EXHIBIT 13
Portions of Annual Report to Stockholders
Incorporated into this Filing
Selected Financial Data
Selected Consolidated Financial Data(1)
(in millions, except per share data)
As of or for the Year Ended December 31 1997 1996 1995 1994 1993
.......................................................................................................................
Income Statement Data
Investment income $ 853.1 $ 796.4 $ 761.8 $ 695.1 $ 675.3
Interest credited to policyholders (594.1) (572.7) (555.8) (481.9) (504.2)
---------- ---------- ---------- --------- ---------
Investment spread 259.0 223.7 206.0 213.2 171.1
---------- ---------- ---------- --------- ---------
Net realized investment gains (losses) 25.9 8.0 (4.0) (8.2) 11.4
---------- ---------- ---------- --------- ---------
Fee income:
Investment advisory and administrative fees 217.9 196.4 155.8 95.9 98.9
Distribution and service fees 49.2 44.9 28.9 -- --
Transfer agency fees 47.7 43.9 30.8 4.0 5.4
Surrender charges and net commissions 36.1 34.7 23.4 20.0 22.9
Separate account fees 17.1 16.0 13.2 12.5 8.0
---------- ---------- ---------- --------- ---------
Total fee income 368.0 335.9 252.1 132.4 135.2
---------- ---------- ---------- --------- ---------
Expenses:
Operating expenses(2) (309.7) (277.9) (225.1) (174.9) (178.9)
Amortization of deferred policy acquisition costs (75.9) (60.2) (58.5) (52.2) (41.0)
Amortization of deferred distribution costs (34.2) (33.9) (18.8) -- --
Amortization of value of insurance in force (10.5) (10.2) ( 9.5) (17.0) (22.4)
Amortization of intangible assets (13.5) (15.4) (12.2) ( 5.8) (15.0)
Interest expense, net (17.0) (19.7) (16.2) ( 4.2) --
---------- ---------- ---------- --------- ---------
Total expenses (460.8) (417.3) (340.3) (254.1) (257.3)
---------- ---------- ---------- --------- ---------
Pretax income 192.1 150.3 113.8 83.3 60.4
Income tax expense (62.6) (49.6) (39.9) (32.5) (29.1)
---------- ---------- ---------- --------- ---------
Net income $ 129.5 $ 100.7 $ 73.9 $ 50.8 $ 31.3
========== ========== ========== ========= =========
Per Share Data(3)
Net income per share--basic $ 2.94 $ 2.36 $ 1.85 $ 1.49 $ 0.91
Net income per share--assuming dilution 2.77 2.24 1.76 1.43 0.88
Dividends on common stock(4) 0.40 0.40 0.30 -- --
Dividends on convertible preferred stock 2.88 2.88 2.21 -- --
Book value 26.82 24.42 23.03 18.25 18.67
Other Operating Data
Net operating income(5) $ 112.4 $ 94.8 $ 76.5 $ 56.2 $ 23.9
Net realized investment gains (losses), net of taxes 17.1 5.9 (2.6) (5.4) 7.4
---------- ---------- ---------- --------- ---------
Net income $ 129.5 $ 100.7 $ 73.9 $ 50.8 $ 31.3
========== ========== ========== ========= =========
Balance Sheet Data
Total investments $12,343.5 $11,537.9 $10,144.7 $ 8,590.2 $ 8,411.7
Intangible assets 199.0 205.4 192.3 29.3 35.2
Total assets 15,851.6 14,427.7 12,749.4 10,968.8 10,324.6
Notes payable to affiliates 229.0 229.0 229.0 75.0 --
Series A redeemable convertible preferred stock 14.6 13.8 13.0 -- --
Stockholders' equity 1,198.9 1,051.4 956.4 624.7 638.8
Shares of common stock outstanding3 44.7 43.1 41.5 34.2 34.2
- -------------
1 Includes data for acquired entities from and after the applicable
acquisition date (the most significant being Colonial, which was acquired
on March 24, 1995). See Note 2 of Notes to the Consolidated Financial
Statements. The data presented should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto and other financial
information included herein and "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION."
2 In 1993, the Company recognized a $22.1 million option plan compensation
charge, which primarily reflected a revision in the benefit plan formula
from an earnings-based formula to one based upon 104% of book value.
3 Share and per share amounts have been adjusted for a three-for-two common
stock split effected in the form of a 50 percent stock dividend distributed
on December 10, 1997. In addition, net income per share amounts were
prepared in accordance with Statement of Financial Accounting Standards No.
128, "Earnings per Share."
4 The amount for 1995 does not include a non-cash dividend of $30.0 million
to an affiliate of Liberty Mutual. See Note 5 of Notes to the Consolidated
Financial Statements.
5 Net operating income is defined as net income, excluding net realized
investment gains and losses, net of related income taxes.
24
Management's Discussion
Management's Discussion and Analysis of Results of Operations and Financial
Condition
Results of Operations
Net Income was $129.5 million or $2.77 per share in 1997 compared to $100.7
million or $2.24 per share in 1996 and $73.9 million or $1.76 per share in
1995. The increase in 1997 compared to 1996 resulted from higher investment
spread, higher fee income, higher net realized investment gains and lower
interest expense, net. Partially offsetting these items were increased
operating expenses, amortization expense and income tax expense. The increase
in 1996 compared to 1995 resulted from higher investment spread, higher fee
income and net realized investment gains in 1996 compared to net realized
investment losses in 1995. Partially offsetting these items were increased
operating expenses, amortization expense, interest expense, net and income tax
expense. The full-period consolidation of the 1995 Colonial and Newport
acquisitions resulted in an $8.9 million increase in 1996 net income compared
to 1995.
Pretax Income was $192.1 million in 1997 compared to $150.3 million in 1996 and
$113.8 million in 1995. The higher pretax income in 1997 compared to 1996
resulted from higher investment spread, higher fee income, higher net realized
investment gains and lower interest expense, net. Partially offsetting these
items were increased operating expenses and amortization expense. The higher
pretax income in 1996 compared to 1995 resulted from higher investment spread,
higher fee income and net realized investment gains in 1996 compared to net
investment losses in 1995. The full-period consolidation of the 1995 Colonial
and Newport acquisitions resulted in an $11.9 million increase in 1996 pretax
income compared to 1995. Partially offsetting these items were increased
operating expenses, amortization expense and interest expense, net.
Investment Spread is the amount by which investment income earned on the
Company's investments exceeds interest credited on policyholder balances.
Investment spread was $259.0 million in 1997 compared to $223.7 million in 1996
and $206.0 million in 1995. The amount by which the average yield on
investments exceeds the average interest credited rate on policyholder balances
is the investment spread percentage. Such investment spread percentage in 1997
was 1.96% compared to 1.89% for 1996 and 1.90% for 1995.
Investment income was $853.1 million in 1997 compared to $796.4 million in 1996
and $761.8 million in 1995. The increase of $56.7 million in 1997 compared to
1996 primarily relates to an $86.2 million increase as a result of the higher
level of average invested assets, partially offset by a $29.5 million decrease
resulting from a lower average investment yield. The 1997 investment income was
net of $47.6 million of S&P 500 Index call option amortization expense related
to the Company's equity-indexed annuities compared to $14.0 million in 1996.
The average investment yield was 6.95% in 1997 compared to 7.21% in 1996.
Investment income increased in 1996 compared to 1995 primarily as a result of
the higher level of average invested assets, partially offset by a decrease in
the average investment yield. The average investment yield was 7.21% in 1996
compared to 7.57% in 1995.
Interest credited to policyholders totaled $594.1 million in 1997 compared to
$572.7 million in 1996 and $555.8 million in 1995. The increase of $21.4
million in 1997 compared to 1996 primarily relates to a $56.4 million increase
as a result of a higher level of average policyholder balances, partially
offset by a $35.0 million decrease resulting from a lower average interest
credited rate. Policyholder balances averaged $11.9 billion (including $10.8
billion of fixed products, consisting of
25
fixed annuities and the closed block of single premium whole life insurance,
and $1.1 billion of equity-indexed annuities) in 1997 compared to $10.8 billion
(including $10.4 billion of fixed products and $0.4 billion of equity-indexed
annuities) in 1996. The average interest credited rate was 4.99% (5.45% on
fixed products and 0.85% on equity-indexed annuities) in 1997 compared to 5.32%
(5.50% on fixed products and 0.85% on equity-indexed annuities) in 1996.
Keyport's equity-indexed annuities credit interest to the policyholder at a
"participation rate" equal to a portion (ranging for existing policies from 60%
to 95%) of the change in value of the S&P 500 Index. Keyport's equity-indexed
annuities also provide a full guarantee of principal if held to term, plus
interest at 0.85% annually. For each of the periods presented the interest
credited to equity-indexed policyholders related to the participation rate was
offset by investment income recognized on the S&P 500 Index call options
resulting in a 0.85% net credited rate. Interest credited to policyholders
increased in 1996 compared to 1995 primarily as a result of a higher level of
average policyholder balances, partially offset by a decrease in the average
interest credited rate. Policyholder balances averaged $10.8 billion in 1996
compared to $9.8 billion in 1995. The average interest credited rate was 5.67%
in 1995.
Average investments in the Company's general account (computed without giving
effect to SFAS 115), including a portion of the Company's cash and cash
equivalents, were $12.3 billion in 1997 compared to $11.0 billion in 1996 and
$10.1 billion in 1995. The increase of $1.3 billion in 1997 compared to 1996
was primarily due to a 100 percent coinsurance agreement with respect to a
$954.0 million block of single premium deferred annuities ("SPDAs") entered
into with Fidelity & Guaranty Life Insurance Company ("F&G Life") during the
third quarter of 1996 and net insurance cash flows of $0.7 billion. The
increase of $0.9 billion in 1996 compared to 1995 was primarily due to the F&G
Life transaction and net insurance cash flows of $0.7 billion.
Net Realized Investment Gains were $25.9 million in 1997 compared to $8.0
million in 1996 and net realized investment losses of $4.0 million in 1995.
Sales of fixed maturity investments generally are made to maximize total
return. The net realized investment gains in 1997 included gains on the sales
of fixed maturity investments of $16.8 million and gains on redemption of seed
money investments in separate account mutual funds sponsored by the Company of
$7.9 million. In addition, there were $1.2 million in gains related to sales of
general corporate securities in the Company's asset management and corporate
operations. The net realized investment gains in 1996 were primarily
attributable to sales of fixed maturity investments and sales of investments
received in the F&G Life transaction. The net realized investment losses in
1995 were attributable to sales of fixed maturity investments.
Investment Advisory and Administrative Fees are based on the market value of
assets managed for mutual funds, wealth management and institutional investors.
Investment advisory and administrative fees were $217.9 million in 1997
compared to $196.4 million in 1996 and $155.8 million in 1995. The increase in
1997 compared to 1996 primarily reflects a higher level of average fee-based
assets under management. The increase in 1996 compared to 1995 primarily
reflects a higher level of average fee-based assets under management due to the
full year consolidation of Colonial and Newport.
