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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 1997
Commission file number: 33-67268
---------
ARM FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 61-1244251
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
515 WEST MARKET STREET
LOUISVILLE, KENTUCKY 40202
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (502) 582-7900
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
/x/ Yes / / No
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Date Class Shares Outstanding
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November 3, 1997 A 21,311,415
November 3, 1997 B 1,947,646
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TABLE OF CONTENTS
Item Page
- ---- ----
PART I. FINANCIAL INFORMATION
1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets--
September 30, 1997 and December 31, 1996 3
Condensed Consolidated Statements of Operations--
Three and Nine Months Ended September 30, 1997 and 1996 5
Condensed Consolidated Statements of Cash Flows--
Nine Months Ended September 30, 1997 and 1996 6
Notes to Condensed Consolidated Financial Statements 7
2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 14
PART II. OTHER INFORMATION
1. Legal Proceedings 28
2. Change in Securities 28
5. Other Information 28
6. Exhibits and Reports on Form 8-K 28
Signatures 30
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
CARRYING AMOUNT FAIR VALUE
------------------------------- ---------------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
(IN THOUSANDS) 1997 1996 1997 1996
- -------------- ------------------------------- ---------------------------------
(Unaudited) (Unaudited)
ASSETS
Cash and investments:
Fixed maturities available-for-sale,
at fair value (amortized cost:
September 30, 1997-$3,852,452;
December 31, 1996-$3,048,834) $3,899,938 $3,054,513 $3,899,938 $3,054,513
Equity securities, at fair value (cost:
September 30, 1997-$39,658;
December 31, 1996-$21,268) 40,478 22,552 40,478 22,552
Mortgage loans on real estate 16,666 36,879 16,666 36,879
Policy loans 123,942 123,466 123,942 123,466
Cash and cash equivalents 186,898 110,067 186,898 110,067
---------- ---------- ---------- ----------
Total cash and investments 4,267,922 3,347,477 4,267,922 3,347,477
Assets held in separate accounts 1,745,848 1,135,048 1,745,848 1,135,048
Accrued investment income 41,169 36,233 41,169 36,233
Value of insurance in force 31,469 52,024 119,897 112,389
Deferred policy acquisition costs 81,391 59,001 -- --
Goodwill 7,019 7,636 7,019 7,636
Deferred federal income taxes 25,572 35,604 39,062 42,653
Other assets 30,652 28,641 30,652 28,641
---------- ---------- ---------- ----------
Total assets $6,231,042 $4,701,664 $6,251,569 $4,710,077
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
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CARRYING AMOUNT FAIR VALUE
-------------------------------- ---------------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
(IN THOUSANDS) 1997 1996 1997 1996
- -------------- -------------------------------- ---------------------------------
(Unaudited) (Unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits $4,024,820 $3,294,174 $4,016,986 $3,260,253
Customer deposits in separate accounts 1,741,251 1,130,159 1,741,251 1,130,159
Long-term debt 38,000 40,000 38,000 40,000
Accounts payable and accrued expenses 18,147 22,684 18,147 22,684
Payable for investment securities
purchased 68,460 10,431 68,460 10,431
Payable to reinsurer 9,087 10,000 9,087 10,000
Other liabilities 29,753 12,274 29,753 12,274
---------- ---------- ---------- ----------
Total liabilities 5,929,518 4,519,722 5,921,684 4,485,801
Contingencies
Shareholders' equity:
Preferred stock, $25.00 stated value 50,000 50,000
Class A common stock, $.01 par value,
21,308,325 shares issued and outstanding 213 *
Class B common stock, $.01 par value,
1,947,646 shares issued and outstanding 19 *
Additional paid-in capital 211,335 124,609
Net unrealized gains on available-for-sale
securities 23,475 3,669
Retained earnings 16,482 3,664
---------- ----------
Total shareholders' equity 301,524 181,942 329,885 224,276
---------- ---------- ---------- ----------
Total liabilities and shareholders' equity $6,231,042 $4,701,664 $6,251,569 $4,710,077
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
* LESS THAN $1,000.
SEE ACCOMPANYING NOTES.
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ --------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1997 1996 1997 1996
- ---------------------------------------- ------------------------ --------------------------
Investment income $87,811 $65,340 $235,270 $183,203
Interest credited on customer deposits (65,724) (47,337) (175,331) (133,349)
------------------------ --------------------------
Net investment spread 22,087 18,003 59,939 49,854
Fee income:
Variable annuity fees 3,865 2,759 10,516 7,783
Asset management fees 2,302 1,789 6,068 4,500
Other fee income 303 416 944 1,044
------------------------ --------------------------
Total fee income 6,470 4,964 17,528 13,327
Other income and expenses:
Surrender charges 1,187 1,022 3,042 3,912
Operating expenses (8,424) (8,318) (23,506) (23,072)
Commissions, net of deferrals (396) (245) (1,576) (1,442)
Interest expense on debt (627) (768) (1,893) (2,299)
Amortization:
Deferred policy acquisition costs (3,069) (1,494) (7,680) (4,599)
Value of insurance in force (2,586) (2,577) (6,945) (7,058)
Acquisition-related deferred charges (126) (496) (377) (1,180)
Goodwill (99) (122) (327) (366)
Non-recurring charges:
Stock-based compensation -- -- (8,145) --
Other (2,489) (1,036) (5,122) (1,036)
Other, net 524 (2,538) (1,385) (5,178)
------------------------ --------------------------
Total other income and expenses (16,105) (16,572) (53,914) (42,318)
Realized investment gains (losses) 376 (1,115) 3,027 (2,332)
------------------------ --------------------------
Income before federal income taxes 12,828 5,280 26,580 18,531
Federal income tax expense (3,735) (956) (9,734) (3,719)
------------------------ --------------------------
Net income 9,093 4,324 16,846 14,812
Dividends on preferred stock (1,187) (1,187) (3,563) (3,563)
------------------------ --------------------------
Net income applicable to common shareholders $7,906 $3,137 $13,283 $11,249
------------------------ --------------------------
------------------------ --------------------------
Net income per common and common equivalent share $ 0.33 $ 0.18 $ 0.66 $ 0.64
------------------------ --------------------------
------------------------ --------------------------
Cash dividends paid per common share $ 0.02 $ -- $ 0.02 $ --
------------------------ --------------------------
------------------------ --------------------------
Average common and common equivalent shares
outstanding 24,323 17,506 20,184 17,495
------------------------ --------------------------
------------------------ --------------------------
SEE ACCOMPANYING NOTES.
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND 1996
(IN THOUSANDS) 1997 1996
- -------------- --------- ---------
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES $ 149,524 $ 136,460
CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
Fixed maturity investments:
Purchases (3,620,622) (2,471,399)
Maturities and redemptions 286,987 189,135
Sales 2,587,832 1,773,723
Other investments:
Purchases (60,292) (51,560)
Maturities and redemptions 20,500 6,787
Sales 43,683 30,474
Policy loans, net (476) (3,238)
Purchase of separate account assets (469,545) (192,883)
Proceeds from sale of separate account assets 74,608 57,338
-----------------------
Cash flows used in investing activities (1,137,325) (661,623)
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Net proceeds from issuance of common stock 78,813 --
Amounts received from customers 1,412,928 835,379
Amounts paid to customers (420,168) (329,052)
Principal payment on long-term debt (2,000) --
Change in payable to reinsurer (913) --
Dividends on common stock (465) --
Dividends on preferred stock (3,563) (3,563)
Change in repurchase agreement liability -- (4,689)
-----------------------
Cash flows provided by financing activities 1,064,632 498,075
-----------------------
Net increase (decrease) in cash and cash equivalents 76,831 (27,088)
Cash and cash equivalents at beginning of period 110,067 76,896
-----------------------
Cash and cash equivalents at end of period $ 186,898 $ 49,808
-----------------------
-----------------------
SEE ACCOMPANYING NOTES.
