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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended: December 31, 1997 Commission file number: 33-67268
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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
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
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Class A Common Stock (par value $.01 American Stock Exchange
per share) 9.5% Cumulative Perpetual American Stock Exchange
Preferred Stock
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
/ / Yes / / No
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /x/
Aggregate market value of voting common stock held by non-affiliates,
computed as of February 20, 1998 was $214,359,305.
Indicate the number of shares outstanding of each of the issuer's classes
of commons stock as of the latest practicable date.
Date Class Shares Outstanding
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February 20, 1998 A 21,441,641
February 20, 1998 B 1,947,646
DOCUMENTS INCORPORATED BY REFERENCE
Certain information contained in registrant's Proxy Statement for the Annual
Meeting of Stockholders to be held May 27, 1998, is incorporated by reference
into Part III hereof.
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PART I
ITEM 1. BUSINESS
GENERAL
ARM Financial Group, Inc. (the "Company") specializes in the growing asset
accumulation business with particular emphasis on retirement savings and
investment products. The Company's earnings are derived from investment spread
(the difference between income earned on investments and interest credited on
customer deposits) and fee income. The Company's retail products include a
variety of fixed, indexed and variable annuities and face-amount certificates
sold through a broad spectrum of distribution channels including independent
broker-dealers, independent agents, stockbrokers, and financial institutions.
The Company offers institutional products, such as funding agreements and
guaranteed investment contracts ("GICs") directly to bank trust departments,
plan sponsors, cash management funds, corporate treasurers, and other
institutional investors.
The Company was established in July 1993 and completed its acquisition of
Integrity Holdings, Inc. in November 1993. The Company's assets under management
have grown from $2.3 billion as of December 31, 1993 to $6.9 billion as of
December 31, 1997. The Company attributes this growth to internally generated
sales, new product offerings and opportunistic acquisitions. 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 which were sold during November
1997) have grown to $34.1 million in 1997 from $22.2 million in 1996 and $4.5
million in 1995. In June 1997, the Company raised $78.8 million through an
initial public offering of its common stock. See "--History."
The Company expects to benefit from demographic trends and a growing demand
for retirement savings. As the U.S. population has aged, demand for retirement
savings has accelerated. According to U.S. Census Bureau information,
approximately 30% of today's population was born during the Baby Boom (1946 to
1964). By the time the Baby Boom generation begins to reach age 65 in 2011, the
population between the ages of 45 and 64 -- the peak period for asset
accumulation -- is projected to increase by approximately 45% to 79 million
people.
The Company also expects to benefit from anticipated higher consumer
savings due to an overburdened social security system, extended life spans,
concerns about corporate restructurings and downsizing, and volatile financial
markets. Among the products expected to benefit are tax-advantaged annuities.
Annual industry sales of individual annuity products increased dramatically from
$65 billion in 1990 to a preliminary estimate of $124 billion in 1997, with
projected growth of 8% to 12% per year for the next few years, according to an
industry study conducted by LIMRA.
The Company also expects to benefit from the growing institutional
marketplace, which is partially fueled by growth in retirement and consumer
savings. The Company intends to expand its institutional deposit base by
increasing penetration in the stable value and fixed income markets and the
development of new products and applications.
2
The discussion of the Company's business contains certain forward-looking
statements, see "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Forward-Looking Statements."
STRATEGY
The Company's strategy is focused on the following:
DEVELOPING AND MARKETING A BROAD ARRAY OF CUSTOMIZED PRODUCTS. The Company
believes that long-term success in the asset accumulation industry will depend
upon the Company's ability to adapt to rapidly changing consumer preferences in
fluctuating interest rate and equity market environments. The Company
continually redesigns existing products with enhanced features and continues to
develop and sell new and innovative products with a particular focus on
minimizing its dependence on any one product and meeting a variety of needs for
consumers and distribution channels. The Company works closely with the people
involved with its retail and institutional distribution to develop products that
are customized to suit their customers' particular needs. The Company was one of
the first to recognize the market opportunity for equity-indexed annuities and
in 1996 introduced OMNI, the Company's equity-indexed annuity product. In 1997,
the Company introduced OMNISELECT, a second generation equity-indexed annuity
product with enhanced features. Additionally in 1997, the Company enhanced its
multi-manager variable annuity product, PINNACLE, making it one of the first in
the industry to offer Bankers Trust indexed funds, along with a diverse
selection of asset classes from well-known fund managers, guaranteed rate
options and the ability for systematic transfer of deposits over time -- all in
one product. In the institutional market, the Company offers a short-term
floating rate institutional spread-based product designed to meet the market
demand for products with attractive current yields and access to liquidity. In
1997, the Company developed and funded a unique asset-backed funding agreement,
in alliance with Bayerische Landesbank Girozentrale, New York Branch, ("BLB"), a
triple-A rated international banking institution. In connection with another
highly-rated international bank, the Company is developing a synthetic GIC
product for the institutional spread marketplace that will provide institutional
clients with either absolute or relative investment performance guarantees.
CAPTURING A GROWING SHARE OF SALES IN RETAIL DISTRIBUTION CHANNELS. Over
the past few years, the Company has built the infrastructure necessary to
support increased growth in the retail market. The Company believes that it
can distinguish itself by strengthening its relationships with individual
distributors, often referred to as producers. To accomplish this objective,
the Company seeks to (i) provide superior service to producers through an
expanded and dedicated producer services unit; (ii) enhance the Company's
technological platform to permit superior and immediate access for producers
to the Company's administrative systems for transacting business; (iii)
heighten producers' awareness of the Company's products and insurance
affiliates through focused advertisements in industry publications and
selective promotional programs; and (iv) quickly develop innovative products
with new features and services which are responsive to market needs. For
example, in 1997, as a means to strengthen its relationships with
distributors, the Company implemented a program, called AnnuiTRAC-SM-,
whereby certain distributors have the capability to remotely access the
Company's systems and transact business with the Company on-line. The Company
also seeks to increase its retail market share by expanding and diversifying
its retail distribution channels. In 1996, the Company began offering
variable annuities through banks and thrifts, and in late 1997 introduced a
new variable annuity product customized for that distribution channel.
Additionally, the Company recognizes the importance of building and
maintaining a strong capital base. Primarily as a result of the Company's
strengthened financial condition, A.M. Best
3
Company, Inc. ("A.M. Best") raised the claims-paying ability rating of the
Company's insurance subsidiaries from "A- (Excellent)" to "A (Excellent)" in
1995.
EXPANDING AND DIVERSIFYING THE DEPOSIT BASE IN THE INSTITUTIONAL
MARKETPLACE. Since the Company's inception, its institutional business has
grown to $2.5 billion of funding agreement and GIC deposits on the Company's
December 31, 1997 balance sheet. The Company believes that its integrated
asset/liability management approach to the business, along with its sound
underwriting philosophy, has allowed it to build competitive advantages. The
Company has found it beneficial to form strategic partnerships with
organizations possessing strong financial ratings and market presence. Since
1995, the Company has written funding agreements and GICs through General
American Life Insurance Company ("General American") and reinsures one-half of
the business written. In late 1997, the Company sold its first funding agreement
structure outside the General American relationship with a $500 million,
five-year term offering, in alliance with BLB, a triple-A rated international
banking institution. In addition to offering its current products, the Company
intends to continue its growth in the institutional market by (i) diversifying
its product line with (a) customized product features for alternative
distribution channels, (b) fixed terms extending beyond current product
offerings and (c) on- and off-balance sheet synthetic products or new funding
agreement products in which the Company offers certain performance guarantees;
(ii) attracting new partners with larger and stronger balance sheets to provide
credit enhancement to help support and market the new product structures and
marketing initiatives; and (iii) expanding market penetration within its
existing clients while maintaining the persistency and profitability of the
current client base.
ENHANCING EFFECTIVE USE OF TECHNOLOGY. The Company continues to invest in
technology designed to enhance the services provided to producers and customers,
increase the efficiency of operations and allow for administration of innovative
and complex products. The Company's technology also allows it to quickly respond
to customer needs for new products by reducing product development time. In
addition, to supplement traditional inquiry and transaction processing methods,
the Company's client/server network can provide producers, customers and
employees with services and information easily accessible through Internet,
voice response and wide-area network technology. One such example is the
Company's 1997 introduction of AnnuiTRAC, its Internet based producer service
program.
MINIMIZING FIXED COST STRUCTURE. The Company attempts to minimize fixed
distribution costs by marketing its products through fiduciaries and other third
parties. Unlike many of its competitors, the Company does not maintain its own
field sales force, and distributors are primarily paid based on production. As a
consequence of its low fixed distribution costs, the Company has flexibility to
shift the mix of its sales and distribution channels in order to respond to
changes in market demand. In addition, the Company believes that its
administrative cost structure has benefited from economies of scale achieved as
a result of its strategic acquisitions. The relocation of the Company's main
processing center from Columbus, Ohio to the Company's headquarters in
Louisville, Kentucky, which was substantially completed during 1997, has
provided benefits of consolidation and supplemented the effective delivery of
service.
4
IMPLEMENTING AN ADVANCED AND INTEGRATED RISK MANAGEMENT PROCESS. Using its
experience in offering investment guarantees in the insurance market sector, the
Company employs a highly analytical and disciplined asset/liability risk
management approach to develop new products and monitor investment portfolios
and liabilities. The Company does not view asset/liability management as a
discrete function to be performed by a separate committee. Instead,
asset/liability management permeates every aspect of the Company's operations.
Beginning with product design and continuing through the product sale and
eventual payout, professionals in each functional area (such as marketing,
actuarial, investments, legal, finance, and administration) work jointly with a
common set of risk/return characteristics to achieve the Company's overall
liquidity and profit objectives (rather than the specific objectives of any
particular functional area). The Company implements this process with the
analytical risk and capital management skills and the experience of its
management team. This foundation is supported with sophisticated computer
software and an emphasis on securities whose cash flows can be modeled
extensively against liability cash flows under different interest rate
scenarios. Risk components that cannot be appropriately modeled are typically
hedged or reinsured.
MAINTAINING FOCUS ON COMPANY PROFITABILITY. The Company designs products
and manages capital with a goal of achieving a superior return on common equity.
The Company's return on average common equity (based on operating earnings and
equity before unrealized gains and losses and giving pro forma effect to the
Company's initial public offering of common stock) was 16.4% in 1997 and 13.5%
in 1996. The Company's focus on profitability is supported by an integrated team
approach to developing products and operating the Company's business. The
Company's compensation system further reinforces the Company's focus on the
objective of profitability. Employees at all levels of the Company are eligible
to receive bonuses based on profitability. As of February 20, 1998, executive
officers held shares and options to purchase shares representing 7% of the
Company's outstanding common stock and options.
The Company, a Delaware Corporation, conducts its different businesses
through the following subsidiaries:
- INTEGRITY LIFE INSURANCE COMPANY ("INTEGRITY") -- provides
individual fixed, indexed and variable annuities to retail
customers and funding agreements and GICs to institutional
customers;
- NATIONAL INTEGRITY LIFE INSURANCE COMPANY ("NATIONAL INTEGRITY")
-- provides individual fixed and variable annuities to retail
customers and funding agreements and GICs to institutional
customers, primarily in New York (wholly owned subsidiary of
Integrity, and collectively, the "Integrity Companies");
- SBM CERTIFICATE COMPANY -- offers retail face-amount certificates
which guarantee a fixed rate of return to investors at a future
date. Face-amount certificates are similar to bank-issued
certificates of deposit but are regulated by the Investment
Company Act of 1940, as amended (the "Investment Company Act")
and are not subject to Federal Deposit Insurance Corporation
("FDIC") protection; and
5
- ARM SECURITIES CORPORATION ("ARM SECURITIES") (FORMERLY KNOWN AS
SBM FINANCIAL SERVICES, INC.) -- this broker-dealer supports the
Company's retail annuity operations and the Company's sales of
independent third-party mutual funds.
In addition, ARM Capital Advisors, LLC ("New ARMCA"), which remains a 20%
owned affiliate, offers fixed income asset management to third-party
institutional clients (currently consisting primarily of defined benefit pension
plans) and to the Company.
HISTORY
INTEGRITY COMPANIES
The Company was established in July 1993 by The Morgan Stanley
Leveraged Equity Fund II, L.P. ("MSLEF II"), an investment fund sponsored by
Morgan Stanley Group Inc. (now known as Morgan Stanley Dean Witter & Co.),
and Analytical Risk Management, Ltd. to acquire Integrity Holdings, Inc.
(formerly N.M. U.S. Limited) from The National Mutual Life Association of
Australasia Limited ("National Mutual"). In connection with the acquisition,
which occurred on November 26, 1993, National Mutual provided the Integrity
Companies with indemnification as to future claims for taxes, assessments
from guaranty funds, and claims from litigation, which arise from preclosing
events.
ARM CAPITAL ADVISORS
Through its acquisition of the U.S. fixed income unit of Kleinwort Benson
Investment Management Americas Inc. ("KBIMA") in January 1995, the Company
obtained a recognized fixed income management business, which became part of the
then newly-formed ARM Capital Advisors, Inc. ("ARM Capital Advisors"), to manage
the investment portfolios of the Company's subsidiaries. In addition, the
acquisition enabled the Company to provide asset management services to
institutional clients. Although third-party assets managed by ARM Capital
Advisors grew since the acquisition, the Company believes that market attitudes
towards developing an asset management business for defined benefit pension
plans within a holding company structure consisting predominantly of insurance
companies 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 a newly formed subsidiary, New ARMCA, and sold an 80%
interest therein 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 has continued to engage New ARMCA as its investment adviser but will
consider retaining other investment management firms as it deems appropriate.
Importantly, the Company has and will continue to monitor the investment
practices of New ARMCA and any other firm it uses to ensure that the Company's
prescribed guidelines are followed. After the sale, ARM Capital Advisors was
renamed Integrity Capital Advisors, Inc.
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 of the Company and as an officer and director of ARM Capital
Advisors.
6
SBM COMPANY
In June 1995, the Company completed the acquisition of substantially all of
the assets and business operations of SBM Company ("SBM"), including all of the
issued and outstanding capital stock of SBM's subsidiaries, SBM Life (which was
subsequently merged with and into Integrity to create certain operating
efficiencies), SBM Financial Services, Inc. (which subsequently changed its name
to ARM Securities Corporation), SBM Certificate Company, and SBM's management
contracts with six mutual funds (the "State Bond Mutual Funds"). The aggregate
purchase price for the SBM acquisition was $38.8 million. The Company issued
approximately 6.9 million shares of common stock (adjusted for the 706-for-1
stock split of June 1997) primarily to Morgan Stanley Capital Partners III,
L.P., Morgan Stanley Capital Investors, L.P., and MSCP III 892 Investors, L.P.
(together with MSLEF II, the "Morgan Stanley Stockholders"), for an aggregate
sale price of $63.5 million. The Company used the proceeds from the issuance of
new common equity to acquire the assets and business operations of SBM and to
make a $19.9 million capital contribution to SBM Life. The Company subsequently
determined that the State Bond Mutual Funds were not a strategic line of
business for the Company and 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. The State Bond Mutual Funds had
aggregate assets of $236.9 million on December 13, 1996.
INITIAL PUBLIC OFFERING OF COMMON STOCK
In June 1997, the Company completed an initial public offering of 9.2
million shares of its Class A common stock, par value $.01 per share (the "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. The net proceeds of
the offering to the Company were $78.8 million, after deducting underwriting
discounts and commissions and other expenses payable by the Company. On June 30,
1997, the Company used $40 million of such net proceeds to make a capital
contribution to its primary insurance subsidiary, Integrity, thereby
strengthening Integrity's capital base to provide for future growth. The Company
plans to use the remaining proceeds from the offering to enhance the Company's
retail market presence, to consolidate operating locations and for other
corporate purposes, which may include acquisitions.
Concurrent with its initial public 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 Class A Common Stock and
Class B Non-Voting Common Stock, par value $.01 per share (the "Class B Common
Stock" and, together with the Class A Common Stock, the "Common Stock"), (ii)
authorized shares of the Class A Common Stock and 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
Class A Common Stock, (iv) certain shares of the Class A Common Stock owned by
the Morgan Stanley Stockholders were converted into 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 Class A Common Stock, and (v) each share of Common Stock was split
into 706 shares of Common Stock. Holders of Class B Common Stock have no right
to vote on matters submitted to a vote of stockholders, except in certain
circumstances. Shares of the Class B Common Stock have no preemptive or other
subscription rights and are convertible into an equal number of shares of Class
7
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 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.
PRODUCTS AND SERVICES
The Company offers a diversified array of products and services to meet the
needs of a variety of customers. The Company endeavors to adapt its products to
respond to changes in the retail and institutional marketplace and generally
seeks to have "a product for every market environment." The Company's retail
products include a variety of variable, indexed and fixed annuities and
face-amount certificates. The Company's retail variable annuity products offer
customers participation in various investment portfolios, some of which are
offered exclusively by the Company's insurance subsidiaries. The Company also
offers funding agreements and GICs to its institutional clients and is currently
developing a synthetic GIC product for its institutional clients.
The Company derives its earnings from the net investment spread and fee
income generated by the assets it manages. With retail and institutional spread
products, the Company's insurance and face-amount certificate subsidiaries agree
to return customer deposits with interest at a specified rate or based on a
specified index (e.g., LIBOR, S&P 500--both defined below). As a result, the
Company's insurance and face-amount certificate subsidiaries accept investment
risk in exchange for the opportunity to achieve a spread between what the
Company earns on invested assets and what it pays or credits on customer
deposits. With retail variable products, the Company's subsidiaries receive a
fee in exchange for managing deposits, and the customer accepts investment risk
associated with their chosen mutual fund option. Because the investment risk is
borne by the customer, this business requires significantly less capital support
than spread-based business.
RETAIL AND INSTITUTIONAL SPREAD PRODUCTS
The Company seeks to limit the volatility of investment spreads in a
variety of interest rate environments. To this end, management (i) structures
investment asset durations, convexity and liquidity characteristics to match
with customer deposit characteristics, (ii) regularly trades investment assets
to improve yield while maintaining other portfolio characteristics, (iii) offers
an array of products whose credited rates are based on differing points on the
yield curve, and (iv) actively manages the trade-off between credited rates and
persistency.
The Company's retail and institutional spread products include retail
guaranteed rate options ("GROs") sold as a stand-alone product or as an
investment option within variable annuity contracts, flexible premium deferred
annuity ("FPDA") contracts, single premium deferred annuity ("SPDA") contracts,
face-amount certificates, and institutional funding agreements and GICs as
described below. Sales of such products include premiums and deposits received.
Sales of such retail and institutional spread products for the years ended
December 31, 1997, 1996 and 1995 were as follows:
8
Year Ended December 31,
(IN MILLIONS) 1997 1996 1995
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Retail spread product sales:
GRO $ 320.3 $ 83.6 $ 47.1
FPDA 31.1 29.9 12.5
SPDA 0.8 8.6 44.3
Face-amount certificates 9.8 8.0 10.7
Other 20.5(1) 0.5 0.8
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Total retail spread products 382.5 130.6 115.4
Institutional spread product sales:
Funding agreements and GICs(2) 1,708.7 747.5 142.2
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Total sales of spread products $2,091.2 $ 878.1 $ 257.6
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(1) Includes $19.8 million of systematic transfer option sales which are
systematically transferred into other products within one year.
(2) The marketing partnership arrangement with General American was converted
from a fee-based to primarily a spread-based arrangement in late 1995
through a reinsurance agreement with General American. General American
cedes 50% of new funding agreement and GIC deposits to Integrity under the
reinsurance agreement which the Company records on its balance sheet. The
Company receives nominal fee income for the 50% portion retained by General
American (which the Company recognizes as "other fee income"); accordingly,
such deposits are not included in sales.
Assets under management for retail and institutional spread products at
December 31, 1997, 1996 and 1995 were as follows:
December 31,
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1997 1996 1995
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Percent Percent Percent
(DOLLARS IN MILLIONS) Amount of Total Amount of Total Amount of Total
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Retail spread products:
GRO $ 558.2 10.4% $ 223.1 6.3% $ 164.5 5.8%
FPDA 403.2 7.5 428.1 12.1 436.2(1) 15.2
SPDA 698.9 13.0 838.2 23.7 969.8(1) 33.9
SPIA 654.4 12.2 650.1 18.4 644.8 22.6
SPE 383.3 7.2 396.7 11.2 403.3 14.1
Face-amount certificates 45.1 0.8 50.2 1.4 52.5(1) 1.8
Other 77.5 1.5 59.8 1.7 45.1 1.6
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Total retail spread products 2,820.6 52.6 2,646.2 74.8 2,716.2 95.0
Institutional spread products:
Funding agreements and GICs(2) 2,542.3 47.4 891.9 25.2 143.2 5.0
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Total assets under management for spread products $ 5,362.9 100.0% $ 3,538.1 100.0% $ 2,859.4 100.0%
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(1) Includes amounts acquired in 1995 in connection with the SBM acquisition of
$297.7 million (SPDA), $436.2 million (FPDA) and $52.5 million (face-amount
certificates).
9
(2) The marketing partnership arrangement with General American was converted
from a fee-based to primarily a spread-based arrangement late in 1995
through a reinsurance agreement with General American. See "--Funding
Agreements and Guaranteed Investment Contracts."
GUARANTEED RATE OPTIONS. Guaranteed rate options provide a fixed-rate
investment alternative for holders of the Company's variable annuity contracts
and are also issued as a separate product by the Company's insurance
subsidiaries. GROs, which were first introduced by the Company's insurance
subsidiaries in 1994, allow customers to lock in a fixed return for three, five,
seven, or ten years. There are no up-front or annual fees attached to these
options, but surrender charges apply to withdrawals in excess of a stated
maximum. Funds may be transferred to or from any of the guaranteed interest rate
periods (or other investment options within the variable annuity contract)
subject to a market value adjustment ("MVA"). The MVA can be either positive or
negative, but the customer is guaranteed principal by the issuing insurance
company plus a return of 3%, before surrender charges. Transfers at the end of a
guarantee period are not subject to the MVA provision. The MVA provision is
intended to offset the gain or loss attributable to the impact of changes in
interest rates on the market value of assets that would be sold to fund
surrenders occurring prior to the end of the guarantee period. The Company
currently uses an immunized investment strategy designed to achieve a target
dollar amount over the selected time horizon despite interest rate volatility,
while maintaining a tight duration match between the assets in the portfolio and
the customer deposits they support. Deposits into GROs are held in a guaranteed
separate account established by the insurance company.
FLEXIBLE PREMIUM DEFERRED ANNUITY CONTRACTS. Flexible premium deferred
annuity contracts are marketed primarily through independent agents. Under these
contracts, the issuing insurance company guarantees the customer's principal and
credits the accumulated deposit with a rate of interest that is guaranteed for a
specified initial period and reset annually or semi-annually thereafter. FPDA
contract holders can make additional contributions, subject to minimums, after
the contract is issued. The Company generally determines the crediting rate by
reference to current yields along the intermediate term section of the yield
curve. Certain FPDA contracts, which were acquired as a result of the SBM
acquisition and which are not currently marketed by the Company, are qualified
under section 403(b) of the Internal Revenue Code of 1986, as amended, and were
sold to qualified employers such as public school districts and churches. The
Company developed a new FPDA product, OMNI, in 1995, with sales commencing in
February of 1996 and developed a second generation of equity-indexed product,
OMNISELECT, in 1997. The OMNI and OMNISELECT products furnish customers with the
ability to allocate assets among equity index-based returns and guaranteed rates
of return. The index-based options offer upside potential tied to a percentage
of the appreciation in the S&P 500 Composite Stock Price Index ("S&P 500"), but
protect the customer against the related downside risk through a guarantee of
principal by the issuing insurance company. By hedging the equity-based risk
component of the product through the purchase of call options or other
investment strategies, the Company focuses on managing the interest rate spread
component.
SINGLE PREMIUM DEFERRED ANNUITY CONTRACTS. Single premium deferred annuity
contracts have in the past been sold through independent broker-dealers,
independent agents, stockbrokers, and financial institutions. Under these
contracts, the issuing insurance company guarantees the
10
customer's principal and credits the accumulated deposit with a rate of interest
that is guaranteed for a specified initial period and reset annually or
semi-annually thereafter, subject to guaranteed minimum crediting rates set
forth in the contracts (currently 3% or 4%). The Company generally determines
the crediting rate by reference to current yields along the intermediate term
section of the yield curve. No front-end sales charges are imposed for purchases
of such contracts, but all contain surrender charges for withdrawals in excess
of a specified amount during the surrender charge period. These surrender
charges vary depending upon the guarantee periods in the contracts. As a result
of changes in the marketing environment for this product and the increased
competition in pricing, the Company is not actively marketing this product.
SINGLE PREMIUM IMMEDIATE ANNUITY CONTRACTS. Single premium immediate
annuity contracts were historically marketed by the Company to insurance
companies and defendants in connection with lawsuits involving structured
liability settlements. As a result of changes in the marketing environment for
this product and the increased competition in pricing, the Company's insurance
subsidiaries are not currently focusing on this segment of the immediate annuity
marketplace. SPIA contracts provide guaranteed payments to contract holders and
are not subject to surrender. Pricing is determined by reference to the
long-term end of the yield curve.
