================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2003
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from___________to___________
Commission file number 1-10890
----------
HORACE MANN EDUCATORS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 37-0911756
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1 Horace Mann Plaza, Springfield, Illinois 62715-0001
(Address of principal executive offices, including Zip Code)
Registrant's Telephone Number, Including Area Code: 217-789-2500
----------
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 [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [_]
As of October 31, 2003, 42,721,940 shares of Common Stock, par value $0.001
per share, were outstanding, net of 17,503,371 shares of treasury stock.
================================================================================
HORACE MANN EDUCATORS CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
INDEX
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Independent Auditors' Review Report......................... 1
Consolidated Balance Sheets as of September 30,
2003 and December 31, 2002................................. 2
Consolidated Statements of Operations for the Three
and Nine Months Ended September 30, 2003 and 2002.......... 3
Consolidated Statements of Changes in Shareholders' Equity
for the Nine Months Ended September 30, 2003 and 2002...... 4
Consolidated Statements of Cash Flows for the Three
and Nine Months Ended September 30, 2003 and 2002.......... 5
Notes to Consolidated Financial Statements.................. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations..................... 13
Item 3. Quantitative and Qualitative Disclosures about
Market Risk............................................. 39
Item 4. Controls and Procedures.................................. 39
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders...... 40
Item 5. Other Information........................................ 40
Item 6. Exhibits and Reports on Form 8-K......................... 40
SIGNATURES.................................................................. 41
INDEPENDENT AUDITORS' REVIEW REPORT
The Board of Directors and Shareholders
Horace Mann Educators Corporation:
We have reviewed the consolidated balance sheet of Horace Mann Educators
Corporation and subsidiaries as of September 30, 2003, and the related
consolidated statements of operations and cash flows for the three-month and
nine-month periods ended September 30, 2003 and 2002, and the related
consolidated statements of changes in shareholders' equity for the nine-month
periods ended September 30, 2003 and 2002. These consolidated financial
statements are the responsibility of the Company's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with auditing standards generally accepted in the United States of
America, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such an
opinion.
Based on our review, we are not aware of any material modifications that
should be made to the consolidated financial statements referred to above for
them to be in conformity with accounting principles generally accepted in the
United States of America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of
Horace Mann Educators Corporation and subsidiaries as of December 31, 2002, and
the related consolidated statements of operations, changes in shareholders'
equity, and cash flows for the year then ended (not presented herein); and in
our report dated February 6, 2003, we expressed an unqualified opinion on those
consolidated financial statements.
/s/ KPMG LLP
KPMG LLP
Chicago, Illinois
October 30, 2003
1
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
September 30, December 31,
2003 2002
------------- -------------
(Unaudited)
ASSETS
Investments
Fixed maturities, available for sale, at
fair value (amortized cost, 2003,
$3,004,075; 2002, $2,859,007) ............... $ 3,170,074 $ 2,991,195
Short-term and other investments ............. 149,787 135,431
Short-term investments, loaned
securities collateral ....................... 433,889 3,937
------------- -------------
Total investments ......................... 3,753,750 3,130,563
Cash ............................................ 47,803 60,162
Accrued investment income and premiums receivable 96,838 99,954
Deferred policy acquisition costs ............... 182,979 174,555
Goodwill ........................................ 47,396 47,396
Value of acquired insurance in force ............ 27,245 31,945
Other assets .................................... 108,503 113,244
Variable annuity assets ......................... 1,031,852 854,470
------------- -------------
Total assets .............................. $ 5,296,366 $ 4,512,289
============= =============
LIABILITIES AND SHAREHOLDERS' EQUITY
Policy liabilities
Fixed annuity contract liabilities ........... $ 1,494,044 $ 1,385,737
Interest-sensitive life contract liabilities . 561,035 544,533
Unpaid claims and claim expenses ............. 337,977 326,575
Future policy benefits ....................... 181,927 180,577
Unearned premiums ............................ 202,346 189,384
------------- -------------
Total policy liabilities .................. 2,777,329 2,626,806
Other policyholder funds ........................ 126,542 125,108
Liability for securities lending agreements ..... 433,889 3,937
Other liabilities ............................... 249,208 228,441
Short-term debt ................................. -- --
Long-term debt .................................. 144,697 144,685
Variable annuity liabilities .................... 1,031,852 854,470
------------- -------------
Total liabilities ......................... 4,763,517 3,983,447
------------- -------------
Preferred stock, $0.001 par value, shares
authorized 1,000,000; none issued .............. -- --
Common stock, $0.001 par value, shares authorized
75,000,000; shares issued, 2003, 60,225,311;
2002, 60,194,615 ............................... 60 60
Additional paid-in capital ...................... 342,306 342,749
Retained earnings ............................... 437,760 455,308
Accumulated other comprehensive income (loss),
net of taxes:
Net unrealized gains on fixed
maturities and equity securities ............ 102,565 80,567
Minimum pension liability adjustment ......... (17,265) (17,265)
Treasury stock, at cost, 17,503,371 shares ...... (332,577) (332,577)
------------- -------------
Total shareholders' equity ................ 532,849 528,842
------------- -------------
Total liabilities and shareholders'
equity ................................ $ 5,296,366 $ 4,512,289
============= =============
See accompanying notes to consolidated financial statements.
2
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(Dollars in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Insurance premiums written
and contract deposits ........................ $ 251,436 $ 232,604 $ 705,736 $ 662,952
========== ========== ========== ==========
Revenues
Insurance premiums
and contract charges earned ............... $ 158,314 $ 155,575 $ 478,039 $ 465,461
Net investment income ...................... 45,438 47,567 138,531 147,602
Realized investment gains (losses) ......... 7,262 (13,161) 4,742 (51,856)
---------- ---------- ---------- ----------
Total revenues .......................... 211,014 189,981 621,312 561,207
---------- ---------- ---------- ----------
Benefits, losses and expenses
Benefits, claims and settlement expenses ... 148,412 112,838 388,589 338,151
Interest credited .......................... 25,915 24,527 76,770 73,117
Policy acquisition expenses amortized ...... 16,444 16,834 50,285 45,760
Operating expenses ......................... 33,013 32,326 99,433 96,316
Amortization of intangible assets .......... 2,273 1,900 4,798 4,577
Interest expense ........................... 1,552 2,286 4,656 6,717
Restructuring charges (adjustments) ........ (408) 4,223 (408) 4,223
Debt retirement costs (gains) .............. -- (785) -- 1,531
Litigation charges ......................... -- -- -- 1,581
---------- ---------- ---------- ----------
Total benefits, losses and expenses ..... 227,201 194,149 624,123 571,973
---------- ---------- ---------- ----------
Income (loss) before income taxes ............. (16,187) (4,168) (2,811) (10,766)
Income tax expense (benefit) .................. (1,921) (4,717) 1,273 (8,552)
---------- ---------- ---------- ----------
Net income (loss) ............................. $ (14,266) $ 549 $ (4,084) $ (2,214)
========== ========== ========== ==========
Net income (loss) per share
Basic ...................................... $ (0.34) $ 0.02 $ (0.10) $ (0.05)
========== ========== ========== ==========
Diluted .................................... $ (0.34) $ 0.02 $ (0.10) $ (0.05)
========== ========== ========== ==========
Weighted average number of shares
and equivalent shares (in thousands)
Basic ...................................... 42,722 40,850 42,710 40,823
Diluted .................................... 42,933 41,025 42,902 41,153
See accompanying notes to consolidated financial statements.
3
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
(Dollars in thousands, except per share data)
Nine Months Ended
September 30,
---------------------------
2003 2002
------------ ------------
Common stock
Beginning balance ............................ $ 60 $ 60
Options exercised, 2002,107,410 shares ....... -- --
Conversion of Director Stock Plan units, 2003,
30,696 shares; 2002, 10,284 shares .......... -- --
------------ ------------
Ending balance ............................... 60 60
------------ ------------
Additional paid-in capital
Beginning balance ............................ 342,749 341,052
Options exercised and conversion
of Director Stock Plan units ................ 645 2,185
Catastrophe-linked equity put
option premium .............................. (1,088) (1,088)
------------ ------------
Ending balance ............................... 342,306 342,149
------------ ------------
Retained earnings
Beginning balance ............................ 455,308 461,139
Net loss ..................................... (4,084) (2,214)
Cash dividends, 2003, $0.315 per share;
2002, $0.315 per share ...................... (13,464) (12,872)
------------ ------------
Ending balance ............................... 437,760 446,053
------------ ------------
Accumulated other comprehensive income (loss),
net of taxes:
Beginning balance ............................ 63,302 14,898
Change in net unrealized gains (losses) on
fixed maturities and equity securities ... 21,998 42,148
Increase in minimum pension liability
adjustment ............................... -- (92)
------------ ------------
Ending balance ............................... 85,300 56,954
------------ ------------
Treasury stock, at cost
Beginning and ending balance, 2003,
17,503,371 shares; 2002, 19,341,296 shares .. (332,577) (357,959)
------------ ------------
Shareholders' equity at end of period ........... $ 532,849 $ 487,257
============ ============
Comprehensive income
Net loss ..................................... $ (4,084) $ (2,214)
Other comprehensive income, net of taxes:
Change in net unrealized gains (losses) on
fixed maturities and equity securities ... 21,998 42,148
Increase in minimum pension liability
adjustment ............................... -- (92)
------------ ------------
Other comprehensive income ............. 21,998 42,056
------------ ------------
Total ............................... $ 17,914 $ 39,842
============ ============
See accompanying notes to consolidated financial statements.
4
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(Dollars in thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -------------------------
2003 2002 2003 2002
----------- ----------- ----------- -----------
Cash flows from operating activities
Premiums collected ............................... $ 175,751 $ 165,743 $ 505,127 $ 496,005
Policyholder benefits paid ....................... (129,386) (114,529) (369,099) (354,698)
Policy acquisition and
other operating expenses paid ................... (33,326) (51,385) (139,730) (156,587)
Federal income taxes paid ........................ -- -- (16,426) (10,850)
Investment income collected ...................... 46,604 50,237 139,821 151,697
Interest expense paid ............................ (961) (1,801) (3,675) (7,058)
Contribution to defined benefit
pension plan trust fund ......................... (8,780) (7,455) (8,780) (7,910)
Other ............................................ 6,215 4,643 4,671 1,682
----------- ----------- ----------- -----------
Net cash provided by operating
activities ................................... 56,117 45,453 111,909 112,281
----------- ----------- ----------- -----------
Cash flows used in investing activities
Fixed maturities
Purchases ..................................... (397,562) (286,535) (1,014,041) (1,137,965)
Sales ......................................... 204,421 98,900 419,213 782,718
Maturities .................................... 160,786 162,795 441,802 262,009
Net cash used for short-term
and other investments ........................... (37,478) (28,999) (11,148) (90,071)
----------- ----------- ----------- -----------
Net cash used in investing activities ......... (69,833) (53,839) (164,174) (183,309)
----------- ----------- ----------- -----------
Cash flows provided by (used in) financing activities
Dividends paid to shareholders ................... (4,489) (4,293) (13,464) (12,872)
Principal repayments on Bank Credit Facility ..... -- -- -- (53,000)
Exercise of stock options ........................ -- 69 -- 2,185
Catastrophe-linked equity put option premium ..... (150) (150) (1,088) (1,088)
Proceeds from issuance of Convertible Notes ...... -- -- -- 163,013
Repurchase of Senior Notes
and Convertible Notes ........................... -- (23,803) -- (80,744)
Annuity contracts, variable and fixed
Deposits ........................................ 78,008 61,804 212,288 190,243
Maturities and withdrawals .................... (22,244) (45,525) (71,725) (132,419)
Net transfer from (to) variable
annuity assets ............................... (26,080) 10,896 (75,353) (23,308)
Net decrease in life policy account balances ..... (2,050) (1,442) (10,752) (4,893)
----------- ----------- ----------- -----------
Net cash provided by (used in)
financing activities ......................... 22,995 (2,444) 39,906 47,117
----------- ----------- ----------- -----------
Net increase (decrease) in cash ..................... 9,279 (10,830) (12,359) (23,911)
Cash at beginning of period ......................... 38,524 20,858 60,162 33,939
----------- ----------- ----------- -----------
Cash at end of period ............................... $ 47,803 $ 10,028 $ 47,803 $ 10,028
=========== =========== =========== ===========
See accompanying notes to consolidated financial statements.
5
HORACE MANN EDUCATORS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2003 and 2002
(Dollars in thousands, except per share data)
Note 1 - Basis of Presentation
The accompanying unaudited consolidated financial statements of Horace Mann
Educators Corporation ("HMEC"; and together with its subsidiaries, the
"Company") have been prepared in accordance with accounting principles generally
accepted in the United States of America ("GAAP") and with the rules and
regulations of the Securities and Exchange Commission. Certain information and
note disclosures normally included in financial statements prepared in
accordance with GAAP have been condensed or omitted. The Company believes that
these financial statements contain all adjustments (consisting of normal
recurring accruals) necessary to present fairly the Company's consolidated
financial position as of September 30, 2003, the consolidated results of
operations and cash flows for the three and nine months ended September 30, 2003
and 2002 and the consolidated changes in shareholders' equity for the nine
months ended September 30, 2003 and 2002.