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 1997
1. BASIS OF PRESENTATION AND ORGANIZATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles
("GAAP") for interim financial information and with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three and nine month periods ended
September 30, 1997, are not necessarily indicative of those to be expected for
the year ending December 31, 1997. For further information, refer to the
consolidated financial statements and footnotes thereto included in the annual
report on Form 10-K of ARM Financial Group, Inc. (the "Company") for the year
ended December 31, 1996.
Certain amounts from the prior year have been reclassified to conform to
the current year's presentation. Such reclassifications have no effect on
previously reported net income or shareholders' equity.
2. FAIR VALUE BALANCE SHEETS
The consolidated balance sheets include a dual presentation of carrying
amount and fair value balances. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," fixed maturities classified as available-for-sale
are reported at fair value in the carrying amount balance sheets; however,
corresponding customer deposits are reported at historical values. In contrast,
in the fair value balance sheets, both assets and liabilities are reported at
fair value. As permitted by SFAS No. 107, "Disclosures About Fair Value of
Financial Instruments," the fair value balance sheets are presented as a
supplemental disclosure of the Company's financial position.
SFAS No. 107 requires disclosure of fair value information about all
financial instruments, including insurance liabilities classified as investment
contracts, unless specifically exempted. The accompanying fair value balance
sheets reflect fair values for those financial instruments specifically covered
by SFAS No. 107, along with fair value amounts for other assets and liabilities
for which disclosure is permitted but not required.
The fair value of a financial instrument is the amount at which the
instrument could
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be exchanged in a current transaction between willing parties, other than in a
forced or liquidation sale. In cases where quoted market prices are not
available, fair values are based on estimates using present value or other
valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. Accordingly, the aggregate fair value amounts presented do not
necessarily represent the underlying value of the Company.
The Company's management of interest rate risk reduces its exposure to
changing interest rates through a close matching of duration, convexity and cash
flow characteristics of both assets and liabilities while maintaining liquidity
redundancies (i.e., sources of liquidity in excess of projected liquidity
needs). As a result, the changes in fair values of the Company's assets and
liabilities will tend to offset each other in response to changes in interest
rates.
The following methods and assumptions were used in estimating fair values:
FIXED MATURITIES AND EQUITY SECURITIES
Fair values for fixed maturities and equity securities are based on quoted
market prices, where available. For fixed maturities for which a quoted market
price is not available, fair values are estimated using internally calculated
estimates or quoted market prices of comparable instruments.
MORTGAGE LOANS ON REAL ESTATE AND POLICY LOANS
The carrying amount of mortgage loans on real estate and policy loans
approximates their fair value.
CASH AND CASH EQUIVALENTS AND ACCRUED INVESTMENT INCOME
The carrying amount of cash and cash equivalents and accrued investment
income approximates their fair value given the short-term nature of these
assets.
ASSETS HELD IN SEPARATE ACCOUNTS AND CUSTOMER DEPOSITS IN SEPARATE ACCOUNTS
Fair value of assets held in non-guaranteed separate accounts is based on
the quoted market prices of the underlying mutual funds. The fair value of
assets held in guaranteed separate accounts is primarily based on quoted market
prices of the fixed maturity securities held in such separate accounts. The fair
value of customer deposits in separate accounts is based on the account values
of the underlying policies, plus or minus market value adjustments applicable to
certain customers who are guaranteed a fixed rate of return.
GOODWILL
The carrying amount of goodwill approximates fair value.
DEFERRED FEDERAL INCOME TAXES
The deferred federal income tax asset and related valuation allowance were
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adjusted for federal income tax which may be incurred as a result of the
differences between the estimated fair values and carrying amounts of the assets
and liabilities.
CUSTOMER DEPOSITS AND VALUE OF INSURANCE IN FORCE
The fair value of customer deposits for single premium immediate annuity
contracts is based on discounted cash flow calculations using a current market
yield rate for assets with similar durations (i.e., indexed to the U.S. Treasury
yield curve). The fair value of customer deposits for single premium immediate
annuity contracts represents the fair values of those contracts as a whole which
implicitly eliminates the corresponding value of insurance in force. The fair
value amounts of the remaining customer deposits, primarily related to deferred
annuity contracts, single premium endowment contracts and funding
agreements/guaranteed investment contracts ("GICs"), represent the account
values of the underlying contracts before applicable surrender charges. The fair
value of the value of insurance in force represents the estimated present value
of future profits for all customer deposits, excluding single premium immediate
annuity contracts, assuming a discount rate of 13%. Deferred policy acquisition
costs do not appear on the fair value presentation because those values are
implicitly considered in the determination of the fair value of the
corresponding customer deposits and value of insurance in force.
LONG-TERM DEBT AND PAYABLE TO REINSURER
The carrying amounts of long-term debt and payable to reinsurer approximate
fair value.
OTHER ASSETS AND LIABILITIES
The fair values of other assets and liabilities are reported at their
financial statement carrying amounts.
3. FEDERAL INCOME TAXES
Federal income taxes are different from the amount determined by
multiplying pretax income by the expected federal income tax rate of 35%. The
differences are primarily attributable to changes in valuation allowances
related to deferred federal income tax assets. Such changes include the
recognition of benefits associated with certain life insurance company deferred
tax assets for which a full valuation allowance was originally provided, offset
by providing a full valuation allowance on the Company's non-life net operating
loss carryforwards, which in 1997 includes a one-time non-cash stock-based
compensation expense charge.
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4. STATUTORY INFORMATION
Following is a reconciliation of income based on statutory accounting
practices prescribed or permitted by insurance regulatory authorities for the
Company's insurance subsidiaries with GAAP net income reported in the
accompanying condensed consolidated statements of operations:
Nine Months Ended
September 30,
----------------------
(IN THOUSANDS) 1997 1996
-------------- --------- ----------
Insurance subsidiaries (statutory-basis)(1) $ 38,242 $ 29,187
Non-insurance companies(2) 1,485 (1,153)
-----------------------
Consolidated statutory-basis pretax 39,727 28,034
Reconciling items:
Amortization of interest maintenance reserve (2,939) (3,271)
Adjustments to customer deposits (14,086) (51)
Interest expense on debt (1,893) (2,299)
Deferral of policy acquisition costs, net of 23,746 10,770
amortization
Amortization of value of insurance in force (6,945) (7,058)
Amortization of acquisition-related deferred (704) (1,546)
charges and goodwill
Adjustments to invested asset carrying values at
acquisition date (48) (485)
Non-recurring charges (13,267) (1,036)
Realized investment gains (losses) 3,027 (2,332)
Other (38) (2,195)
-----------------------
GAAP-basis:
Income before federal income taxes 26,580 18,531
Federal income tax expense (9,734) (3,719)
-----------------------
Net income 16,846 14,812
Dividends on preferred stock (3,563) (3,563)
-----------------------
Net income applicable to common shareholders 13,283 11,249
Exclude, net of tax:
Realized investment (gains) losses (1,968) 1,516
Non-recurring charges 13,267 940
Income from defined benefit pension plan asset
management operations (1,178) (263)
-----------------------
Operating earnings(3) $ 23,404 $ 13,442
-----------------------
-----------------------
(1) Insurance company statutory-basis pretax income excluding realized gains
and losses.
(2) Non-insurance company pretax income excluding amortization of
acquisition-related deferred charges, interest expense on debt, realized
investment gains and losses, and non-recurring corporate costs and charges
related to acquisition, financing and restructuring activities.
(3) Net income applicable to common shareholders, excluding, net of tax,
realized investment gains and losses, non-recurring charges and income from
defined benefit pension plan asset management operations of ARM Capital
Advisors which were sold on November 7, 1997.