SINGLE PREMIUM ENDOWMENT CONTRACTS. While single premium endowment
contracts continue to represent a portion of the Company's insurance
subsidiaries' business in force, as a result of changes in applicable tax laws,
the Company is no longer selling this product. Under these contracts, principal
is guaranteed, and the face amount of the policy is paid upon the death of the
insured. The contracts are credited with a specified rate of interest that is
guaranteed for a period of time and then reset annually thereafter, subject to
guaranteed minimums and certain other restrictions. The Company generally
determines the crediting rate by reference to current yields along the
intermediate term section of the yield curve. Due to changes in applicable tax
laws, and the consequential loss of tax benefits associated with SPEs in the
event of a withdrawal, the Company believes that the level of surrenders of SPEs
associated with increases in interest rates will be lower than would otherwise
be the case.
FACE-AMOUNT CERTIFICATES. Face-amount certificates are obligations of SBM
Certificate Company which require it to pay holders the original invested amount
of the certificate, plus a three-year fixed-rate return, at a given maturity
date. Holders are required to accept a reduced rate of interest it they withdraw
their investment prior to the maturity date. The Company determines the interest
rate offered on face-amount certificates based on the short to intermediate term
sections of the yield curve. Face-amount certificates, which are similar to bank
certificates of deposit, generally compete with various types of individual
savings products offered by banks and insurance companies that provide a fixed
rate of return on investors' money. Face-amount certificates are regulated under
the Investment Company Act and, unlike bank certificates of deposit of less than
$100,000, are not guaranteed by the FDIC. The Company continues to investigate
opportunities to expand upon its face-amount certificate retail distribution
channels.
FUNDING AGREEMENTS AND GUARANTEED INVESTMENT CONTRACTS. Funding agreements
and guaranteed investment contracts are issued by the Company to institutional
customers primarily through a marketing partnership with General American, which
began as a fee-based arrangement
11
in March 1993. Funding agreements are investment contracts issued by the
Company's insurance subsidiaries to the nonqualified (i.e., non retirement
plans) market, and GICs are issued by the Company's insurance subsidiaries to
qualified pension plans. The marketing partnership with General American
permits the Company to use its established distribution channel contacts to
market funding agreements and GICs that are backed by the financial strength
of General American's higher claims-paying ability ratings. The Company
markets General American contracts which have been designed by the Company to
meet customer needs. Since September 1995, General American has ceded 50% of
new deposits to Integrity under a coinsurance agreement. Sales of funding
agreements and GICs made through General American accounted for 48% and
69% of total retail and institutional sales for the years ended December 31,
1997 and 1996, respectively. The interest rate on funding agreements and GICs
is typically based upon a short-term floating rate, such as the London
Interbank Offered Rate ("LIBOR"), which periodically resets to provide
current yields. Funding agreement and GIC products offered by the Company are
designed and have historically been held by customers as long-term core cash
investments, even though under most contracts customers have the option to
liquidate their holdings with written notice of thirty days or less. The
Company has experienced withdrawals (excluding scheduled interest payments)
by funding agreement and GIC customers of approximately 4.5% and 0.0% of
average funding agreement and GIC customer deposits for the years ended
December 31, 1997 and 1996, respectively. The Company also broadened its
institutional product lines and distribution channels by launching a new
funding agreement product. In November 1997, the Company received a deposit
of $500 million for the new product, which was sold in partnership with BLB
and initially matures in five years and is renewable annually thereafter.
RETAIL VARIABLE PRODUCTS
The Company's retail variable products business is less capital intensive
than spread business and generally provides the Company with a diversified
source of income, due to the relative insensitivity of fee-based income to
changes in interest rates. However, significant decreases in price levels in the
securities market could adversely affect sales and the level of fee income
earned by the Company from variable annuities and, thereby, the Company's
results of operations.
The Company's retail variable products are the investment portfolio options
of variable annuity contracts. Sales of such products represent premiums and
deposits received. Sales of retail variable products for years ended
December 31, 1997, 1996 and 1995 were as follows:
Year Ended December 31,
--------------------------------
(IN MILLIONS) 1997 1996 1995
- -----------------------------------------------------------------------------------------------
Retail variable product sales:
Investment portfolio options of variable annuities $ 206.3 $ 200.1 $ 177.7
--------------------------------
--------------------------------
12
Assets under management for retail variable products at December 31, 1997,
1996 and 1995 were as follows:
December 31,
-----------------------------------
(IN MILLIONS) 1997 1996 1995
- --------------------------------------------------------------------------------------------------
Retail variable product assets under management:
Investment portfolio options of variable annuities $ 1,129.1 $ 844.3 $ 617.3
-----------------------------------
-----------------------------------
VARIABLE ANNUITY CONTRACTS. Variable annuity contracts issued by the
Company's insurance subsidiaries are distributed through independent
broker-dealers, stockbrokers and financial institutions. Under variable annuity
contracts, customers may allocate all or a portion of their account values to a
nonguaranteed separate account that invests in shares of one or more investment
portfolios (registered investment companies). Values in the separate account
will vary with the investment performance of the underlying investment
portfolio. The Integrity Companies receive income in the form of mortality and
expense fees based primarily on the market value of the invested deposits and
from administrative expense charges in connection with variable annuity contract
deposits. The Company reinsures most of the mortality risk associated with its
variable annuity contracts. The Integrity Companies also receive spread income
from deposits allocated to the Company's GRO products. Because the investment
risk under the investment portfolio options of variable annuity products is
borne by the customer, these products are treated as securities under federal
securities laws and, therefore, the salespeople are both appointed as insurance
agents for the Company's insurance subsidiaries and registered as securities
representatives. In addition, Integrity Capital Advisors, Inc. earns fee income
by serving as an advisory manager and by providing supervisory and
administrative services to the portfolios of the Legends Fund, Inc. ("Legends
Fund"), a registered investment company. Shares of the Legends Fund are offered
only to nonguaranteed separate accounts of Integrity and National Integrity.
DISTRIBUTION
RETAIL DISTRIBUTION
The Company's retail distribution strategy is focused on diversifying sales
of its products across various distribution channels, reducing its reliance on
any one third-party marketing organization and providing superior services to
its producers and customers. Currently, the Company's fixed, variable and
equity-indexed annuities are sold through the independent broker-dealer,
independent agent, stockbroker, and financial institution channels. In addition,
registered representatives affiliated with ARM Securities sell the Company's
annuities and face-amount certificates and independent third-party mutual funds.
During 1996, the Company began the process of working with its producers to
enhance its existing products and develop new products that are customized to
meet the needs of customers in each channel. The Company has initiated a
streamlined product development process designed to enable the Company to
respond quickly to changes in the marketplace and reduce the time required to
introduce new or enhanced products. By working with producers in this manner,
the Company
13
was one of the first to recognize the market opportunity for equity-indexed
annuities and introduced OMNI in 1996, the Company's equity-indexed annuity
product. Based on these initial marketing efforts, the Company developed
OMNISELECT, a second generation of equity-indexed product that provides enhanced
benefits to customers in the independent agent channel and is more appealing to
other distribution channels. The Company's 1997 product development efforts
included the addition of new investment options to GRANDMASTER and PINNACLE, the
Company's variable annuity products, and the introduction of a new variable
annuity product customized for the financial institution channel.
In addition to diversifying sales across distribution channels, the Company
is focused on reducing its reliance on any one third-party marketing
organization. During 1996, this effort involved the development of an in-house
wholesaling unit, a function that in 1995 was performed by an outside marketing
organization. This unit works in the stockbroker and independent agent channels
and is responsible for generating sales from existing producers, recruiting and
developing new producers and promoting the features and benefits of the
Company's products through seminars and one-on-one meetings with producers.
The Company uses third-party marketing organizations with sales networks
to distribute certain of its retail annuity products. One such organization,
Financial Marketing Group, Inc. ("FMG"), supplements the Company's in-house
wholesaling unit by performing this function for certain independent
broker-dealers. Broker-dealers affiliated with FMG accounted for 45% and 61%
of total retail sales, and 11% and 19% of total retail and institutional
sales, for the years ended December 31, 1997 and 1996, respectively. No
individual broker-dealer affiliated with FMG accounted for more than 9% and
13% of total retail sales for the years ended December 31, 1997 and 1996,
respectively. In addition to FMG, the Company utilizes PaineWebber
Incorporated ("PaineWebber") in the stockbroker channel for the distribution
of certain products. For the years ended December 31, 1997 and 1996,
approximately 13% and 19% of the Company's total retail sales, respectively,
and approximately 3% and 6% of total retail and institutional sales,
respectively, were made through PaineWebber.
To strengthen relationships with existing producers and assist the
wholesaling unit in recruiting new producers, the Company has significantly
expanded its in-house capability to provide service to producers and to promote
the Company's products and services. Company representatives directly servicing
producers have immediate system response capabilities for virtually any service
request through the Company's PC-based client/server system. Service requests
can also be turned into sales opportunities by keeping producers informed of new
product features and current rate and performance information. In addition,
through this servicing group, the Company works with producers and customers to
retain existing business.
Retail sales by distribution channel for the years ended December 31,
1997 and 1996 were as follows:
Year Ended December 31,
---------------------------------------------
1997 1996
---------------------------------------------
Percent
Percent of
(DOLLARS IN MILLIONS) Amount of Total Amount Total
- ------------------------------------------------------------------------------
Distribution channel:
Independent broker-
dealers $264.5 44.9% $199.0 60.2%
Independent agents 218.2 37.1 60.6 18.3
Stockbrokers 96.7 16.4 70.2 21.2
Financial institutions 9.4 1.6 0.9 0.3
---------------------------------------------
Total retail sales $588.8 100.0% $330.7 100.0%
---------------------------------------------
---------------------------------------------
14
INSTITUTIONAL DISTRIBUTION
In the institutional market, the Company has been able to generate a
significant level of sales volume with relatively minimal overhead or marketing
expenses. A small team of in-house marketing professionals markets and sells the
Company's products which are distributed directly to defined contribution plans,
bank trust departments, investment managers, consultants, corporate treasurers,
cash management funds, endowments and foundations, and other insurance
companies. Where the Company's financial strength ratings constrain in its
ability to underwrite products directly, the Company structures arrangements
with highly-rated and respected partners, in essence, to credit enhance the
performance guarantees.
ASSET/LIABILITY SPREAD MANAGEMENT
The Company views asset/liability spread management as an integrated
process, rather than as a series of segregated functions, and incorporates this
process into each aspect of its operations. The Company's overall goal is to
ensure that invested asset cash flows will be sufficient to meet customer
obligations and to maximize investment spreads on a consistent basis. Beginning
with product design and continuing through the product sale and contract
maturity, professionals in each functional area (such as marketing, actuarial,
investments, legal, finance and administration) work jointly with a common set
of risk/return characteristics toward the goal of achieving the Company's
liquidity and profit objectives (rather than the specific objectives of any
particular functional area). The Company also conducts a thorough periodic
analysis of its assets and liabilities using sophisticated software to model the
effect of changes in economic conditions on both its assets and liabilities.
During product development, the Company sets product features and rate
crediting strategies only after it has devised an appropriate investment
strategy. The Company employs an extensive, iterative modeling process to test
various asset combinations against proposed product features over sets of
randomly generated interest rate scenarios. The modeling evaluates whether a
particular investment strategy backing the product features under consideration,
will provide adequate cash flow and generate yields that achieve specified
minimum targets consistently over a reasonable range of interest rate
environments. If necessary, the Company redesigns investment strategies or
product features until these objectives are met.
The Company utilizes several key strategies in managing its spread-based
products. This approach allows the Company to leverage its resources and
expertise. One example is an immunization strategy currently used for the
Company's GRO products, in which a portfolio of assets is constructed and
managed to provide a target dollar amount over a pre-established time
horizon. The Company engineers and packages its spread products to deliver
products to suit the needs of different types of customers in both the retail
and institutional marketplaces.
Once the Company has constructed an asset portfolio having the desired
performance characteristics, the Company's investment managers have the
flexibility to trade the portfolio in order to increase yields while remaining
within well-defined risk parameters (such as duration, convexity, credit
quality, and liquidity). In so doing, these professionals follow prescribed
measures designed to (i) limit exposure to credit risks, (ii) manage call,
prepayment or extension losses and
15
(iii) enhance yield through sector rotation and security selection. In addition,
the Company aims to generate and maintain liquidity from scheduled interest and
principal payments, projected prepayments and early calls, cash on hand,
floating rate securities and lines of credit (but not from new product sales),
sufficient to presently cover approximately two times expected cash needs (for
benefits and withdrawals for general account retail spread products, expenses
and dividends) without having to sell any investments at a material loss.
Internal control measures are in place throughout the process to help
identify any necessary adjustments in the investment portfolio as promptly as
possible. For example, Company personnel assess, independently of portfolio
managers, whether trades would alter portfolio characteristics and how
investment yields or realized gains or losses would be accounted for under
statutory accounting practices and generally accepted accounting principles
("GAAP"). The Company also remodels its assets and liabilities periodically to
determine whether any significant changes in assumptions or interest rates have
changed the overall risk profile.
In pursuing its investment spread objectives, the Company focuses primarily
on cash flow risks that are quantifiable and measurable. This approach permits
the Company to measure specifically the changes in yield and cash flow on its
investments at any given time. This approach emphasizes securities which are
liquid and easily tradeable and more easily modeled and hedged, if appropriate.
The Company's array of retail and institutional spread deposits, with
crediting rates pegged to various points on the interest rate yield curve, also
supports the Company's approach to asset/liability management. The liability
structures, in combination with asset structures, generally are aimed at
providing balance in the portfolio as interest rates fluctuate. As a result, the
Company believes it is better positioned to achieve stable margins. In addition,
the Company believes that this diversity gives it flexibility to respond to
changing market conditions and to take advantage of investment opportunities.
SURRENDERS
To encourage persistency and discourage withdrawals, the Company's
insurance products generally incorporate surrender charges, market value
adjustments and/or other features which may discourage or prevent such
surrenders or withdrawals for a specified number of years. As of December 31,
1997, the Company had approximately $2.8 billion of customer deposits (43% of
total customer deposits), including $2.0 billion of institutional spread product
deposits, which were not subject to surrender charges or other restrictions on
withdrawal. During 1998, surrender charges will no longer apply to an additional
$206.3 million of customer deposits which were in force as of December 31, 1997.
During 1994 and continuing to date, the Company has implemented programs
designed to improve persistency. Such programs involve direct contact with
customers and are designed to inform customers of the financial strength of the
Company and its insurance subsidiaries and to describe other product offerings
available.
16
REINSURANCE CEDED
The Company's insurance subsidiaries reinsure risks under certain of their
products with other insurance companies through reinsurance agreements. Through
these reinsurance agreements, substantially all mortality risks associated with
SPE and most variable annuity deposits and substantially all risks associated
with the variable life business have been reinsured. The Company's primary
reinsurers in respect of mortality risks associated with SPE deposits are Swiss
Reinsurance Company, RGA Reinsurance Company and The Equitable Life Assurance
Society, which are respectively rated A+, A+ and A by A.M. Best. Connecticut
General Life Insurance Company is the Company's principal reinsurer of the
mortality risks associated with variable annuity deposits and is rated A+ by
A.M. Best. Phoenix Home Life Mutual and American Franklin Life are the Company's
principal reinsurers in respect of risks associated with the variable life
business and are respectively rated A and A++ by A.M. Best. In addition,
Integrity cedes a block of SPDAs on a coinsurance basis to Harbourton
Reassurance, Inc., and in accordance with the treaty all assets supporting the
liabilities are held in trust. Reinsurance does not fully discharge the
Company's obligation to pay policy claims on the reinsured business; the ceding
reinsurer remains responsible for policy claims to the extent the reinsurer
fails to pay such claims.
RATINGS AND RATING AGENCIES
Insurance companies are rated by independent rating agencies to provide
both industry participants and insurance consumers meaningful information on
specific insurance companies. Higher ratings generally indicate a higher
relative level of financial stability and a stronger ability to pay claims. In
general, the rating agencies issue opinions on the insurance companies'
abilities to meet policyholder claims and obligations on a timely basis. The
basis for an opinion on a particular rating includes such factors as capital
resources, financial strength, demonstrated management expertise and stability
of cash flow as well as the quality of investment operations, administration and
marketing. These particular types of ratings are based upon factors relevant to
policyholders and are not directed toward protection of stockholders. Such
ratings are neither a rating of securities nor a recommendation to buy, hold or
sell any security. The Company's insurance subsidiaries currently hold ratings
from four such rating agencies: A.M. Best, Standard & Poor's Corporation
("S&P"), Duff & Phelps, and Moody's Investors Service ("Moody's").
The Company's insurance subsidiaries are currently classified "A
(Excellent)" by A.M. Best, reflecting an upgrade from A- in October 1995. A.M.
Best's ratings range from "A++ (Superior)" to "F (In liquidation)", and some
companies are not rated.
The Company's insurance subsidiaries currently hold an "A (Good)"
claims-paying ability rating from S&P. The S&P claims-paying ability rating
categories range from "AAA (Superior)" to "D (Liquidation)."
In addition, the Company's insurance subsidiaries currently hold an "A-1"
short-term rating from S&P. The short-term rating is used for any obligation
whose maturity is typically one year or less or would apply to a put option or
demand feature which would give the policyholder the right to
17
receive their funds within one year. The S&P short-term rating categories range
from "A-1+" to "D."
The Company's insurance subsidiaries currently have a claims-paying ability
rating from Duff & Phelps of "A+ (High)" and a short-term claims paying ability
of "D-1." Duff & Phelps' claims-paying ability ratings range from "AAA" to "DD"
and short-term claims paying ability ratings range from "D-1+" to "D-5".
Moody's has currently assigned the Company's insurance subsidiaries a "Baa1
(Adequate)" insurance financial strength rating. Moody's ratings range from "Aaa
(Exceptional)" to "C (Lowest)," and some companies are not rated.
Customers and many financial institutions and broker-dealers tend to focus
on the A.M. Best ratings of an insurer in determining whether to buy or market
the insurer's annuities. If any of the Company's ratings were downgraded from
their current levels or if the ratings of the Company's competitors improved and
the Company's did not, the ability of the Company to distribute its products and
the persistency of its existing business could be adversely affected. Each of
the rating agencies reviews its ratings periodically, and there can be no
assurance that the Company's current ratings will be maintained in the future.
PRODUCER AND CUSTOMER SERVICE, TECHNOLOGY AND ADMINISTRATION
The Company believes that it can strategically employ technology to
strengthen individual distributor and customer relationships by providing
superior service, reducing operating costs, improving work flow efficiency, and
reducing product development time.
The Company's integrated approach to business requires that information be
shared within and across functional groups. Management, therefore, believes that
a PC-based client/server data processing platform provides users with direct
access to information more efficiently than a mainframe system. To facilitate
this process, the Company's principal locations in Kentucky, Ohio, New York and
Minnesota use linked voice and data communications technologies over a wide-area
network ("WAN"). With proper security clearance, employees can access data bases
on file servers from any location. Some of these file servers are owned and
operated by the Company, while others and some main frame systems are owned and
operated by external entities. Using an automated interface system to access
these data bases, the Company achieves reduced costs, strengthened internal
control, and decreased possibility for error from manual intervention. The
Company has and will continue to outsource systems or administrative functions
in which the Company does not possess critical mass. The Company improved the
productivity and effectiveness of its processing operations by relocating and
consolidating its Columbus, Ohio office to the corporate headquarters in
Louisville, Kentucky. Final consolidation of non-critical operating functions in
the Ohio office is anticipated to be completed by the end of the second quarter
of 1998.
The Company maintains a plan to recover its systems and operations
promptly in the event of a disaster. For critical WAN applications, redundant
servers with backed-up data are in place. Key functions are intended to be
available within a matter of a few hours. For recovery of computer
18
systems accessed through external parties, these vendors provide their own
disaster recovery plans. Off-site storage of magnetic media is intended to
ensure that data processing systems and the imaging system can also be restored
in the event of a disaster.
Additionally, in 1996, the Company expanded and improved the efficiency of
its work flow processing and management reporting systems by employing an image
based work flow system to route packets of information within and across
functional groups. Not only does this system reduce the amount of paper
generated in the back office, but it also reduces the manual work required to
process transactions and allows the Company to track transactions and measure
the performance of its personnel in order to improve operations and deliver more
effective results to customers. Continued software development and systems
migration projects will help eliminate computer redundancies in certain lines of
business and improve the Company's ability to quickly bring increasingly complex
and competitive products to market.
The Company believes that the World Wide Web will become an important
vehicle for conducting business in the financial services industry. In 1997, the
Company introduced its Internet based producer service program called AnnuiTRAC.
The Company further believes that the convenience and ease of using this system
will help attract and retain producers. AnnuiTRAC uses Web-based technology to
provide producers with on-line access to policy and product information, 24
hours a day, seven days a week. Not only does this system automate account
processing, but it also helps the Company meet the demands of a growing sales
force without significantly increasing operating costs. Using this technology,
producers can devote more time to selling new business and the Company spends
less time processing the paperwork. Previously, when producers needed the status
on pending accounts, historical transaction data, or product summaries, they
requested the information from the Company's producer services unit and received
it via facsimile or mail. With AnnuiTRAC, this process is simplified with an
interactive software system. Producers can now find valuable account information
immediately and directly by accessing AnnuiTRAC through the Internet.
The Company also uses technology to decrease the amount of time it takes to
develop new products. Additionally, in 1997, the Company developed an improved
policy administration system that allows it to quickly respond to changing
customer needs and reduces the amount of time required to modify software
necessary to implement new product features. The Company envisions using this
system to support various aspects of its business in the future.
COMPETITION
The financial services industry is highly competitive, and each of the
Company's subsidiaries competes with companies that are significantly larger and
have greater access to financial and other resources.
The life insurance industry comprises approximately 1,800 companies in the
United States and is highly competitive, with no one company dominating any of
the principal markets in which the Company's insurance subsidiaries operate.
Many insurance companies and insurance holding companies have substantially
greater capital and surplus, larger and more diversified portfolios of
19
life insurance policies and annuities, higher ratings and greater access to
distribution channels than the Company's insurance subsidiaries. Competition is
based upon many factors, such as the form and content of annuity policies,
premiums charged, investment return, customer and producer service, access to
distribution channels, financial strength and ratings of the company,
experience, and reputation. The Company's insurance subsidiaries also encounter
increasing competition from banks, securities brokerage firms, mutual funds, and
other financial intermediaries marketing insurance products, annuities and other
forms of savings and pension products.
On January 18, 1995, the United States Supreme Court held in NATIONSBANK OF
NORTH CAROLINA V. VARIABLE ANNUITY LIFE INSURANCE COMPANY that annuities are not
insurance for purposes of the National Bank Act. In addition, the Supreme Court
held on March 26, 1996 in BARNETT BANK OF MARION COUNTY V. NELSON that state
laws prohibiting national banks from selling insurance in small town locations
are pre-empted by federal law. The Office of the Comptroller of the Currency
also adopted a ruling in November 1996 that permits national banks, under
certain circumstances, to expand into other financial services, thereby
increasing potential competition for the Company. At present, the extent to
which banks can sell insurance and annuities without regulation by state
insurance departments is being litigated in various courts in the United States.
Although the effect of these recent developments on the Company and its
competitors is uncertain, the Company may encounter increased competition from
banks in the future. The Company believes that the fact that it is not hampered
with a large captive sales force like many insurance companies is an advantage
in creating strategic alliances with banks and other financial institutions.
The principal competitive factors in the sale of annuity products are
product features, perceived stability of the insurer, customer and producer
service, name recognition, crediting rates, and commissions. The Company's
insurance subsidiaries compete in their markets with numerous major national
life insurance companies. Management believes that its ability to build market
share and compete with other insurance companies is dependent upon its ability
to expand and diversify its distribution channels and develop competitive
products with unique features and services that focus on the needs of targeted
market segments.
REGULATION
The Company's business activities are subject to extensive regulation. Set
forth below is a summary discussion of the principal regulatory requirements
applicable to the Company.
INSURANCE REGULATION
The Company's insurance subsidiaries are subject to regulation and
supervision by the states in which they are organized and in the other
jurisdictions where they are authorized to transact business. State insurance
laws establish supervisory agencies with broad administrative and supervisory
powers including granting and revoking licenses to transact business, regulation
of marketing and other trade practices, operating guaranty associations,
licensing agents, approving policy forms, regulating certain premium rates,
regulating insurance holding company systems, establishing reserve requirements,
prescribing the form and content of required financial statements and reports,
performing financial and other examinations, determining the reasonableness and
adequacy of statutory capital and surplus, regulating the type and amount of
investments permitted, limiting the amount of dividends that can be paid without
first obtaining regulatory approval, and
20
other related matters. The primary purpose of such supervision and regulation
under the insurance statutes of Ohio and New York, as well as other
jurisdictions, is the protection of policyholders rather than investors or
shareholders of an insurer. State insurance departments also conduct periodic
examinations of the affairs of insurance companies and require the filing of
annual and other reports relating to the financial condition of insurance
companies.
