Selected Financial Data
SELECTED CONSOLIDATED FINANCIAL DATA(1)
(IN MILLIONS, EXCEPT PER SHARE DATA)
AS OF OR FOR THE YEAR ENDED DECEMBER 31 1998 1997 1996 1995 1994
- --------------------------------------------------------------------------------------------------------------------------
Income Statement Data
Investment income $ 820.9 $ 853.1 $ 796.4 $ 761.8 $ 695.1
Interest credited to policyholders (562.2) (594.1) (572.7) (555.8) (481.9)
- --------------------------------------------------------------------------------------------------------------------------
Investment spread 258.7 259.0 223.7 206.0 213.2
- --------------------------------------------------------------------------------------------------------------------------
Net realized investment gains (losses) 2.4 25.9 8.0 (4.0) (8.2)
- --------------------------------------------------------------------------------------------------------------------------
Fee income:
Investment advisory and administrative fees 237.7 217.9 196.4 155.8 95.9
Distribution and service fees 52.7 49.2 44.9 28.9 --
Transfer agency fees 49.0 47.7 43.9 30.8 4.0
Surrender charges and net commissions 33.7 36.1 34.7 23.4 20.0
Separate account fees 20.6 17.1 16.0 13.2 12.5
- --------------------------------------------------------------------------------------------------------------------------
Total fee income 393.7 368.0 335.9 252.1 132.4
- --------------------------------------------------------------------------------------------------------------------------
Expenses:
Operating expenses (328.2) (309.7) (277.9) (225.1) (174.9)
Amortization of deferred policy acquisition costs (69.2) (75.9) (60.2) (58.5) (52.2)
Amortization of deferred distribution costs (40.1) (34.2) (33.9) (18.8) --
Amortization of value of insurance in force (8.2) (10.5) (10.2) (9.5) (17.0)
Amortization of intangible assets (15.3) (13.5) (15.4) (12.2) (5.8)
Interest expense, net (14.9) (17.0) (19.7) (16.2) (4.2)
- --------------------------------------------------------------------------------------------------------------------------
Total expenses (475.9) (460.8) (417.3) (340.3) (254.1)
- --------------------------------------------------------------------------------------------------------------------------
Pretax income 178.9 192.1 150.3 113.8 83.3
Income tax expense (54.4) (62.6) (49.6) (39.9) (32.5)
- --------------------------------------------------------------------------------------------------------------------------
Income before extraordinary item 124.5 129.5 100.7 73.9 50.8
Extraordinary loss on extinguishment of
debt, net of tax (9.7) -- -- -- --
- --------------------------------------------------------------------------------------------------------------------------
Net income $ 114.8 $ 129.5 $ 100.7 $ 73.9 $ 50.8
==========================================================================================================================
Per Share Data(2)
Net income per share--basic $ 2.51 $ 2.94 $ 2.36 $ 1.85 $ 1.49
Net income per share--assuming dilution 2.42 2.77 2.24 1.76 1.43
Dividends on common stock(3) 0.40 0.40 0.40 0.30 --
Dividends on convertible preferred stock 2.88 2.88 2.88 2.21 --
Book value 27.41 26.82 24.42 23.03 18.25
Other Operating Data
Net operating income(4) $ 122.6 $ 112.4 $ 94.8 $ 76.5 $ 56.2
Extraordinary loss on extinguishment of debt,
net of tax (9.7) -- -- -- --
Net realized investment gains (losses), net of taxes 1.9 17.1 5.9 (2.6) (5.4)
- --------------------------------------------------------------------------------------------------------------------------
Net income $ 114.8 $ 129.5 $ 100.7 $ 73.9 $ 50.8
==========================================================================================================================
Balance Sheet Data
Total investments $ 12,598.3 $ 12,343.5 $ 11,537.9 $ 10,144.7 $ 8,590.2
Intangible assets 292.8 199.0 205.4 192.3 29.3
Total assets 16,519.1 15,851.6 14,427.7 12,749.4 10,968.8
Notes payable to affiliates -- 229.0 229.0 229.0 75.0
Notes payable 486.4 26.5 52.5 61.0 --
Series A redeemable convertible preferred stock 15.3 14.6 13.8 13.0 --
Stockholders' equity 1,271.3 1,198.9 1,051.4 956.4 624.7
Shares of common stock outstanding(2) 46.4 44.7 43.1 41.5 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). 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 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.
3 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.
4 Net operating income is defined as net income, excluding extraordinary items
and net realized investment gains and losses, net of related income taxes.
27
Management's Discussion
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION
RESULTS OF OPERATIONS
Net Income was $114.8 million or $2.42 per share in 1998 compared to $129.5
million or $2.77 per share in 1997 and $100.7 million or $2.24 per share in
1996. The decrease in 1998 compared to 1997 resulted primarily from lower net
realized investment gains and higher operating expenses. Partially offsetting
these items were increased fee income and decreased amortization expense,
interest expense, net and income tax expense. In addition, net income for 1998
included an extraordinary loss on extinguishment of debt, net of tax, of $9.7
million. The increase in 1997 compared to 1996 resulted primarily 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.
Pretax Income was $178.9 million in 1998 compared to $192.1 million in
1997 and $150.3 million in 1996. The lower pretax income in 1998 compared to
1997 resulted primarily from lower net realized investment gains and higher
operating expenses. Partially offsetting these items were increased fee income
and decreased amortization expense and interest expense, net. The higher pretax
income in 1997 compared to 1996 resulted primarily 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.
Investment Spread is the amount by which investment income earned on the
Company's investments exceeds interest credited on policyholder balances.
Investment spread was $258.7 million in 1998 compared to $259.0 million in 1997
and $223.7 million in 1996. The amount by which the average yield on investments
exceeds the average interest credited rate on policyholder balances is the
investment spread percentage. The investment spread percentage in 1998 was 1.83%
compared to 1.96% for 1997 and 1.89% for 1996.
Investment income was $820.9 million in 1998 compared to $853.1 million in
1997 and $796.4 million in 1996. The decrease of $32.2 million in 1998 compared
to 1997 primarily relates to a $66.0 million decrease as a result of a lower
average investment yield, partially offset by a $33.8 million increase resulting
from a higher level of average invested assets. The 1998 investment income was
net of $70.8 million of S&P 500 Index call option amortization expense related
to the Company's equity-indexed annuities compared to $47.6 million in 1997. The
average investment yield was 6.41% in 1998 compared to 6.95% in 1997. 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 1996 investment income was net of $14.0 million of S&P 500
Index call option amortization expense. The average investment yield was 7.21%
in 1996.
Interest credited to policyholders totaled $562.2 million in 1998 compared
to $594.1 million in 1997 and $572.7 million in 1996. The decrease of $31.9
million in 1998 compared to 1997 primarily relates to a $48.6 million decrease
resulting from a lower average interest credited rate, partially offset by a
$16.8 million increase as a result of a higher level of average policyholder
balances. Policyholder balances averaged $12.3 billion (including $10.5 billion
of fixed products, consisting of fixed annuities and a closed block of single
premium whole life insurance, and $1.8
28
billion of equity-indexed annuities) in 1998 compared to $11.9 billion
(including $10.8 billion of fixed products and $1.1 billion of equity-indexed
annuities) in 1997. The average interest credited rate was 4.58% (5.23% on
fixed products and 0.85% on equity-indexed annuities) in 1998 compared to 4.99%
(5.45% on fixed products and 0.85% on equity-indexed annuities) in 1997.
Keyport's equity-indexed annuities credit interest to the policyholder at a
"participation rate" equal to a portion (ranging for existing policies from 25%
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 and
futures, resulting in a 0.85% net credited rate. 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 $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 5.32% (5.50% on fixed products and 0.85% on
equity-indexed annuities) in 1996.
Average investments in the Company's general account (computed without
giving effect to Statement of Financial Accounting Standards No. 115),
including a portion of the Company's cash and cash equivalents, were $12.8
billion in 1998 compared to $12.3 billion in 1997 and $11.0 billion in 1996.
The increase of $0.5 billion in 1998 compared to 1997 was primarily due to the
reinvestment of portfolio earnings. 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 the reinvestment of portfolio
earnings of $0.7 billion.
Net Realized Investment Gains were $2.4 million in 1998 compared to $25.9
million in 1997 and $8.0 million in 1996. The net realized investment gains in
1998 were net of losses of $28.3 million for certain fixed maturity investments
where the decline in value was determined to be other than temporary.
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 $237.7 million in
1998 compared to $217.9 million in 1997 and $196.4 million in 1996. These
increases primarily reflect a higher level of average fee-based assets under
management.
Average fee-based assets under management were $41.9 billion in 1998
compared to $37.2 billion in 1997 and $33.9 billion in 1996. The increase
during 1998 compared to 1997 resulted from acquisitions, market appreciation
and net sales for the year ended December 31, 1998. The increase during 1997
compared to 1996 was primarily due to market appreciation. Investment advisory
and administrative fees were 0.57% of average fee-based assets under management
in 1998, 0.59% in 1997 and 0.58% in 1996.
The amount of fee-based assets under management are affected by product
sales and redemptions, acquisitions, 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).
