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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 31, 2003
Commission File Number 0-4690
FINANCIAL INDUSTRIES CORPORATION
(Exact Name of Registrant as specified in its charter)
Texas 74-2126975
(State of Incorporation) (I.R.S. Employer Identification Number)
6500 River Place Blvd., Building One
Austin, Texas 78730
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (512) 404-5000
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
Number of common shares outstanding, $0.20 par value, as of March 31, 2003:
9,605,939.
- 1 -
Forward-Looking Statements
Except for historical factual information set forth in this Quarterly Report on
Form 10-Q of Financial Industries Corporation (the "Company" or "FIC"), the
statements, analyses, and other information contained in this report relating to
trends in the Company's operations and financial results, the markets for the
Company's products, the future development of the Company's business, and the
contingencies and uncertainties to which the Company may be subject, as well as
other statements including words such as "anticipate," "believe," "path,"
"estimate," "expect," "intend" and other similar expressions constitute
forward-looking statements under the Private Securities Litigation Reform Act of
1995. Such statements are made based upon management's current expectations and
beliefs concerning the financial results, economic conditions and are subject to
known and unknown risks, uncertainties and other factors contemplated by the
forward-looking statements. Such factors include, among other things: (1)
general economic conditions and other factors, including prevailing interest
rate levels and stock market performance, which may affect the ability of FIC to
sell its products, the market value of FIC's investments and the lapse rate and
profitability of policies; (2) FIC's ability to achieve anticipated levels of
operational efficiencies and cost-saving initiatives; (3) customer response to
new products, distribution channels and marketing initiatives; (4) mortality,
morbidity and other factors which may affect the profitability of FIC's
insurance products; (5) changes in the Federal income tax laws and regulations
which may affect the relative tax advantages of some of FIC's products; (6)
increasing competition in the sale of insurance and annuities; (7) regulatory
changes or actions, including those relating to regulation of insurance products
and insurance companies; (8) ratings assigned to FIC's insurance subsidiaries by
independent rating organizations such as A.M. Best Company, which FIC believes
are particularly important to the sale of annuity and other accumulation
products; and (9) unanticipated litigation. There can be no assurance that other
factors not currently anticipated by management will not also materially and
adversely affect FIC.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
INDEX
Page No.
Part I - Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets
March 31, 2003 and December 31, 2002................................. 4
Consolidated Statements of Income
For the three month periods ended
March 31, 2003 and March 31, 2002 (as restated)..................... 6
Consolidated Statements of Cash Flows
For the three month periods ended
March 31, 2003 and March 31, 2002 (as restated)......................8
Notes to Consolidated Financial Statements...................................10
Item 2. Management's Discussion and Analysis of
Financial Conditions and Results of Operations......................19
Item 3. Quantitative and Qualitative Disclosures
About Market Risk ...................................................34
Item 4. Controls and Procedures..............................................35
Part II
Other Information...........................................................36
Signature Page..............................................................38
Certifications.............................................................. 39
- 3 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
March 31 December 31
2003 2002
(unaudited)
Investments:
Fixed maturities held to maturity,
at amortized cost (market value
approximates $22 and $1,069 at
March 31, 2003 and December 31, 2002,
respectively) $ 28 $ 1,090
Fixed maturities available for sale,
at market value (amortized cost
of $528,441 and $479,433 at March 31,
2003 and December 31, 2002, respectively) 538,927 493,827
Trading securities, at market value 20,075 0
Equity securities, at market value (cost
approximates $6,348 and $6,381 at March 31,
2003 and December 31, 2002, respectively) 6,089 6,351
Policy loans 45,880 46,607
Mortgage loans 7 17
Invested real estate 74,867 75,393
Short-term investments 135,651 137,944
Total investments 821,524 761,229
Cash and cash equivalents 16,745 24,975
Accrued investment income 8,913 8,308
Agency advances and other receivables 20,524 19,728
Reinsurance receivables 12,668 12,330
Due and deferred premiums 11,534 11,981
Real estate occupied by Company 19,597 19,702
Property and equipment, net 1,454 1,367
Deferred policy acquisition costs 77,139 77,210
Present value of future profits of
acquired businesses 23,507 23,796
Other assets 14,865 15,739
Separate account assets 326,649 334,637
Total Assets $ 1,355,119 $ 1,311,002
The accompanying notes are an integral part
of these consolidated financial statements.
- 4 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands)
March 31 December 31
2003 2002
(unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Policy liabilities and contractholder
deposit funds:
Contractholder deposit funds $ 557,305 $ 557,466
Future policy benefits 170,067 172,008
Other policy claims and benefits payable 15,687 17,035
743,059 746,509
Deferred federal income taxes 22,743 25,814
Other liabilities 91,224 29,400
Separate account liabilities 326,649 334,637
Total Liabilities 1,183,675 1,136,360
Commitments and Contingencies
Shareholders' equity:
Common stock, $.20 par value, 25,000
shares authorized in 2003 and 2002,
11,858 and 11,856 shares issued in
2003 and 2002, 9,606 and 9,601
shares outstanding in 2003 and 2002 2,373 2,372
Additional paid-in capital 66,558 66,541
Accumulated other comprehensive income 2,971 4,949
Retained earnings 121,781 123,046
193,683 196,908
Common treasury stock, at cost,
2,252 and 2,255 shares in
2003 and 2002 (22,239) (22,266)
Total Shareholders' Equity 171,444 174,642
Total Liabilities and Shareholders' Equity $ 1,355,119 $ 1,311,002
The accompanying notes are an integral part of these
consolidated financial statements.
- 5 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share data)
Three Months Ended March 31,
2003 2002
RESTATED
Revenues: (unaudited)
Premiums, net $ 7,939 $ 9,915
Earned insurance charges 10,608 10,825
Net investment income 9,043 10,434
Real estate income 288 613
Net realized investment gains 1,629 1
Other 259 452
29,766 32,240
Benefits and expenses:
Policyholder benefits and expenses 9,843 10,868
Interest expense on contractholders
deposit funds 7,339 7,985
Amortization of present value of
future profits of acquired businesses 1,114 1,085
Amortization of deferred policy
acquisition costs 2,632 2,009
Litigation settlement 2,915 0
Operating expenses 7,869 9,087
31,712 31,034
(Loss) income before federal income tax
and cumulative effect of change in
accounting principle (1,946) 1,206
Provision for federal income taxes (681) 624
(Loss) income before cumulative effect
of change in accounting principle (1,265) 582
Cumulative effect of change in
accounting principle 0 10,429
Net (Loss) Income $ (1,265) $ 11,011
The accompanying notes are an integral part of these
consolidated statements.