Average fee-based assets under management were $37.2 billion in 1997 compared
to $33.9 billion in 1996 and $27.2 billion in 1995. The increase during 1997
compared to 1996 was primarily due to market appreciation. The increase during
1996 compared to 1995 was primarily due to the full year inclusion of the
assets acquired in the Colonial and Newport acquisitions, net mutual fund sales
and market appreciation. Investment advisory and administrative fees were 0.59%
of average fee-based assets under management in 1997, 0.58% in 1996 and 0.57%
in 1995. These increases in the effective fee
26
rate in 1997 and 1996 were primarily due to the increased proportion of higher
average fee-based mutual fund assets under management.
The amount of fee-based assets under management are affected by product sales
and redemptions and by changes in the market values of such assets under
management. Fee-based assets under management and changes in such assets are
set forth in the tables below (in billions).
Fee-Based Assets Under Management
As of December 31
--------------------------------
1997 1996 1995
.............................................................................
Mutual Funds:
Intermediary-distributed $16.1 $16.1 $15.7
Direct-marketed 7.2 6.6 4.8
Closed-end 2.2 1.9 1.8
Variable annuity 1.3 1.1 1.0
----- ----- -----
26.8 25.7 23.3
Wealth management 6.6 5.3 4.5
Institutional 5.3 4.9 4.1
----- ----- -----
Total fee-based assets under management* $38.7 $35.9 $31.9
===== ===== =====
* As of December 31, 1997, 1996 and 1995, Keyport's insurance assets of $12.8
billion, $12.1 billion and $10.6 billion, respectively, bring total assets
under management to $51.5 billion, $48.0 billion and $42.5 billion,
respectively.
Changes in Fee-Based Assets Under Management
Year Ended December 31
--------------------------------
1997 1996 1995
..............................................................................
Fee-based assets under management--beginning $35.9 $31.9 $16.3
Sales and reinvestments 6.6 7.5 4.8
Redemptions and withdrawals (6.6) (5.7) (8.5)
Acquisitions -- 0.3 14.9
Market appreciation 2.8 1.9 4.4
----- ----- -----
Fee-based assets under management--ending $38.7 $35.9 $31.9
===== ===== =====
Distribution and Service Fees are based on the market value of the Company's
intermediary-distributed mutual funds. Distribution fees of 0.75% are generally
earned on the average assets attributable to such funds sold with contingent
deferred sales charges and service fees of 0.25% (net of amounts passed on to
selling brokers) are generally earned on the total of such average mutual fund
assets. These fees totaled $49.2 million in 1997 compared to $44.9 million in
1996 and $28.9 million in 1995. These increases in 1997 and 1996 were primarily
attributable to the higher asset levels of mutual
27
funds with contingent deferred sales charges. As a percentage of weighted
average assets, distribution and service fees were approximately 0.71% in 1997
and 0.69% in each of 1996 and 1995.
Transfer Agency Fees are based on the market value of the assets managed in the
Company's intermediary-distributed and direct-marketed mutual funds. Such fees
were $47.7 million on average assets of $24.1 billion in 1997, $43.9 million on
average assets of $22.6 billion in 1996 and $30.8 million on average assets of
$17.4 billion in 1995. These increases in 1997 and 1996 were primarily due to
higher average assets in direct-marketed mutual funds. As a percentage of total
average mutual fund assets under management, transfer agency fees were
approximately 0.20%, 0.19% and 0.18% in 1997, 1996 and 1995, respectively.
Surrender Charges and Net Commissions are revenues earned on: a) the early
withdrawal of annuity policyholder balances and redemptions of the
intermediary-distributed mutual funds which were sold with contingent deferred
sales charges; b) the distribution of the Company's intermediary-distributed
mutual funds (net of the substantial portion of commissions that is passed on
to the selling brokers); and c) the sales of non-proprietary products in the
Company's bank marketing businesses (net of commissions that are paid to the
Company's client banks and brokers). Total surrender charges and net
commissions were $36.1 million in 1997 compared to $34.7 million in 1996 and
$23.4 million in 1995.
Surrender charges on fixed and variable annuity withdrawals generally are
assessed at declining rates applied to policyholder withdrawals during the
first five to seven years of the contract; contingent deferred sales charges on
mutual fund redemptions are assessed at declining rates on amounts redeemed
generally during the first six years. Such charges totaled $21.4 million, $19.8
million and $18.4 million in 1997, 1996 and 1995, respectively. Total annuity
withdrawals represented 11.6%, 11.6% and 9.9% of the total average annuity
policyholder and separate account balances in 1997, 1996 and 1995,
respectively. Excluding surrenders from the older block of annuities acquired
in the F&G Life transaction, the withdrawal percentages were 10.6% and 10.0% in
1997 and 1996, respectively.
Net commissions were $14.7 million in 1997, $14.9 million in 1996 and $5.0
million in 1995. The increase in 1996 compared to 1995 was primarily
attributable to the acquisition of Independent in March 1996.
Separate Account Fees are primarily mortality and expense charges earned on
variable annuity and variable life policyholder balances. These fees, which are
based on the market values of the assets in separate accounts supporting the
contracts, were $17.1 million in 1997 compared to $16.0 million in 1996 and
$13.2 million in 1995. Such fees represented 1.54%, 1.68% and 1.61% of average
variable annuity and variable life separate account balances in 1997, 1996 and
1995, respectively.
Operating Expenses primarily represent compensation, marketing and other
general and administrative expenses. These expenses were $309.7 million in 1997
compared to $277.9 million in 1996 and $225.1 million in 1995. The increase in
1997 compared to 1996 was primarily due to increases in compensation and
marketing expenses. The increase in 1996 compared to 1995 was primarily due to
increases in compensation and marketing expenses and to the acquisition of
Independent. Operating expenses expressed as a percent of average total assets
under management were 0.63%, 0.62% and 0.60% in 1997, 1996 and 1995,
respectively.
28
Amortization of Deferred Policy Acquisition Costs relates to the costs of
acquiring new business which vary with, and are primarily related to, the
production of new annuity business. Such costs include commissions, costs of
policy issuance and underwriting and selling expenses. Amortization was $75.9
million in 1997 compared to $60.2 million in 1996 and $58.5 million in 1995.
These increases in amortization in 1997 and 1996 were primarily related to the
increase in investment spread from the growth of business in force associated
with fixed and indexed products and the increased sales of variable annuity
products. Amortization expense represented 29.3%, 26.9% and 28.4% of investment
spread in 1997, 1996 and 1995, respectively.
Amortization of Deferred Distribution Costs relates to the deferred sales
commissions acquired in connection with the Colonial acquisition and the
distribution of mutual fund shares sold with contingent deferred sales charges.
Amortization was $34.2 million in 1997 compared to $33.9 million in 1996 and
$18.8 million in 1995. The increase in amortization in 1997 compared to 1996
was primarily attributable to the continuing sales of such fund shares during
1997 and 1996 partially offset by a $3.8 million charge in the fourth quarter
of 1996 relating to a reduction in the amortization period. The increase in
1996 was primarily attributable to the full period consolidation of Colonial,
the continuing sales of such fund shares during 1996 and 1995 and the $3.8
million charge in the fourth quarter of 1996.
Amortization of Value Insurance in Force relates to the actuarially-determined
present value of projected future gross profits from policies in force at the
date of acquisition. Amortization totaled $10.5 million in 1997 compared to
$10.2 million in 1996 and $9.5 million in 1995. The increase in amortization in
1997 compared to 1996 included increased amortization of $4.0 million related
to the F&G Life transaction partially offset by decreased amortization related
to a change in mortality assumptions. The increase in amortization in 1996
compared to 1995 was primarily due to $2.7 million of amortization recorded in
1996 relating to the F&G Life transaction, partially offset by lower
amortization in 1996 due to an increase in estimated amortization periods in
the last quarter of 1995 of the Company's closed block of single premium whole
life insurance.
Amortization of Intangible Assets relates to goodwill and certain identifiable
intangible assets arising from business combinations accounted for as
purchases. Amortization was $13.5 million in 1997 compared to $15.4 million in
1996 and $12.2 million in 1995. The decrease in amortization in 1997 compared
to 1996 was primarily attributable to certain assets becoming fully amortized
in the third quarter of 1996. The increase in amortization in 1996 compared to
1995 was primarily attributable to the acquisitions of Independent, Colonial
and Newport.
Interest Expense, Net was $17.0 million in 1997 compared to $19.7 million in
1996 and $16.2 million in 1995. The decrease in 1997 compared to 1996 was due
to lower interest expense related to Colonial's credit facility which is
utilized to finance the sale of shares of the mutual funds which have
contingent deferred sales charges and to higher interest income which is netted
against interest expense. The increase in 1996 compared to 1995 was primarily
attributable to the full year impact of the $100.0 million note issued in
connection with the Colonial acquisition, the $24.0 million note issued in
connection with the Newport acquisition and the $30.0 million note issued in
1995 to an affiliate of Liberty Mutual.
Income Tax Expense was $62.6 million or 32.6% of pretax income in 1997 compared
to $49.6 million or 33.0% of pretax income in 1996 and $39.9 million or 35.1%
of pretax income in 1995. The lower effective tax rates in 1997 and 1996 were
29
attributable primarily to reductions in the deferred tax asset valuation
reserve. For all periods, substantially all the federal income tax expense
related to the Company's annuity insurance business.
Effective July 18, 1997, the Company is no longer included in the consolidated
tax return of Liberty Mutual. The Company will be required to file a separate
life return and a consolidated non-life return. The Company does not expect
this change to have a material effect on its financial condition or its results
of operations.
Financial Condition
Stockholders' Equity as of December 31, 1997 was $1.20 billion compared to
$1.05 billion as of December 31, 1996. Net income in 1997 was $129.5 million
and cash dividends on the Company's Preferred and Common Stock totaled $4.9
million. Common stock totaling $7.5 million and $2.5 million was issued in
connection with the exercise of stock options and for earn-out stock payments
related to the acquisition of Independent, respectively. In addition, the
exercise of certain stock options resulted in a federal income tax benefit to
the Company of $4.7 million which was credited to additional paid-in capital.
An increase in net unrealized investment gains, net of adjustments to deferred
policy acquisition costs and value of insurance in force, during the period
increased stockholders' equity by $8.6 million.
Book Value Per Share amounted to $26.82 at December 31, 1997 compared to $24.42
at December 31, 1996. Excluding net unrealized gains on investments, book value
per share amounted to $24.97 at December 31, 1997 and $22.70 at December 31,
1996. As of December 31, 1997, there were 44.7 million common shares
outstanding compared to 43.1 million shares as of December 31, 1996.
Investments not including cash and cash equivalents, totaled $12.3 billion at
December 31, 1997 compared to $11.5 billion at December 31, 1996. The increase
primarily reflects general account investment earnings.