In recent years, the insurance regulatory framework has been placed under
increased scrutiny by various states, the federal government and the National
Association of Insurance Commissioners ("NAIC"). Various states have considered
or enacted legislation that changes, and in many cases increases, the states'
authority to regulate insurance companies. Over the past few years, the NAIC has
approved and recommended to the states for adoption and implementation several
regulatory initiatives designed to reduce the risk of insurance company
insolvencies. These initiatives include new investment reserve requirements,
risk-based capital standards and restrictions on an insurance company's ability
to pay dividends to its stockholders. Specifically, the NAIC "Codification of
Statutory Accounting Principles" project may revamp the current statutory
accounting practices for the Company's insurance subsidiaries. Certain proposals
under consideration may have a negative impact on the statutory surplus of the
Company's insurance subsidiaries and thus their ability to pay dividends to the
Company. Issue papers were released for industry review and Statements of
Statutory Accounting Principles were issued by the NAIC in 1997, subject to
final approval. In certain states, this project will not undermine the states'
authority to make a final determination on acceptable and appropriate accounting
practices as the NAIC proposals may be subject to implementation only upon
legislative enactment by the applicable state legislature. The Company is
monitoring developments in the regulatory area and assessing the potential
effects any changes would have on the Company.
Although the federal government currently does not directly regulate the
business of insurance generally, federal initiatives can significantly affect
the insurance business. Legislation has been introduced from time to time in
Congress that could result in the federal government assuming a role in the
regulation of insurance companies. Congress and certain federal agencies are
investigating the current condition of the insurance industry in the United
States in order to decide whether some form of federal regulation of insurance
companies would be appropriate. It is not possible to predict the outcome of any
such congressional activity, which could result in the federal government
assuming some role in the regulation of the insurance industry, or the potential
effects thereof on the Company.
INSURANCE HOLDING COMPANY REGULATION. The Company and its affiliates are
subject to regulation under the insurance holding company statutes of Ohio, the
domiciliary state of Integrity, and of New York, the domiciliary state of
National Integrity, and under the insurance statutes of other states in which
the Integrity Companies are licensed to transact the business of insurance. Most
states have enacted legislation which regulates insurance holding company
systems, including acquisitions, extraordinary dividends, the terms of
transactions between affiliates including insurance companies and other related
matters. The Integrity Companies are required to file certain reports in Ohio,
New York and certain other states, including information concerning their
capital structure, ownership, financial condition, and general business
operations. The Ohio and New York insurance laws also require prior notice or
approval of changes in control of an insurer or its holding companies and of
21
material intercorporate transfers of assets and material agreements between an
insurer and affiliates within the holding company structure. Under the Ohio and
New York insurance laws, any person, corporation or other entity which seeks to
acquire, directly or indirectly, 10% or more of the voting securities of an Ohio
or New York insurance company or any of its parent companies is presumed to
acquire "control" of such insurance company and must obtain the prior approval
of both the Ohio Insurance Director and New York Insurance Superintendent. Prior
to acquiring such control, the proposed acquirer must either file an application
containing certain information including, but not limited to, the identity and
background of the acquirer and its affiliates and the source and amount of funds
to be used to effect the acquisition, or obtain an exemption from the approval
requirement.
In the event of a default on the Company's debt or the insolvency,
liquidation or other reorganization of the Company, the creditors and
stockholders of the Company will have no right to proceed against the assets of
Integrity or National Integrity or to cause their liquidation under federal or
state bankruptcy laws. Insurance companies are not subject to such bankruptcy
laws but are instead governed by state insurance laws relating to liquidation or
rehabilitation due to insolvency or impaired financial condition. Therefore, if
Integrity or National Integrity were to be liquidated or be the subject of
rehabilitation proceedings, such liquidation or rehabilitation proceedings would
be conducted by the Ohio Insurance Director and the New York Insurance
Superintendent, respectively, as the receiver with respect to all of Integrity's
or National Integrity's assets and business. Under the Ohio and New York
insurance laws, all creditors of Integrity or National Integrity, including
policyholders, would be entitled to payment in full from such assets before the
Company or Integrity Holdings, Inc., as indirect or direct stockholders, would
be entitled to receive any distribution therefrom.
DIVIDEND RESTRICTIONS. The Company's ability to declare and pay dividends
are affected by Ohio and New York laws regulating the ability of National
Integrity to pay dividends to Integrity and the ability of Integrity to pay
dividends to the Company.
Under Ohio law, an Ohio domestic life insurance company may not make,
without the prior approval of the Ohio Insurance Director, dividend payments in
excess of the greater of (i) 10% of such insurance company's statutory capital
and surplus as of the preceding December 31 and (ii) such insurance company's
statutory net income for the preceding year. Under New York insurance law,
National Integrity may pay dividends to Integrity only out of its earnings and
surplus and may not distribute any dividends without at least 30 days' prior
written notice to the New York Insurance Superintendent, who may disapprove a
proposed dividend upon a determination that National Integrity's financial
condition does not warrant such distribution. Because National Integrity is a
subsidiary of Integrity, dividend payments made by National Integrity to
Integrity must be made in compliance with New York standards, and the ability of
Integrity to pass those dividends on to the Company is subject to compliance
with Ohio standards.
Integrity paid $26 million in dividends to the Company during 1997, the
maximum amount that was payable. For 1998, the maximum dividend payments that
may be paid by Integrity to the Company without prior regulatory approval are
$38 million.
22
MANDATORY INVESTMENT RESERVE. Under NAIC rules, life insurance companies
must maintain an asset valuation reserve ("AVR"), supplemented by an interest
maintenance reserve ("IMR"). These reserves are recorded for purposes of
statutory accounting practices; they are not recorded under the provisions of
GAAP and therefore have no impact on the Company's reported results of
operations or financial position. These reserves affect the determination of
statutory surplus, and changes in such reserves may impact the ability of the
Integrity Companies to pay dividends or other distributions to the Company. The
extent of the impact of the AVR will depend upon the future composition of the
investment portfolio of the Integrity Companies. The extent of the impact of the
IMR will depend upon the extent of the gains and losses of the Integrity
Companies' investment portfolio and the related amortization thereof. Based on
the current investment portfolio of the Company's insurance subsidiaries, the
Company does not anticipate that expected provisions for the AVR and IMR will
materially adversely affect the ability of the Integrity Companies to pay
dividends or other distributions to the Company.
RISK-BASED CAPITAL REQUIREMENTS. The NAIC Risk-Based Capital ("RBC")
requirements evaluate the adequacy of a life insurance company's adjusted
statutory capital and surplus in relation to investment, insurance and other
business risks. The RBC formula is used by the states as an early warning tool
to identify potential weakly capitalized companies for the purpose of initiating
regulatory action and is not designed to be a basis for ranking the financial
strength of insurance companies. In addition, the formula defines a minimum
capital standard which supplements the previous system of low fixed minimum
capital and surplus requirements. The RBC requirements provide for four
different levels of regulatory attention depending on the ratio of a company's
adjusted capital and surplus to its RBC.
The consolidated statutory capital and surplus of the Company's life
insurance subsidiaries totaled $211.8 million and $163.8 million at December 31,
1997 and 1996, respectively, and were substantially in excess of the minimum
level of RBC that would require regulatory action. In addition, the consolidated
statutory AVRs of the Company's insurance subsidiaries totaled $24.9 million and
$15.6 million at December 31, 1997 and 1996, respectively (excluding voluntary
reserves of $5.3 million and $12.5 million at December 31, 1997 and 1996,
respectively). AVRs are generally added to statutory capital and surplus for
purposes of assessing capital adequacy against various measures used by rating
agencies and regulators, including RBC.
GUARANTY FUND ASSESSMENTS. Under the insurance guaranty fund laws existing
in each state, insurers licensed to do business in the state can be assessed for
certain obligations of insolvent insurance companies to policyholders and
claimants. In connection with the acquisition by the Company of the Integrity
Companies from National Mutual, National Mutual agreed to indemnify the Company
for guaranty fund assessments levied in respect of companies declared insolvent
or subject to conservatorship prior to November 26, 1993. The amounts actually
assessed to and paid by the Company's insurance subsidiaries for the years ended
December 31, 1997, 1996 and 1995 were approximately $1.6 million, $1.5 million
and $1.1 million, respectively. Of such amounts, approximately $0.5 million,
$0.5 million and $0.4 million, respectively, were reimbursed by National Mutual
under its indemnity obligation to the Company. Because such assessments are
typically not made for several years after an insurer fails and depend upon the
final outcome of liquidation or rehabilitation proceedings, the Company cannot
accurately determine the precise
23
amount or timing of its exposure to known insurance company insolvencies at this
time. During 1996 and 1995, the Company recorded provisions for future state
guaranty fund association assessments of $1.6 million and $0.3 million,
respectively. No provision was recorded during 1997. At December 31, 1997, the
Company's reserve for such assessments was $4.9 million. No assurance can be
given that the Company's reserve for assessments or such indemnity will be
adequate in the event of any loss suffered by the Company in respect of any
assessment made under state insurance guaranty fund laws. The reserve does not
include any provision for future assessments related to unknown failures or to
known failures for which no estimate of the Company's exposure currently can be
made. The Company estimates its reserve for assessments using information
provided by the National Organization of Life and Health Guaranty Associations.
The insolvency of large life insurance companies in future years could result in
additional material assessments to the Company by state guaranty funds that
could have a material adverse impact on the Company's future earnings and
liquidity.
TRIENNIAL EXAMINATIONS. The Ohio and New York insurance departments usually
conduct an examination of Integrity and National Integrity, respectively, every
three years, and may do so at such other times as are deemed advisable by the
Ohio Insurance Director and New York Insurance Superintendent. The report with
respect to the most recent triennial examination of Integrity issued in 1997
covered the periods 1993 through 1995 and contained no material adverse
findings. The report with respect to the most recent triennial examination of
National Integrity issued in 1997 covered the periods 1993 through 1995 and also
contained no material adverse findings.
INSURANCE REGULATORY INFORMATION SYSTEM. The NAIC has developed a set of
financial relationships or "tests" called the Insurance Regulatory Information
System ("IRIS") that were designed for early identification of companies that
may require special attention by insurance regulatory authorities. These tests
were developed primarily to assist state insurance departments in executing
their statutory mandate to oversee the financial condition of insurance
companies. Insurance companies submit data on an annual basis to the NAIC, which
in turn analyzes the data using ratios covering twelve categories of financial
data with defined "usual ranges" for each category.
Falling outside the usual range of IRIS ratios is not considered a failing
result; rather, unusual values are viewed as a part of the regulatory early
warning monitoring system. Furthermore, in some years, it may not be unusual for
financially sound companies to have several ratios with results outside the
usual ranges. An insurance company may fall outside of the usual range for one
or more ratios because of specific transactions that are in themselves
immaterial or eliminated at the consolidated level. Generally, an insurance
company will become subject to increased regulatory scrutiny if it falls outside
the usual ranges of four or more of the ratios. In normal years, 15% of the
companies included in the IRIS system are expected by the NAIC to be outside the
usual range on four or more ratios.
In 1997, two IRIS ratios for Integrity and three IRIS ratios for National
Integrity fell outside the usual range due to normal business operations which
included the sale of a substantial volume of funding agreements and GICs
("institutional spread products"). For Integrity, the change in premium ratio
was +197%, as compared to the usual range of between +50% and -10%. This ratio
was above
24
the usual range due to an increase in institutional spread product premiums from
$507.9 million in 1996 to $1.7 billion in 1997 and an increase in guaranteed
rate option annuity premiums from $51.6 million in 1996 to $210.4 million in
1997. Such increases were a result of increased marketing efforts. Integrity's
change in reserving ratio was -99% as compared to the usual range of between
+20% and -20%. This ratio measures the difference in reserves as a percentage of
premiums from one year to the next for business classified as life insurance for
statutory accounting and reporting purposes. This ratio is not meaningful as it
applies to Integrity because Integrity primarily writes retail fixed, indexed
and variable annuity products and institutional spread products rather than life
insurance, and due to its mix of life insurance reserves and premiums. Over 85%
of Integrity's life insurance reserves are a closed block of SPE contracts which
have reserve changes from year to year, but generate no premiums. Integrity's
life insurance premiums ($1.2 million in 1997) are primarily generated from
variable life business which is reinsured through a modified coinsurance
reinsurance treaty. This treaty generates premium flow but not reserve
adjustments. Thus, for Integrity, the ratio, in essence, compares SPE reserve
changes to variable life premiums.
For National Integrity, the change in premium ratio was -38%, as compared
to the usual range of between +50% and -10%. This ratio was below the usual
range due to a decrease in institutional spread product premiums from $239.6
million in 1996 to zero in 1997, partially offset by an increase in guaranteed
rate option annuity premiums from $31.9 million in 1996 to $125.3 million in
1997. National Integrity's change in product mix ratio was 9.9%, as compared to
the usual range of 5% or less. This ratio was slightly above the usual range due
to the decrease in sales of institutional spread products and the increase in
sales of guaranteed rate option annuities during 1997. National Integrity's
change in reserving ratio was -23% as compared to the usual range of between
+20% and -20%. This ratio is not meaningful as it applies to National Integrity
because National Integrity primarily writes fixed and variable annuity products
rather than life insurance, and due to its mix of life insurance reserves and
premiums.
OTHER REGULATION
The Company's non-insurance activities are also subject to extensive
regulation. Integrity Capital Advisors, Inc. is registered with the Securities
and Exchange Commission (the "SEC") as an investment adviser under the
Investment Advisers Act of 1940 (the "Advisers Act") and is subject to
regulation and examination under the Employee Retirement Income Security Act
("ERISA") by the U.S. Department of Labor and under the Advisers Act by the SEC.
In addition, variable annuities and the related nonguaranteed separate accounts
of the Company's insurance subsidiaries are subject to regulation by the SEC
under the Securities Act of 1933, as amended, and the Investment Company Act.
The Company's broker-dealer subsidiary, ARM Securities, is registered with
the SEC under the Securities Exchange Act of 1934 and is subject to regulation
by the SEC. ARM Securities is also subject to regulation, supervision and
examination by the states in which it transacts business, as well as by the
National Association of Securities Dealers, Inc. ("NASD"). The NASD has broad
administrative and supervisory powers relative to all aspects of ARM Securities'
business and may examine its business and accounts at any time.
SBM Certificate Company is subject to regulation and supervision by federal
and state regulators. The Investment Company Act and rules issued by the SEC
thereunder specify certain
25
terms applicable to face-amount certificates, the method for calculating reserve
liabilities on outstanding certificates, the minimum amounts and types of
investments to be deposited with a qualified custodian to support such reserve
liabilities, and a variety of other restrictions on the operation and governance
of a face-amount certificate company. Pursuant to statutory authority, the
Minnesota Department of Commerce (the "MDC") exercises supervisory powers over
SBM Certificate Company's face-amount certificate business similar to those
exercised by the SEC under the Investment Company Act. In addition, the MDC
conducts annual examinations of SBM Certificate Company. The offer and sale of
its face-amount certificates also are subject to federal and state securities
laws.
The securities laws and regulations referred to above generally grant
supervisory agencies and bodies broad administrative powers, including the power
to fine, limit or restrict a firm from conducting its business in the event that
it fails to comply with such laws and regulations. In addition to maintaining
registrations, the regulatory requirements include reporting, maintaining books
and records in prescribed forms, maintaining certain mandatory custodial
arrangements, approving employees, representatives and, in some cases, owners,
and other compliance procedures. Possible sanctions that may be imposed in the
event of noncompliance include, without limitation, the suspension of individual
employees, limitations on the firm's engaging in business for specified periods
of time, revocation of the firm's registration as an investment advisor or
broker-dealer, censures and fines. The regulators make periodic examinations and
review annual, monthly and other reports on the operations of the Company or its
subsidiaries. Changes in these laws or regulations could have a material adverse
impact on the profitability and mode of operations of the Company.
EXAMINATIONS. During 1997, the SEC conducted an examination of National
Integrity's nonguaranteed separate account products, which are registered. No
material control deficiencies were found during this examination. In addition,
the SEC conducts routine examinations of the Company's registered investment
adviser operations to ensure compliance with the requirements prescribed by the
Advisers Act. Similarly, the NASD regulates the activities of the Company's
broker-dealer operations and conducts routine examinations thereof.
FEDERAL INCOME TAX
In recent years, several proposals have been made to change the federal
income tax system. These proposals have included various flat tax rate and
consumption taxes. Under a proposal currently included in The
Administration's Fiscal Year 1999 Budget all exchanges involving a variable
annuity contract and all reallocations within variable annuity contracts
would be taxed. It is impossible to predict the effect on the Company's
business of the adoption of any of these proposals. It is possible that the
adoption of a tax proposal that reduces or eliminates the tax-deferred status
of annuities could adversely affect the Company's business.
EMPLOYEES
At December 31, 1997, the Company and its subsidiaries had approximately
300 employees, none of whom was represented by a labor union. The Company
believes that its relations with its employees are good.
26
ITEM 2. PROPERTIES
The Company leases approximately 62,000 square feet of office space in
Louisville, Kentucky under a lease agreement (the "Lease") which expires on
September 1, 2006, and which is subject to two five-year renewal options. This
office space accommodates the executive, marketing, product development,
actuarial, accounting, corporate finance, and legal functions of the Company.
The Company has a standby letter of credit in the amount of approximately $1.7
million with one of its lending institutions to secure the Company's obligations
under the Lease.
In addition to its headquarters, the Company and its subsidiaries lease
approximately 72,000 square feet of space in the Columbus, Ohio vicinity, 15,000
square feet of space on Chamberlain Lane in Louisville, Kentucky and subleases
approximately 1,000 square feet of office space in New York City from New ARMCA.
The operations of the Company's New York insurance subsidiary, National
Integrity, are conducted from the New York facility. Additional office space
owned in New Ulm, Minnesota supports the distribution operations of SBM
Certificate Company. The Chamberlain Lane space in Louisville, Kentucky serves
as the Company's primary distribution center for all of its operations. The
Columbus office space was vacated upon the consolidation of the Company's
Columbus operations with the corporate headquarters in Louisville and the
Company intends to either sublease this space or buy out the remainder of the
lease at a discount.
ITEM 3. LEGAL PROCEEDINGS
As a consequence of the acquisition of SBM Life and SBM Life's 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 the
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 and settlement discussions are 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 on the financial position of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth
quarter of 1997.
27
EXECUTIVE OFFICERS OF THE COMPANY
The executive officers of the Company, their ages, and positions with the
Company as of March 26, 1998, are set forth below:
Name Age Title
- ----------------------------------------------------------------------------------------------------------------
Martin H. Ruby 47 Chairman of the Board and Chief Executive Officer
John R. Lindholm 49 President--Retail Business Division
Dennis L. Carr 48 Executive Vice President and Chief Actuary
David E. Ferguson 50 Executive Vice President and Chief Technology Officer
John R. McGeeney 41 Executive Vice President--Retail Business Division
Robert H. Scott 51 Executive Vice President, General Counsel and Secretary
Patricia L. Winter 39 Executive Vice President--Investment Assurance and
Institutional Products
Edward L. Zeman 43 Executive Vice President and Chief Financial Officer
Peter S. Resnik 37 Treasurer
Barry G. Ward 36 Controller
MARTIN H. RUBY was named Chairman of the Board and Chief Executive Officer
of the Company in February 1998. Prior to that time, he had served as
Co-Chairman of the Board and Co-Chief Executive Officer of the Company since
July 1993. From its inception in March 1992 until November 1993, Mr. Ruby served
as Co-Chief Executive Officer of Oldarm L.P. From May 1990 to January 1992, he
was President and Managing Director of the ICH Capital Management Group of ICH
Corporation, and the President of Constitution Life Insurance Company, the
accumulation product subsidiary of ICH Corporation. From 1986 to 1989, Mr. Ruby
was the Chief Executive Officer and Managing Director of Capital Initiatives
Corporation, a subsidiary of the former Capital Holding Corporation. Mr. Ruby
also held various other positions with Capital Holding Corporation from 1980
until 1986.
JOHN R. LINDHOLM has served as President--Retail Business Division of the
Company since January 1997. He had been Executive Vice President and Chief
Marketing Officer of the Company since July 1993. Until November 1993, he served
as the Chief Marketing Officer of Oldarm L.P., a position he held since its
inception in March 1992. From June 1990 to February 1992, Mr. Lindholm was the
Chief Marketing Officer and a Managing Director of the ICH Capital Management
Group of ICH Corporation. From 1980 to 1990, he was employed by Capital Holding
Corporation, first as Vice President--Compensation and Benefits and then as
Chief Marketing Officer and Managing Director of its Accumulation and Investment
Group. Mr. Lindholm is also Chairman of the Board of The Legends Fund, Inc.
DENNIS L. CARR has served as Executive Vice President and Chief Actuary of
the Company since June 1996. He had been Executive Vice President and Chief
Product Development Officer of the Company since September 1993, and was
appointed Actuary in June 1995. Prior to joining the
28
Company in September 1993, he was Director of Product Development for the
Accumulation and Investment Group of Capital Holding Corporation. From July
1983 to July 1988, Mr. Carr was a consulting actuary for Tillinghast, being
named a principal of that firm in 1987.
DAVID E. FERGUSON has served as Executive Vice President and Chief
Technology Officer of the Company since January 1997. He had been Executive Vice
President and Chief Administrative Officer of the Company since July 1993. He
also served as Chief Technology Officer of Oldarm L.P. from January 1993 until
November 1993, and was Chief Technology Officer of Franco Associates, Ltd. from
its inception in March 1992 to its merger with Oldarm L.P. in December 1992.
From 1990 to March 1992, Mr. Ferguson was employed as the President and Chief
Executive Officer of the James Graham Brown Foundation, Inc., a private
philanthropic association in Louisville, Kentucky. From 1984 to 1990, Mr.
Ferguson was a partner at Ernst & Young LLP (or its predecessor Arthur Young)
and National Director of their Insurance Industry Consulting groups.
JOHN R. MCGEENEY has served as Executive Vice President--Retail Business
Division of the Company since January 1997. He had been Co-General Counsel of
the Company since January 1994, was Assistant General Counsel of the Company
from October 1993 to December 1993, and served as Secretary from December 1993
to December 1995. From February 1988 to October 1993, Mr. McGeeney served as
Assistant General Counsel for the Accumulation and Investment Group of Capital
Holding Corporation. He had also been an associate with the law firm of
Middleton & Reutlinger from 1986 until 1988.
ROBERT H. SCOTT has served as Executive Vice President and General Counsel
of the Company since January 1997, and was appointed Secretary of the Company in
December 1995. He had been Co-General Counsel of the Company since January 1994,
and was Assistant General Counsel of the Company from July 1993 to December
1993. From June 1993 until November 1993, he served as Assistant General Counsel
of Oldarm L.P. Mr. Scott also served as Deputy General Counsel for ICH
Corporation from June 1990 to March 1993. Prior to that time, he was employed by
Capital Holding Corporation as Second Vice President--Tax from November 1976 to
May 1990.
PATRICIA L. WINTER was named Executive Vice President--Investment Assurance
and Institutional Products of the Company in February 1998. She had been Senior
Vice President--Mergers/Acquisitions and Investment Assurance since March 1997.
Ms. Winter also served in other various positions within the Company from April
1992 to February 1997, the last of which was Asset/Liability Officer. Prior to
that time, Ms. Winter was a Director--Accumulation Product Development of the
ICH Capital Management Group of ICH Corporation from August 1990 to March 1992.
EDWARD L. ZEMAN has been Executive Vice President and Chief Financial
Officer of the Company since September 1995. Prior to joining the Company, Mr.
Zeman served in various positions with SBM Company from June 1990 to June 1995,
the last of which was Vice President, Chief Operating Officer, Chief Financial
Officer and Treasurer. He also served in various positions with Deloitte &
Touche LLP, a certified public accounting firm, from 1977 through 1990, the last
of which was Senior Manager. Mr. Zeman currently serves on the Board of
Directors of Dotronix, Inc.
29
PETER S. RESNIK has been the Treasurer of the Company since December 1993.
From December 1992 to November 1993, he served in various financial and
operational positions for Oldarm L.P. From June 1986 through July 1992, he
served as Assistant Vice President of Commonwealth Life Insurance Company, a
subsidiary of Capital Holding Corporation in various management positions, the
last of which was Director of Planning and Budgets in the Agency Group Division.
BARRY G. WARD has served as Controller of the Company since April 1996.
From October 1993 to April 1996, Mr. Ward served as financial officer directly
responsible for the Company's financial reporting function. From January 1989 to
October 1993, he served in various positions within Ernst & Young LLP's
Insurance Practice, the last of which was Audit Manager.
30
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
On June 19, 1997, the Company's Class A Common Stock began trading on the
American Stock Exchange under the symbol "ARM". Prior to such date, no
established public trading of the Company's common equity existed. There is no
trading or other market for the non-voting Class B Common Stock. At December 31,
1997, approximately 53% of the outstanding shares of the Class A and Class B
Common Stock of the Company were held by the Morgan Stanley Stockholders.
The following table sets forth for the periods indicated, the high and low
sale prices of the Company's Class A Common Stock as reported on the American
Stock Exchange:
1997
----------------------------------
Cash
Dividend
High Low Per Share
----------------------------------
2nd Quarter (from June 19, 1997) $20 $18 1/2 $ --
3rd Quarter 23 13/16 19 7/16 0.02
4th Quarter 26 3/8 20 0.02
As of December 31, 1997, there were approximately 2,400 holders of record
of the outstanding shares of Class A Common Stock and 4 holders of record of the
outstanding shares of Class B Common Stock.
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 dividends on the preferred stock and common
stock. The ability of the Company's insurance subsidiaries to pay dividends and
enter into agreements with affiliates is limited by state insurance laws. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Financial Resources - Holding Company Operations."
On February 13, 1998, the Company declared a dividend of $0.02 per share of
Common Stock and $0.59375 per share of 9.5% Cumulative Perpetual Preferred
Stock. Both dividends were paid on March 16, 1998, to shareholders of record on
February 27, 1998.