- 6 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands except per share data)
Three Months Ended March 31,
2003 2002
RESTATED
Net (Loss) Income Per Share (unaudited)
Basic:
Weighted average shares outstanding 9,602 9,500
Basic earnings per share:
(Loss) income per share before cumulative
effect of change in accounting principle $ (0.13) $ 0.06
Cumulative effect of change in
accounting principle 0.00 1.10
Basic earnings per share $ (0.13) $ 1.16
Diluted:
Common stock and common stock equivalents 9,602 9,575
Diluted earnings per share:
(Loss) income per share before cumulative
effect of change in accounting principle $ (0.13) $ 0.06
Cumulative effect of change in
accounting principle 0.00 1.09
Diluted earnings per share $ (0.13) $ 1.15
The accompanying notes are an integral part of these
consolidated financial statements.
- 7 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Three Months Ended March 31,
2003 2002
RESTATED
(unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net (Loss) Income $ (1,265) $ 11,011
Adjustments to reconcile net income to
net cash used in operating activities:
Amortization of present value of future
profits of acquired business 1,114 1,085
Amortization of deferred policy
acquisition costs 2,632 2,009
Depreciation 855 554
Cumulative effect of change in
accounting principle 0 (10,429)
Realized gain on investments (1,629) (1)
Changes in assets and liabilities:
Increase in accrued investment income (605) 2,252)
(Increase) decrease in agent advances
and other receivables (1,134) 818
Decrease in due premiums 447 550
Increase in deferred policy acquisition
costs (2,376) (2,335)
Decrease (increase) in other assets 874 (3,478)
Increase (decrease) in policy liabilities
and accruals 271 (4,243)
Increase in other liabilities 2,214 176
Decrease in deferred federal income taxes (1,991) (1,828)
Net activity from trading securities (20,071) 0
Other, net 545 76
Net cash used in operating activities $ (20,121) $ (8,287)
The accompanying notes are an integral part
of these consolidated financial statements.
- 8 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued
(in thousands)
Three Months Ended March 31,
2003 2002
RESTATED
(unaudited)
CASH FLOWS FROM INVESTING ACTIVITIES
Fixed maturities purchased $ (127,344) $ (27,395)
Real estate capitalized (84) (3,374)
Change in policy loans 727 868
Proceeds from calls, maturities and
sales of fixed maturities 140,712 31,276
Net decrease in short-term investments 2,293 10,020
Purchase and retirement of property
and equipment (227) (87)
Net cash provided by investing activities 16,077 11,308
CASH FLOW FROM FINANCING ACTIVITIES
Cash dividends to shareholders (483) 0
Contractholder fund deposits 12,632 12,518
Contractholder fund withdrawals (16,353) (12,548)
Issuance of capital stock 18 194
Purchase of treasury stock 0 (460)
Net cash used in financing activities (4,186) (296)
Net (decrease) increase in cash (8,230) 2,725
Cash and cash equivalents, beginning of year 24,975 7,094
Cash and cash equivalents, end of period $ 16,745 $ 9,819
The accompanying notes are an integral part of these
consolidated financial statements.
- 9 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The financial statements included herein have been presented to conform to the
requirements of Form 10-Q. This presentation includes year end balance sheet
data which was derived from audited financial statements. The notes to the
financial statements do not necessarily include all disclosures required by
generally accepted accounting principles (GAAP). The reader should refer to Form
10-K for the year ended December 31, 2002 previously filed with the Securities
and Exchange Commission for financial statements prepared in accordance with
GAAP. Management believes the financial statements reflect all adjustments
necessary to present a fair statement of interim results. Certain prior year
amounts have been reclassified to conform with current year presentation.
The consolidated financial statements include the accounts of Financial
Industries Corporation ("FIC") and its wholly-owned subsidiaries. All
significant intercompany items and transactions have been eliminated.
Other Comprehensive Income
The following is a reconciliation of the change in accumulated other
comprehensive income from December 31, 2002 to March 31, 2003 (in thousands):
Net
(unrealized)
gain Total
(loss) on accu-
investments Net mulated
in fixed apprecia- other
maturities tion compre-
available of equity hensive
for sale securities Other Income
Balance at December 31, 2002 $ 6,601 $ (20) $ (1,632) $ 4,949
Current Period Change (1,830) (148) 0 (1,978)
Balance at March 31, 2003 $ 4,771 $ (168) $ (1,632) $ 2,971
- 10 -
Earnings Per Share:
The following table reflects the calculation of basic and diluted earnings per
share:
March 31, 2003 2002
Restated
(Amounts in thousands, except per share amounts)
BASIC:
Net (loss) income available to common
shareholders (1,265) 11,011
Weighted average common shares
outstanding 9,602 9,500
Basic earnings per share (0.13) 1.16
DILUTED:
Net (loss) income available to common
shareholders (1,265) 11,011
Weighted average common shares
outstanding 9,602 9,500
Common stock options 0 318
Repurchase of treasury stock 0 (243)
Common stock and common stock
equivalents 9,602 9,575
Diluted earnings per share (0.13) 1.15
Options to purchase 206,650 shares of common stock at prices ranging from $8.18
to $14.30 were outstanding at March 31, 2003, but were not included in the
computation of diluted earnings per share because the inclusion would result in
an antidilutive effect in periods where a loss from continuing operations was
incurred.
Stock Option Plans and Other Equity Incentive Plans
The Company follows the disclosure-only provisions of SFAS No. 123, "Accounting
for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock
Based Compensation - Transition and Disclosure." SFAS No. 123 allows companies
to follow existing accounting rules (APB 25) provided that pro forma disclosures
are made of what net income and earnings per share would have been had the
company recognized expense for stock-based awards based on their fair value at
date of grant.
- 11 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
For purpose of pro forma disclosures, the estimated fair value of the options is
amortized to expense over the options' vesting period. Pro forma income
information is as follows (in thousands except for net income per share) for the
three months ended March 31:
2003 2002
RESTATED
Net (loss) income as reported $ (1,265) $ 11,011
Pro forma compensation expense,
net of tax benefits 0 37
Pro forma net (loss) income $ (1,265) $ 10,974
Net (loss) income per share:
Basic as reported $ (0.13) $ 1.16
Diluted as reported $ (0.13) $ 1.15
Basic - Pro Forma $ (0.13) $ 1.16
Diluted - Pro Forma $ (0.13) $ 1.15
Dividends Declared
On December 13, 2002, the Board of Directors met to review and amend the
previously-adopted dividend policy of the Company. The Board adopted a new
policy whereby it anticipates the payment of a dividend on a semi-annual basis;
however, the new policy is designed to reflect a dividend based on the results
of operations, capital requirements and similar financial criteria of the
Company, rather than on the market price of the common stock of the Company.
