mortgage Life
Insurance Company ("SBM Life"), SBM Certificate Company ("SBMC") and SBM
Financial Services, Inc.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted. It is suggested that these financial statements
be read in conjunction with the financial statements and notes thereto included
in the Company's Annual Report on Form 10-K for the year ended December 31,
1994.
B. SALE AND LIQUIDATION OF THE COMPANY
Pursuant to an Amended and Restated Stock and Asset Purchase Agreement dated
February 16, 1995, between the Company and ARM Financial Group, Inc. (ARM), the
Company has agreed to sell substantially all of the business operations and
assets of the Company to ARM (the Proposed Transaction) for a purchase price of
$38.6 million, subject to certain adjustments. As part of the Proposed
Transaction, ARM will acquire all of the outstanding stock of the subsidiaries
and certain assets of the Company and assume certain liabilities of the Company.
Additionally, the agreement requires ARM to contribute between $15-20 million in
additional capital to the subsidiaries. The completion of the Proposed
Transaction is subject to a number of contingencies, including the obtaining of
regulatory and shareholder approvals.
As soon as practicable after consummation of the Proposed Transaction, the
Company intends to wind up and liquidate the Company. The Company has adopted a
Plan of Dissolution, such Plan to be effective upon consummation of the Proposed
Transaction. In the liquidation, distributions to the holders of common stock
will be subject to the senior rights of the holders of the Series A Preferred
Stock and the Series B Preferred Stock (no Series B shares are outstanding as of
March 31, 1995).
At the Company's regular meeting of shareholders, to be held May 18, 1995,
the Company's shareholders will vote on the above matters. A proxy statement was
sent to all shareholders with detailed information concerning the Proposed
Transaction and the Plan of Dissolution.
The Proposed Transaction and the Plan of Dissolution each require the
affirmative vote of the holders of a majority of the voting power of all shares
entitled to vote, voting together as a single class. Approval of the Proposed
Transaction also requires the affirmative vote of the holders of 66 2/3% of the
outstanding shares of Series A Preferred Stock, voting separately as a class.
The accompanying consolidated financial statements have been prepared on an
historical basis of accounting and do not include any purchase accounting,
liquidation accounting or other adjustments which would result upon completion
of the Proposed Transaction and the Plan of Dissolution.
F-68
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
C. DEBT SECURITIES AVAILABLE FOR SALE
Effective January 1, 1994, the Company adopted Financial Accounting
Standards Board Statement of Financial Accounting Standards No. 115 "Accounting
for Certain Investments in Debt and Equity Securities" (SFAS 115). The primary
impact of SFAS 115 is to require the Company to classify its securities into
categories based upon the Company's intent relative to the eventual disposition
of the securities. SFAS 115 established three categories of securities: (1)
Held-to-maturity securities are comprised of securities which the Company has
the positive intent and ability to hold to maturity. These securities are
carried at amortized cost. SFAS 115 prevents the Company from classifying a
security as held-to-maturity if the security might be sold for liquidity needs
or based on changes in interest rates. (2) Available-for-sale securities may be
sold to address liquidity and other needs of the Company. These securities are
held at "fair value" on the balance sheet with an increase or decrease to
stockholders' equity for unrealized gains or losses after adjustment of
amortization of deferred policy acquisition costs (per Securities and Exchange
Commission guidance as to the effect of SFAS 115 on SFAS 97 calculations of
deferred acquisition costs) and the recording of deferred income taxes. (3)
Trading securities acquired for the purpose of selling them in the near term.
The Company does not currently intend to classify any of its securities as
trading securities.
Upon adoption of SFAS 115, the Company analyzed its debt securities and
determined that to maintain flexibility in its investment portfolio it would
classify a significant portion of its investment portfolio as available-for-sale
even though management did not have the intention of selling these securities.
As such, as of January 1, 1994 approximately $505.6 million of its debt
securities were classified as available-for-sale with approximately $254.2
million classified as held-to-maturity. The fair value of the available-for-sale
securities created a net unrealized after tax gain of $3.8 million, after
adjustment for acquisition costs, at January 1, 1994. Due to the investment
portfolio repositioning program in mid 1994, the Company's life insurance
subsidiary transferred approximately $234 million of securities classified as
held-to-maturity in the available-for-sale category with an unrealized loss of
$15.9 million. With the significant increase in interest rates in 1994, the fair
value of the available-for-sale securities at December 31, 1994 resulted in a
net pretax unrealized loss of $79.1 million and a deferred tax benefit of
approximately $6.6 million. A tax valuation allowance of approximately $20.3
million had been established for the additional tax benefit that cannot be
recognized at that time. In addition, deferred policy acquisition costs have
been increased by $12.8 million, net of a deferred tax liability of $6.5
million, in conjunction with SFAS 115. The aggregate of these amounts is
included in the stockholders' equity section for unrealized losses on debt
securities at December 31, 1994.
During the first quarter of 1995 interest rates have decreased and the
market value of the debt securities classified as available-for-sale has risen
resulting in the pretax unrealized loss dropping by $28.7 million from December
31, 1994 to $50.4 million at March 31, 1995. The corresponding effects of this
is a deferred tax benefit of $4.2 million, a tax valuation allowance of $12.1
million and deferred policy acquisition costs increase of $14 million, net of a
deferred tax adjustment of $4.8 million, at March 31, 1995. In the past, changes
in market interest rates have caused fluctuations in the value of securities
classified as available-for-sale which has created volatility in the Company's
stockholders' equity.
D. COMMITMENTS AND CONTINGENCIES
The Company's life insurance subsidiary is subject to state guaranty
association assessments. The assessments are made by associations to obtain
funds to pay off policyholders of insolvent insurance companies. During the
three month periods ended March 31, 1995 and 1994, the Company recorded
F-69
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
D. COMMITMENTS AND CONTINGENCIES (CONTINUED)
approximately $75,550 and $226,210 of assessments, respectively. The Company has
no control over these assessments and additional assessments in future years are
probable but undeterminable at this time.
The Internal Revenue Service (the "IRS") has conducted examinations of the
Company's income tax returns for the years 1986 through 1990 and has proposed
several adjustments to increase taxable income relating to the timing of certain
deductions. Based on these adjustments, additional tax due would be
approximately $1.3 million plus interest. However, additional taxes currently
payable would be principally offset by deductions to taxable income in future
periods. The Company has filed a protest with the Appellate Division of the IRS
and is vigorously contesting all of the proposed adjustments. The Company
believes the ultimate resolution of this matter will not have a material adverse
effect on the Company's consolidated results of operations or financial
position.
The Company and its subsidiaries are involved in various litigation in the
ordinary course of business. In the opinion of management, the ultimate
resolution of such litigation will not have a material adverse effect upon the
financial condition or results of operations of the Company.