31
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected historical financial information of
the Company and its subsidiaries for the years ended December 31, 1997, 1996,
1995 and 1994, for the period from November 27, 1993 through December 31, 1993,
and for the period from January 1, 1993 through November 26, 1993 (for the
Historical Integrity Companies). The financial information has been derived from
consolidated financial statements of the Company, prepared in conformity with
GAAP, that have been audited by Ernst & Young LLP.
Effective May 31, 1995, the Company acquired substantially all of the
assets and business operations of SBM. This acquisition was accounted for as a
purchase, and the results of operations of the acquired businesses are included
in the Company's historical financial information from the date of acquisition.
Because 1997 and 1996 include full years of acquired SBM business operations
compared to seven months in 1995, the results of operations for 1997, 1996,
1995, and 1994 are not completely comparable. "Historical Integrity Companies"
refers to operations, for accounting and reporting purposes, prior to the
Company's November 26, 1993 acquisition of the Integrity Companies. The
Historical Integrity Companies' results of operations for 1993 are presented for
purposes of comparison; however, because of purchase accounting adjustments, a
new capital structure and new management team resulting from that acquisition,
the Company's results have differed from the results of the Historical Integrity
Companies.
The selected historical financial information set forth below should be
read in conjunction with "Management's Discussion and Analysis of Financial
Condition and Results of Operations," the Company's consolidated financial
statements and the notes thereto and other financial and operating information
included herein.
32
Historical
Integrity
The Company Companies(1)
------------------------------------------------------------------------ ------------
Period form
Period from January 1,
Year Ended December 31, November 27, 1993 through
------------------------------------------------------- 1993 through November 26,
(IN THOUSANDS, December 31, 1993
EXCEPT PER SHARE AMOUNTS) 1997 1996 1995 1994 1993
- ------------------------------------------------------------------------------------------------------------------ ------------
INCOME STATEMENT DATA:
Investment income $ 329,979 $ 250,031 $ 196,024 $ 149,142 $ 16,260 $ 148,120
Interest credited on customer deposits (247,418) (182,161) (146,867) (116,463) (13,563) (116,341)
----------------------------------------------------------------------- ----------
Net investment spread 82,561 67,870 49,157 32,679 2,697 31,779
Fee income:
Variable annuity fees 14,630 10,786 7,238 4,291 91 1,000
Asset management fees 8,595 5,780 3,161 -- -- --
Other fee income 1,386 1,267 949 4,100 369 1,258
----------------------------------------------------------------------- ----------
Total fee income 24,611 17,833 11,348 8,391 460 2,258
Other income and expenses:
Surrender charges 4,482 5,024 3,339 2,356 145 1,615
Operating expenses (32,528) (31,055) (22,957) (21,484) (1,423) (30,663)
Commissions, net of deferrals (2,218) (2,372) (1,557) (2,551) (309) (4,877)
Interest expense on debt (2,517) (3,146) (3,461) (3,136) (245) (133)
Amortization:
Deferred policy acquisition costs (10,416) (6,835) (2,932) (1,296) (12) (1,470)
Value of insurance in force (9,293) (7,320) (7,104) (3,830) (552) (6,444)
Acquisition-related deferred
charges (503) (1,503) (9,920) (2,163) (249) --
Goodwill (424) (488) (358) -- -- --
Non-recurring charges(2):
Stock-based compensation (8,145) -- -- -- -- --
Other (6,678) (5,004) -- -- -- --
Other, net (386) (5,366) (687) 4,972 (46) --
----------------------------------------------------------------------- ----------
Total other income and expenses (68,626) (58,065) (45,637) (27,132) (2,691) (41,972)
Realized investment gains (losses) 3,192 907 4,048 (36,727) (79) (32,776)
----------------------------------------------------------------------- ----------
Income (loss) before income taxes 41,738 28,545 18,916 (22,789) 387 (40,711)
Income tax benefit (expense) (14,139) (5,167) (7,026) 6,018 (508) --
----------------------------------------------------------------------- ----------
Net income (loss) 27,599 23,378 11,890 (16,771) (121) $ (40,711)
Dividends on preferred stock (4,750) (4,750) (4,750) (4,750) (462) ----------
----------------------------------------------------------------------- ----------
Net income (loss) applicable to
common shareholders $ 22,849 $ 18,628 $ 7,140 $ (21,521) $ (583)
-----------------------------------------------------------------------
-----------------------------------------------------------------------
Net income (loss) per common and
common equivalent share (diluted)(3) $ 1.07 $ 1.06 $ 0.49 $ (2.03) $ (0.06)
-----------------------------------------------------------------------
-----------------------------------------------------------------------
Average common and common
equivalent shares outstanding(3) 21,305 17,498 14,614 10,590 10,590
-----------------------------------------------------------------------
-----------------------------------------------------------------------
OTHER OPERATING DATA:
Operating earnings (loss)(4) $ 34,149 $ 22,227 $ 4,509 $ 2,352 $ (532)
-----------------------------------------------------------------------
-----------------------------------------------------------------------
Operating earnings (loss) per common
and common equivalent share
(diluted)(3) $ 1.60 $ 1.27 $ 0.31 $ 0.22 $ (0.05)
-----------------------------------------------------------------------
-----------------------------------------------------------------------
33
December 31,
--------------------------------------------------------------------------------
(IN THOUSANDS) 1997 1996 1995 1994 1993
- -------------------------------------------------------------------------------------------------------------------
BALANCE SHEET AND OTHER DATA:
Total cash and investments(5) $ 4,467,477 $ 3,347,477 $ 2,798,027 $ 1,782,501 $ 2,103,856
Assets held in separate accounts 2,439,884 1,135,048 809,927 506,270 231,687
Total assets(5) 7,138,424 4,701,664 3,793,580 2,447,888 2,427,886
Long-term debt 38,000 40,000 40,000 40,000 40,000
Total liabilities 6,830,879 4,519,722 3,605,589 2,462,021 2,315,535
Shareholders' equity:
Carrying amount(5) 307,545 181,942 187,991 (14,133) 112,351
Excluding the effects of SFAS
No. 115(6) 287,245 178,273 159,461 90,816 n/a(8)
Fair value(7) 321,087 224,276 187,721 115,192 111,709
(1) The Company had no significant business activity until November 26, 1993,
when it acquired the Integrity Companies from National Mutual. Results of
operations prior to the acquisition for the period from January 1, 1993
through November 26, 1993 are presented for comparative purposes.
(2) The Company recorded non-recurring charges of $14.8 million for 1997
including a one-time non-cash stock-based compensation charge of $8.1
million related to the Company's initial public offering of common stock,
and other non-recurring costs primarily attributable to the relocation and
consolidation of the Company's operations facilities from Columbus, Ohio to
Louisville, Kentucky. The Company recorded a non-recurring charge of $5.0
million in 1996 that also included $3.2 million for facilities
consolidation and costs of $1.8 million primarily related to merger and
acquisition activity that did not result in a transaction.
(3) Shares and per share amounts have been restated, for all periods presented,
to reflect the 706-for-1 stock split that occurred in conjunction with the
initial public offering of the Company's common stock.
(4) "Operating earnings" is defined as 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 which were sold during November 1997.
(5) Total cash and investments, total assets and carrying amount shareholders'
equity for the periods ending subsequent to December 31, 1993 reflect a
change in accounting principle for the January 1, 1994 adoption of SFAS
No. 115, "Accounting for Certain Investments in Debt and Equity
Securities."
(6) Excludes from carrying amount shareholders' equity the net unrealized gains
and losses on securities classified as available-for-sale, net of related
amortization and taxes.
(7) The methodologies used to estimate fair value are described in the notes to
the consolidated financial statements contained herein.
(8) Not applicable.
34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company specializes in the growing asset accumulation business with
particular emphasis on retirement savings and investment products. The Company's
products and services are sold in two principal markets, the retail and
institutional markets, through a broad spectrum of distribution channels.
The Company derives its earnings from the investment spread and fee
income generated by the assets it manages. The Company earns a spread between
what is earned on invested assets and what is credited to customer accounts
with its retail spread products (primarily fixed annuities) and institutional
spread products (funding agreements and GICs). The Company receives a fee in
exchange for managing customers' deposits, and the customer accepts the
investment risk with its retail variable products (variable annuities). 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. In addition, the Company expects to benefit from the growing
institutional marketplace by increasing penetration in the stable value and
fixed income markets and developing new products and applications. 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 its fee-based business, such as expanded offerings of
synthetic GICs. Fee-based business is less capital intensive than
spread-based business and provides the Company with diversified sources of
income.
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. Although third-party assets managed by ARM Capital Advisors grew
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 constrained ARM Capital Advisors' growth.
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. Had the sale of ARM Capital Advisors' operations and
the sale of the management contracts for the State Bond Mutual Funds occurred on
January 1, 1995, they would not have had a material effect on the Company's net
income for the years ended December 31, 1997, 1996 and 1995.
The following discussion compares the results of operations for the Company
for the three years ended December 31, 1997. As the Company acquired
substantially all of the assets and business operations of SBM effective May 31,
1995, results for 1996 and 1997 each include a full year of
35
acquired SBM business operations compared to seven months in 1995. Therefore,
results of operations for 1995 are not completely comparable with 1996 and 1997.
For certain financial information regarding the Company's business segments,
see Note 13 of the consolidated financial statements included herein.
RESULTS OF OPERATIONS
1997 COMPARED TO 1996
Net income during 1997 was $27.6 million compared to $23.4 million for
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
which were sold) were $34.1 million and $22.2 million for 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 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 the Company believes could have
been earned at an assumed rate of 7.5% on the net proceeds of the Company's
initial public offering of common stock assuming it occurred on January 1,
1996) were $36.3 million and $26.8 million for 1997 and 1996, respectively.
Pro forma operating earnings per share were $1.51 and $1.13 for the same
respective years. This pro forma information is not necessarily indicative of
what would have occurred had the offering occurred on the date indicated.
Operating earnings for retail spread products were 1.36% and 1.30% of
average assets under management of $2.76 billion and $2.66 billion for that
segment during 1997 and 1996, respectively. This increase in retail spread
margins is primarily attributable to ongoing asset/liability management, which
generated higher net investment spreads. Operating earnings for institutional
spread products were 0.62% and 0.57% of average assets under management of $1.48
billion and $567.7 million for that segment during 1997 and 1996, respectively.
The increase in institutional spread margins is also primarily attributable to
ongoing asset/liability management. Operating earnings for retail variable
products were 0.52% and 0.66% of average assets under management of $970.3
million and $728.2 million for that segment during 1997 and 1996, respectively.
The decline in retail variable margins is primarily attributable to lower
amortization expense of deferred policy acquisition costs during 1996. The
Company's corporate and other segment primarily includes earnings on insurance
subsidiaries surplus and holding company cash and investments, marketing
partnership and broker-dealer fee income, and unallocated corporate overhead.
Income tax expense and preferred stock dividends are not allocated to any
segment.
36
Net investment spread for the years ended December 31, 1997 and 1996 was as
follows:
Year Ended
December 31,
---------------------------
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED) 1997 1996
- --------------------------------------------------------------------------------------
Investment income $ 329,979 $ 250,031
Interest credited on customer deposits (247,418) (182,161)
---------------------------
Net investment spread $ 82,561 $ 67,870
---------------------------
---------------------------
Investment yield 7.60% 7.75%
Average credited rate (5.83)% (5.67)%
---------------------------
Investment spread rate 1.77% 2.08%
---------------------------
---------------------------
Average cash and investments (IN BILLIONS) $ 4.34 $ 3.23
Average spread-based customer deposits (IN BILLIONS) $ 4.24 $ 3.21
The decrease in the overall investment spread rate from 2.08% in 1996 to
1.77% in 1997 is attributable to a greater proportion of institutional spread
product deposits in 1997, which generate lower spreads. Changes in investment
yield and interest credited rates must be analyzed in relation to the liability
portfolios to which they relate. When analyzed individually, investment spread
rates increased in 1997 for both retail and institutional spread products. The
investment yield on cash and investments, excluding assets supporting
institutional spread product deposits, was 8.04% for 1997, up from 8.01% in
1996. In comparison, the investment yield on cash and investments supporting
institutional spread product deposits was 6.74% and 6.53% for 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 $567.7 million during 1996 to $1.48 billion
during 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 $24.6 million in 1997 from $17.8 million in
1996. This increase is attributable to variable annuity fees, which are based
on the market value of the mutual fund assets supporting variable annuity
customer deposits in nonguaranteed separate accounts. Variable annuity fees
increased to $14.6 million in 1997 from $10.8 million 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. Variable annuity deposits averaged $970.3 million
in 1997, an increase from $728.2 million 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 $8.6 million in 1997 from $5.8 million in 1996,
reflecting a significant increase
37
in the average fair value of off-balance sheet assets managed due to sales. As a
result of the sale of ARM Capital Advisors' operations and the State Bond Mutual
Funds management contracts, asset management fee income will decrease in the
future.
Assets under management as of December 31, 1997 and 1996 were as follows:
1997 1996
---------------------------- ----------------------------
Percent of Percent of
(DOLLARS IN MILLIONS) Amount Total Amount Total
- ----------------------------------------------------------------------------------------------------------------------------
Retail spread products (primarily fixed and indexed
annuity and face-amount certificate deposits) $ 2,820.6 41% $ 2,646.2 55%
Institutional spread products (funding agreement
and GIC deposits) 2,542.3 37 891.9 18
Retail variable products (variable annuity deposits
invested in mutual funds) 1,129.1 16 844.3 17
Corporate and other:
Off-balance sheet deposits under marketing
partnership arrangements 232.9 3 366.2 8
Cash and investments in excess of customer deposits 180.8 3 77.0 2
--------------------------------------------------------
Total corporate and other 413.7 6 443.2 10
--------------------------------------------------------
Total assets under management $ 6,905.7 100% $ 4,825.6 100%
--------------------------------------------------------
--------------------------------------------------------
The increase in total assets under management was primarily attributable
to sales of floating rate funding agreements and GICs to institutional
customers and, to a lesser extent, an increase in retail variable product
deposits attributable to variable annuity sales and the investment
performance of variable annuity mutual funds due to strong stock market
returns.
Sales of retail and institutional spread products include premiums and
deposits received for products issued by the Company's insurance and face-amount
certificate subsidiaries. Sales of retail variable products include premiums for
the investment portfolio options of variable annuity products issued by the
Company's insurance subsidiaries.
38
Sales by market and type of product for 1997 and 1996 were as follows:
Year Ended
December 31,
------------------------
(In millions) 1997 1996
- ------------------------------------------------------------------------------
Retail:
Spread products $ 382.5 $ 130.6
Variable products 206.3 200.1
------------------------
Total retail 588.8 330.7
Institutional:
Institutional spread products 1,708.7 747.5
------------------------
Total sales $ 2,297.5 $ 1,078.2
------------------------
------------------------
Total sales during 1997 rose to $2,297.5 million, an increase of
approximately 113% over 1996. The growth is primarily attributable to continued
diversification and expansion in the retail and institutional markets. The
growth in retail spread product sales is largely due to an increase in marketing
efforts for the Company's guaranteed rate option annuity products. Institutional
spread product sales increased as a result of (i) the addition of sales staff
and further penetration into institutional channels and (ii) the launching of a
new funding agreement product. In November 1997, the Company received a deposit
of $500 million for the new product, which was sold in partnership with BLB and
initially matures in five years and is renewable annually thereafter.
Net surrenders of retail fixed and variable annuity products issued by the
Company's insurance subsidiaries were $344.5 million for 1997 compared to $326.2
million for 1996. Surrender charge income decreased to $4.5 million in 1997 from
$5.0 million in 1996. The decrease in surrender charge income is attributable to
a larger portion of the surrenders being partial surrenders which do 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 in 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 attempts to reduce
surrender activity and improve persistency through various programs.
Operating expenses increased to $32.5 million in 1997 from $31.1 million 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 continues to actively pursue and retain
producers within its distribution channels to market its products.
39
Amortization of deferred policy acquisition costs related to operations was
$10.4 million and $6.8 million in 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 commissions and certain policy issuance and
marketing costs) are deferred and then amortized over the expected life of the
contract.
Amortization of value of insurance in force related to operations of $9.3
million and $7.3 million for 1997 and 1996, respectively, primarily reflects the
amortization of the value of insurance in force established as an asset by the
Company in connection with the acquisition of SBM's insurance subsidiary. The
increase in amortization expense corresponds with lower than expected gross
margins for that block of annuity business.
The Company recorded non-recurring charges of $14.8 million for 1997
including a one-time non-cash stock-based compensation charge of $8.1 million
related to the Company's initial public offering of common stock, and other
non-recurring costs primarily attributable to the relocation and consolidation
of the Company's operations facilities from Columbus, Ohio to Louisville,
Kentucky. The Company recorded a non-recurring charge of $5.0 million in 1996
that also included $3.2 million for facilities consolidation and costs of $1.8
million primarily related to merger and acquisition activity that did not result
in a transaction.
Other expenses, net decreased to $0.4 million in 1997 from $5.4 million in
1996. This decrease is attributable to higher mortality costs in 1996 related to
immediate annuity deposits. In addition, 1997 benefited from mortgage loan
prepayment penalty income of $2.1 million and the favorable resolution of a
reinsurance claim of $2.4 million.
Realized investment gains, which are reported net of related
amortization of deferred policy acquisition costs and value of insurance in
force, were $3.2 million in 1997 compared to $0.9 million in 1996. Realized
investment gains in 1997 includes an estimated loss of $4.0 million related
to the write-down to fair value of an investment in a fixed income security.
Realized investment gains in 1996 includes an estimated loss of $15.2 million
related to the write-down to fair value of an investment in a fixed income
security and a gain of $4.5 million, before selling expenses, related to the
transfer of the State Bond Mutual Funds management contracts. Other 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.
40
Income tax expense was $14.1 million and $5.2 million in 1997 and 1996,
respectively, reflecting effective tax rates of 33.9% and 18.1% as a percentage
of pretax income. If the non-recurring stock-based compensation charge was added
back to pretax income, the effective tax rate for 1997 would be 28.3%. A tax
benefit was not recognized for the charge because a full valuation allowance was
provided on the Company's non-life deferred tax assets.
1996 COMPARED TO 1995
During 1996, net income for the Company was $23.4 million compared to
$11.9 million for 1995. 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 which were sold during November 1997) were $22.2
million and $4.5 million for 1996 and 1995, respectively. The increase in
operating earnings is primarily attributable to (i) an increase in net
investment spread due to ongoing asset/liability management and deposit
growth from the full year's effects of the May 31, 1995 acquisition of the
SBM assets and business operations and additional sales of retail and
institutional spread products and (ii) an increase in fee income as a result
of a growing base of variable annuity deposits. Such increases in revenues
were partially offset by an increase in operating expenses as a result of
business growth.
Operating earnings for retail spread products were 1.30% and 0.91% of
average assets under management of $2.66 billion and $2.43 billion for that
segment during 1996 and 1995, respectively. This increase in retail spread
margins is primarily attributable to ongoing asset/liability management, which
generated higher net investment spreads. Operating earnings for institutional
spread products were 0.57% and 0.60% of average assets under management of
$567.7 million and $38.5 million for that segment during 1996 and 1995,
respectively. Operating earnings for retail variable products for 1996 were
slightly higher than the corresponding prior period as evidenced by the increase
to 0.66% from 0.64% of average retail variable assets under management of $728.2
million and $491.5 million during 1996 and 1995, respectively.
Net investment spread for the years ended December 31, 1996 and 1995 was as
follows:
Year Ended December 31,
-----------------------
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED) 1996 1995
- ------------------------------------------------------------------------------
Investment income $ 250,031 $ 196,024
Interest credited on customer deposits (182,161) (146,867)
-----------------------
Net investment spread $ 67,870 $ 49,157
-----------------------
-----------------------
Investment yield 7.75% 7.84%
Average credited rate (5.67)% (5.90)%
-----------------------
Investment spread rate 2.08% 1.94%
-----------------------
-----------------------
Average cash and investments (IN BILLIONS) $ 3.23 $ 2.50
Average customer deposits (IN BILLIONS) $ 3.21 $ 2.49
41
The decrease in investment yields on cash and investments primarily
relates to a significant increase in institutional spread product deposits
which grew from zero to $143.2 million during 1995 and to $891.9 million at
December 31, 1996. 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
investment yield on cash and investments supporting institutional spread
product deposits was 6.53% for 1996. In comparison, the investment yield on
cash and investments, excluding assets supporting institutional spread
product deposits, was 8.01% for 1996, up from 7.85% for 1995, which reflects
the benefits of the ongoing management of the Company's investment
portfolios. The decrease in the average rate of interest credited on
customer deposits during 1996 was due primarily to annual or semi-annual
crediting rate resets occurring at a time when the overall interest rate
environment was generally lower (the last half of 1995 and the first half of
1996 compared to the last half of 1994 and the first half of 1995).
Fee income increased to $17.8 million in 1996 from $11.3 million in 1995.
This increase is in part attributable to variable annuity fees which are based
on the market value of assets supporting the investment portfolio options of
variable annuity customer deposits in separate accounts. Variable annuity fees
increased to $10.8 million in 1996 from $7.2 million in 1995 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. Variable annuity deposits increased to $844.3 million
in 1996 from $617.3 million in 1995. In addition, asset management fees earned
by ARM Capital Advisors on off-balance sheet assets, related to defined benefit
pension plans and the State Bond Mutual Funds, increased to $5.8 million in 1996
from $3.2 million in 1995. This increase in asset management fees reflects a
significant increase in the average amount of corresponding off-balance sheet
assets managed due to new defined benefit pension plan accounts. The average
amount of off-balance sheet assets managed by ARM Capital Advisors was $2.16
billion in 1996 compared to $1.10 billion in 1995.
Assets under management as of December 31, 1996 and 1995 were as follows:
1996 1995
---------------------------- ----------------------------
Percent of Percent of
(DOLLARS IN MILLIONS) Amount Total Amount Total
- -------------------------------------------------------------------------------------------- ----------------------------
Retail spread products (primarily fixed and indexed annuity
and face-amount certificate deposits) $ 2,646.2 55% $ 2,716.2 69%
Institutional spread products (funding agreement and GIC
deposits) 891.9 18 143.2 4
Retail variable products (variable annuity deposits
invested in mutual funds) 844.3 17 617.3 16
Corporate and other:
Off-balance sheet deposits under marketing partnership
arrangements 366.2 8 387.3 10
Cash and investments in excess of customer deposits 77.0 2 61.1 1
---------------------------- ----------------------------
Total corporate and other 443.2 10 448.4 11
---------------------------- ----------------------------
Total assets under management* $ 4,825.6 100% $ 3,925.1 100%
---------------------------- ----------------------------
---------------------------- ----------------------------
42
* Does not include off-balance sheet assets managed by ARM Capital Advisors
for institutional clients and off-balance sheet assets in the State Bond
Mutual Funds. Including such assets, total assets under management at
December 31, 1996 and 1995 were $7,553.0 million and $5,364.2 million,
respectively.
The increase in total assets under management was primarily attributable to
an increase in sales of funding agreements and GICs to institutional customers
and, to a lesser extent, increased sales of retail variable products.
Sales by market and type of product for 1996 and 1995 were as follows:
Year Ended
December 31,
------------------
(IN MILLIONS) 1996 1995
- -----------------------------------------------------------------------
Retail:
Spread products $ 130.6 $115.4
Variable products 200.1 177.7
------------------
Total retail 330.7 293.1
Institutional:
Institutional spread products 747.5 142.2
Fee-based marketing partnerships -- 272.9
------------------
Total institutional 747.5 415.1
------------------
Total sales*
$1,078.2 $708.2
------------------
------------------
* Does not include new deposits related to off-balance sheet assets managed
by ARM Capital Advisors for institutional clients and the State Bond Mutual
Funds. Total retail sales for the years ended December 31, 1996 and 1995
were $342.8 million and $300.9 million, respectively, and total
institutional sales for the years ended December 31, 1996 and 1995 were
$2,401.5 million and $886.9 million, respectively, including such deposits.
The increase in retail sales was primarily attributable to an increase
in sales of investment portfolio options of variable annuity contracts due,
in part, to the strong stock market returns during 1996 and an increased
emphasis on marketing efforts of retail products during the fourth quarter,
principally through stockbrokers and independent agents. Expanded
distribution of funding agreement and GIC products through bank trust
departments, mutual fund companies, investment managers, insurance companies
and investment consultants contributed to the increase in sales of such
products. The decrease in institutional fee-based sales was attributable to
the Company's marketing partnership arrangement with General American which
was converted from a fee-based to primarily a spread-based arrangement in
late 1995.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $326.2 million and $319.8 million in 1996 and 1995,
respectively. Of these amounts, $106.9 million and $62.8 million, respectively,
can be attributed to fixed annuity business acquired from SBM. Surrender charge
income increased to $5.0 million in 1996 from $3.3 million in 1995, due to
higher average surrender charges associated with SBM products compared to other
products of the Company's insurance subsidiaries and to the overall increase in
the volume of surrenders. The surrender and withdrawal activity during 1995 and
1996 was generally expected by the Company due to the level of customer deposits
written several years ago that were subject to declining or expiring surrender
charges and the Company's strategy of maintaining investment spreads.
43
Operating expenses increased to $31.1 million in 1996 from $23.0 million in
1995. The increase was primarily attributable to (i) the inclusion of twelve
months of incremental operating expenses related to the acquired SBM operations
in the 1996 results versus seven months for the comparable 1995 period, (ii) the
expansion of product distribution channels and (iii) a charge of $1.6 million to
increase the reserve for anticipated future guaranty fund assessments.