The Company manages the majority of its invested assets internally. The
Company's general investment policy is to hold fixed maturity assets for
long-term investment and, accordingly, the Company does not have a trading
portfolio. To provide for maximum portfolio flexibility and appropriate tax
planning, the Company classifies its entire fixed maturities investments as
"available for sale" and accordingly carries such investments at fair value.
The Company's total investments at December 31, 1997 and 1996 reflected net
unrealized gains of $280.2 million and $229.8 million, respectively, relating
to its fixed maturity and equity portfolios. The increase in net unrealized
gains in 1997 principally reflects the lower interest rates at the end of 1997.
Approximately $11.0 billion or 81.7% of the Company's general account
investments at December 31, 1997 was rated by Standard & Poor's Corporation,
Moody's Investors Service or under comparable statutory rating guidelines
established by the National Association of Insurance Commissioners ("NAIC"). At
December 31, 1997, the carrying value of investments in below investment grade
securities totaled $1.1 billion or 7.9% of general account investments of $13.5
billion. Below investment grade securities generally provide higher yields and
involve greater risks than investment grade securities because their issuers
typically are more highly leveraged and more vulnerable to adverse economic
conditions than investment grade issuers. In addition, the trading market for
these securities may be more limited than for investment grade securities.
30
Management of the Company's Investments
Asset-liability duration management is utilized by the Company to minimize the
risks of interest rate fluctuations and policyholder withdrawals. The Company
believes that its fixed and indexed policyholder balances should be backed by
investments, principally comprised of fixed maturities, that generate
predictable rates of return. The Company does not have a specific target rate
of return. Instead, its rates of return vary over time depending on the current
interest rates, the slope of the yield curve and the excess at which fixed
maturities are priced over the yield curve. Its portfolio strategy is designed
to achieve acceptable risk-adjusted returns by effectively managing portfolio
liquidity and credit quality.
The Company conducts its investment operations to closely match the duration of
the assets in its investment portfolio to its policyholder balances. The
Company seeks to achieve an acceptable spread between what it earns on its
assets and interest credited on its policyholder balances by investing
principally in fixed maturities. The Company's fixed-rate products incorporate
surrender charges to encourage persistency and to make the cost of its
policyholder balances more predictable. Approximately 83.0% of the Company's
fixed annuity policyholder balances were subject to surrender charges at
December 31, 1997.
As part of its asset-liability management discipline, the Company conducts
detailed computer simulations that model its fixed-maturity assets and
liabilities under commonly used stress-test interest rate scenarios. Based on
the results of these computer simulations, the investment portfolio has been
constructed with a view toward maintaining a desired investment spread between
the yield on portfolio assets and the interest credited on policyholder
balances under a variety of possible future interest rate scenarios. At
December 31, 1997, the effective duration of the Company's fixed maturities
investments (including certain cash and cash equivalents) was approximately
2.9. Effective duration is a common measure for the price sensitivity of a
fixed-income portfolio to changes in interest rates. It measures the
approximate percentage change in the market value of a portfolio when interest
rates change by 100 basis points. This measure includes the impact of estimated
changes in portfolio cash flows from features such as prepayment and bond
calls.
As a component of its investment strategy and to reduce its exposure to
interest rate risk, the Company utilizes interest rate swap agreements and
interest rate cap agreements to match assets more closely to liabilities. Swap
agreements are agreements to exchange with a counterparty interest rate
payments of differing character (e.g. fixed-rate payments exchanged for
variable-rate payments) based on an underlying principal balance (notional
principal) to hedge against interest rate changes. The Company currently
utilizes swap agreements to reduce asset duration and to better match interest
rates earned on longer-term fixed rate assets with interest credited to
policyholders. The Company had 45 outstanding swap agreements with an aggregate
notional principal amount of $2.6 billion and 39 outstanding swap agreements
with an aggregate notional principal amount of $2.3 billion as of December 31,
1997 and 1996, respectively.
Cap agreements are agreements with a counterparty which require the payment of
a premium for the right to receive payments for the difference between the cap
interest rate and a market interest rate on specified future dates based on an
underlying principal balance (notional principal) to hedge against rising
interest rates. The Company had interest rate cap agreements with an aggregate
notional amount of $250.0 million and $450.0 million as of December 31, 1997
and 1996, respectively.
31
With respect to the Company's equity-indexed annuities, the Company buys call
options on the S&P 500 Index to hedge its obligation to provide returns based
upon this index. The Company had call options with a book value of $323.3
million and $109.7 million as of December 31, 1997 and 1996, respectively.
There are risks associated with some of the techniques the Company uses to
match its assets and liabilities. The primary risk associated with swap, cap
and call option agreements is counterparty nonperformance. The Company believes
that the counterparties to its swap, cap and call option agreements are
financially responsible and that the counterparty risk associated with these
transactions is minimal. In addition, swap and cap agreements have interest
rate risk and call options have stock market risk. These swap and cap
agreements hedge fixed-rate assets and the Company expects that any interest
rate movements that adversely affect the market value of swap and cap
agreements would be offset by changes in the market values of such fixed rate
assets. However, there can be no assurance that these hedges will be effective
in offsetting the potential adverse effects of changes in interest rates.
Similarly, the call options hedge the Company's obligations to provide returns
on equity-indexed annuities based upon the S&P 500 Index, and the Company
believes that any stock market movements that adversely affect the market value
of S&P 500 Index call options would be substantially offset by a reduction in
policyholder liabilities. However, there can be no assurance that these hedges
will be effective in offsetting the potentially adverse effects of changes in
S&P 500 Index levels. Keyport's profitability could be adversely affected if
the value of its swap and cap agreements increase less than (or decrease more
than) the change in the market value of its fixed rate assets and/or if the
value of its S&P 500 Index call options increase less than (or decrease more
than) the value of the guarantees made to equity-indexed policyholders.
The Company routinely reviews its portfolio of investment securities. The
Company identifies monthly any investments that require additional monitoring,
and carefully reviews the carrying value of such investments at least quarterly
to determine whether specific investments should be placed on a nonaccrual
basis and to determine declines in value that may be other than temporary.
There were no non-income producing investments in the Company's fixed maturity
portfolio at December 31, 1997 or 1996. In making these reviews, the Company
principally considers the adequacy of collateral (if any), compliance with
contractual covenants, the borrower's recent financial performance, news
reports, and other externally generated information concerning the borrower's
affairs. In the case of publicly traded fixed maturities investments,
management also considers market value quotations if available.
Liquidity
The Company is a holding company whose liquidity needs include the following:
(i) operating expenses; (ii) debt service; (iii) dividends on Preferred Stock
and Common Stock; (iv) acquisitions; and (v) working capital where needed by
its operating subsidiaries. The Company's principal sources of cash are
dividends from its operating subsidiaries, and, in the case of funding for
acquisitions and certain long-term capital needs of its subsidiaries, long-term
borrowings, which to date have been from affiliates of Liberty Mutual Insurance
Company ("Liberty Mutual").
Current Rhode Island insurance law applicable to Keyport permits the payment of
dividends or distributions, which, together with dividends and distributions
paid during the preceding 12 months, do not exceed the lesser of (i) 10% of
Keyport's statutory surplus as of the preceding December 31 or (ii) Keyport's
statutory net gain from operations for the preceding fiscal year. Any proposed
dividend in excess of this amount is called an "extraordinary dividend" and may
not
32
be paid until it is approved by the Commissioner of Insurance of the State of
Rhode Island. As of December 31, 1997, the amount of dividends that Keyport
could pay without such approval was $70.3 million. However, Keyport has not
paid any dividends since its acquisition in 1988.
Based upon the historical cash flow of the Company, the Company's current
financial condition and the Company's expectation that there will not be a
material adverse change in the results of operations of the Company and its
subsidiaries during the next twelve months and the assumption that Liberty
Mutual will continue to participate in the Dividend Reinvestment Plan, the
Company believes that cash flow provided by operating activities over this
period will provide sufficient liquidity for the Company to meet its working
capital, capital investment and other operational cash needs, its debt service
obligations, its obligations to pay dividends on the Preferred Stock and its
intentions to pay dividends on the Common Stock. The Company anticipates that
it would require external sources of liquidity in order to finance material
acquisitions where the purchase price is not paid in equity.
Each of the Company's business segments has its own liquidity needs and
financial resources. In the Company's annuity insurance operations, liquidity
needs and financial resources pertain to the management of the general account
assets and policyholder balances. In the Company's asset management business,
liquidity needs and financial resources pertain to the investment management
and distribution of mutual funds, wealth management and institutional accounts.
The Company expects that, based upon their historical cash flow and current
prospects, these operating subsidiaries will be able to meet their liquidity
needs from internal sources and, in the case of Colonial, from its credit
facility used to finance sales of mutual fund shares sold with contingent
deferred sales charges.
Keyport uses cash for the payment of annuity and life insurance benefits,
operating expenses and policy acquisition costs, and the purchase of
investments. Keyport generates cash from annuity premiums and deposits, net
investment income, and from the sales and maturities of fixed investments.
Annuity premiums, maturing investments and net investment income have
historically been sufficient to meet Keyport's cash requirements. Keyport
monitors cash and cash equivalents in an effort to maintain sufficient
liquidity and has strategies in place to maintain sufficient liquidity in
changing interest rate environments. Consistent with the nature of its
obligations, Keyport has invested a substantial amount of its general account
assets in readily marketable securities. As of December 31, 1997, $10.3
billion, or 76.2 % of Keyport's general account investments are considered
readily marketable.
To the extent that unanticipated surrenders cause Keyport to sell for liquidity
purposes a material amount of securities prior to their maturity, such
surrenders could have a material adverse effect on the Company. Although no
assurances can be given, Keyport believes that liquidity to fund anticipated
withdrawals would be available through incoming cash flow and the sale of
short-term or floating-rate instruments, thereby precluding the sale of fixed
maturity investments in a potentially unfavorable market.
33
Year 2000
Many companies and organizations have computer programs that use only two
digits to identify a year in the date field. These programs were designed and
developed without considering the impact of the upcoming change in the century.
If not corrected, this could cause a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions.
In addressing the Year 2000 issue, the Company has substantially completed an
inventory of its computer programs and assessed its Year 2000 readiness. The
Company's computer programs include internally developed programs, third-party
purchased programs and third-party custom developed programs. For programs
which were identified as not being Year 2000 ready, the Company is in the
process of implementing a remedial plan which includes repairing or replacing
the programs and appropriate testing for Year 2000. In addition, the Company
has initiated communications with third parties to determine the extent to
which the Company's interface systems are vulnerable to those third parties'
failure to remediate their own Year 2000 issues.
If such modifications and conversions are not made, or are not timely
completed, or if the systems of the companies on which the Company's interface
system relies are not timely converted, the Year 2000 issue could have a
material impact on the operations of the Company. However, the Company believes
that with modifications to existing software and conversions to new software,
the Year 2000 issue will not pose significant operational problems for its
computer systems.
In the opinion of management, the cost of addressing the Year 2000 issue is not
expected to have a material adverse effect on the Company's financial condition
or its results of operations.