E. COMMON STOCK HELD BY EMPLOYEE BENEFIT PLANS
The Company's two employee benefit plans own 304,693 shares of Company
common stock. The value of the shares owned by the plans has been classified
outside of stockholders' equity as a separate line item on the Company's
consolidated balance sheet. The Company has entered into a written trustee
agreement with the trustee for the two plans pursuant to which the Company has
agreed to purchase common shares tendered to it from either benefit plan by the
trustee at a price equal to the higher of adjusted book value or fair market
value. Adjusted book value is defined in the agreement as the consolidated net
assets of the Company as reflected in its financial statements plus unrealized
losses on marketable equity securities plus the deferred income tax liability
(if any) of the Company's life insurance subsidiary. Historically, adjusted book
value of Company common stock in the two plans has been computed based upon
amortized cost value of debt securities. However, as it is discussed in Note C,
effective January 1, 1994, SFAS 115 requires that the debt securities classified
as available-for-sale be valued on a mark-to-market basis rather than at
amortized cost. Accordingly, with the required adoption of SFAS 115, common
stockholders' equity is in a deficit position. The Company has determined that,
in connection with the adoption of SFAS 115, the adjusted book value of Company
common stock held by employee benefit plans for purposes of the trustee
agreement must be computed based upon market value of available-for-sale debt
securities. As such, the adjusted book value for the common stock held by the
plans is currently negative.
However, as is discussed above, under the terms of the trustee agreement the
Company is required to repurchase Company common stock from the plans at a price
equal to the higher of adjusted book value or fair market value. In the past,
for purposes of the trustee agreement the Company has regarded adjusted book
value of the Company stock as being equivalent to the fair market value of such
stock. However, with the adoption of SFAS 115, adjusted book value of Company
common stock frequently will be greater or less than the fair market value of
such stock. Accordingly, the Company has obtained an independent determination
of the fair market value of its common stock as of June 30, 1994, for purposes
of valuating the Company's stock pursuant to the trustee agreement. The fair
market value of the Company stock held by the plans was determined by the
valuation to be $6.29 per common share. As this amount exceeds the adjusted book
value of Company stock, it has been used by management to determine the value of
the stock in the plans as of March 31, 1995. Because the valuation was performed
as of June 30, 1994, it may
F-70
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
E. COMMON STOCK HELD BY EMPLOYEE BENEFIT PLANS (CONTINUED)
not precisely reflect the value of SBM common stock held by the plans as of
March 31, 1995. The Company is in the process of obtaining an independent
valuation as of December 31, 1994 for purposes of valuating the Company's stock
pursuant to the trustee agreement. Further, the value determined by the
independent valuation does not reflect the value of the Company's common stock
held by the Company's other shareholders.
During the first quarter of 1995, the trustee of the plans notified the
Company that it was tendering all shares held by the plans to the Company under
the trustee agreement. The tender indicated that the value of the stock should
be based on amortized cost adjusted book value in that it was the trustee's
interpretation that this was the appropriate method of valuing the stock under
the trustee agreement. The Company believes the trustee's tender of all shares
is not consistent with the trustee agreement and the valuation of the common
stock held by the Plans should not be based upon amortized cost but rather based
on the methodology described above. The Company has subsequently commenced a
lawsuit against the trustee to obtain a declaratory judgment as to the
appropriate interpretation of the trustee agreement.
While the Company believes its interpretation of the trustee agreement is
appropriate, if it were determined that, for the limited purpose of establishing
the adjusted book value of the Company common stock in the two plans under the
trustee agreement, the plans should use amortized cost value of portfolio
securities rather than market value, this would have the effect at March 31,
1995 of increasing the value of the stock held by the plans by approximately
$2.5 million or $1.33 per share and reducing stockholders' equity by an equal
amount.
F. REGULATORY MATTERS
On November 16, 1994, the Commissioner of the MDC issued an administrative
order to the Company's life insurance subsidiary (SBM Life). The order restricts
the following types of material transactions without approval of the
Commissioner; merging or consolidating with another company; paying dividends;
entering into new reinsurance agreements; making material changes in management;
increasing salaries and benefits of officers or directors or making payment of
bonuses; entering into any transactions with officers and directors, including
employment agreements, or making other payments determined preferential by the
commissioner, disposing of, conveying, or encumbering its assets or its business
in force; or amending or entering into new contracts with the holding company or
other affiliated companies.
The issuance of the order was influenced by the SBM Life's A.M. Best rating
reduction and the significant unrealized depreciation in its investment
portfolio. An additional capital infusion to SBM Life will be necessary to
address the issues of the MDC and for possible re-evaluation of its rating.
The Company's face amount certificate subsidiary, SBMC, is subject to two
principal restrictions relating to its regulatory capital requirements. First,
under the Investment Company Act of 1940, SBMC is required to establish and
maintain minimum qualified assets in an amount of certificate reserves plus
$250,000 ($57,133,384 as of March 31, 1995). SBMC has qualified assets of
$62,614,363 at March 31, 1995 (before reduction of $3,387,258 for net unrealized
pretax losses on marketable equity and debt securities). Second, the Minnesota
Department of Commerce (MDC) has historically recommended to SBMC that face
amount certificate companies should maintain a ratio of stockholder's equity to
total assets at a minimum of 5% based upon a valuation of available-for-sale
securities reflected at amortized cost for purposes of this calculation. Under
this formula, SBMC's capital level was 9.7% at March 31, 1995. In
F-71
SBM COMPANY AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
F. REGULATORY MATTERS (CONTINUED)
November 1994, based on the decline in value of SBMC's investment portfolio,
resulting from increasing interest rates in 1994 and SBMC's decreasing liquidity
resulting from reduced principal payments on SBMC's CMO portfolio, the MDC
recommended that SBMC increase its capital level. The MDC's concern was
influenced by SBMC's capital ratio, calculated including the effects of SFAS
115, which would have been approximately 3.0% at March 31, 1995 without the
capital contribution on March 29, 1995. Therefore, on March 29, 1995, SBM Life,
the parent company of SBMC, contributed $1.5 million to the capital of SBMC.
SBMC is now in compliance with the MDC's recommendation.
The subsidiary has not paid dividends in the past and has no present
intentions to pay dividends in the near future, in order to increase capital
resources.
F-72
PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma condensed consolidated statement of
operations for the year ended December 31, 1995 has been prepared to reflect the
effects of the Company's acquisition of substantially all of the assets and
business operations of SBM effective May 31, 1995 as if the acquisition had
occurred on January 1, 1995. Pro forma adjustments to reflect the acquisition
have been applied to the respective historical consolidated statement of
operations of the Company for the year ended December 31, 1995 and for SBM for
the five months ended May 31, 1995, the designated effective date of the
acquisition. The pro forma adjustments are based upon available information and
certain assumptions that management of the Company believes are reasonable in
the circumstances. The pro forma condensed consolidated statement of operations
should be read in conjunction with the Company's consolidated financial
statements, including the notes thereto, and other financial information
pertaining to the acquired SBM operations included elsewhere in this Prospectus.
The pro forma condensed consolidated statement of operations and notes thereto
are provided for informational purposes only and do not purport to be indicative
of the consolidated results of operations of the Company that would have been
reported if the acquisition had occurred at the date indicated, or of the
consolidated results of future operations of the Company.
The acquisition has been accounted for as a purchase in accordance with
Accounting Principles Board Opinion No. 16, "Business Combinations." Under
purchase accounting, the purchase price is allocated to assets and liabilities
acquired based on their respective fair values. Allocations of the purchase
price were subject to valuations based on the interest rate environment as of
January 1, 1995 for purposes of the pro forma calculations.
