---------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the period ended: March 31, 1998
Commission file number: 33-67268
ARM FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 61-1244251
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
515 WEST MARKET STREET
LOUISVILLE, KENTUCKY 40202
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (502) 582-7900
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. X Yes - No
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
DATE CLASS SHARES OUTSTANDING
- --------------------------------------------------------------------------------
May 14, 1998 A 23,397,471
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
March 31, December 31,
(IN THOUSANDS) 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------------
(Unaudited)
ASSETS
Cash and investments:
Fixed maturities, available-for-sale, at fair value (amortized cost: March 31,
1998-$4,413,322; December 31, 1997-$4,021,495) $4,420,538 $4,068,386
Equity securities, at fair value (cost: March 31, 1998-$28,165; December 31,
1997-$28,177) 27,897 28,342
Mortgage loans on real estate 16,235 16,429
Policy loans 126,300 126,114
Cash and cash equivalents 344,079 228,206
------------------------------------
Total cash and investments 4,935,049 4,467,477
Assets held in separate accounts:
Guaranteed 1,292,589 1,266,796
Nonguaranteed 1,345,118 1,173,088
Accrued investment income 50,117 44,546
Value of insurance in force 30,951 25,975
Deferred policy acquisition costs 95,914 87,170
Goodwill 6,229 6,523
Deferred federal income taxes 43,763 31,049
Other assets 59,006 35,800
------------------------------------
Total assets $7,858,736 $7,138,424
------------------------------------
------------------------------------
2
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (CONTINUED)
March 31, December 31,
(IN THOUSANDS) 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------------
(Unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits $4,647,540 $4,242,578
Customer deposits in separate accounts:
Guaranteed 1,281,509 1,254,801
Nonguaranteed 1,336,469 1,160,595
Long-term debt 38,000 38,000
Accounts payable and accrued expenses 23,004 18,741
Payable for investment securities purchased 195,026 69,286
Payable to reinsurer 8,330 8,800
Other liabilities 31,301 38,078
------------------------------------
Total liabilities 7,561,179 6,830,879
Contingencies
Shareholders' equity:
Preferred stock, $25.00 stated value 50,000 50,000
Class A common stock, $.01 par value, 21,441,641 and 21,316,068 shares issued and
outstanding, respectively 214 213
Class B common stock, $.01 par value, 1,947,646 shares issued and outstanding 19 19
Additional paid-in capital 216,024 211,430
Retained earnings 30,474 25,583
Accumulated other comprehensive income from net unrealized gains on available-for-
sale securities 826 20,300
------------------------------------
Total shareholders' equity 297,557 307,545
------------------------------------
Total liabilities and shareholders' equity $7,858,736 $7,138,424
------------------------------------
------------------------------------
SEE ACCOMPANYING NOTES.
3
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND 1997
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------------
Investment income $104,406 $69,700
Interest credited on customer deposits (81,680) (51,325)
------------------------------------
Net investment spread 22,726 18,375
Fee income:
Variable annuity fees 4,426 3,239
Asset management fees -- 1,884
Other fee income 232 397
------------------------------------
Total fee income 4,658 5,520
Other income and expenses:
Surrender charges 1,334 882
Operating expenses (7,550) (8,156)
Commissions, net of deferrals (598) (638)
Interest expense on debt (617) (686)
Amortization:
Deferred policy acquisition costs (2,724) (2,175)
Value of insurance in force (1,531) (2,241)
Acquisition-related deferred charges (126) (126)
Goodwill (94) (122)
Non-recurring charges (3,570) (1,445)
Other, net (593) (995)
------------------------------------
Total other income and expenses (16,069) (15,702)
Realized investment gains 5,165 2,231
------------------------------------
Income before income taxes 16,480 10,424
Income tax expense (5,499) (2,814)
------------------------------------
Net income 10,981 7,610
Dividends on preferred stock (1,188) (1,188)
------------------------------------
Net income applicable to common shareholders $9,793 $6,422
------------------------------------
------------------------------------
Net income per common share (basic) $0.42 $0.37
------------------------------------
------------------------------------
Net income per common and common equivalent share (diluted) $0.40 $0.37
------------------------------------
------------------------------------
Cash dividends paid per common share $0.02 --
------------------------------------
------------------------------------
SEE ACCOMPANYING NOTES.