29
Fee-Based Assets Under Management
As of December 31
------------------------------
1998 1997 1996
- -------------------------------------------------------------------------
Mutual Funds:
Intermediary-distributed $ 17.9 $ 16.1 $ 16.1
Direct-marketed 6.8 7.2 6.6
Closed-end 2.4 2.2 1.9
Variable annuity 1.5 1.3 1.1
- -------------------------------------------------------------------------
28.6 26.8 25.7
Private Capital Management 7.9 6.6 5.3
Institutional 11.4 5.3 4.9
- -------------------------------------------------------------------------
Total fee-based assets under management* $ 47.9 $ 38.7 $ 35.9
=========================================================================
* As of December 31, 1998, 1997 and 1996, Keyport's insurance assets of $13.1
billion, $12.8 billion and $12.1 billion, respectively, bring total assets
under management to $61.0 billion, $51.5 billion and $48.0 billion,
respectively.
Changes in Fee-Based Assets Under Management
Year Ended December 31
--------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------
Fee-based assets under management--beginning $ 38.7 $ 35.9 $ 31.9
Sales and reinvestments 8.5 6.6 7.5
Redemptions and withdrawals ( 6.8) ( 6.6) ( 5.7)
Acquisitions 5.4 -- 0.3
Market appreciation 2.1 2.8 1.9
- -------------------------------------------------------------------------------
Fee-based assets under management--ending $ 47.9 $ 38.7 $ 35.9
===============================================================================
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 12b-1
distribution fees and 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 $52.7 million in
1998 compared to $49.2 million in 1997 and $44.9 million in 1996. These
increases in 1998 and 1997 were primarily attributable to the higher asset
levels of mutual funds with 12b-1 distribution fees and contingent deferred
sales charges. As a percentage of weighted average assets, distribution and
service fees were approximately 0.71% in 1998, 0.71% in 1997 and 0.69% in 1996.
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 $49.0 million on average assets of $24.9 billion in 1998, $47.7 million on
average assets of $24.1 billion in 1997 and $43.9 million on average assets of
$22.6 billion in 1996. These increases in 1998 and 1997 were primarily due to
higher average assets. As a percentage of total average mutual fund assets
under management, transfer agency fees were approximately 0.20%, 0.20% and
0.19% in 1998, 1997 and 1996, respectively.
30
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 12b-1 distribution
fees and 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 $33.7 million in 1998 compared to
$36.1 million in 1997 and $34.7 million in 1996.
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 $21.9 million, $21.4
million and $19.8 million in 1998, 1997 and 1996, respectively. Total annuity
withdrawals represented 13.2%, 11.6% and 11.6% of the total average annuity
policyholder and separate account balances in 1998, 1997 and 1996,
respectively. Net commissions were $11.8 million in 1998, $14.7 million in 1997
and $14.9 million in 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 $20.6 million in 1998 compared to $17.1 million in 1997 and
$16.0 million in 1996. Such fees represented 1.44%, 1.54% and 1.68% of average
variable annuity and variable life separate account balances in 1998, 1997 and
1996, respectively.
Operating Expenses primarily represent compensation, marketing and other
general and administrative expenses. These expenses were $328.2 million in 1998
compared to $309.7 million in 1997 and $277.9 million in 1996. These increases
were primarily due to increases in compensation and marketing expenses.
Operating expenses expressed as a percent of average total assets under
management were 0.60%, 0.63% and 0.62% in 1998, 1997 and 1996, respectively.
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 $69.2
million in 1998 compared to $75.9 million in 1997 and $60.2 million in 1996.
The decrease in amortization in 1998 compared to 1997 was primarily related to
revisions in investment spread assumptions, partially offset by increased
amortization from the growth of business in force associated with increased
sales of variable annuity products during 1998. The increase in amortization in
1997 compared to 1996 was 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 during 1997.
Amortization expense represented 24.8%, 27.5% and 25.1% of investment spread
and separate account fees in 1998, 1997 and 1996, respectively.
Amortization of Deferred Distribution Costs relates to the distribution of
mutual fund shares sold with 12b-1 distribution fees and contingent deferred
sales charges. Amortization was $40.1 million in 1998 compared to $34.2 million
in 1997 and $33.9 million in 1996. The increase in amortization in 1998
compared to 1997 was primarily attributable to the continuing sales of such
fund shares during 1998 and 1997. The increase in amortization in 1997
31
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.
Amortization of Value of 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 $8.2 million
in 1998 compared to $10.5 million in 1997 and $10.2 million in 1996. The
decrease in amortization in 1998 compared to 1997 was primarily due to lower
amortization related to the F&G Life block of SPDAs. The increase in
amortization in 1997 compared to 1996 included increased amortization of $4.0
million related to the F&G Life block of SPDAs partially offset by decreased
amortization related to a change in mortality assumptions.
Amortization of Intangible Assets relates to goodwill and certain
identifiable intangible assets arising from business combinations accounted for
as purchases. Amortization was $15.3 million in 1998 compared to $13.5 million
in 1997 and $15.4 million in 1996. The increase in amortization in 1998
compared to 1997 was primarily attributable to acquisitions during 1998. The
decrease in amortization in 1997 compared to 1996 was primarily attributable to
certain assets becoming fully amortized in the third quarter of 1996.
Interest Expense, Net was $14.9 million in 1998 compared to $17.0 million
in 1997 and $19.7 million in 1996. The decrease in 1998 compared to 1997 was
due largely to higher interest income, which is netted against interest
expense, and lower interest expense related to Colonial's revolving credit
facility which is utilized to finance deferred sales commissions paid in
connection with the distribution of mutual fund shares sold with 12b-1
distribution fees and contingent deferred sales charges. Partially offsetting
these items was higher interest expense on debt. The decrease in 1997 compared
to 1996 was due to lower interest expense related to Colonial's credit facility
and to higher interest income which is netted against interest expense.
Income Tax Expense was $54.4 million or 30.4% of pretax income in 1998
compared to $62.6 million or 32.6% of pretax income in 1997 and $49.6 million
or 33.0% of pretax income in 1996. The Company expects its effective tax rate
on pretax income in 1999 to approximate 38.5%. The significantly lower
effective tax rates on pretax income in 1998, 1997 and 1996 were primarily
attributable to reductions in the deferred tax asset valuation allowance on
federal net operating loss carryforwards. At December 31, 1998, the valuation
allowance on federal net operating loss carryforwards has been reduced to zero.
FINANCIAL CONDITION
Stockholders' Equity as of December 31, 1998 was $1.27 billion compared to
$1.20 billion as of December 31, 1997. Net income in 1998 was $114.8 million
and cash dividends on the Company's preferred and common stock totaled $5.9
million. Common stock totaling $8.9 million was issued in connection with the
acquisition of Crabbe Huson and common stock totaling $7.3 million was issued
in connection with the exercise of stock options. In addition, the exercise of
certain stock options resulted in a federal income tax benefit to the Company
of $2.5 million which was credited to additional paid-in capital. A decrease in
accumulated other comprehensive income which consists of net unrealized
investment gains, net of adjustments to deferred policy acquisition costs,
value of insurance in force and income taxes, during the period decreased
stockholders' equity by $55.8 million.
Book Value Per Share amounted to $27.41 at December 31, 1998 compared to
$26.82 at December 31, 1997. Excluding net unrealized gains on investments,
book value per share amounted to $26.82 at December 31, 1998 and
32
$24.97 at December 31, 1997. As of December 31, 1998, there were 46.4 million
common shares outstanding compared to 44.7 million common shares outstanding as
of December 31, 1997.
Investments not including cash and cash equivalents, totaled $12.6 billion
at December 31, 1998 compared to $12.3 billion at December 31, 1997. The
increase primarily reflects the reinvestment of portfolio earnings.
The Company manages the majority of its invested assets internally. The
Company's general investment policy is to hold fixed maturity securities 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 portfolio of fixed maturity
securities as "available for sale" and accordingly carries such investments at
fair value. The Company's total investments at December 31, 1998 and 1997
reflected net unrealized gains of $105.3 million and $283.8 million,
respectively, relating to its fixed maturity and equity portfolios.
Approximately $11.3 billion or 84.9% of the Company's general account
investments at December 31, 1998 were 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, 1998, the carrying value of investments in below investment grade
securities totaled $1.1 billion or 8.1% of general account investments of $13.3
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.
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. 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 maturity securities, management also considers market value quotations if
available. As of December 31, 1998, the carrying value of fixed maturity
securities that were non-income producing was $30.0 million, which constituted
0.2% of investments.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market-Sensitive Instruments and Risk Management
Market risk is the risk that the Company will incur losses due to adverse
changes in market rates and prices. The Company's primary market risk exposures
are to changes in interest rates and to changes in equity prices.
The active management of market risk is integral to the Company's
operations. The Company may use the following approaches to manage its exposure
to market risk within defined tolerance ranges: rebalance its existing asset
and liability portfolios, change the character of future investment purchases,
or use derivative instruments to modify the market risk characteristics of
existing assets and liabilities or assets expected to be purchased.
33
Corporate Oversight
The Company generates substantial investable funds from its annuity operations.
The Company believes that its fixed and indexed policyholder balances should be
backed by investments, principally comprised of fixed maturities, which
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. The Company's portfolio
strategy is designed to achieve acceptable risk-adjusted returns by effectively
managing portfolio liquidity and credit quality.