F-73
PRO FORMA CONDENSED CONSOLIDATED
STATEMENT OF OPERATIONS (UNAUDITED)
SBM
----------- PRO FORMA
FIVE COMPANY
COMPANY MONTHS ------------
----------------- ENDED YEAR ENDED
YEAR ENDED MAY 31, PRO FORMA DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 31, 1995 1995 ADJUSTMENTS 1995
- ----------------------------------------------------------- ----------------- ----------- ----------- ------------
INCOME STATEMENT DATA:
Investment income.......................................... $ 196,024 $24,909 $ 6,877(2a) $ 227,810
Interest credited on customer deposits..................... (146,867) (19,118) (165,985)
----------------- ----------- ----------- ------------
Net investment spread...................................... 49,157 5,791 6,877 61,825
Fee income:
Variable annuity fees.................................... 7,238 7,238
Asset management fees.................................... 3,161 682 3,843
Other fee income......................................... 949 246 1,195
----------------- ----------- ----------- ------------
Total fee income........................................... 11,348 928 -- 12,276
Other income and expenses:
Surrender charges........................................ 3,339 794 4,133
Operating expenses....................................... (22,957) (3,727) --(2b) (26,684)
Commissions, net of deferrals............................ (1,557) (744) (2,301)
Interest expense on long-term debt....................... (3,461) (3,461)
Amortization:
Deferred policy acquisition costs...................... (2,932) (2,972) 2,914(2c) (2,990)
Value of insurance in force............................ (7,104) (1,300)(2c) (8,404)
Acquisition-related deferred charges................... (9,920) (69)(1a) (9,989)
Goodwill............................................... (358) (3,542)(2d) (3,900)
Other, net............................................... (687) 133 (554)
----------------- ----------- ----------- ------------
Total other income and expenses............................ (45,637) (6,516) (1,997) (54,150)
Realized investment gains (losses)......................... 4,048 (458) 17,047(2a) 20,637
----------------- ----------- ----------- ------------
Income (loss) before federal income taxes.................. 18,916 (255) 21,927 40,588
Federal income tax benefit (expense)....................... (7,026) 140 (7,674)(3) (14,560)
----------------- ----------- ----------- ------------
Net income (loss).......................................... 11,890 (115) 14,253 26,028
Discount accretion of preferred stock...................... (57) 57(1b) --
Dividends on preferred stock............................... (4,750) (672) 672(1b) (4,750)
----------------- ----------- ----------- ------------
Net income (loss) applicable to common shareholders........ $ 7,140 $ (844) $ 14,982 $ 21,278
----------------- ----------- ----------- ------------
----------------- ----------- ----------- ------------
Net income (loss) per common share......................... $ 344.94 $ 859.02
----------------- ------------
----------------- ------------
Average common shares outstanding.......................... 20,699 24,770
----------------- ------------
----------------- ------------
F-74
NOTES TO PRO FORMA CONDENSED CONSOLIDATED
STATEMENT OF OPERATIONS (CONTINUED)
(UNAUDITED)
In connection with the Company's June 14, 1995 acquisition of substantially
all of the assets and business operations of SBM, the following pro forma
adjustments are being made to the historical consolidated statement of
operations of the Company for the year ended December 31, 1995 and for SBM for
the five months ended May 31, 1995, the designated effective date of the
acquisition. The objective of these adjustments is to illustrate the possible
scope of the change in the Company's and SBM's historical consolidated results
of operations as a result of the acquisition. The pro forma condensed
consolidated statement of operations assumes the acquisition occurred as of
January 1, 1995.
The pro forma condensed consolidated statement of operations does not
purport to be indicative of the operating results which would have been achieved
had the acquisition been consummated as of the date indicated and should not be
construed as representation of future operating results.
The following describes the pro forma adjustments reflected in the
accompanying pro forma condensed consolidated statement of operations.
1. FINANCING AND STRUCTURE OF THE SBM ACQUISITION
(a) To consummate the acquisition, the Company obtained approximately
$63.5 million from the sale of 9,770 shares of Class A Common Stock. Such
proceeds were used to (i) pay the aggregate purchase price of $38.8 million;
(ii) make a capital contribution of approximately $19.9 million to SBM Life;
(iii) acquire SBM Certificate Company from SBM Life for $3.3 million; and
(iv) along with approximately $1.0 million of additional cash from the
Company, provide for fees and expenses related to the acquisition of
approximately $2.5 million. The $2.5 million of fees and expenses related to
the acquisition include approximately $2.0 million related to issuance of
the Class A Common Stock and $0.5 million of other costs directly related to
the acquisition, the latter of which is expected to be amortized over a
period of three years.
The capital contribution to SBM Life of approximately $19.9 million was
used to strengthen SBM Life's financial position and allowed for a
significant investment portfolio restructuring immediately following the
acquisition with no net adverse effect on statutory capital and surplus.
This restructuring of the investment portfolio of SBM Life was intended to
reduce exposure to mortgage-backed securities, reduce the asset/liability
duration mismatch, and increase cash flows generated by the portfolios.
(b) Pursuant to the terms of the acquisition, SBM utilized a portion of
the proceeds from the sale to liquidate its Series A preferred stock.
Accordingly, all activity related to SBM Series A preferred stock is
eliminated in the accompanying pro forma statement of operations.
2. PURCHASE ACCOUNTING MATTERS
The acquisition was accounted for using the purchase method. The aggregate
purchase price of $38.8 million is allocated based on the estimated fair value
of total assets less the estimated fair value of liabilities. Accordingly, the
following adjustments are made:
(a) As of January 1, 1995, the amortized cost of SBM Life's and SBM
Certificate Company's fixed maturities, equity securities and mortgage loans
were decreased to reflect their fair values. Net investment income was
increased to reflect the amortization of these decreases computed in
accordance with the interest method. Net realized investment losses were
decreased as a result of adjusting the amortized cost of the invested assets
to fair value. These pro forma adjustments to fixed
F-75
NOTES TO PRO FORMA CONDENSED CONSOLIDATED
STATEMENT OF OPERATIONS (CONTINUED)
(UNAUDITED)
maturities, equity securities and mortgage loans were based upon interest
rates at January 1, 1995 and are not reflective of future results as the
actual fair value adjustments and related future income statement effects
are based upon the market interest rate environment as of May 31, 1995. To
illustrate, the five year treasury rate at January 1, 1995 was 7.83%
compared to 6.05% at May 31, 1995, resulting in lower asset fair values at
January 1, 1995 than at May 31, 1995. Such differences in fair values, which
are driven by the prevailing market interest rates, affect the timing of
future earnings.
(b) Other liabilities were increased to reflect the accrual for costs to
exit certain activities of the acquired companies and for costs of employee
termination benefits and relocation costs. It is expected that operating
costs and expenses of the consolidated companies will be less than those
reflected in the accompanying pro forma statement of operations. The
estimated expense reductions are primarily related to the elimination of
duplicate facilities, personnel, and functions. For purposes of the pro
forma condensed consolidated statement of operations, these expense
reductions have not been included.
