UTG INC - Quarter Report: 2007 March (Form 10-Q)

 

 

 

 

 

The Financial Accounting Standards Board (“FASB”) issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115.  The statement permits entities to choose to measure many financial instruments and certain other items at fair value.  The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.  The statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007.  The Company will account for all qualifying financial instruments in accordance with the requirements of Statement No. 159.

 

 

 

The Company is currently negotiating an agreement to sell its 50% interest in Harbor Village Partners, LP, an upscale gated-community residential development located outside Dallas, Texas.  Under the terms of the agreement, the Company will receive $3,400,000 at closing, a put option to receive another $1,000,000 one year from closing and the right to receive approximately 10% of the future gains from the project up to $1,400,000.  Management has not placed any value on the future potential gains or losses of the project in its determination of current gain or loss on the sale.  This transaction is expected to close sometime in May 2007.  The Company anticipates recording a net loss after taxes of between $650,000 and $800,000 from this sale transaction during the second quarter 2007.  Management determined it was in the Company’s long term best interest to divest of this investment due to new perceived risks that management was no longer comfortable with over the long term development of the project.

 

 

The purpose of this section is to discuss and analyze the Company's consolidated results of operations, financial condition and liquidity and capital resources.  This analysis should be read in conjunction with the consolidated financial statements and related notes that appear elsewhere in this report.  The Company reports financial results on a consolidated basis.  The consolidated financial statements include the accounts of UTG and its subsidiaries at March 31, 2007.

 

 

Any forward-looking statement contained herein or in any other oral or written statement by the Company or any of its officers, directors or employees is qualified by the fact that actual results of the Company may differ materially from any such statement due to the following important factors, among other risks and uncertainties inherent in the Company's business:

 

1.   Prevailing interest rate levels, which may affect the ability of the Company to sell its products, the market value of the Company's investments and the lapse ratio of the Company's policies, notwithstanding product design features intended to enhance persistency of the Company's products.

 

2.   Changes in the federal income tax laws and regulations which may affect the relative tax advantages of the Company's products.

 

3.   Changes in the regulation of financial services, including bank sales and underwriting of insurance products, which may affect the competitive environment for the Company's products.

 

4.   Other factors affecting the performance of the Company, including, but not limited to, market conduct claims, insurance industry insolvencies, insurance regulatory initiatives and developments, stock market performance, an unfavorable outcome in pending litigation, and investment performance.

 

 

In our Form 10-K for the year ended December 31, 2006, we identified the accounting policies that are critical to the understanding of our results of operations and our financial position.  They relate to deferred acquisition costs (DAC), cost of insurance acquired, assumptions and judgments utilized in determining if declines in fair values of investments are other-than-temporary, and valuation methods for investments that are not actively traded.

 

We believe that these policies were applied in a consistent manner during the first three months of 2007.

 

 

In December 2006, the Company completed an acquisition transaction whereby it acquired a controlling interest in Acap Corporation, which owns two life insurance subsidiaries (AC and TI).  The acquisition resulted in an increase of approximately $90,000,000 in invested assets, $160,000,000 in total assets and 200,000 additional policies to administer.  The acquisition had a material impact on many of the balance sheet and income statement line items.  The income statement for the period ended March 31, 2006 does not reflect the operating results of the acquired entities.  The following analysis and discussion considers the overall changes when comparing 2007 results to 2006 and the impact of the new entities to the Company.

 

 

 

The Company experienced an increase of approximately $ 1,556,000 in premiums and policy fee revenues, net of reinsurance premiums and policy fees, when comparing the first three months of 2007 to the same period in 2006.  The majority of this increase, $ 1,076,000, is related to the acquisition of the two life insurance subsidiaries at the end of 2006.  The remaining increase relates to the timing of reinsurance premiums paid during the reporting period.  The Company currently writes little new business.  Unless the Company acquires a block of in-force business or significantly increases its marketing, management expects premium revenue to continue to decline at a similar rate, which is consistent with prior experience.