Effects of Inflation
Inflation has not had a material effect on the Company's consolidated results
of operations to date. The Company manages its investment portfolio in part to
reduce its exposure to interest rate fluctuations. In general, the market value
of the Company's fixed maturity portfolio increases or decreases in inverse
relationship with fluctuations in interest rates, and the Company's net
investment income increases or decreases in direct relationship with interest
rate changes. For example, if interest rates decline, the Company's fixed
maturity investments generally will increase in market value, while net
investment income will decrease as fixed maturity investments mature or are
sold and the proceeds are reinvested at reduced rates. However, inflation may
result in increased operating expenses that may not be readily recoverable in
the prices of the services charged by the Company.
34
Liberty Financial Companies, Inc.
Consolidated Balance Sheets
($ in millions)
December 31 1997 1996
..................................................................................................
Assets
Assets:
Investments $12,343.5 $11,537.9
Cash and cash equivalents 1,290.1 875.8
Accrued investment income 165.0 146.8
Deferred policy acquisition costs 232.0 250.4
Value of insurance in force 53.3 70.8
Deferred distribution costs 108.1 114.4
Intangible assets 199.0 205.4
Other assets 131.4 134.7
Separate account assets 1,329.2 1,091.5
--------- ---------
$15,851.6 $14,427.7
========= =========
Liabilities and Stockholders' Equity
Liabilities:
Policyholder balances $12,086.1 $11,637.5
Notes payable to affiliates 229.0 229.0
Payable for investments purchased and loaned 722.1 211.2
Other liabilities 336.9 267.1
Separate account liabilities 1,264.0 1,017.7
--------- ---------
Total liabilities 14,638.1 13,362.5
--------- ---------
Series A redeemable convertible preferred stock, par value $.01;
authorized, issued and outstanding 327,006 shares in 1997 and 327,340
shares in 1996 14.6 13.8
--------- ---------
Stockholders' Equity:
Common stock, $.01 par value, authorized 100,000,000 shares; issued
44,706,398 shares in 1997 and 43,057,523 shares in 1996 0.4 0.3
Additional paid-in capital 866.5 835.3
Net unrealized investment gains 83.0 74.4
Retained earnings 251.5 141.4
Cost of common stock held in treasury (9,465 shares at
December 31, 1997) (0.3) --
Unearned compensation (2.2) --
--------- ---------
Total stockholders' equity 1,198.9 1,051.4
--------- ---------
$15,851.6 $14,427.7
========= =========
See accompanying notes to consolidated financial statements.
35
Liberty Financial Companies, Inc.
Consolidated Income Statements
(in millions, except per share data)
Year Ended December 31 1997 1996 1995
.........................................................................................
Investment income $ 853.1 $ 796.4 $ 761.8
Interest credited to policyholders (594.1) (572.7) (555.8)
-------- -------- --------
Investment spread 259.0 223.7 206.0
-------- -------- --------
Net realized investment gains (losses) 25.9 8.0 (4.0)
-------- -------- --------
Fee income:
Investment advisory and administrative fees 217.9 196.4 155.8
Distribution and service fees 49.2 44.9 28.9
Transfer agency fees 47.7 43.9 30.8
Surrender charges and net commissions 36.1 34.7 23.4
Separate account fees 17.1 16.0 13.2
-------- -------- --------
Total fee income 368.0 335.9 252.1
-------- -------- --------
Expenses:
Operating expenses (309.7) (277.9) (225.1)
Amortization of deferred policy acquisition costs (75.9) (60.2) (58.5)
Amortization of deferred distribution costs (34.2) (33.9) (18.8)
Amortization of value of insurance in force (10.5) (10.2) (9.5)
Amortization of intangible assets (13.5) (15.4) (12.2)
Interest expense, net (17.0) (19.7) (16.2)
-------- -------- --------
Total expenses (460.8) (417.3) (340.3)
-------- -------- --------
Pretax income 192.1 150.3 113.8
Income tax expense (62.6) (49.6) (39.9)
-------- -------- --------
Net income $ 129.5 $ 100.7 $ 73.9
======== ======== ========
Net income per share--basic $ 2.94 $ 2.36 $ 1.85
======== ======== ========
Net income per share--assuming dilution $ 2.77 $ 2.24 $ 1.76
======== ======== ========
See accompanying notes to consolidated financial statements.
36
Liberty Financial Companies, Inc.
Consolidated Statements of Stockholders' Equity
(in millions)
Net
Additional Unrealized Total
Common Paid-In Investment Retained Treasury Unearned Stockholders'
Stock Capital Gains Earnings Stock Compensation Equity
................................................................................................................................
Balance, December 31, 1994 $0.2 $659.9 $(64.5) $29.1 $ 624.7
Common stock issued in Colonial merger 0.1 117.3 117.4
Effect of stock-based compensation plans 0.7 $1.2 1.9
Reclassification of accrued option
compensation liability 22.4 (2.1) 20.3
Contribution of treasury stock 7.1 $(7.1)
Accretion to face value of preferred stock (0.6) (0.6)
Common stock dividends 3.1 (12.3) 7.1 (2.1)
Note issued in connection with common
stock dividend (30.0) (30.0)
Preferred stock dividends (0.7) (0.7)
Change in net unrealized investment gains 151.6 151.6
Net income 73.9 73.9
---- ------ ------ ------ ----- ----- --------
Balance, December 31, 1995 0.3 810.5 87.1 59.4 (0.9) 956.4
Common stock issued in Independent
acquisition 8.5 8.5
Effect of stock-based compensation plans 2.4 0.9 3.3
Accretion to face value of preferred stock (0.9) (0.9)
Common stock dividends 13.9 (16.9) (3.0)
Preferred stock dividends (0.9) (0.9)
Change in net unrealized investment gains (12.7) (12.7)
Net income 100.7 100.7
---- ------ ------ ------ ----- ----- --------
Balance, December 31, 1996 0.3 835.3 74.4 141.4 1,051.4
3 for 2 common stock split effected in the
form of a 50 percent stock dividend 0.1 (0.1)
Common stock issued in Independent
acquisition 2.5 2.5
Effect of stock-based compensation plans 15.2 (0.4) (2.2) 12.6
Accretion to face value of preferred stock (0.8) (0.8)
Common stock dividends 13.5 (17.6) 0.1 (4.0)
Preferred stock dividends (0.9) (0.9)
Change in net unrealized investment gains 8.6 8.6
Net income 129.5 129.5
---- ------ ------ ------ ----- ----- --------
Balance, December 31, 1997 $0.4 $866.5 $ 83.0 $251.5 $(0.3) $(2.2) $1,198.9
==== ====== ====== ====== ===== ===== ========
See accompanying notes to consolidated financial statements.
37
Liberty Financial Companies, Inc.
Consolidated Statements of Cash Flows
(in millions)
Year Ended December 31 1997 1996 1995
...........................................................................................
Cash flows from operating activities:
Net income $ 129.5 $ 100.7 $ 73.9
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 74.4 74.3 51.6
Interest credited to policyholders 594.1 572.7 555.8
Net realized investment (gains) losses (25.9) ( 8.0) 4.0
Net amortization (accretion) on investments 29.9 (29.1) 9.7
Change in deferred policy acquisition costs (10.3) (24.4) (24.6)
Change in current and deferred income taxes 66.9 4.9 13.3
Net change in other assets and liabilities (33.2) (81.8) (59.7)
--------- -------- ---------
Net cash provided by operating activities 825.4 609.3 624.0
--------- -------- ---------
Cash flows from investing activities:
Investments purchased available for sale (4,592.3) (4,493.2) (2,851.0)
Investments sold held to maturity -- -- 14.9
Investments sold available for sale 2,563.5 1,714.0 605.2
Investments matured held to maturity -- -- 317.8
Investments matured available for sale 1,531.6 1,387.7 906.5
Increase in policy loans, net (21.9) (34.5) (21.0)
Decrease in mortgage loans, net 6.4 7.5 55.0
Acquisitions, net of cash acquired -- (41.5) (106.0)
--------- -------- ---------
Net cash used in investing activities (512.7) (1,460.0) (1,078.6)
--------- -------- ---------
Cash flows from financing activities:
Withdrawals from policyholder accounts (1,320.8) (1,154.1) (933.8)
Deposits to policyholder accounts 950.5 2,134.5 1,116.9
Securities lending 495.2 (119.2) 317.7
Borrowings from affiliates -- -- 124.0
Repayments under revolving credit (26.0) (8.5) (19.5)
Exercise of stock options 7.5 2.4 0.7
Common stock issued to 401(k) Plan 0.1 -- --
Dividends paid (4.9) (3.9) (2.8)
--------- -------- ---------
Net cash provided by financing activities 101.6 851.2 603.2
--------- -------- ---------
Increase in cash and cash equivalents 414.3 0.5 148.6
Cash and cash equivalents at beginning of year 875.8 875.3 726.7
--------- -------- ---------
Cash and cash equivalents at end of year $ 1,290.1 $ 875.8 $ 875.3
========= ======== =========
Noncash Investing Activities: The Company made several acquisitions during 1995
using $106.0 million of cash, net of cash acquired. The fair value of assets
acquired was $352.6 million; total liabilities assumed were $108.8 million.
Noncash Financing Activities: Noncash financing activities relate to dividends
paid primarily to an affiliate of Liberty Mutual in the amount of $13.6
million, $13.9 million and $10.2 million in 1997, 1996 and 1995, respectively,
pursuant to the Company's dividend reinvestment plan and, in 1995, $30.0
million in the form of an 8.0% note due in 2000.
See accompanying notes to consolidated financial statements.
38
Notes to Consolidated Financial Statements
Liberty Financial Companies, Inc.
Notes to Consolidated Financial Statements
1. Accounting Policies
Organization
Liberty Financial Companies, Inc. (the "Company") is an asset accumulation and
management company providing investment management products and
retirement-oriented insurance products through multiple distribution channels.
The Company is a majority owned subsidiary of Liberty Mutual Insurance Company
("Liberty Mutual").
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its subsidiaries, including Keyport Life Insurance Company ("Keyport"), Stein
Roe & Farnham Incorporated ("Stein Roe") and, from the date of acquisition: The
Colonial Group, Inc. ("Colonial"), Newport Pacific Management, Inc. ("Newport")
and Independent Holdings, Inc. ("Independent"). All significant intercompany
balances and transactions have been eliminated. Certain prior year amounts have
been reclassified to conform to the current year's presentation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
Investments
Investments in debt and equity securities classified as available for sale are
carried at fair value, and after-tax unrealized gains and losses (net of
adjustments to deferred policy acquisition costs and value of insurance in
force) are reported as a separate component of stockholders' equity. The cost
basis of securities is adjusted for declines in value that are determined to be
other than temporary. Realized investment gains and losses are calculated on a
first-in, first-out basis.
On December 31, 1995, pursuant to the "Guide to Implementation of Statement 115
on Accounting for Certain Investments in Debt and Equity Securities," the
Company made a one-time reclassification of certain fixed maturity securities
from held to maturity to available for sale. The amortized cost of those
securities at the time of transfer was $1.4 billion, and the unrealized gain of
$13.9 million was recorded net of taxes in stockholders' equity.