The Company administers and oversees the investment risk management
processes primarily through its Investment Committee and its Board of
Directors. The Investment Committee and Board of Directors provide executive
oversight of investment activities. The Investment Committee is a committee
consisting of the Chief Executive Officer and other members of senior
management of the Company. The Investment Committee meets monthly to provide
detailed oversight of investment risk, including market risk.
The Company has investment guidelines that define the overall framework
for managing market and other investment risks, including the accountability
and control over these activities. In addition, the Company has specific
investment policies that delineate the investment limits and strategies that
are appropriate given the Company's liquidity, product and regulatory
requirements.
The Company monitors and manages its exposure to market risk through asset
allocation limits, duration limits, and stress tests. Asset allocation limits
place restrictions on the aggregate fair value which may be invested within an
asset class. Duration limits on the aggregate investment portfolio, and, as
appropriate, on individual components of the portfolio, place restrictions on
the amount of interest rate risk that may be taken. Stress tests measure
downside risk to fair value and earnings over longer time intervals and for
adverse market scenarios.
The day-to-day management of market risk within defined tolerance ranges
occurs as portfolio managers buy and sell within their respective markets based
upon the acceptable boundaries established by asset allocation, duration and
other limits, including but not limited to credit and liquidity.
Interest Rate Risk
Interest rate risk is the risk that the Company will incur economic losses due
to adverse changes in interest rates. This risk arises from the Company's
primary activities, as the Company invests substantial funds in
interest-sensitive assets and also has interest-sensitive liabilities. The
Company's asset/liability management emphasizes a conservative approach, which
is oriented toward reducing downside risk in adverse markets, as opposed to
maximizing spread in favorable markets.
The Company manages the interest rate risk inherent in its assets relative
to the interest rate risk inherent in its liabilities. One of the measures the
Company uses to quantify this exposure is effective duration. Effective
duration is a common measure for the price sensitivity of assets and
liabilities to changes in interest rates. It measures the approximate
percentage change in the market value of assets and liabilities when interest
rates change by 100 basis points. This measure includes the impact of estimated
changes in portfolio cash flows from features such as prepayments and bond
calls. The effective duration of assets and related liabilities are produced
using standard financial valuation techniques. At December 31, 1998, the
estimated difference between the Company's asset and
34
liability duration was approximately 1.2. This positive duration gap indicates
that the fair value of the Company's assets is somewhat more sensitive to
interest rate movements than the fair value of its liabilities.
The Company seeks to invest premiums and deposits to create future cash
flows that will fund future benefits, claims, and expenses, and earn stable
margins across a wide variety of interest rate and economic scenarios. In order
to achieve this objective and limit its exposure to interest rate risk, the
Company adheres to a philosophy of managing the effective duration of assets and
related liabilities. The Company uses interest rate swaps, futures and caps to
reduce the interest rate risk resulting from effective duration mismatches
between assets and liabilities. To the extent that actual results differ from
the assumptions utilized, the Company's effective duration could be
significantly impacted. Important assumptions include the timing of cashflows on
mortgage-related assets and liabilities subject to policyholder surrenders.
Additionally, the Company's calculation assumes that the current relationship
between short-term and long-term interest rates (the term structure of interest
rates) will remain constant over time. As a result, these calculations may not
fully capture the impact of non-parallel changes in the term structure of
interest rates and/or large changes in interest rates.
The Company's potential exposure due to a 10% increase in prevailing
interest rates from their December 31, 1998 levels is a loss of $87.0 million
in fair value of its fixed-rate assets that is not offset by a decrease in the
fair value of its fixed-rate liabilities. Because the Company actively manages
its assets and liabilities and has strategies in place to minimize its exposure
to loss as interest rate changes occur, it expects that actual losses would be
less than the estimated potential loss.
Equity Price Risk
Equity price risk is the risk that the Company will incur economic losses due
to adverse changes in a particular stock or stock index. At December 31, 1998,
the Company had approximately $24.6 million in common stocks and $535.1 million
in other equity investments (primarily equity options and equity futures).
At December 31, 1998, the Company had $2.0 billion in equity-indexed
annuity liabilities which provide customers with contractually guaranteed
participation in price appreciation of the Standard & Poor's 500 Composite
Price Index ("S&P 500 Index"). The Company purchases equity-indexed options and
futures to hedge the risk associated with the price appreciation component of
equity-indexed annuity liabilities.
The Company manages the equity risk inherent in its assets relative to the
equity risk inherent in its liabilities by conducting detailed computer
simulations that model its S&P 500 Index derivatives and its equity-indexed
annuity liabilities under stress-test scenarios in which both the index level
and the index option implied volatility are varied through a wide range.
Implied volatility is a value derived from standard option valuation models
representing an implicit forecast of the standard deviation of the returns on
the underlying asset over the life of the option or future. The fair values of
S&P 500 Index linked securities, derivatives, and annuities are produced using
standard derivative valuation techniques. The derivatives portfolio is
constructed to maintain acceptable interest margins under a variety of possible
future S&P 500 Index levels and option and futures cost environments. In order
to achieve this objective and limit its exposure to equity price risk, the
Company measures and manages these exposures using methods based on the fair
value of assets and the price appreciation component of related liabilities.
The Company uses derivatives, including futures and options, to modify its net
exposure to fluctuations in the S&P 500 Index.
35
Based upon the information and assumptions the Company uses in its
stress-test scenarios at December 31, 1998, management estimates that if the
S&P 500 Index increases by 10%, the net fair value of its assets and
liabilities described above would decrease by approximately $2.0 million. If
option implied volatilities increase by 100 basis points, management estimates
that the net fair value of its assets and liabilities will decrease by
approximately $6.0 million.
The simulations do not consider the effects of other changes in market
conditions that could accompany changes in the equity option and futures
markets including the effects of changes in implied dividend yields, interest
rates, and equity-indexed annuity policy surrenders.
DERIVATIVES
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.
Interest rate 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 interest rate swap agreements to reduce asset duration and
to better match interest earned on longer-term fixed-rate assets with interest
credited to policyholders. The Company had 42 and 45 outstanding interest rate
swap agreements with an aggregate notional principal amount of $2.4 billion and
$2.6 billion as of December 31, 1998 and 1997, respectively.
Interest rate 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 as of
December 31, 1998 and 1997.
With respect to the Company's equity-indexed annuities, the Company buys
call options and futures on the S&P 500 Index to hedge its obligations to
provide returns based upon this index. The Company had call options with a
carrying value of $535.7 million and $323.3 million as of December 31, 1998 and
1997, respectively. The Company had futures with a carrying value of $(0.6)
million and $0.8 million as of December 31, 1998, and 1997, 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 non-performance. 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. Futures contracts trade on organized exchanges
and therefore, have minimal credit risk. In addition, swap and cap agreements
have interest rate risk and call options and futures 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 and futures 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
36
of S&P 500 Index call options and futures 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. The Company'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 and futures increase less
than (or decrease more than) the value of the guarantees made to equity-indexed
policyholders.
In June 1998, Statement of Financial Accounting Standards No. 133
"Accounting for Derivative Instruments and Hedging Activities" was issued. This
statement standardizes the accounting for derivative instruments and the
derivative portion of certain other contracts that have similar characteristics
by requiring that an entity recognize those instruments on the balance sheet at
fair value. This statement also requires a new method of accounting for hedging
transactions, prescribes the type of items and transactions that may be hedged,
and specifies detailed criteria to be met to qualify for hedge accounting. This
statement is effective for fiscal years beginning after June 15, 1999. Earlier
adoption is permitted. The Company is evaluating the impact of this statement.
Upon adoption, the Company will be required to record a cumulative effect
adjustment to reflect this accounting change. At this time, the Company has not
completed its analysis and evaluation of the requirements and impact of this
statement.
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 and offerings of preferred and common stock. In connection with the
Crabbe Huson acquisition, the Company entered into a $100.0 million revolving
credit facility with a commercial bank (the "Bridge Facility"). The Bridge
Facility matures on March 30, 1999 and bears interest at a per annum rate equal
to LIBOR plus twenty-five basis points. The Company borrowed $90.0 million
under the Bridge Facility to finance the acquisition of Crabbe Huson. In
November 1998, the Company issued $450.0 million of senior debt securities. The
offering consisted of $300.0 million of 6-3/4% 10-year notes due November 15,
2008 and $150.0 million of 7-5/8% 30-year debentures due November 15, 2028. The
proceeds were utilized to repay the $90.0 million borrowed under the Bridge
Facility and to repay the $229.0 million notes payable to affiliates. The
balance of the proceeds will be utilized for general corporate purposes.
The Company also has 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 12b-1
distribution fees and contingent deferred sales charges. This Facility is
subject to annual renewal. If not renewed, effective April 11, 1999 this
Facility converts to a term loan which matures on April 11, 2004. Upon such
conversion, 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 plus 0.225%. The terms of the Facility place certain restrictions on
Colonial's ability to pay dividends. Under the terms of the Facility, Colonial
could pay dividends of up to $32.3 million as of December 31, 1998.
37
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 be paid until it is approved by the Commissioner of
Insurance of the State of Rhode Island. As of December 31, 1998, the amount of
dividends that Keyport could pay without such approval was $59.1 million.