 

The Company’s primary source of new business production comes from the conservation effort implemented several years ago.  This effort was an attempt to improve the persistency rate of insurance company’s policies.  Several of the customer service representatives of the Company are also licensed insurance agents, allowing them to offer other products within the Company’s portfolio to existing customers.  Additionally, stronger efforts have been made in policy retention through more personal contact with the customer including telephone calls to discuss alternatives and reasons for a customer’s request to surrender their policy.  Previously, the Company’s agency force was primarily responsible for conservation efforts.  AC and TI have as small agency force which continues to write new business on existing products.  Management will continue to monitor these efforts and make adjustments as seen appropriate to enhance the future success of the program.  In 2003, the Company replaced its original universal life product with a new universal life contract referred to as “the Legacy”.  This product was designed for use with several distribution channels including the Company’s own internal agents, bank agent/employees and through personally producing general agents “PPGA”.  In addition, the Company has introduced other new and updated products in recent periods including the Horizon Annuity and Kid Kare (as single premium, child term policy).  The company is currently working on development of a level term and decreasing term product.  New product development is anticipated to be utilized in conservation efforts and sales to existing customers.  Such sales are not expected to be material.

 

The Company has considered the feasibility of a marketing opportunity with First Southern National Bank (FSNB) an affiliate of UTG’s largest shareholder, Chairman and CEO, Mr. Jesse T. Correll.  Management has considered various products including annuity type products, mortgage protection products and existing insurance products, as potential products that could be marketed to banking customers.  This marketing opportunity has potential and is believed to be a viable niche.  This potential is in the very early states of consideration.  Management will proceed cautiously and may even determine not to proceed.  The introduction of new products is not expected to produce significant premium writings.  The Company is currently looking at other types of products to compliment the existing offerings.

 

Net investment income increased 76% when comparing the first three months of 2007 to the same period in 2006.  The increase in investment income was only 14% excluding the investment income of the new entities.  While there has not been a significant increase in the national prime rate during the last several months, the Company has benefited from our efforts to lengthen the average life of the bond portfolio.  In recent years, the Company has evaluated the bond portfolio for interest rate risks and its correlation to the expected liabilities of the life companies.  Interest rates on long-term bonds available in the marketplace have not increased as significantly as prevailing bank prime rates.  The Company will continue to lengthen the life of the bond portfolio, while monitoring interest and extension risk.  In addition, the Company has begun to evaluate the debt securities acquired with the acquired life companies in order to match the bond portfolio to the investment strategy of the Company.

 

Also in response to the interest rate environment in the bond market, the Company increased its investment in mortgage loans in previous years to improve earnings potential.  The balance of mortgage loan investments remained approximately 9% of total invested assets at March 31, 2007, which is consistent with December 31, 2006.  This has allowed the Company to obtain higher yields than available in the bond market, lengthen the overall portfolio average life and still maintain a conservative investment portfolio.  The mortgage loan inventory has remained level during the first three months of 2007.  These loans have an average loan to value rate of 50% and an average yield of 6.97%.

 

The Company's investments are generally managed to match related insurance and policyholder liabilities.  The comparison of investment return with insurance or investment product crediting rates establishes an interest spread.  The Company monitors investment yields, and when necessary adjusts credited interest rates on its insurance products to preserve targeted interest spreads, ranging from 1% to 2%.  The Company has lowered all rate-adjustable products to their guaranteed minimums.  The guaranteed minimum crediting rates on these products range from 3% to 5.5%.  If short-term interest rates continue to rise, the Company does not expect to increase guaranteed crediting rates, which will improve both net investment income and net income.

 

The Company had realized investment losses of $ 315,758 in the first three months of 2007 compared to net realized investment gains of $ 3,163,693 for the same period in 2006.  In 2007, the net realized losses primarily originated from the liquidation of certain debt securities in anticipation of the completion of a real estate investment opportunity.  The net realized gains in 2006 were primarily comprised of net realized gains from the disposal of certain equity securities.