4
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND 1997
(IN THOUSANDS) 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES $60,234 $46,677
CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
Fixed maturity investments:
Purchases (2,105,306) (1,199,200)
Maturities and redemptions 202,755 59,905
Sales 1,617,874 947,397
Other investments:
Purchases -- (10,489)
Maturities and redemptions 337 8,029
Sales 75 10,892
Policy loans, net (186) 169
Transfers (to) from the separate accounts:
Purchase of assets held in separate accounts (112,026) (102,059)
Proceeds from sale of assets held in separate accounts 37,657 20,383
------------------------------------
Cash flows used in investing activities (358,820) (264,973)
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Amounts received from customers from the sale of general
account and separate account products 565,728 357,581
Amounts paid to customers for benefits and withdrawals
related to general and separate account products (149,143) (112,693)
Principal payment on long-term debt -- (2,000)
Change in payable to reinsurer (470) --
Dividends on common stock (468) --
Dividends on preferred stock (1,188) (1,188)
------------------------------------
Cash flows provided by financing activities 414,459 241,700
------------------------------------
Net increase in cash and cash equivalents 115,873 23,404
Cash and cash equivalents at beginning of period 228,206 110,067
------------------------------------
Cash and cash equivalents at end of period $344,079 $133,471
------------------------------------
------------------------------------
SEE ACCOMPANYING NOTES.
5
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
March 31, 1998
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles
("GAAP") for interim financial information and with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by GAAP for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three months ended March 31, 1998 are not
necessarily indicative of those to be expected for the year ending December 31,
1998. For further information, refer to the consolidated financial statements
and footnotes thereto included in the annual report on Form 10-K of ARM
Financial Group, Inc. (the "Company") for the year ended December 31, 1997.
Certain amounts from prior years have been reclassified to conform to the
current year's presentation. Such reclassifications have no effect on previously
reported net income or shareholders' equity.
2. INCOME TAXES
Income tax expense differs from that computed using the expected federal
income tax rate of 35%. The differences are primarily attributable to changes in
valuation allowances related to deferred federal income tax assets.
3. NON-RECURRING CHARGES
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 recorded a non-recurring charge of $3.6
million in the first quarter of 1998. The charge consisted of (i) a $2.1 million
non-cash charge in connection with the vesting of the unvested portion of the
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
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.
The Company recorded non-recurring charges of $1.4 million in the first
quarter of 1997 primarily related to the relocation and consolidation of the
Company's operations facilities from Ohio to Louisville, Kentucky.
6
4. EARNINGS PER SHARE
In 1997, the Company adopted the provisions of Statement of Financial
Accounting Standards ("SFAS") No. 128, "Earnings Per Share," which superseded
Accounting Principles Board Opinion No. 15 of the same name. Earnings per share
("EPS") for all periods presented reflect the adoption of SFAS No. 128. SFAS No.
128 requires companies to present basic and, if applicable, diluted EPS, instead
of primary and fully diluted EPS. Basic EPS 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 EPS reflects the
potential dilution that could occur if options to issue common stock were
exercised into common stock.
The following is a reconciliation of the number of shares used in the
basic and diluted EPS computations:
Three Months Ended March 31,
1998 1997
---------------------- ----------------------
Weighted Weighted
Average Per Share Average Per Share
Shares Amount Shares Amount
- ------------------------------------------------------- ----------------------
(SHARES IN THOUSANDS)
Basic EPS 23,322 $0.42 17,506 $0.37
Effect of dilutive stock options 1,030 (0.02) -- --
---------------------- ----------------------
Diluted EPS 24,352 $0.40 17,506 $0.37
---------------------- ----------------------
---------------------- ----------------------
5. 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. 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, guaranteed investment contracts ("GICs")
and face-amount certificates), retail variable products (fee-based 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. Income tax expense and preferred stock dividends are not
allocated to any segment.