Commissions, net of deferrals, were $2.4 million and $1.6 million in 1996
and 1995, respectively. The increase was primarily attributable to the inclusion
in 1996 results of twelve months' renewal and trailer commissions under certain
deferred annuity contracts acquired through the SBM acquisition versus seven
months for the comparable 1995 period.
Amortization of deferred policy acquisition costs related to operations was
$6.8 million and $2.9 million during 1996 and 1995, respectively. This increase
was the result of growth in the deferred policy acquisition cost asset due to
additional sales of fixed and variable annuity products.
Amortization of value of insurance in force related to operations increased
to $7.3 million in 1996 from $7.1 million in 1995. The increase is attributable
to amortization of the value of insurance in force established as an asset by
the Company on May 31, 1995 in connection with the acquisition of SBM's
insurance subsidiary.
Amortization of acquisition-related deferred charges was $1.5 million and
$9.9 million in 1996 and 1995, respectively. The decrease was primarily
attributable to the accelerated amortization during the third quarter of 1995 of
certain costs and charges deferred during 1993 and 1994. During the third
quarter of 1995, Company management determined that changes in facts and
circumstances had resulted in a change in their original estimate of the periods
benefited by these costs and charges. As a result of this change in estimate,
the remaining unamortized balances of these deferred costs and charges were
fully amortized as of September 30, 1995, resulting in lower amortization in
future periods.
Other expenses, net were $5.4 million in 1996 compared to $0.7 million in
1995. The increase is primarily attributable to an increase in premiums and fees
paid or accrued in 1996, net of a reduction in net benefits paid, under
reinsurance agreements. Through the reinsurance agreements, one of which
commenced December 31, 1995, substantially all mortality risks associated with
single premium endowment deposits have been reinsured.
The Company recorded a $5.0 million non-recurring charge in 1996 including
$3.2 million related to the move of operations facilities from Columbus, Ohio to
Louisville, Kentucky and costs of $1.8 million primarily related to mergers and
acquisitions activities that did not result in a transaction.
Realized investment gains, which are reported net of related amortization
of deferred policy acquisition costs and value of insurance in force, were $0.9
million in 1996 compared to $4.0 million in 1995. Realized investment gains
in 1996 include an estimated loss of $15.2 million related to the write-down to
fair value of an investment in a fixed income security and a gain of $4.5
million, before selling expenses, related to the transfer of the State Bond
Mutual Funds management
44
contracts. Other 1996 and all 1995 realized investment gains and losses were
interest-rate related and attributable to the ongoing management of the
Company's fixed maturity securities classified as available-for-sale which
can result in period-to-period swings in realized investment gains and losses
since securities are sold during both rising and falling interest rate
environments.
Income tax expense was $5.2 million and $7.0 million in 1996 and 1995,
respectively, reflecting effective tax rates of 18.1% and 37.1%. The lower
effective tax rate in 1996 resulted primarily from the recognition of benefits
associated with certain deferred tax assets established in connection with the
Company's acquisition of the Integrity Companies on November 26, 1993 for which
a full valuation allowance was originally provided. These deferred tax benefits
are being recognized based on the taxable income generated by the Integrity
Companies in the post-acquisition period and projections of future taxable
income.
ACQUISITION ACTIVITY
ARM CAPITAL ADVISORS
Through its acquisition of the U.S. fixed income unit of KBIMA in January
1995, the Company obtained a recognized fixed income management service which
became part of the then newly-formed ARM Capital Advisors. In addition to
providing asset management services to institutional clients, ARM Capital
Advisors managed the investment portfolios of the Company's subsidiaries.
Although third-party assets managed by ARM Capital Advisors grew since the
acquisition, 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 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.
SBM COMPANY
Effective May 31, 1995, the Company completed the acquisition of
substantially all of the assets and business operations of SBM, including all of
the issued and outstanding capital stock of SBM's subsidiaries, SBM Life and ARM
Securities (formerly known as SBM Financial Services, Inc.), as well as the
management contracts for the State Bond Mutual Funds. The aggregate purchase
price for the SBM acquisition was $38.8 million. The Company financed the
acquisition by issuing approximately 6.9 million shares of common stock,
primarily to the Morgan Stanley Stockholders, for an aggregate sale price of
$63.5 million. The Company used proceeds from the issuance of the new common
equity in excess of the adjusted purchase price for the acquisition to make a
$19.9 million capital contribution to SBM Life and acquire SBM Certificate
Company from SBM Life for $3.3 million. The capital contribution to SBM Life of
$19.9 million was used to strengthen SBM Life's financial position and allowed
for a significant investment portfolio restructuring immediately following the
acquisition with no net adverse effect on statutory adjusted capital and
surplus. On December 31, 1995, SBM Life was merged with and into Integrity to
create certain operating efficiencies. The SBM acquisition provided the Company
with expanded distribution channels, as well as a deposit base in the 403(b)
tax-deferred annuity marketplace. On December 13, 1996, the Company transferred
its responsibility for performing management and investment advisory services
45
for the State Bond Mutual Funds to Federated Investors for $4.5 million. The
State Bond Mutual Funds had aggregate assets of $236.9 million on December 13,
1996.
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. At amortized cost, fixed maturities at December 31, 1997 totaled $4.0
billion, compared with $3.0 billion at December 31, 1996, both representing
approximately 91% of total cash and investments. This increase in investments in
fixed maturities primarily resulted from the investment of the proceeds from
sales of institutional spread products.
The Company's cash and investments as of December 31, 1997 are detailed as
follows:
Amortized Cost
--------------------------
Estimated
Percent Fair
(DOLLARS IN MILLIONS) Amount of Total Value
- -----------------------------------------------------------------------------------------------------------------------------------
Fixed maturities:
Corporate securities $ 1,390.3 31.5% $ 1,410.0
U.S. Treasury securities and obligations of U.S. government agencies 318.6 7.2 319.7
Other government securities 84.3 1.9 83.8
Asset-backed securities 400.3 9.1 400.4
Mortgage-backed securities:
Agency pass-throughs 268.9 6.1 271.1
Collateralized mortgage obligations:
Agency 423.3 9.6 432.0
Non-agency 1,135.8 25.7 1,151.4
-------------------------------------------
Total fixed maturities 4,021.5 91.1 4,068.4
Equity securities (i.e., non-redeemable preferred stock) 28.2 0.6 28.3
Mortgage loans on real estate 16.4 0.4 16.4
Policy loans 126.1 2.8 126.1
Cash and cash equivalents 228.2 5.1 228.2
-------------------------------------------
Total cash and investments $ 4,420.4 100.0% $ 4,467.4
-------------------------------------------
-------------------------------------------
Agency pass-through certificates are mortgage-backed securities ("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. Collateralized mortgage obligations
("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-
46
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
CMO investments at December 31, 1997, 90.2% used mortgage loans or mortgage
loan pools, letters of credit, agency mortgage pass-through securities and
other types of credit enhancement as collateral. The remaining 9.8% of the
non-agency CMOs used 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 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 may be 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 has gross unamortized
premiums and unaccreted discounts of MBSs of $44.5 million and $82.7 million,
respectively, at December 31, 1997. Although the interest rate environment has
experienced significant volatility during 1997, 1996 and 1995, prepayments and
extensions of cash flows from MBSs have not materially affected investment
income of the Company.
Asset-backed securities ("ABS") are securitized bonds which can be
backed by, but not limited to, collateral such as home equity loans, second
mortgages, automobile loans and credit card receivables. At December 31, 1997
home equity loan collateral represented 53.8% of the Company's investments in
the ABS market. The typical structure of an ABS provides for favorable
yields, high credit rating and stable prepayments.
Total cash and investments were 95% and 96% investment grade or equivalent
as of December 31, 1997 and 1996, respectively. Investment grade securities are
those classified as 1 or 2 by the NAIC or, where such classifications are not
available, having a rating on the scale used by 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 has a diversified
foreign portfolio of Yankee Bonds, including a limited exposure to the Asian
market. The Company reduces the risks associated with buying foreign securities
by limiting the exposure to both issuer and country. The Company closely
monitors the creditworthiness of such issuers and the stability of each country.
Additionally, the
47
Company's investment portfolio has minimal exposure to real estate, mortgage
loans and common equity securities, which represent less than 1% of cash and
investments as of December 31, 1997.
The Company analyzes its investment portfolio, including below investment
grade securities, at least quarterly in order to determine if its ability to
realize its carrying 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 December 31, 1997 the ratings assigned by the NAIC and comparable S&P
ratings on the Company's fixed maturity portfolio, and the percentage of total
fixed maturity investments classified in each category were as follows:
Amortized Cost
---------------------------
Percent Estimated
NAIC Designation (Comparable S&P Rating) Amount of Total Fair Value
- --------------------------------------------------------------------------------------------------------------
(Dollars in millions)
1 (AAA, AA, A) $ 2,758.0 69% $ 2,793.6
2 (BBB) 1,023.8 25 1,041.6
3 (BB) 137.9 3 139.0
4 (B) 101.8 3 94.2
5 (CCC, CC, C) -- -- --
6 (CI, D) -- -- --
--------------------------------------------
Total fixed maturities $ 4,021.5 100% $ 4,068.4
--------------------------------------------
--------------------------------------------
Pursuant to Statement of Financial Accounting Standards ("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 1997 resulted in unrealized gains
on available-for-sale securities which totaled $20.3 million (net of $15.8
million of related amortization of deferred policy acquisition costs and value
of insurance in force and $10.9 million of deferred income taxes) at December
31, 1997, compared to unrealized gains of $3.7 million (net of $1.3 million of
related
48
amortization of deferred policy acquisition costs and value of insurance in
force and $2.0 million of deferred income taxes) at December 31, 1996. This
change in net unrealized gains on available-for-sale securities for the year
ended December 31, 1997 increased reported shareholders' equity by $16.6 million
as compared to a decrease of $24.9 million for the year ended December 31, 1996.
This volatility in reported shareholders' equity occurs as a result of SFAS
No. 115, which requires that available-for-sale securities be carried at fair
value while other assets and all liabilities are carried at historical values.
At December 31, 1997 and 1996, shareholders' equity excluding the effects of
SFAS No. 115 was $287.2 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 or other assets creates volatility in reported shareholders' equity
but does not reflect the underlying economics of the Company's business. The
Company's accompanying consolidated financial statements include fair value
balance sheets which demonstrate that the general rise in interest rates during
1996 and subsequent decrease during 1997 did not have a material effect on the
financial position of the Company when all assets and liabilities are adjusted
to estimated fair values.
Assets held in the Company's guaranteed separate accounts include $1,255.5
million and $258.7 million of cash and investments at December 31, 1997 and
1996, of which approximately 87% and 89% were fixed maturities, respectively.
Total guaranteed separate account cash and investments were 99% and 98%
investment grade at December 31, 1997 and 1996, respectively. Separate accounts
are investment accounts maintained by an insurer to which funds have been
allocated for certain policies under provisions of relevant state law. The
investments in each separate account are maintained separately from those in
other separate accounts and from the general account.
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 not absorbed by management fees
charged to its subsidiaries, 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 dividends on its common and preferred stock.
The ability of the Company's insurance subsidiaries to pay dividends and
enter into agreements with affiliates for the payment of service or other fees
is limited by state insurance laws. During 1997, the Company received dividends
of $14.9 million from Integrity. The maximum dividend payments that may be made
by Integrity to the Company during 1998 without the prior approval of the Ohio
Insurance Director are $38.2 million of which $6.0 million was paid in the first
quarter of 1998. The Company had cash and investments at the holding company
level of $41.9 million at
49
December 31, 1997. In addition, the Company has access to bank lines of credit
totaling $37.0 million at December 31, 1997.
In June 1997, the Company completed an initial public offering of 9.2
million shares of 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 Morgan Stanley Stockholders. On June 30, 1997, the Company used a
portion of such net proceeds to make a $40 million capital contribution to its
primary insurance subsidiary, Integrity, thereby strengthening Integrity's
capital base to provide for future growth. The Company plans 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 years ended December 31, 1997, 1996 and 1995, the Company met
its liquidity needs entirely by cash flows from operating activities and
principal payments and redemptions of investments. At December 31, 1997, cash
and cash equivalents totaled $228.2 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 $216.1 million, $192.9 million and
$138.4 million from operating activities during the years ended December 31,
1997, 1996 and 1995, respectively. These cash flows resulted principally from
investment income, less commissions and operating expenses. Proceeds from sales,
maturities and redemptions of investments generated $3,884.2 million, $2,214.3
million and $1,463.3 million in cash flows during 1997, 1996 and 1995,
respectively, which were offset by purchases of investments of $4,782.6 million,
$2,772.0 million and $1,506.5 million, respectively. An increase in investment
purchases and sales activity during 1997 compared to 1996 reflects the Company's
ongoing management of its fixed maturity portfolio which has increased in size
due to sales of retail and institutional spread products.
50
INCOME TAXES
At December 31, 1997, the Company reported an asset for deferred income
taxes of $31.0 million on the carrying amount balance sheet. Such amount is
net of a valuation allowance of $36.6 million. The net deferred tax asset
represents deductible temporary differences and net operating loss
carryforwards. Based on historical operating results and projections of
future taxable ordinary income, management believes that the net tax benefit
recorded will be fully utilized.
DERIVATIVES
The Company has only limited involvement with derivative financial
instruments and does not use them for trading purposes. They are used to manage
specific interest rate risks and, with respect to the Company's equity-indexed
annuity deposits, equity market risks.
EFFECTS OF INFLATION AND INTEREST RATE CHANGES
The Company believes that inflation will not have a material adverse effect
on results of operations. The Company manages its investment portfolios in part
to reduce its exposure to interest rate fluctuations. In general, the fair value
of the Company's fixed maturities portfolio increases or decreases inversely
with fluctuations in interest rates, and the Company's investment income
increases or decreases directly with interest rate changes. For example, if
interest rates decline, the Company's fixed maturity investments generally will
increase in fair value, while investment income will decrease as fixed income
investments are sold or mature and proceeds are reinvested at declining rates.
The converse will generally be true if interest rates rise.
YEAR 2000
The Company is currently evaluating, on an ongoing basis, its computer
systems and the systems of other companies on which the Company's operations
rely to determine if they will function properly with respect to dates in the
year 2000 and beyond. These activities are designed to ensure that there is no
adverse effect on the Company's core business operations. While the Company
believes its planning efforts are adequate to address its Year 2000 concerns,
there can be no guarantee that the systems of other companies on which the
Company's operations rely will be converted on a timely basis and will not have
a material effect on the Company. The cost of the Company's Year 2000
initiatives is not expected to be material to the Company's results of
operations or financial condition.
51
FORWARD-LOOKING STATEMENTS
Except for historical information contained in the Annual Report on Form
10-K, certain matters discussed herein, including (without limitation) in
particular under Part I, Item 1, "Business - General" and "Business -
Strategy" and under Part II, Item 7, "Management's Discussion and Analysis of
Financial Condition and Results of Operations" are forward looking statements
that involve risks and uncertainties, including (without limitation) the
Company's belief as to its competitive position in the industry and factors
affecting its business. In particular, the statements of the Company's
belief as to the growth of the long-term savings and retirement market, the
stimulation of future demand for the long-term savings and retirement
products and the statements regarding the development of future products to
meet the changing needs of the markets that the Company serves. 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.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's consolidated financial statements begin on page F-3.
Reference is made to the Index to Financial Statements on page F-1 herein.
Additional financial statement schedules are included on pages S-3 through
S-10. Reference is made to the Index to Financial Statement Schedules on page
S-1 herein.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
There have been no changes in or disagreements with accountants.
PART III
The Proxy Statement for the Annual Meeting of Stockholders (excluding
the Report on Executive Compensation and the Performance Graph sections),
which, when filed pursuant to Regulation 14A under the Securities Exchange
Act of 1934, is incorporated by reference in this Annual Report on Form 10-K
pursuant to General Instruction G(3) of Form 10-K, provides the information
required under Part III (Item 10 - Directors and Executive Officers of the
Company, Item 11 - Executive Compensation, Item 12 - Security Ownership of
Certain Beneficial Owners and Management, and Item 13 - Certain Relationships
and Related Transactions), except for the information regarding the executive
officers of the Company, which is included in Part I on pages 28-30.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, AND
REPORTS ON FORM 8-K
Financial Statements and Financial Statement Schedules
Reference is made to the indexes set forth on pages F-1 and S-1 of this
report.
REPORTS ON FORM 8-K
No reports on Form 8-K were filed by the Company during the fourth quarter
of 1997.
52
EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
- -------------------------------------------------------------------------------
2.1 Asset Purchase Agreement, dated as of January 5, 1995, among
Kleinwort Benson Investment Management Holdings Ltd., Kleinwort
Benson Investment Management Americas Inc., ARM Financial
Group, Inc., and ARM Capital Advisors, Inc. (Incorporated by
reference to the Form 10-K filed by the Company on March 30,
1995.)
2.2 Stock and Asset Purchase Agreement by and between SBM Company
and ARM Financial Group, Inc. dated as of February 16, 1995.
(Incorporated by reference to the Form 10-K filed by the
Company on March 30, 1995.)
2.3 Amended and Restated Stock and Asset Purchase Agreement dated
as of April 7, 1995, by and between SBM Company and ARM
Financial Group, Inc. (Incorporated by reference to the Form
10-Q filed by the Company on May 15, 1995.)
2.4 Subscription Agreement dated as of June 12, 1995, among ARM
Financial Group, Inc. and Morgan Stanley Capital Partners III,
L.P., Morgan Stanley Capital Investors, L.P. and MSCP III 892
Investors, L.P. (Incorporated by reference to the Form 10-K
filed by the Company on March 29, 1996.)
2.5 Subscription Agreement dated as of June 12, 1995, among ARM
Financial Group, Inc. and New ARM, LLC, Dudley J. Godfrey, Jr.,
and Edward Powers. (Incorporated by reference to the Form 10-K
filed by the Company on March 29, 1996.)
2.6 Subscription Agreement dated as of July 1, 1996, between ARM
Financial Group, Inc. and Warren M. Foss. (Incorporated by
reference to the Form S-1 Registration Statement filed by the
Company on October 23, 1996.)
3(i).1 Restated Certificate of Incorporation of ARM Financial Group,
Inc. filed with the Delaware Secretary of State on June 20,
1997. (Filed herewith.)
3(ii).1 Amended and Restated By-laws of ARM Financial Group, Inc.
(Filed herewith.)
4.1 Second Amended and Restated Stockholders Agreement dated as of
June 24, 1997, among ARM Financial Group, Inc., The Morgan
Stanley Leveraged Equity Fund II, L.P., John Franco, Martin H.
Ruby, Oldarm L.P., Morgan Stanley Capital Partners III, L.P.,
Morgan Stanley Capital Investors, L.P., MSCP III 892 Investors,
L.P., and New ARM, LLC. (Incorporated by reference to Amendment
No. 3 to the Form S-1 Registration Statement filed by the
Company on May 23, 1997.)
10.1 ARM Financial Group, Inc. Amended and Restated Stock Option
Plan dated as of June 14, 1995. (Incorporated by reference to
the Form 10-K filed by the Company on March 29, 1996.)
10.2 Amendment No. 2 to ARM Financial Group, Inc. Amended and
Restated Stock Option Plan. (Incorporated by reference to
Amendment No. 3 to the Form S-1 Registration Statement filed by
the Company on May 23, 1997.)
53
EXHIBIT
NUMBER DESCRIPTION
- -------------------------------------------------------------------------------
10.3 1997 Equity Incentive Plan. (Incorporated by reference to
Amendment No. 3 to the Form S-1 Registration Statement filed by
the Company on May 23, 1997.)
10.4 Guaranty dated as of December 13, 1995, made by ARM Financial
Group, Inc. in favor of First Bank, FSB, in connection with the
sale of certain SBM Certificate Company mortgage loans.
(Incorporated by reference to the Form 10-K filed by the
Company on March 29, 1996.)
10.5 Guaranty dated as of December 13, 1995, made by ARM Financial
Group, Inc. in favor of First Bank, FSB, in connection with the
sale of certain State Bond and Mortgage Life Insurance Company
mortgage loans. (Incorporated by reference to the Form 10-K
filed by the Company on March 29, 1996.)
10.6 Credit Agreement dated June 24, 1997 (the "Credit Agreement"),
among ARM Financial Group, Inc., the financial institutions
listed in Schedule 2.01 of the Credit Agreement (the
"Lenders"), and The Chase Manhattan Bank, as administrative
agent for the Lenders ("Chase"). (Incorporated by reference to
the Form 10-Q filed by the Company on August 14, 1997.)
10.7 Assignment Agreement dated as of June 24, 1997, between ARM
Financial Group, Inc., Integrity Holdings, Inc. ("Integrity
Holdings") and Chase. (Incorporated by reference to the Form
10-Q filed by the Company on August 14, 1997.)
10.8 Guarantee Agreement dated as of June 24, 1997, between
Integrity Holdings and Chase. (Incorporated by reference to the
Form 10-Q filed by the Company on August 14, 1997.)
10.9 Pledge Agreement dated as of June 24, 1997, among ARM Financial
Group, Inc., Integrity Holdings and Chase. (Incorporated by
reference to the Form 10-Q filed by the Company on August 14,
1997.)
10.10 Amendment Agreement dated as of December 15, 1997, to the
Credit Agreement between ARM Financial Group, Inc., the Lenders
and Chase. (Filed herewith.)
10.11 Administrative Services Agreement dated as of September 28,
1994, between ARM Financial Group, Inc. and National Integrity
Life Insurance Company. (Incorporated by reference to Amendment
No. 2 to the Form S-1 Registration Statement filed by the
Company on May 7, 1997.)
10.12 Administrative Services Agreement dated as of January 1, 1995,
between ARM Financial Group, Inc. and Integrity Life Insurance
Company. (Incorporated by reference to the Form 10-K filed by
the Company on March 29, 1996.)
10.13 Administrative Services Agreement dated as of June 14, 1995,
between ARM Financial Group, Inc. and SBM Certificate Company.
(Incorporated by reference to the Form 10-K filed by the
Company on March 29, 1996.)
10.14 Administrative Services Agreement dated as of June 14, 1995,
between ARM Financial Group, Inc. and ARM Financial Services,
Inc. (Incorporated by reference to the Form 10-K filed by the
Company on March 29, 1996.)
54
EXHIBIT
NUMBER DESCRIPTION
- -------------------------------------------------------------------------------
10.15 Administrative Services Agreement dated as of November 7, 1997,
between ARM Financial Group, Inc. and ARM Capital Advisors,
LLC. (Filed herewith.)
10.16 Investment Advisory Agreement dated as of July 29, 1994,
between ARM Financial Group, Inc. and National Integrity Life
Insurance Company. (Incorporated by reference to Amendment No.
2 to the Form S-1 Registration Statement filed by the Company
on May 7, 1997.)
10.17 Investment Services Agreement dated as of January 1, 1995,
between ARM Financial Group, Inc. and Integrity Life Insurance
Company. (Incorporated by reference to the Form 10-K filed by
the Company on March 29, 1996.)
10.18 Investment Services Agreement dated as of June 14, 1995,
between ARM Financial Group, Inc. and SBM Certificate Company.
(Incorporated by reference to the Form 10-K filed by the
Company on March 29, 1996.)
10.19 Investment Services Agreement dated as of November 7, 1997,
between ARM Financial Group, Inc. and ARM Capital Advisors,
LLC. (Filed herewith.)
10.20 Tax Allocation Agreement dated as of March 21, 1996 by and
among ARM Financial Group, Inc. and certain of its subsidiaries
for taxable periods beginning January 1, 1995. (Incorporated by
reference to the Form 10-K filed by the Company on March 29,
1996.)
10.21 Employment Agreement dated as of July 1, 1996, between ARM
Financial Group, Inc. and John Franco. (Incorporated by
reference to the Form S-1 Registration Statement filed by the
Company on October 23, 1996.)
10.22 Employment Agreement dated as of July 1, 1996, between ARM
Financial Group, Inc. and Martin H. Ruby. (Incorporated by
reference to the Form S-1 Registration Statement filed by the
Company on October 23, 1996.)
10.23 Employment Agreement dated as of July 1, 1996, between ARM
Financial Group, Inc. and David E. Ferguson. (Incorporated by
reference to the Form S-1 Registration Statement filed by the
Company on October 23, 1996.)
10.24 Employment Agreement dated as of July 1, 1996, between ARM
Financial Group, Inc. and John R. Lindholm. (Incorporated by
reference to the Form S-1 Registration Statement filed by the
Company on October 23, 1996.)
10.25 Letter Amendment dated as of December 4, 1997, to the
Employment Agreement between ARM Financial Group, Inc. and John
Franco. (Filed herewith.)
10.26 Letter Amendment dated as of December 4, 1997, to the
Employment Agreement between ARM Financial Group, Inc. and
Martin H. Ruby. (Filed herewith.)
55
EXHIBIT
NUMBER DESCRIPTION
- -------------------------------------------------------------------------------
10.27 Letter Amendment dated as of March 20, 1998, to the Employment
Agreement, as amended, between ARM Financial Group, Inc. and
Martin H. Ruby. (Filed herewith.)