(c) The carrying values of SBM Life's and SBM Certificate Company's
deferred policy acquisition costs were eliminated and a value of insurance
in force was established for SBM Life which represents the
actuarially-determined present value of the expected pretax future profits
to the Company from the acquired policies assuming a discount rate of 13%.
After the value of insurance in force is determined, it is amortized based
on the incidence of the expected profits, and interest is accrued on the
balance annually at a rate consistent with the rate credited on the acquired
policies.
Recoverability of the value of insurance in force is evaluated annually
by comparing the current estimate of the present value of expected pretax
future profits to the unamortized asset balance. If such current estimate
indicates that the present value of pretax future profits from the block of
business acquired will not be sufficient to recover the existing value of
insurance in force, the difference is charged to expense. Amortization is
also adjusted for future years to reflect the revised estimate of pretax
future profits.
Amortization of deferred policy acquisition costs was adjusted to
reflect only the amortization of SBM Life's and SBM Certificate Company's
deferrals occurring subsequent to January 1, 1995.
(d) Goodwill represents the difference between the adjusted purchase
price and the fair value of net assets acquired. The pro forma adjustment
reflects amortization expense related to the pro forma goodwill balance.
3. IMPACT OF FEDERAL INCOME TAXES
Income tax effects resulting from the above pro forma adjustment have been
reflected at a rate of 35%.
F-76
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
The following table shows the expenses payable by the Company, other than
underwriting discounts and commissions, to be incurred in connection with the
sale and distribution of the securities being registered. All amounts are
estimates (except for the Securities and Exchange Commission (the "SEC")
registration fee and the listing fee).
SEC registration fee............................................ $34,848.48
National Association of Securities Dealers, Inc. filing fee..... 12,000.00
listing fee............................................... *
Printing and engraving expenses................................. *
Legal fees and expenses......................................... *
Accountants' fees and expenses.................................. *
Blue Sky qualification fees and expenses........................ *
Transfer Agent and Registrar fees............................... *
Miscellaneous................................................... *
---------
Total................................................... $ *
---------
---------
- ------------------------
* To be furnished by amendment.
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS
Section 145 of the Delaware General Corporation Law provides, in summary,
that directors and officers of Delaware corporations are entitled, under certain
circumstances, to be indemnified against all expenses and liabilities (including
attorneys' fees) incurred by them as a result of suits brought against them in
their capacity as a director or officer, if they acted in good faith and in a
manner they reasonably believed to be in or not opposed to the best interests of
the corporation, and, with respect to any criminal action or proceeding, if they
had no reasonable cause to believe their conduct was unlawful; PROVIDED that no
indemnification may be made against expenses in respect of any claim, issue or
matter as to which they shall have been adjudged to be liable to the
corporation, unless and only to the extent that the court in which such action
or suit was brought shall determine upon application that, despite the
adjudication of liability but in view of all the circumstances of the case, they
are fairly and reasonably entitled to indemnity for such expenses which the
court shall deem proper. Any such indemnification may be made by the corporation
only as authorized in each specific case upon a determination by the
stockholders or disinterested directors that indemnification is proper because
the indemnitee has met the applicable standard of conduct.
The Certificate of Incorporation of the Registrant (the "Certificate of
Incorporation") provides that no director of the Registrant shall be personally
liable to the Registrant or its stockholders for monetary damages for any breach
of fiduciary duty as a director, except for liability: (i) for any breach of the
director's duty of loyalty to the Registrant or its stockholders; (ii) for acts
or omissions not in good faith or which involve intentional misconduct or a
knowing violation of law; (iii) in respect of certain unlawful dividend payments
or stock redemptions or purchases or (iv) for any transaction from which the
director derived an improper personal benefit.
The Certificate of Incorporation and the By-laws of the Registrant provide
for indemnification of its directors and officers to the fullest extent
permitted by Delaware law, as the same may be amended from
II-1
time to time. In addition, MS Group indemnifies those directors of the
Registrant who are also officers of MS & Co.
The Underwriting Agreement (Exhibit 1.1 hereto) contains provisions for
certain indemnification rights to the directors and officers of the Registrant.
In addition, the Registrant and MS Group maintains directors' and officers'
liability insurance for their respective directors and officers.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES
Within the past three years, the Registrant has issued securities without
registration under the Act, as follows:
(a) Common Stock
(i) On July 15, 1993, the Registrant issued 100 shares of its Class A
Common Stock par value $.01 per share, to The Morgan Stanley Leveraged Fund,
L.P. ("MSLEF II") for an aggregate purchase price of $1.00.
(ii) On November 26, 1993, the Registrant issued to Oldarm L.P. 1,000
shares of its Class B Common Stock, in exchange for the contribution of
substantially all of the assets of Oldarm, L.P. to the Registrant.
(iii) On November 26, 1993, the Registrant issued an aggregate of 13,900
shares of its Class A Common Stock to MSLEF II and to the following members
of management, current and former employees and directors:
Dennis L. Carr John R. Lindholm
M. Lisa Cooper Madison McCarty
Don W. Cummings John McGeeney
David E. Ferguson James F. Myjak
John Franco Edward D. Powers
Pamela Raque Freeman Peter S. Resnik
Dudley J. Godfrey, David M. Roth
Jr.
Cynthia A. Hartnett Martin H. Ruby
Peter J.G. Herbener Robert J. Scott
Stephen B. Jones Rick O. Turnock
Martin P. Klein Irwin T.
Vanderhoof
C. Prewett Lane Barry G. Ward
Patty Winter
(iv) On June 14, 1995, in connection with the acquisition of
substantially all of the assets and business operations of SBM Company, the
Registrant issued 9,770 shares of its Class A Common Stock to the Morgan
Stanley Capital Partners III, L.P., Morgan Stanley Capital Investors, L.P.,
MSCP III 892 Investors, L.P., New Arm, LLC, Dudley J. Godfrey, Jr. and
Edward D. Powers for an aggregate offering price of $63,505,000.
(v) On February 23, 1996, the Registrant issued 5 shares of its Class A
Common Stock to Patty Winter in connection with the exercise of options for
an aggregate offering price of $31,360.
(vi) On July 1, 1996, the Registrant issued 21 shares of its Class A
Common Stock to Warren M. Foss for an aggregate offering price of $152,880.
(b) Grants and Exercises of Stock Options
II-2
As of September 30, 1996, options to purchase 2,680 shares of Class A
Common Stock were outstanding and unexercised under the Registrant's Stock
Option Plan. On February 23, 1996, the Registrant issued 5 shares of Class A
Common Stock upon exercise of options granted under such plan for an
aggregate consideration of approximately $31,360. As of September 30, 1996,
there were 3,445 shares of Common Stock reserved for issuance under this
plan.
The securities issued in the transactions described in paragraph (a) above
were issued in reliance on the exemption from registration under Section 4(2)
and/or Regulation D of the Securities Act as transactions not involving a public
offering. The recipients in each such case represented their intentions to
acquire the securities for investment purposes only and not with a view to
distribution thereof, and appropriate restrictive legends were affixed to the
securities issued in each transaction. All recipients were furnished or had
adequate access, through employment or other relationships, to information about
the Registrant.