7
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. Operating earnings represents net
income applicable to common shareholders, excluding, net of tax, realized
investment gains and losses, non-recurring charges and for 1997, income from
defined benefit pension plan asset management operations which were sold.
Three Months Ended March 31,
-----------------------------
(IN THOUSANDS) 1998 1997
- ---------------------------------------------------------------------------------------------------
REVENUES
Retail spread products $ 55,508 $ 51,959
Institutional spread products 46,966 16,036
Retail variable products 4,426 3,239
Corporate and other 2,164 3,986
-----------------------------
Consolidated total revenues (investment income and fee income) $ 109,064 $ 75,220
-----------------------------
-----------------------------
EARNINGS SUMMARY
Retail spread products $ 10,517 $ 8,726
Institutional spread products 4,182 1,345
Retail variable products 1,601 878
Corporate and other (1,415) (1,892)
-----------------------------
Pretax operating earnings (before preferred stock dividends) 14,885 9,057
Income taxes on operations (3,691) (2,033)
Preferred stock dividends (1,188) (1,188)
-----------------------------
Operating earnings 10,006 5,836
Realized investment gains, net of tax 3,357 1,450
Non-recurring charges (3,570) (1,445)
Income from defined benefit pension plan asset management operations -- 581
-----------------------------
Net income applicable to common shareholders $ 9,793 $ 6,422
-----------------------------
-----------------------------
6. COMPREHENSIVE INCOME
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income." SFAS No. 130 establishes new rules for the reporting and
display of comprehensive income and its components; however, the adoption of
this Statement had no impact on the Company's net income or total shareholders'
equity. SFAS No. 130 requires unrealized gains or losses on the Company's
available-for-sale securities to be included in other comprehensive income.
8
The components of comprehensive income (loss), net of related tax, for the
three months ended March 31, 1998 and 1997 are as follows:
Three Months Ended March 31,
- -----------------------------------------------------------------------------------
(IN THOUSANDS) 1998 1997
- -----------------------------------------------------------------------------------
Net income $ 10,981 $ 7,610
Net unrealized losses on available-for-sale securities (19,474) (30,390)
---------------------------
Comprehensive income (loss) $ (8,493) $ (22,780)
---------------------------
---------------------------
7. SUBSEQUENT EVENTS
312 CERTIFICATE COMPANY
The Company established a new subsidiary, 312 Certificate Company ("312"), a
bankruptcy-remote, restricted special purpose corporation, to sell face-amount
certificates in the institutional market. On April 24, 1998, 312 completed its
first sale of a $500 million face-amount certificate to a large institutional
purchaser. 312 is a wholly-owned subsidiary of ARM Face-Amount Certificate
Group, which is a wholly-owned subsidiary of the Company.
PUBLIC OFFERING
In May 1998, the Company completed a public offering of approximately 12.4
million shares of common stock held by certain private equity funds (the "Morgan
Stanley Stockholders") sponsored by Morgan Stanley Dean Witter & Co. The
Company did not receive any of the proceeds from the public offering. As a
result of the public offering, the Morgan Stanley Stockholders no longer own any
shares of the Company's outstanding common stock and all Class B common stock
was converted into Class A common stock.
ITEM 2. 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 and indexed annuities) and institutional
spread products (funding agreements, GICs and face-amount certificates). The
9
Company receives a fee in exchange for managing customers' deposits, and the
customer accepts the investment risk with its retail variable products
(variable annuity mutual fund options). 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 fixed, indexed and variable 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. 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, Inc. ("ARM Capital Advisors") to ARM
Capital Advisors, LLC ("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. ARM Capital
Advisors' management of defined benefit pension plan accounts generated asset
management fees of $1.9 million during the first quarter of 1997.
RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 1998 COMPARED WITH THREE MONTHS ENDED MARCH 31,
1997
Net income during the first quarter of 1998 was $11.0 million compared to
$7.6 million for the first quarter of 1997. Operating earnings (net income
applicable to common shareholders, excluding, net of tax, realized investment
gains and losses, non-recurring charges and for 1997, income from defined
benefit pension plan asset management operations which were sold) were $10.0
million and $5.8 million for the first quarter of 1998 and 1997, respectively.
The increase in operating earnings is primarily attributable to an increase in
net investment spread due to deposit growth from sales of retail and
institutional spread products.
Pro forma operating earnings for the first quarter of 1997 (operating
earnings including a pro forma adjustment to reflect investment income at an
assumed rate of 7.5% on the net proceeds of the Company's June 1997 initial
public offering of Class A common stock assuming it occurred on January 1,
1997) were $7.0 million. Operating earnings per share (pro forma for 1997)
were $0.41 and $0.29 for the first quarter of 1998 and 1997, respectively.
The pro forma information for 1997 is not necessarily indicative of what
would have occurred had the initial public offering occurred on the date
indicated.
Annualized pretax operating earnings for retail spread products were 1.49%
and 1.33% of average assets under management of $2.82 billion and $2.63
billion for that segment during the first quarter of 1998 and 1997,
respectively. Annualized pretax operating earnings for institutional spread
products were 0.60% and 0.54% of average assets under management of $2.80
billion and $1.00 billion for that segment during the first quarter of 1998
and 1997, respectively. Annualized pretax operating earnings for retail
variable products (fee business) were 0.53% and 0.41% of average assets
10
under management of $1.20 billion and $847.9 million for that segment during the
first quarter of 1998 and 1997, respectively. 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 fee operations, unallocated amortization expenses, and other
various corporate expenditures that are not allocated to specific products.
Income tax expense and preferred stock dividends are not allocated to any
segment.
Net investment spread for the three months ended March 31, 1998 and 1997 was
as follows:
Three Months Ended
March 31,
-----------------------------
(DOLLARS IN THOUSANDS, EXCEPT AS NOTED) 1998 1997
- -------------------------------------------------------------------------------------
Investment income $ 104,406 $ 69,700
Interest credited on customer deposits (81,680) (51,325)
-----------------------------
Net investment spread $ 22,726 $ 18,375
-----------------------------
-----------------------------
Annualized investment yield 7.24% 7.45%
Annualized average credited rate (5.94)% (5.67)%
-----------------------------
Investment spread rate 1.30% 1.78%
-----------------------------
-----------------------------
Average cash and investments (IN BILLIONS) $ 5.77 $ 3.74
Average spread-based customer deposits (IN BILLIONS) $ 5.58 $ 3.67
The decrease in the overall investment spread rate from 1.78% in 1997 to
1.30% in 1998 is primarily attributable to a greater proportion of
institutional spread product deposits in 1998, which generate lower spreads.
Changes in investment yield and average credited rates must be analyzed in
relation to the liability portfolios to which they relate. The annualized
investment yield on cash and investments, excluding assets supporting
institutional spread product deposits, was 7.74% for the first quarter of
1998, down slightly from 7.83% for the comparable 1997 period. In comparison,
the annualized investment yield on cash and investments supporting
institutional spread product deposits was 6.70% and 6.42% for the first
quarter of 1998 and 1997, respectively. Average cash and investments related
to institutional spread product deposits grew from $1.00 billion during the
first quarter of 1997 to $2.80 billion during the first quarter of 1998,
contributing to 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, frequency of credited rate
resets and business mix. Crediting rates are reset monthly or quarterly based
on London Interbank Offered Rates ("LIBOR") for institutional spread products
and semi-annually or annually for certain fixed annuities. The increase in
the average rate of interest credited on customer deposits during the first
quarter of 1998 was primarily attributable to higher LIBOR compared to the
first quarter of 1997 and to a greater proportion of institutional spread
product deposits in 1998. To date, the Company has been able to react to
changes in market interest rates and maintain an adequate investment spread
without a significant effect on retail surrender and withdrawal activity,
although there can be no assurance that the Company will be able to continue
to do so.