Pursuant to the new policy, the Board declared a dividend of $0.05 per common
share payable on January 24, 2003 to record holders as of January 3, 2003
Trading Securities
FIC's trading securities consist of Collateralized Mortgage Obligations
("CMO's") of the type which are generally referred to as "inverse floaters"
which have coupon rates that vary in an inverse relationship with a specified
benchmark rate. The value of FIC's trading securities as of March 31, 2003 was
$20.1 million. The change in the market value of trading securities during the
period is included in net realized investment gains on the income statement. The
change in market value included in income during the three months ended March
31, 2003 is $5,000. FIC did not have any trading securities at December 31,
2002.
New Accounting Pronouncements
During 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards No. 143 ("SFAS 143"), "Accounting for Asset
Retirement Obligations", which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. SFAS 143 is effective for financial
statements issued for fiscal years beginning after June 15, 2002, the adoption
of which did not materially affect FIC's results of operations, liquidity or
financial position.
- 12 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In May 2002, the FASB issued SFAS No. 145, "Rescission of FAS Nos. 4, 44, and
64, Amendment of SFAS No.13, and Technical Corrections," as of April 2002. Among
other changes, this Statement rescinds FASB Statement No. 4, "Reporting Gains
and Losses from Extinguishment of Debt" and SFAS Statement No. 64,
"Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." This
Statement also amends other existing authoritative pronouncements to make
various technical corrections, clarify meanings, or describe their applicability
under changed conditions. SFAS No.145 is effective for financial statements
issued for fiscal years beginning after May 15, 2002, the adoption of which did
not materially affect FIC's results of operations, liquidity or financial
position.
The American Institute of Certified Public Accountants ("AICPA") also recently
issued Statement of Position No. 01-06 ("SOP 01-06") "Accounting by Certain
Entities (Including Entities with Trade Receivables) That Lend to or Finance the
Activities of Others." The guidance in SOP 01-06 relating to financing and
lending activities is explicitly applicable to insurance companies. SOP 01-06
reconciles and conforms the accounting and financial reporting guidance
presently contained in other accounting guidance. SOP 01-06 is effective for
financial statements issued for fiscal years beginning after December 15, 2001.
The Company's accounting practices for its lending activities are already
consistent with the guidance contained in SOP 01-06. The adoption of SOP 01-06
did not have a significant effect on the Company's financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," which addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies
Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." SFAS No. 146 is
effective for exit or disposal activities that are initiated after December 31,
2002. The adoption of SFAS No. 146 did not materially affect FIC's results of
operations, liquidity or financial position.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure." The statement amends SFAS No.123 to
provide alternative methods of transition for voluntary change to the fair value
based method of accounting for stock-based employee compensation. In addition,
SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. SFAS No. 148 prescribes a specific tabular
format for the pro forma disclosures required by SFAS No. 123 and requires their
disclosure in the "Summary of Significant Accounting Policies" or its
equivalent. In addition, SFAS No. 148 requires inclusion of these pro forma
disclosures in financial reports for interim periods. SFAS No. 148 is effective
for financial statements for fiscal years ending after December 15, 2002. FIC
continues to account for its stock option plans under APB 25 and related
interpretations as allowed by this statement. FIC has adopted the disclosure
provisions of SFAS No. 148.
- 13 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others" ("FIN 45"). FIN 45 elaborates on the disclosures to be
made by a guarantor in its interim and annual financial statements about its
obligations under certain guarantees that it has issued. It also clarifies that
a guarantor is required to recognize, at the inception of a guarantee, a
liability for the fair value of the obligation undertaken in issuing the
guarantee. The initial measurement provisions of FIN 45 are applicable on a
prospective basis to guarantees issued or modified after December 31, 2002. The
disclosure requirements of FIN 45 are effective for years ending after
December 15, 2002. FIN 45 did not have a material effect on the Company.
In January 2003, the FASB issued Interpretation No. 46 "Consolidation of
Variable Interest Entities, an interpretation of ARB 51" ("FIN 46"). The primary
objectives of FIN 46 are to provide guidance on the identification of entities
for which control is achieved through means other than through voting rights
("variable interest entities" or "VIEs") and how to determine when and which
business enterprise should consolidate the VIE (the "primary beneficiary"). This
new model for consolidation applies to an entity which either (1) the equity
investors (if any) do not have a controlling financial interest or (2) the
equity investment at risk is insufficient to finance that entity's activities
without receiving additional subordinated financial support from other parties.
In addition, FIN 46 requires that both the primary beneficiary and all other
enterprises with a significant variable interest in a VIE make additional
disclosures. FIN 46 is not expected to have a material effect on the Company.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities". This statement amends SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities," for
decisions made (1) as part of the FASB's Derivatives Implementation Group
process that effectively required amendments to SFAS No. 133, (2) in connection
with other FASB projects dealing with financial instruments, and (3) in
connection with implementation issues raised in relation to the application of
the definition of a derivative. The adoption of SFAS No. 149 is not expected to
materially affect FIC's results of operations, liquidity or financial position.
- 14 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Restatement
The financial statements as of and for the three month period ended March 31,
2002 have been restated. In the fourth quarter of 2002, the Company identified
uncollectible receivables for which adequate allowance had not been made and
policyholder benefits and expenses that were understated due to an interface
error between the policy administration system and the general ledger. The
Company extended its investigation to determine the years affected and expanded
the scope of its review to include other areas, including certain adjustments
that were deemed not material in prior years. As a result of this review, the
financial statements for 2001 and 2000 and previously reported unaudited
quarterly financial data were restated for the following items:
1. Family Life (a wholly owned subsidiary of the Company) did not
properly apply the accounting requirements of SFAS No. 87, "Employers'
Accounting for Pensions," in accounting for its defined benefit
pension plan. The Company had accounted for its pension expense on a
cash basis. As a result, the Company had not properly recognized
pension expense or benefit and had not recorded a prepaid pension
asset in years prior to January 1, 2000.
2. Agency advances and other receivables had not been analyzed for
collectibility and contained balances pertaining to agents that should
have been written off.
3. Depreciation on certain property and equipment had not been recorded
since purchase.
4. Certain lease incentives had been recognized in income as received in
1997 instead of being deferred and recognized over the lease period.
Further, certain other lease termination benefits had been deferred
instead of being recognized in income in the period the lease was
terminated.