The subsidiaries of HMEC sell and underwrite tax-qualified retirement
annuities and private passenger automobile, homeowners, and life insurance
products, primarily to educators and other employees of public schools and their
families. The Company's principal operating subsidiaries are Horace Mann Life
Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company,
Horace Mann Property & Casualty Insurance Company and Horace Mann Lloyds.
It is suggested that these financial statements be read in conjunction with
the financial statements and the related notes included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2002.
The results of operations for the three and nine months ended September 30,
2003 are not necessarily indicative of the results to be expected for the full
year.
6
Note 2 - Stock Based Compensation
The Company grants stock options to executive officers, other employees and
directors. The exercise price of the option is equal to the fair market value of
the Company's common stock on the date of grant. Additional information
regarding the Company's stock-based compensation plans is contained in Note 6 -
Shareholders' Equity and Stock Options of the Company's Annual Report on Form
10-K for the year ended December 31, 2002. The Company accounts for stock option
grants using the intrinsic value based method in accordance with Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees," and accordingly, recognizes no compensation expense for the stock
option grants.
Alternatively, Financial Accounting Standards Board ("FASB") Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation," allows companies to recognize compensation cost for stock-based
compensation plans, determined based on the fair value at the grant dates. If
the Company had applied this alternative accounting method, net income (loss)
and net income (loss) per share would have been reduced to the pro forma amounts
indicated below:
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Net income (loss)
As reported ....................... $ (14,266) $ 549 $ (4,084) $ (2,214)
Add: Stock-based
compensation expense,
after tax, included in
reported net income ........... -- -- -- --
Deduct: Stock-based
compensation expense,
after tax, determined under
the fair value based
method for all awards (1) ..... 1,348 1,110 4,026 3,328
------------ ------------ ------------ ------------
Pro forma ...................... $ (15,614) $ (561) $ (8,110) $ (5,542)
============ ============ ============ ============
Basic net income (loss) per share
As reported ....................... $ (0.34) $ 0.02 $ (0.10) $ (0.05)
Pro forma ......................... $ (0.37) $ (0.01) $ (0.19) $ (0.13)
Diluted net income (loss)
per share
As reported ....................... $ (0.34) $ 0.02 $ (0.10) $ (0.05)
Pro forma ......................... $ (0.36) $ (0.01) $ (0.19) $ (0.13)
<FN>
(1) The fair value of each option grant was estimated on the date of grant
using the Modified Roll-Geske option-pricing model with the following
weighted average assumptions for 2003 and 2002, respectively: risk-free
interest rates of 3.8% and 5.2%; dividend yield of 3.0% and 2.0%; expected
lives of 10 years; and volatility of 28.3% and 39.2%. The nine-month
expense amounts represent three-fourths of the full year expense reflecting
options vesting during the respective calendar year. The 2003 expense
includes vesting related to options granted through September 30, 2003. The
2002 expense includes vesting related to options granted through December
31, 2002.
</FN>
7
Note 3 - Restructuring Charges
Restructuring charges were incurred and separately identified in the
Statements of Operations for the years ended December 31, 2002, 2001 and 2000,
as described in Note 2 - Restructuring Charges of the Company's Annual Report on
Form 10-K for the year ended December 31, 2002.
The Company's Consolidated Balance Sheets at September 30, 2003 and
December 31, 2002 did not reflect any accrued amounts due to the restructuring
of its Massachusetts automobile business recorded in 2001. The following table
provides information about the components of the other charges taken in 2002,
2001 and 2000, the balance of accrued amounts at December 31, 2002 and September
30, 2003, and payment activity during the nine months ended September 30, 2003.
The adjustments, recorded in the three months ended September 30, 2003, reflect
final resolution of the printing services, group insurance and credit union
marketing operations restructures as well as additional data regarding the
restructure of the property and casualty claims operations.
Original Reserve at Reserve at
Pretax December 31, September
Charge 2002 Payments Adjustments 30, 2003
------------ ------------ ------------ ------------ ------------
Charges to earnings:
Property and Casualty
Claims Operations
Employee termination costs .... $ 2,542 $ 1,929 $ 1,546 $ 56 $ 439
Additional defined benefit
pension plan costs ........... 1,179 1,179 843 (98) 238
Termination of lease
agreements ................... 502 425 197 (177) 51
------------ ------------ ------------ ------------ ------------
Subtotal ................... 4,223 3,533 2,586 (219) 728
------------ ------------ ------------ ------------ ------------
Printing Services Operations
Employee termination costs .... 409 38 40 2 --
Write-off of equipment ........ 41 -- -- -- --
------------ ------------ ------------ ------------ ------------
Subtotal ................... 450 38 40 2 --
------------ ------------ ------------ ------------ ------------
Group Insurance and Credit
Union Marketing Operations
Employee termination costs .... 1,827 291 100 (191) --
Termination of lease
agreements ................... 285 -- -- -- --
Write-off of capitalized
software ..................... 106 -- -- -- --
Other ......................... 18 -- -- -- --
------------ ------------ ------------ ------------ ------------
Subtotal ................... 2,236 291 100 (191) --
------------ ------------ ------------ ------------ ------------
Total ................... $ 6,909 $ 3,862 $ 2,726 $ (408) $ 728
============ ============ ============ ============ ============
8
Note 4 - Debt
Indebtedness outstanding was as follows:
September December
30, 2003 31, 2002
----------- -----------
Long-term debt:
1.425% Senior Convertible Notes due May 14,
2032. Aggregate principal amount of $244,500
less unaccrued discount of $128,362
(3.0% imputed rate)............................. $ 116,138 $ 116,138
6 5/8% Senior Notes, due January 15, 2006.
Aggregate principal amount of $28,600 less
unaccrued discount of $41 and $53
(6.7% imputed rate)............................. 28,559 28,547
----------- -----------
Total......................................... $ 144,697 $ 144,685
=========== ===========
Note 5 - Investments
The following table presents the composition and value of the Company's
fixed maturity securities portfolio by rating category. The Company has
classified the entire fixed maturity securities portfolio as available for sale,
which is carried at fair value.
Percent of Fair Value September 30, 2003
---------------------------- ----------------------------
Rating of Fixed September December 31, Fair Amortized
Maturity Securities (1) 30, 2003 2002 Value (2) Cost
- ----------------------- ------------ ------------ ------------ ------------
AAA ................... 38.7% 40.0% $ 1,225,971 $ 1,183,389
AA .................... 6.0 6.8 189,364 179,191
A ..................... 25.5 24.9 807,926 752,343
BBB ................... 24.0 23.7 761,521 714,733
BB .................... 2.4 2.2 74,846 73,940
B ..................... 2.5 1.3 80,107 78,756
CCC or lower .......... 0.8 1.0 26,501 17,872
Not rated (3) ......... 0.1 0.1 3,838 3,851
------------ ------------ ------------ ------------
Total .............. 100.0% 100.0% $ 3,170,074 $ 3,004,075
============ ============ ============ ============
<FN>
<F1>
(1) Ratings are as assigned primarily by Standard & Poor's Corporation ("S&P")
when available, with remaining ratings as assigned on an equivalent basis
by Moody's Investors Service, Inc. ("Moody's"). Ratings for publicly traded
securities are determined when the securities are acquired and are updated
monthly to reflect any changes in ratings.
<F2>
(2) Fair values are based on quoted market prices, when available. Fair values
for private placements and certain other securities that are infrequently
traded are estimated with the assistance of the Company's investment
advisors utilizing recognized valuation methodology, including cash flow
modeling.
<F3>
(3) This category includes $3,838 of private placement securities not rated by
either S&P or Moody's. The National Association of Insurance Commissioners
("NAIC") has rated 96.5% of these private placement securities as
investment grade.
</FN>
9
Note 5 - Investments-(Continued)
The Company reviews the fair value of all investments in its portfolio on a
monthly basis to assess whether an other-than-temporary decline in value has
occurred. These reviews, in conjunction with the Company's investment managers'
monthly credit reports and relevant factors such as (1) the financial condition
and near-term prospects of the issuer, (2) the Company's intent and ability to
retain the investment long enough to allow for the anticipated recovery in fair
value, (3) the stock price trend of the issuer, (4) the market leadership
position of the issuer, (5) the debt ratings of the issuer and (6) the cash
flows of the issuer, are all considered in the impairment assessment. A
write-down of an investment is recorded when a decline in the fair value of that
investment is deemed to be other-than-temporary, with a realized investment loss
reflected in the Statement of Operations for the period. In 2003, as a result of
these reviews, the Company recorded pretax impairment charges of $6,117, $1,943
and $1,225 for the three months ended March 31, June 30 and September 30,
respectively.
The following table presents the expected maturity of the Company's fixed
maturity securities portfolio. Expected maturities differ from contractual
maturities based on assumptions regarding borrowers' utilization of the right to
call or prepay obligations with or without call or prepayment penalties.
Fair
Percent of Total Value
---------------------------- ------------
September December September
30, 2003 31, 2002 30, 2003
------------ ------------ ------------
Due in 1 year or less .......... 9.4% 12.8% $ 297,854
Due after 1 year through
5 years ....................... 21.6 26.5 686,034
Due after 5 years through
10 years ...................... 39.7 32.7 1,257,950
Due after 10 years through
20 years ...................... 7.5 7.5 236,989
Due after 20 years ............. 21.8 20.5 691,247
------------ ------------ ------------
Total ....................... 100.0% 100.0% $ 3,170,074
============ ============ ============
The Company's investment portfolio includes no derivative financial
instruments (futures, forwards, swaps, option contracts or other financial
instruments with similar characteristics).
The Company loans fixed income securities to third parties, primarily major
brokerage firms. As of September 30, 2003 and December 31, 2002, fixed
maturities with a fair value of $433,889 and $3,937, respectively, were on loan.
Loans of securities are required at all times to be secured by collateral from
borrowers at least equal to 100% of the market value of the securities loaned.
The Company maintains effective control over the loaned securities and therefore
reports them as Fixed Maturity Securities in the Consolidated Balance Sheets.
SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities," as amended by SFAS No. 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,"
requires the securities lending collateral to be classified as investments with
a corresponding liability in the Company's Consolidated Balance Sheets.
10
Note 6 - Reinsurance
The Company recognizes the cost of reinsurance premiums over the contract
periods for such premiums in proportion to the insurance protection provided.
Amounts recoverable from reinsurers for unpaid claims and claim settlement
expenses, including estimated amounts for unsettled claims, claims incurred but
not reported and policy benefits, are estimated in a manner consistent with the
insurance liability associated with the policy. The effect of reinsurance on
premiums written and contract deposits; premiums and contract charges earned;
and benefits, claims and settlement expenses is shown below. In the three months
ended September 30, 2003, assumed amounts were negatively impacted by an
adjustment to anticipated results from state automobile reinsurance facilities.