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5. SHAREHOLDERS' EQUITY
INITIAL PUBLIC OFFERING OF COMMON STOCK
In June 1997, the Company completed an initial public offering (the
"Offering") of 9.2 million shares of Class A common stock, par value of $.01 per
share (the "New Class A Common Stock"), of which 5.75 million shares were sold
by the Company and 3.45 million shares were sold by the Morgan Stanley
Stockholders (as defined below). The net proceeds of the Offering to the Company
were $78.8 million, after deducting underwriting discounts and commissions and
other expenses of the Offering payable by the Company. On June 30, 1997, the
Company used a portion of such net proceeds to make a capital contribution to
its primary insurance subsidiary, Integrity Life Insurance Company
("Integrity"), thereby strengthening Integrity's capital base to provide for
future growth. The Company intends to also use the net proceeds to enhance the
Company's retail market presence, to consolidate operating locations and for
other corporate purposes, which may include acquisitions.
Concurrent with the closing of the Offering, the Company amended and
restated its Certificate of Incorporation to effectuate a recapitalization such
that (i) the common equity of the Company consists of New Class A Common Stock
and Class B Non-Voting Common Stock, par value of $.01 per share (the "New Class
B Common Stock" and, together with the New Class A Common Stock, the "New Common
Stock"), (ii) authorized shares of the New Class A Common Stock and New Class B
Common Stock were increased to 150 million shares and 50 million shares,
respectively, (iii) each outstanding share of common stock of the Company was
converted into one share of New Class A Common Stock, (iv) certain shares of the
New Class A Common Stock owned by private equity funds sponsored by Morgan
Stanley, Dean Witter, Discover & Co. (the successor to Morgan Stanley Group Inc.
in its merger with Dean Witter, Discover & Co.) (the "Morgan Stanley
Stockholders") were converted into New Class B Common Stock such that, after
giving effect to such conversion, but not giving effect to the Offering, the
Morgan Stanley Stockholders owned, in the aggregate, 49% of the outstanding New
Class A Common Stock, and (v) each share of New Common Stock was split into 706
shares of New Common Stock. Holders of New Class B Common Stock have no right to
vote on matters submitted to a vote of stockholders, except in certain
circumstances. Shares of the New Class B Common Stock have no preemptive or
other subscription rights and are convertible into an equal number of shares of
New Class A Common Stock (1) at the option of the holder thereof to the extent
that, following such conversion, the Morgan Stanley Stockholders will not, in
the aggregate, own more than 49% of the outstanding shares of New Class A Common
Stock, and (2) automatically upon the transfer of such shares by any Morgan
Stanley Stockholder to a person that is not a Morgan Stanley Stockholder or an
affiliate of a Morgan Stanley Stockholder. The Morgan Stanley Stockholders owned
approximately 91% of the outstanding shares of the Company's common stock prior
to the Offering and approximately 53% following the Offering.
All references to number of shares, per share amounts and stock option data
appearing in the financial statements and notes thereto have been retroactively
adjusted for the stock split.
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STOCK OPTIONS
The Company's Amended and Restated Stock Option Plan (the "Plan"),
originally adopted in December 1993, provides for granting of options to
purchase up to 2,432,170 shares of Class A common stock. In connection with the
Offering, the remaining 512,980 unallocated options were granted on a pro rata
basis to participants of the Plan with the exercise prices and vesting schedules
of such options being the average weighted exercise prices and vesting
percentages of the options previously held by such holders. As of June 30, 1997,
all options of the Plan had been issued, of which at September 30, 1997,
2,428,640 were outstanding and 1,115,139 were exercisable. Prior to the
Offering, the Plan provided that the option exercise price increased at the end
of every three month period following the date of grant at a rate of 12% per
annum, compounded annually, while the option remained unexercised. Concurrent
with the Offering, the exercise prices applicable to the outstanding options
were fixed at exercise prices ranging from $11.14 per share to $12.24 per share.
The Company has elected to follow Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations in accounting for its employee stock options. As a result of the
granting of previously unallocated options and the determination of the exercise
prices for all options of the Plan which occurred in conjunction with the
Offering, a one-time non-cash stock-based compensation expense charge of $8.1
million was recorded during June 1997. Such charge equals the aggregate
difference between the $15 initial public offering price of the New Class A
Common Stock and the exercise prices of all of the outstanding options.
In June 1997, the Company adopted the 1997 Equity Incentive Plan (the "1997
Equity Plan") which will be administered by the Company's Compensation
Committee. The 1997 Equity Plan provides for the granting of incentive stock
options and nonqualified stock options, stock appreciation rights, restricted
stock, performance units, and performance shares to those officers and other key
employees and consultants with potential to contribute to the future success of
the Company or its subsidiaries; provided that only employees may be granted
incentive stock options. The maximum number of shares of New Class A Common
Stock that may be granted under the 1997 Equity Plan is 1.6 million shares,
subject to adjustment in accordance with the terms of the 1997 Equity Plan. No
awards under the 1997 Equity Plan have been granted as of September 30, 1997.
EARNINGS PER SHARE
Net income per common and common equivalent share is based on the
weighted average number of common and common equivalent shares outstanding
during the period. Fully-diluted net income per common share is not presented
as it approximates net income per common and common equivalent share. In
February 1997, the Financial Accounting Standards Board issued SFAS No. 128,
"Earnings Per Share," which is required to be adopted by the Company on
December 31, 1997. At that time, the Company will be required to change the
method currently used to compute earnings per share and to restate all prior
periods. Under the new requirements for calculating primary earnings per
share, the potentially dilutive effect of stock options will be excluded. If
SFAS No. 128 had been adopted by the Company at September 30, 1997, the
impact on the calculation of earnings per share would not have been material.
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6. DEBT
On June 24, 1997, the Company entered into a Credit Agreement to provide
the Company with a new senior secured revolving credit facility. The maximum
amount that may be borrowed under this Credit Agreement is $75 million, of which
$38 million was drawn on June 24, 1997 and used to repay $38 million of
outstanding borrowings under the Company's prior Credit Agreement, which was
terminated. Borrowings under the new Credit Agreement bear a floating interest
rate equal to the London Interbank Offered Rate ("LIBOR") plus a percentage
ranging from 0.325% to 0.875%, depending on the ratings of the Company's
preferred stock. The Credit Agreement has a variable annual commitment fee which
can range from 0.10% to 0.25% of the unused portion of the borrowing, depending
on the ratings of the Company's preferred stock. The Credit Agreement matures on
June 24, 2002, subject to optional prepayment and contingent upon the Company's
compliance with various financial covenants.
7. SALE OF ARM CAPITAL ADVISORS
On November 7, 1997, the Company transferred substantially all of the
assets and operations of ARM Capital Advisors, Inc. ("ARM Capital Advisors") to
a newly formed subsidiary, ARM Capital Advisors, LLC ("New ARMCA"), and sold an
80% interest in New ARMCA to ARM Capital Advisors Holdings, LLC, an entity
controlled by Emad A. Zikry, the President of ARM Capital Advisors prior to the
sale. The Company recognized an immaterial gain on the sale. ARM Capital
Advisors is a registered investment adviser and wholly owned subsidiary of the
Company that provided asset management services to the Company's subsidiaries
and certain institutional clients, primarily defined benefit pension plans. The
sale allows New ARMCA to better compete with other independent asset managers
that are not affiliated with insurance companies. Under the terms of the sale,
New ARMCA will provide the Company's subsidiaries with investment management
services through December 31, 1997 on the same basis as in the past. The terms
of the sale further provide that after December 31, 1997, the Company can
continue to engage New ARMCA as its investment adviser at agreed upon rates;
but, the Company may also consider retaining other investment management firms.
It is expected that ARM Capital Advisors will be renamed Integrity Capital
Advisors, Inc. in the fourth quarter of 1997.