 

Other income decreased 25%, or $171,977, when comparing the first three months of 2007 to the same period in 2006.  The majority of the revenue in this line item comes from the Company performing administrative work as a third party administrator (“TPA”) for unaffiliated life insurance companies, and as such, receives monthly fees based on policy in force counts and certain other activity indicators such as number of premium collections performed.  During the first three months of 2007 and 2006, the Company received $ 451,193 and $ 444,519 respectively, for this work.  These TPA revenue fees are included in the line item “other income” on the Company’s consolidated statements of operations.  In 2006, the Company completed a conversion project for one of its TPA clients, receiving approximately $ 200,000 in additional revenue that accounts for the difference between 2007 and 2006.  The Company intends to pursue other TPA arrangements through its alliance with Fiserv Life Insurance Solutions (Fiserv LIS), to provide TPA services to insurance companies seeking business process outsourcing solutions.  Fiserv LIS is responsible for the marketing and sales function for the alliance, as well as providing the data center operations.  UTG will staff the administration effort.  Management believes this alliance with Fiserv LIS positions the Company to generate additional revenues by utilizing the Company’s current excess capacity, administrative services, and implementation of the new Fiserv LIS “ID3” software system.  In addition, due to ongoing regulatory changes and the fact the Company is repositioning itself for future growth; the Company believes implementation of the “ID3” software system is critical in order to proceed in the Company’s new direction of TPA services.  Fiserv LIS is a unit of Fiserv, Inc. (Nasdaq: FISV) which is an independent, full-service provider of integrated data processing and information management systems to the financial industry, headquartered in Brookfield, Wisconsin.

 

 

 

Life benefits, claims and settlement expenses net of reinsurance benefits and claims, increased approximately 43% in the first three months of 2007 compared to the same period in 2006.  Eliminating the impact of the acquired companies, life benefit expenses increased approximately 19% in 2007.  Mortality expense in UG was 50% higher for the first three months of 2007 than for the same period of 2006.  Policy claims vary from period to period and therefore, fluctuations in mortality are to be expected and are not considered unusual by management.  Overall, reserves continue to increase on in-force policies as the average age of the insured increases.

 

Commissions and amortization of deferred policy acquisition costs decreased 93%, or approximately $ 12,000, for the first three months of 2007 compared to the same period in 2006, excluding the impact of the acquired companies.  The most significant factor in the decrease is attributable to the Company paying fewer commissions, since the company writes very little new business and renewal premiums on existing business continue to decline.  Commissions paid will continue to decline as terminated agents discontinue their association with the Company.  Depending upon the nature of the contract that the agent has with the Company, the agent may become vested; a process which allows them to continue to receive commissions for a certain period even after the agent has discontinued his association with the Company.  Over time, fewer and fewer agents have remained vested, further reducing the commissions payable by the Company.  Another factor of the decrease is attributable to normal amortization of the deferred policy acquisition costs asset.  The Company reviews the recoverability of the asset based on current trends and known events compared to the assumptions used in the establishment of the original asset.  No impairments were recorded in either of the periods reported.

 

Operating expenses increased 23% in the first three months of 2007 compared to the same period in 2006.  The increase in operating expenses is primarily related to the increase in activity related to the new companies acquired at the end of 2006.  These costs include such items as new staff, postage and supplies.  The Company continually monitors expenditures looking for savings opportunities.  Management places significant emphasis on expense monitoring and cost containment.  Maintaining administrative efficiencies directly impacts net income.

 

 

 

The Company had a net loss of $ 832,465 in the first three months of 2007 compared to a net gain of $ 1,679,322 for the same period in 2006.  The net loss in 2007 is mainly attributable to the increase in benefit expenses.  The net gain in 2006 was mainly attributable to the sale of certain equity securities and increased TPA revenues.

 

 

 

Total shareholders’ equity declined approximately $ 511,000 as of March 31, 2007 compared to December 31, 2006.  The decrease is attributable the Company’s current period loss.  The loss was partially offset by an increase in market value of the debt investments of approximately $ 36,000, net of deferred taxes, that was included in the accumulated other comprehensive income.  In addition, the Company issued approximately $ 328,000 of common stock during the period under the Employee and Director Stock Purchase Program.

 

Investments represent approximately 70% and 72% of total assets at March 31, 2007 and December 31, 2006, respectively.  Accordingly, investments are the largest asset group of the Company.  The Company's insurance subsidiaries are regulated by insurance statutes and regulations as to the type of investments that they are permitted to make and the amount of funds that may be used for any one type of investment.  In light of these statutes and regulations, the majority of the Company’s investment portfolio is invested in high quality, low risk investments.