10.28 Letter Amendment dated as of December 4, 1997, to the
Employment Agreement between ARM Financial Group, Inc. and John
R. Lindholm. (Filed herewith.)
10.29 Letter Amendment dated as of March 20, 1998, to the Employment
Agreement, as amended, between ARM Financial Group, Inc. and
John R. Lindholm. (Filed herewith.)
10.30 Letter Amendment dated as of December 4, 1997, to the
Employment Agreement between ARM Financial Group, Inc. and
David E. Ferguson. (Filed herewith.)
10.31 Letter Amendment dated as of March 20, 1998, to the Employment
Agreement, as amended, between ARM Financial Group, Inc. and
David E. Ferguson. (Filed herewith.)
10.32 Agreement dated as of February 10, 1998, between ARM Financial
Group, Inc. and John Franco. (Filed herewith.)
10.33 Termination Agreement dated as of May 21, 1997, between ARM
Capital Advisors Holding, LLC and ARM Financial Group, Inc.
(Filed herewith.)
10.34 Termination Agreement dated as of November 7, 1997, to the
Employment Agreement between Emad A. Zikry and ARM Financial
Group, Inc. (Filed herewith.)
10.35 Change in Control Agreement dated as of December 4, 1997,
between ARM Financial Group, Inc. and Dennis L. Carr. (Filed
herewith.)
10.36 Letter Amendment dated as of March 20, 1998, to the Change in
Control Agreement between ARM Financial Group, Inc. and Dennis
L. Carr. (Filed herewith.)
10.37 Change in Control Agreement dated as of December 4, 1997,
between ARM Financial Group, Inc. and Edward L. Zeman. (Filed
herewith.)
10.38 Letter Amendment dated as of March 20, 1998, to the Change in
Control Agreement between ARM Financial Group, Inc. and Edward
L. Zeman. (Filed herewith.)
10.39 Change in Control Agreement dated as of December 4, 1997,
between ARM Financial Group, Inc. and Daniel R. Gattis. (Filed
herewith.)
10.40 Change in Control Agreement dated as of December 4, 1997,
between ARM Financial Group, Inc. and Robert H. Scott. (Filed
herewith.)
56
EXHIBIT
NUMBER DESCRIPTION
- -------------------------------------------------------------------------------
10.41 Letter Amendment dated as of March 20, 1998, to the Change in
Control Agreement between ARM Financial Group, Inc. and Robert
H. Scott. (Filed herewith.)
10.42 Change in Control Agreement dated as of December 4, 1997,
between ARM Financial Group, Inc. and John R. McGeeney. (Filed
herewith.)
10.43 Letter Amendment dated as of March 20, 1998, to the Change in
Control Agreement between ARM Financial Group, Inc. and John R.
McGeeney. (Filed herewith.)
10.44 Change in Control Agreement dated as of December 4, 1997,
between ARM Financial Group, Inc. and Patricia L. Winter.
(Filed herewith.)
10.45 Letter Amendment dated as of March 20, 1998, to the Change in
Control Agreement between ARM Financial Group, Inc. and
Patricia L. Winter. (Filed herewith.)
10.46 Assignment and Assumption of Lease dated January 5, 1995,
between Kleinwort Benson International Investments, Ltd. and
A R M Capital Advisors, Inc. (Obligations of ARM Capital
Advisors, Inc. have been fully guaranteed by ARM Financial
Group, Inc.) (Incorporated by reference to the Form 10-K filed
by the Company on March 30, 1995.)
10.47 Consent to Assignment of Lease dated October 9, 1997, between
ARM Financial Group, Inc., ARM Capital Advisors, Inc. and
Metropolitan Life Insurance Company. (Filed herewith.)
10.48 Lease made as of June 14, 1996, by and between Northwestern
National Life Insurance Company and ARM Financial Group, Inc.
(Incorporated by reference to the Form 10-K filed by the
Company on March 29, 1996.)
10.49 Assignment and Assumption Agreement dated as of June 28, 1996,
between Northwestern National Life Insurance Company and ARM
Financial Group, Inc. (Incorporated by reference to the Form S-
1 Registration Statement filed by the Company on October 23,
1996.)
10.50 First Amendment to Lease made as of March 1, 1997, by and
between Reliastar Life Insurance Company and ARM Financial
Group, Inc. (Incorporated by reference to Amendment No. 4 to
the Form S-1 Registration Statement filed by the Company on
June 10, 1997.)
10.51(*) Engagement Agreement, dated March 12, 1993, between Analytical
Risk Management, LTD and General American Life Insurance
Company--Group Pension. (Incorporated by reference to Amendment
No. 2 to the Form S-1 Registration Statement filed by the
Company on May 7, 1997.)
10.52 Consent to Assignment of Engagement Agreement, dated September
8, 1993, between General American Life Insurance Company--Group
Pension. (Incorporated by reference to Amendment No. 2 to the
Form S-1 Registration Statement filed by the Company on May 7,
1997.)
57
EXHIBIT
NUMBER DESCRIPTION
- -------------------------------------------------------------------------------
10.53 Amendment No. 1 to Engagement Agreement, dated as of August 14,
1995, between General American Life Insurance Company and ARM
Financial Group, Inc. (Incorporated by reference to Amendment
No. 2 to the Form S-1 Registration Statement filed by the
Company on May 7, 1997.)
10.54 Amendment No. 2 to Engagement Agreement, dated September 1,
1995, between General American Life Insurance Company and ARM
Financial Group, Inc. (Incorporated by reference to Amendment
No. 2 to the Form S-1 Registration Statement filed by the
Company on May 7, 1997.)
10.55(*) Reinsurance Agreement between General American Life Insurance
Company and Integrity Life Insurance Company. (Incorporated by
reference to Amendment No. 3 to the Form S-1 Registration
Statement filed by the Company on May 23, 1997.)
10.56 Amendment No. 1 to Trust Agreement effective as of April 1,
1996, among, Integrity Life Insurance Company, General American
Life Insurance Company and Fleet National Bank. (Incorporated
by reference to the Form 10-Q filed by the Company on August
14, 1997.)
21.1 Subsidiaries of the Company. (Filed herewith.)
23.1 Consent of Ernst & Young LLP. (Filed herewith.)
27 Financial Data Schedule. (Filed herewith.)
(*) Portions of the exhibit have been omitted pursuant to the SEC granting
confidential treatment under Rule 406. The omitted material has been filed
separately with the SEC.
58
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on March 27, 1998.
ARM FINANCIAL GROUP, INC.
By: /s/ MARTIN H. RUBY
----------------------------
Martin H. Ruby
Chief Executive Officer
59
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
Company and in the capacities indicated on the 27th day of March, 1998.
Name Title
- ------------------------------------- -------------------------------------
/s/ MARTIN H. RUBY Chief Executive Officer and Director
- ------------------------------------- (Principal Executive Officer)
Martin H. Ruby
/s/ EDWARD L. ZEMAN Executive Vice President - Chief
- ------------------------------------- Financial Officer (Principal
Edward L. Zeman Financial Officer)
/s/ BARRY G. WARD Controller (Principal Accounting
- ------------------------------------- Officer)
Barry G. Ward
/s/ DUDLEY J. GODFREY, JR. Director
- -------------------------------------
Dudley J. Godfrey, Jr.
/s/ ALAN E. GOLDBERG Director
- -------------------------------------
Alan E. Goldberg
/s/ ROBERT H. NIEHAUS Director
- -------------------------------------
Robert H. Niehaus
/s/ EDWARD D. POWERS Director
- -------------------------------------
Edward D. Powers
/s/ COLIN F. RAYMOND Director
- -------------------------------------
Colin F. Raymond
/s/ IRWIN T. VANDERHOOF Director
- -------------------------------------
Irwin T. Vanderhoof
60
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
Page
----
Report of Independent Auditors. . . . . . . . . . . . . . . . . . . . . . .F-2
Consolidated Balance Sheets at December 31, 1997 and 1996 . . . . . . . . .F-3
Consolidated Statements of Income for the Years
Ended December 31, 1997, 1996 and 1995. . . . . . . . . . . . . . . . . .F-5
Consolidated Statements of Shareholders' Equity for the Years
Ended December 31 1997, 1996 and 1995 . . . . . . . . . . . . . . . . . .F-6
Consolidated Statements of Cash Flows for the Years
Ended December 31, 1997, 1996 and 1995. . . . . . . . . . . . . . . . . .F-7
Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . . .F-8
F-1
REPORT OF INDEPENDENT AUDITORS
Board of Directors and Shareholders
ARM Financial Group, Inc.
We have audited the accompanying consolidated carrying amount balance sheets of
ARM Financial Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and
the related consolidated statements of income, shareholders' equity, and cash
flows for each of the three years in the period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by the
Company's management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
We have also audited in accordance with generally accepted auditing standards
the consolidated supplemental fair value balance sheets of ARM Financial Group,
Inc. and subsidiaries as of December 31, 1997 and 1996. As described in Note 4,
the consolidated supplemental fair value balance sheets have been prepared by
management to present relevant financial information that is not provided by the
carrying amount balance sheets and is not intended to be a presentation in
conformity with generally accepted accounting principles. In addition, the
consolidated supplemental fair value balance sheets do not purport to present
the net realizable, liquidation or market value of ARM Financial Group, Inc. as
a whole. Furthermore, amounts ultimately realized by ARM Financial Group, Inc.
from the disposal of assets may vary significantly from the fair values
presented. In our opinion, the consolidated supplemental fair value balance
sheets referred to above present fairly, in all material respects, the
information set forth therein as described in Note 4.
In our opinion, the financial statements referred to in paragraph one above
present fairly, in all material respects, the consolidated financial position of
ARM Financial Group, Inc. and subsidiaries at December 31, 1997 and 1996, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
/s/ Ernst & Young LLP
Louisville, Kentucky
February 10, 1998
F-2
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
Carrying Amount Fair Value
----------------------------- -----------------------------
December 31, December 31,
(IN THOUSANDS) 1997 1996 1997 1996
- --------------------------------------------------------------------------------------------------- -----------------------------
ASSETS
Cash and investments:
Fixed maturities, available-for-sale, at fair value
(amortized cost: 1997-$4,021,495; 1996-$3,048,834) $ 4,068,386 $ 3,054,513 $ 4,068,386 $ 3,054,513
Equity securities, at fair value (cost:
1997-$28,177; 1996-$21,268) 28,342 22,552 28,342 22,552
Mortgage loans on real estate 16,429 36,879 16,429 36,879
Policy loans 126,114 123,466 126,114 123,466
Cash and cash equivalents 228,206 110,067 228,206 110,067
----------------------------- -----------------------------
Total cash and investments 4,467,477 3,347,477 4,467,477 3,347,477
Assets held in separate accounts:
Guaranteed 1,266,796 261,823 1,266,796 261,823
Nonguaranteed 1,173,088 873,225 1,173,088 873,225
Accrued investment income 44,546 36,233 44,546 36,233
Value of insurance in force 25,975 52,024 -- --
Deferred policy acquisition costs 87,170 59,001 -- --
Goodwill 6,523 7,636 6,523 7,636
Deferred federal income taxes 31,049 35,604 51,887 42,653
Other assets 35,800 28,641 35,800 28,641
----------------------------- -----------------------------
Total assets $ 7,138,424 $ 4,701,664 $ 7,046,117 $ 4,597,688
----------------------------- -----------------------------
----------------------------- -----------------------------
F-3
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (CONTINUED)
Carrying Amount Fair Value
----------------------------- -----------------------------
December 31, December 31,
(IN THOUSANDS) 1997 1996 1997 1996
- --------------------------------------------------------------------------------------------------- -----------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits $ 4,242,578 $ 3,294,174 $ 4,218,297 $ 3,199,638
Customer deposits in separate accounts:
Guaranteed 1,254,801 261,823 1,224,551 249,132
Nonguaranteed 1,160,595 868,336 1,109,277 829,253
Long-term debt 38,000 40,000 38,000 40,000
Accounts payable and accrued expenses 18,741 22,684 18,741 22,684
Payable for investment securities purchased 69,286 10,431 69,286 10,431
Payable to reinsurer 8,800 10,000 8,800 10,000
Other liabilities 38,078 12,274 38,078 12,274
----------------------------- -----------------------------
Total liabilities 6,830,879 4,519,722 6,725,030 4,373,412
Contingencies
Shareholders' equity:
Preferred stock, $.01 par value, $25.00 stated value; 2,300,000
shares authorized; 2,000,000 shares issued and outstanding 50,000 50,000
Class A Common Stock, $.01 par value; 150,000,000 and 19,259,680
shares authorized, respectively; 21,316,068 and 16,799,976
shares issued and outstanding, respectively 213 *
Class B Common Stock, $.01 par value; 50,000,000 and 762,480
shares authorized, respectively; 1,947,646 and 706,000
shares issued and outstanding, respectively 19 *
Additional paid-in capital 211,430 124,609
Net unrealized gains on available-for-sale securities 20,300 3,669
Retained earnings 25,583 3,664
-----------------------------
Total shareholders' equity 307,545 181,942 321,087 224,276
----------------------------- -----------------------------
Total liabilities and shareholders' equity $ 7,138,424 $ 4,701,664 $ 7,046,117 $ 4,597,688
----------------------------- -----------------------------
----------------------------- -----------------------------
* LESS THAN $1,000.
SEE ACCOMPANYING NOTES.
F-4
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Year Ended December 31,
-------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------
Investment income $ 329,979 $ 250,031 $ 196,024
Interest credited on customer deposits (247,418) (182,161) (146,867)
-------------------------------------------
Net investment spread 82,561 67,870 49,157
Fee income:
Variable annuity fees 14,630 10,786 7,238
Asset management fees 8,595 5,780 3,161
Other fee income 1,386 1,267 949
-------------------------------------------
Total fee income 24,611 17,833 11,348
Other income and expenses:
Surrender charges 4,482 5,024 3,339
Operating expenses (32,528) (31,055) (22,957)
Commissions, net of deferrals (2,218) (2,372) (1,557)
Interest expense on debt (2,517) (3,146) (3,461)
Amortization:
Deferred policy acquisition costs (10,416) (6,835) (2,932)
Value of insurance in force (9,293) (7,320) (7,104)
Acquisition-related deferred charges (503) (1,503) (9,920)
Goodwill (424) (488) (358)
Non-recurring charges:
Stock-based compensation (8,145) -- --
Other (6,678) (5,004) --
Other, net (386) (5,366) (687)
-------------------------------------------
Total other income and expenses (68,626) (58,065) (45,637)
Realized investment gains 3,192 907 4,048
-------------------------------------------
Income before income taxes 41,738 28,545 18,916
Income tax expense (14,139) (5,167) (7,026)
-------------------------------------------
Net income 27,599 23,378 11,890
Dividends on preferred stock (4,750) (4,750) (4,750)
-------------------------------------------
Net income applicable to common shareholders $ 22,849 $ 18,628 $ 7,140
-------------------------------------------
-------------------------------------------
Net income per common share (basic) $ 1.11 $ 1.06 $ 0.49
-------------------------------------------
-------------------------------------------
Net income per common and common equivalent share (diluted) $ 1.07 $ 1.06 $ 0.49
-------------------------------------------
-------------------------------------------
Cash dividends paid per common share $ 0.04 $ -- $ --
-------------------------------------------
-------------------------------------------
SEE ACCOMPANYING NOTES.
F-5
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Net
Unrealized
Gains
(Losses) on
Class A Class B Additional Available- Total
Preferred Common Common Paid-In for-Sale Retained Shareholders'
(IN THOUSANDS) Stock Stock Stock Capital Securities Earnings Equity
- -----------------------------------------------------------------------------------------------------------------------------------
Balance, January 1, 1995 $ 50,000 $ * $ * $ 62,920 $ (104,949) $ (22,104) $ (14,133)
Issuance of 6,897,620
shares of Class A
common stock * 61,505 61,505
Net income 11,890 11,890
Dividends on preferred stock (4,750) (4,750)
Change in net unrealized
losses on available-
for-sale securities 133,479 133,479
------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 50,000 * * 124,425 28,530 (14,964) 187,991
Issuance of 18,356 shares of
Class A common stock * 184 184
Net income 23,378 23,378
Dividends on preferred stock (4,750) (4,750)
Change in net unrealized
gains on available-for-
sale securities (24,861) (24,861)
------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 50,000 * * 124,609 3,669 3,664 181,942
Recapitalization of Class A
and Class B common
stock 156 19 (175) --
Issuance of 5,750,000 shares
of Class A Common Stock
from initial public
offering 57 78,755 78,812
Issuance of 7,743 shares of
Class A Common Stock
from exercise of stock
options * 96 96
Net income 27,599 27,599
Dividends on preferred stock (4,750) (4,750)
Dividends on common stock (930) (930)
Stock-based compensation
charge 8,145 8,145
Change in net unrealized
gains on available-for-
sale securities 16,631 16,631
------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 $ 50,000 $ 213 $ 19 $ 211,430 $ 20,300 $ 25,583 $ 307,545
------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------
* LESS THAN $1,000.
SEE ACCOMPANYING NOTES.
F-6
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31,
-------------------------------------------
(IN THOUSANDS) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES:
Net income $ 27,599 $ 23,378 $ 11,890
Adjustments to reconcile net income to cash flows provided by operating activities:
Interest credited on general account customer deposits 212,964 172,202 136,824
Stock-based compensation charge 8,145 -- --
Realized investment gains (3,192) (907) (4,048)
Amortization of value of insurance in force and deferred policy
acquisition costs 19,709 14,155 10,036
Other amortization 1,426 1,374 12,406
Deferral of policy acquisition and other costs (40,033) (24,202) (24,505)
Deferred tax expense 1,003 2,554 6,385
(Increase) decrease in accrued investment income (8,313) 149 (1,609)
Changes in other assets and liabilities (3,243) 4,171 (9,020)
-------------------------------------------
Cash flows provided by operating activities 216,065 192,874 138,359
CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
Fixed maturity investments:
Purchases (4,710,312) (2,716,010) (1,498,623)
Maturities and redemptions 445,772 241,391 205,319
Sales 3,355,461 1,922,689 1,197,468
Other investments:
Purchases (72,283) (55,995) (7,891)
Maturities and redemptions 20,806 7,310 24,377
Sales 62,196 42,961 36,119
Policy loans, net (2,648) (5,938) (6,428)
Transfers (to) from the separate accounts:
Purchase of assets held in separate accounts (1,066,348) (302,993) (226,812)
Proceeds from sale of assets held in separate accounts 110,524 83,077 45,249
Cash and cash equivalents acquired in excess of purchase price paid for
substantially all assets of SBM Company -- -- 36,490
-------------------------------------------
Cash flows used in investing activities (1,856,832) (783,508) (194,732)
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Amounts received from customers from the sale of general
and separate account products 2,268,496 1,072,323 425,628
Amounts paid to customers for benefits and withdrawals related
to general and separate account products (579,618) (441,944) (406,977)
Net proceeds from issuance of common stock 80,308 184 63,505
Organizational, debt and stock issuance costs (1,400) -- (2,000)
Principal payment on long-term debt (2,000) -- --
Change in payable to reinsurer (1,200) 10,000 --
Dividends on common stock (930) -- --
Dividends on preferred stock (4,750) (4,750) (4,750)
Change in repurchase agreement liability -- (12,008) 12,008
-------------------------------------------
Cash flows provided by financing activities 1,758,906 623,805 87,414
-------------------------------------------
Increase in cash and cash equivalents 118,139 33,171 31,041
Cash and cash equivalents at beginning of year 110,067 76,896 45,855
-------------------------------------------
Cash and cash equivalents at end of year $ 228,206 $ 110,067 $ 76,896
-------------------------------------------
-------------------------------------------
Supplemental cash flow information:
Interest paid on debt $ 1,837 $ 2,613 $ 2,736
-------------------------------------------
-------------------------------------------
Income taxes paid $ 2,943 $ 7,230 $ --
-------------------------------------------
-------------------------------------------
SEE ACCOMPANYING NOTES.
F-7
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
ARM Financial Group, Inc. (the "Company") specializes in the growing asset
accumulation business with particular emphasis on retirement savings and
investment products. The Company's retail products include a variety of fixed,
indexed and variable annuities and face-amount certificates sold through a broad
spectrum of distribution channels including independent broker-dealers,
independent agents, stockbrokers, and financial institutions. The Company offers
institutional products, such as funding agreements and guaranteed investment
contracts ("GICs") directly to bank trust departments, plan sponsors, cash
management funds, corporate treasurers, and other institutional investors.
The Company derives its earnings from the net investment spread and fee
income generated by the assets it manages. With retail and institutional spread
products offered by the Company, the Company's insurance and face-amount
certificate subsidiaries agree to return customer deposits with interest at a
specified rate or based on a specified index (e.g., LIBOR, S&P 500 -- both
defined below). As a result, the Company's insurance and face-amount certificate
subsidiaries accept investment risk in exchange for the opportunity to achieve a
spread between what the Company earns on invested assets and what it pays or
credits on customer deposits. With retail variable products offered by the
Company, the Company's subsidiaries receive a fee in exchange for managing
deposits, and the customer accepts investment risk associated with their chosen
mutual fund options. Because the investment risk is borne by the customer, this
business requires significantly less capital support than spread-based business.
The Company conducts its different businesses through a variety of
subsidiaries. Retail fixed, indexed and variable annuities and institutional
funding agreements and GICs are issued by the Company's insurance subsidiaries,
Integrity Life Insurance Company ("Integrity") and National Integrity Life
Insurance Company ("National Integrity") (collectively, the "Integrity
Companies"). ARM Securities Corporation ("ARM Securities"), a registered
broker-dealer, provides a distribution channel for selling affiliated and
nonaffiliated retail products. SBM Certificate Company is an issuer of
face-amount certificates, a retail product similar to certificates of deposit
issued by banks.
The Company received initial start-up capital as partial funding for the
acquisition of the Integrity Companies through the private issuance of common
stock in November 1993. In June 1995, the Company received additional capital
to fund the acquisition of substantially all of the assets and business
operations of SBM Company ("SBM") also through the private issuance of common
stock. Such capital was primarily provided by certain private equity funds
sponsored by Morgan Stanley Dean Witter & Co. (the "Morgan Stanley
Stockholders"). In June 1997, the Company completed an initial public
offering (the "Offering") of common stock. The Morgan Stanley Stockholders
owned approximately 91% of the outstanding shares of the Company's common
stock prior to the Offering and, as a result of the Offering, owned
approximately 53% at December 31, 1997. At December 31,
F-8
1997, approximately 40% of the outstanding shares of the Company's common stock
was publicly held, with the remainder being nonregistered common stock issued to
certain original private investors of the Company (excluding the Morgan Stanley
Stockholders).
The Company had no significant business activity until November 26, 1993,
when it acquired the Integrity Companies resulting in $2.3 billion of assets
under management. Assets under management have grown to $6.9 billion as of
December 31, 1997.
BASIS OF PRESENTATION
The consolidated financial statements have been prepared in accordance with
generally accepted accounting principles ("GAAP") and include the accounts of
the Company and its subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation. Certain amounts from prior
years have been reclassified to conform to the current year's presentation.
The preparation of financial statements in conformity with GAAP requires
management of the Company to make estimates and assumptions that affect the
amounts reported in the consolidated financial statements and accompanying
notes. Actual results could differ from those estimates.
The consolidated balance sheets include a dual presentation of carrying
amount and fair value balances. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in
Debt and Equity Securities," fixed maturities classified as available-for-sale
are reported at fair value in the carrying amount balance sheets; however,
corresponding customer deposits are reported at historical values. In contrast,
in the fair value balance sheets, both assets and liabilities are reported at
fair value. As permitted by SFAS No. 107, "Disclosures About Fair Value of
Financial Instruments," the fair value balance sheets are presented as a
supplemental disclosure to provide a more meaningful picture of the Company's
financial position. Note 4 describes the methods and assumptions used by the
Company in estimating fair value.
INVESTMENTS
All of the Company's fixed maturities and equity securities are classified
as available-for-sale and stated at fair value. Unrealized gains and losses on
available-for-sale securities are reported as a separate component of
shareholders' equity, net of adjustments to value of insurance in force and
deferred policy acquisition costs equal to the change in amortization that would
have been recorded if these securities had been sold as of the balance sheet
date, and net of deferred income taxes. The amortized cost of fixed maturities
is adjusted for amortization of premiums and accretion of discounts to maturity,
or in the case of mortgage-backed and asset-backed securities, over the
estimated life of the security. Such amortization and accretion is computed
using the interest method and is included in investment income. Anticipated
prepayments on mortgage-backed and asset-backed securities are considered in
determining the effective yield on such securities. If a difference arises
between anticipated and actual prepayments, the carrying value of the investment
is adjusted with a corresponding charge or credit to investment income. Interest
and dividends are included in investment income. Mortgage loans on real estate
and policy loans are carried at their unpaid principal balances. Cash and cash
equivalents consist of highly liquid investments with maturities of three months
or less at their time of purchase.
F-9
Realized gains and losses on the sale of investments are determined based
upon the average cost method and include provisions for other-than-temporary
impairments where appropriate. In addition, the amortization of value of
insurance in force and deferred policy acquisition costs is adjusted for gains
and losses realized on sales of investments which support customer deposits. The
adjustment to amortization associated with such realized gains and losses is
included in Realized Investment Gains in the consolidated statements of income.
VALUE OF INSURANCE IN FORCE, DEFERRED POLICY ACQUISITION COSTS AND GOODWILL
A portion of the purchase price paid for the insurance subsidiaries was
allocated to the value of insurance in force based on the actuarially-determined
present value of the expected pretax future profits from the business assuming a
discount rate of 13%. This present value amount was reduced to the extent that
the fair value of the net assets acquired including the value of insurance in
force exceeded the purchase price allocated to the insurance subsidiaries.