11
Variable annuity fees, which are based on the market value of the mutual fund
assets supporting variable annuity customer deposits in nonguaranteed separate
accounts, increased to $4.4 million in the first quarter of 1998 from $3.2
million in the first quarter of 1997. This increase is 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.
Assets under management as of March 31, 1998 and 1997 were as follows:
March 31,
------------------------------------------
1998 1997
------------------------------------------
Percent of Percent of
(DOLLARS IN MILLIONS) Amount Total Amount Total
- --------------------------------------------------------------------------------------
Retail spread products (primarily
fixed and indexed annuity and
face-amount certificate deposits) $2,815.4 37% $2,653.5 52%
Institutional spread products
(funding agreement and
GIC deposits) 2,989.6 40 1,141.3 22
Retail variable products
(variable annuity deposits
invested in mutual funds) 1,302.1 17 859.5 17
Corporate and other:
Off-balance sheet deposits under
marketing partnership arrangements 233.7 3 368.7 7
Cash and investments in excess
of customer deposits 190.6 3 75.1 2
------------------------------------------
Total assets under management $7,531.4 100% $5,098.1 100%
------------------------------------------
------------------------------------------
The increase in total assets under management was primarily attributable to
sales of floating rate funding agreements and GICs to institutional customers
and 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.
12
Sales by market and type of product for the three months ended March 31, 1998
and 1997 were as follows:
Three Months Ended
March 31,
---------------------
(IN MILLIONS) 1998 1997
- --------------------------------------------------------------------------------
Retail:
Spread products $38.0 $68.8
Variable products 83.5 36.3
---------------------
Total retail 121.5 105.1
Institutional:
Spread products 447.2 248.6
---------------------
Total sales $568.7 $353.7
---------------------
---------------------
Sales of retail variable products increased $47.2 million over the first
quarter of 1997. This increase is primarily attributable to the reintroduction
and enhancement of the PINNACLE variable annuity product in late 1997. Sales of
retail spread products decreased to $38.0 million for the first quarter of 1998.
This decrease is related to the decline in the yield on intermediate-term
U.S. Treasury securities which is one of the factors considered in setting
credited rates on retail spread products. The Company's sales strategy is to
broaden its mix of products, services and distribution channels to enable it to
achieve its target sales within different interest rate environments. The
increase in institutional sales was attributable to increased sales of
institutional funding agreements.
Net surrenders of retail spread and variable annuity products issued by
the Company's insurance subsidiaries were $79.7 million in the first quarter
of 1998 compared to $76.1 million in the first quarter of 1997. Surrender
charge income increased to $1.3 million in the first quarter of 1998 from
$0.9 million in the first quarter of 1997. The increase in surrender charge
income is attributable to a larger mix of surrenders of customer deposits
acquired in connection with the 1995 acquisition of SBM Company's insurance
subsidiary which have higher surrender charge penalties. Retail products
issued by the Company's insurance subsidiaries generally include lapse
protection provisions that provide a deterrent to surrenders when interest
rates rise. These provisions can include surrender charges and market value
adjustments on annuity withdrawals. During the period that surrender charges
are assessable (generally the first five to seven years after a policy is
issued) surrenders are relatively low. The surrender and withdrawal activity
during the first quarters of 1997 and 1998 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
retail surrender activity and improve persistency through various programs.
The Company has experienced minimal withdrawals (excluding scheduled interest
payments) by institutional spread product customers during the first quarter
of 1997 and 1998.