5. Deferred acquisition cost amortization for traditional life policies
issued prior to January 1, 2002 had been calculated using amortization
factors which did not properly take into account the pattern of
commission expense recognized on these policies, which understated
amortization of these costs in early years of the policies and
overstated amortization of these costs in later years of the policies.
Also, deferred acquisition cost amortization for universal life
policies issued prior to January 1, 2002 was based on undiscounted
estimates of future gross profits, which overstated amortization of
these costs.
6. Present value of future profits amortization ha not reflected certain
adjustments that reduced the present value of future profits asset.
7. Certain death benefit and annuity benefit expenses incurred during the
years ended 1999, 2000, 2001 and 2002 were not recorded due to an
interface error between the Company's policy administration system and
its general ledger.
- 15 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSULIDATED FINANCIAL STATEMENTS (UNAUDITED)
8. InterContinental Life Corporation ("ILCO") had been accounted for as
an investment of the Company under the equity method of accounting
prior to May 18, 2001 and consolidated after that date upon FIC's
acquisition of ILCO's remaining outstanding shares. ILCO's financial
statements also required adjustment for the following items:
a. ILCO had not recorded dividend and capital gain distributions
prior to 1998 on its investment in one of its variable annuity
separate accounts (which understated ILCO January 1, 2000
retained earnings) and had not recorded unrealized gains or
losses to adjust the carrying value of its investment in the
separate account to market value (which understated ILCO January
1, 2000 accumulated other comprehensive income).
b. Agency advances and other receivables and other assets had not
been analyzed for recoverability and contained balances that
should have been written off.
c. Certain adjustments to reinsurance recoverables that related to
periods prior to January 1, 2000 were recorded during 2000.
d. ILCO did not properly apply the accounting requirements of SFAS
No. 87, "Employers' Accounting for Pensions," in accounting for
its defined benefit pension plan. ILCO had accounted for its
pension expense on a cash basis. As a result, the Company had not
properly recognized pension expense or benefit and had not
recorded a prepaid pension asset in years prior to January 1,
2000.
e. Certain lease incentives had been recognized in income as
received in 1997 instead of being deferred and recognized over
the lease period. Further, certain other lease termination
benefits had been deferred instead of being recognized in income
in the period the lease was terminated.
f. An unreconciled difference between suspense account balances
included in the Company's general ledger and those included in
its policy administration system resulted in an unsupported net
asset (included in other liabilities on the consolidated balance
sheet) that should have been written off.
9. The negative goodwill recognized as a result of the Company's
acquisition of the remaining common shares of ILCO on May 18, 2001 and
related amortization of negative goodwill in 2001 was adjusted to
reflect the impact on ILCO of the above items.
10. Deferred federal income tax balances were adjusted for the above items.
- 16 -
FINANCIAL INDUSTRIES CORPORATION AN
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Net income for the three months ended March 31, 2002 was decreased from
amounts previously reported by $5,873,000 as a result of the restatement,
as follows (in thousands except per share data):
Three Months Three Months
Ended Ended
March 31, 2002 March 31, 2002
As Previously As Restated
Reported
Net income before cumulative effect of
change in accounting principle $ 1,157 $ 582
Cumulative effect of change in accounting
principle $ 15,727 $ 10,429
Net income $ 16,884 $ 11,011
Basic earnings per share:
Net income before cumulative effect of
change in accounting principle $ 0.12 $ 0.06
Cumulative effect of change in accounting
principle 1.66 1.10
Net income $ 1.78 $ 1.16
Diluted earnings per share:
Net income before cumulative effect of
change in accounting principle $ 0.12 $ 0.06
Cumulative effect of change in accounting
principle 1.64 1.09
Net income $ 1.76 $ 1.15
- 17 -
The change in net income for the three months ended March 31, 2002 was due to
the following adjustments that increased (decreased) net income (in thousands):
Three Months
Ended
March 31,
2002
Premiums $ 1
Policyholder benefits and expenses (584)
Amortization of present value of future profits (15)
Amortization of deferred policy acquisition costs (86)
Provision for uncollectible receivables (200)
Provision for deferred federal income taxes 309
Cumulative effect of change in accounting principle (5,298)
Net income $ (5,873)
- 18 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
A summary of the effects of the restatement on the Company's consolidated
balance sheet as of March 31, 2002 is as follows (in thousands):
As
Previously As
Reported Restated
ASSETS
Equity securities $ 48 $ 8,346
Invested real estate 64,029 67,049
Total Investments 739,454 750,772
Agency advances and other receivables 30,072 16,224
Property and equipment, net 3,576 798
Deferred policy acquisition costs 81,191 77,952
Present value of future profits of
acquired businesses 30,590 29,854
Other assets 17,553 18,676
Separate account assets 388,480 380,714
Total Assets $ 1,359,257 $ 1,343,331
LIABILITIES AND SHAREHOLDERS' EQUITY
Deferred federal income taxes 29,090 24,051
Other liabilities 9,283 17,322
Total liabilities 1,165,873 1,168,872
Accumulated other comprehensive income (441) (2,424)
Retained earnings 148,345 131,403
Total shareholders' equity
before treasury stock 215,741 196,816
Total shareholders' equity 193,384 174,459
Total liabilities and share-
holders' equity $ 1,359,257 $ 1,343,331
- 19 -
The consolidated balance sheet as of March 31, 2002 was restated to reflect the
following:
* An increase of $8.3 million in FIC's investments in equity securities
to properly reflect the market value of the Company's investment in
the separate account;
* An increase $3.0 million in invested real estate primarily due to a
reclassification of certain real estate expenditures that were
classified as property and equipment;
- 20 -
FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
* A decrease of $13.8 million in agency advances and other receivables
primarily due to a write-off of uncollectible agent balances, a
write-off of a reinsurance receivable, and a write-off of assets
related to an interface error between the Company's policy
administration system and its general ledger;
* A decrease of $2.8 million in property and equipment primarily due to
a reclassification of certain amounts classified as property and
equipment to invested real estate and a write-off of assets that had
not been depreciated since purchase;
* A decrease of $3.2 million in deferred policy acquisition costs due to
a revision of the factors used to calculate Family Life's deferred
policy acquisition costs;
* A decrease of $736,000 in present value of future profits of acquired
businesses due to an adjustment in the calculation of this asset;
* An increase of $1.1 million in other assets primarily related to the
establishment of unrecorded pre- paid pension assets related to Family
Life's and ILCO's pension plans;
* A decrease of $7.8 million in separate account assets due to a
reclassification of separate account assets to equity securities;
* A decrease of $5.0 million in the liability for deferred federal
income taxes as a result of the restatement adjustments described
herein;
* An increase of $8.0 million in other liabilities primarily related to
an unreconciled difference between suspense account balances included
in the Company's general ledger and those included in its policy
administration system.