The options granted under the Stock Option Plan and the shares issued upon
exercise of the options described in paragraph (b) above were issued in reliance
on the exemption from registration under Section 4(2) and/or Regulation D of the
Securities Act as transactions not involving a public offering. The recipients,
by virtue of their employment or other relationships with the Registrant, had
adequate access to information about the Registrant. Upon exercise of the
options, the recipients represented their intentions to acquire the shares for
investment purposes only and not with a view to distribution thereof, and
appropriate restrictive legends were affixed to the certificates evidencing such
shares.
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) Exhibits
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- ----------- ---------------------------------------------------------------------------------------------------
1.1 ** --Form of Underwriting Agreement.
2.1 --Asset Purchase Agreement, dated as of January 5, 1995, among Kleinwort Benson Investment
Management Holdings Ltd., Kleinwort Benson Investment Management Americas Inc., ARM Financial
Group, Inc., and ARM Capital Advisors, Inc.++
2.2 --Amended and Restated Stock and Asset Purchase Agreement, dated as of April 7, 1995, by and
between SBM Company and ARM Financial Group, Inc.+++, amending the Stock and Asset Purchase
Agreement, dated as of February 16, 1995.++
2.3 --Subscription Agreement dated as of June 12, 1995, among ARM Financial Group, Inc. and Morgan
Stanley Capital Partners III, L.P., Morgan Stanley Capital Investors, L.P. and MSCP III 892
Investors, L.P.++++
2.4 --Subscription Agreement dated as of June 12, 1995, among ARM Financial Group, Inc. and New ARM,
LLC, Dudley J. Godfrey, Jr. and Edward Powers.+++++
2.5 * --Subscription Agreement dated as of July 1, 1996, between ARM Financial Group, Inc. and Warren M.
Foss.
3(i).1 --Certificate of Incorporation of ARM Financial Group, Inc.+
3(i).2 --Certificate of Amendment to the Certificate of Incorporation of ARM Financial Group, Inc., filed
with the Delaware Secretary of State on October 5, 1993.+
3(i).3 --Certificate of Amendment to the Certificate of Incorporation of ARM Financial Group, Inc., filed
with the Delaware Secretary of State on November 10, 1993.+++++
3(i).4 --Certificate of Designations of Cumulative Perpetual Preferred Stock of ARM Financial Group, Inc.,
filed with the Delaware Secretary of State on November 23, 1993.+
3(i).5 --Certificate of Amendment to the Certificate of Incorporation of ARM Financial Group, Inc., filed
with the Delaware Secretary of State on June 12, 1995.+++++
3(i).6 * --Certificate of Amendment to the Certificate of Incorporation of ARM Financial Group, Inc., filed
with the Delaware Secretary of State on May 8, 1996.
II-3
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- ----------- ---------------------------------------------------------------------------------------------------
3(i).7 ** --Amended and Restated Certificate of Incorporation of ARM Financial Group, Inc., filed with the
Delaware Secretary of State on , 1996.
3(ii).1 --By-laws of ARM Financial Group, Inc.+
3(ii).2 --Amendment to By-laws of ARM Financial Group, Inc., adopted by the Board of Directors on November
9, 1994.++
3(ii).3 ** --Amendment to By-laws of ARM Financial Group, Inc., adopted by the Board of Directors on ,
1996.
4.1 --Amended and Restated Stockholders Agreement dated as of June 14, 1995, among ARM Financial Group,
Inc., The Morgan Stanley Leveraged Equity Fund II, L.P., John Franco, Martin H. Ruby, Oldarm
L.P., Morgan Stanley Capital Partners III, L.P., Morgan Stanley Capital Investors, L.P., MSCP III
892 Investors, L.P. and New ARM, LLC.+++++
4.2 ** --Amended and Restated Stockholders Agreement dated as of , 1996, among ARM Financial Group,
Inc., The Morgan Stanley Leveraged Equity Fund II, L.P., John Franco, Martin H. Ruby, Oldarm
L.P., Morgan Stanley Capital Partners III, L.P., Morgan Stanley Capital Investors, L.P., MSCP III
892 Investors, L.P. and New ARM, LLC.
5.1 ** --Opinion of Shearman & Sterling as to the validity of the Common Stock.
10.1 --ARM Financial Group, Inc. Amended and Restated Stock Option Agreement dated as of June 14,
1995.+++++
10.2 --Amendment, Waiver and Consent dated as of March 27, 1995 to (a) the Credit Agreement dated as of
November 15, 1993 (as amended, the "Credit Agreement"), among ARM Financial Group, Inc.,
Integrity Holdings, Inc., the financial institutions listed on Schedule 2.01 to the Credit
Agreement (the "Lenders"), The Chase Manhattan Bank, N.A. ("Chase"), and Chemical Bank
("Chemical"), as managing agents for the Lenders, (b) the Security Agreement dated as of November
26, 1993 (as amended, the "Security Agreement"), between ARM Financial Group, Inc. and Chase, and
(c) the Pledge Agreement dated as of November 26, 1993 (as amended, the "Pledge Agreement"),
among ARM Financial Group, Inc., Integrity Holdings, Inc. and Chase.++++
10.3 --Second Amendment to the Credit Agreement, Security Agreement and Pledge Agreement dated as of
June 29, 1995.++++
10.4 --Third Amendment to the Credit Agreement, Security Agreement and Pledge Agreement dated as of
December 13, 1995.+++++
10.5 --Fourth Amendment to the Credit Agreement dated as of June 28, 1996.++++++
10.6 ** --Fifth Amendment to the Credit Agreement dated as of , 1996.
10.7 --Guaranty dated as of December 13, 1995, made by ARM Financial Group, Inc. in favor of First Bank,
FSB, in connection with sale of certain SBM Certificate Company mortgage loans.+++++
10.8 --Guaranty dated as of December 13, 1995, made by ARM Financial Group, Inc. in favor of First Bank,
FSB, in connection with the sale of certain State Bond and Mortgage Life Insurance Company
mortgage loans.+++++
10.9 --Assignment and Assumption of Lease dated January 5, 1995, between Kleinwort Benson International
Investments, Ltd., and ARM Capital Advisors, Inc. (obligations of ARM Capital Advisors, Inc. have
been fully guaranteed by ARM Financial Group, Inc.)++
10.10* --Administrative Services Agreement dated as of September 28, 1994 between ARM Financial Group,
Inc. and National Integrity Life Insurance Company.
10.11* --Administrative Services Agreement dated as of January 1, 1995 between ARM Financial Group, Inc.
and ARM Capital Advisors, Inc.
II-4
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- ----------- ---------------------------------------------------------------------------------------------------
10.12 --Administrative Services Agreement dated as of January 1, 1995, between ARM Financial Group, Inc.
and Integrity Life Insurance Company.+++++
10.13 --Administrative Services Agreement dated as of June 14, 1995, between ARM Financial Group, Inc.
and SBM Certificate Company.+++++
10.14 --Administrative Services Agreement dated as of June 14, 1995, between ARM Financial Group, Inc.
and ARM Financial Services, Inc.+++++
10.15* --Investment Advisory Agreement dated as of July 29, 1994 between ARM Financial Group, Inc. and
National Integrity Life Insurance Company.