In connection with the consummation of the sale, the Company and Mr. Zikry
mutually agreed to terminate his employment with the Company and he resigned as
an officer and director of ARM Capital Advisors.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company specializes in the asset accumulation business, providing
retail and institutional customers with a variety of products and services
designed to serve the growing long-term savings and retirement markets.
The Company's revenues are derived from its spread-based business and its
fee-based business. The products and services comprising the spread-based and
fee-based businesses are sold in two principal markets, the retail and
institutional markets, through a broad spectrum of distribution channels. In the
spread-based line of business the Company earns a spread between what is earned
on invested assets and what is credited to customer accounts. In the fee-based
line of business the Company receives a fee in exchange for managing customers'
deposits, and the customer accepts the investment risk. The Company believes
that market forces and population demographics are producing and will continue
to generate strong consumer demand for long-term savings and retirement
products, including variable, indexed and fixed annuity products. Acquisitions
by the Company have provided it with the opportunity to leverage its resources
and enter into new markets in order to try to meet this demand. Although the
Company's core business is developing and managing spread-based investment
products, it has also focused on the development of its fee-based variable
annuity business in addition to exploring other alternatives to increase the
size of the fee-based business line. Fee-based business is less capital
intensive than the spread-based business and provides the Company with
diversified sources of income. Although the Company believes it is desirable to
achieve a reasonable business mix between its spread-based and fee-based
businesses, the business mix may vary from time to time, due to opportunistic
acquisitions and market conditions.
Although third-party assets managed by ARM Capital Advisors have grown
since 1995 when ARM Capital Advisors began its operations, the Company believes
that market attitudes towards developing an asset management service for defined
benefit pension plans within a holding company structure consisting
predominantly of insurance companies has constrained ARM Capital Advisors'
growth. Accordingly, on November 7, 1997 the Company transferred substantially
all of the assets and operations of ARM Capital Advisors to New ARMCA and sold
an 80% interest in New ARMCA.
On December 13, 1996, the Company transferred its contracts to perform
management and advisory services for the State Bond Mutual Funds to Federated
Investors for $4.5 million. Asset management fee income of $1.2 million was
recorded by the Company during the nine months ended September 30, 1996 with
respect to the management of such funds. Had the sale of New ARMCA and the
management contracts for the State Bond Mutual Funds occurred on January 1,
1996, they would have had an immaterial effect on the Company's net income for
the nine months ended September 30, 1997 and 1996, respectively.
- --------------------------------------------------------------------------------
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RESULTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 1997 COMPARED WITH NINE MONTHS ENDED
SEPTEMBER 30, 1996
Net income during the nine months ended September 30, 1997 was $16.8
million compared to $14.8 million for the nine months ended September 30, 1996.
Operating earnings (net income applicable to common shareholders, excluding, net
of tax, realized investment gains and losses, non-recurring charges and income
from defined benefit pension plan asset management operations of ARM Capital
Advisors) were $23.4 million and $13.4 million for the nine months ended
September 30, 1997 and 1996, respectively. The increase in operating earnings is
primarily attributable to an increase in net investment spread due to both
deposit growth from sales of retail and institutional spread-based products and
ongoing asset/liability management and, to a lesser extent, an increase in fee
income as a result of a larger base of variable annuity deposits.
Pro forma operating earnings (operating earnings including a pro forma
adjustment to reflect investment income that could have been earned on the net
proceeds of the Company's Offering assuming it occurred at the beginning of the
period) were $25.6 million and $16.9 million for the nine months ended
September 30, 1997 and 1996, respectively. Pro forma operating earnings per
share were $1.07 and $0.71 for the same respective nine month periods. This pro
forma information is not necessarily indicative of what would have occurred had
the Offering occurred on the dates indicated.
Spread-based operating earnings were $33.9 million and $22.4 million during
the nine months ended September 30, 1997 and 1996, respectively. Retail spread
products (primarily fixed annuities) and institutional spread products (funding
agreements and GICs) comprise the spread-based line of business. Funding
agreements are investment contracts issued by the Company's insurance
subsidiaries to the nonqualified (i.e., non retirement plans) markets. For
retail spread products, annualized operating earnings were 1.36% and 1.03% of
average retail spread-based assets under management for the nine months ended
September 30, 1997 and 1996, respectively. For institutional spread products,
annualized operating earnings were 0.62% and 0.59% of average institutional
spread-based assets under management for the 1997 and 1996 periods,
respectively. The increase in spread-based margins for both retail and
institutional products is attributable to ongoing asset/liability management,
which generated higher net investment spreads, and for retail spread products
only, a reduction of other expenses. Fee-based operating earnings of $3.3
million and $3.1 million, which are primarily derived from retail variable
products (variable annuities) and minimally from institutional enhanced fee
products (synthetic GICs), were 0.46% and 0.59% (annualized) of average
fee-based assets under management for the nine months ended September 30, 1997
and 1996, respectively. The decrease in fee-based margins for the nine months
ended September 30, 1997 is due to an increase in the amortization of deferred
policy acquisition costs. Certain expenses including federal income taxes and
unallocated corporate overhead are not reflected in spread-based and fee-based
operating earnings.
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Net investment spread for the nine months ended September 30, 1997 and 1996
was as follows:
Nine Months Ended
September 30,
-----------------------
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED) 1997 1996
---------- -----------
- --------------------------------------------------------------------------------
Investment income $ 235,270 $ 183,203
Interest credited on customer deposits (175,331) (133,349)
-----------------------
Net investment spread $ 59,939 $ 49,854
-----------------------
-----------------------
Annualized investment yield 7.63% 7.74%
Annualized average credited rate (5.84)% (5.74)%
-----------------------
Annualized investment spread rate 1.79% 2.00%
-----------------------
-----------------------
Average cash and investments (in billions) $ 4.11 $ 3.15
Average spread-based customer deposits (in billions) $ 4.01 $ 3.10
Investment spread rates increased in 1997 for both retail and institutional
spread products. However, a greater mix of institutional spread product deposits
in 1997, which generate lower margins, resulted in the overall decrease in the
investment spread rate. Accordingly, changes in investment yield and interest
credited rates must be analyzed in relation to the liability portfolios to which
they relate. The annualized investment yield on cash and investments, excluding
assets supporting institutional spread product deposits, was 8.05% for the first
nine months of 1997, up from 7.96% for the same period in 1996. In comparison,
the annualized investment yield on cash and investments supporting institutional
spread product deposits was 6.69% and 6.54% for the nine months ended
September 30, 1997 and 1996, respectively. These increases reflect the benefits
of ongoing investment portfolio management. Average cash and investments related
to institutional spread product deposits grew from $484.4 million during the
nine months ended September 30, 1996 to $1.3 billion during the same period in
1997, causing the aggregate decrease in investment yields. The proceeds from
institutional spread product sales are invested in securities of shorter
duration (which generally have lower investment yields) than the Company's other
investment portfolios. The average credited rate pattern is dependent upon the
general trend of market interest rates (which were somewhat higher on the
average in 1997), frequency of credited rate resets and business mix. Crediting
rates are reset monthly based on the LIBOR for institutional spread products and
semi-annually or annually for certain fixed annuities. To date, the Company has
been able to react to changes in market interest rates and maintain a desired
investment spread without a significant effect on surrender and withdrawal
activity, although there can be no assurance that the Company will be able to
continue to do so.