Gross
Amount Ceded Assumed Net
------------ ------------ ------------ ------------
Three months ended
September 30,2003
- ----------------------------
Premiums written
and contract deposits ..... $ 258,740 $ 5,885 $ (1,419) $ 251,436
Premiums and contract
charges earned ............ 165,958 5,905 (1,739) 158,314
Benefits, claims and
settlement expenses ....... 152,175 3,483 (280) 148,412
Three months ended
September 30,2002
- ----------------------------
Premiums written
and contract deposits ..... $ 233,656 $ 5,009 $ 3,957 $ 232,604
Premiums and contract
charges earned ............ 159,180 7,662 4,057 155,575
Benefits, claims and
settlement expenses ....... 115,740 6,150 3,248 112,838
Nine months ended
September 30,2003
- ----------------------------
Premiums written
and contract deposits ..... $ 716,377 $ 17,331 $ 6,690 $ 705,736
Premiums and contract
charges earned ............ 489,658 17,396 5,777 478,039
Benefits, claims and
settlement expenses ....... 388,060 3,172 3,701 388,589
Nine months ended
September 30,2002
- ----------------------------
Premiums written
and contract deposits ..... $ 668,708 $ 14,603 $ 8,847 $ 662,952
Premiums and contract
charges earned ............ 480,321 25,530 10,670 465,461
Benefits, claims and
settlement expenses ....... 351,754 24,740 11,137 338,151
11
Note 7 - Segment Information
The Company conducts and manages its business through four segments. The
three operating segments, representing the major lines of insurance business,
are: property and casualty insurance, principally personal lines automobile and
homeowners insurance; annuity products, principally individual, tax-qualified;
and life insurance. The Company does not allocate the impact of corporate level
transactions to the insurance segments, consistent with management's evaluation
of the results of those segments, but classifies those items in the fourth
segment, Corporate and Other. Historically, in addition to debt service and
realized investment gains and losses, such charges have included restructuring
charges, debt retirement costs, litigation charges and the provision for prior
years' taxes. Summarized financial information for these segments is as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------------- ----------------------------
2003 2002 2003 2002
------------ ------------ ------------ ------------
Insurance premiums and
contract charges earned
Property and casualty .................. $ 130,330 $ 130,051 $ 395,758 $ 386,706
Annuity ................................ 3,828 3,487 10,561 10,907
Life ................................... 24,359 22,357 72,537 68,814
Intersegment eliminations .............. (203) (320) (817) (966)
------------ ------------ ------------ ------------
Total ............................... $ 158,314 $ 155,575 $ 478,039 $ 465,461
============ ============ ============ ============
Net investment income
Property and casualty .................. $ 7,922 $ 8,030 $ 23,893 $ 26,399
Annuity ................................ 25,966 26,281 78,106 81,192
Life ................................... 11,855 13,364 37,381 40,563
Corporate and other .................... (15) 185 24 330
Intersegment eliminations .............. (290) (293) (873) (882)
------------ ------------ ------------ ------------
Total ............................... $ 45,438 $ 47,567 $ 138,531 $ 147,602
============ ============ ============ ============
Net income (loss)
Property and casualty .................. $ (22,118) $ 5,577 $ (19,974) $ 16,016
Annuity ................................ 2,958 3,082 8,732 12,273
Life ................................... 2,044 4,401 9,556 13,552
Corporate and other .................... 2,850 (12,511) (2,398) (44,055)
------------ ------------ ------------ ------------
Total ............................... $ (14,266) $ 549 $ (4,084) $ (2,214)
============ ============ ============ ============
Amortization of intangible assets, pretax
(included in segment net income)
Value of acquired insurance in force
Annuity ............................. $ 1,867 $ 1,468 $ 3,564 $ 3,263
Life ................................ 406 432 1,234 1,314
------------ ------------ ------------ ------------
Total ............................ $ 2,273 $ 1,900 $ 4,798 $ 4,577
============ ============ ============ ============
September December
30,2003 31,2002
------------ ------------
Assets
Property and casualty ................. $ 793,327 $ 773,362
Annuity ............................... 3,281,817 2,628,083
Life .................................. 1,146,200 1,036,078
Corporate and other ................... 127,034 112,102
Intersegment eliminations ............. (52,012) (37,336)
------------ ------------
Total .............................. $ 5,296,366 $ 4,512,289
============ ============
12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollars in millions, except per share data)
Forward-looking Information
Statements made in the following discussion that state the Company's or
management's intentions, hopes, beliefs, expectations or predictions of future
events or the Company's future financial performance are forward-looking
statements and involve known and unknown risks, uncertainties and other factors.
It is important to note that the Company's actual results could differ
materially from those projected in such forward-looking statements due to, among
other risks and uncertainties inherent in the Company's business, the following
important factors:
. Changes in the composition of the Company's assets and liabilities.
. Fluctuations in the market value of securities in the Company's investment
portfolio and the related after-tax effect on the Company's shareholders'
equity and total capital through either realized or unrealized investment
losses. In addition, the impact of fluctuations in the financial markets
on the Company's defined benefit pension plan assets and the related
after-tax effect on the Company's operating expenses, shareholders' equity
and total capital.
. Prevailing interest rate levels, including the impact of interest rates on
(i) unrealized gains and losses in the Company's investment portfolio and
the related after-tax effect on the Company's shareholders' equity and
total capital, (ii) the book yield of the Company's investment portfolio
and (iii) the Company's ability to maintain appropriate interest rate
spreads over the fixed rates guaranteed in the Company's life and annuity
products.
. Defaults on interest or dividend payments in the Company's investment
portfolio due to credit issues and the resulting impact on investment
income.
. The impact of fluctuations in the capital markets on the Company's ability
to refinance outstanding indebtedness.
. The frequency and severity of catastrophes such as hurricanes, earthquakes
and storms and the ability of the Company to maintain a favorable
catastrophe reinsurance program.
. The collectibility of reinsurance receivables.
. Future property and casualty loss experience and its impact on estimated
claims and claim settlement expenses for losses occurring in prior years.
. The cyclicality of the insurance industry.
. Business risks inherent in the Company's redesign of its property and
casualty claims operation.
. The risk related to the Company's dated and complex information systems,
which are more prone to error than advanced technology systems.
. Disruptions of the general business climate, investments, capital markets
and consumer attitudes caused by geopolitical acts such as terrorism, war
or other similar events.
. The impact of a disaster or catastrophic event affecting the Company's
employees or its home office facilities and the Company's ability to
recover and resume its business operations on a timely basis.
. The Company's ability to develop and expand its agent force and its direct
product distribution systems, as well as the Company's ability to maintain
and secure product sponsorships by local, state and national education
associations.
13
. The competitive impact of new entrants such as mutual funds and banks into
the tax-deferred annuity products markets, and the Company's ability to
profitably expand its property and casualty business in highly competitive
environments.
. Changes in insurance regulations, including (i) those affecting the
ability of the Company's insurance subsidiaries to distribute cash to the
holding company and (ii) those impacting the Company's ability to
profitably write property and casualty insurance policies in one or more
states.
. Changes in federal income tax laws and changes resulting from federal tax
audits affecting corporate tax rates or taxable income.
. Changes in federal and state laws and regulations which affect the
relative tax and other advantages of the Company's life and annuity
products to customers.
. The impact of fluctuations in the financial markets on the Company's
variable annuity fee revenues, valuations of deferred policy acquisition
costs and value of acquired insurance in force, and the level of
guaranteed minimum death benefit reserves.
. The Company's ability to maintain favorable claims-paying ability,
financial strength and debt ratings.
. Adverse changes in policyholder mortality and morbidity rates.
. The resolution of legal proceedings and related matters.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP") requires
the Company's management to make estimates and assumptions based on information
available at the time the financial statements are prepared. These estimates and
assumptions affect the reported amounts of the Company's assets, liabilities,
shareholders' equity and net income. Certain accounting estimates are
particularly sensitive because of their significance to the Company's financial
statements and because of the possibility that subsequent events and available
information may differ markedly from management's judgements at the time the
financial statements were prepared. Management has discussed with the Audit
Committee the quality, not just the acceptability, of the Company's accounting
principles as applied in its financial reporting. The discussions generally
included such matters as the consistency of the Company's accounting policies
and their application, and the clarity and completeness of the Company's
financial statements, which include related disclosures. For the Company, the
areas most subject to significant management judgements include: reserves for
property and casualty claims and claim settlement expenses, reserves for future
policy benefits, deferred policy acquisition costs, value of acquired insurance
in force, valuation of investments and valuation of assets and liabilities
related to the defined benefit pension plan.
Underwriting results of the property and casualty segment are significantly
influenced by estimates of the Company's ultimate liability for insured events.
Reserves for property and casualty claims include provisions for payments to be
made on reported claims, claims incurred but not yet reported and associated
settlement expenses. The process by which these reserves are established
requires reliance upon estimates based on known facts and on interpretations of
circumstances, including the Company's experience with similar cases and
historical trends involving claim payment patterns, claim payments, pending
levels of unpaid claims and product mix, as well as other factors including
court decisions, economic conditions and public attitudes. Adjustments may be
required as information develops which varies from experience, or, in some
cases, augments data which previously were not considered sufficient for use in
determining liabilities. The effects of these adjustments may be significant and
are charged or credited to income for the period in which the adjustments are
made. Due to the nature of the Company's
14
personal lines business, the Company has no exposure to claims for toxic waste
cleanup, other environmental remediation or asbestos-related illnesses other
than claims under homeowners insurance policies for environmentally related
items such as toxic mold.
The Company completes a detailed study of property and casualty reserves
based on information available at the end of each quarter and year. Trends of
reported losses (paid amounts and case reserves on claims reported to the
Company) for each accident year are reviewed and ultimate loss costs for those
accident years are estimated. The Company engages an independent property and
casualty actuarial consulting firm to prepare an independent study of the
Company's property and casualty reserves twice a year - at June 30 and December
31.
Liabilities for future benefits on life and annuity policies are
established in amounts adequate to meet the estimated future obligations on
policies in force. Liabilities for future policy benefits on certain life
insurance policies are computed using the net level premium method and are based
on assumptions as to future investment yield, mortality and withdrawals.
Mortality and withdrawal assumptions for all policies have been based on
actuarial tables which are consistent with the Company's own experience.
Liabilities for future benefits on annuity contracts and certain long-duration
life insurance contracts are carried at accumulated policyholder values without
reduction for potential surrender or withdrawal charges. In the event actual
experience varies from the estimated liabilities, adjustments are charged or
credited to income for the period in which the adjustments are made.
The Company has established a guaranteed minimum death benefit ("GMDB")
reserve on variable annuity contracts and regularly monitors this reserve
considering fluctuations in the financial markets. At September 30, 2003 and
December 31, 2002, under GAAP, the GMDB reserve was $0.5 million and $0.8
million, respectively. The comparable reserve under statutory accounting
principles was $0.9 million and $1.6 million at the respective dates. The
Company has a relatively low exposure to GMDB because approximately 25% of
contract values have no guarantee; approximately 70% have only a return of
premium guarantee; and approximately 5% have a guarantee of premium at an annual
interest rate of 3% to 5%. The aggregate in-the-money death benefits under the
GMDB provision totaled $55 million and $115 million at September 30, 2003 and
December 31, 2002, respectively. Regarding the sensitivity of the GMDB reserve
to market fluctuations, an approximation for the impact on the GMDB is: for each
1 point of negative/positive market performance for the underlying mutual funds
of the Company's variable annuities, the GMDB reserve would currently
increase/decrease less than $0.1 million.
Policy acquisition costs, consisting of commissions, policy issuance and
other costs, which vary with and are primarily related to the production of
business, are capitalized and amortized on a basis consistent with the type of
insurance coverage. For investment (annuity) contracts, acquisition costs, and
also the value of annuity business acquired in the 1989 acquisition of the
Company ("Annuity VIF"), are amortized over 20 years in proportion to estimated
future gross profits. Capitalized acquisition costs for interest-sensitive life
contracts are also amortized over 20 years in proportion to estimated future
gross profits. The most significant assumptions that are involved in the
estimation of future gross profits include future financial market performance,
business surrender/lapse rates and the impact of realized investment gains and
losses. For the annuity segment, the Company amortizes policy acquisition costs
and the Annuity VIF utilizing a 10% reversion to the mean approach with a 200
basis point corridor around the mean. At September 30, 2003 and December 31,
2002, capitalized annuity policy acquisition costs and the Annuity VIF asset
represented approximately 3% and 4%, respectively, of the total annuity
accumulated cash value. In the event actual experience differs significantly
from assumptions or assumptions are significantly revised, the Company may be
required to record a material charge
15
or credit to amortization expense for the period in which the adjustment is
made. As noted above, there are a number of assumptions involved in the
valuation of capitalized policy acquisition costs and the Annuity VIF.
Generally, if all other assumptions are met, with regard to financial market
performance assumptions for the underlying mutual funds of the Company's
variable annuities, a 1% deviation from the targeted financial market
performance would currently impact amortization between $0.1 million and $0.2
million depending on the magnitude and direction of the deviation.
The Company's methodology of assessing other-than-temporary impairments is
based on security-specific facts and circumstances as of the date of the
reporting period. Based on these facts, if management believes it is probable
that amounts due will not be collected according to the contractual terms of a
debt security, or if the Company does not have the ability or intent to hold a
security with an unrealized loss until it matures or recovers in value, an
other-than-temporary impairment shall be considered to have occurred. As a
general rule, if the fair value of a debt security has fallen below 80% of book
value for more than six months, this security will be reviewed for an
other-than-temporary impairment. Additionally, if events become known that call
into question whether the security issuer has the ability to honor its
contractual commitments, whether or not such security has been trading above an
80% fair value to book value relationship, such security holding will be
evaluated to determine whether or not such security has suffered an
other-than-temporary decline in value.
The Company reviews the fair value of all investments in its portfolio on a
monthly basis to assess whether an other-than-temporary decline in value has
occurred. These reviews, in conjunction with the Company's investment managers'
monthly credit reports and relevant factors such as (1) the financial condition
and near-term prospects of the issuer, (2) the Company's intent and ability to
retain the investment long enough to allow for the anticipated recovery in fair
value, (3) the stock price trend of the issuer, (4) the market leadership
position of the issuer, (5) the debt ratings of the issuer and (6) the cash
flows of the issuer, are all considered in the impairment assessment. A
write-down of an investment is recorded when a decline in the fair value of that
investment is deemed to be other-than-temporary, with a realized investment loss
charged to income for the period.
A decline in fair value below amortized cost is not assumed to be
other-than-temporary for fixed maturity investments with unrealized losses due
to market conditions or industry-related events where there exists a reasonable
market recovery expectation and the Company has the intent and ability to hold
the investment until maturity or a market recovery is realized. An
other-than-temporary impairment loss will be recognized based upon all relevant
facts and circumstances for each investment, as appropriate, in accordance with
Securities and Exchange Commission Staff Accounting Bulletin ("SAB") No. 59,
"Accounting for Non-Current Marketable Equity Securities," Financial Accounting
Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS")
No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and
related guidance.