Interest is accrued on the balance annually at a rate consistent with the rate
credited on the acquired policies on the acquisition date. Recoverability of the
value of insurance in force is evaluated quarterly by comparing the current
estimate of the present value of expected pretax future profits to the
unamortized asset balance. If such current estimate is less than the existing
asset balance, the difference would be charged to expense. To the extent
recoverable from future gross profits, costs of producing new business
(primarily commissions and certain policy issuance and marketing costs) which
vary with and are primarily related to the production of new business are
deferred. Value of insurance in force and deferred policy acquisition costs are
amortized in proportion to the emergence of future gross profits, including
related realized investment gains and losses, over the estimated term of the
underlying policies. In addition, an adjustment is made to value of insurance in
force and deferred policy acquisition costs equal to the change in amortization
that would have been recorded if unrealized gains and losses on
available-for-sale securities had been realized as of the balance sheet date.
A portion of the purchase price paid for subsidiaries was allocated to
goodwill representing the excess of the purchase price paid over the fair value
of net assets acquired. Goodwill currently recorded is amortized over a period
not exceeding twenty years using the straight-line method.
Incremental costs directly related to the integration of acquired companies
are deferred, to the extent recoverable from future gross profits of the
acquired companies. Such deferred transition costs are amortized using the
straight-line method over the estimated term of the policies underlying the
acquired companies.
ASSETS HELD IN SEPARATE ACCOUNTS AND CUSTOMER DEPOSITS IN SEPARATE ACCOUNTS
Assets held in separate accounts of the Company's insurance subsidiaries
are segregated from other investments and are not subject to claims that arise
out of any other business of the Company. The separate accounts include customer
deposits and related invested assets, for retail and institutional spread
products (guaranteed) and retail variable products (nonguaranteed). Separate
account assets and liabilities are carried at estimated fair values. Investment
income and interest credited on customer deposits related to spread product
deposits are included as such in the statements of income. The Company receives
administrative fees for managing retail variable product deposits and other fees
for assuming mortality and certain expense risks. Such fees are included in
Variable Annuity Fees in the statements of income.
F-10
During 1996, the Company began offering an equity-indexed annuity product
through its separate accounts which aims to meet consumer demand for equity
investments with downside protection. In connection with this product, the
Company's separate accounts purchased call options based on the S&P 500
Composite Stock Price Index ("S&P 500"). The options perform as a hedge against
the Company's obligation to pay equity-indexed annuity policyholders returns
tied to the S&P 500. As of December 31, 1997 and 1996, these options are carried
at fair value and unrealized gains and losses increase or decrease obligations
to policyholders.
CUSTOMER DEPOSITS
For single and flexible premium deferred annuities, single premium
endowments, face-amount certificates, funding agreements, and guaranteed
investment contracts, customer deposits represent account values before
applicable surrender charges. Such account values represent premiums and
deposits received, plus interest credited, less withdrawals and assessed fees.
For structured settlements and other single premium immediate annuities,
customer deposits represent the present value of future benefit payments and
maintenance expenses. The interest rate used in determining such present value
was approximately 7.35% as of December 31, 1997.
RECOGNITION OF FEE INCOME
Variable annuity fees and asset management fees are recorded in income as
earned. Other fee income includes marketing partnership fees earned related to
ventures with other insurance companies and certain fees earned by ARM
Securities (primarily net retained commissions). Premiums and deposits received
from customers are not included in the statements of income.
FEDERAL INCOME TAXES
Deferred income tax reflects the net tax effects of (i) temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes and (ii)
operating and capital losses.
NET INCOME PER SHARE OF COMMON STOCK
In 1997, the Company adopted the provisions of SFAS No. 128, "Earnings Per
Share," which superseded Accounting Principles Board Opinion No. 15 of the same
name. Earnings per share for all periods presented reflect the adoption of SFAS
No. 128. SFAS No. 128 requires companies to present basic earnings per share,
and, if applicable, diluted earnings per share, instead of primary and fully
diluted earnings per share. Basic earnings per share excludes dilution and is
computed by dividing net income applicable to common shareholders by the
weighted average number of common shares outstanding for the period. Diluted
earnings per share reflects the potential dilution that could occur if options
to issue common stock were exercised into common stock.
2. ACQUISITIONS
SBM COMPANY
Effective May 31, 1995, the Company completed the acquisition of
substantially all of the assets and business operations of SBM, including all of
the issued and outstanding capital stock of SBM's subsidiaries, State Bond and
Mortgage Life Insurance Company ("SBM Life"), SBM Financial Services, Inc.
(which subsequently changed its name to ARM Securities), SBM Certificate
F-11
Company, and SBM's management contracts with six mutual funds (the "State Bond
Mutual Funds").
The aggregate purchase price for the acquisition was $38.8 million. The
Company financed the acquisition by issuing approximately 6.9 million shares of
the Company's Class A common stock, primarily to the Morgan Stanley
Stockholders, for an aggregate sale price of $63.5 million. The Company used the
proceeds from the issuance of new common equity in excess of the aggregate
purchase price for the acquisition to make a $19.9 million capital contribution
to SBM Life and acquire all of the issued and outstanding capital stock of SBM
Certificate Company from SBM Life for a purchase price of $3.3 million.
The capital contribution to SBM Life was used to strengthen SBM Life's
financial position and allowed for a significant investment portfolio
restructuring immediately following the acquisition with no net adverse effect
on statutory adjusted capital and surplus. On December 31, 1995, SBM Life was
merged with and into Integrity to create certain operating efficiencies intended
to benefit the Company and its customers. 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 $1.6 million and $1.0 million was recorded by the
Company during 1996 and 1995, respectively, with respect to the management of
such funds. The State Bond Mutual Funds had aggregate assets of $236.9 million
on December 13, 1996.
ARM CAPITAL ADVISORS
On January 5, 1995, the Company completed the acquisition of substantially
all the assets and business of the U.S. fixed income unit of Kleinwort Benson
Investment Management Americas Inc. ("KBIMA"), including its third-party account
asset management operations. KBIMA provided investment advisory services to the
Company during 1994. The business acquired became part of the then newly-formed
ARM Capital Advisors, Inc. ("ARM Capital Advisors"). ARM Capital Advisors is a
registered investment advisor and wholly owned subsidiary of the Company. ARM
Capital Advisors' management of third-party accounts generated asset management
fees of $8.6 million, $4.2 million and $2.2 million during 1997, 1996 and 1995,
respectively. Although third-party assets managed by ARM Capital Advisors grew
since the acquisition, the Company believes that market attitudes towards
developing an asset management business for defined benefit pension plans within
a holding company structure consisting predominantly of insurance companies
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 a newly formed subsidiary, ARM Capital Advisors, LLC ("New
ARMCA"), and sold an 80% interest therein 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. The
Company has continued to engage New ARMCA as its investment adviser but will
consider retaining other investment management firms as it deems appropriate.
The terms of the sale provided for a transition period following the sale
through December 31, 1997 whereby the Company (i) provided all accounting and
administrative services required by New ARMCA and paid all of its costs and
expenses and (ii) received all of the gross revenues of New ARMCA. After the
sale, ARM Capital Advisors was renamed Integrity Capital Advisors, Inc.
F-12
INTEGRITY COMPANIES
On November 26, 1993, the Company completed the acquisition of the
Integrity Companies from the National Mutual Life Association of Australasia
Limited ("National Mutual"). In connection with the acquisition, National Mutual
provided the Integrity Companies with indemnification as to future claims
for taxes, assessments from guaranty funds, and claims from litigation, which
arise from preclosing events.
3. INVESTMENTS
The amortized cost and estimated fair values of available-for-sale securities
were as follows:
GROSS GROSS
UNREALIZED UNREALIZED ESTIMATED
(IN THOUSANDS) COST GAINS LOSSES FAIR VALUE
- -----------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 1997:
Fixed Maturities:
Mortgage-backed securities $1,828,062 $ 29,881 $ 3,456 $1,854,487
Corporate securities 1,390,274 35,875 16,134 1,410,015
Asset-backed securities 400,276 1,981 1,832 400,425
U.S. Treasury securities and obligations of
U.S. government agencies 318,583 1,464 371 319,676
Foreign governments 79,466 1,633 1,867 79,232
Obligations of state and political subdivisions 4,834 12 295 4,551
------------------------------------------------
Total fixed maturities 4,021,495 70,846 23,955 4,068,386
Equity securities 28,177 309 144 28,342
------------------------------------------------
Total available-for-sale securities $4,049,672 $ 71,155 $ 24,099 $4,096,728
------------------------------------------------
------------------------------------------------
DECEMBER 31, 1996:
Fixed Maturities:
Mortgage-backed securities $1,459,851 $ 19,393 $ 11,644 $1,467,600
Corporate securities 992,003 13,260 13,693 991,570
Asset-backed securities 299,365 686 1,951 298,100
U.S. Treasury securities and obligations of
U.S. government agencies 247,041 1,363 1,481 246,923
Foreign governments 45,611 611 462 45,760
Obligations of state and political subdivisions 4,963 3 406 4,560
------------------------------------------------
Total fixed maturities 3,048,834 35,316 29,637 3,054,513
Equity securities 21,268 1,286 2 22,552
------------------------------------------------
Total available-for-sale securities $3,070,102 $ 36,602 $ 29,639 $3,077,065
------------------------------------------------
------------------------------------------------
F-13
The amortized cost and estimated fair value of available-for-sale
securities, by contractual maturity, are shown below:
December 31, 1997
-----------------------
Estimated
(IN THOUSANDS) Cost Fair Value
- ----------------------------------------------------------------------------
Due in one year or less $ 13,522 $ 13,584
Due after one year through five years 143,662 143,102
Due after five years through ten years 335,043 333,618
Due after ten years 1,300,930 1,323,169
Asset-backed securities 400,276 400,426
Mortgage-backed securities 1,828,062 1,854,487
Equity securities 28,177 28,342
-----------------------
Total available-for-sale securities $4,049,672 $4,096,728
-----------------------
-----------------------
Expected maturities will differ from contractual maturities because
borrowers may have the right to call or repay obligations with or without call
or prepayment penalties and because mortgage-backed and asset-backed securities
(including floating-rate securities) provide for periodic payments throughout
their lives.
During 1997, 1996 and 1995, gross gains of $45.0 million, $33.5 million and
$24.1 million, respectively, and gross losses of $36.0 million, $18.9 million
and $15.6 million, respectively, were realized on sales of fixed maturities. For
the years ended December 31, 1997 and 1996, the Company recorded losses of $4.0
million and $15.2 million related to write-downs to the fair value of
investments in fixed income securities. For the years ended December 31, 1997
and 1996, the recognition of net realized gains on investments supporting
customer deposits resulted in an increase in the amortization of value of
insurance in force of $3.0 million and $1.9 million, respectively, and in an
increase in the amortization of deferred policy acquisition costs of $0.4
million and $28,000, respectively.
In accordance with SFAS No. 115, net unrealized gains and losses on
investments classified as available-for-sale were reduced by deferred federal
income taxes and adjustments to value of insurance in force and deferred policy
acquisition costs that would have been required had such gains and losses been
realized. Net unrealized gains on available-for-sale securities reflected as a
separate component of shareholders' equity are summarized as follows:
December 31,
--------------------
(IN THOUSANDS) 1997 1996
- --------------------------------------------------------------------------------
Net unrealized gains on available-for-sale securities
before adjustments for the following: $ 47,056 $ 6,963
Amortization of value of insurance in force and
deferred policy acquisition costs (15,825) (1,318)
Deferred federal income taxes (10,931) (1,976)
--------------------
Net unrealized gains on available-for-sale securities $ 20,300 $ 3,669
--------------------
--------------------
F-14
Investments, aggregated by issuer, in excess of 10% of shareholders' equity
(before net unrealized gains on available-for-sale securities) at December 31,
1997 and 1996, other than investments in affiliates and investments issued or
guaranteed by the United States government are as follows. Such securities were
99.8% and 97.4% investment grade at December 31, 1997 and 1996, respectively.
Carrying
(IN MILLIONS) Amount
- --------------------------------------------------------------------------------
1997:
Fixed maturities:
Aames Mortgage Trust $ 31.7
Aircraft Lease Portfolio Securities 34.6
Bear Stearns Mortgage Securities 39.7
Countrywide Mortgage Backed 39.1
CRAVE Trust 52.7
Delta Funding Home Equity Loan Trust 31.6
DLJ Mortgage Acceptance Corporation 75.9
First Chicago/Lennar 34.5
General Electric Capital Mortgage Services 33.4
Greenwich Capital Acceptance 50.6
Headlands Mortgage Securities, Inc. 30.5
J.P. Morgan & Company 35.9
LB Mortgage Trust 62.9
Merit Securities Corporation 55.3
Norwest Asset Securities Corporation 64.5
PNC Mortgage Securities Corporation 46.7
Residential Accredit Loans 47.1
Residential Asset Securities Trust 50.4
Residential Funding 47.3
Salomon Brothers Mortgage Securities VII 95.4
Sears Mortgage Securities 29.8
Structured Asset Securities Corporation 64.6
1996:
Fixed maturities:
ABN AMRO Bank 19.3
Advanta Corporation 20.1
Aircraft Lease Portfolio Securities 27.4
American President Company 18.4
Amresco Residential Mortgage Loan 23.8
Augusta Funding LTD VI 20.0
Augusta Funding LTD VIII 24.8
Bear Stearns Company 30.4
Chevy Chase Master Credit Card Trust 20.0
Commonwealth Edison Company 19.2
Conseco Commercial Mortgage 20.2
Countrywide Home Loans 29.1
Countrywide Mortgage Backed 50.7
Delta Funding Home Equity Loan Trust 17.9
DLJ Acceptance Corporation 58.7
First USA Credit Card Trust 25.0
Ford Motor Corporation 25.0
General Electric Capital Mortgage 91.3
Greenwich Capital Acceptance 36.8
Guardian National Acceptance Corporation 21.4
J.P. Morgan & Company 24.8
LB Mortgage Trust 27.3
Lehman Brothers Holdings 23.5
Matterhorn One, Ltd. 45.2
Merit Securities Corporation 30.0
Mobil Producing Nigeria 19.0
National Westminster Bank 22.3
Paine Webber Group, Incorporated 29.4
Philadelphia Electric 18.5
Residential Funding Mortgage 44.0
Resolution Trust Corporation 47.0
Ryland Mortgage Securities Corporation 34.4
Salomon Brothers Mortgage Securities VII 22.2
Structured Asset Securities Corporation 106.2
TCI Communications, Incorporated 23.9
Tenaga Nasional Berhad 19.2
Time Warner Entertainment Company, L.P. 21.6
TMS Home Equity Loan Trust 48.0
Wilshire Manufactured Housing Trust 22.9
Equity securities:
Santander Finance, Ltd. 19.2
F-15
The components of investment income were:
Year Ended December 31,
-------------------------------
(IN THOUSANDS) 1997 1996 1995
- --------------------------------------------------------------------------
Fixed maturities $ 300,327 $ 228,473 $ 177,123
Policy loans 8,925 8,629 7,579
Mortgage loans on real estate 4,038 4,321 6,712
Cash and cash equivalents 13,514 5,705 3,096
Income from other investments 3,175 2,903 1,514
-------------------------------
Investment income $ 329,979 $ 250,031 $ 196,024
-------------------------------
-------------------------------
At December 31, 1997, the fair value of futures contracts, call and put
options and interest rate swaps held by the Company was $11.3 million. These
derivative financial instruments are used to hedge specific market value
risks associated with the Company's equity-indexed annuity products and separate
account seed money investments and interest rate risks associated with certain
institutional spread deposits. The derivative financial instruments are not held
for trading purposes and are classified on the Company's balance sheet as assets
held in guaranteed separate accounts. The derivative financial instruments hedge
items carried at fair value and are therefore marked to market with unrealized
gains and losses recognized through the separate account statements of
operations. The Company is exposed to credit-related losses in the event of
nonperformance by counter parties to the derivative financial instruments, but
does not expect any counter parties to fail to meet their obligations given
their high credit ratings.
4. FAIR VALUE BALANCE SHEETS
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments,"
requires disclosure of fair value information about all financial instruments,
including insurance liabilities classified as investment contracts, unless
specifically exempted. The accompanying fair value balance sheets reflect fair
values for those financial instruments specifically covered by SFAS No. 107,
along with fair value amounts for other assets and liabilities for which
disclosure is permitted but not required.
The fair value of a financial instrument is the amount at which the
instrument could be exchanged in a current transaction between willing parties,
other than in a forced or liquidation sale. In cases where quoted market prices
are not available, fair values are based on estimates using present value or
other valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. Accordingly, the aggregate fair value amounts presented do not
necessarily represent the underlying value of the Company.
The Company's management of interest rate risk reduces its exposure to
changing interest rates through a close matching of duration, convexity and cash
flow characteristics of both assets and liabilities while maintaining liquidity
redundancies (i.e., sources of liquidity in excess of projected
F-16
liquidity needs). As a result, fair values of the Company's assets and
liabilities will tend to respond similarly 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
The fair value of assets held in guaranteed separate accounts is primarily
based on quoted market prices of fixed maturity securities held in such
separate accounts. The fair value of customer deposits in guaranteed separate
accounts is based on the account values of the underlying policies, plus or
minus market value adjustments. Fair values of assets and customer deposits
in nonguaranteed separate accounts is based on the quoted market prices of
the underlying mutual funds. The reduction in fair values for customer
deposits in separate accounts reflect the present value of future gross
margins from net investment spread, product charges, distribution fees, and
surrender charges.
GOODWILL
The carrying amount of goodwill approximates fair value.
DEFERRED POLICY ACQUISITION COSTS AND VALUE OF INSURANCE IN FORCE
Deferred policy acquisition costs and value of insurance in force 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 customer deposits in separate accounts.
DEFERRED FEDERAL INCOME TAXES
The deferred federal income tax asset and related valuation allowance were
adjusted for federal income tax which may be incurred as a result of the
differences between the estimated fair values and carrying amounts of the assets
and liabilities.
CUSTOMER DEPOSITS
The fair value of customer deposits for single premium immediate annuity
contracts is based on discounted cash flow calculations using rates from a
current market yield curve for assets with similar durations. The fair value
amounts of the remaining customer deposits, primarily related to deferred
annuity contracts, single premium endowment contracts, and funding agreements
and GICs,
F-17
represent the estimated present value of cash flows using current market rates
and the duration of the liabilities.
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.
5. VALUE OF INSURANCE IN FORCE
The following provides information on the value of insurance in force
during 1997, 1996 and 1995:
Year Ended December 31,
-----------------------------------------
(IN THOUSANDS) 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------------------
Amortization excluding effects of realized and unrealized investment gains
and losses $ (11,798) $ (10,474) $ (10,490)
Interest accrued on unamortized balance 2,505 3,154 3,386
-----------------------------------------
Net amortization as reported in the statements of income (9,293) (7,320) (7,104)
Amortization related to realized investment gains and losses(a) (2,987) (1,890) (2,562)
Change in amortization related to unrealized gains and losses on available-
for-sale securities(b) (13,769) 13,180 (14,170)
Addition resulting from the acquisition of SBM Life -- -- 61,131
Recognition of acquired tax benefits -- (2,997) (18,004)
-----------------------------------------
Net change in value of insurance in force (26,049) 973 19,291
Balance at beginning of period 52,024 51,051 31,760
-----------------------------------------
Balance at end of period $ 25,975 $ 52,024 $ 51,051
-----------------------------------------
-----------------------------------------
(a) Included in Realized Investment Gains in the statements of income.
(b) Included in Change in Net Unrealized Gains and Losses on
Available-for-Sale Securities in the statements of shareholders'
equity.
The interest rates used to accrue interest on the unamortized value of
insurance in force are consistent with the rates credited on acquired policies
and range from 5% to 8%. Net amortization of the value of insurance in force,
excluding the effects of realized and unrealized investment gains and losses, in
each of the following years is estimated to be: 1998 -- $7.0 million; 1999 --
$6.1 million; 2000 -- $4.9 million; 2001 -- $4.0 million; and 2002 -- $3.4
million.
F-18
6. NON-RECURRING CHARGES
The Company recorded non-recurring charges of $14.8 million for the year
ended December 31, 1997, including a one-time non-cash stock-based compensation
charge of $8.1 million (see Note 10), and costs primarily related to the
relocation and consolidation of the Company's operations facilities from
Columbus, Ohio to Louisville, Kentucky. The Company recorded a $5.0 million
non-recurring charge in 1996, including $3.2 million for facilities
consolidation charges and costs of $1.8 million primarily related to merger and
acquisition activities that did not result in a transaction.
7. DEBT
LONG-TERM DEBT
On June 24, 1997, the Company entered into a Credit Agreement to provide
the Company with a new senior 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.
PAYABLE TO REINSURER
The Company holds $8.8 million of funds withheld under a modified
coinsurance reinsurance agreement related to a block of variable annuity
contracts. This liability bears a floating interest rate indexed to the LIBOR.
Repayment is scheduled for equal quarterly installments over the next five
years.
8. INCOME TAXES
The components of the provision for income tax expense consist of the
following:
Year Ended December 31,
-----------------------------------
(IN THOUSANDS) 1997 1996 1995
- -------------------------------------------------------------------
Current $ 13,136 $ 2,613 $ 641
Deferred 1,003 2,554 6,385
-----------------------------------
Total income tax expense $ 14,139 $ 5,167 $ 7,026
-----------------------------------
-----------------------------------
F-19
Significant components of the deferred tax liabilities and assets as of
December 31, 1997 and 1996 were:
(IN THOUSANDS) 1997 1996
- -------------------------------------------------------------------------------
Deferred tax assets:
Difference between GAAP and tax reserves $ 78,404 $ 72,513
Net operating loss carryforward 13,863 11,783
Other 16,285 10,752
--------------------
Total deferred tax assets 108,552 95,048
Valuation allowance for deferred tax assets (36,568) (38,798)
--------------------
Net deferred tax assets 71,984 56,250
Deferred tax liabilities:
Deferred policy acquisition costs 26,096 16,910
Net unrealized gains on available-for-sale securities 10,931 1,976
Other 3,908 1,760
--------------------
Total deferred tax liabilities 40,935 20,646
--------------------
Total deferred federal income taxes $ 31,049 $ 35,604
--------------------
--------------------
In the event that deferred tax assets are recognized on deductible
temporary differences for which a valuation allowance was provided at the date
of an acquisition, such benefits will be applied to first reduce the balance of
intangible assets related to the acquisition, such as value of insurance in
force and goodwill.
A full valuation allowance was provided on the difference between
deferred tax assets and liabilities of the Integrity Companies as of the
acquisition date resulting in zero deferred federal income taxes at that
date. Based on the Integrity Companies' ability to generate taxable income in
the post-acquisition period and projections of future taxable income, the
Integrity Companies' valuation allowance was reduced by $8.0 million, $11.0
million and $27.9 million during 1997, 1996 and 1995, respectively. As a
result of realizing such benefits, the value of insurance in force was
reduced by $3.0 million and $18.0 million during 1996 and 1995, respectively.
The balance of goodwill was also reduced by $0.7 million during 1997 and $1.0
million during 1995. Additionally, the Company has established a full
valuation allowance on its non-life net operating loss carryforwards.
Realization of these carryforward benefits is dependent on future non-life
earnings.
The Company files a consolidated federal income tax return with its
non-life subsidiaries, but is not currently eligible to file with its life
insurance subsidiaries. Accordingly, Integrity and National Integrity file a
consolidated federal life insurance company income tax return.
F-20
Income tax expense differs from that computed using the federal income tax
rate of 35% for the following reasons:
Year Ended December 31,
------------------------------
(IN THOUSANDS) 1997 1996 1995
- --------------------------------------------------------------------------------
Income tax expense at statutory rate $ 14,608 $ 9,991 $ 6,621
Increase (decrease) in valuation allowance (1,540) (5,490) 1,052
Other 1,071 666 (647)
------------------------------
Total income tax expense $ 14,139 $ 5,167 $ 7,026
------------------------------
------------------------------
The Company had net operating loss carryforwards of approximately $39.6
million, $33.7 million and $43.8 million at December 31, 1997, 1996 and 1995,
respectively. The net operating loss carryforwards expire in years 2005 to 2012.
F-21
9. 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 statements of income:
Year Ended December 31,
-------------------------------------
(IN THOUSANDS) 1997 1996 1995
- -----------------------------------------------------------------------------------------------------------------------
Insurance subsidiaries (statutory-basis)(1) $ 49,718 $ 38,769 $ 31,179
Non-insurance companies(2) 3,273 927 255
-------------------------------------
Consolidated statutory-basis pretax operating income 52,991 39,696 31,434 (3)
Reconciling items:
Amortization of interest maintenance reserve (3,920) (4,091) (3,905)
Adjustments to customer deposits (16,004) (2,324) (5,994)
Interest expense on debt (2,517) (3,146) (3,461)
Deferral of policy acquisition costs, net of amortization 29,331 16,223 16,650
Amortization of value of insurance in force (9,293) (7,320) (7,104)
Amortization of acquisition-related deferred charges and goodwill (927) (1,991) (10,278)
Adjustments to invested asset carrying values at acquisition date (107) (572) (769)
Non-recurring charges (14,823) (5,004) --
Realized investment gains 3,192 907 4,048
Other 3,815 (3,833) (1,705)
-------------------------------------
GAAP-basis:
Income before income taxes 41,738 28,545 18,916
Income tax expense (14,139) (5,167) (7,026)
-------------------------------------
Net income 27,599 23,378 11,890
Dividends on preferred stock (4,750) (4,750) (4,750)
-------------------------------------
Net income applicable to common shareholders 22,849 18,628 7,140
Exclude, net of tax:
Realized investment gains (2,075) (590) (2,631)
Non-recurring charges 14,823 4,539 --
Income from defined benefit pension plan asset management operations (1,448) (350) --
-------------------------------------
Operating earnings(4) $ 34,149 $ 22,227 $ 4,509
-------------------------------------
-------------------------------------
(1) Insurance company general account and separate account 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) Includes the results of operations of the acquired SBM businesses for
the seven months ended December 31, 1995.