10.16 --Investment Services Agreement dated as of January 1, 1995, between ARM Financial Group, Inc. and
Integrity Life Insurance Company.+++++
10.17 --Investment Services Agreement dated as of June 14, 1995, between ARM Financial Group, Inc. and
SBM Certificate Company.+++++
10.18 --Tax Allocation Agreement dated as of March 21, 1996 by and among ARM Financial Group, Inc. and
certain of its subsidiaries for taxable periods beginning January 1, 1995.+++++
10.19 --Lease made as of June 14, 1996 by and between Northwestern National Life Insurance Company and
ARM Financial Group, Inc.++++++
10.20* --Assignment and Assumption Agreement dated as of June 28, 1996 between Northwestern National Life
Insurance Company and ARM Financial Group, Inc.
10.21* --Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and John Franco.
10.22* --Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and Martin H.
Ruby.
10.23* --Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and David E.
Ferguson.
10.24* --Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and John R.
Lindholm.
10.25** --Employment Agreement dated as of , 1996 between ARM Financial Group, Inc. and Emad Zikry.
10.26** --[Amendment to Stock Option Plan].
10.27** --[Equity Incentive Plan].
21.1 * --Subsidiaries of the Registrant.
23.1 ** --Consent of Shearman & Sterling (included in its opinion delivered under Exhibit No. 5)
23.2 * --Consent of Ernst & Young LLP.
23.3 * --Consent of Deloitte & Touche LLP
24.1 * --Powers of Attorney (included in the signature page of this Registration Statement).
- ------------------------
* Filed herewith.
** To be filed by amendment.
+ Incorporated by reference to the Registration Statement on Form S-1 of
the Registrant, File No. 33-67268.
++ Incorporated by reference to the Form 10-K filed by the Registrant on
March 30, 1995.
+++ Incorporated by reference to the Form 10-Q filed by the Registrant on
May 15, 1995.
++++ Incorporated by reference to the Form 10-Q filed by the Registrant on
August 14, 1995.
+++++ Incorporated by reference to the Form 10-K filed by the Registrant on
March 29, 1996.
II-5
++++++ Incorporated by reference to the Form 10-Q filed by the Registrant on
August 13, 1996.
(b) Financial Statement Schedules
The following schedules are included in this Part II of the Registration
Statement:
Report of Independent Public Accountant on Financial Statement Schedules
Schedule I--Summary of Investments (Other than Investments in Related
Parties)
Schedule II--Condensed Financial Information of Registrant
Schedule III--Supplementary Insurance Information
Schedule IV--Reinsurance
Schedule V--Valuation and Qualifying Accounts
Any schedules otherwise required by Article 7 of Regulation S-X other than
those listed are omitted because they are not required or are inapplicable in
this case, or equivalent information has been included in the financial
statements and notes thereto, or elsewhere herein.
ITEM 17. UNDERTAKINGS
(a) Insofar as indemnification for liabilities arising under the Securities
Act of 1933, as amended (the "Securities Act") may be permitted to directors,
officers and controlling persons of the Registrant pursuant to the provisions
described under Item 14 above or otherwise, the Registrant has been advised that
in the opinion of the SEC such indemnification is against public policy as
expressed in the Securities Act and is, therefore, unenforceable. In the event
that a claim for indemnification against such liabilities (other than the
payment by the Registrant of expenses incurred or paid by a director, officer or
controlling person of the Registrant in the successful defense of any action,
suit or proceeding) is asserted by such director, officer or controlling person
in connection with the securities being registered, the Registrant will, unless
in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the
Securities Act and will be governed by the final adjudication of such issue.
(b) The undersigned Registrant hereby undertakes that:
(i) For the purposes of determining any liability under the Securities
Act, the information omitted from the form of Prospectus filed as part of
this Registration Statement in reliance upon Rule 430A and contained in the
form of Prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4)
or 497(h) under the Securities Act shall be deemed to be part of this
Registration Statement as of the time it was declared effective.
(ii) For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.
II-6
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Louisville, Commonwealth
of Kentucky on the 23rd day of October, 1996.
ARM FINANCIAL GROUP, INC.
BY: /S/ JOHN FRANCO
-----------------------------------------
John Franco
CO-CHAIRMAN OF THE BOARD OF DIRECTORS
AND CO-CHIEF EXECUTIVE OFFICER
/S/ MARTIN H. RUBY
-----------------------------------------
Martin H. Ruby
CO-CHAIRMAN OF THE BOARD OF DIRECTORS
AND CO-CHIEF EXECUTIVE OFFICER
We, the undersigned officers and directors of ARM Financial Group, Inc.,
hereby severally constitute and appoint John Franco and Martin H. Ruby, and each
of them acting singly, our true and lawful attorneys-in-fact, with full power to
them, and each of them acting singly, in any and all capacities, to sign any
amendments (including post-effective amendments) to this Registration Statement,
and any related registration statement filed pursuant to Rule 462(b) of all
Securities Act of 1933 or amendment thereto, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed below by the following persons in the
capacities and on the dates indicated.
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------
/s/ JOHN FRANCO Co-Chairman of the Board of
- ------------------------------ Directors and Co-Chief October 23, 1996
John Franco Executive Officer
/s/ MARTIN H. RUBY Co-Chairman of the Board of
- ------------------------------ Directors and Co-Chief October 23, 1996
Martin H. Ruby Executive Officer
/s/ EDWARD L. ZEMAN Executive Vice
- ------------------------------ President--Chief October 23, 1996
Edward L. Zeman Financial Officer
/s/ JAMES S. COLE Director
- ------------------------------ October 23, 1996
James S. Cole
/s/ WARREN M. FOSS Director
- ------------------------------ October 23, 1996
Warren M. Foss
/s/ DUDLEY J. GODFREY, JR. Director
- ------------------------------ October 23, 1996
Dudley J. Godfrey, Jr.
/s/ EDWARD D. POWERS Director
- ------------------------------ October 23, 1996
Edward D. Powers
II-7
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------
/s/ DAVID R. RAMSAY Director
- ------------------------------ October 23, 1996
David R. Ramsay
/s/ FRANK V. SICA Director
- ------------------------------ October 23, 1996
Frank V. Sica
/s/ IRWIN T. VANDERHOOF Director
- ------------------------------ October 23, 1996
Irwin T. Vanderhoof
II-8
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of ARM Financial Group, Inc. and
subsidiaries and the related Report of Independent Auditors are included in Item
14(d):
SCHEDULE PAGE
- ---------------------------------------------------------------------------------------------------------------- ---------
Report of Independent Auditors.................................................................................. S-2
I --Summary of Investments (Other than Investments in Related Parties)................................. S-3
II --Condensed Financial Information of Registrant...................................................... S-4
III --Supplementary Insurance Information................................................................ S-8
IV --Reinsurance........................................................................................ S-9
V --Valuation and Qualifying Accounts.................................................................. S-10
Schedules required by Article 7 of Regulation S-X other than those listed
are omitted because they are not required, are not applicable, or equivalent
information has been included in the financial statements and notes thereto, or
elsewhere herein.