The Company's cost estimates for its defined benefit pension plan are
determined annually based on assumptions which include the discount rate,
expected return on plan assets, anticipated retirement rate and estimated lump
sum distributions. Effective April 1, 2002, participants stopped accruing
benefits under the defined benefit plan but continue to retain the benefits they
had accrued to date. A discount rate of 6.75% was used by the Company at
December 31, 2002, which was based on the average yield for long-term, high
grade securities having maturities generally consistent with the defined benefit
pension payout period. To set its discount rate, the Company looks to leading
indicators, including Moody's Aa long-term bond index. The expected annual
return on plan assets assumed by the Company at December 31, 2002 was 7.50%.
16
Management believes that it has adopted realistic assumptions for investment
returns, discount rates and other key factors used in the estimation of pension
costs and asset values. To the extent that actual experience differs from the
Company's assumptions, subsequent adjustments may be required, with the effects
of those adjustments charged or credited to income and/or shareholders' equity
for the period in which the adjustments are made.
Results of Operations
Insurance Premiums and Contract Charges
Insurance Premiums Written and Contract Deposits
Nine Months Ended Growth Over
September 30, Prior Year
--------------------------- ----------------------------
2003 2002 Percent Amount
------------ ------------ ------------ ------------
Automobile and property (voluntary) ............ $ 410.2 $ 382.1 7.4% $ 28.1
Annuity deposits ............................... 212.3 190.2 11.6% 22.1
Life ........................................... 81.5 81.5 --
------------ ------------ ------------
Subtotal - core lines .................... 704.0 653.8 7.7% 50.2
Involuntary and other property & casualty ...... 1.7 9.2 (7.5)
Excluding Massachusetts automobile .......... 1.7 7.8 (6.1)
Massachusetts automobile .................... -- 1.4 (1.4)
------------ ------------ ------------
Total .................................... $ 705.7 $ 663.0 6.4% $ 42.7
============ ============ ============
Total, excluding Massachusetts
automobile .............................. $ 705.7 $ 661.6 6.7% $ 44.1
============ ============ ============
Insurance Premiums and Contract Charges Earned
(Excludes annuity and life contract deposits)
Nine Months Ended Growth Over
September 30, Prior Year
--------------------------- ----------------------------
2003 2002 Percent Amount
------------ ------------ ------------ ------------
Automobile and property (voluntary) ............ $ 396.0 $ 376.7 5.1% $ 19.3
Excluding Massachusetts automobile .......... 396.0 367.4 7.8% 28.6
Massachusetts automobile .................... -- 9.3 (9.3)
Annuity ........................................ 10.6 10.9 -2.8% (0.3)
Life ........................................... 71.7 67.8 5.8% 3.9
------------ ------------ ------------
Subtotal - core lines .................... 478.3 455.4 5.0% 22.9
Subtotal - core lines, excluding
Massachusetts automobile ................ 478.3 446.1 7.2% 32.2
Involuntary and other property and casualty .... (0.3) 10.1 (10.4)
Excluding Massachusetts automobile .......... (0.5) 5.1 (5.6)
Massachusetts automobile .................... 0.2 5.0 (4.8)
------------ ------------ ------------
Total .................................... $ 478.0 $ 465.5 2.7% $ 12.5
============ ============ ============
Total, excluding Massachusetts
automobile .............................. $ 477.8 $ 451.2 5.9% $ 26.6
============ ============ ============
17
The Company restructured its presence in the Massachusetts automobile
market and ceased writing automobile insurance policies in that state on
December 31, 2001. Through a marketing alliance with an unaffiliated company,
The Commerce Group, Inc. ("Commerce"), the Company's agents are authorized to
offer Massachusetts customers automobile insurance policies written by Commerce.
Horace Mann agents continue to write the Company's other products in
Massachusetts, including retirement annuities and property and life insurance.
Premiums written and contract deposits for the Company's core lines
increased 7.7% compared to the prior year, resulting from rate increases in the
property and automobile lines and an increased rate of growth in new annuity
deposits in the third quarter of 2003. Voluntary property and casualty business,
a component of the Company's core lines, represents policies sold through the
Company's marketing organization and issued under the Company's underwriting
guidelines.
The Company's exclusive agent force totaled 899 at September 30, 2003,
reflecting growth of 3.5% compared to a year earlier. Of the total, 401 agents
were in their first 24 months with the Company, an increase of 12.3% compared to
September 30, 2002, with year-to-date 2003 new hires increasing 12.0% compared
to the same period a year earlier. The number of experienced agents in the agent
force, 498, was down 2.7% at September 30, 2003 compared to a year earlier, due
primarily to terminations of less-productive agents over the 12 months. In the
first nine months of 2003, average agent productivity for all lines of business
combined was comparable to the same period in 2002. Third quarter 2003 average
agent productivity improved compared to both the prior quarter and the prior
year, primarily reflecting increased annuity volume. Average agent productivity
is measured as new sales premiums from the exclusive agent force per the average
number of exclusive agents for the period. Year-to-date total sales, which
include the independent agent distribution channel, have increased 11.5%, two
thirds of which was from the increasing momentum in the Company's independent
agent distribution of annuities.
In December 2001, the North Carolina Commissioner of Insurance (the
"Commissioner") ordered a 13% reduction in private passenger automobile
insurance premium rates to be effective in April 2002. The Commissioner's Order
was in response to a request from the North Carolina Rate Bureau (the "Bureau"),
which represents the insurance industry, to increase private passenger
automobile insurance rates by 5%. The Bureau voted to appeal the Commissioner's
Order in the state appellate court and raise rates while the case is being
heard. The difference between the rates ordered by the Commissioner and the
Bureau are anticipated to have an adverse impact of approximately $350 million
for the insurance industry. The difference in rates between the Commissioner and
the Bureau must be held in an escrow account pending the court's decision. If
the court should rule in favor of the Bureau, the insurers will be entitled to
the funds previously escrowed. If the court should rule in favor of the
Commissioner, the escrowed funds plus interest will be refunded to the
policyholders. Following the April 2002 effective date, this issue negatively
impacted the Company's earned premiums and pretax income by $1.8 million for the
twelve months ended December 31, 2002. The Company's 2003 earned premiums and
pretax income are expected to be negatively impacted by approximately $2.5
million as a result of this dispute over 2002 rates. A similar dispute between
the Commissioner and the Bureau is also in process regarding 2003 rates for
policies written or renewed January through June, which requires the Company to
escrow additional amounts and is expected to have a further adverse impact on
2003 results of $0.6 million pretax. In April 2003, the Commissioner and the
Bureau reached an agreement regarding premium rates to be effective in July
2003. Because of this agreement, the Company can cease adding to the escrow for
policies written or renewing after July 1, 2003. Escrowed amounts established
for the previous disputes will be maintained until final resolution is
18
reached. During the nine months ended September 30, 2003, $2.8 million was
escrowed due to the 2002 and 2003 rate disputes.
Growth in total voluntary automobile and homeowners premium written was
7.4% for the nine months ending September 30, 2003. Voluntary automobile
insurance premium written increased 6.0% ($16.9 million) compared to the first
nine months of 2002, and homeowners premium increased 11.1% ($11.2 million). The
increase in property and casualty premiums resulted from the impact of rate
increases on average premium per policy. Average written premium was up 5% for
voluntary automobile and 14% for homeowners compared to the same period a year
earlier; average earned premium also increased 5% for voluntary automobile and
14% for homeowners. Through nine months, 2003 approved rate increases for the
Company's automobile and homeowners business were 7% and 15%, respectively. Many
of the Company's competitors are believed to have taken similar rate increases.
Over the prior 12 months and excluding a 6,000 unit decrease in Massachusetts,
automobile policies in force increased slightly compared to both September 30,
2002 and December 31, 2002, reflecting an increase in policies for educators
which more than offset a decrease in non-educator policies. There were no
Massachusetts voluntary automobile policies in force at September 30, 2003 and
December 31, 2002. Homeowners policies in force at September 30, 2003 were 6,000
less than at both September 30, 2002 and December 31, 2002, reflecting expected
reductions due to the Company's pricing and underwriting actions. At September
30, 2003, there were 574,000 voluntary automobile and 278,000 homeowners
policies in force, for a total of 852,000.
Based on policies in force, the property and casualty 12-month retention
rate for new and renewal policies was 86%, equal to the 12 months ended
September 30, 2002, despite the anticipated reductions in homeowners policies in
force and the aggressive pricing and underwriting actions implemented during the
period. The Company plans additional rate increases in 2003 and 2004 for both
its automobile and homeowners lines of business, which may have an adverse
impact on policy retention.
Involuntary property and casualty business includes allocations of business
from state mandatory insurance facilities and assigned risk business. For the
first nine months of 2003, involuntary and other property and casualty premiums
written were comparable to the prior year excluding the negative impact of an
adjustment made in the third quarter to anticipated premiums from state
mandatory insurance facilities.
In the first nine months of 2003, new annuity deposits increased 11.6%
compared to the prior year including a 26.2% increase in the third quarter. The
year-to-date growth primarily reflected a 41.6% increase in single premium and
rollover deposits partially offset by a 4.3% decrease in new scheduled annuity
deposits. New deposits to fixed accounts were 30.2%, or $30.9 million, higher
than in the first nine months of 2002 and new deposits to variable accounts
decreased 10.0%, or $8.8 million, compared to a year earlier.
Annualized new annuity sales by Horace Mann agents increased 13.5% compared
to the third quarter of 2002; resulting in nine month growth of 4.8% compared to
the prior year. Total new annuity sales increased 51.7% and 17.3% for the
quarter and nine months, respectively, including Horace Mann's independent agent
distribution initiative. Ongoing production from independent agents has shown
steady sequential growth for each month in 2003, with strong growth in the third
quarter.
19
In 2001, the Company began building a nationwide network of independent
agents who will comprise a second distribution channel for the Company's 403(b)
tax-qualified annuity products. The independent agent distribution channel,
which included 433 authorized agents at September 30, 2003, generated $21.0
million in annualized Horace Mann annuity contract deposits during the first
nine months of 2003, compared to $7.2 million in the same period last year and
$10.5 million for the full year 2002. A significant portion of the 2002 amount,
over $6 million, was produced as a result of Horace Mann being named as one of
four providers for fixed and variable annuity options to Chicago, Illinois
public school employees and the Company's partnering with an independent
broker/dealer having two decades of experience in providing retirement planning
services to Chicago Public School employees.
Fixed accumulated cash value for annuities was $1.6 billion at September
30, 2003, $142.9 million, or 9.7%, more than a year earlier. Fixed accumulated
cash value retention for the 12 months ended September 30, 2003 was 94.9%, 0.8
percentage points better than the prior year. Variable accumulated deposit
retention of 92.4% for the twelve months ended September 30, 2003, impacted by
financial market performance, decreased 0.1% percentage point compared to a year
earlier. Variable accumulated funds on deposit at September 30, 2003 were $1.0
billion, a $214.1 million, or 26.2%, increase from the prior year. The number of
annuity contracts outstanding increased 4.2%, or 6,000 contracts, compared to
September 30, 2002.
For the nine months ended September 30, 2003, annuity segment contract
charges earned decreased 2.8%, or $0.3 million, compared to the same period a
year earlier. Declines in market valuations during 2002 and the first quarter of
2003 resulted in lower variable accumulated balances in force against which
contract charges are principally applied. Market appreciation in the second and
third quarters of 2003, however, resulted in variable annuity accumulated
balances at September 30, 2003 which were 26.2%, or $214.1 million, higher than
at September 30, 2002.
Life segment premiums and contract deposits for the first nine months of
2003 were equal to a year earlier. The life insurance in force lapse ratio was
8.1% for the twelve months ended September 30, 2003 compared to 9.4% for the
same period last year. The lapse ratio improved for both the term and whole life
portions of the business compared to the prior year.
Consistent with the Company's Value Proposition and overall strategy to
meet a broader array of consumer financial needs, the product portfolio that the
Company's agents can offer was expanded through two new marketing alliances. The
first is with Jefferson Pilot Financial for universal life insurance. Jefferson
Pilot was a leading issuer of universal life policies in the U.S. for 2002. The
second alliance is with American Funds for retail mutual funds. Both product
rollouts began in the second quarter of 2003 and are intended to help the
Company reach more educators while deepening relationships with existing
clients.
Net Investment Income
Pretax investment income of $138.5 million for the nine months ended
September 30, 2003 decreased 6.2%, or $9.1 million, (4.9%, or $4.9 million,
after tax) compared to the prior year as a decline in the portfolio yield and
lost income related to investment credit issues in 2002 offset growth in the
size of the investment portfolio. Average investments (excluding the securities
lending collateral) increased 5.7% over the past 12 months. The average pretax
yield on the investment portfolio was 6.0% (4.1% after tax) for the first nine
months of 2003 compared to a pretax yield of 6.8% (4.5% after tax) a year
earlier. Through the remainder of 2003, investment
20
income is expected to continue to be under pressure due to lower interest rates
and the continuing impact of investment credit issues in 2002.