(4) 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 which
were sold during November 1997.
F-22
Dividends that the Company may receive from Integrity in any year without
prior approval of the Ohio Insurance Director are limited by statute to the
greater of (i) 10% of Integrity's statutory capital and surplus as of the
preceding December 31 and (ii) Integrity's statutory net income for the
preceding year. For 1998, the maximum dividend payments that may be paid by
Integrity to the Company without prior regulatory approval are $38.2 million.
The consolidated statutory capital and surplus of the Company's
insurance subsidiaries was $211.8 million and $163.8 million at December 31,
1997 and 1996, respectively. In addition, the consolidated statutory asset
valuation reserve ("AVR") of the Company's insurance subsidiaries was $24.9
million and $15.6 million at December 31, 1997 and 1996, respectively
(excluding statutory voluntary investment reserves of $5.3 million and $12.5
million). The AVR is generally added to statutory capital and surplus for
purposes of assessing capital adequacy against various measures used by
rating agencies and regulators.
The National Association of Insurance Commissioners Risk-Based Capital
("RBC") requirements attempt to evaluate the adequacy of a life insurance
company's statutory-basis adjusted capital and surplus in relation to
investment, insurance and other business risks. The RBC formula is used by
the states as an early warning tool to identify possible weakly capitalized
companies for the purpose of initiating regulatory action and is not designed
to be a basis for ranking the financial strength of insurance companies. In
addition, the formula establishes a minimum capital standard which
supplements the prevailing system of low fixed minimum capital and surplus.
The RBC requirements provide for four different levels of regulatory
attention depending on the ratio of the company's adjusted capital and
surplus to its RBC. As of December 31, 1997 and 1996, the adjusted capital
and surplus of Integrity and National Integrity are substantially in excess
of the minimum level of RBC that would require regulatory response.
10. SHAREHOLDERS' EQUITY
PREFERRED STOCK
During 1993, the Company issued 2,000,000 shares of non-voting 9.5%
Cumulative Perpetual Preferred Stock, stated value $25, in connection with the
acquisition of the Integrity Companies. Cash dividends at a rate of 9.5% per
annum per share are payable quarterly (equivalent to an annual amount of $2.375
per share). The shares of preferred stock may not be redeemed prior to
December 15, 1998. On or after December 15, 1998, the Company may, at its
option, redeem all or part of the shares at a redemption price of $25 per share.
INITIAL PUBLIC OFFERING OF COMMON STOCK
In June 1997, the Company completed an initial public offering of 9.2
million shares of Class A common stock, par value $.01 per share (the "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. 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,
thereby strengthening Integrity's capital base to provide for future growth. The
Company plans to also use the net proceeds to enhance the
F-23
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 Class A Common
Stock and Class B Non-Voting Common Stock, par value $.01 per share (the
"Class B Common Stock" and, together with the Class A Common Stock, the
"Common Stock"), (ii) authorized shares of the Class A Common Stock and 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 Class A Common Stock, (iv) certain shares of the
Class A Common Stock owned by the Morgan Stanley Stockholders were converted
into 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 Class A Common Stock, and (v) each
share of Common Stock was split into 706 shares of Common Stock. Holders of
Class B Common Stock have no right to vote on matters submitted to a vote of
stockholders, except in certain circumstances. Shares of the Class B Common
Stock have no preemptive or other subscription rights and are convertible
into an equal number of shares of Class A Common Stock (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 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.
All references to number of shares, per share amounts and stock option data
appearing in the financial statements and notes thereto have been restated, for
all periods presented, to reflect the stock split.
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, 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. At December 31, 1997 a total of 2,420,897 were
outstanding and 1,399,399 were exercisable at an average price of $11.44. 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.
F-24
Information with respect to the stock option plan is as follows:
Outstanding
-------------------------
Shares Average
Subject to Exercise
Option Price
-------------------------
Balance at December 31, 1994 816,136 $ 7.93
Options granted 883,912 9.17
Options forfeited (14,120) 9.21
------------
Balance at December 31, 1995 1,685,928 9.33
Options granted 240,040 10.01
Options exercised (3,530) 8.88
Options forfeited (38,830) 10.22
------------
Balance at December 31, 1996 1,883,608 10.50
Options granted 887,587 11.45
Options exercised (7,743) 12.23
Options forfeited (342,555) 11.66
------------
Balance at December 31, 1997 2,420,897 11.65
------------
------------
Shares under options that were exercisable were 633,282 and 306,404 as of
December 31, 1996 and 1995, respectively, at an average exercise price of $10.22
and $8.88. At December 31, 1997, outstanding option shares had exercise prices
ranging from $11.14 to $12.24 and average contractual life remaining of 1.8
years.
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 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 Class A Common Stock and
the exercise prices of all of the outstanding options.
The Company adopted the disclosure-only option under SFAS No. 123,
"Accounting for Stock-Based Compensation," as of December 31, 1995. If the
accounting provisions of SFAS No. 123 had been adopted as of the beginning of
1995, the effects on 1995, 1996 and 1997 net income would have been immaterial.
In June 1997, the Company adopted the 1997 Equity Incentive Plan (the "1997
Equity Plan"). 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
F-25
success of the Company or its subsidiaries; provided that only employees may be
granted incentive stock options. The maximum amount of 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 December 31, 1997.
EARNINGS PER SHARE
The following is a reconciliation of the number of shares (denominator)
used in the basic and diluted earnings per share ("EPS") computations:
1997 1996 1995
------------------------------------------------------------------
Per Share Per Share Per Share
(SHARES IN THOUSANDS) Shares Amount Shares Amount Shares Amount
- ----------------------------------------------------------------------------------------------------
Basic EPS 20,579 $ 1.11 17,498 $ 1.06 14,614 $ 0.49
Effect of dilutive stock options 726 (0.04) -- -- -- --
------------------------------------------------------------------
Diluted EPS 21,305 $ 1.07 17,498 $ 1.06 14,614 $ 0.49
------------------------------------------------------------------
------------------------------------------------------------------
11. CONTINGENCIES
The Company is a defendant in various lawsuits in connection with the
normal conduct of its operations. Company management believes the ultimate
resolution of such litigation will not result in any material adverse impact to
the financial position of the Company.
The number of insurance companies that are under regulatory supervision has
resulted in and is expected to continue to result in assessments by state
guaranty funds to cover losses to policyholders of insolvent or rehabilitated
companies. The Company has accrued for expected non-indemnified assessments.
F-26
12. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
(IN THOUSANDS,
EXCEPT PER SHARE DATA) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
- -----------------------------------------------------------------------------------------------------------------------------------
1997:
Net investment spread $ 18,375 $ 19,477 $ 22,087 $ 22,622
Fee income 5,520 5,538 6,470 7,083
Other income and expenses (15,702) (22,107) (16,105) (14,712)
Realized investment gains 2,231 420 376 165
-----------------------------------------------------------
Income before income taxes 10,424 3,328 12,828 15,158
Income tax expense (2,814) (3,185) (3,735) (4,405)
-----------------------------------------------------------
Net income 7,610 143 9,093 10,753
Dividends on preferred stock (1,188) (1,188) (1,187) (1,187)
-----------------------------------------------------------
Net income (loss) applicable to common shareholders 6,422 (1,045) 7,906 9,566
Exclude, net of tax:
Realized investment gains (1,450) (273) (245) (107)
Non-recurring charges 1,445 9,333 2,489 1,556
Income from defined benefit pension plan
asset management operations (581) (272) (325) (270)
-----------------------------------------------------------
Operating earnings $ 5,836 $ 7,743 $ 9,825 $ 10,745
-----------------------------------------------------------
-----------------------------------------------------------
Per common and common equivalent share (diluted):
Net income (loss) $ 0.37 $ (0.06) $ 0.33 $ 0.39
Operating earnings $ 0.33 $ 0.42 $ 0.40 $ 0.44
1996:
Net investment spread $ 14,078 $ 17,773 $ 18,003 $ 18,016
Fee income 4,162 4,201 4,964 4,506
Other income and expenses (11,779) (13,967) (16,572) (15,747)
Realized investment gains (losses) (403) (814) (1,115) 3,239
-----------------------------------------------------------
Income before income taxes 6,058 7,193 5,280 10,014
Income tax expense (1,573) (1,190) (956) (1,448)
-----------------------------------------------------------
Net income 4,485 6,003 4,324 8,566
Dividends on preferred stock (1,188) (1,188) (1,187) (1,187)
-----------------------------------------------------------
Net income applicable to common shareholders 3,297 4,815 3,137 7,379
Exclude, net of tax:
Realized investment (gains) losses 262 529 725 (2,106)
Non-recurring charges -- -- 940 3,599
Income from defined benefit pension plan (88) (88) (87) (87)
asset management operations
-----------------------------------------------------------
Operating earnings $ 3,471 $ 5,256 $ 4,715 $ 8,785
-----------------------------------------------------------
-----------------------------------------------------------
Per common and common equivalent share (diluted):
Net income $ 0.19 $ 0.28 $ 0.18 $ 0.42
Operating earnings $ 0.20 $ 0.30 $ 0.27 $ 0.50
F-27
13. SEGMENT INFORMATION
Effective December 31, 1997, the Company adopted SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." SFAS
No. 131 superseded SFAS No. 14, "Financial Reporting for Segments of a
Business Enterprise." SFAS No. 131 establishes standards for the way that
public business enterprises report information about operating segments. SFAS
No. 131 also establishes standards for related disclosures about products and
services, geographic areas, and major customers. The adoption of SFAS No. 131
did not affect results of operations or financial position, but did affect
the disclosure of segment information.
The Company currently has four reportable segments: retail spread products
(fixed and indexed annuities and face-amount certificates), institutional spread
products (funding agreements and GICs), retail variable products (variable
annuity mutual fund options), and corporate and other. The Company's corporate
and other segment includes earnings on surplus of insurance subsidiaries and
holding company cash and investments, fee income from marketing partnerships and
broker-dealer operations, unallocated amortization expenses, and other various
corporate expenditures that are not allocated to specific products.
The Company's reportable segments are based on the characteristics of the
product or service and the markets through which the product or service is sold.
The reportable segments are each managed separately because the impact of
fluctuating interest rates and changes in the equity market environment affects
each segments' products and services differently. The Company evaluates
performance based on operating earnings. The accounting policies of the
reportable segments are the same as those described in the summary of
significant accounting policies.
Year Ended December 31,
---------------------------------------------
(IN THOUSANDS) 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------------------
REVENUES
Retail spread products $ 220,810 $ 206,296 $ 185,961
Institutional spread products 99,861 37,210 2,515
Retail variable products 14,630 10,786 7,238
Corporate and other 19,289 13,572 11,658
---------------------------------------------
Consolidated total revenues (investment income and fee income) $ 354,590 $ 267,864 $ 207,372
---------------------------------------------
---------------------------------------------
AMORTIZATION EXPENSE
Retail spread products $ 13,951 $ 10,804 $ 8,422
Retail variable products 5,758 3,839 1,837
Corporate and other 927 1,503 10,055
---------------------------------------------
Consolidated total amortization expense $ 20,636 $ 16,146 $ 20,314
---------------------------------------------
---------------------------------------------
F-28
Year Ended December 31,
--------------------------------
(IN THOUSANDS) 1997 1996 1995
- -------------------------------------------------------------------------------------------------------
EARNINGS SUMMARY
Retail spread products $ 37,618 $ 34,440 $ 22,072
Institutional spread products 9,221 3,241 250
Retail variable products 5,068 4,827 3,168
Corporate and other 14 (10,216) (10,622)
-----------------------------------
Pretax operating earnings (before preferred stock dividends) 51,921 32,292 14,868
Income taxes on operations (13,022) (5,315) (5,609)
Preferred stock dividends (4,750) (4,750) (4,750)
-----------------------------------
Operating earnings 34,149 22,227 4,509
Realized investment gains 3,192 907 4,048
Non-recurring charges (14,823) (5,004) --
Income from defined benefit pension plan asset management operations 1,448 350 --
Income taxes not related to operating results (1,117) 148 (1,417)
-----------------------------------
Net income applicable to common shareholders $ 22,849 $ 18,628 $ 7,140
-----------------------------------
-----------------------------------
ASSETS
Retail spread products $3,153,040 $2,789,626 $2,887,920
Institutional spread products 2,542,350 891,936 143,156
Retail variable products 1,192,875 883,483 647,132
Corporate and other 250,159 136,619 115,372
-----------------------------------
Consolidated total assets $7,138,424 $4,701,664 $3,793,580
-----------------------------------
-----------------------------------
14. SUBSEQUENT EVENT
Effective February 10, 1998, John Franco, the Company's Co-Chairman and
Co-Chief Executive Officer retired. Mr. Franco had shared that title with Martin
H. Ruby since the Company was founded in 1993. As part of the retirement package
for Mr. Franco, the Company will take a one-time charge of approximately $3.5
million during the first quarter of 1998. The charge will consist of (i) a $2.0
million non-cash charge for accelerating the vesting period of options held by
Mr. Franco to purchase 232,647 shares of the Company's common stock and (ii) a
$1.5 million charge for fulfilling remaining compensation agreements related to
his employment agreement.
Concurrent with Mr. Franco's retirement, Mr. Ruby assumed the role of
Chairman and Chief Executive Officer of the Company.
F-29
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
INDEX TO FINANCIAL STATEMENT SCHEDULES
Page
----
Report of Independent Auditors on Financial Statement Schedules. . . . . . S-2
Schedule I Summary of Investments (Other than Investments in
Related Parties) . . . . . . . . . . . . . . . . . . . . . . S-3
Schedule II Condensed Financial Information of Registrant. . . . . . . . S-4
Schedule III Supplementary Insurance Information. . . . . . . . . . . . . S-8
Schedule IV Reinsurance. . . . . . . . . . . . . . . . . . . . . . . . . S-9
Schedule V Valuation and Qualifying Accounts. . . . . . . . . . . . . .S-10
Schedules required by Article 7 of Regulation S-X other than those listed are
omitted because they are not required, are not applicable, or equivalent
information has been included in the financial statements and notes thereto, or
elsewhere herein.
S-1
REPORT OF INDEPENDENT AUDITORS
ON FINANCIAL STATEMENT SCHEDULES
Board of Directors and Shareholders
ARM Financial Group, Inc.
We have audited the consolidated financial statements of ARM Financial
Group, Inc. as of December 31, 1997 and 1996, and for each of the three years in
the period ended December 31, 1997, and have issued our report thereon dated
February 10, 1998, included elsewhere in this Annual Report (Form 10-K). Our
audits also included the financial statement schedules listed in the Index at
Item 14 of this Annual Report (Form 10-K). These schedules are the
responsibility of the Company's management. Our responsibility is to express an
opinion based on our audits.
In our opinion, the financial statement schedules referred to above, when
considered in relation to the basic financial statements taken as a whole,
present fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
Louisville, Kentucky
February 10, 1998
S-2
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE I--SUMMARY OF INVESTMENTS
(OTHER THAN INVESTMENTS IN RELATED PARTIES)
DECEMBER 31, 1997
Amount at
Which Shown in
the Balance
Type of Investment Cost Value Sheet
- -----------------------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS)
Fixed maturities:
Bonds:
U.S. government and government agencies and authorities $ 318,583 $ 319,676 $ 319,676
States, municipalities and political subdivisions 4,834 4,551 4,551
Foreign governments 79,466 79,232 79,232
Public utilities 173,000 178,700 178,700
Industrial and miscellaneous 3,445,612 3,486,227 3,486,227
--------------------------------------------
Total fixed maturities 4,021,495 4,068,386 4,068,386
Equity securities 28,177 28,342 28,342
Mortgage loans on real estate 16,429 16,429 16,429
Policy loans 126,114 126,114 126,114
Cash and cash equivalents 228,206 228,206 228,206
--------------------------------------------
Total cash and investments $ 4,420,421 $ 4,467,477 $ 4,467,477
--------------------------------------------
--------------------------------------------
S-3
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS
December 31,
-------------------
(IN THOUSANDS) 1997 1996
- ------------------------------------------------------------------------------
ASSETS
Fixed maturities, available-for-sale, at fair value $ 27,115 $ --
Equity securities, at fair value 5,215 109
Cash and cash equivalents 7,058 3,317
Investments in subsidiaries* 296,431 212,423
Receivable from subsidiaries* 4,103 5,185
Goodwill 2,525 2,670
Deferred federal income taxes 577 --
Other assets 15,922 8,550
-------------------
Total assets $ 358,946 $232,254
-------------------
-------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Long-term debt $ 38,000 $ 40,000
Accounts payable and other liabilities 13,401 10,312
-------------------
Total liabilities 51,401 50,312
Shareholders' equity:
Preferred stock 50,000 50,000
Common stock 232 **
Additional paid-in capital 211,430 124,609
Net unrealized gains on available-for-sale securities 20,300 3,669
Retained earnings (including undistributed net income
of subsidiaries*: 1997--$45,415; 1996--$19,110) 25,583 3,664
-------------------
Total shareholders' equity 307,545 181,942
-------------------
Total liabilities and shareholders' equity $ 358,946 $232,254
-------------------
-------------------
* Eliminated in consolidation.
** Less than $1,000.
SEE ACCOMPANYING NOTE.
S-4
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
CONDENSED STATEMENTS OF OPERATIONS
Year Ended December 31,
----------------------------
(IN THOUSANDS) 1997 1996 1995
- ---------------------------------------------------------------------------------
Revenues:
Dividends from subsidiary* $ 14,934 $ 16,000 $ 12,800
Management and service fee income* 37,574 28,901 19,040
Investment and other income 3,848 1,332 689
Realized investment gains (losses) 1,257 3,712 (45)
----------------------------
Total revenues 57,613 49,945 32,484
Expenses:
Operating expenses 38,586 31,813 22,735
Interest expense 2,517 3,161 3,461
Amortization:
Acquisition-related deferred charges 503 1,503 9,695
Goodwill 145 145 84
Non-recurring charges:
Stock-based compensation 8,145 -- --
Other 6,678 5,004 --
----------------------------
Total expenses 56,574 41,626 35,975
----------------------------
Income (loss) before federal income tax benefit
and equity in undistributed net income of
subsidiaries 1,039 8,319 (3,491)
Federal income tax benefit 255 242 271
----------------------------
Income (loss) before equity in undistributed net
income of subsidiaries 1,294 8,561 (3,220)
Equity in undistributed net income of subsidiaries* 26,305 14,817 15,110
----------------------------
Net income $ 27,599 $ 23,378 $ 11,890
----------------------------
----------------------------
* Eliminated in consolidation.
SEE ACCOMPANYING NOTE.
S-5
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31,
--------------------------
(IN THOUSANDS) 1997 1996 1995
- -------------------------------------------------------------------------------
Net cash flows provided by operating activities $ 4,742 $ 2,962 $ 1,175
Cash flows provided by (used in) investing
activities:
Net (purchases) sales of investments (32,229) 2,437 5,986
Contribution of capital to subsidiaries (40,000) -- (21,100)
Acquisition of subsidiaries -- -- (42,134)
--------------------------
Net cash flows (used in) provided by investing
activities (72,229) 2,437 (57,248)
Cash flows provided by (used in) financing
activities:
Proceeds from issuance of common stock 80,308 184 63,505
Organization, debt and stock issuance costs (1,400) -- (2,000)
Principal payment on long-term debt (2,000) -- --
Dividends on common stock (930) -- --
Preferred stock dividends (4,750) (4,750) (4,750)
--------------------------
Net cash flows provided by (used in) financing
activities 71,228 (4,566) 56,755
--------------------------
Increase in cash and cash equivalents 3,741 833 682
Cash and cash equivalents at beginning of year 3,317 2,484 1,802
--------------------------
Cash and cash equivalents at end of year $ 7,058 $ 3,317 $2,484
--------------------------
--------------------------
SEE ACCOMPANYING NOTE.
S-6
ARM FINANCIAL GROUP, INC. (PARENT COMPANY)
SCHEDULE II--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED)
Note to Condensed Financial Statements
December 31, 1997
1. BASIS OF PRESENTATION
The accompanying condensed financial statements should be read in
conjunction with the consolidated financial statements and notes of ARM
Financial Group, Inc. and subsidiaries for the year ended December 31, 1997
included herein.
S-7
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE III--SUPPLEMENTARY INSURANCE INFORMATION
Customer
Deposits
and
Deferred Customer Interest
Policy Deposits in Credited on Other
Acquisition Separate Investment Customer Income and
Segment Costs Accounts Income* Deposits Fee Income Expenses*
- ----------------------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS)
December 31, 1997:
Retail spread products $ 35,852 $ 2,862,828 $ 220,810 $ 159,761 $ -- $ (23,431)
Institutional spread products -- 2,624,551 99,861 87,657 -- (2,983)
Retail variable products 51,318 1,129,064 -- -- 14,630 (9,562)
Corporate and other -- 41,531 9,308 -- 9,981 (32,650)
------------------------------------------------------------------------------------
Consolidated $ 87,170 $ 6,657,974 $ 329,979 $ 247,418 $ 24,611 $ (68,626)
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
December 31, 1996:
Retail spread products $ 19,919 $ 2,646,180 $ 206,179 $ 148,594 $ 117 $ (23,262)
Institutional spread products -- 891,936 37,210 32,877 -- (1,092)
Retail variable products 39,082 844,330 -- -- 10,786 (5,959)
Corporate and other -- 41,887 6,642 690 6,930 (27,752)
------------------------------------------------------------------------------------
Consolidated $ 59,001 $ 4,424,333 $ 250,031 $ 182,161 $ 17,833 $ (58,065)
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
December 31, 1995:
Retail spread products $ 14,787 $ 2,716,183 $ 185,961 $ 143,947 $ -- $ (19,943)
Institutional spared products -- 143,156 2,515 2,194 -- (71)
Retail variable products 28,326 617,312 -- -- 7,238 (4,070)
Corporate and other -- 39,954 7,548 726 4,110 (21,553)
------------------------------------------------------------------------------------
Consolidated $ 43,113 $ 3,516,605 $ 196,024 $ 146,867 $ 11,348 $ (45,637)
------------------------------------------------------------------------------------
------------------------------------------------------------------------------------
* Allocation of "investment income" and "other income and expenses" is based
on a number of assumptions and estimates, the results of which would change
if different methods were applied.
S-8
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE IV--REINSURANCE
Percentage of
Ceded to Other Assumed from Amount Assumed
Gross Amount Companies Other Companies Net Amount to Net Amount
- ----------------------------------------------------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
Year Ended December 31, 1997
Life insurance in force $ 1,137,219 $ 2,015,951 $ 1,740,519 $ 861,787 202.0%
Year Ended December 31, 1996
Life insurance in force $ 1,214,895 $ 2,056,073 $ 1,852,732 $ 1,011,554 183.2%
Year Ended December 31, 1995
Life insurance in force $ 1,309,604 $ 1,728,116 $ 985,870 $ 567,358 173.8%
S-9
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
SCHEDULE V--VALUATION AND QUALIFYING ACCOUNTS
Additions
---------------------------
Charged Charged to
Beginning of to Other End of Year
Description Year Expense Accounts Deductions
- ----------------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS)
Valuation allowance on deferred tax
assets:
1997 $ 38,798 $ 6,692 $ -- $ (8,922)(1) $ 36,568
1996 $ 37,336 $ 2,517 $ 9,949 (2) $ (11,004)(1) $ 38,798
1995 $ 66,489 $ 5,895 $ 3,956 (3) $ (39,004)(1) $ 37,336
(1) In the event that deferred tax assets are recognized on deductible
temporary differences for which a valuation allowance was provided at the
date of an acquisition, such benefits are applied to first reduce the
balance of intangible assets related to the acquisition, and then income
tax expense. As such, the Company reduced its valuation allowance with an
offsetting reduction to acquisition-related intangible assets such as value
of insurance in force and goodwill. In addition, after acquisition-related
intangible assets were reduced to zero for two of the Company's
subsidiaries, the reduction in valuation allowance resulted in a reduction
of income taxes. The portion of the December 31, 1994 valuation allowance
related to deferred tax assets for net unrealized losses on
available-for-sale securities was reduced to zero as of December 31, 1995.
The Company's available-for-sale portfolios had net unrealized gains at
December 31, 1997, 1996 and 1995 which did not require a valuation
allowance.
(2) As the acquisition-related valuation allowance described in (1) above was
initially released, the reduction in the intangible assets related to the
acquisition generated additional deferred tax assets. A valuation allowance
was provided for these additional deferred tax assets.
(3) Related to deferred tax assets on acquired capital losses established on
May 31, 1995 in connection with the SBM acquisition.
S-10