S-1
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders
ARM Financial Group, Inc.
We have audited the consolidated carrying amount balance sheets of ARM
Financial Group, Inc. and subsidiaries as of December 31, 1995 and 1994, the
related consolidated statements of operations, shareholders' equity and cash
flows for the years ended December 31, 1995 and 1994, and the period from
November 27, 1993 (date operations commenced) through December 31, 1993, and the
consolidated statements of operations, shareholder's equity and cash flows of
Integrity Holdings, Inc. (formerly N.M. U.S. Limited) and subsidiaries
(Predecessor) for the period from January 1, 1993 through November 26, 1993, and
have issued our report thereon dated February 23, 1996 (included elsewhere in
this Registration Statement). Our audits also included the financial statement
schedules listed in Item 16(b) of this Registration Statement. These Schedules
are the responsibility of the Company's management. Our responsibility is to
express an opinion based on our audits.
In our opinion, the financial statement schedules referred to above, when
considered in relation to the basic financial statements taken as a whole,
present fairly in all material respects the informaton set forth therein.
/s/ ERNST & YOUNG LLP
Louisville, Kentucky
February 23, 1996
S-2
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE I--SUMMARY OF INVESTMENTS
(OTHER THAN INVESTMENTS IN RELATED PARTIES)
DECEMBER 31, 1995
AMOUNT AT
WHICH
SHOWN IN THE
TYPE OF INVESTMENT COST VALUE BALANCE SHEET
- ----------------------------------------------------------------------- ------------ ------------ -------------
(IN THOUSANDS)
Fixed maturities:
Bonds:
U.S. government and government agencies and authorities............ $ 902,881 $ 927,805 $ 927,805
States, municipalities and political subdivisions.................. 10,126 9,688 9,688
Foreign governments................................................ 80,394 83,495 83,495
Public utilities................................................... 63,578 64,594 64,594
Industrial and miscellaneous....................................... 1,433,864 1,462,327 1,462,327
------------ ------------ -------------
Total fixed maturities........................................... 2,490,843 2,547,909 2,547,909
Equity Securities:
Nonredeemable preferred stocks..................................... 10,644 11,639 11,639
Common Stocks...................................................... 112 112 112
Mortgage loans on real estate.......................................... 43,943 XXXX 43,943
Policy loans........................................................... 117,528 XXXX 117,528
Cash and cash equivalents.............................................. 76,896 XXXX 76,896
------------ ------------ -------------
Total cash and investments....................................... $ 2,739,966 XXXX $ 2,798,027
------------ ------------ -------------
------------ ------------ -------------
S-3
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
DECEMBER 31,
----------------------
1995 1994
---------- ----------
(IN THOUSANDS)
ASSETS
Fixed maturities:
Available-for-sale, at fair value..................................................... $ 1,537 $ 5,644
Held-to-maturity, at amortized cost................................................... -- 1,537
Equity securities, at fair value.......................................................... 109 --
Cash and cash equivalents................................................................. 2,484 1,802
Investments in subsidiaries*.............................................................. 222,465 11,078
Other assets.............................................................................. 4,971 8,082
Goodwill.................................................................................. 2,816 --
Receivable from subsidiaries*............................................................. 1,155 2,649
---------- ----------
Total assets...................................................................... $ 235,537 $ 30,792
---------- ----------
---------- ----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Accounts payable and other liabilities................................................ $ 7,546 $ 4,925
Long-term debt........................................................................ 40,000 40,000
---------- ----------
Total liabilities..................................................................... 47,546 44,925
Shareholders' equity:
Preferred stock....................................................................... 50,000 50,000
Common stock.......................................................................... ** **
Additional paid-in capital............................................................ 124,425 62,920
Net unrealized gains (losses) on available-for-sale securities........................ 28,530 (104,949)
Retained-earnings deficit (including undistributed net income (loss) of subsidiaries*:
1995--$4,293; 1994--$(10,817))...................................................... (14,964) (22,104)
---------- ----------
Total shareholders' equity........................................................ 187,991 (14,133)
---------- ----------
Total liabilities and shareholders' equity........................................ $ 235,537 $ 30,792
---------- ----------
---------- ----------
- ------------------------
* Eliminated in consolidation.
** Less than $1,000.
See accompanying note.
S-4
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
STATEMENT OF OPERATIONS
PERIOD FROM
NOVEMBER 27,
YEAR ENDED DECEMBER 1993*
31, THROUGH
--------------------- DECEMBER 31,
1995 1994 1993
--------- ---------- -------------
(IN THOUSANDS)
Revenues:
Dividends from subsidiary**....................................... $ 12,800 $ -- $ --
Management and service fee income**............................... 19,040 19,090 --
Investment and other income....................................... 689 694 81
Realized investment losses........................................ (45) -- --
--------- ---------- -------------
Total Revenues................................................ 32,484 19,784 81
Expenses:
Operating expenses................................................ 22,735 19,453 694
Interest expense.................................................. 3,461 3,136 245
Amortization of acquisition-related deferred charges.............. 9,695 2,163 249
Amortization of goodwill.......................................... 84 -- --
--------- ---------- -------------
Total expenses................................................ 35,975 24,752 1,188
--------- ---------- -------------
Loss before federal income tax benefit and equity in undistributed net
income (loss) of subsidiaries....................................... (3,491) (4,968) (1,107)
Federal income tax benefit............................................ 271 -- --
--------- ---------- -------------
Loss before equity in undistributed net income (loss) of
subsidiaries........................................................ (3,220) (4,968) (1,107)
Equity in undistributed net income (loss) of subsidiaries**........... 15,110 (11,803) 986
--------- ---------- -------------
Net income (loss)..................................................... $ 11,890 $ (16,771) $ (121)
--------- ---------- -------------
--------- ---------- -------------
- ------------------------
* Commencement of operations.
** Eliminated in consolidation.
See accompanying note.
S-5
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
STATEMENTS OF CASH FLOWS
PERIOD FROM
NOVEMBER 27,
YEAR ENDED DECEMBER 1993*
31, THROUGH
---------------------- DECEMBER 31,
1995 1994 1993
---------- ---------- ------------
(IN THOUSANDS)
Net cash flows provided by (used in) operating activities............ $ 1,175 $ (19,211) $ (750)
Cash flows provided by (used in) investing activities:
Net sales (purchases) of investments............................. 5,986 (6,847) --
Acquisition of subsidiaries...................................... (42,134) 3,250 (124,300)
Contribution of capital to subsidiaries.......................... (21,100) -- --
---------- ---------- ------------
Net cash flows used in investing activities.......................... (57,248) (3,597) (124,300)
Cash flows provided by (used in) financing activities:
Issuance of long-term debt....................................... -- -- 40,000
Proceeds from issuance of preferred stock........................ -- -- 50,000
Proceeds from issuance of common stock........................... 63,505 -- 70,000
Organization, debt and stock issuance costs...................... (2,000) -- (5,326)
Preferred stock dividends........................................ (4,750) (5,014) --
---------- ---------- ------------
Net cash flows provided by (used in) financing activities............ 56,755 (5,014) 154,674
---------- ---------- ------------
Net change in cash and cash equivalents.............................. 682 (27,822) 29,624
Cash and cash equivalents at beginning of year....................... 1,802 29,624 --
---------- ---------- ------------
Cash and cash equivalents at end of year............................. $ 2,484 $ 1,802 $ 29,624
---------- ---------- ------------
---------- ---------- ------------
- ------------------------
* Commencement of operations.