Realized Investment Gains and Losses
Net realized investment gains were $4.7 million for the nine months ended
September 30, 2003 compared to realized investment losses of $51.9 million in
the prior year period. For the first nine months of 2003, the Company recorded
fixed income security impairment charges totaling $9.3 million, $3.0 million
related to one of the Company's collateralized debt obligation ("CDO")
securities, $3.1 million related to one manufactured housing asset-backed
security and the remaining $3.2 million primarily related to two airline
industry issuers. In the third quarter of 2002, $13.2 million of realized
investment losses were recorded, in large part from the impairment of fixed
income securities issued by companies in the communications sector, primarily
Qwest Communications International Inc. and the NTL companies. By September 30,
2002, the Company had sold all of its holdings of securities issued by WorldCom,
Inc. In the second quarter of 2002, $41.3 million of realized investment losses
were recorded which included a loss of $19.4 million related to the sale and
impairment of securities issued by WorldCom, Inc. Additionally, impairment
losses of $21.2 million were recognized in the second quarter of 2002 relating
primarily to holdings of fixed income securities of other companies in the
communications sector. The first quarter of 2002 included impairment charges of
$9.9 million related to fixed income securities issued by two telecommunications
companies and a realized investment loss of $2.0 million from the Company's sale
of all of its holdings in securities issued by Kmart Corporation. Net realized
investment gains and losses for the respective periods also reflected gains
realized from ongoing investment portfolio management activity.
21
The table below presents the Company's fixed maturity securities portfolio
as of September 30, 2003 by major asset class, including the ten largest sectors
of the Company's corporate bond holdings.
Pretax
Number of Fair Amortized Unrealized
Issuers Value Cost Gain(Loss)
------------ ----------- ------------ ------------
Corporate bonds
Banking and Finance ................. 36 $ 300.3 $ 271.7 $ 28.6
Energy .............................. 38 229.6 211.7 17.9
Food and Beverage ................... 27 143.9 137.0 6.9
Utilities ........................... 20 141.1 135.7 5.4
Telecommunications .................. 18 108.4 95.6 12.8
Transportation ...................... 13 85.6 83.8 1.8
Broadcasting and Media .............. 24 79.5 72.6 6.9
Industry, Manufacturing ............. 12 74.2 71.3 2.9
Insurance ........................... 11 81.7 73.4 8.3
Real Estate ......................... 7 63.4 59.0 4.4
Automobiles ......................... 5 53.7 52.3 1.4
All Other Corporates (1) ............ 101 409.4 385.8 23.6
------------ ------------ ------------ ------------
Total corporate bonds ............ 312 1,770.8 1,649.9 120.9
Mortgage-backed securities
Government .......................... 451 539.5 526.0 13.5
Other ............................... 9 45.9 42.2 3.7
Municipal bonds ........................ 164 460.3 439.3 21.0
Government bonds
U.S. ................................ 5 217.2 209.2 8.0
Foreign ............................. 8 36.5 33.2 3.3
Collateralized debt obligations (2) .... 11 73.7 78.6 (4.9)
Asset-backed securities ................ 10 26.2 25.7 0.5
------------ ------------ ------------ ------------
Total fixed maturity securities .. 970 $ 3,170.1 $ 3,004.1 $ 166.0
============ ============ ============ ============
- ----------
<FN>
<F1>
(1) The All Other Corporates category contains 16 additional industry
classifications. Defense, chemicals, paper, retail, health care and cable
represented $258.0 million of fair value at September 30, 2003, with the
remaining 10 classifications each representing less than $28 million of the
fair value at September 30, 2003.
<F2>
(2) Each of the securities was rated investment grade by Standard and Poor's
Corporation and/or Moody's Investors Service, Inc. at September 30, 2003.
</FN>
22
The asset-backed security initially impaired in the second quarter of 2003
and further impaired in the third quarter of 2003 was issued by Green Tree
Financial and the corporate bond securities impaired in the first quarter of
2003 were issued by Northwest Airlines, Delta Air Lines and UnumProvident, an
insurance carrier. The securities issued by Northwest Airlines and UnumProvident
were sold in the second quarter of 2003. As of September 30, 2003, the Delta
holdings represented the only remaining exposure to the airline sector in the
Company's investment portfolio with a fair value of $2.5 million. In addition,
one CDO security was impaired in the first quarter. As discussed below, the
Company consolidated the management of its fixed maturity securities portfolio
in March 2003. As part of the transition to a single manager, BlackRock, Inc.,
completed a comprehensive appraisal and evaluation of the transferred CDO
holdings, which resulted in the first quarter impairment. The securities
impaired in the third quarter of 2002, including some increases to previously
recorded impairments, included seven communications companies (Qwest, NTL,
Charter Communications, International Cabletel, Telewest, Diamond Cable, and IGC
Holdings) and one energy company (Mirant). The securities impaired in the second
quarter of 2002 included four telecommunications companies (WorldCom, partial
sale of Qwest, Western Wireless, and American Tower) and three cable companies
(Adelphia, Century Communications, and Telewest). Petrozuata Finance, which had
declined in value due to political risk associated with Venezuela, was also
impaired in the second quarter of 2002. Securities issued by two companies in
the telecommunications sector (NTL and Diamond Cable) were impaired in the first
quarter of 2002. In each of the periods, the impaired securities were marked to
fair value, and the write-downs were recorded as realized investment losses in
the Statement of Operations. These impairments were deemed to be
other-than-temporary for one or more of the following reasons: the recovery of
full value was not likely, the issuer defaulted or was likely to default due to
the need to restructure its debt, or the Company had an intent to sell the
security in the near future.
23
At September 30, 2003, the Company's diversified fixed maturity portfolio
consisted of 1,179 investment positions and totaled approximately $3.2 billion
in fair value. The portfolio was 94.2% investment grade, based on fair value,
with an average quality rating of A+. At September 30, 2003, the portfolio had
approximately $16 million pretax of total gross unrealized losses related to 105
positions. At December 31, 2002, the total pretax gross unrealized losses were
approximately $27 million related to 137 positions. The following table provides
information regarding fixed maturity securities that had an unrealized loss at
September 30, 2003, including the length of time that the securities have
continuously been in an unrealized loss position.
Investment Positions With Unrealized Losses Segmented by Quality
and Period of Continuous Unrealized Loss
As of September 30, 2003
Pretax
Number of Fair Amortized Unrealized
Positions Value Cost Loss
--------- ------- --------- ----------
Investment grade
6 Months or less ................. 51 $ 289.1 $ 296.0 $ (6.9)
7 through 12 months .............. 9 50.3 53.6 (3.3)
13 through 24 months ............. 6 33.7 36.1 (2.4)
25 through 36 months ............. 1 7.8 8.4 (0.6)
37 through 48 months ............. -- -- -- --
Greater than 48 months ........... 2 4.7 5.0 (0.3)
--------- ------- --------- ----------
Total ......................... 69 $ 385.6 $ 399.1 $ (13.5)
========= ======= ========= ==========
Non-investment grade
6 Months or less ................. 27 $ 27.9 $ 28.4 $ (0.5)
7 through 12 months .............. -- -- -- --
13 through 24 months ............. -- -- -- --
25 through 36 months ............. 1 5.5 6.1 (0.6)
37 through 48 months ............. -- -- -- --
Greater than 48 months ........... 2 11.8 13.0 (1.2)
--------- ------- --------- ----------
Total ......................... 30 $ 45.2 $ 47.5 $ (2.3)
========= ======= ========= ==========
Not rated
Total, all 13 through 24 months 6 $ 2.6 $ 2.6 *
========= ======= ========= ==========
Grand total ................ 105 $ 433.4 $ 449.2 $ (15.8)
========= ======= ========= ==========
- ----------
* Less than $0.1 million
Of the securities with unrealized losses, no issuers had pretax unrealized
losses greater than $2 million and securities of only one issuer were trading
below 80% of book value at September 30, 2003. The Company views the decrease in
value of all of the securities with unrealized losses at September 30, 2003 as
temporary, expects recovery in fair value, anticipates continued payments under
the terms of the securities, and has the intent and ability to hold these
securities until maturity or a recovery in fair value occurs. Therefore, no
impairment of these securities was recorded at September 30, 2003. Future
changes in circumstances related to these securities could require subsequent
impairment of their value.
24
Historically, the Company's investment guidelines limited single corporate
issuer exposure to 1% of invested assets. Effective in the third quarter of
2002, the Company revised its guidelines to limit the single corporate issuer
exposure to 4.0% (after tax) of shareholders' equity for "AA" or "AAA" rated
securities, 2.5% (after tax) of shareholders' equity for "A" rated securities,
2.0% (after tax) of shareholders' equity for "BBB" rated securities, and 1.0%
(after tax) of shareholders' equity for non-investment grade securities.
Additional sub-sector limitations were also developed as part of the revised
guidelines. The change in the investment guidelines was immediately effective
for new purchases of securities. It is anticipated that the existing portfolio
will be brought into substantial compliance with the new guidelines by the end
of 2003.
The Company's investments are managed by outside managers and advisors
which follow the investment guidelines established by the Company. In
conjunction with the review of investment guidelines, the Company also
periodically reviews its overall investment program and the performance of its
investment managers. Effective in March 2003, the Company consolidated the
management of its fixed maturity securities portfolio with BlackRock, with the
exception of a small portion allocated to a specialty high-yield manager.
BlackRock has managed a portion of the Company's fixed maturity securities
portfolio since 1994. Effective in July 2003, the Company transferred the
management of its high yield investment portfolio to Shenkman Capital
Management, Inc.
Benefits, Claims and Settlement Expenses
Nine Months Ended Growth Over
September 30, Prior Year
------------------ ---------------------
2003 2002 Percent Amount
-------- -------- --------- --------
Property and casualty.............. $ 353.0 $ 305.7 15.5% $ 47.3
Annuity............................ 0.7 1.9 -63.2% (1.2)
Life............................... 34.9 30.6 14.1% 4.3
-------- -------- --------
Total........................... $ 388.6 $ 338.2 14.9% $ 50.4
======== ======== ========
Property and casualty
statutory loss ratio (1):
Before catastrophe losses....... 84.0% 78.0% 6.0%
After catastrophe losses........ 88.8% 79.6% 9.2%
Impact of litigation charges (2) -- 0.4% -0.4%
- ----------
(1) For additional information, see footnote (2) to the table under "Net
Income."
(2) Under statutory accounting practices, the $1.6 million litigation charge is
reflected in property and casualty claims and settlement expenses. On a
GAAP basis, this item is reported separately in the Statement of Operations
as litigation charges in the Corporate and Other segment.
For the first nine months of 2003, the voluntary automobile statutory loss
ratio increased compared to the first nine months of 2002 primarily reflecting
adverse development of prior years' reserves and strengthening of reserves for
the current accident year, as described below. The Company's benefits, claims
and settlement expenses also reflected underlying improvement in the homeowners
statutory loss ratio as a result of loss containment initiatives and the
favorable impact of rate increases on earned premiums which was offset by an
increase in catastrophe and other weather-related losses.
25
Excluding involuntary business, net adverse development of reserves for
property and casualty claims occurring in prior years was $43.8 million for the
first nine months of 2003, primarily related to automobile liability loss
reserves from the 2001 and 2002 accident years, compared to adverse reserve
development of $8.6 million in the prior year which was primarily related to
loss adjustment expense and educator excess professional liability reserves and
also included $1.6 million due to a provision for the costs of resolving class
action lawsuits related to diminished value brought against the Company. Total
reserves for property and casualty claims occurring in prior years, including
involuntary business, were strengthened $44.3 million in the current year
compared to strengthening of $8.8 million for the nine months ended September
30, 2002. The Company's property and casualty reserves were $308 million and
$273 million at September 30, 2003 and 2002, respectively, net of anticipated
reinsurance recoverables.
Over the 18 months ended September 30, 2003, the Company made changes in
its property and casualty claims function including hiring of new management and
claim adjusters (new hires represented 175 of the Company's 300 claims employees
at September 30, 2003), implementing improved processes and consolidating the
previous 17 branch offices into 6 regional claims offices, which began in
late-November 2002 and was completed in the first quarter of 2003. Installation
and implementation of the new claims administration system, including related
process changes, occurred in the third quarter of 2003 in the first claims
office with the remaining five offices planned for the last quarter of 2003 and
the first half of 2004.
As part of the claims redesign effort, open claim files are being reviewed
by the new team, including a reassessment of reserves on older cases. In the
first half of 2003, these reassessments resulted in a re-estimated ultimate
liability for claims from accident years 2001, 2000 and 1999 and prior that was
higher than the amount previously established. The high level of property and
casualty paid and case reserve activity on older bodily injury claims that was
observed in the second quarter of 2003 continued in the third quarter -- across
all prior accident years -- as the Company's new claims organization intensified
their efforts to bring older claims files up to date. Furthermore, the
acceleration of claim disposition rates extended into the third quarter, as the
new organization also moved to reduce the backlog of older claims and handle
current claims on a timely basis. These actions resulted in a continuation in
the third quarter of the high level of adverse reserve development experienced
in the second quarter of 2003.