 

As of March 31, 2007, the carrying value of fixed maturity securities in default as to principal or interest was immaterial in the context of consolidated assets or shareholders' equity.  The Company has identified securities it may sell and classified them as "investments held for sale".  Investments held for sale are carried at market, with changes in market value charged directly to shareholders' equity. To provide additional flexibility and liquidity, the Company has categorized almost all fixed maturity investments acquired since 2000 as available for sale.

 

 

 

The Company has three principal needs for cash - the insurance companies' contractual obligations to policyholders, the payment of operating expenses and debt reduction.  Cash and cash equivalents as a percentage of total assets were approximately 4% and 2% as of March 31, 2007, and December 31, 2006, respectively.  Fixed maturities as a percentage of total assets were approximately 47% and 50% as of March 31, 2007 and December 31, 2006, respectively.

 

Future policy benefits are primarily long-term in nature and therefore, the Company's investments are predominantly in long-term fixed maturity investments such as bonds and mortgage loans which provide sufficient return to cover these obligations.  The Company has the ability and intent to hold these investments to maturity; consequently, the Company's investment in fixed maturities held to maturity is reported in the financial statements at their amortized cost.

 

Many of the Company's products contain surrender charges and other features which reward persistency and penalize the early withdrawal of funds.  With respect to such products, surrender charges are generally sufficient to cover the Company's unamortized deferred policy acquisition costs with respect to the policy being surrendered.

 

Net cash provided by (used in) operating activities was $ (943,865) and $ 2,640,066 for the three months ending March 31, 2007 and 2006, respectively.

 

Net cash provided by investing activities was $ 8,990,151 and $ 2,437,841 for the three-month periods ending March 31, 2007 and 2006, respectively.  The most significant aspects of cash provided by (used in) investing activities are the sale of certain debt securities and the fixed maturity transactions.  During the current quarter, the Company sold $ 31,482,161 of certain debt securities for a net loss of $ 491,407.  Fixed maturities of $ 2,647,657 were either sold or matured in the first three months of 2006.  In addition, the Company purchased $ 21,024,943 and $ 2,135,700 of fixed maturities in 2007 and 2006, respectively.

 

Net cash provided by financing activities was $ 965,990 and $ 399,940 for the three month periods ending March 31, 2007 and 2006, respectively.  Policyholder contract deposits increased less than 1% in the first three months of 2007 compared to the same period in 2006.  Policyholder contract withdrawals increased 10% in the first three months of 2007 compared to the same period in 2006.  The acquired companies have minimal policyholder contract activity.

 

At March 31, the Company had $ 24,223,083 of long-term debt outstanding.  The acquisition of Acap Corporation accounted for a majority of the activity in this area during 2006.  At March 31, 2006, the Company had no short-term debt outstanding, respectively.

 

UTG is a holding company that has no day-to-day operations of its own.  Funds required to meet its expenses, generally costs associated with maintaining the company in good standing with states in which it does business, are primarily provided by its subsidiaries.  On a parent only basis, UTG's cash flow is dependent on management fees received from its subsidiaries and earnings received on cash balances.  At March 31, 2007, substantially all of the consolidated shareholders equity represents net assets of its subsidiaries.  The Company's insurance subsidiaries have maintained adequate statutory capital and surplus and have not used surplus relief or financial reinsurance, which have come under scrutiny by many state insurance departments.  The payment of cash dividends to shareholders is not legally restricted.  However, the state insurance department regulates insurance company dividend payments where the company is domiciled.  No dividends were paid to shareholders in 2006.

 

UG is an Ohio domiciled insurance company, which requires five days prior notification to the insurance commissioner for the payment of an ordinary dividend.  Ordinary dividends are defined as the greater of: a) prior year statutory earnings or b) 10% of statutory capital and surplus.  At December 31, 2006, UG’s total statutory capital and surplus amounted to $ 31,209,934.  At December 31, 2006, UG had a statutory gain from operations of $ 5,162,322.  Extraordinary dividends (amounts in excess of ordinary dividend limitations) require prior approval of the insurance commissioner and are not restricted to a specific calculation.

 

Management believes the overall sources of liquidity available will be sufficient to satisfy the Company’s financial obligations.