Amortization of deferred policy acquisition costs related to operations was
$2.7 million and $2.2 million during the three months ended March 31, 1998 and
1997, respectively. This increase was primarily the result of growth in the
deferred policy acquisition cost asset due to additional sales of fixed, indexed
and variable annuity products. Variable costs of selling and issuing the
Company's
13
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 $1.5
million and $2.2 million for the three months ended March 31, 1998 and 1997,
respectively, primarily reflects the amortization of the value of insurance
in force established as an asset by the Company in connection with the 1995
acquisition of SBM Company's insurance subsidiary. The decrease in
amortization of value of insurance in force related to operations is a result
of the decrease in the value of insurance in force asset from $50.8 million
at March 31, 1997 to $31.0 million at March 31, 1998.
The Company recorded non-recurring charges of $3.6 million in the first
quarter of 1998 as part of a retirement package for John Franco, the Company's
Co-Chairman and Co-Chief Executive Officer. Mr. Franco retired effective
February 10, 1998. These charges consisted of (i) a $2.1 million non-cash
charge in connection with the vesting of the unvested portion of the 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 related to his
employment agreement. The Company recorded non-recurring charges of $1.4
million in the first quarter of 1997 primarily related to the relocation and
consolidation of the Company's operations facilities from Ohio to Louisville,
Kentucky.
Other expenses, net primarily includes premiums paid on agreements to
reinsure the majority of the mortality risks associated with single premium
endowment and variable annuity deposits.
Realized investment gains, which are reported net of related amortization of
deferred policy acquisition costs and value of insurance in force, were $5.2
million in the first quarter of 1998 compared to $2.2 million in the first
quarter of 1997. Such realized investment gains 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.
Income tax expense was $5.5 million and $2.8 million during the three
months ended March 31, 1998 and 1997, respectively, reflecting effective tax
rates of 33.4% and 27.0%.
14
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 March 31, 1998 totaled $4.4
billion, compared with $4.0 billion at December 31, 1997, representing
approximately 90% and 91% of total cash and investments, respectively. This
increase in investments in fixed maturities primarily resulted from the
investment of the proceeds from the sales of institutional spread products.
The Company's cash and investments as of March 31, 1998 are detailed as
follows:
Amortized Cost
------------------------
Percent of Estimated
(DOLLARS IN MILLIONS) Amount Total Fair Value
- ------------------------------------------------------------------------------------ --------------
Fixed maturities:
Corporate securities $1,595.6 32% $1,599.1
U.S. Treasury securities and obligations of U.S.
government agencies 333.5 7 334.3
Other government securities 84.9 2 85.9
Asset-backed securities 416.5 9 415.1
Mortgage-backed securities ("MBSs"):
Agency pass-throughs 37.5 1 37.6
Collateralized mortgage obligations ("CMOs"):
Agency 258.3 5 260.4
Non-agency 1,687.0 34 1,688.1
------------------------ --------------
Total fixed maturities 4,413.3 90 4,420.5
Equity securities (i.e., non-redeemable preferred stock) 28.2 1 27.9
Mortgage loans on real estate 16.2 * 16.2
Policy loans 126.3 2 126.3
Cash and cash equivalents 344.1 7 344.1
------------------------ --------------
Total cash and investments $4,928.1 100% $4,935.0
------------------------ --------------
------------------------ --------------
* Less than 1%.
Agency pass-through certificates are MBSs which represent an undivided
interest in a specific pool of residential mortgages. The payment of principal
and interest is guaranteed by the U.S. government or U.S. government agencies.
CMOs are pools of mortgages that are segregated into sections, or tranches,
which provide prioritized retirement of bonds rather than a pro rata share of
principal return as in the pass-through structure. The underlying mortgages of
agency CMOs are guaranteed by the U.S. government or U.S. government agencies.