While the Company has begun to realize improvements in its claims handling
process and is confident in the ultimate benefits to be gained from the redesign
of its claims operation, those benefits have not been realized as quickly as the
Company had originally anticipated. In addition, the estimation of claims costs,
settlement rates and severity has been complicated in recent quarters due to the
degree of change involved. As a result of these factors, and in light of the
pattern of adverse prior years' reserve development observed over the last five
quarters, the Company's management has retained independent property and
casualty actuarial and claims consultants from Deloitte & Touche LLP to conduct
a review of the Company's claims operations and reserving processes. This review
is in addition to the Company's regularly scheduled independent reserve studies.
This review will include an evaluation of claim files and claim handling
processes and procedures (including case reserving and establishment of
supplemental and IBNR reserves) and will help management understand the
continuing adverse reserve development as well as provide perspective on future
expectations and reserving implications. Completion of this independent review
is targeted for January 2004. While further adjustments to the Company's
reserves may be necessary based on this study, the September 30, 2003 held
reserves of $308 million were established toward what management, and its
independent advisors, believe to be the high end of a reasonable range. In
addition to the adverse development of prior years' reserves, the Company's
September 30, 2003 held reserves also
26
reflected strengthening of current accident year reserves by approximately $8
million in the third quarter.
The following table quantifies the amount of first quarter 2003, second
quarter 2003 and third quarter 2003 adverse/(favorable) development for each
line of business and the accident years to which the re-estimates relate:
Other
Voluntary Total Property &
Total Automobile Property Casualty
--------- ---------- ---------- ----------
Three months ended
March 31, 2003
- ----------------------------
Accident Years:
2002 .................... $ 0.8 $ 1.1 $ (0.9) $ 0.6
2001 .................... 1.4 1.7 0.6 (0.9)
2000 & Prior ............ 2.1 2.8 (0.1) (0.6)
--------- ---------- ---------- ----------
Total ................ $ 4.3 $ 5.6 $ (0.4) $ (0.9)
========= ========== ========== ==========
Three months ended
June 30, 2003
- ----------------------------
Accident Years:
2002 .................... $ 5.8 $ 6.4 $ (0.6) $ --
2001 .................... 0.7 1.0 (0.3) --
2000 & Prior ............ 3.4 2.8 0.2 0.4
--------- ---------- ---------- ----------
Total ................ $ 9.9 $ 10.2 $ (0.7) $ 0.4
========= ========== ========== ==========
Three months ended
September 30, 2003
- ----------------------------
Accident Years:
2002 .................... $ 12.9 $ 10.7 $ 1.3 $ 0.9
2001 .................... 8.8 9.0 0.2 (0.4)
2000 & Prior ............ 8.4 7.7 0.1 0.6
--------- ---------- ---------- ----------
Total ................ $ 30.1 $ 27.4 $ 1.6 $ 1.1
========= ========== ========== ==========
For the first nine months of 2003, incurred catastrophe losses for all
lines were $19.2 million compared to $6.0 million for the same period in the
prior year, with the increase generating approximately 5 percentage points of
the increase in the property and casualty statutory loss ratio. Claims from
Hurricane Isabel, primarily in the homeowners line, represented $4.0 million of
the losses and occurred in the third quarter of 2003. In addition to the
catastrophes, widespread severe weather primarily in the second quarter of 2003
resulted in an increase in non-catastrophe weather-related losses, which
generated approximately 1 percentage point of the increase in the property and
casualty statutory loss ratio.
Including the higher level of weather-related losses, the property
statutory loss ratio of 87.7% for the first nine months of 2003 increased 3.9
percentage points compared to the same period in 2002. Higher catastrophe losses
in the current period accounted for a 10.2 percentage point increase in the loss
ratio compared to the prior year while non-catastrophe weather losses increased
the ratio by approximately 3 percentage points. These adverse impacts were
partially offset by an increase in average premium per policy and loss
containment initiatives.
27
The voluntary automobile statutory loss ratio was 88.5% for the first nine
months of 2003 compared to 76.8% for the same period last year. The statutory
loss ratio in the current period included 14.8 percentage points due to adverse
development of prior years' reserves compared to an impact of 1.9 percentage
points a year earlier.
The annuity benefits in the first nine months of 2003 and 2002 reflected
mortality charges for annuity contracts on payout status. In addition, annuity
benefits in both years included changes in the GMDB reserve on variable annuity
contracts due to fluctuations in the financial markets. For the first nine
months of 2003, the GMDB reserve decreased $0.3 million, while the reserve
increased $0.7 million in the first nine months of 2002.
Life mortality costs in the current period increased slightly compared to a
year earlier, however they continue to be within an expected range.
As disclosed in the Company's Annual Report on Form 10-K for 2002, early in
2001 management discovered deficiencies in the tax compliance testing procedures
associated with certain of the Company's life insurance policies that could
jeopardize the tax status of some of those life policies. Deficiencies in the
Company's computer-based monitoring of premiums, combined with the complexity of
certain of the Company's life insurance products, resulted in the acceptance of
too much premium for certain policies under the applicable tax test the Company
was using. As a result of this discovery, the Company retained outside experts
to assist with the investigation and remediation of this issue. The deficiencies
in the testing procedures related to compliance with Internal Revenue Code
("IRC") Section 7702 (Definition of Life Insurance) were identified and
corrected. Such a problem is not uncommon in the life insurance industry and the
Company pursued a remedy following Internal Revenue Service ("IRS") procedures
that have been established to address this type of situation. The Company
recorded $2.0 million of policyholder benefits in the Corporate and Other
segment in the fourth quarter of 2001, as well as $1.0 million of operating
expense, which represented the Company's best estimate of the costs to the
Company to resolve these problems. In July 2003, the Company entered into
agreements with the IRS resolving its compliance with IRC Section 7702
(Definition of Life Insurance). The accrual established at December 31, 2001 was
adequate to cover these costs.
The Company is in the process of identifying and correcting any related
deficiencies in the testing procedures and quantifying any potential exposure
associated with IRC Section 7702A (Modified Endowment Contracts). The Company
recorded $0.8 million of operating expense in the Corporate and Other segment in
the second quarter of 2003 which represents its current best estimate of the
costs to the Company to complete this correction and assessment process. By the
end of 2004, the Company expects to determine if any IRS filings are required
under Section 7702A.
Interest Credited to Policyholders
Nine Months Ended Growth Over
September 30, Prior Year
------------------- ----------------------
2003 2002 Percent Amount
-------- -------- --------- ---------
Annuity .................... $ 53.2 $ 50.8 4.7% $ 2.4
Life ....................... 23.6 22.3 5.8% 1.3
-------- -------- --------- ---------
Total ................... $ 76.8 $ 73.1 5.1% $ 3.7
======== ======== ========= =========
28
The increase in annuity segment interest credited reflected an 8.9%
increase in average accumulated fixed deposits, partially offset by a decline in
the average annual interest rate credited of 21 basis points compared to the
first nine months of 2002. Life insurance interest credited increased as a
result of the growth in interest-sensitive life insurance reserves.
Operating Expenses
For the first nine months of 2003, operating expenses increased $2.9
million, or 3.0%, compared to the prior year. The current period included an
increase in investments in technology and property and casualty underwriting
initiatives.
In 2001, the Company determined that it would freeze its defined benefit
pension plan in 2002 and move to a defined contribution structure. Costs of
transitioning to the new structure, based upon assumptions of future events,
were $6.2 million in 2002 and are currently estimated to be approximately $5.5
million for 2003. These costs are largely as a result of settlement accounting
provisions that are expected to be triggered as a result of the higher
retirement rate currently being experienced by the Company, coupled with more
retirees choosing lump sum distributions, and the impact of declines in the
market value of the pension plan's assets.
The Company's policy with respect to funding the defined benefit pension
plan is to contribute amounts which are actuarially determined to provide the
plan with sufficient assets to meet future benefit payments consistent with the
funding requirements of federal laws and regulations. In 2002, the Company
contributed $7.9 million to the defined benefit pension plan, which was greater
than the $1.8 million actuarially-determined required minimum amount, reflecting
a degree of conservatism which the Company believed to be appropriate in light
of the current volatility in the financial markets. In September 2003, the
Company contributed $8.8 million to the defined benefit pension plan, with the
entire amount being in excess of the required minimum amount based on
assumptions at the time of this Report on Form 10-Q. All defined benefit pension
plan investments have been set aside in a trust fund.
The property and casualty statutory expense ratio of 22.7% for the nine
months ended September 30, 2003 was 1 percentage point lower than the same
period a year earlier primarily as a result of the non-recurring charge related
to the restructure of the property and casualty claims operation which
represented 1.1 percentage points of the expense ratio in 2002.
Amortization of Policy Acquisition Expenses and Intangible Assets
For the first nine months of 2003, the combined amortization of policy
acquisition expenses and intangible assets was $55.1 million compared to $50.4
million recorded for the same period in 2002.
Amortization of intangible assets was $4.8 million for the nine months
ended September 30, 2003 compared to $4.6 million for the same period in 2002.
The valuations of annuity value of business acquired in the 1989 acquisition of
the Company ("Annuity VIF") resulted in increases in amortization of $0.8
million and $0.4 million for the nine months ended September 30, 2003 and 2002,
respectively.
Policy acquisition expenses amortized for the nine months ended September
30, 2003 of $50.3 million were $4.5 million more than the prior year, primarily
related to the property and casualty segment. Over the past 12 months, this
segment has experienced accelerated growth in new business and the acquisition
cost amortization period matches the terms of the insurance policies (six and
twelve months). The increase in amortization for the property and casualty
29
segment was partially offset by a $0.3 million decrease in amortization for the
annuity and life segments combined, primarily as a result of the current year
valuation compared to the impact of the 2002 valuation. For the annuity segment,
the current year valuation decreased amortization $1.2 million compared to an
increase of $0.8 million in 2002. The current year valuation had no year-to-date
impact on amortization for the life segment compared to a decrease of $0.9
million in the prior year.
Income Tax Expense
The effective income tax rate on the Company's pretax loss, including
realized investment gains and losses, was a tax of 46.4% for the nine months
ended September 30, 2003 compared to a benefit of 79.6% a year earlier. In the
third quarter of 2003, the Company revised its estimated 2003 annual effective
income tax rate on income before realized investment gains and losses to
approximately 3% compared to the prior estimate of 26%, reflecting the property
and casualty net loss recorded in the current period.
Income from investments in tax-advantaged securities reduced the effective
income tax rate 132.4 and 24.4 percentage points for the nine months ended
September 30, 2003 and 2002, respectively. While the amount of income from
tax-advantaged securities in the current year increased somewhat compared to the
prior year, the reduced level of income before income taxes in the current
period resulted in this having a more significant impact on the effective income
tax rate.
Net Income
For the first nine months of 2003, the Company reported a net loss of $4.1
million, or $0.10 per share, compared to a net loss of $2.2 million, or $0.05
per share, for the first nine months of 2002. In the current period, the net
loss was driven by adverse development and strengthening of property and
casualty reserves. Realized investment losses, primarily related to fixed income
securities of companies in the communications sector, significantly impacted the
nine month net loss in 2002.
For the nine months ended September 30, 2003, net income was unfavorably
affected by adverse development of property and casualty prior years' reserves,
which resulted in a pretax charge of $44.3 million for the nine months, $30.1
million of which was recorded in the third quarter. Net income comparisons to
the prior year were also negatively impacted by severe weather experienced in
the current period and by lower interest rates and decreases in investment
income related to investment credit issues experienced in 2002. These negative
prior year comparisons were partially offset by the impact of property and
casualty rate increases, underwriting initiatives and the Company's
restructuring of its Massachusetts automobile business.
30
Net income (loss) by segment and net income (loss) per share were as
follows:
Nine Months Ended Growth Over
September 30, Prior Year
------------------- -----------------
2003 2002 Percent Amount
-------- -------- ------- -------
Net income (loss)
Property & casualty
Before catastrophe losses .......... $ (7.6) $ 20.0 $ (27.6)
Catastrophe losses, after tax ...... (12.4) (3.9) (8.5)
-------- -------- -------
Total including catastrophe
losses ......................... (20.0) 16.1 (36.1)
Annuity ............................ 8.7 12.3 -29.3% (3.6)
Life ............................... 9.6 13.5 -28.9% (3.9)
Corporate and other (1) ............ (2.4) (44.1) 41.7
-------- -------- -------
Total ........................... $ (4.1) $ (2.2) $ (1.9)
======== ======== =======
Net income (loss) per share, diluted... $ (0.10) $ (0.05) $ (0.05)
======== ======== =======
Property and casualty
statutory combined ratio (2):
Before catastrophe losses .......... 106.7% 101.7% 5.0%
After catastrophe losses ........... 111.5% 103.3% 8.2%
Expense ratio impact of
restructuring charges (3) ......... -- 1.1% -1.1%
Loss ratio impact of
litigation charges (4) ............ -- 0.4% -0.4%
- ----------
(1) The Corporate and Other segment includes interest expense on debt, realized
investment gains and losses and other corporate level items. The Company
does not allocate the impact of corporate level transactions to the
insurance segments, consistent with management's evaluation of the results
of those segments.