Keyport paid dividends of $20.0 million during 1998 but had not previously paid
any dividends since its acquisition in 1988. Future regulatory changes and
credit agreements may create additional limitations on the ability of the
Company's subsidiaries to pay dividends.
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, 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 may 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, private capital 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 12b-1
distribution fees and 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, 1998, $9.7 billion,
or 73.3% 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. In addition, the
Company's fixed-rate products incorporate
38
surrender charges to encourage persistency and to make the cost of its
policyholder balances more predictable. Approximately 80.6% of the Company's
fixed annuity policyholder balances were subject to surrender charges or
restrictions as of December 31, 1998.
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.
The Company relies significantly on computer systems and applications in its
operations. Some of these systems are not presently Year 2000 compliant. If not
corrected, this could cause system failures. Such failures could have an
adverse effect on the Company causing disruption of operations, including,
among other things, an inability to process transactions.
In addressing the Year 2000 issue, the Company has completed an inventory
of its information technology systems and assessed its Year 2000 readiness. The
Company's systems include internally developed programs, third-party purchased
programs and third-party custom developed programs. For programs which were
identified as not being Year 2000 compliant, the Company has implemented a
remediation plan which includes repairing or replacing the programs and testing
for Year 2000 compliance. The remediation plan is substantially complete and is
currently in the final testing phase. The Company also identified its
non-information technology systems affected by Year 2000 issues. The Company
initiated remediation efforts in this area and expects to complete this phase
during 1999.
The Company has initiated communication with third parties to determine
the extent to which the Company's systems are vulnerable to those third
parties' failure to remediate their own Year 2000 issues. The Company received
feedback from such parties and is in the process of requesting confirmation
from these parties with respect to remediation of their Year 2000 issues.
The Company is developing, and will continue to develop, contingency plans
for dealing with adverse effects that are known in the event the Company's
remediation plans are not successful or third parties fail to remediate their
own Year 2000 issues. The Company expects contingency planning to be
substantially complete by June, 1999. If necessary modifications and
conversions are not made, or are not timely completed, or if the systems of the
companies on which the Company's systems rely are not timely converted, the
Year 2000 issues 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.
Through December 31, 1998, the external cost of the Year 2000 project was
approximately $2.5 million, which was primarily related to consultants and
replacement hardware and software. The additional external costs to complete
the project are currently expected to be approximately $4.0 million, which are
primarily related to testing and contingency plan development. All of the costs
of the Year 2000 project are funded through operating cash flows. 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.
39
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. Inflation may result in
increased operating expenses that may not be readily recoverable in the prices
of the services charged by the Company.
FORWARD-LOOKING STATEMENTS
The Company desires to take advantage of the "safe harbor" provisions of the
Private Securities Litigation Reform Act of 1995 (the "Reform Act"). Investors
are cautioned that all statements, trend analyses and other information
contained in this report or in any of the Company's filings under Section 13 or
15(d) of the Securities Exchange Act of 1934 (the "Exchange Act"), relative to
the markets for the Company's products and trends in the Company's operations
or financial results, as well as other statements including words such as
"anticipate", "believe", "plan", "estimate", "expect", "intend" and other
similar expressions, constitute forward-looking statements under the Reform
Act. These forward-looking statements are subject to known and unknown risks,
uncertainties and other factors, many of which are beyond the Company's
control, that may cause actual results to be materially different from those
contemplated by the forward-looking statements. Such factors include, among
other things: (1) general economic conditions and market factors, such as
prevailing interest rate levels, stock market performance and fluctuations in
the market for retirement-oriented savings products and investment management
products, which may adversely affect the ability of the Company to sell its
products and services and the market value of the Company's investments and
assets under management and, therefore, the portion of its revenues that are
based on a percentage of assets under management; (2) the Company's ability to
manage effectively its investment spread (i.e. the amount by which investment
income exceeds interest credited to annuity and life insurance policyholders)
as a result of changes in interest rates and crediting rates to policyholders,
market conditions and other factors (the Company's results of operations and
financial condition are significantly dependent on the Company's ability to
manage effectively its investment spread); (3) levels of surrenders,
withdrawals and net redemptions of the Company's retirement-oriented insurance
products and investment management products; (4) relationships with investment
management clients, including levels of assets under management; (5) the
ability of the Company to manage effectively certain risks with respect to its
investment portfolio, including risks relating to holding below investment
grade securities and the ability to dispose of illiquid and/or restricted
securities at desired times and prices, and the ability to manage and hedge
against interest rate changes through asset/liability management techniques;
(6) competition in the sale of the Company's products and services, including
the Company's ability to establish and maintain relationships with distributors
of its products; (7) changes in financial ratings of Keyport or those of its
competitors; (8) the Company's ability to attract and retain key employees,
including senior officers, portfolio managers and sales executives; (9) the
impact of and compliance by the Company with existing and future regulation,
including restrictions on the ability of
40
certain subsidiaries to pay dividends and any obligations of the Company under
any guaranty fund assessment laws; (10) changes in applicable tax laws which
may affect the relative tax advantages and attractiveness of some of the
Company's products; (11) the result of any litigation or legal proceedings
involving the Company; (12) changes in generally accepted accounting principles
and the impact of accounting principles and pronouncements on the Company's
financial condition and results of operation; (13) the impact of Year 2000
issues on the operations of the Company and its subsidiaries; (14) changes in
the Company's senior debt ratings; and (15) the other risk factors or
uncertainties contained from time to time in any document incorporated by
reference in this report or otherwise filed by the Company under the Exchange
Act. Given these uncertainties, prospective investors are cautioned not to
place undue reliance on such forward-looking statements and no assurances can
be given that the estimates and expectations reflected in such statements will
be achieved.
41
LIBERTY FINANCIAL COMPANIES, INC.
Consolidated Financial Statements
CONSOLIDATED BALANCE SHEETS
($ IN MILLIONS)
DECEMBER 31 1998 1997
- ---------------------------------------------------------------------------------------------------------
ASSETS
Assets:
Investments $ 12,598.3 $ 12,343.5
Cash and cash equivalents 984.1 1,290.1
Accrued investment income 161.0 165.0
Deferred policy acquisition costs 341.0 232.0
Value of insurance in force 66.6 53.3
Deferred distribution costs 130.2 108.1
Intangible assets 292.8 199.0
Other assets 179.6 131.4
Separate account assets 1,765.5 1,329.2
- ---------------------------------------------------------------------------------------------------------
$ 16,519.1 $ 15,851.6
=========================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Policyholder balances $ 12,504.1 $ 12,086.1
Notes payable to affiliates -- 229.0
Notes payable 486.4 26.5
Payable for investments purchased and loaned 240.4 722.1
Other liabilities 278.4 310.4
Separate account liabilities 1,723.2 1,264.0
- ---------------------------------------------------------------------------------------------------------
Total liabilities 15,232.5 14,638.1
- ---------------------------------------------------------------------------------------------------------
Series A redeemable convertible preferred stock, par value $.01; authorized,
issued and outstanding 324,759 shares in 1998 and 327,006 shares in 1997 15.3 14.6
- ---------------------------------------------------------------------------------------------------------
Stockholders' equity:
Common stock, $.01 par value, authorized 100,000,000 shares; issued
46,384,015 shares in 1998 and 44,706,398 shares in 1997 0.5 0.4
Additional paid-in capital 901.5 866.2
Retained earnings 346.4 251.5
Accumulated other comprehensive income 27.2 83.0
Unearned compensation (4.3) (2.2)
- ---------------------------------------------------------------------------------------------------------
Total stockholders' equity 1,271.3 1,198.9
- ---------------------------------------------------------------------------------------------------------
$ 16,519.1 $ 15,851.6
=========================================================================================================
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
42
CONSOLIDATED INCOME STATEMENTS
(IN MILLIONS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31 1998 1997 1996
- ------------------------------------------------------------------------------------------
Investment income $ 820.9 $ 853.1 $ 796.4
Interest credited to policyholders (562.2) (594.1) (572.7)
- ------------------------------------------------------------------------------------------
Investment spread 258.7 259.0 223.7
- ------------------------------------------------------------------------------------------
Net realized investment gains 2.4 25.9 8.0
- ------------------------------------------------------------------------------------------
Fee income:
Investment advisory and administrative fees 237.7 217.9 196.4
Distribution and service fees 52.7 49.2 44.9
Transfer agency fees 49.0 47.7 43.9
Surrender charges and net commissions 33.7 36.1 34.7
Separate account fees 20.6 17.1 16.0
- ------------------------------------------------------------------------------------------
Total fee income 393.7 368.0 335.9
- ------------------------------------------------------------------------------------------
Expenses:
Operating expenses (328.2) (309.7) (277.9)
Amortization of deferred policy acquisition costs (69.2) (75.9) (60.2)
Amortization of deferred distribution costs (40.1) (34.2) (33.9)