Fee income increased to $17.5 million during the nine months ended
September 30,
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1997 from $13.3 million during the same period in 1996. This increase is
primarily attributable to variable annuity fees, which are based on the market
value of the mutual fund assets supporting variable annuity customer deposits in
separate accounts. Variable annuity fees increased to $10.5 million during the
nine months ended September 30, 1997 from $7.8 million during the same period in
1996 principally due to asset growth from the receipt of variable annuity
deposits and from a market-driven increase in the value of existing variable
annuity deposits invested in mutual funds. Fee-based variable annuity deposits
averaged $933.0 million during the nine months ended September 30, 1997, an
increase from $712.3 million during the same period in 1996. In addition, asset
management fees earned by ARM Capital Advisors on off-balance sheet assets,
primarily related to defined benefit pension plans (and, in 1996 only, fees from
the State Bond Mutual Funds which were sold by the Company in December 1996),
increased to $6.1 million during the nine months ended September 30, 1997 from
$4.5 million during the same period in 1996, reflecting a significant increase
in the average fair value of off-balance sheet assets managed due to sales, from
$2.0 billion during the nine months ended September 30, 1996 to $3.8 billion
during the same period in 1997. As a result of the sale of ARM Capital Advisors'
operations and the State Bond Mutual Funds, asset management fee income is
expected to decrease in the future.
Assets under management by type of product and service as of September 30,
1997 and 1996 were as follows:
September 30,
1997 1996
--------------------------------- ---------------------------------
Percent Percent
(DOLLARS IN MILLIONS) Amount of Total Amount of Total
- ---------------------------------------------------------------------------------------------- --------------------------------
Spread-based:
Retail (fixed and indexed annuity and
face-amount certificate deposits) $ 2,843.2 46.4% $ 2,583.8 56.3%
Institutional (funding agreement and GIC deposits) 1,770.5 28.9 769.7 16.8
-------------------------------- --------------------------------
Total spread-based 4,613.7 75.3 3,353.5 73.1
Fee-based:
Retail (variable annuity deposits invested in
mutual funds) 1,080.3 17.6 794.1 17.3
Institutional (off-balance sheet synthetic GIC
deposits) 10.9 0.2 -- --
-------------------------------- --------------------------------
Total fee-based* 1,091.2 17.8 794.1 17.3
Corporate and other:
Off-balance sheet deposits under marketing
partnership arrangements 251.1 4.1 374.2 8.2
Cash and investments in excess of customer deposits 176.8 2.8 68.2 1.4
-------------------------------- --------------------------------
Total corporate and other 427.9 6.9 442.4 9.6
-------------------------------- --------------------------------
Total assets under management* $ 6,132.8 100.0% $ 4,590.0 100.0%
-------------------------------- --------------------------------
-------------------------------- --------------------------------
* Does not include off-balance sheet assets managed by ARM Capital Advisors
for institutional clients and, for 1996 only, off-balance sheet assets in
the State Bond Mutual Funds. Including such assets, total fee-based assets
under management at September 30, 1997 and 1996 were $5,947.6 million and
$3,195.4 million, respectively, and total assets under management at
September 30, 1997 and 1996 were $10,989.2 million and $6,991.3 million,
respectively.
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The increase in spread-based deposits was primarily attributable to sales
of floating rate funding agreements and GICs to institutional customers and, to
a lesser extent, sales of guaranteed rate option fixed annuities to retail
customers. The increase in the fee-based line of business was primarily
attributable to the investment performance of variable annuity mutual funds due
to strong stock market returns and, to a lesser extent, variable annuity sales.
Sales of spread-based products include premiums and deposits received for
products issued by the Company's insurance and face-amount certificate
subsidiaries. Sales of fee-based products include premiums for the investment
portfolio options of variable annuity products issued by the Company's insurance
subsidiaries.
Sales by market and type of business for the nine months ended
September 30, 1997 and 1996 were as follows:
Nine Months Ended
September 30,
--------------------
(IN MILLIONS) 1997 1996
- ---------------------------------------------------------------------------
Retail:
Spread-based $ 356.0 $ 52.9
Fee-based 132.2 164.2
--------------------
Total retail 488.2 217.1
Institutional:
Spread-based 926.9 624.7
--------------------
Total sales* $1,415.1 $ 841.8
--------------------
--------------------
* Does not include new deposits related to off-balance sheet assets managed
by ARM Capital Advisors for institutional clients and, for 1996 only, new
deposits in the State Bond Mutual Funds. Including such deposits, total
retail sales for the nine months ended September 30, 1997 and 1996 were
$488.2 million and $227.2 million, respectively, and total institutional
sales for the nine months ended September 30, 1997 and 1996 were $3,122.5
million and $1,658.2 million, respectively.
Total sales gained momentum during the first nine months of 1997 with an
increase of approximately 68% over the corresponding prior period. This growth
is primarily attributable to an increase in marketing efforts for the Company's
retail spread-based guaranteed rate option annuity products and institutional
spread products. Successful efforts to expand and diversify the Company's retail
market presence by increasing the
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number of producers also contributed to an increase in spread-based sales
through the independent agent channel where non-registered investment products
are sold. Late year momentum driven by the addition of sales staff and by
further penetration into institutional markets produced an increase in
institutional spread-based sales.
Net surrenders of retail fixed and variable annuity products issued by the
Company's insurance subsidiaries were $252.6 million for the nine months ended
September 30, 1997 compared to $249.7 million for the same period in 1996.
Surrender charge income decreased to $3.0 million for the nine months ended
September 30, 1997 from $3.9 million for the same period in 1996. The decrease
in surrender charge income is primarily attributable to an increase in partial
surrenders which did not result in a surrender charge penalty. Retail products
issued by the Company's insurance subsidiaries generally include lapse
protection provisions that provide a deterrent to surrenders when interest rates
rise. These provisions can include surrender charges and market value
adjustments on annuity withdrawals. During the period that surrender charges are
assessable, generally the first five to seven years after a policy is issued,
surrenders are relatively low. The surrender and withdrawal activity during the
nine month periods ended September 30, 1996 and 1997 was generally expected by
the Company due to the level of customer deposits written several years ago that
were subject to declining or expiring surrender charges, and the Company's
strategy of maintaining investment spreads. The Company has programs designed to
reduce surrender activity and improve persistency.
Operating expenses increased to $23.5 million for the nine months ended
September 30, 1997 from $23.1 million for the same period in 1996. The increase
is primarily attributable to increased marketing efforts (including an increase
in marketing staff and additional investments in technology) to expand and
enhance the support of distribution channels in the retail and institutional
markets, partially offset by a reduction in guaranty fund assessment accruals.
The Company is actively pursuing and retaining producers within its distribution
channels to market its products.
Amortization of deferred policy acquisition costs related to operations was
$7.7 million and $4.6 million during the nine months ended September 30, 1997
and 1996, respectively. This increase was primarily the result of growth in the
deferred policy acquisition cost asset due to additional sales of retail fixed
and variable annuity products. Amortization specifically attributable to
variable annuity products increased $1.9 million during 1997. Variable costs of
selling and issuing the Company's insurance subsidiaries' products (primarily
first-year commissions and issuance costs) are deferred and then amortized over
the expected life of the contract.
The Company recorded non-recurring charges of $13.3 million for the nine
months ended September 30, 1997 including a one-time non-cash stock-based
compensation expense charge of $8.1 million, and other non-recurring costs
primarily related to the relocation and consolidation of the Company's
operations facilities from Columbus,
- --------------------------------------------------------------------------------
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Ohio to Louisville, Kentucky. Costs associated with the relocation are expected
to continue through the end of 1997. The Company recorded non-recurring charges
of $1.0 million for the nine months ended September 30, 1996 for merger and
acquisition activities that did not result in a transaction.
Other expenses, net decreased to $1.4 million for the nine months ended
September 30, 1997 from $5.2 million for the same period in 1996. This decrease
is attributable to higher accruals for reinsurance agreement premiums in the
third quarter of 1996 and higher mortality costs in 1996 related to immediate
annuity deposits. In addition, the Company benefited from mortgage loan
prepayment penalty income during the third quarter of 1997.