* A decrease of $2.0 million of accumulated other comprehensive income
due to the changes in the accounting treatment for the pre-paid
pension asset and the separate account investment; and
* A decrease in retained earnings of $16.9 million due to the
restatement adjustments described herein.
- 21 -
Commitments and Contingencies
The Company and its subsidiaries are defendants in certain legal actions related
to the normal business operations of the Company. Management believes that the
resolution of such matters will not have a material impact on the financial
statements.
Universal Life Litigation. On January 22, 2002, the Travis County District Court
in Austin, Texas denied certification to a proposed nationwide class of
plaintiffs who purchased certain universal life insurance policies from INA Life
Insurance Company (which was merged into Investors Life in 1992). The lawsuit,
which was filed in 1996 as a "vanishing premium" life insurance litigation,
initially alleged that the universal life insurance policies sold to plaintiffs
by INA Life Insurance Company utilized unfair sales practices. In April 2001,
the plaintiffs filed an amended complaint, so as to include various post- sale
allegations, including allegations related to the manner in which increases in
the cost of insurance were applied, the allocation of portfolio yields to the
universal life policies and changes in the spread between the earned rate and
the credited rate. Plaintiffs' Motion for Class Certification was denied in its
entirety.
Litigation Relating to the FIC/ILCO Merger. On the day that FIC and ILCO each
publicly announced the formation of a special committee to evaluate a potential
merger, two class action lawsuits were filed against ILCO, FIC and the officers
and directors of ILCO. The action allege that a cash consideration in the
proposed merger is unfair to the shareholders of ILCO, that it would prevent the
ILCO shareholders from realizing the true value of ILCO, and that FIC and the
named officers and directors had material conflicts of interest in approving the
transaction. In their initial pleadings, the Plaintiffs sought certification of
the cases as class actions and the named plaintiffs as class representatives,
and among other relief, requested that the merger be enjoined (or, if
consummated, rescinded and set aside) and that the defendants account to the
class members for their damages. The defendants believe that the lawsuits are
without merit and intend to vigorously contest the lawsuits. Management is
unable to determine the impact, if any, that the lawsuits may have on the
results of operations of the Company.
Subsequent Events
As previously reported in its Annual Report on Form 10-K for the year ended
December 31, 2002, the Company filed a lawsuit against Roy F. Mitte ("Mitte"),
The Roy F. and Joann Cole Mitte Foundation (the "Foundation") and Joann Mitte
(collectively referred to as the "Defendants"). Mitte was the Chairman,
President and Chief Executive Officer of FIC until he was placed on
administrative leave in August, 2002. The administrative leave, and the
subsequent action by the Board of Directors in October, 2002 to terminate the
employment agreement between FIC and Mitte, resulted from an investigation
conducted by the FIC Audit Committee. Subsequent to the filing of the lawsuit,
Mr. Mitte filed a counterclaim against the Company alleging that the Company
breached the employment agreement between the Company and Mr. Mitte by refusing
to pay Mitte the severance benefits and compensation provided for under the
employment agreement and amendment thereto.
- 22 -
On May 15, 2003, the Company entered into a settlement agreement with the
Defendants and Scott Mitte (a director of the Company and the son of Roy Mitte)
(the "Mitte Parties"). Under the terms of the agreement the Mitte Parties
released the Company from any past, present or future claims which they may have
against the Company, including any claims which Roy Mitte may assert under the
employment agreement. In addition, the Company agreed to release the Mitte
Parties from any past, present or future claims which the Company may have
against the Mitte Parties.
The settlement provides for payments by the Company to Roy Mitte of $1 million
on June 1, 2003, $1 million on June 1, 2004 and $1 million on June 1, 2005, with
a provision for acceleration of payments in the event of a change in control.
The settlement agreement also includes provisions whereby, the Company agrees
(i) to use commercially reasonable efforts to locate a purchaser or purchasers
of specified installments over a two year period of the 1,552,206 shares of FIC
common stock owned by the Foundation during future periods set forth in the
settlement agreement, at a price of $14.64 per share, (ii) to purchase (or,
alternatively, locate a purchaser) on or before June 1, 2003 of the 39, 820
shares of FIC common stock owned by Roy Mitte and the 35,502 shares of common
stock held in the ESOP account of Roy Mitte, at a price of $14.64 per share. The
agreement also includes provisions related to the continuation of health
insurance of Roy and Joann Mitte and payment for the cancellation of options
held by Roy Mitte to purchase 6,600 shares of FIC common stock. The Company has
recognized a charge of $2.9 million (before tax) in the first quarter of 2003
for amounts to be paid under the settlement agreement, representing the
discounted amount of the non-interest bearing settlement.
As a condition of the obligations of the Company under the settlement agreement,
the Mitte Parties agreed to grant a limited proxy to the persons named as
proxies by FIC in any proxy statement filed by FIC with the SEC. With respect to
the future shareholders meetings, the proxy may be voted "for" all nominees for
the Board of Directors named on FIC's proxy statement, "against" any proposal by
a person other than FIC for the removal of any members of the Board of
Directors, "withheld" as to nominees for the Board of Directors proposed by any
person other than FIC and "against" any proposal by any person other than FIC to
amend the bylaws or articles of FIC. The proxy also extends to certain matters
which may be proposed by FIC at the 2004 annual meeting of shareholders, or any
later annual or special meeting, regarding changes in the ownership percentage
required in order for a shareholder to call a special meeting of shareholders
and the elimination of cumulative voting. The granting of the proxy is generally
conditioned upon the performance of the scheduled purchases of the shares of FIC
common stock owned by the Foundation.
- 23 -
Item 2. Management's Discussion and Analysis of Financial Conditions and Results
of Operations
The following discussion addresses the financial condition of Financial
Industries Corporation ("FIC") as of March 31, 2003, compared with December 31,
2002, and its results of operations for the three months ended March 31, 2003,
compared with the same period last year. This discussion should be read in
conjunction with Management's Discussion and Analysis included in FIC's 10-K for
the year ended December 31, 2002, to which the reader is directed for additional
information.
Restatement
In this Item 2, references to results for the quarter ended March 31, 2002 are
to restated results. See the Notes to the Consolidated Financial Statements.
Transactions Affecting Comparability of Results of Operations
In 2002, net income and earnings per share were affected by the cumulative
effect of a change in accounting principle of $10.4 million. This amount
represents the excess of fair value of net assets acquired over cost as of the
beginning of 2002 related to the merger of InterContinental Life Corporation
("ILCO") with and into a subsidiary of FIC on May 18, 2001. The Company recorded
this cumulative effect in conjunction with adopting Statement of Financial
Accounting Standards No. 141 ("SFAS 141"), "Business Combinations," in the first
quarter of 2002, as required by SFAS 141.