Amortization of value of insurance in force (8.2) (10.5) (10.2)
Amortization of intangible assets (15.3) (13.5) (15.4)
Interest expense, net (14.9) (17.0) (19.7)
- ------------------------------------------------------------------------------------------
Total expenses (475.9) (460.8) (417.3)
- ------------------------------------------------------------------------------------------
Pretax income 178.9 192.1 150.3
Income tax expense (54.4) (62.6) (49.6)
- ------------------------------------------------------------------------------------------
Income before extraordinary item 124.5 129.5 100.7
Extraordinary loss on extinguishment of debt (9.7) -- --
- ------------------------------------------------------------------------------------------
Net income $ 114.8 $ 129.5 $ 100.7
==========================================================================================
Net income per share--basic:
Income before extraordinary item $ 2.72 $ 2.94 $ 2.36
- ------------------------------------------------------------------------------------------
Net income $ 2.51 $ 2.94 $ 2.36
- ------------------------------------------------------------------------------------------
Net income per share--assuming dilution:
Income before extraordinary item $ 2.63 $ 2.77 $ 2.24
- ------------------------------------------------------------------------------------------
Net income $ 2.42 $ 2.77 $ 2.24
- ------------------------------------------------------------------------------------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
43
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated
Additional Other Total
Common Paid-In Retained Comprehensive Unearned Stockholders'
(IN MILLIONS) Stock Capital Earnings Income Compensation Equity
- --------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 $ 0.3 $ 810.5 $ 59.4 $ 87.1 $ (0.9) $ 956.4
---------
Comprehensive income:
Net income 100.7 100.7
Other comprehensive income, net of taxes:
Net unrealized losses on securities (12.7) (12.7)
---------
Total comprehensive income 88.0
---------
Common stock issued for 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)
- --------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 0.3 835.3 141.4 74.4 -- 1,051.4
---------
Comprehensive income:
Net income 129.5 129.5
Other comprehensive income, net of taxes:
Net unrealized gains on securities 8.6 8.6
---------
Total comprehensive income 138.1
---------
3 for 2 common stock split effected in the
form of a 50 percent stock dividend 0.1 (0.1) --
Common stock issued for acquisition 2.5 2.5
Effect of stock-based compensation plans 14.8 (2.2) 12.6
Accretion to face value of preferred stock (0.8) (0.8)
Common stock dividends 13.6 (17.6) (4.0)
Preferred stock dividends (0.9) (0.9)
- --------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 0.4 866.2 251.5 83.0 (2.2) 1,198.9
---------
Comprehensive income:
Net income 114.8 114.8
Other comprehensive income, net of taxes:
Net unrealized losses on securities (55.8) (55.8)
---------
Total comprehensive income 59.0
---------
Common stock issued for acquisition 8.9 8.9
Effect of stock-based compensation plans 0.1 13.2 (2.1) 11.2
Accretion to face value of preferred stock (0.8) (0.8)
Common stock dividends 13.2 (18.2) (5.0)
Preferred stock dividends (0.9) (0.9)
- --------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 $ 0.5 $ 901.5 $ 346.4 $ 27.2 $ (4.3) $ 1,271.3
==========================================================================================================================
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
44
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
YEAR ENDED DECEMBER 31 1998 1997 1996
- --------------------------------------------------------------------------------------------------------
Cash flows from operating activities:
Net income $ 114.8 $ 129.5 $ 100.7
Adjustments to reconcile net income to net cash
provided by operating activities:
Extraordinary loss on extinguishment of debt, net of tax 9.7 -- --
Depreciation and amortization 81.6 74.4 74.3
Interest credited to policyholders 562.2 594.1 572.7
Net realized investment gains (2.4) (25.9) (8.0)
Net amortization (accretion) on investments 75.4 29.9 (29.1)
Change in deferred policy acquisition costs (33.7) (10.3) (24.4)
Change in current and deferred income taxes (3.8) 71.9 7.3
Net change in other assets and liabilities (115.1) (8.2) (62.5)
- --------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 688.7 855.4 631.0
- --------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Investments purchased available for sale (6,789.0) (4,548.4) (4,365.4)
Investments sold available for sale 5,406.0 2,563.5 1,714.0
Investments matured available for sale 1,273.5 1,531.6 1,387.7
Increase in policy loans, net (24.1) (21.9) (34.5)
Decrease in mortgage loans, net 5.5 6.4 7.5
Acquisitions, net of cash acquired (98.7) -- (41.5)
Other (9.7) (73.9) (149.5)
- --------------------------------------------------------------------------------------------------------
Net cash used in investing activities (236.5) (542.7) (1,481.7)
- --------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Withdrawals from policyholder accounts (1,690.0) (1,320.8) (1,154.1)
Deposits to policyholder accounts 1,225.0 950.5 2,134.5
Securities lending (510.6) 495.2 (119.2)
Repayment of notes payable to affiliates (244.0) -- --
Change in notes payable 459.9 (26.0) (8.5)
Exercise of stock options 7.4 7.6 2.4
Dividends paid (5.9) (4.9) (3.9)
- --------------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities (758.2) 101.6 851.2
- --------------------------------------------------------------------------------------------------------
(Decrease) increase in cash and cash equivalents (306.0) 414.3 0.5
Cash and cash equivalents at beginning of year 1,290.1 875.8 875.3
- --------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of year $ 984.1 $ 1,290.1 $ 875.8
========================================================================================================
Noncash Financing Activities: Noncash financing activities relate to dividends
paid in common stock, primarily to an affiliate of Liberty Mutual, in the
amount of $13.2 million, $13.6 million and $13.9 million in 1998, 1997 and
1996, respectively, pursuant to the Company's dividend reinvestment plan.
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
45
LIBERTY FINANCIAL COMPANIES, INC.
Notes to Consolidated Financial Statements
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 indirect 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"), The Colonial Group ("Colonial"),
Newport Pacific Management, Inc. ("Newport") and, from the date of acquisition:
The Crabbe Huson Group, Inc. ("Crabbe Huson"), Progress Investment Management
Company ("Progress") 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 which are classified as available for
sale are carried at fair value, and unrealized gains and losses (net of
adjustments to deferred policy acquisition costs, value of insurance in force
and income taxes) 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, net of adjustment for amortization
of deferred policy acquisition costs and value of insurance in force.
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 generally
accounted for by using the equity method of accounting. Partnership investments
totaled $126.8 million and $117.3 million at December 31, 1998 and 1997,
respectively.
46
Derivatives
The Company uses interest rate swap and cap agreements to manage its interest
rate risk and call options and futures 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.
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, call options and
futures 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.
Futures are carried at fair value and require daily cash settlement. Changes in
the fair value of futures that qualify as hedges are deferred and recognized as
an adjustment to the hedged asset or liability. Call options and futures that
do not qualify as hedges are carried at fair value; changes in value are
immediately recognized in income.
In June 1998, Statement of Financial Accounting Standards No. 133,
"Accounting for Derivative Instruments and Hedging Activities" was issued. This
statement standardizes the accounting for derivative instruments and the
derivative portion of certain other contracts that have similar characteristics
by requiring that an entity recognize those instruments on the balance sheet at
fair value. This statement also requires a new method of accounting for hedging
47
transactions, prescribes the type of items and transactions that may be hedged,
and specifies detailed criteria to be met to qualify for hedge accounting. This
statement is effective for fiscal years beginning after June 15, 1999. Earlier
adoption is permitted. The Company is evaluating the impact of this statement.
Upon adoption, the Company will be required to record a cumulative effect
adjustment to reflect this accounting change. At this time, the Company has not
completed its analysis and evaluation of the requirements and impact of this
statement.
Fee Income
Fees from asset management and investment advisory services and from transfer
agent, bookkeeping, 12b-1 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 $56.0 million at December 31, 1998 and
$126.9 million at December 31, 1997, 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 $10.3 million and $31.8 million at December
31, 1998 and 1997, respectively, relating to this adjustment.
Deferred Distribution Costs
Sales commissions and other direct costs related to the sale of Company-
sponsored intermediary-distributed mutual funds which charge 12b-1 distribution
fees and 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.
48
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 30 years.
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
$42.3 million and $65.2 million at December 31, 1998 and 1997, 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. 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
Effective July 18, 1997, the Company and its non-life insurance subsidiaries
file a consolidated federal income tax return and the Company's life insurance
subsidiaries file separate life company returns. Prior to July 18, 1997, the
Company was included in the consolidated federal income tax return filed by
Liberty Mutual. 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
Basic earnings per share is calculated using income available to common
shareholders divided by the weighted average of common shares outstanding
during the year. Diluted earnings per share is similar to basic earnings per
share except that the weighted average of common shares outstanding is
increased to include the number of additional common shares that would have
been outstanding if the dilutive potential common shares had been issued.
Cash Equivalents
Short-term investments having an original maturity of three months or less are
classified as cash equivalents.
49
Comprehensive Income
As of January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130,"Reporting Comprehensive Income" ("SFAS 130"). SFAS 130
establishes new rules for the reporting and display of comprehensive income and
its components. SFAS 130 requires unrealized gains or losses on the Company's
available-for-sale securities, which prior to adoption were reported separately
in stockholders' equity, to be included in accumulated other comprehensive
income. The adoption of SFAS 130 had no impact on the Company's net income or
stockholders' equity. Prior year financial statements have been reclassified to
conform to the requirements of SFAS 130.