Realized investment gains, which are reported net of related amortization
of deferred policy acquisition costs and value of insurance in force, were $3.0
million for the nine months ended September 30, 1997 compared to realized
investment losses of $2.3 million for the same period in 1996. Such realized
investment gains and losses were primarily interest-rate related and
attributable to the ongoing management of the Company's fixed maturity
securities classified as available-for-sale which can result in period-to-period
swings in realized investment gains and losses since securities are sold during
both rising and falling interest rate environments. The ongoing management of
securities is a significant component of the Company's asset/liability
management strategy. The ongoing portfolio management process involves
evaluating the various asset sectors (i.e., security types and industry classes)
and individual securities comprising the Company's investment portfolios and,
based on market yield rates, repositioning holdings from sectors perceived to be
relatively overvalued to sectors perceived to be undervalued with the aim of
improving cash flows. The Company endeavors to accomplish this repositioning
without materially changing the overall credit, asset duration, convexity, and
liquidity characteristics of its investment portfolios.
Federal income tax expense was $9.7 million and $3.7 million for the nine
months ended September 30, 1997 and 1996, respectively, reflecting effective tax
rates of 36.6% and 20.1% as a percentage of pretax income. If the non-recurring
stock-based compensation expense charge was added back to pretax income, the
effective tax rate for the nine months ended September 30, 1997 would be 28.0%.
A tax benefit was not recognized for the charge because a full valuation
allowance was provided on the Company's non-life net operating loss
carryforwards.
THREE MONTHS ENDED SEPTEMBER 30, 1997 COMPARED WITH THREE MONTHS ENDED
SEPTEMBER 30, 1996
Net income during the third quarter of 1997 was $9.1 million compared to
$4.3 million for the third quarter of 1996. Operating earnings were $9.8 million
and $4.7 million for the third quarters of 1997 and 1996, respectively. The
increase in operating earnings is attributable to an increase in net investment
spread due to deposit growth
- --------------------------------------------------------------------------------
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from sales of retail and institutional spread-based products, an increase in fee
income as a result of a larger base of variable annuity deposits, an increase in
other income, and a decrease in other expenses.
Pro forma operating earnings were $9.8 million and $5.9 million for the
three months ended September 30, 1997 and 1996, respectively. Pro forma
operating earnings per share were $0.40 and $0.25 for the same respective three
month periods.
Total net investment spread for the three months ended September 30, 1997
and 1996 was as follows:
Three Months Ended
September 30,
-----------------------
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED) 1997 1996
- ------------------------------------------------------------------------------
Investment income $ 87,811 $ 65,340
Interest credited on customer deposits (65,724) (47,337)
-----------------------
Net investment spread $ 22,087 $ 18,003
-----------------------
-----------------------
Annualized investment yield 7.67% 7.83%
Annualized average credited rate (5.85)% (5.70)%
-----------------------
Annualized investment spread rate 1.82% 2.13%
-----------------------
-----------------------
Average cash and investments (in billions) $ 4.58 $ 3.34
Average spread-based customer deposits (in billions) $ 4.46 $ 3.29
-----------------------
Although investment spread rates were higher during the third quarter
of 1997 compared to 1996 for both retail and institutional spread products, a
greater mix of institutional spread deposits in 1997 resulted in the overall
decrease in the investment spread rate. The annualized investment yield on cash
and investments, excluding assets supporting institutional spread product
deposits, was 8.15% for the third quarter of 1997, up from 8.14% for the same
period in 1996. In comparison, the annualized yield on cash and investments
supporting the institutional spread product deposits was 6.77% and 6.64% for the
three months ended September 30, 1997 and 1996, respectively. Average cash and
investments related to institutional spread product deposits, which are invested
in lower yielding short-term securities, have grown from $704.0 million during
the three months ended September 30, 1996 to $1.6 billion during the same period
in 1997.
Fee income grew to $6.5 million in the third quarter of 1997 from $5.0
million in the third quarter of 1996. This increase is attributable to sales and
a market-driven increase in the value of both variable annuity deposits and
off-balance sheet assets managed by ARM Capital Advisors. Variable annuity fees
increased to $3.9 million in the third quarter of 1997 from $2.8 million in the
third quarter of 1996. Asset management fees earned by ARM Capital Advisors on
off-balance sheet assets, primarily related to defined benefit pension plans
(and, in 1996 only, fees from the State Bond Mutual
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Funds), increased to $2.3 million in the third quarter of 1997 from $1.8 million
in the third quarter of 1996.
Sales by market and type of business for the three months ended
September 30, 1997 and 1996 were as follows:
Three Months Ended
September 30,
-------------------
(IN MILLIONS) 1997 1996
- ----------------------------------------------------------------------------
Retail:
Spread-based $ 42.8 $ 21.8
Fee-based 64.5 44.6
-------------------
Total retail 107.3 66.4
Institutional:
Spread-based 466.1 183.3
-------------------
Total sales* $573.4 $249.7
-------------------
-------------------
* Does not include new deposits related to off-balance sheet assets managed
by ARM Capital Advisors for institutional clients and, for 1996 only, new
deposits in the State Bond Mutual Funds. Including such deposits, total
retail sales for the three months ended September 30, 1997 and 1996 were
$107.3 million and $68.6 million, respectively, and total institutional
sales for the three months ended September 30, 1997 and 1996 were $1,177.4
million and $394.4 million, respectively.
The increase in retail sales is attributable to increases in both
spread-based fixed annuity and fee-based variable annuity products due to
increased marketing efforts and from continuing strong stock market returns
during the third quarter of 1997. The increase in institutional spread-based
sales is attributable to the addition of sales staff and by further penetration
into institutional markets.
Net surrenders of retail fixed and variable annuity products issued by the
Company's insurance subsidiaries were $91.5 million in the third quarter of 1997
compared to $76.2 million in the third quarter of 1996. Surrender charge income
increased to $1.2 million in the third quarter of 1997 from $1.0 million in the
third quarter of 1996. The increase in surrender charge income is primarily
attributable to the increase in surrenders.
Amortization of deferred policy acquisition costs related to operations was
$3.1 million and $1.5 million during the three months ended September 30, 1997
and 1996, respectively. This increase was the result of growth in the deferred
policy acquisition cost asset related to retail fixed and variable annuity
products.
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The Company recorded non-recurring charges of $2.5 million for the three
months ended September 30, 1997 related to the relocation and consolidation of
the Company's operations facilities from Columbus, Ohio to Louisville, Kentucky.
Non-recurring charges of $1.0 million were recorded for the three months ended
September 30, 1996 for merger and acquisition activities that did not result in
a transaction.
Other expenses, net decreased from $2.5 million for the three months ended
September 30, 1996 to $0.5 million of income for the three months ended
September 30, 1997. This decrease is attributable to higher accruals for
reinsurance agreement premiums in the third quarter of 1996 and higher mortality
costs in 1996 related to immediate annuity deposits. In addition, the Company
benefited from mortgage loan prepayment penalty income during the third quarter
of 1997.
Realized investment gains were $0.4 million in the third quarter of 1997
compared to realized investment losses of $1.1 million in the third quarter of
1996. Such realized investment gains and losses were primarily interest-rate
related and attributable to the ongoing management of the Company's fixed
maturity securities classified as available-for-sale which can result in
period-to-period swings in realized investment gains and losses since securities
are sold during both rising and falling interest rate environments.
Federal income tax expense was $3.7 million and $1.0 million for the
quarters ended September 30, 1997 and 1996, respectively, reflecting effective
tax rates of 29.1% and 18.1% as a percentage of pretax income.
ASSET PORTFOLIO REVIEW
The Company primarily invests in securities with fixed maturities with the
objective of earning reasonable returns while limiting credit and liquidity
risks. The amortized cost of fixed maturities at September 30, 1997 totaled
$3.85 billion, compared with $3.05 billion at December 31, 1996, representing
90% and 91%, respectively, of total cash and investments. This increase in fixed
maturities is primarily attributable to the investment of the proceeds from the
sale of institutional spread products.