Of the Company's non-agency CMO investments at March 31, 1998 (on an amortized
cost basis), 87% 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 13% of the non-agency CMOs used commercial mortgage
loans as collateral.
15
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 had gross unamortized
premiums and unaccreted discounts of MBSs of $19.9 million and $15.3 million,
respectively, at March 31, 1998. Although the interest rate environment has
experienced volatility during 1997 and the first quarter of 1998, prepayments
and extensions of cash flows from MBSs have not materially affected investment
income of the Company.
Asset-backed securities ("ABSs") 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 March 31, 1998, home equity
loan collateral represented 42% 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 (on an amortized cost basis) were 93% and 95%
investment grade or equivalent as of March 31, 1998 and December 31, 1997,
respectively. Investment grade securities are those classified as 1 or 2 by the
National Association of Insurance Commissioners ("NAIC") or, where such
classifications are not available, having a rating on the scale used by Standard
& Poor's Corporation ("S&P") of BBB- or above. Yields available on
non-investment grade securities are generally higher than are available on
investment grade securities. However, credit risk is greater with respect to
such non-investment grade securities. The Company 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 Company's investment portfolio has minimal exposure to real
estate, mortgage loans and common equity securities, which represented less than
1% of cash and investments as of March 31, 1998.
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
16
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 March 31, 1998 the ratings assigned by the NAIC and comparable S&P ratings
on the Company's fixed maturity portfolio 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) $2,804.4 64% $2,803.4
2 (BBB) 1,241.5 28 1,250.6
3 (BB) 204.8 4 206.3
4 (B) 162.6 4 160.2
5 (CCC, CC, C) -- -- --
6 (CI, D) -- -- --
-----------------------------------------
Total fixed maturities $4,413.3 100% $4,420.5
-----------------------------------------
-----------------------------------------
Pursuant to SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities," the Company classifies its entire fixed maturities portfolio
as available-for-sale. Fixed maturities classified as available-for-sale are
carried at fair value and changes in fair value, net of related deferred policy
acquisition cost and value of insurance in force amortization and deferred
income taxes, are charged or credited directly to shareholders' equity and
classified as accumulated other comprehensive income from net unrealized gains
on available-for-sale securities.
The fluctuations in interest rates during the first quarter of 1998 resulted
in net unrealized gains on available-for-sale securities which totaled $0.8
million (net of $5.7 million of related amortization of deferred policy
acquisition costs and value of insurance in force and $0.4 million of deferred
income taxes) at March 31, 1998, compared to net unrealized gains of $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. This change in net unrealized gains on
available-for-sale securities for the first quarter of 1998 decreased reported
shareholders' equity by $19.5 million as compared to an increase of $16.6
million for the year ended December 31, 1997. 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 March 31, 1998 and
December 31, 1997, shareholders' equity excluding the effects of SFAS No. 115
was $296.7 million and $287.2 million, respectively.
17
Assets held in the Company's guaranteed separate accounts include $1.20
billion and $1.26 billion of cash and investments at March 31, 1998 and December
31, 1997, of which approximately 93% and 87% were fixed maturities,
respectively. Total guaranteed separate account cash and investments were 98%
and 99% investment grade at March 31, 1998 and December 31, 1997, 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 an insurance company's 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 agreements, dividend payments on
its common and 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 Life Insurance Company
("Integrity") and management and service fee income from the Company's
subsidiaries to meet ongoing cash needs.
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. In March 1998, the Company received a cash
dividend of $6.0 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. The Company had cash and
investments at the holding company level of $44.6 million at March 31, 1998. In
addition, the Company has access to bank lines of credit totaling $75.0 million
at March 31, 1998, of which $37.0 million is available to the Company.
In May 1998, the Company completed a public offering of approximately 12.4
million shares of common stock held by the Morgan Stanley Stockholders. The
Company did not receive any of the proceeds from the public offering. As a
result of the public offering, the Morgan Stanley Stockholders no longer own any
shares of the Company's outstanding common stock and all Class B common stock
was converted into Class A common stock.