2. ACQUISITIONS
On August 31, 1998, the Company acquired certain assets and assumed certain
liabilities of Progress Investment Management Company, a registered investment
adviser to institutional accounts with approximately $2.1 billion in assets
under management as of that date. On September 30, 1998, the Company acquired
certain assets and assumed certain liabilities of The Crabbe Huson Group, Inc.,
a registered investment adviser with approximately $3.3 billion in assets under
management as of that date. The combined purchase price for these transactions
was approximately $104.0 million and consisted of $95.1 million in cash and
$8.9 million in the Company's common stock. In addition, the Company has agreed
to pay up to an additional approximate $71.5 million in cash and common stock
over five years, contingent upon the attainment of certain earnings objectives.
These transactions were accounted for as purchases and resulted in the
recording of goodwill and other intangible assets of approximately $101.6
million.
3. INVESTMENTS
Investments, all of which pertain to the Company's annuity insurance
operations, were comprised of the following
(in millions):
December 31 1998 1997
- ---------------------------------------------------
Fixed maturities $ 11,277.2 $ 11,246.5
Equity securities 24.6 40.8
Policy loans 578.9 554.7
Other invested assets 717.6 501.5
- ---------------------------------------------------
$ 12,598.3 $ 12,343.5
===================================================
As of December 31, 1998, 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, 1998, $1.1 billion of fixed maturities were below
investment grade. These securities represented 8.1% of the Company's total
investments, including certain cash and cash equivalents.
50
Fixed Maturities
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, 1998 Cost Gains Losses Fair Value
- --------------------------------------------------------------------------------------------------
U.S. Treasury securities $ 90.8 $ 3.1 $ (0.2) $ 93.7
Mortgage backed securities of U.S. government
corporations and agencies 940.1 28.4 (2.9) 965.6
Debt securities issued by foreign governments 251.1 9.4 (16.2) 244.3
Corporate securities 5,396.3 185.1 (156.3) 5,425.1
Other mortgage backed securities 2,286.6 65.1 (19.5) 2,332.2
Asset backed securities 1,942.0 25.9 (16.5) 1,951.4
Senior secured loans 267.8 1.2 (4.1) 264.9
- --------------------------------------------------------------------------------------------------
Total fixed maturities $ 11,174.7 $ 318.2 $ (215.7) $ 11,277.2
==================================================================================================
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
==================================================================================================
At December 31, 1998 and 1997, gross unrealized gains on equity
securities, interest rate cap agreements and investments in separate accounts
aggregated $7.8 million and $27.4 million, and gross unrealized losses
aggregated $3.6 million and $6.9 million, respectively.
Net unrealized gains (losses) on securities included in other
comprehensive income in 1998, 1997 and 1996 include: gross unrealized gains
(losses) on securities of $(182.1) million, $73.7 million and $(64.4) million,
respectively; reclassification adjustments for realized (gains) losses in net
income of $3.6 million, $(31.3) million and $(7.7) million, respectively; and
adjustments to deferred policy acquisition costs and value of insurance in
force of $92.5 million, $(29.1) million and $54.2 million, respectively. The
above amounts are shown before income tax expense (benefit) of $(30.2) million,
$4.7 million and $(5.2) million, respectively.
51
Deferred tax liabilities for the Company's unrealized investment gains and
losses, net of adjustments to deferred policy acquisition costs and value of
insurance in force, were $14.1 million and $44.3 million at December 31, 1998
and 1997, respectively.
Contractual Maturities
The amortized cost and estimated fair value of fixed maturities by contractual
maturity as of December 31, 1998 are as follows (in millions):
Amortized Fair
December 31, 1998 Cost Value
- ------------------------------------------------------------------
Due in one year or less $ 334.9 $ 335.2
Due after one year through five years 2,998.4 3,005.1
Due after five years through ten years 1,638.5 1,656.2
Due after ten years 1,034.3 1,031.5
- ------------------------------------------------------------------
6,006.1 6,028.0
Mortgage and asset backed securities 5,168.6 5,249.2
- ------------------------------------------------------------------
$ 11,174.7 $ 11,277.2
==================================================================
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 1998 1997 1996
- --------------------------------------------------------------------------------------
Fixed maturities $ 810.5 $ 811.7 $ 737.4
Equity securities 4.4 5.4 4.5
Policy loans 33.2 32.2 30.2
Other invested assets 18.2 27.8 11.4
Cash and cash equivalents 38.3 34.5 36.1
- --------------------------------------------------------------------------------------
Gross investment income 904.6 911.6 819.6
Investment expenses (11.6) (9.2) (6.7)
Amortization of call options and interest rate caps (72.1) (49.3) (16.5)
- --------------------------------------------------------------------------------------
Net investment income $ 820.9 $ 853.1 $ 796.4
======================================================================================
As of December 31, 1998, the carrying value of fixed maturity investments
that were non-income producing was $30.0 million.
52
Net Realized Investment Gains (Losses)
Net realized investment gains (losses) primarily relate to the Company's fixed
maturity investments. Gross realized gains were $88.5 million, $51.6 million
and $28.3 million for 1998, 1997 and 1996, respectively. Gross realized losses
were $90.4 million, $19.2 million and $18.6 million for 1998, 1997 and 1996,
respectively. Gross realized losses in 1998 included $28.3 million for certain
fixed maturity investments where the decline in value was determined to be
other than temporary.
Proceeds from sales of fixed maturities available for sale were $5.3
billion, $2.6 billion and $1.7 billion in 1998, 1997 and 1996, respectively.
4. DERIVATIVES
Outstanding derivatives are as follows (in millions):
Assets (Liabilities)
---------------------------------------------------
Notional Amounts 1998 1997
----------------------------- ---------------------------------------------------
Carrying Fair Carrying Fair
December 31 1998 1997 Value Value Value Value
- --------------------------------------------------------------------------------------------------------------------
Interest rate swap agreements $ 2,369.0 $ 2,575.0 $ (71.2) $ (71.2) $ (42.1) $ (42.1)
Interest rate cap agreements 250.0 250.0 -- -- 0.1 0.1
S&P 500 Index call options -- -- 535.7 607.0 323.3 345.3
S&P 500 Index futures -- -- ( 0.6) ( 0.6) 0.8 0.8
- --------------------------------------------------------------------------------------------------------------------
The interest rate swap agreements expire in 1999 through 2005. The
interest rate cap agreements expire in 1999 through 2000. The S&P 500 call
options and futures maturities range from 1999 to 2002.
The Company currently utilizes interest rate 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. With respect to the Company's equity-
indexed annuities, the Company buys call options and futures on the S&P 500
Index to hedge its obligations to provide returns based upon this index. At
December 31, 1998 and 1997, the Company had approximately $156.4 million and
$155.0 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 and futures are based upon quoted
market prices.
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. Futures trade
on organized exchanges and, therefore, have minimal credit risk.
53
5. NOTES PAYABLE
Notes payable include the following (in millions):
December 31 1998 1997
- --------------------------------------------------------------------------------
Notes payable to affiliates:
8.0% promissory note due April 3, 2000 $ -- $ 99.0
8.0% promissory note due March 31, 2000 -- 30.0
8.5% promissory notes due March 24, 2005 -- 100.0
- --------------------------------------------------------------------------------
-- 229.0
6-3/4% notes due 2008, net of unamortized discount of
$2.3 million in 1998, effective rate 6.86% 297.7 --
7-5/8% debentures due 2028, net of unamortized discount of
$0.8 million in 1998, effective rate 7.67% 149.2 --
Revolving credit facility 39.5 26.5
- --------------------------------------------------------------------------------
$486.4 $ 255.5
================================================================================
In connection with the Crabbe Huson acquisition, the Company entered into
a $100.0 million revolving credit facility with a commercial bank (the "Bridge
Facility"). The Bridge Facility matures on March 30, 1999 and bears interest at
a per annum rate equal to LIBOR plus twenty-five basis points. The Company
borrowed $90.0 million under the Bridge Facility to finance the acquisition of
Crabbe Huson. In November 1998, the Company issued $450.0 million of senior
debt securities. The offering consisted of $300.0 million of 6-3/4% 10-year
notes due November 15, 2008 and $150.0 million of 7-5/8% 30-year debentures due
November 15, 2028. The proceeds were utilized to repay the $90.0 million
borrowed under the Bridge Facility and to discharge the Company's existing
$229.0 million notes payable to affiliates. The early extinguishment of the
notes payable to affiliates resulted in an extraordinary charge of $9.7
million, net of a tax benefit of $5.3 million. The Indenture under which the
senior notes and debentures were issued contains covenants which prohibit the
Company from granting a lien on or disposing of the stock of any subsidiary
which accounts for more than 10% of the consolidated revenues or assets of the
Company.
The Company also has 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 12b-1
distribution fees and contingent deferred sales charges. This Facility is
subject to annual renewal. If not renewed, effective April 11, 1999 this
Facility converts to a term loan which matures on April 11, 2004. Upon such
conversion, 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 plus 0.225%. The terms of the Facility place certain restrictions on
Colonial's ability to pay dividends.
Interest paid was $25.5 million, $21.7 million and $22.9 million in 1998,
1997 and 1996, respectively.