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The Company's cash and investments as of September 30, 1997 are detailed as
follows:
Amortized Cost
----------------------
Percent of Estimate
(DOLLARS IN MILLIONS) Amount Total Fair Value
- ----------------------------------------------------------------- -----------
Fixed maturities:
Corporate securities $1,193.4 28.3% $1,217.0
U.S. Treasury securities and
obligations of U.S. government
agencies 207.0 4.9 208.4
Other government securities 76.2 1.8 77.8
Asset-backed securities ("ABSs") 363.3 8.6 364.4
Mortgage-backed securities ("MBSs"):
Agency pass-throughs 333.8 7.9 335.7
Collateralized mortgage
obligations ("CMOs"):
Agency 502.3 11.9 511.9
Non-agency 1,160.0 27.5 1,173.5
Interest only 16.5 0.4 11.2
----------------------- -----------
Total fixed maturities 3,852.5 91.3 3,899.9
Equity securities (i.e., non-redeemable 39.7 0.9 40.5
preferred stocks)
Mortgage loans on real estate 16.7 0.4 16.7
Policy loans 123.9 3.0 123.9
Cash and cash equivalents 186.9 4.4 186.9
Total cash and investments $4,219.7 100.0% $4,267.9
----------------------- -----------
----------------------- -----------
Agency pass-through certificates are MBSs which represent an undivided
interest in a specific pool of residential mortgages. The payment of principal
and interest is guaranteed by the U.S. government or U.S. government agencies.
CMOs are pools of mortgages that are segregated into sections, or tranches,
which provide prioritized retirement of bonds rather than a pro rata share of
principal return as in the pass-through structure. The underlying mortgages of
agency CMOs are guaranteed by the U.S. government or U.S. government agencies.
Of the Company's non-agency CMOs (on an amortized cost basis), 83.6% are backed
by mortgage loans or mortgage loan pools, letters of credit, agency mortgage
pass-through securities, and other types of credit enhancement as collateral.
The remaining 16.4% of the non-agency CMOs are backed by commercial mortgage
loans as collateral.
The Company manages prepayment exposure on CMO holdings by diversifying not
only within the more stable CMO tranches, but across alternative collateral
classes such as commercial mortgages and Federal Housing Administration project
loans, which are generally less volatile than agency-backed residential
mortgages. Additionally, prepayment sensitivity is evaluated and monitored,
giving full consideration to the collateral characteristics such as weighted
average coupon rate, weighted
- --------------------------------------------------------------------------------
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average maturity and the prepayment history of the specific collateral. MBSs are
subject to risks associated with prepayments of the underlying collateral pools.
Prepayments cause these securities to have actual maturities different from
those projected at the time of purchase. Securities that have an amortized cost
that is greater than par (i.e., purchased at a premium) that are backed by
mortgages that prepay faster than expected will incur a reduction in yield or a
loss, versus an increase in yield or a gain if the mortgages prepay slower than
expected. Those securities that have an amortized cost that is less than par
(i.e., purchased at a discount) that are backed by mortgages that prepay faster
than expected will generate an increase in yield or a gain, versus a decrease in
yield or a loss if the mortgages prepay slower than expected. The reduction or
increase in yields is partially offset as funds from prepayments are reinvested
at current interest rates. The degree to which a security is susceptible to
either gains or losses is influenced by the difference between its amortized
cost and par, the relative sensitivity of the underlying mortgages backing the
assets to prepayments in a changing interest rate environment and the repayment
priority of the securities in the overall securitization structure. The Company
had gross unamortized premiums and unaccreted discounts of MBSs of $31.9 million
and $31.2 million, respectively, at September 30, 1997. Although the interest
rate environment has experienced significant volatility during 1996 and the
first nine months of 1997, prepayments and extensions of cash flows from MBSs
have not materially affected the investment income of the Company.
ABSs are securitized bonds which can be backed by collateral such as, but
not limited to, home equity loans, second mortgages, automobile loans, and
credit card receivables. Home equity loan collateral represents 63.9% of the
Company's investments in the ABS market. The typical structure of an ABS
provides for favorable yields, high credit ratings and stable prepayments.
Total cash and investments (on an amortized cost basis) were 94% and 96%
investment grade or equivalent as of September 30, 1997 and December 31, 1996,
respectively. Investment grade securities are those classified as 1 or 2 by the
National Association of Insurance Commissioners ("NAIC") or, where such
classifications are not available, having a rating on the scale used by Standard
& Poor's Corporation ("S&P") of BBB- or above. Yields available on
non-investment grade securities are generally higher than are available on
investment grade securities. However, credit risk is greater with respect to
such non-investment grade securities. The Company attempts to reduce the risks
associated with non-investment grade securities by limiting the exposure to any
one issuer and by closely monitoring the creditworthiness of such issuers.
Additionally, the Company's investment portfolio has minimal exposure to real
estate, non-indemnified mortgage loans and common equity securities, which
represented less than 0.1% of cash and investments as of September 30, 1997.
The Company continually monitors and analyzes its investment portfolio,
including non-investment grade securities, in order to determine if its ability
to realize its carrying
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value on any investment has been impaired. For fixed maturity and equity
securities, if impairment in value is determined to be other than temporary
(i.e., if it is probable that the Company will be unable to collect all amounts
due according to the contractual terms of the security), the cost basis of the
impaired security is written down to fair value, which becomes the security's
new cost basis. The amount of the write-down is included in earnings as a
realized loss. Future events may occur, or additional or updated information may
be received, which may necessitate future write-downs of securities in the
Company's portfolio. Significant write-downs in the carrying value of
investments could materially adversely affect the Company's net income in future
periods.
At September 30, 1997, the ratings assigned by the NAIC and comparable S&P
ratings on the Company's fixed maturity portfolio, the percentage of total fixed
maturity investments classified in each category and the corresponding fair
value, were as follows:
Amortized Cost
----------------------
Percent Estimated
NAIC Designation (Comparable S&P Rating) Amount of Total Fair Value
- -------------------------------------------------------------------------------
(Dollars in millions)
1 (AAA, AA, A) $2,766.4 72% $2,794.2
2 (BBB) 812.9 21 825.6
3 (BB) 141.3 4 146.1
4 (B) 127.2 3 127.9
5 (CCC, CC, C) -- -- --
6 (CI, D) 4.7 * 6.1
-------------------------------------
Total fixed maturities $3,852.5 100% $3,899.9
-------------------------------------
-------------------------------------
* Less than 1%.
Pursuant to SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," the Company classifies its entire fixed maturities portfolio
as available-for-sale. Fixed maturities classified as available-for-sale are
carried at fair value and changes in fair value, net of related value of
insurance in force and deferred policy acquisition cost amortization and
deferred income taxes, are charged or credited directly to shareholders' equity.
The fluctuations in interest rates during the nine months ended
September 30, 1997 contributed to net unrealized gains on available-for-sale
securities which totaled $23.5 million (net of $12.2 million of related
amortization and $12.6 million in deferred income taxes) at September 30, 1997,
compared to net unrealized gains of $3.7 million (net of $1.3 million of related
amortization and $2.0 million in deferred income taxes) at December 31, 1996.
This volatility in reported shareholders' equity occurs as a result of
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SFAS No. 115 which requires that available-for-sale securities be carried at
fair value while corresponding customer deposit liabilities are carried at
historical values. At September 30, 1997 and December 31, 1996, shareholders'
equity excluding the effects of SFAS No. 115 was $278.0 million and $178.3
million, respectively.
The Company manages assets and liabilities in a closely integrated manner,
with the aim of reducing the volatility of investment spreads during a changing
interest rate environment. As a result, adjusting shareholders' equity for
changes in the fair value of the Company's fixed maturities and equity
securities without reflecting offsetting changes in the value of the Company's
liabilities creates volatility in reported shareholders' equity but does not
fully reflect the underlying economics of the Company's business.