(2) Consistent with management's evaluation of the property and casualty
operations, the combined ratio, which is the sum of the loss ratio and the
expense ratio, is computed based on financial information prepared in
accordance with statutory accounting principles and as reported to state
insurance departments. Expenses are divided by net written premiums.
Statutory expenses differ from GAAP expenses primarily with regard to
policy acquisition costs, which are not deferred and amortized for
statutory purposes, but rather recognized as incurred. The sum of losses
and loss adjustment expenses incurred is divided by net earned premiums.
Property and casualty statutory net written premiums and net earned
premiums differ from the comparable GAAP amounts primarily with regard to
the classification of certain service fees and escrowed amounts.
(3) Under statutory accounting practices, the $4.2 million restructuring charge
is reflected in property and casualty operating expenses. On a GAAP basis,
this item is reported separately in the Statement of Operations as
restructuring charges in the Corporate and Other segment.
(4) See footnote (2) on page 25.
As discussed above, adverse development of prior years' reserves,
strengthening of reserves for the current accident year and severe weather were
the primary drivers of the decrease in property and casualty net income for the
first nine months of 2003 compared to a year earlier. The Company is continuing
to approach the pricing and underwriting of its property and casualty products
aggressively to accelerate margin recovery.
31
The property and casualty statutory combined ratio increased 8.2 percentage
points compared to the first nine months of 2002. Adverse development of prior
years' reserves represented 11.1 percentage points of the statutory combined
ratio in the current period compared to 2.3 percentage points in the prior year,
an increase of 8.8 percentage points. In addition, severe weather resulted in
increases in the combined ratio of 3.2 percentage points related to catastrophe
losses and approximately 1 percentage point related to non-catastrophe
weather-related losses.
Annuity segment net income in the first nine months of 2003 decreased $3.6
million compared to the prior year. Annuity segment net income in 2002 benefited
from a reduction in federal income taxes, due to an updated estimate of the 2002
tax rate. On a pretax basis, income decreased $3.7 million compared to the first
nine months of 2002. Current year income was adversely impacted by a reduction
in the pretax net interest margin of $5.5 million, reflecting lower investment
income due to lower interest rates and investment credit issues in 2002. In
addition, as discussed above, valuation of annuity segment deferred acquisition
costs and value of acquired insurance in force at September 30, 2003 resulted in
a slight reduction in amortization compared to a $1.2 million increase resulting
from similar valuations a year earlier. A decrease in the GMDB reserves
increased current year pretax income by $0.3 million compared to a decrease in
pretax income of $0.7 million a year earlier. For the third quarter of 2003, fee
income related to variable annuity deposits increased $0.4 million compared to
the prior year due primarily to favorable equity market performance over the
second and third quarters. On a year-to-date basis, fee income was slightly
below the nine months ended September 30, 2002.
Life segment net income decreased $3.9 million compared to the first nine
months of 2002, reflecting a decline in investment income and an increase in
mortality costs. Valuation of life segment deferred acquisition costs at
September 30, 2003 resulted in no change in amortization for the nine months. In
the prior year, a similar valuation resulted in a reduction in amortization of
$0.9 million pretax.
The decrease in the net loss for the Corporate and Other segment compared
to last year primarily reflected the significant reduction in realized
investment losses, including impairment charges, compared to the first nine
months of 2002. Interest expense on the Company's outstanding debt decreased
compared to the prior year, reflecting refinancing transactions completed in the
last eight months of 2002.
In May and September 2002, the Company used a portion of the proceeds from
the sale of its Convertible Notes to repay the balance outstanding under the
previous Bank Credit Agreement and repurchase $61.2 million of its outstanding
Senior Notes and $40.0 million aggregate principal amount, $19.0 million
carrying value, of its outstanding Senior Convertible Notes. The debt retirement
resulted in a pretax charge of $1.5 million for the nine months. In June 2002,
the Company recorded a pretax charge of $1.6 million to income, representing the
Company's best estimate of the costs of resolving class action lawsuits related
to diminished value brought against the Company. In addition, in the third
quarter of 2002 the Company recorded a pretax charge of $4.2 million due to
restructuring of its property and casualty claim operations. These three charges
were reflected in the Corporate and Other net loss for the nine months ended
September 30, 2002.
Return on shareholders' equity based on net income was 2% for the 12 months
ended September 30, 2003.
32
At the time of this Quarterly Report on Form 10-Q, management anticipates
that 2003 full year net income before realized investment gains and losses will
be within a range of $0.30 to $0.40 per share assuming a normal level of
catastrophe and weather-related losses in the fourth quarter and before any
property and casualty reserve actions which may be identified by the Deloitte &
Touche review. Management is assessing the impact of claims from the recent
California wildfires and at the time of this Quarterly Report on Form 10-Q has
not yet completed that analysis. Compared to the anticipated results disclosed
in the Company's 2002 Annual Report on Form 10-K, this projection reflects the
adverse development of property and casualty prior years' reserves and current
year reserve strengthening, the increased level of catastrophe losses recorded
in the second and third quarters and lower investment income. Compared to 2002
results, this projection includes an approximate $0.09 reduction in per share
net income as a result of the Company's capital transactions completed in the
fourth quarter of 2002. In addition, this projection reflects management's
anticipation of improvement in the underlying (current accident year) property
and casualty statutory combined ratio, mitigated by the pressure on investment
income and compression in the Company's annuity margins. As described in
"Critical Accounting Policies," certain of the Company's significant accounting
measurements require the use of estimates and assumptions. As additional
information becomes available, adjustments may be required. Those adjustments
are charged or credited to income for the period in which the adjustments are
made and may impact actual results compared to management's current estimate. A
projection of net income is not accessible on a forward-looking basis because it
is not possible to provide a reliable forecast of realized investment gains and
losses, which can vary substantially from one period to another and may have a
significant impact on net income. At the time of this Quarterly Report on Form
10-Q, any other reconciling items to net income are assumed to be limited to the
$0.4 million favorable pretax adjustment to restructuring charges which was
recorded in the third quarter of 2003.
Liquidity and Financial Resources
Special Purpose Entities
At September 30, 2003 and 2002, the Company did not have any relationships
with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or for other contractually narrow or limited purposes. As such, the Company is
not exposed to any financing, liquidity, market or credit risk that could arise
if the Company had engaged in such relationships.
Related Party Transactions
The Company does not have any contracts or other transactions with related
parties that are required to be reported under the applicable securities laws
and regulations.
Ariel Capital Management, Inc., HMEC's largest shareholder with 30% of the
common shares outstanding per their SEC filing on Form 13F as of June 30, 2003,
is the investment adviser for two of the mutual funds offered to the Company's
annuity customers. In addition, T. Rowe Price Associates, Inc., HMEC's third
largest shareholder with 8% of the common shares outstanding per their SEC
filing on Form 13F as of June 30, 2003, is the investment advisor for two of the
mutual funds offered to the Company's annuity customers.
33
Investments
The Company's investment strategy emphasizes investment grade, publicly
traded fixed income securities. At September 30, 2003, fixed income securities
represented 95.5% of investments excluding the securities lending collateral. Of
the fixed income investment portfolio, 94.2% was investment grade and 99.9% was
publicly traded. The average quality of the total fixed income portfolio was A+
at September 30, 2003.
The duration of the investment portfolio is managed to provide cash flow to
satisfy policyholder liabilities as they become due. The average option adjusted
duration of total investments was 5.8 years at September 30, 2003 and 4.8 years
at December 31, 2002. The Company has included in its annuity products
substantial surrender penalties to reduce the likelihood of unexpected increases
in policy or contract surrenders. All annuities issued since 1982, and
approximately 79% of all outstanding fixed annuity accumulated cash values, are
subject in most cases to substantial early withdrawal penalties.
Additional discussion of the Company's investment guidelines is included in
"Results of Operations--Realized Investment Gains and Losses."
Cash Flow
The short-term liquidity requirements of the Company, within a 12-month
operating cycle, are for the timely payment of claims and benefits to
policyholders, operating expenses, interest payments and federal income taxes.
Cash flow in excess of these amounts has been used to fund business growth,
retire short-term debt, pay dividends to shareholders and repurchase shares of
the Company's common stock. Long-term liquidity requirements, beyond one year,
are principally for the payment of future insurance policy claims and benefits
and retirement of long-term debt.
Operating Activities
As a holding company, HMEC conducts its principal operations in the
personal lines segment of the property and casualty and life insurance
industries through its subsidiaries. HMEC's insurance subsidiaries generate cash
flow from premium and investment income, generally well in excess of their
immediate needs for policy obligations, operating expenses and other cash
requirements. Cash provided by operating activities primarily reflects net cash
generated by the insurance subsidiaries. For the first nine months of 2003, net
cash provided by operating activities was comparable to the prior year.
Payment of principal and interest on debt, fees related to the
catastrophe-linked equity put option and reinsurance agreement, dividends to
shareholders and parent company operating expenses, as well as the share
repurchase program, are dependent upon the ability of the insurance subsidiaries
to pay cash dividends or make other cash payments to HMEC, including tax
payments pursuant to tax sharing agreements. The insurance subsidiaries are
subject to various regulatory restrictions which limit the amount of annual
dividends or other distributions, including loans or cash advances, available to
HMEC without prior approval of the insurance regulatory authorities. Dividends
which may be paid by the insurance subsidiaries to HMEC during 2003 without
prior approval are approximately $43 million, of which none had been paid as of
September 30, 2003. The insurance subsidiaries paid dividends of $11 million to
HMEC in October 2003. Although regulatory restrictions exist, dividend
availability from subsidiaries has been, and is expected to be, adequate for
HMEC's capital needs.
34
Investing Activities
HMEC's insurance subsidiaries maintain significant investments in fixed
maturity securities to meet future contractual obligations to policyholders. In
conjunction with its management of liquidity and other asset/liability
management objectives, the Company, from time to time, will sell fixed maturity
securities prior to maturity and reinvest the proceeds in other investments with
different interest rates, maturities or credit characteristics. Accordingly, the
Company has classified the entire fixed maturity securities portfolio as
"available for sale."
Financing Activities
Financing activities include primarily payment of dividends, the receipt
and withdrawal of funds by annuity contractholders, repurchases of the Company's
common stock, and borrowings, repayments and repurchases related to its debt
facilities. Fees related to the catastrophe-linked equity put option and
reinsurance agreement, which augments the Company's traditional reinsurance
program, have been charged directly to additional paid-in capital.
For the nine months ended September 30, 2003, receipts from annuity
contracts increased 11.6%. Annuity contract maturities and withdrawals decreased
$60.7 million, or 45.8%, compared to the same period last year. Cash value
retentions for variable and fixed annuity options were 92.4% and 94.9%,
respectively, for the 12 month period ended September 30, 2003. Net transfers to
variable annuity accumulated cash values increased $52.0 million compared to the
same period last year.
Contractual Obligations
Payments Due By Period
As of December 31, 2002
------------------------------------------------
More
1 - 3 3 - 5 Than
Less Years Years 5 Years
Than (2004 (2006 (2008
1 Year and and and
Total (2003) 2005) 2007) beyond)
-------- ------ ------- ------- --------
Long-Term Debt Obligations (1):
Convertible Notes Due 2032 ..... $ 260.2 $ 3.5 $ 7.0 $ 5.2 $ 244.5
Senior Notes Due 2006 .......... 35.2 1.9 3.8 29.5 --
-------- ------ ------- ------- --------
Total ....................... $ 295.4 $ 5.4 $ 10.8 $ 34.7 $ 244.5
======== ====== ======= ======= ========
- ----------
<FN>
<F1>
(1) Includes principal and interest.
</FN>
The Company has entered into various operating lease agreements, primarily
for computer equipment, computer software and real estate (agency and claims
offices across the country and portions of the home office complex). These
leases have varying commitment periods with most in the 1 to 3 year range.
Payments on these leases were approximately $6 million for the nine months ended
September 30, 2003 and 2002. It is anticipated that the Company's payments under
operating leases for the full year 2003 will be comparable to payments in 2002
of approximately $8 million. The Company does not have any other arrangements
that expose it to material liability that are not recorded in the financial
statements.
35
Capital Resources
The Company has determined the amount of capital which is needed to
adequately fund and support business growth, primarily based on risk-based
capital formulas including those developed by the National Association of
Insurance Commissioners ("NAIC"). Historically, the Company's insurance
subsidiaries have generated capital in excess of such needed capital. These
excess amounts have been paid to HMEC through dividends. HMEC has then utilized
these dividends and its access to the capital markets to service and retire
long-term debt, increase and pay dividends to its shareholders, fund growth
initiatives, repurchase shares of its common stock and for other corporate
purposes. Management anticipates that the Company's sources of capital will
continue to generate capital in excess of its needs for business growth, debt
interest payments and shareholder dividends.