54
6. INCOME TAXES
Income tax expense is summarized as follows (in millions):
Year Ended December 31 1998 1997 1996
- --------------------------------------------------------
Current $ 10.1 $ (42.0) $ 54.8
Deferred 44.3 104.6 (5.2)
- --------------------------------------------------------
$ 54.4 $ 62.6 $ 49.6
========================================================
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 1998 1997 1996
- ---------------------------------------------------------------------------------------
Expected income tax expense $ 62.6 $ 67.3 $ 52.6
Increase (decrease) in income taxes resulting from:
Nontaxable investment income (2.1) (1.4) (1.2)
Reduction in deferred tax asset valuation allowance (10.6) (10.0) (6.7)
Amortization of goodwill and other intangible assets 3.8 3.1 2.0
State taxes, net of federal tax benefit 0.7 1.2 2.5
Stock option plan compensation -- -- 0.8
Other, net -- 2.4 (0.4)
- ---------------------------------------------------------------------------------------
Income tax expense $ 54.4 $ 62.6 $ 49.6
=======================================================================================
55
The components of deferred federal income taxes are as follows (in
millions):
December 31 1998 1997
- ----------------------------------------------------------------------------
Deferred tax assets:
Policy liabilities $ 107.4 $ 124.3
Guaranty fund expense 2.1 2.8
Stock option plan compensation -- 1.0
Deferred compensation and other benefit plans 16.2 11.4
Net operating loss carryforwards 25.3 13.1
Distribution fees 18.4 17.8
Other 7.4 3.4
- ----------------------------------------------------------------------------
Total deferred tax assets 176.8 173.8
Less: valuation allowance (2.3) (10.6)
- ----------------------------------------------------------------------------
Net deferred tax assets 174.5 163.2
- ----------------------------------------------------------------------------
Deferred tax liabilities:
Deferred policy acquisition costs (92.5) (56.3)
Value of insurance in force and intangible assets (23.3) (18.0)
Excess of book over tax basis of investments (141.0) (187.6)
Deferred revenue (24.0) (4.1)
Amortization of deferred distribution costs (35.8) (34.8)
Other (9.1) (1.9)
- ----------------------------------------------------------------------------
Total deferred tax liabilities (325.7) (302.7)
- ----------------------------------------------------------------------------
Net deferred tax liability $ (151.2) $ (139.5)
============================================================================
As of December 31, 1998, the Company had Federal net operating loss
carryforwards related to certain of the Company's non-insurance operations of
$60.7 million. Of this amount, $10.4 million, which expires through 2003, is
limited to use against future profits in a component of the Company's
non-insurance operations. The remaining Federal non-insurance loss
carryforwards of $50.3 million expire through 2018. As of December 31, 1998,
the Company also had $5.1 million of purchased Federal net operating loss
carryforwards, which expire through 2006, relating to an acquisition in its
insurance operations. Utilization of these loss carryforwards 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
benefit of the deferred tax asset related to its Federal net operating loss
carryforwards. Additionally, as of December 31, 1998, the Company had state net
operating loss carryforwards related to certain of the Company's non-insurance
operations of $48.6 million. Utilization of these loss carryforwards, which
expire through 2008, is limited to use against future profits of a component of
the Company's non-insurance operations. The Company believes that it is not
more likely than not that it will realize the benefit of the deferred tax asset
related to these state net operating loss carryforwards.
56
Income taxes paid (refunded) were $27.6 million, ($4.2) million and $45.7
million in 1998, 1997 and 1996, respectively.
7. REDEEMABLE CONVERTIBLE PREFERRED STOCK
The Series A Redeemable Convertible Preferred Stock, which has 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 to 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 (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.
57
The following table sets forth the Plans' funded status (in millions) as
of December 31, 1998 and 1997.
December 31 1998 1997
- ----------------------------------------------------------------------------------------
Change in benefit obligation
Benefit obligation at beginning of year $ 27.1 $ 23.4
Service cost 1.8 1.6
Interest cost 2.1 1.8
Actuarial loss 2.4 0.7
Benefits paid (0.6) (0.4)
- ----------------------------------------------------------------------------------------
Benefit obligation at end of year 32.8 27.1
- ----------------------------------------------------------------------------------------
Change in plan assets
Fair value of plan assets at beginning of year 14.7 11.7
Expected return on plan assets 1.1 1.7
Employer contribution 0.9 1.7
Benefits paid (0.6) (0.4)
- ----------------------------------------------------------------------------------------
Fair value of plan assets at end of year 16.1 14.7
- ----------------------------------------------------------------------------------------
Projected benefit obligation in excess of the plans' assets 16.7 12.4
Unrecognized net actuarial loss (4.4) (2.0)
Prior service cost not yet recognized in net periodic pension cost (1.8) (2.2)
- ----------------------------------------------------------------------------------------
Accrued pension cost $ 10.5 $ 8.2
========================================================================================
Pension cost includes the following components (in millions):
Year Ended December 31 1998 1997 1996
- ----------------------------------------------------------------------------------------
Service cost benefits earned during the period $ 1.8 $ 1.6 $ 1.6
Interest cost on projected benefit obligation 2.1 1.8 1.6
Expected return on plan assets (1.2 (1.7) (1.3)
Net amortization and deferred amounts 0.4 1.2 1.1
- ---------------------------------------------------------------------------------------
Total net periodic pension cost $ 3.1 $ 2.9 $ 3.0
- ---------------------------------------------------------------------------------------
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:
Year Ended December 31 1998 1997 1996
- ----------------------------------------------------------------------------------------
Discount rate 6.75% 7.25% 7.50%
Rate of increase in compensation level 4.75% 5.00% 5.25%
Expected long-term rate of return on assets 9.00% 8.50% 8.50%
58
The Company provides various other funded and unfunded defined
contribution plans, which include savings and investment plans and supplemental
savings plans. Expenses related to these defined contribution plans totaled
$9.5 million, $8.5 million and $7.6 million in 1998, 1997 and 1996,
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 1995 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 in 1996. There was no such compensation expense in 1998 or
1997.
In April 1997, the Company began to award nonvested stock under the 1995
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 of employment, any nonvested shares would
generally be forfeited. The Company recorded $1.0 million and $0.4 million in
compensation expense related to nonvested stock in 1998 and 1997, respectively.
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: 4.68% for 1998, 5.73% for 1997 and 6.26% for 1996; dividend
yield: 1.22% for 1998, 1.25% for 1997 and 1.99% for 1996; expected volatility
of the market price of the Company's Common Stock: 23.2% for 1998, 19.1% for
1997 and 15.0% for 1996; 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. Pro forma information
follows (in millions, except for earnings per share information):
59
Year Ended December 31 1998 1997 1996
- -------------------------------------------------------------------------------------------
Income before extraordinary item $ 120.6 $ 127.1 $ 99.3
Extraordinary loss on extinguishment of debt, net of tax (9.7) -- --
- -------------------------------------------------------------------------------------------
Net income $ 110.9 $ 127.1 $ 99.3
===========================================================================================
Net income per share--basic:
Income before extraordinary item $ 2.64 $ 2.88 $ 2.32
Extraordinary loss on extinguishment of debt, net of tax (0.21) -- --
- -------------------------------------------------------------------------------------------
Net income $ 2.43 $ 2.88 $ 2.32
===========================================================================================
Net income per share--assuming dilution:
Income before extraordinary item $ 2.55 $ 2.73 $ 2.21
Extraordinary loss on extinguishment of debt, net of tax (0.21) -- --
- -------------------------------------------------------------------------------------------
Net income $ 2.34 $ 2.73 $ 2.21
===========================================================================================
Because SFAS 123 is applicable only to options granted subsequent to
December 31, 1994, its pro forma effect was not fully reflected until 1998.
A summary of the stock option activity, and related information for the
years ended December 31 follows (in thousands, except price data):
1998 1997 1996
-----------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
- -------------------------------------------------------------------------------------------------------
Outstanding--beginning of year 4,038 $ 16.31 4,484 $ 12.49 4,133 $ 9.58
Granted 627 36.92 699 28.67 918 22.00
Exercised (936) 8.57 (1,027) 7.56 (489) 4.81
Forfeited -- -- (118) 20.74 (78) 17.95
- -------------------------------------------------------------------------------------------------------
Outstanding--end of year 3,729 $ 21.72 4,038 $ 16.31 4,484 $ 12.49
=======================================================================================================
Exercisable--end of year 2,051 $ 15.72 2,346 $ 11.11 2,709 $ 8.60
=======================================================================================================
Weighted-average fair value of options
granted during year $ 10.62 $ 8.15 $ 5.31
=======================================================================================================
Exercise prices for options outstanding as of December 31, 1998 ranged
from $0.67 to $38.94. The weighted-average remaining contractual life of these
options is 6.88 years.