Customer deposits in separate accounts related to retail guaranteed rate
option and indexed annuities are held in a guaranteed separate account where the
Company provides some form of guarantee on the rate credited to the annuity
contract. Assets held in the Company's guaranteed separate account include
$617.9 million of cash and investments at September 30, 1997, of which
approximately 94% are fixed maturities. Total guaranteed separate account cash
and investments were 99% investment grade at September 30, 1997.
LIQUIDITY AND FINANCIAL RESOURCES
HOLDING COMPANY OPERATIONS
The Company's principal need for liquidity has historically consisted of
debt service obligations under its bank financing agreement, dividend payments
on its preferred stock, operating expenses, and corporate development
expenditures. The Company is dependent on dividends from Integrity and
management and service fee income from the Company's subsidiaries to meet
ongoing cash needs, including amounts required to pay debt service and dividends
on its common and preferred stock.
The ability of the Company's insurance subsidiaries to pay dividends and
enter into agreements with affiliates is limited by state insurance laws. During
the first nine months of 1997, the Company received dividends of $14.9 million
from Integrity. The Company had cash and investments at the holding company
level of $48.3 million at September 30, 1997. In addition, the Company had
access to bank lines of credit totaling $37.0 million at September 30, 1997.
In June 1997, the Company completed an initial public offering of 9.2
million shares of New Class A Common Stock of which 5.75 million shares were
sold by the Company for net proceeds of $78.8 million. The remaining 3.45
million shares were sold by the Morgan Stanley Stockholders. On June 30, 1997,
the Company used a portion of such net proceeds to make a capital contribution
to its primary insurance subsidiary, Integrity,
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thereby strengthening Integrity's capital base to provide for future growth. The
Company intends to also use the net proceeds to enhance the Company's retail
market presence, to consolidate operating locations and for other corporate
purposes, which may include acquisitions.
INSURANCE SUBSIDIARIES OPERATIONS
The primary sources of liquidity of the Company's insurance subsidiaries
are investment income and proceeds from maturities and redemptions of
investments. The principal uses of such funds are benefits, withdrawals and
loans associated with customer deposits, commissions, operating expenses, and
the purchase of new investments.
The Company develops cash flow projections under a variety of interest rate
scenarios generated by the Company. The Company attempts to structure asset
portfolios so that the interest and principal payments, along with other fee
income, are more than sufficient to cover the cash outflows for benefits,
withdrawals and expenses under the expected scenarios developed by the Company.
In addition, the Company maintains other liquid assets and aims to meet
unexpected cash requirements without exposure to material realized losses during
a higher interest rate environment. These other liquid assets include cash and
cash equivalents and high-grade floating-rate securities held by both the
Company and its insurance subsidiaries.
During the nine months ended September 30, 1997 and 1996, the Company met
its liquidity needs entirely from cash flows provided by operating activities
and principal payments on and redemptions of investments. At September 30, 1997,
cash and cash equivalents totaled $186.9 million compared to $110.1 million at
December 31, 1996. The Company's aim is to manage its cash and cash equivalents
position in order to satisfy short-term liquidity needs. In connection with this
management of cash and cash equivalents, the Company may invest idle cash in
short-duration fixed maturities to capture additional yield when short-term
liquidity requirements permit.
The Company generated cash flows of $149.5 million and $136.5 million from
operating activities during the nine months ended September 30, 1997 and 1996,
respectively. These cash flows resulted principally from investment income, less
commissions and operating expenses. Proceeds from sales, maturities and
redemptions of investments generated $2,939.0 million and $2,000.1 million in
cash flows during the nine months ended September 30, 1997 and 1996,
respectively, which were offset by purchases of investments of $3,680.9 million
and $2,523.0 million, respectively. An increase in investment purchases and
sales activity during the first nine months of 1997 reflects the Company's
ongoing management of its fixed maturity portfolio which has increased in size
due to sales of spread-based products.
The net increase to Integrity's adjusted capital and surplus, under
statutory
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accounting practices, for the capital contribution from the holding company from
the proceeds of the Offering, net of dividends paid by Integrity during the nine
months ended September 30, 1997, was approximately 7%.
FORWARD-LOOKING STATEMENTS
The Company has made a number of forward-looking statements in this
document that are subject to risks and uncertainties. Forward-looking statements
include the information concerning possible or assumed future results of
operations and those preceded by, followed by or that include the words
"believes," "expects," "anticipates" or similar expressions. Such
forward-looking statements are based on the Company's beliefs as to its
competitive position in its industry and the factors affecting its business. In
particular, the statements of the Company's belief as to the stimulation of
future demand for long-term savings and retirement products, including variable,
indexed and fixed annuity products under the heading "General" are
forward-looking statements. Factors that could cause actual results to differ
materially from the forward-looking statements related to the demand for
variable, indexed and fixed annuity products include, but are not limited to, a
change in population demographics, development of alternative investment
products, a change in economic conditions, and changes in current federal income
tax laws. In addition, there can be no assurance that (i) the Company has
correctly identified and assessed all of the factors affecting its business;
(ii) the publicly available and other information on which the Company has based
its analyses is complete or correct; (iii) the Company's analyses are correct;
or (iv) the Company's strategy, which is based in part on these analyses, will
be successful.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
As a consequence of the acquisition of State Bond and Mortgage Life
Insurance Company and its merger with and into Integrity, Integrity became a
party to a marketing agreement with Multico Marketing Corporation ("Multico").
In reliance upon the marketing agreement, Integrity eliminated commissions to
Multico on new product sales on a prospective basis effective July 1, 1995.
Multico filed a lawsuit in the United States District Court for the Western
District of Kentucky against Integrity on February 23, 1996, alleging breach of
contract and breach of the covenant of good faith and fair dealing, and seeking
a trial by jury and compensatory and punitive damages of approximately $61
million. Integrity filed a counterclaim against Multico seeking a declaration
that Integrity's actions in revising commissions did not constitute a breach of
contract, and the recovery of commissions, fees, trailers, overwrites, and
bonuses paid to Multico in the amount of approximately $9.3 million. On May 23,
1996, Integrity filed a motion for summary judgement in the litigation; this
motion was denied by the court on March 10, 1997. Discovery is proceeding
between the parties. Company management believes that the ultimate resolution of
this litigation will not result in any material adverse impact to the financial
position of the Company.
Except as described above, the Company is currently involved in no material
legal or administrative proceedings that could result in a material adverse
impact to the financial position of the Company.
ITEM 2. CHANGES IN SECURITIES
On September 30, 1997, the Company filed a Form S-8 Registration Statement
with the SEC to register the underlying shares of New Class A Common Stock
reserved for issuance upon the exercise of stock options under the ARM Financial
Group, Inc. Amended and Restated Stock Option Plan and the 1997 Equity Incentive
Plan.
ITEM 5. OTHER INFORMATION
The Board of Directors by unanimous written consent dated November 7, 1997,
declared a quarterly dividend of 59.375 cents per share payable December 15,
1997 to holders of the 9 1/2% Cumulative Perpetual Preferred Stock of record on
November 28, 1997, and a quarterly dividend of 2 cents per share payable
December 15, 1997 to holders of the New Common Stock of record on November 28,
1997.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
REPORTS ON FORM 8-K
The Company did not file any reports on Form 8-K during the three months
ended September 30, 1997.
EXHIBITS
11 Statement re computation of per share earnings (see page 31).
27 Financial Data Schedule (electronic filing only).
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, on November 10, 1997.
ARM FINANCIAL GROUP, INC.
By: /S/ EDWARD L. ZEMAN
---------------------------------------------
Edward L. Zeman
Executive Vice President-
Chief Financial Officer(Principal Financial
Officer)
By: /S/ BARRY G. WARD
---------------------------------------------
Barry G. Ward
Controller (Principal Accounting Officer)