The total capital of the Company was $677.5 million at September 30, 2003,
including $144.7 million of long-term debt and no short-term debt outstanding.
Total debt represented 25.2% of capital excluding unrealized investment gains
and losses (21.4% including unrealized investment gains and losses) at September
30, 2003, consistent with the Company's long-term target of 25%.
Shareholders' equity was $532.8 million at September 30, 2003, including a
net unrealized gain in the Company's investment portfolio of $102.6 million
after taxes and the related impact on deferred policy acquisition costs and the
value of acquired insurance in force associated with annuity and
interest-sensitive life policies. The market value of the Company's common stock
and the market value per share were $619.9 million and $14.51, respectively, at
September 30, 2003. Book value per share was $12.47 at September 30, 2003,
$10.07 excluding investment fair value adjustments.
On May 14, 2002, the Company issued $353.5 million aggregate principal
amount of 1.425% senior convertible notes due in 2032 ("Convertible Notes") at a
discount of 52.5% resulting in an effective yield of 3.0%. The Convertible Notes
were privately offered only to qualified institutional buyers under Rule 144A
under the Securities Act of 1933 and outside the United States of America
("U.S.") to non-U.S. persons under Regulation S under the Securities Act of
1933. A Securities and Exchange Commission registration statement registering
the Convertible Notes was declared effective on November 4, 2002. Prior to
December 31, 2002, the Company repurchased $109.0 million aggregate principal
amount, $51.8 million carrying value, of the outstanding Convertible Notes. At
September 30, 2003, $244.5 million aggregate principal amount, $116.1 million
carrying value, of the Convertible Notes were outstanding. The Convertible Notes
are traded in the open market (HMN 1.425). Also see "Financial Ratings".
In January 1996, the Company issued $100.0 million aggregate principal
amount of 6 5/8% Senior Notes ("Senior Notes") at a discount of 0.5% which will
mature on January 15, 2006. In 2002, the Company repurchased $71.4 million
aggregate principal amount of its outstanding Senior Notes utilizing a portion
of the proceeds from the issuance of the Convertible Notes. At September 30,
2003, $28.6 million aggregate principal amount of Senior Notes were outstanding.
The Senior Notes are traded on the New York Stock Exchange (HMN 6 5/8). Also see
"Financial Ratings".
As of September 30, 2003 and December 31, 2002, the Company had no amounts
outstanding under its Bank Credit Agreement. The Bank Credit Agreement provides
for unsecured borrowings of up to $25.0 million, with a provision that allows
the commitment amount to be increased to $35.0 million (the "Bank Credit
Facility"). The Bank Credit Facility expires on May 31,
36
2005. Interest accrues at varying spreads relative to corporate or eurodollar
base rates and is payable monthly or quarterly depending on the applicable base
rate. The unused portion of the Bank Credit Facility is subject to a variable
commitment fee, which was 0.20% on an annual basis at September 30, 2003.
The Company's ratio of earnings to fixed charges for the nine months ended
September 30, 2003 was 0.4x, reflecting the impact of $44.3 million of pretax
adverse development of prior years' property and casualty reserves recorded
during the period, compared to 0x for the same period last year, reflecting the
impact of $51.9 million of pretax realized investment losses recognized in the
same period in 2002.
Total shareholder dividends were $13.5 million for the nine months ended
September 30, 2003. In February 2003, May 2003 and August 2003, the Board of
Directors announced regular quarterly dividends of $0.105 per share.
Descriptions of the Company's material property and casualty reinsurance
programs and a life reinsurance agreement with Sun Life Reinsurance Company
Limited are contained in the Company's Annual Report on Form 10-K for 2002
within "Management's Discussion and Analysis of Financial Condition and Results
of Operations--Liquidity and Financial Resources--Capital Resources." There have
been no material changes to the Company's reinsurance coverage as of the time of
this Quarterly Report on Form-10-Q.
Financial Ratings
Complete descriptions of the Company's Insurance Financial Ratings are
contained in the Company's Annual Report on Form 10-K for 2002 within
"Business--Insurance Financial Ratings," "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Financial
Resources--Capital Resources" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Financial
Resources--Insurance Financial Ratings."
In October 2003, Fitch Ratings, Ltd. ("Fitch") lowered by one notch the
insurance financial strength and senior debt ratings of Horace Mann Educators
Corporation. The financial strength ratings of the Company's insurance
subsidiaries were lowered to "A+" from "AA-" and the senior debt ratings were
lowered to "BBB+" from "A-". The outlook for each of the ratings is Stable.
Fitch indicated that the rating action reflects their belief that it will
be difficult for Horace Mann's property and casualty operations to return to the
significantly better than industry average underwriting performance that had
historically been achieved. Additionally, Fitch believes that life and annuity
earnings and surplus growth will be below historical levels due to spread
compression on the fixed annuity products and lower levels of separate account
assets under management. Fitch also indicated that the ratings continue to be
supported by the Company's strong risk based capitalization, well defined market
niche in the educator market, strong reinsurance protection and a high quality,
liquid investment portfolio. Fitch noted that the Company continues to have an
advantageous position in the educator marketplace and reasonable business
strategies for profitable growth.
On October 27, 2003, the Company pre-announced the third quarter 2003
adverse development and strengthening of property and casualty reserves and the
related impact on net income for the third quarter of 2003. Following this
announcement, Standard & Poor's Corporation ("S&P") placed the Company's "BBB+"
debt ratings and "A+" financial strength ratings on
37
CreditWatch with negative implications. Moody's Investors Service, Inc.
("Moody's") also placed the Company's "Baa2" debt ratings and "A2" insurance
financial strength ratings on review for possible downgrade. Both rating
agencies noted that they will review and update their analyses of the Company's
property and casualty reserve adequacy and development trends, as well as
prospective earnings, interest coverage, capitalization levels and spread
compression on the Company's annuity business.
Market Value Risk
Market value risk, the Company's primary market risk exposure, is the risk
that the Company's invested assets will decrease in value. This decrease in
value may be due to a change in (1) the yields realized on the Company's assets
and prevailing market yields for similar assets, (2) an unfavorable change in
the liquidity of the investment, (3) an unfavorable change in the financial
prospects of the issuer of the investment, or (4) a downgrade in the credit
rating of the issuer of the investment. See also "Results of
Operations--Realized Investment Gains and Losses."
Significant changes in interest rates expose the Company to the risk of
experiencing losses or earning a reduced level of income based on the difference
between the interest rates earned on the Company's investments and the credited
interest rates on the Company's insurance liabilities.
The Company manages its market value risk by coordinating the projected
cash outflows of assets with the projected cash outflows of liabilities. For all
its assets and liabilities, the Company seeks to maintain reasonable durations,
consistent with the maximization of income without sacrificing investment
quality, while providing for liquidity and diversification. The investment risk
associated with variable annuity deposits and the underlying mutual funds is
assumed by those contractholders, and not by the Company. Certain fees that the
Company earns from variable annuity deposits are based on the market value of
the funds deposited.
A more detailed description of the Company's exposure to market value risks
and the management of those risks is presented in the Company's Annual Report on
Form 10-K for 2002 "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Market Value Risk."
Information Systems Risk
The Company administers its insurance business with information systems
that are dated and complex, and require extensive manual input, calculation and
control procedures. These systems are more prone to error than more advanced
technology systems. To address these issues, over the past three years the
Company has enhanced its existing systems and technology infrastructure and
begun installing new systems, including a new general ledger and financial
reporting system which was implemented in the second quarter of 2003. In the
meantime, enhanced checks and control procedures have been established to review
the output of existing information systems, including periodic internal and
external third party reviews. Nevertheless, there are risks that inaccuracies in
the processing of data may occur which might not be identified by those
procedures and checks on a timely basis.
38
Business Continuity Risk
Given the events of September 11, 2001, the continuing threat of terrorism
and the current geopolitical climate, the Company has undertaken a reassessment
of its business continuity plans. While current contingency plans are felt to be
adequate to restore some of the more critical business processes and the Company
is aggressively working to strengthen its continuity plans, in the current
environment there is believed to exist a higher than acceptable level of risk
that the Company's ability to recover and resume most or all of its key business
operations on a timely basis would be compromised.
Recent Accounting Changes
SOP 03-1
In July 2003, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 03-1, "Accounting and Reporting
by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts for
Separate Accounts." This SOP is effective for fiscal years beginning after
December 15, 2003. The new rules change accounting for separate accounts and
sales inducements and change the liability model by expanding the definition of
"account balance" and addressing annuitization guarantees and minimum guaranteed
death benefits. The adoption of this SOP is currently not expected to have a
material impact on the Company's operating results or financial position.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
The information required by Item 305 of Regulation S-K is contained in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" contained in this Quarterly Report on Form 10-Q.
Item 4: Controls and Procedures
The Company carried out an evaluation, under the supervision and with the
participation of the Company's management, including the Company's Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Company's disclosure controls and procedures as of
September 30, 2003 pursuant to Exchange Act Rule 13a-15 and15d-15. Based upon
that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective in
timely alerting them to material information relating to the Company (including
its consolidated subsidiaries) required to be included in the Company's periodic
Securities and Exchange Commission filings. No significant deficiencies or
material weaknesses in the Company's disclosure controls and procedures were
identified in the evaluation and therefore, no corrective actions were taken.
There were no significant changes in the Company's internal controls or in other
factors that could significantly affect these controls subsequent to the date of
their evaluation.
39
PART II: OTHER INFORMATION
Item 4: Submission of Matters to a Vote of Security Holders
None.
Item 5: Other Information
In compliance with Section 202 of the Sarbanes-Oxley Act of 2002, the Audit
Committee of the Board of Directors of Horace Mann Educators Corporation has
preapproved the continuing provision of certain non-audit services by KPMG LLP,
Horace Mann Educators Corporation's independent auditor. Such services relate
primarily to statutory regulatory audit requirements, SEC registration statement
review services, tax consultation and employee compliance affirmations.
The Audit Committee has determined that the services provided by KPMG LLP
under non-audit services are compatible with maintaining the auditor's
independence.
Item 6: Exhibits and Reports on Form 8-K
Exhibit
No. Description
- ------- -----------
(a) The following items are filed as Exhibits.
(11) Statement re computation of per share earnings.
(15) KPMG LLP letter regarding unaudited interim financial
information.
(31) Certification pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.1 Certification by Louis G. Lower II, Chief Executive
Officer of HMEC.
31.2 Certification by Peter H. Heckman, Chief Financial
Officer of HMEC.
(32) Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
32.1 Certification by Louis G. Lower II, Chief Executive
Officer of HMEC.
32.2 Certification by Peter H. Heckman, Chief Financial
Officer of HMEC.
(b) During the third quarter of 2003, HMEC filed two Current Reports on
Form 8-K with the SEC as follows:
1. Dated July 28, 2003, regarding the Company's press release
regarding guidance on financial results for the year ended
December 31 2003, containing an Item 9 Regulation FD Disclosure
and an Item 7 Financial Statements and Exhibits.
2. Dated August 4, 2003, regarding the Company's press release
reporting its financial results for the three and six month
periods ended June 30, 2003, containing an Item 12 Disclosure of
Results of Operations and Financial Condition and an Item 7
Financial Statements and Exhibits.
40
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.
HORACE MANN EDUCATORS CORPORATION
(Registrant)
Date November 12, 2003 /s/ Louis G. Lower II
--------------------------------- --------------------------------------
Louis G. Lower II
President and Chief Executive Officer
Date November 12, 2003 /s/ Peter H. Heckman
--------------------------------- --------------------------------------
Peter H. Heckman
Executive Vice President
and Chief Financial Officer
Date November 12, 2003 /s/ Bret A. Conklin
--------------------------------- --------------------------------------
Bret A. Conklin
Senior Vice President
and Controller
41
================================================================================
HORACE MANN EDUCATORS CORPORATION
EXHIBITS
To
FORM 10-Q
For the Quarter Ended September 30, 2003
VOLUME 1 OF 1
================================================================================
The following items are filed as Exhibits to Horace Mann Educators
Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30,
2003. Management contracts and compensatory plans are indicated by an
asterisk(*).
EXHIBIT INDEX
Exhibit
No. Description
- ------- -----------
(11) Statement re computation of per share earnings.
(15) KPMG LLP letter regarding unaudited interim financial information.
(31) Certification pursuant to Section 302 of the Sarbanes-Oxley Act of
2002. 31.1 Certification by Louis G. Lower II, Chief Executive Officer
of HMEC. 31.2 Certification by Peter H. Heckman, Chief Financial
Officer of HMEC.
(32) Certification pursuant to Section 906 of the Sarbanes-Oxley Act of
2002. 32.1 Certification by Louis G. Lower II, Chief Executive Officer
of HMEC. 32.2 Certification by Peter H. Heckman, Chief Financial
Officer of HMEC.