60
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:
1998 1997 1996
- -----------------------------------------------------------------------------------------------------------
Numerator (in millions)
Income before extraordinary item $ 124.5 $ 129.5 $ 100.7
Less: preferred stock dividends (0.9) (0.9) (0.9)
- -----------------------------------------------------------------------------------------------------------
Numerator for income per share--basic--income before
extraordinary item available to common stockholders 123.6 128.6 99.8
Extraordinary loss on extinguishment of debt, net of tax (9.7) -- --
- -----------------------------------------------------------------------------------------------------------
Numerator for net income per share--basic--net income
available to common stockholders $ 113.9 $ 128.6 $ 99.8
- -----------------------------------------------------------------------------------------------------------
Income available to common stockholders $ 123.6 $ 128.6 $ 99.8
Plus: income impact of assumed conversions
Preferred stock dividends 0.9 0.9 0.9
- -----------------------------------------------------------------------------------------------------------
Numerator for income per share--assuming dilution--income
before extraordinary item available to common stockholders
after assumed conversions 124.5 129.5 100.7
Extraordinary loss on extinguishment of debt, net of tax (9.7) -- --
- -----------------------------------------------------------------------------------------------------------
Numerator for net income per share--assuming dilution--net
income available to common stockholders after assumed
conversions $ 114.8 $ 129.5 $ 100.7
- -----------------------------------------------------------------------------------------------------------
Denominator
Denominator for basic--weighted average shares 45,330,561 43,808,904 42,353,927
- -----------------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 1,521,333 2,403,729 2,115,125
Convertible preferred stock 515,657 518,081 519,012
- -----------------------------------------------------------------------------------------------------------
Dilutive potential common shares 2,036,990 2,921,810 2,634,137
- -----------------------------------------------------------------------------------------------------------
Denominator for assuming dilution 47,367,551 46,730,714 44,988,064
===========================================================================================================
Net income per share--basic:
Income before extraordinary item $ 2.72 $ 2.94 $ 2.36
Extraordinary loss on extinguishment of debt, net of tax (0.21) -- --
- -----------------------------------------------------------------------------------------------------------
Net income $ 2.51 $ 2.94 $ 2.36
===========================================================================================================
Net income per share--assuming dilution:
Income before extraordinary item $ 2.63 $ 2.77 $ 2.24
Extraordinary loss on extinguishment of debt, net of tax (0.21) -- --
- -----------------------------------------------------------------------------------------------------------
Net income $ 2.42 $ 2.77 $ 2.24
===========================================================================================================
61
11. FAIR VALUE OF FINANCIAL INSTRUMENTS
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 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 fair values for equity securities are based on quoted market prices.
Policy loans: The carrying value of policy loans approximates fair value.
Other invested assets: The fair values for other invested assets are generally
based on quoted market prices.
Cash and cash equivalents: The carrying value of cash and cash equivalents
approximates fair value.
Policyholder balances: 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: The fair value of the Company's notes payable is either
estimated based on quoted market prices or using discounted cash flow analyses
based on the Company's incremental borrowing rate.
The fair values and carrying values of the Company's financial instruments are
as follows (in millions):
1998 1997
---------------------------------------------------
Carrying Fair Carrying Fair
December 31 Value Value Value Value
- ---------------------------------------------------------------------------------------
Assets:
Fixed maturity securities $ 11,277.2 $ 11,277.2 $ 11,246.5 $ 11,246.5
Equity securities 24.6 24.6 40.8 40.8
Policy loans 578.9 578.9 554.7 554.7
Other invested assets 717.6 787.0 501.5 525.7
Cash and cash equivalents 984.1 984.1 1,290.1 1,290.1
Liabilities:
Policyholder balances 12,504.1 11,647.6 12,086.1 11,366.5
Notes payable 486.4 511.7 255.5 271.5
62
12. SEGMENT INFORMATION
The Company has two reportable 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, private capital management
and institutional asset management. The Company evaluates performance based on
earnings before income taxes, not including net realized gains and losses. The
Company's reportable segments offer different products and are each managed
separately. Information by reported segment for 1998, 1997 and 1996 is shown
below (in millions):
Year Ended December 31 1998 1997 1996
- ----------------------------------------------------------------------------------------------------
Statement of Operations Data
Revenues:
Annuity:
Unaffiliated $ 870.9 $ 922.4 $ 840.8
Intersegment (10.5) (9.3) (8.6)
- ----------------------------------------------------------------------------------------------------
Total annuity 860.4 913.1 832.2
- ----------------------------------------------------------------------------------------------------
Asset management:
Unaffiliated 346.1 324.6 299.5
Intersegment 10.5 9.3 8.6
Total asset management 356.6 333.9 308.1
- ----------------------------------------------------------------------------------------------------
Total revenues $ 1,217.0 $ 1,247.0 $ 1,140.3
====================================================================================================
Income before income taxes and extraordinary item:
Annuity:
Income before net realized investment gains and amortization
of intangible assets $ 155.2 $ 143.1 $ 127.3
Net realized investment gains 0.8 24.7 5.5
Amortization of intangible assets (1.3) (1.1) (1.1)
- ----------------------------------------------------------------------------------------------------
Subtotal annuity 154.7 166.7 131.7
- ----------------------------------------------------------------------------------------------------
Asset management:
Income before net realized investment gains and amortization
of intangible assets 77.0 79.9 68.7
Net realized investment gains 1.3 1.8 2.5
Amortization of intangible assets (13.8) (12.1) (14.1)
- ----------------------------------------------------------------------------------------------------
Subtotal asset management 64.5 69.6 57.1
- ----------------------------------------------------------------------------------------------------
Other:
Loss before net realized investment gains (losses) and
amortization of intangible assets (40.4) (43.3) (38.3)
Net realized investment gains (losses) 0.3 (0.6) --
Amortization of intangible assets (0.2) (0.3) (0.2)
- ----------------------------------------------------------------------------------------------------
Subtotal other (40.3) (44.2) (38.5)
- ----------------------------------------------------------------------------------------------------
Total income before income taxes and extraordinary item $ 178.9 $ 192.1 $ 150.3
====================================================================================================
63
December 31 1998 1997 1996
- ------------------------------------------------------------------------
Balance Sheet Data
Identifiable Assets:
Annuity $15,742.9 $15,342.2 $13,924.6
Asset management 575.3 477.1 484.0
Other 200.9 34.0 22.0
Intercompany eliminations -- (1.7) (2.9)
- ------------------------------------------------------------------------
Total consolidated assets $16,519.1 $15,851.6 $14,427.7
========================================================================
All revenues are attributed to the United States. All long-lived assets
are located in the United States.
13. QUARTERLY FINANCIAL DATA, IN MILLIONS, EXCEPT PER SHARE AMOUNTS (UNAUDITED)
Quarter Ended 1998 March 31 June 30 September 30 December 31
- --------------------------------------------------------------------------------------------------
Investment income $ 207.4 $ 202.3 $ 202.7 $ 208.5
Interest credited to policyholders (142.1) (140.2) (143.3) (136.6)
- --------------------------------------------------------------------------------------------------
Investment spread 65.3 62.1 59.4 71.9
Net realized investment gains (losses) 2.2 (2.4) 4.2 (1.6)
Fee income 94.7 100.0 97.1 101.9
Pretax income 45.4 43.5 49.4 40.6
Income before extraordinary item 31.5 29.7 33.5 29.8
Extraordinary loss on extinguishment of debt,
net of tax -- -- -- (9.7)
Net income 31.5 29.7 33.5 20.1
Net income per share--basic:
Income before extraordinary item $ 0.70 $ 0.65 $ 0.73 $ 0.64
Extraordinary loss on extinguishment of debt,
net of tax -- -- -- (0.21)
- --------------------------------------------------------------------------------------------------
Net income per share--basic $ 0.70 $ 0.65 $ 0.73 $ 0.43
==================================================================================================
Net income per share--assuming dilution:
Income before extraordinary item $ 0.67 $ 0.63 $ 0.71 $ 0.63
Extraordinary loss on extinguishment of debt,
net of tax -- -- -- (0.21)
- --------------------------------------------------------------------------------------------------
Net income per share--assuming dilution $ 0.67 $ 0.63 $ 0.71 $ 0.42
==================================================================================================
64
Quarter Ended 1997 March 31 June 30 September 30 December 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
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 shareholder's 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 (in millions):
Year Ended December 31 1998 1997 1996
- ----------------------------------------------------------
Statutory surplus $ 790.9 $ 702.6 $ 567.7
Statutory net income 95.4 107.1 40.2
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 $0.6 million, $0.7 million and $0.6 million in 1998, 1997 and
1996, 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.
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, 1998, Keyport could pay dividends of up to $59.1 million
without the approval of the Commissioner of Insurance of the State of Rhode
Island. Keyport paid dividends of $20.0 million during 1998 but had not
previously paid any dividends since its acquisition in 1988.
65
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 $16.5 million, $15.0 million and $16.0
million for the years ended December 31, 1998, 1997 and 1996, respectively. For
each of the next five years, and in the aggregate, as of December 31, 1998, the
following are the minimum future rental payments under noncancelable operating
leases having remaining terms in excess of one year (in millions):
Year Payments
- ------------------------------
1999 $ 19.0
2000 19.0
2001 18.3
2002 17.1
2003 16.7
Thereafter 42.8
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 1998, 1997
and 1996, Keyport was assessed $3.2 million, $5.9 million and $10.0 million,
respectively. During 1998, 1997 and 1996, Keyport recorded $1.2 million, $1.0
million and $1.0 million, respectively, of provisions for state guaranty fund
association expense. At December 31, 1998 and 1997, the reserve for such
assessments was $6.0 million and $8.0 million, respectively.
66
Report of Independent Auditors
[logo: Ernst & 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, 1998 and 1997, and the related
consolidated statements of income, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 1998. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and 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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Liberty Financial Companies, Inc. at December 31, 1998 and 1997, and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
/s/ Ernst & Young LLP
Boston, Massachusetts
February 2, 1999
67