See accompanying note.
S-6
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT-(CONTINUED)
NOTE TO FINANCIAL STATEMENTS
DECEMBER 31, 1995
1. BASIS OF PRESENTATION
The accompanying condensed financial statements should be read in
conjunction with the consolidated financial statements and notes of ARM
Financial Group, Inc. and subsidiaries included in the Annual Report for the
year ended December 31, 1995, and incorporated by reference in Item 8 of this
report.
S-7
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
CUSTOMER
DEPOSITS
AND INTEREST
DEFERRED SEPARATE CREDITED
POLICY ACCOUNT ON OTHER
ACQUISITION CUSTOMER INVESTMENT CUSTOMER INCOME AND
SEGMENT COSTS DEPOSITS INCOME (1) DEPOSITS FEE INCOME EXPENSES(1)
- --------------------------------------------- ----------- ------------ ----------- ---------- ----------- -----------
December 31, 1995:
Risk-Based............................... $ 14,877 $ 2,859,339 $ 188,476 $ 146,141 $ -- $ (20,275)
Fee-Based................................ 28,236 617,312 -- -- 10,682 (7,694)
Corporate and Other...................... -- 39,954 7,548 726 666 (17,668)
----------- ------------ ----------- ---------- ----------- -----------
Consolidated............................. $ 43,113 $ 3,516,605 $ 196,024 $ 146,867 $ 11,348 $ (45,637)
----------- ------------ ----------- ---------- ----------- -----------
----------- ------------ ----------- ---------- ----------- -----------
December 31, 1994:
Risk-Based............................... $ 9,526 $ 1,977,758 $ 143,890 $ 115,771 $ -- $ (15,027)
Fee-Based................................ 17,141 388,888 -- -- 4,459 (1,987)
Corporate and Other...................... -- 34,594 5,252 692 3,932 (10,118)
----------- ------------ ----------- ---------- ----------- -----------
Consolidated............................. $ 26,667 $ 2,401,240 $ 149,142 $ 116,463 $ 8,391 $ (27,132)
----------- ------------ ----------- ---------- ----------- -----------
----------- ------------ ----------- ---------- ----------- -----------
December 31, 1993(2):
Risk-Based............................... $ 397 $ 1,991,264 $ 14,976 $ 13,487 $ -- $ (201)
Fee-Based................................ 2,294 199,155 -- -- 274 (244)
Corporate and Other...................... -- 36,575 1,284 76 186 (2,246)
----------- ------------ ----------- ---------- ----------- -----------
Consolidated............................. $ 2,691 $ 2,226,994 $ 16,260 $ 13,563 $ 460 $ (2,691)
----------- ------------ ----------- ---------- ----------- -----------
----------- ------------ ----------- ---------- ----------- -----------
- ------------------------
(1) Allocation of "investment income" and "other income and expenses" are based
on a number of assumptions and estimates, and the results would change if
different methods were applied.
(2) Statement of operations information presented for 1993 is for the period
from November 27, 1993 (commencement of operations) to December 31, 1993.
S-8
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE IV--REINSURANCE
PERCENTAGE
CEDED TO ASSUMED OF AMOUNT
GROSS OTHER FROM OTHER ASSUMED TO
AMOUNT COMPANIES COMPANIES NET AMOUNT NET AMOUNT
------------ ------------ ----------- ------------ -------------
(IN THOUSANDS EXCEPT PERCENTAGES)
Year Ended December 31, 1995
Life insurance in force.................... $ 1,309,604 $ 1,728,116 $ 985,870 $ 567,358 173.8%
Year Ended December 31, 1994
Life insurance in force.................... $ 1,301,723 $ 1,166,982 $ 810,450 $ 945,191 85.7%
Year Ended December 31, 1993
Life insurance in force.................... $ 1,469,483 $ 438,339 $ 520,807 $ 1,551,951 33.6%
S-9
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE V-VALUATION AND QUALIFYING ACCOUNTS
ADDITIONS
------------------------------
CHARGED TO
DECEMBER 31, CHARGED TO OTHER DECEMBER 31,
DESCRIPTION 1994 EXPENSE ACCOUNTS(1) DEDUCTIONS(2) 1995
- -------------------------------------- ------------ ----------- ----------------- ------------- ------------
(IN THOUSANDS)
Valuation allowance on deferred tax
assets.............................. $ 66,489 $ 5,895 $ 3,956 $ (39,004) $ 37,336
Information required in Schedule V for 1994 and 1993 is ascertainable from
the notes to the consolidated financial statements.
- ------------------------
(1) Related to deferred tax assets on acquired capital losses established on May
31, 1995 in connection with the SBM acquisition.
(2) In the event that deferred tax assets are recognized on deductible temporary
differences for which a valuation allowance was provided at the date of an
acquisition, such benefits are applied to first reduce the balance of
intangible assets related to the acquisition, and then income tax expense.
As such, the Company reduced its valuation allowance with an offsetting
reduction to acquisition-related intangible assets such as value of
insurance in force and goodwill. In addition, after acquisition-related
intangible assets were reduced to zero for one of the Company's insurance
subsidiaries, a portion of the reduction in valuation allowance resulted in
a reduction of income taxes. The portion of the December 31, 1994 valuation
allowance related to deferred tax assets for net unrealized losses on
available-for-sale securities was reduced to zero as of December 31, 1995 as
the Company's available-for-sale portfolios had net unrealized gains at year
end.
S-10
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- ----------- ---------------------------------------------------------------------------------------------
2.5 -- Subscription Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and Warren
M. Foss.
3(i).6 -- Certificate of Amendment to the Certificate of Incorporation of ARM Financial Group, Inc.,
filed with the Delaware Secretary of State on May 8, 1996.
10.10 -- Administrative Services Agreement dated as of September 28, 1994 between ARM Financial Group,
Inc. and National Integrity Life Insurance Company.
10.11 -- Administrative Services Agreement dated as of January 1, 1995 between ARM Financial Group,
Inc. and ARM Capital Advisors, Inc.
10.15 -- Investment Advisory Agreement dated as of July 29, 1994 between ARM Financial Group, Inc. and
National Integrity Life Insurance Company.
10.20 -- Assignment and Assumption Agreement dated as of June 28, 1996 between Northwestern National
Life Insurance Company and ARM Financial Group, Inc.
10.21 -- Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and John
Franco.
10.22 -- Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and Martin H.
Ruby.
10.23 -- Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and David E.
Ferguson.
10.24 -- Employment Agreement dated as of July 1, 1996 between ARM Financial Group, Inc. and John R.
Lindholm.
21.1 -- Subsidiaries of the Registrant.
23.2 -- Consent of Ernst & Young LLP.
23.3 -- Consent of Deloitte & Touche LLP.
24.1 -- Powers of Attorney (included in the signature page of this Registration Statement).