In the first quarter of 2003, net income was affected by a $2.9 million expense
related to the settlement of the litigation between FIC, and Roy F. Mitte (the
former Chairman and Chief Executive Officer of the Company), and the Roy F. and
Joann Cole Mitte Foundation (see "Subsequent Events", herein, for a further
description of this settlement, referred to as the "Mitte Settlement").
Results of Operations - Three Months Ended March 31, 2003 and 2002
For the three-month period ended March 31, 2003, FIC's net loss was ($1.3)
million (basic and diluted loss of ($0.13) per common share) on revenues of
$29.8 million as compared to net income of $11.0 million (basic earnings of
$1.16 per common share, or diluted earnings of $1.15 per common share) on
revenues of $32.2 million in the first three months of 2002. Net income for the
first three months of 2002, before the cumulative effect of change in accounting
principle, was $0.6 million (basic and diluted earnings of $0.06 per common
share).
- 24 -
Revenues.
Premium revenues reported for traditional life insurance products are recognized
when due. Premium income for the first three months of 2003, net of reinsurance
ceded, was $7.9 million, as compared to $9.9 million in the first three months
of 2002. This source of revenues is related to the traditional life insurance
book of business of FIC's insurance subsidiaries. The level of net collected
premiums for traditional life insurance products at Family Life for the three
months ending March 31, 2003 was $5.8 million, as compared to $7.4 million in
the same period in 2002. The decrease in net collected premium is attributable
to the decrease in the traditional life insurance book of business.
Income from universal life and annuity charges for the first three months of
2003 was $10.6 million, as compared to $10.8 million in the same period of 2002.
The face amount of in force universal life policies was $5,210 million at March
31, 2002 as compared to $4,897 million at March 31, 2003.
Net investment income for the first three months of 2003 was $9.0 million as
compared to $10.4 million in the same period of 2002. Net investment income was
adversely affected by the decline in the level of interest income received from
fixed income and short-term investments. This decline is attributable to lower
interest rates during the period.
Real estate income is primarily earned from the leases on the buildings at River
Place Pointe, an office complex in Austin, Texas which is owned and being
developed by Investors Life. Real estate income was $288,000 for the three-month
period ended March 31, 2003, as compared to $613,000 for the same period in
2002. The decrease in real estate income from the three months ended March 31,
2002 to the same period ended March 31, 2003 is due to the completion of the
remainder of the buildings in River Place Pointe and the related expenses and
depreciation of those buildings.
Net realized investment gains were $1.6 million in the first three months of
2003, as compared to $0.001 million in the first three months of 2002.
Benefits and Expenses.
Policyholder benefits and expenses were $9.8 million in the first three months
of 2003, as compared to $10.9 million in the first three months of 2002. The
decrease in policyholder benefits and expenses was primarily attributable to a
decrease in reserves of $1.8 million offset by an increase in death benefits of
$0.8 million.
Interest expense on contract holders deposit funds was $7.3 million in the first
three months of 2003, as compared to $8.0 million in the same period of the year
2002. This expense is related to payment of interest to policyholders for cash
values accumulated in their accounts. This decrease was due primary to the
lowering of credited rates on these accounts
- 25 -
The costs related to acquiring new business, including certain costs of issuing
policies and certain other variable selling expenses (principally commissions),
are deferred policy acquisition costs ("DAC"). The expense related to the
amortization of DAC was $2.6 million in the first three months of 2003, as
compared to $2.0 million in the first three months of 2002. The amount not
capitalized was recorded as an expense in the first quarter. See "Critical
Accounting Policies, Deferred Policy Acquisition Costs and Present Value of
Future Profits of Acquired Business" herein for a further discussion of
capitalization of expenses related to acquiring new business.
In the first three months of 2003, the expense related to the amortization of
present value of future profits of acquired business was $1.1 million as
compared to $1.1 million in the first three months of 2002.
Operating expenses for the first three months of 2003 were $10.8 million, as
compared to $9.1 million in the first three months of 2002. The level of
operating expenses for the three month period ending March 31, 2003 included:
(i) expenses related to acquiring new business; (ii) $2.9 million related to the
Mitte Settlement (see "Subsequent Events" for a further discussion of the Mitte
Settlement); (iii) legal expenses related to litigation and proxy matters; and
(iv) fees paid to Salomon Smith Barney related to the matter set forth in the
Company's Current Report on Form 8-K filed with the Securities and Exchange
Commission on January 28, 2003.
The provision for federal income taxes was ($0.7) million in the first three
months of 2003 as compared to $0.6 million in the first three months of 2002.
The decrease was due to the decrease in income for the three month period ended
March 31, 2003 compared to the same period in 2002.
Liquidity and Capital Resources
Liquidity describes the ability of a company to generate sufficient cash flows
to meet the cash requirements of business operations. FIC is an insurance
holding company whose principal assets consist of the outstanding capital stock
of its insurance subsidiaries - Family Life Insurance Company ("Family Life")
and Investors Life Insurance Company of North America ("Investors Life"). As a
holding company, FIC's ability to meet its cash requirements, pay interest on
any debt, pay expenses related to its affairs and pay dividends on its common
stock substantially depends upon dividends from its subsidiaries. Applicable
state insurance laws generally restrict the ability of insurance companies to
pay cash dividends in excess of prescribed limitations without prior approval.
The ability of Family Life and Investors Life to pay shareholder dividends is
and will continue to be subject to restrictions set forth in the insurance laws
and regulations of Washington, their domiciliary state. Washington limits how
and when Family Life and Investors Life can pay shareholder dividends by (a)
including the "greater of" standard for payment of dividends to shareholders,
(b) requiring that prior notification of a proposed dividend be given to the
Washington Insurance Commissioner and (c) requiring that cash dividends be paid
only from earned surplus. Under the "greater of" standard, an insurer may pay a
dividend in an amount equal to the greater of : (i) 10% of the policyholder
surplus or (ii) the insurer's net gain from operations for the previous year.
Neither Investors Life nor Family Life paid any dividends during the first
quarter of 2003. For the three month period ended March 31, 2003, Investors Life
had earned surplus of $26.2 million and a net loss from operations of $0.6
million, and Family Life ad earned surplus of $2.2 million and a net gain from
operations of $0.1 million.