For the mortgage-backed bond portion of the fixed maturity investment
portfolio, the Company recognizes income using a constant effective yield based
on anticipated prepayments over the estimated economic life of the security.
When actual prepayments differ significantly from anticipated prepayments, the
effective yield is recalculated to reflect actual payments to date and
anticipated future payments; and any resulting adjustment is included in
investment income.
Mortgage loans are carried at amortized cost. Policy loans are carried at the
unpaid principal balances plus accrued interest. Partnerships are accounted for
by using the equity method of accounting. Partnership investments totaled
$117.3 million and $72.6 million at December 31, 1997 and 1996, respectively.
Derivatives
The Company uses interest rate swap and cap agreements to manage its interest
rate risk and call options on the Standard & Poor's 500 Composite Stock Price
Index ("S&P 500 Index") to hedge its obligations to provide returns based upon
this index.
The Company utilizes interest rate swap agreements ("swap agreements") and
interest rate cap agreements ("cap agreements") to match assets more closely to
liabilities. Swap agreements are agreements to exchange with a counterparty
interest rate payments of differing character (e.g., fixed-rate payments
exchanged for variable-rate payments) based on an underlying principal balance
(notional principal) to hedge against interest rate changes. The Company
currently utilizes swap agreements to reduce asset duration and to better match
interest rates earned on longer-term fixed rate assets with interest rates
credited to policyholders.
39
Cap agreements are agreements with a counterparty which require the payment of
a premium for the right to receive payments for the difference between the cap
interest rate and a market interest rate on specified future dates based on an
underlying principal balance (notional principal) to hedge against rising
interest rates.
Hedge accounting is applied after the Company determines that the items to be
hedged expose it to interest rate or price risk, designates the instruments as
hedges and assesses whether the instruments reduce the indicated risks through
the measurement of changes in the value of the instruments and the items being
hedged at both inception and throughout the hedge period. From time to time,
interest rate swap agreements, cap agreements and call options are terminated.
If the terminated position was accounted for as a hedge, realized gains or
losses are deferred and amortized over the remaining lives of the hedged assets
or liabilities. Conversely, if the terminated position was not accounted for as
a hedge, or the assets and liabilities that were hedged no longer exist, the
position is "marked to market" and realized gains or losses are immediately
recognized in income.
The net differential to be paid or received on interest rate swap agreements is
recognized as a component of net investment income. Premiums paid for interest
rate cap agreements are deferred and amortized to net investment income on a
straight-line basis over the terms of the agreements. The unamortized premium
is included in other invested assets. Amounts earned on interest rate cap
agreements are recorded as an adjustment to net investment income. Interest
rate swap agreements and cap agreements hedging investments designated as
available for sale are adjusted to fair value with the resulting unrealized
gains and losses included in stockholders' equity.
Premiums paid on call options are amortized to net investment income over the
terms of the contracts. The call options are included in other invested assets
and are carried at amortized cost plus intrinsic value, if any, of the call
options as of the valuation date. Changes in intrinsic value of the call
options are recorded as an adjustment to interest credited to policyholders.
Fee Income
Fees from asset management and investment advisory services and from transfer
agent, bookkeeping, distribution and service fees are recognized as revenues
when services are provided. Revenues from fixed and variable annuities and
single premium whole life policies include mortality charges, surrender
charges, policy fees and contract fees and are recognized when earned under the
respective contracts. Net commission revenue is recognized on the trade date.
Deferred Policy Acquisition Costs
Policy acquisition costs are the costs of acquiring new business which vary
with, and are primarily related to, the production of new annuity business.
Such costs include commissions, costs of policy issuance and underwriting and
selling expenses. These costs are deferred and amortized in relation to the
present value of estimated gross profits from mortality, investment spread and
expense margins. Deferred policy acquisition costs are adjusted for amounts
relating to unrealized gains and losses on fixed maturity securities the
Company has designated as available for sale. This adjustment, net of tax, is
included with the change in net unrealized investment gains or losses that is
credited or charged directly to stockholders' equity. Deferred policy
acquisition costs were decreased by $126.9 million at December 31, 1997 and
$103.7 million at December 31, 1996, respectively, relating to this adjustment.
Value of Insurance in Force
Value of insurance in force represents the actuarially-determined present value
of projected future gross profits from policies in force at the date of their
acquisition. This amount is amortized in proportion to the projected emergence
of profits over periods not exceeding 15 years for annuities and 25 years for
life insurance.
The value of insurance in force is adjusted for amounts relating to the
recognition of unrealized investment gains and losses. This adjustment, net of
tax, is included with the change in net unrealized investment gains or losses
that is credited or charged directly to stockholders' equity. Value of
insurance in force was decreased by $31.8 million and $26.0 million at December
31, 1997 and 1996, respectively, relating to this adjustment.
40
Deferred Distribution Costs
Sales commissions and other direct costs related to the sale of
Company-sponsored intermediary-distributed funds which charge contingent
deferred sales commissions are recorded as deferred distribution costs.
Amortization is provided on a straight-line basis over periods up to six years
to match the estimated period in which the associated fees will be earned.
Contingent deferred sales charges (back-end loads) received are applied to
deferred distribution costs to the extent of the estimated unamortized portion
of such costs, with the remainder recognized as additional distribution fee
income.
Intangible Assets
Intangible assets consist of goodwill and certain identifiable intangible
assets arising from business combinations accounted for as a purchase.
Amortization is provided on a straight-line basis over estimated lives of the
acquired intangibles which range from 5 to 25 years. The carrying value of
intangible assets is adjusted when the expected present value of future gross
profits attributable to such assets is less than their carrying value.
Separate Account Assets and Liabilities
The assets and liabilities resulting from variable annuity and variable life
policies are segregated in separate accounts. Separate account assets, which
are carried at fair value, consist principally of investments in mutual funds.
Investment income and changes in asset values are allocated to the
policyholders, and therefore, do not affect the operating results of the
Company. The Company provides administrative services and bears the mortality
risk related to these contracts. Keyport also classified as separate account
assets investments in Company-sponsored mutual funds and other investments of
$65.2 million and $73.8 million at December 31, 1997 and 1996, respectively.
Policy Liabilities
Policy liabilities consist of deposits received plus interest credited, less
accumulated policyholder charges, assessments, and withdrawals related to
deferred annuities and single premium whole life policies. Policy benefits that
are charged to expense include benefit claims incurred in the period in excess
of related policy account balances.
Stock Options
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations in accounting for its employee stock options because the
alternative fair value accounting provided for under Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123") requires use of option valuation models that were not developed for use
in valuing employee stock options. Under APB 25, because the exercise price of
the Company's employee stock options equals the market price of the underlying
stock on the date of grant, no compensation expense is recognized.
Income Taxes
Prior to July 18, 1997, the Company was included in the consolidated federal
income tax return filed by Liberty Mutual. Effective July 18, 1997, the Company
is no longer included in the consolidated tax return of Liberty Mutual. The
Company will be required to file a separate life return and a consolidated
non-life return. Income taxes have been provided using the liability method in
accordance with Statement of Financial Accounting Standards No. 109,
"Accounting for Income Taxes," and, for periods prior to July 18, 1997, were
calculated as if the Company filed its own consolidated income tax return.
Earnings Per Share
In 1997, the Financial Accounting Standards Board (the "FASB") issued Statement
of Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128").
SFAS 128 replaced the calculation of primary and fully diluted earnings per
share with basic and diluted earnings per share. Unlike primary earnings per
share, basic earnings per share excludes any dilutive effects of options and
convertible securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings per share
amounts for all periods have been presented to conform to the SFAS 128
requirements.
41
Cash Equivalents
Short-term investments having an original maturity of three months or less are
classified as cash equivalents.
Recent Accounting Pronouncements
In June 1997, the FASB issued Statement of Financial Accounting Standards No.
131, "Disclosures about Segments of an Enterprise and Related Information"
("SFAS 131"). SFAS 131 establishes standards for the reporting of financial
information from operating segments in annual and interim financial statements.
SFAS 131 requires that financial information be reported on the basis that it
is reported internally for evaluating segment performance and deciding how to
allocate resources to segments. It is not expected that the adoption will have
a material effect on the Company's financial statements. SFAS 131 will become
effective in 1998.
In June 1996, the FASB issued Statement of Financial Accounting Standards No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 125"). The relevant provisions of SFAS
125 relating to securities lending, dollar rolls and other similar secured
transactions become effective after December 31, 1997. It is not expected that
the adoption of SFAS 125 will have a material effect on the Company's
consolidated financial position or results of operations.
In January 1998, the FASB voted to proceed with the drafting of an accounting
standard entitled "Accounting for Derivative Instruments and for Hedging
Activities." This accounting standard requires companies to report derivatives
on the balance sheet at fair value with changes in fair value recorded in
income or equity. The accounting standard also changes the accounting for
derivatives used in hedging strategies from traditional deferral accounting to
a current recognition approach which could impact a company's results of
operations and financial position and expand the definition of a derivative
instrument. The Company is evaluating the impact of this accounting standard.
This accounting standard will become effective in 2000.
2. Acquisitions
In March 1996, the Company acquired all the outstanding common stock of
Independent, a distributor of annuity and investment products through banks. In
April 1996, the Company acquired all the outstanding capital stock of KJMM
Investment Management Company, Inc., a registered investment advisor primarily
in the wealth management business. The purchase price for these two
transactions has totaled $22.7 million in cash and Common Stock, and the
Company may be obligated to make additional cash or stock payments through
approximately 2000 based upon the attainment of certain performance objectives.
These acquisitions are not material to the financial condition or results of
operation of the Company.
In March 1995, the Company completed the acquisition of Colonial, an investment
advisor, distributor and transfer agent to mutual funds. The purchase price was
$264.8 million, consisting of $100.0 million in cash, 328,209 shares of
redeemable convertible preferred stock and 7,016,712 shares of common stock.
In April 1995 and September 1995, respectively, the Company acquired Newport
and American Asset Management Company, each a registered investment advisor.
The purchase price for these two transactions has totaled $32.9 million in
cash. In addition, at the time of the Newport acquisition the Company made a
capital contribution to Newport in the amount of $3.5 million. The Company may
be obligated in each transaction to make contingent additional cash payments
through approximately 1999 based upon the attainment of certain performance
objectives.
The above transactions were recorded using the purchase method of accounting
and have resulted in the recording of intangible assets of $204.8 million,
including goodwill of $105.2 million. Each company's results of operations are
included in the Company's consolidated financial statements from the dates of
their acquisition. The following table discloses 1995 pro forma results of
operations (in millions) for the Company had the 1995 acquisitions occurred as
of January 1, 1995. These pro forma results of operations are not necessarily
indicative of actual results which might have occurred had the Company owned
these companies on that date.
42
Year Ended December 31 1995
....................................................