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
18
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 three months ended March 31, 1998 and 1997, the Company met its
liquidity needs entirely by cash flows from operating activities and
principal payments and redemptions of investments. At March 31, 1998, cash
and cash equivalents totaled $344.1 million compared to $228.2 million at
December 31, 1997. This increase in cash and cash equivalents is temporary
and is a result of deposits for institutional spread products received prior
to March 31, 1998, which were not fully invested until after March 31, 1998.
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 $60.2 million and $46.7 million from
operating activities during the quarters ended March 31, 1998 and 1997,
respectively. These cash flows resulted principally from investment income, less
commissions and operating expenses. Proceeds from sales, maturities and
redemptions of investments generated $1,821.0 million and $1,026.2 million in
cash flows during the quarters ended March 31, 1998 and 1997, respectively,
which were offset by purchases of investments of $2,105.3 million and $1,209.7
million, respectively. An increase in investment purchases and sales activity
during the first quarter of 1998 reflects the Company's ongoing management of
its fixed maturity portfolio which has increased in size due primarily to sales
of retail and institutional spread products.
FORWARD-LOOKING STATEMENTS
The Company has made a number of forward-looking statements in this document
that are subject to risks and uncertainties. Forward-looking statements include
the information concerning possible or assumed future results of operations and
those preceded by, followed by or that include the words "believes," "expects,"
or similar expressions. Such forward-looking statements are based on the
Company's beliefs as to its competitive position in its industry and the factors
affecting its business. In particular, the statements of the Company's belief as
to the growth of the long-term savings and retirement market and the stimulation
of future demand for long-term savings and retirement products, including fixed,
indexed and variable annuity products under the heading "General" are
forward-looking statements. Factors that could cause actual results to differ
materially from the forward-looking statements related to the demand for fixed,
indexed and variable 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.
19
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is currently involved in no material legal or administrative
proceedings. The Company's subsidiaries are currently involved only in routine
legal and administrative proceedings incidental to the conduct of their
businesses. The Company believes that none of these proceedings will have a
material adverse impact to the financial position or results of operations of
the Company or its subsidiaries.
ITEM 5. OTHER INFORMATION
The Board of Directors by unanimous written consent dated May 12, 1998,
declared a quarterly dividend of 59.375 cents per share payable June 15, 1998 to
holders of the 9 1/2% Cumulative Perpetual Preferred Stock of record on May 29,
1998, and a quarterly dividend of 4 cents per share payable June 15, 1998 to
holders of Class A common stock of record on May 29, 1998.
As a result of the successful public offering of Class A common stock held
by the Morgan Stanley Stockholders. Messrs. Alan E. Goldberg and Robert H.
Niehaus resigned from the Company's Board of Directors on May 13, 1998.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
REPORTS ON FORM 8-K
On March 4, 1998, the Company filed a current report on Form 8-K
announcing that (i) as of February 10, 1998, Martin H. Ruby was named Chief
Executive Officer and Chairman of the Board of Directors and (ii) as of
February 20, 1998, Patricia L. Winter was named Executive Vice
President--Investment Assurance and Institutional Products.
20
EXHIBITS (ELECTRONIC FILING ONLY)
3(ii) Second Amended and Restated By-Laws of ARM Financial Group, Inc.
10 Release and Settlement Agreement effective as of February 13, 1998,
entered into between Daniel R. Gattis and ARM Financial Group, Inc.
27 Financial Data Schedule.
21
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, on May 15, 1998.
ARM FINANCIAL GROUP, INC.
By: /S/ EDWARD L. ZEMAN
----------------------
Edward L. Zeman
Executive Vice President-Chief
Financial Officer (Principal
Financial Officer)
By: /S/ BARRY G. WARD
----------------------
Barry G. Ward
Controller (Principal Accounting
Officer)
22