- 26 -
Sources of cash for FIC's insurance subsidiaries consist of premium payments
from policyholders and annuity holders, charges on policies and contracts,
investment income, and proceeds from the sale of investment assets. These funds
are applied primarily to provide for the payment of claims under insurance and
annuity policies, payment of policy withdrawals, surrenders and loans, operating
expenses, taxes, investments in portfolio securities, and shareholder dividends.
FIC's cash and cash equivalents at March 31, 2003 was $16.7 million as compared
to $25.0 million at December 31, 2002. The $8.3 million decrease in cash and
cash equivalents at March 31, 2003 from December 31, 2002 was due primarily to
reinvestment of cash into purchases of intermediate-and long-term bonds. Cash
and cash equivalents at March 31, 2002 was $9.8 million. The increase in cash
from March 31, 2002 to March 31, 2003 was primarily attributable to maturities
and early redemptions of fixed income investments which resulted in an increased
cash position pending reinvestments.
FIC's net cash flow used in operating activities was $20.1 million for the three
month period ending March 31, 2003, as compared to $8.3 million used in
operating activities for the same period in the year 2002. The increase in cash
used in operating activities of $11.8 million from 2002 to 2003 was primarily
attributable to $20.1 million of net activity from trading securities in the
three-month period ending March 31, 2003, which was offset by changes in other
assets and policy liabilities and accruals.
Net cash flow provided by investing activities was $16.1 million in the three
month period ending March 31, 2003, as compared to $11.3 million provided by
investing activities in the same period of 2002. The $4.8 million increase in
cash provided by investing activities in 2003 from 2002 was due primarily to
proceeds from calls, maturities and sales of fixed maturities.
Net cash flow used in financing activities was $4.2 million in the first three
months of 2003, as compared to $0.3 million in the first three months of 2002.
The increase in cash used in financing activities of $3.9 million is
attributable to a dividend to shareholders of $0.5 million, as well as an
increase of contractholder fund withdrawals of $3.8 million.
A primary liquidity consideration with respect to life insurance and annuity
products is the risk of early policyholder and contractholder withdrawal.
Deposit fund liabilities for universal life and annuity products as of March 31,
2003 were $557.3 million, as compared to $557.5 million at March 31, 2002.
Individual life insurance policies are less susceptible to withdrawal than are
annuity contracts because policyholders may incur surrender charges and undergo
a new underwriting process in order to obtain a new insurance policy. At March
31, 2003, the bulk of the liabilities for contractholder deposit funds on FIC's
balance sheet, $415.9 million, were related to insurance products, as compared
to only $141.4 million of annuity product liabilities.
- 27 -
The cash requirements of FIC, and its holding company subsidiary, Family Life
Corporation, consist primarily of its service of the indebtedness created in
connection with FIC's ownership of Family Life. As of March 31, 2003, the
investment portfolio of Investors Life included $21.5 million of notes
receivable from affiliates, represented by (i) a loan of $30 million by
Investors Life to Family Life Corporation made in July 1993, in connection with
the prepayment of indebtedness which had been previously issued to Merrill Lynch
as part of the 1991 acquisition of Family Life by a wholly- owned subsidiary of
FIC, and (ii) a loan of $4.5 million by Investors Life to Family Life Insurance
Investment Company made in July 1993, in connection with the same transaction
described above.
The provisions of the notes owned by Investors Life include the following
provisions: (a) the $30 million note provides for quarterly principal payments,
in the amount of $1,336,458; the final quarterly principal payment is due on
September 12, 2006; the interest rate on the note is 9%, and (b) the $4.5
million note provides for quarterly principal payments, in the amount of
$200,469; the final quarterly principal payment is due on September 12, 2006;
the interest rate on the note is 9%.
Due to the merger of InterContinental Life Corporation (which owns 100% of the
outstanding stock of Investors Life) with a subsidiary of FIC on May 18, 2001,
this indebtedness is not included as a liability on the consolidated financial
statements of FIC. FIC's other liquidity requirements relate principally to the
need for cash flow to meet operating expenses, as well as the liabilities
associated with its insurance subsidiaries' various life insurance and annuity
products.
In 2002, management reviewed the Company's liquidity to determine whether the
cash, cash equivalents and short term investments of the Company were sufficient
to meet the Company's needs for cash for operations, capital requirements and
commitments. Based on such review, management has reduced the amount of
dividends paid to shareholders, discontinued donations to the Roy F. and Joann
Cole Mitte Foundation, and implemented plans to streamline the operations of the
Company. Because of such review and subsequent initiatives set forth by
management, management believes that the cash, cash equivalents and short term
investments of FIC and its subsidiaries are sufficient to meet the needs of its
business and to satisfy debt service. There are no trends, commitments or
capital asset requirements that are expected to have an adverse effect on the
liquidity of FIC.
Investments
As of March 31, 2003, FIC's invested assets, excluding separate accounts, $821.5
million, compared to $761.2 million at December 31, 2002. The increase is
primarily attributable to a $20 million increase in trading securities and an
increase in fixed maturities available for sale of $45.1 million. There are no
significant differences between the portfolio composition as of March 31, 2003
as compared to December 31, 2002 other than the addition of trading securities,
which compromise 2.44% of the investment portfolio at March 31, 2003 as compared
to 0% at December 31, 2003.
- 28 -
The assets held by FIC's life insurance subsidiaries must comply with applicable
state insurance laws and regulations. In selecting investments for the
portfolios of its life insurance subsidiaries, the emphasis is to obtain
targeted profit margins, while minimizing the exposure to changing interest
rates. This objective is implemented by selecting primarily short- to
medium-term, investment grade fixed income securities. In making such portfolio
selections, the Company generally does not select new investments which are
commonly referred to as "high yield" or "non-investment grade". The general
investment objective of the Company emphasizes the selection of short to medium
term high quality fixed income securities, rated Baa-3 (investment grade) or
better by Moody's Investors Service, Inc. FIC determines the allocation of our
assets primarily on the basis of cash flow and return requirements of our
products and secondarily by the level of investment risk.
Another key element of the Company's investment strategy is to avoid large
exposure in other investment categories which the Company believes carry higher
credit or liquidity risks, including private placements, partnerships and bank
participations. These categories accounted for only $22,094 of invested assets
as of March 31, 2003 and $26,049 of invested assets at December 31, 2002.
Fixed Maturity Securities
The Company's fixed maturity securities portfolio is predominately comprised of
low risk, investment grade, available for sale publicly traded corporate
securities, mortgage-backed securities and United States Government bonds. As of
March 31, 2003, the market value of fixed maturities available for sale was
$538.9 million as compared to an amortized cost of $528.4 million or an
unrealized gain of $10.5 million. The increase reflects unrealized gains on such
investments related to changes in interest rates subsequent to the purchase of
such investments. At December 31, 2002, the market value of the fixed maturities
available for sale segment was $493.8 million as compared to an amortized cost
of $479.4 million.