Revenues $1,044.5
Net income 79.0
Net income per share--assuming dilution 1.88
In addition to the above acquisitions, in August 1996, Keyport entered into a
100 percent coinsurance agreement for a $954.0 million block of single premium
deferred annuities issued by Fidelity & Guaranty Life Insurance Company ("F&G
Life"). Under this transaction, the investment risk of the annuity policies was
transferred to Keyport. However, F&G Life will continue to administer the
policies and will remain contractually liable for the performance of all policy
obligations. This transaction increased investments by $923.1 million and value
of insurance in force by $30.9 million.
3. Investments
Investments, all of which pertain to the Company's annuity insurance
operations, were comprised of the following (in millions):
December 31 1997 1996
.....................................................
Fixed maturities $11,246.5 $10,718.6
Equity securities 40.8 35.9
Mortgage loans 60.7 67.0
Policy loans 554.7 532.8
Other invested assets 440.8 183.6
--------- ---------
$12,343.5 $11,537.9
========= =========
As of December 31, 1997, the Company did not have a material concentration of
financial instruments in a single investee, industry or geographic location and
no investment in any person or its affiliates (other than bonds issued by
agencies of the United States government) exceeded ten percent of stockholders'
equity.
As of December 31, 1997, $1.1 billion of fixed maturities were below investment
grade. These securities represented 7.9% of the Company's total investments,
including certain cash and cash equivalents.
Fixed Maturities
As of December 31, 1997 and 1996, the Company did not hold any investments in
fixed maturities that were classified as held to maturity or as trading
securities. The amortized cost, gross unrealized gains and losses and fair
value of fixed maturity securities are as follows (in millions):
Gross Gross
Amortized Unrealized Unrealized
December 31, 1997 Cost Gains Losses Fair Value
............................................................................................................
U.S. Treasury securities $ 128.6 $ 1.1 $ -- $ 129.7
Mortgage backed securities of U.S. government
corporations and agencies 1,089.8 49.5 ( 1.6) 1,137.7
Debt securities issued by foreign governments 272.5 12.7 ( 5.0) 280.2
Corporate securities 4,744.2 189.4 (83.6) 4,850.0
Other mortgage backed securities 2,325.9 81.9 ( 2.6) 2,405.2
Asset backed securities 2,200.7 26.2 ( 3.1) 2,223.8
Senior secured loans 219.9 -- -- 219.9
--------- ------ ------ ---------
Total fixed maturities $10,981.6 $360.8 $(95.9) $11,246.5
========= ====== ====== =========
43
Gross Gross
Amortized Unrealized Unrealized
December 31, 1996 Cost Gains Losses Fair Value
............................................................................................................
U.S. Treasury securities $ 35.3 $ 0.2 $ (0.1) $ 35.4
Mortgage backed securities of U.S. government
corporations and agencies 1,690.0 41.8 ( 8.7) 1,723.1
Debt securities issued by foreign governments 246.3 11.7 ( 0.5) 257.5
Corporate securities 4,093.5 153.4 (12.3) 4,234.6
Other mortgage backed securities 2,413.0 47.6 (24.0) 2,436.6
Asset backed securities 1,736.0 15.5 ( 6.4) 1,745.1
Senior secured loans 286.3 -- -- 286.3
--------- ------ ------ ---------
Total fixed maturities $10,500.4 $270.2 $(52.0) $10,718.6
========= ====== ====== =========
At December 31, 1997, gross unrealized gains on equity securities, interest
rate cap agreements and investments in separate accounts aggregated $27.4
million, and gross unrealized losses aggregated $6.9 million, respectively. At
December 31, 1996, gross unrealized gains on equity securities, interest rate
cap agreements and investments in separate accounts aggregated $29.9 million,
and gross unrealized losses aggregated $5.3 million, respectively.
Contractual Maturities
The amortized cost and estimated fair value of fixed maturities by contractual
maturity as of December 31, 1997 are as follows (in millions):
Amortized Fair
December 31, 1997 Cost Value
.....................................................................
Due in one year or less $ 147.2 $ 147.5
Due after one year through five years 1,925.7 1,926.4
Due after five years through ten years 2,350.3 2,419.8
Due after ten years 942.0 986.1
--------- ---------
5,365.2 5,479.8
Mortgage and asset backed securities 5,616.4 5,766.7
---------- ---------
$10,981.6 $11,246.5
========= =========
Actual maturities may differ from those shown above because borrowers may have
the right to call or prepay obligations.
Net Investment Income
Net investment income is summarized as follows (in millions):
Year Ended December 31 1997 1996 1995
.........................................................................................
Fixed maturities $811.7 $737.4 $682.0
Policy loans 32.2 30.2 28.5
Equity securities 5.4 4.5 4.8
Mortgage loans and other invested assets 27.8 11.4 12.9
Cash and cash equivalents 34.5 36.1 41.6
------ ------ ------
Gross investment income 911.6 819.6 769.8
Investment expenses (9.2) (6.7) (5.0)
Amortization of call options and interest rate caps (49.3) (16.5) (3.0)
------ ------ ------
Net investment income $853.1 $796.4 $761.8
====== ====== ======
There were no non-income producing fixed maturity investments as of December
31, 1997 or 1996.
44
Net Realized Investment Gains (Losses)
Net realized investment gains (losses) on the investments in the Company's
annuity insurance operations are summarized as follows (in millions):
Year Ended December 31 1997 1996 1995
...............................................................................................
Fixed maturities held to maturity:
Gross gains $ -- $ -- $ 1.3
Gross losses -- -- ( 0.1)
Fixed maturities available for sale:
Gross gains 42.5 24.3 8.2
Gross losses (19.1) (17.8) (16.0)
Equity securities ( 0.1) 1.5 ( 0.4)
Investments in separate accounts 7.9 ( 0.6) 1.7
Interest rate swaps -- -- ( 0.9)
Other -- ( 0.2) --
------- ------- -------
Gross realized investment gains (losses) 31.2 7.2 ( 6.2)
Amortization adjustments of deferred policy acquisition costs
and value of insurance in force ( 6.5) ( 1.7) 2.2
------- ------- -------
Net realized investment gains (losses) $ 24.7 $ 5.5 $ (4.0)
======= ======= =======
Proceeds from sales of fixed maturities available for sale were $2.6 billion,
$1.7 billion and $565.4 million in 1997, 1996 and 1995, respectively.
Deferred tax liabilities for the Company's unrealized holding gains and losses,
net of adjustments to deferred policy acquisition costs and value of insurance
in force were $44.3 million and $39.5 million at December 31, 1997 and 1996,
respectively.
In addition to the net realized investment gains (losses) shown above,
additional gains of $1.2 million and $2.5 million were realized in 1997 and
1996, respectively, relating to sales of general corporate securities in the
Company's asset management and corporate operations.
4. Derivatives
Outstanding derivatives, shown in notional amounts along with their carrying
values and estimated fair values, are as follows (in millions):
Assets (Liabilities)
---------------------------------------
1997 1996
-------------------- ------------------
Notional Amounts
-----------------------
Carrying Fair Carrying Fair
December 31 1997 1996 Value Value Value Value
..........................................................................................
Interest rate cap agreemen $ 250.0 $ 450.0 $ 0.1 $ 0.1 $ 1.4 $ 1.4
Interest rate swaps 2,575.0 2,275.0 (42.1) (42.1) ( 8.8) ( 8.8)
Indexed call options -- -- 323.3 345.3 109.7 122.4
- ------------------------------------------------------------------------------------------
The interest rate swap agreements expire in 1998 to 2001. The interest rate cap
agreements expire in 1999 through 2000. The call options' maturities range from
1998 to 2002.
45
The Company currently utilizes swap agreements to reduce asset duration and to
better match interest rates earned on longer-term fixed rate assets with
interest credited to policyholders. Cap agreements are used to hedge against
rising interest rates. Call options are used for purposes of hedging the
Company's equity-indexed products. The call options hedge the interest credited
on these 1, 5 and 7 year term products, which is based on the changes in the
S&P 500 Index. At December 31, 1997 and 1996, the Company had approximately
$155.0 million and $73.1 million, respectively, of unamortized premium in call
option contracts.
Fair values for swap and cap agreements are based on current settlement values.
The current settlement values are based on quoted market prices and brokerage
quotes, which utilize pricing models or formulas using current assumptions.
Fair values for call options are based upon quoted market prices.
Deferred losses of $5.1 million and $7.9 million as of December 31, 1997 and
1996, respectively, resulting from terminated interest rate swap agreements are
included with the related fixed maturity securities to which the hedge applied
and are being amortized over the life of such securities.
There are risks associated with some of the techniques the Company uses to
match its assets and liabilities. The primary risk associated with swap, cap
and call option agreements is the risk associated with counterparty
nonperformance. The Company believes that the counterparties to its swap, cap
and call option agreements are financially responsible and that the
counterparty risk associated with these transactions is minimal.
5. Indebtedness
The Company has notes payable to affiliates as follows (in millions):
December 31 1997 1996
...................................................................
8.0% promissory note due April 3, 2000 $ 99.0 $ 99.0
8.0% promissory note due March 31, 2000 30.0 30.0
8.5% promissory notes due March 24, 2005 100.0 100.0
------ ------
$229.0 $229.0
====== ======
The $100.0 million 8.5% promissory notes become due and payable in the event
Liberty Mutual ceases to own more than a 50% interest in the Company. The $30.0
million 8.0% promissory note was issued in connection with the payment of a
dividend to an affiliate of Liberty Mutual.
The Company has available a $60.0 million revolving credit facility (the
"Facility") which is utilized to finance deferred sales commissions paid in
connection with the distribution of mutual fund shares sold with contingent
deferred sales charges. This Facility is subject to annual renewal. If not
renewed, effective April 11, 1998, this Facility converts to a term loan which
matures on April 11, 2003. As of December 31, 1997 and 1996, balances of $26.5
million and $52.5 million, respectively, were outstanding under the Facility
and were included in other liabilities. Upon conversion to a term loan, minimum
quarterly payments of principal equal to 5.0% of outstanding borrowings as of
the conversion date are required. Interest accrues on the outstanding
borrowings of the Facility at floating rates based upon LIBOR options plus
0.225%. The Facility contains certain covenants. The Company was in compliance
with these covenants at December 31, 1997.
Interest paid was $21.7 million, $22.9 million and $19.2 million in 1997, 1996
and 1995, respectively.
6. Income Taxes
Income tax expense is summarized as follows (in millions):
Year Ended December 31 1997 1996 1995
...........................................................
Current $(42.0) $54.8 $39.3
Deferred 104.6 (5.2) 0.6
------ ----- -----
$ 62.6 $49.6 $39.9
====== ===== =====
46
A reconciliation of income tax expense with expected federal income tax expense
computed at the applicable federal income tax rate of 35% is as follows (in
millions):
Year Ended December 31 1997 1996 1995
........................................................................................
Expected income tax expense $ 67.3 $52.6 $39.9
Increase (decrease) in income taxes resulting from:
Nontaxable investment income (1.4) (1.2) (1.7)
Change in deferred tax asset valuation allowance (10.0) (6.7) (8.3)
Amortization of goodwill and other intangible assets 3.1 2.0 2.0
State taxes, net of federal tax benefit 1.2 2.5 1.0
Stock option plan compensation -- 0.8 6.0
Other, net 2.4 (0.4) 1.0
------ ----- -----
Income tax expense $ 62.6 $49.6 $39.9
====== ===== =====
The components of deferred federal income taxes are as follows (in millions):
December 31 1997 1996
......................................................................................
Deferred tax assets:
Policy liabilities $ 124.3 $ 171.3
Guaranty fund expense 2.8 6.3
Stock option plan compensation 1.0 3.8
Deferred compensation and other benefit plans 11.4 6.4
Excess of book over tax basis depreciation and amortization -- 1.6
Net operating loss carryforwards 13.1 31.2
Distribution fees 17.8 14.8
Other 3.4 7.8
------- -------
Total deferred tax assets 173.8 243.2
Less: valuation allowance ( 10.6) (20.6)
------- -------
Net deferred tax assets 163.2 222.6
------- -------
Deferred tax liabilities:
Deferred policy acquisition costs ( 56.3) (63.1)
Value of insurance in force and intangible assets ( 18.0) (20.5)
Excess of book over tax basis of investments (181.3) (125.7)
Deferred revenue ( 4.1) ( 2.0)
Amortization of deferred distribution costs ( 34.8) ( 49.8)
Other ( 8.2) ( 4.0)
------- -------
Total deferred tax liabilities (302.7) (265.1)
------- -------
Net deferred tax liability $(139.5) $ (42.5)
======= =======
As of December 31, 1997, the Company had net operating loss carryforwards
relating to certain of the Company's non-insurance operations of $31.6 million.
Utilization of these net operating losses is limited to use against future
profits in these non-insurance operations. Additionally, as of December 31,
1997, the Company had approximately $6.0 million of purchased net operating
loss carryforwards (relating to an acquisition in its insurance operations).
Utilization of these net operating loss carryforwards, which expire through
2006, is limited to use against future profits in a component of the Company's
insurance operations. The Company believes that it is more likely than not that
it will realize the benefits of its net deferred tax asset.
Income taxes paid (refunded) were ($4.2) million, $45.7 million and $43.2
million in 1997, 1996 and 1995, respectively.
47
7. Redeemable Convertible Preferred Stock
The Series A Redeemable Convertible Preferred Stock (the "Preferred Stock"),
with a $50 face value, has an annual cumulative cash dividend rate of $2.875
per share and is convertible into shares of Company Common Stock at a rate of
1.58385 for each share of such Preferred Stock. The Preferred Stock is
redeemable at the option of the Company anytime after March 24, 1998 provided
that the market value of the Company's Common Stock exceeds a specified amount.
The Preferred Stock may also be put to the Company by the holders of such
Preferred Stock after March 24, 2000, for a period of sixty days, at face value
plus cumulative unpaid dividends. Each share of Preferred Stock is entitled to
that number of votes equal the number of common shares into which it is
convertible. The difference between the face value of the Preferred Stock and
its fair value at the time of its issuance is being added to the carrying value
of the Preferred Stock ratably over a five year period by a direct charge to
retained earnings.
8. Retirement Plans
The Company maintains a noncontributory defined benefit pension plan (the
"Plan") covering its employees (except employees of Stein Roe and Colonial, who
participate in separate profit sharing plans, and except employees of
Independent). It is the Company's practice to fund amounts for the Plan
sufficient to meet the minimum requirements of the Employee Retirement Income
Security Act of 1974. Additional amounts are contributed from time to time when
deemed appropriate by the Company. Under the Plan, all employees are vested
after five years of service. Benefits are based on years of service, the
employee's average pay for the highest five consecutive years during the last
ten years of employment and the employee's estimated social security retirement
benefit. The Company also has an unfunded nonqualified Supplemental Pension
Plan ("Supplemental Plan"), collectively with the Plan, (the "Plans"), to
replace benefits lost due to limits imposed on Plan benefits under the Internal
Revenue Code. Plan assets consist of investments in certain Company-sponsored
mutual funds.
The following table sets forth the Plans' funded status (in millions) as of
December 31, 1997 and 1996.
December 31 1997 1996
..........................................................................................
Actuarial present value of benefit obligations:
Vested benefit obligations $ 19.8 $ 16.5
Accumulated benefit obligation 2.0 1.8
------- -------
$ 21.8 $ 18.3
======= =======
Projected benefit obligation $ 27.1 $ 23.4
Plan assets at fair value (14.7) (11.7)
------- -------
Projected benefit obligation in excess of the Plans' assets 12.4 11.7
Unrecognized net actuarial loss (2.0) (2.0)
Prior service cost not yet recognized in net periodic pension cost (2.2) (3.1)
------- -------
Accrued pension cost $ 8.2 $ 6.6
======= =======
Pension cost includes the following components (in millions):
Year Ended December 31 1997 1996 1995
...........................................................................
Service cost benefits earned during the period $ 1.6 $ 1.6 $ 1.3
Interest cost on projected benefit obligation 1.8 1.6 1.3
Actual return on Plan assets (1.7) (1.3) (1.7)
Net amortization and deferred amounts 1.2 1.1 1.5
----- ----- -----
Total net periodic pension cost $ 2.9 $ 3.0 $ 2.4
===== ===== =====
The assumptions used to develop the actuarial present value of the projected
benefit obligation, and the expected long-term rate of return on plan assets
are as follows:
48
Year Ended December 31 1997 1996 1995
...........................................................................
Discount rate 7.25% 7.50% 7.25%
Rate of increase in compensation level 5.00% 5.25% 5.25%
Expected long-term rate of return on assets 8.50% 8.50% 8.50%
The Company provides various other funded and unfunded defined contribution
plans, which include savings and investment plans, supplemental savings plans,
profit sharing plans, and supplemental profit sharing plans. Expenses related
to these defined contribution plans totaled $8.5 million, $7.6 million and $5.4
million in 1997, 1996 and 1995, respectively.
9. Stockholders' Equity
On December 10, 1997, the Company effected a three-for-two common stock split
in the form of a 50 percent stock dividend.
The Company has two stock-based compensation plans, the 1990 Stock Option Plan
(the "1990 Plan") and the 1995 Stock Incentive Plan (the "1995 Plan"). The 1990
Plan provided for grants of incentive and nonqualified stock options, which
were issued from 1990 through 1994. The 1995 Plan provides for grants of
incentive and nonqualified stock options, stock appreciation rights, nonvested
stock, unrestricted stock and performance shares, as well as cash and other
awards. To date, only stock options and nonvested stock have been granted under
the 1995 Plan. For any year, the Company may issue awards under the Plan
providing for the issuance of not more than two percent of the total number of
shares outstanding as of December 31 of the preceding year, subject to certain
adjustments and to certain carryovers for expired and forfeited awards. This
amount does not include 911,700 nonqualified options at prices ranging from
$0.67 to $21.00 that were assumed by the Company in connection with the
Colonial acquisition.
All options granted under the 1990 Plan were granted at a price not less than
the fair market value of the Company's Common Stock (determined by the
valuation provisions of the 1990 Plan). All options granted under the 1995 Plan
have been granted at the market price of the Company's Common Stock on the
grant date. All granted options provide for vesting in four equal annual
installments, beginning one year after the date of grant, and expire 10 years
after the grant date. Compensation expense associated with these option plans
was $0.9 million and $1.3 million in 1996 and 1995, respectively. There was no
such compensation expense in 1997.
In April 1997, the Company instituted a nonvested stock plan. The nonvested
shares issued to employees vest generally after the end of six years. Such
vesting date may accelerate if the Company achieves certain performance
targets. Upon termination, any unvested shares would be forfeited. The Company
recorded $0.4 million in compensation expense for the year ended December 31,
1997.
Pro forma information regarding net income and earnings per share is required
by SFAS 123, which also requires that the information be determined as if the
Company accounted for its employee stock options granted subsequent to December
31, 1994 under the fair value method of that Statement. As provided for under
SFAS 123, the fair value for these options was estimated using a Black-Scholes
option pricing model with the following assumptions: risk free interest rate
- --5.73% for 1997 and 6.26% for 1996 and 1995; dividend yield--1.25% for 1997
and 1.99% for 1996 and 1995; expected volatility of the market price of the
Company's Common Stock--19.1% for 1997 and 15.0% for 1996 and 1995; and the
weighted average life of the options--6 years for all three periods.
For pro forma disclosure purposes, the estimated fair value of the options is
amortized to expense over the options' vesting period. The Company's pro forma
information follows (in millions, except for earnings per share information):
Year Ended December 31 1997 1996 1995
........................................................................
Net income $127.1 $99.3 $73.6
Net income per share--basic 2.88 2.32 1.84
Net income per share--assuming dilution 2.73 2.21 1.75
Because SFAS 123 is applicable only to options granted subsequent to December
31, 1994, its pro forma effect will not be fully reflected until 1998.
49
A summary of the stock option activity, and related information for the years
ended December 31 follows (in thousands, except price data):
1997 1996 1995
------------------------ ---------------------- ---------------------
Options Weighted Options Weighted Options Weighted
Average Average Average
Exercise Exercise Exercise
Price Price Price
Outstanding--beginning of year 4,484 $ 12.49 4,133 $ 9.58 3,182 $ 7.97
Granted 699 28.67 918 22.00 722 17.17
Assumed -- -- -- -- 912 6.83
Exercised for shares (1,027) (7.56) (489) (4.81) (150) (4.53)
Forfeited or cashed out (118) (20.74) (78) (17.95) (533) (7.11)
------ -------- ------ -------- ------ -------
Outstanding--end of year 4,038 $ 16.31 4,484 $ 12.49 4,133 $ 9.58
====== ======== ====== ======== ====== =======
Exercisable--end of year 2,346 $ 11.11 2,709 $ 8.60 2,591 $ 7.25
====== ======== ====== ======== ====== =======
Weighted-average fair value of options
granted during year $ 8.15 $ 5.31 $ 4.16
====== ====== ======
Exercise prices for options outstanding as of December 31, 1997 ranged from
$0.67 to $37.08. The weighted-average remaining contractual life of these
options is 6.79 years.
10. Net Income per Share
The following table sets forth the computation of net income per share--basic
and net income per share--assuming dilution:
1997 1996 1995
...........................................................................................................
Numerator:
Net income $ 129.5 $ 100.7 $ 73.9
Preferred stock dividends (0.9) (0.9) (0.7)
----------- ----------- -----------
Numerator for net income per share--basic--income available to
common stockholders 128.6 99.8 73.2
Effect of dilutive securities:
Preferred stock dividends 0.9 0.9 0.7
----------- ----------- -----------
0.9 0.9 0.7
----------- ----------- -----------
Numerator for net income per share--assuming dilution--income
available to common stockholders after assumed conversions $ 129.5 $ 100.7 $ 73.9
Denominator:
Denominator for net income per share--basic--weighted-average
shares 43,808,904 42,353,927 39,645,722
Effect of dilutive securities:
Employee stock options 2,403,729 2,115,125 1,897,842
Convertible preferred stock 518,081 519,012 401,316
----------- ----------- -----------
Dilutive potential common shares 2,921,810 2,634,137 2,299,158
Denominator for net income per share--assuming dilution--
adjusted weighted-average shares and assumed conversions 46,730,714 44,988,064 41,944,880
=========== =========== ===========
Net income per share--basic $2.94 $2.36 $1.85
=========== =========== ===========
Net income per share--assuming dilution $2.77 $2.24 $1.76
=========== =========== ===========
50
11. Fair Value of Financial Instruments
The following discussion outlines the methodologies and assumptions used to
determine the fair value of the Company's financial instruments. The aggregate
fair value amounts presented herein do not necessarily represent the underlying
value of the Company, and accordingly, care should be exercised in deriving
conclusions about the Company's business or financial condition based on the
fair value information presented herein.
The following methods and assumptions were used by the Company in determining
fair values of financial instruments:
Fixed maturities and equity securities: Fair values for fixed maturity
securities are based on quoted market prices, where available. For fixed
maturities not actively traded, the estimated fair values are determined using
values from independent pricing services, or, in the case of private
placements, are determined by discounting expected future cash flows using a
current market rate applicable to the yield, credit quality, and maturity of
the securities. The estimated fair values for equity securities are based on
quoted market prices.
Mortgage loans: The estimated fair value of mortgage loans are determined by
discounting future cash flows to the present at current market rates, using
expected prepayment rates.
Other invested assets, Cash: With the exception of call options, the carrying
value for assets classified as other invested assets and cash in the
accompanying balance sheets approximates their fair value. Fair values for call
options are based on quoted market prices.
Policy liabilities: Deferred annuity contracts are assigned fair value equal to
current net surrender value. Annuitized contracts are valued based on the
present value of the future cash flows at current pricing rates.
Notes payable to affiliates, Revolving credit facility: Fair values for debt
are estimated using discounted cash flow analyses based on the Company's
incremental borrowing rate for similar types of borrowing arrangements.
The fair values and carrying values of the Company's financial instruments are
as follows (in millions):
1997 1996
------------------------------- ------------------------------
Carrying Fair Carrying Fair
December 31 Value Value Value Value
...................................................................................................
Assets:
Fixed maturity securities $11,246.5 $11,246.5 $10,718.6 $10,718.6
Equity securities 40.8 40.8 35.9 35.9
Mortgage loans 60.7 63.0 67.0 73.4
Other invested assets 440.8 462.7 183.6 196.3
Cash and cash equivalents 1,290.1 1,290.1 875.8 875.8
Liabilities:
Policy liabilities 12,086.1 11,366.5 11,637.5 11,127.4
Notes payable to affiliates 229.0 229.0 229.0 229.0
Revolving credit facility 26.5 26.5 52.5 52.5
12. Industry Segment Information
The Company's operations are classified in two business segments: annuity and
asset management. Annuity operations relate principally to the issuance of
fixed, indexed and variable annuity products and a closed block of
investment-oriented life insurance products. Asset management includes mutual
funds, wealth management and institutional asset management. Information by
industry segment for 1997, 1996 and 1995 is shown below (in millions):
51
Year Ended December 31 1997 1996 1995
......................................................................................
Statement of Operations Data
Revenues:
Annuity:
Unaffiliated $ 922.4 $ 840.8 $ 790.1
Intersegment (9.3) (8.6) (7.7)
-------- -------- --------
Total annuity 913.1 832.2 782.4
-------- -------- --------
Asset management:
Unaffiliated 324.6 299.5 219.8
Intersegment 9.3 8.6 7.7
-------- -------- --------
Total asset management 333.9 308.1 227.5
-------- -------- --------
Total revenues $1,247.0 $1,140.3 $1,009.9
======== ======== ========
Income before income taxes:
Annuity:
Income before amortization of intangible assets $ 167.8 $ 132.6 $ 101.6
Amortization of intangible assets (1.1) (1.1) (1.2)
-------- -------- --------
Subtotal annuity 166.7 131.5 100.4
-------- -------- --------
Asset management:
Income before amortization of intangible assets 81.7 71.5 55.4
Amortization of intangible assets (12.2) (14.1) (10.8)
-------- -------- --------
Subtotal asset management 69.5 57.4 44.6
-------- -------- --------
Corporate:
Income before amortization of intangible assets (43.9) (38.4) (31.0)
Amortization of intangible assets (0.2) (0.2) (0.2)
-------- -------- --------
Subtotal corporate (44.1) (38.6) (31.2)
-------- -------- --------
Total income before income taxes $ 192.1 $ 150.3 $ 113.8
======== ======== ========
December 31 1997 1996 1995
......................................................................
Balance Sheet Data
Identifiable Assets:
Annuity $15,342.2 $13,924.6 $12,279.2
Asset management 477.1 484.0 469.3
Corporate 34.0 22.0 17.2
Intercompany eliminations (1.7) (2.9) (16.3)
----------- --------- ---------
Total $15,851.6 $14,427.7 $12,749.4
========= ========= =========
52
13. Quarterly Financial Data, in Millions, Except Per Share Amounts (unaudited)
March June September December
Quarter Ended 1997 31 30 30 31
...............................................................................................................
Investment income $ 208.0 $ 212.2 $ 212.0 $ 220.9
Interest credited to policyholders (147.3) (147.2) (150.9) (148.7)
-------- -------- -------- ---------
Investment spread 60.7 65.0 61.1 72.2
Net realized investment gains 12.9 3.1 6.1 3.8
Fee income 89.4 89.1 95.2 94.3
Pretax income 51.8 43.9 47.8 48.6
Net income 35.0 30.0 32.9 31.6
Net income per share--basic 0.80 0.68 0.74 0.71
Net income per share--assuming dilution 0.76 0.65 0.70 0.67
March June September December
Quarter Ended 1996 31 30 30 31
...............................................................................................................
Investment income $ 189.2 $ 189.8 $ 201.7 $ 215.7
Interest credited to policyholders (138.1) (136.2) (146.0) (152.4)
--------- --------- -------- ---------
Investment spread 51.1 53.6 55.7 63.3
Net realized investment gains (losses) 3.8 (1.7) 0.7 5.2
Fee income 78.6 83.7 85.9 87.7
Pretax income 36.3 34.0 36.4 43.6
Net income 23.8 23.1 24.7 29.1
Net income per share--basic 0.57 0.54 0.57 0.67
Net income per share--assuming dilution 0.54 0.51 0.55 0.64
The 1996 and first three quarters of 1997 earnings per share amounts have been
restated to comply with Statement of Financial Accounting Standards No. 128,
"Earnings per Share."
14. Statutory Information
Keyport is domiciled in Rhode Island and prepares its statutory financial
statements in accordance with accounting principles and practices prescribed or
permitted by the State of Rhode Island Insurance Department. Statutory surplus
and statutory net income differ from shareholders' equity and net income
reported in accordance with GAAP primarily because policy acquisition costs are
expensed when incurred, policy liabilities are based on different assumptions,
and income tax expense reflects only taxes paid or currently payable. Keyport's
statutory surplus and net income are as follows:
Year Ended December 31 1997 1996 1995
..........................................................
Statutory surplus $702.6 $567.7 $535.2
Statutory net income 107.1 40.2 38.3
15. Transactions with Affiliated Companies
Liberty Mutual from time to time provides management, legal, audit and
financial services to the Company. Reimbursements to Liberty Mutual for these
services totaled $0.7 million, $0.6 million and $0.9 million in 1997, 1996 and
1995, respectively. These reimbursements are based on direct and indirect costs
incurred by Liberty Mutual and are allocated to the Company primarily based
upon the amount of time spent by Liberty Mutual's employees on the Company's
behalf. The Company believes that this allocation methodology is reasonable.
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The Company provided asset management services to real estate limited
partnerships in 1995 for which an affiliate of Liberty Mutual served as the
general partner. The affiliate paid the Company fees for such services which
totaled $6.7 million in 1995. These limited partnerships were liquidated in
1995.
During 1996, the Company sold to a wholly owned subsidiary of Liberty Mutual a
wholly owned subsidiary which had provided real estate management services to
certain affiliates of Liberty Mutual. The sales price was $2.1 million, the net
book value of the transferred subsidiary.
Regulatory authorities permit dividend payments from Keyport to the Company up
to the lesser of (i) 10% of statutory surplus as of the preceding December 31
or (ii) the net gain from operations for the preceding fiscal year. As of
December 31, 1997, Keyport could pay dividends of up to $70.3 million without
the approval of the Commissioner of Insurance of the State of Rhode Island.
16. Commitments and Contingencies
Leases: The Company leases data processing equipment, furniture and certain
office facilities from others under operating leases expiring in various years
through 2009. Rental expense amounted to $15.0 million, $16.0 million and $14.7
million for the years ended December 31, 1997, 1996 and 1995, respectively. For
each of the next five years, and in the aggregate, as of December 31, 1997, the
following are the minimum future rental payments under noncancelable operating
leases having remaining terms in excess of one year (in millions):
Year Payments
.........................................
1998 $14.3
1999 14.4
2000 14.2
2001 14.7
2002 10.1
Thereafter 29.5
Legal Matters: The Company is involved at various times in litigation common to
its business. In the opinion of management, the resolution of any such
litigation is not expected to have a material adverse effect on the Company's
financial condition, results of operations or cash flows.
Regulatory Matters: Under existing guaranty fund laws in all states, insurers
licensed to do business in those states can be assessed for certain obligations
of insolvent insurance companies to policyholders and claimants. The actual
amount of such assessments will depend upon the final outcome of rehabilitation
proceedings and will be paid over several years. In 1997, 1996 and 1995,
Keyport was assessed $5.9 million, $10.0 million and $8.1 million,
respectively. During 1997, 1996 and 1995, Keyport recorded $1.0 million, $1.0
million and $2.0 million, respectively, of provisions for state guaranty fund
association expense. At December 31, 1997 and 1996, the reserve for such
assessments was $8.0 million and $12.9 million, respectively.
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Report of Independent Auditors
[Logo] Ernest & Young LLP
Shareholders and Board of Directors
Liberty Financial Companies, Inc.
We have audited the accompanying consolidated balance sheets of Liberty
Financial Companies, Inc. as of December 31, 1997 and 1996, and the related
consolidated statements of income, stockholders' equity, and cash flows for the
years then ended. 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. The financial statements of Liberty
Financial Companies, Inc. for the year ended December 31, 1995 were audited by
other auditors whose report dated February 16, 1996, expressed an unqualified
opinion on the statements.
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 the 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 1997 and 1996 financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Liberty Financial Companies, Inc. at December 31, 1997 and 1996, and the
consolidated results of its operations and its cash flows for the years then
ended in conformity with generally accepted accounting principles.
[Signature of Ernest & Young LLP]
Boston, Massachusetts
February 3, 1998
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