The investments of FIC's insurance subsidiaries in mortgage-backed securities
included collateralized mortgage obligations ("CMOs") of $223.2 million as of
March 31, 2003 as compared to $175.4 million at December 31, 2002, and
mortgage-backed pass-through securities of $66.8 million as of March 31, 2003
and $29.6 million at December 31, 2002. Mortgage-backed pass- through
securities, sequential CMO's and support bonds, which comprised approximately
52.9% of the book value of FIC's mortgage-backed securities at March 31, 2003,
are sensitive to prepayment and extension risks. FIC's insurance subsidiaries
have reduced the risk of prepayment associated with mortgage-backed securities
by investing in planned amortization class ("PAC"), target amortization class
("TAC") instruments and scheduled bonds. These investments are designed to
amortize in a predictable manner by shifting the risk of prepayment of the
underlying collateral to other investors in other tranches ("support classes")
of the CMO. At March 31, 2003, PAC and TAC instruments and scheduled bonds
represented approximately 32.8% of the book value of FIC's mortgage-backed
securities. Sequential and support classes represented approximately 14.3% of
the book value of FIC's mortgage-backed securities at March 31, 2003.
Additionally, the insurance subsidiaries make selected investments in CMOs of
the inverse floater category. Such instruments, which are subject to strict
quantitative and qualitative standards, carry a higher current interest rate
- 29 -
which varies in an inverse relationship with a specified benchmark interest
rate. The investment guidelines do not permit the purchase of CMOs which are
interest only or principal only instruments. The prepayment risk that certain
mortgage-backed securities are subject to is prevalent in periods of declining
interest rates, when mortgages may be repaid more rapidly than scheduled as
individuals refinance higher rate mortgages to take advantage of the lower
current rates. As a result, holders of mortgage-backed securities may receive
large prepayments on their investments which cannot be reinvested at an interest
rate comparable to the rate on the prepaying mortgages. For the year 2003, the
investment objectives of FIC's insurance subsidiaries include a strategy of
reducing the concentration in short-term investments by making selected
investments in a variety of medium-term CMO instruments.
The securities valuation office (SVO) of the National Association of Insurance
Commissioners evaluates all public and private bonds purchased as investments by
insurance companies. The SVO assigns one of six investment categories to each
security it reviews. Category 1 is the highest quality rating, and Category 6 is
the lowest. As of March 31, 2003, the majority of our bonds are investment grade
(Category 1 and 2). The Company's fixed maturities portfolio (including
short-term investments), included only a non-material amount of debt securities
which, in the annual statements of the companies as filed with state insurance
departments, were designated by the SVO as "3" (medium quality) or below.
Trading Securities
FIC's trading securities consist of CMOs of the type which are generally
referred to as "inverse floaters" which have coupon rates that vary in an
inverse relationship with a specified benchmark rate. The value of FIC's trading
securities as of March 31, 2003 was $20.1 million. The change in the market
value of trading securities during the period is included in net realized
investment gains on the income statement. The change in market value included in
income during the three months ended March 31, 2003 is $5,000. FIC did not have
any trading securities at December 31, 2002.
Equity Securities
FIC's equity securities consist primarily of its investment in the separate
account of Investors Life. As of March 31, 2003, the market value of FIC's
equity securities was $6.1 million, as compared to $6.4 million at December 31,
2002. The decrease is related to a decline in the value of the underlying funds
in the separate account.
Policy Loans
Policy loans totaled $45.9 million at March 31, 2003, as compared to $46.6
million at December 31, 2002.
- 30 -
Mortgage Loans
As of March 31, 2003, $7,000 was invested in mortgage loans, as compared to
$17,000 at December 31, 2002. The Company does not make new mortgage loans on
commercial properties.
Real Estate
Invested real estate at March 31, 2003 was $74.9 million as compared to $75.4
million at December 31, 2002. The real estate investment is primarily related to
the development of the River Place Pointe project ("River Place Pointe") by
Investors Life. In October 1998, Investors Life purchased River Place Pointe,
which consisted of two adjoining tracts of land located in Austin, Texas
totaling 47.995 acres. The aggregate purchase price for these tracts was $8.1
million. Investors Life obtained a Site Development Permit for the tracts from
the City of Austin allowing for the construction of seven office buildings
totaling 600,000 square feet, with associated parking, drives and related
improvements. Construction on the first section of the project, which consists
of four office buildings, an associated parking garage, and related
infrastructure was completed during 2000 and 2001. Construction on the second
section of the project, which consists of three office buildings, an associated
parking garage, and related infrastructure was completed in 2002.
As of March 31, 2003, Investors Life had invested $93.8 million in the
construction of River Place Pointe, of which $19.6 million is recorded on FIC's
balance sheet as real estate occupied by the Company. As of March 31, 2003,
226,039.5 rentable square feet of office space was leased to third party tenants
and 273,497 rentable square feet was available for lease. According to the
Federal Deposit Insurance Corporation's ("FDIC") National Edition of Regional
Outlook, Fourth Quarter, 2002, the Austin office market vacancy rate (including
sublease space available) was 27.2% as of September 30, 2002, the highest in the
nation.
The Company views the River Place Pointe investment as a long term commitment.
Based on this assumption, the Company has examined future anticipated cash flow
on the development and has determined that the investment is not impaired.
Short-term investments
FIC's short-term investments consist primarily of U.S. Government bonds. The
level of short-term investments at March 31, 2003 was $135.7 million, as
compared to $137.9 million as of December 31, 2002.
- 31 -
Critical Accounting Policies
The financial statements contain a summary of FIC's critical accounting
policies, including a discussion of recently-issued accounting pronouncements.
Certain of these policies are considered to be important to the portrayal of
FIC's financial condition, since they require management to make difficult,
complex or subjective judgments, some of which may relate to matters that are
inherently uncertain. These policies include valuation of investments and
deferred acquisition costs and present value of future profits. For the year
2002, the Company's critical accounting policies also included the cumulative
effect of accounting changes regarding the goodwill acquired from the merger
with ILCO.
Cumulative Effect of Accounting Changes. During the first quarter of 2002, the
Company adopted Statement of Financial Accounting Standards (SFAS) No. 141,
"Business Combinations." SFAS No. 141 eliminates the practice of amortizing and
deferring excess of net assets acquired over costs and requires unallocated
negative goodwill to be recognized immediately. In accordance with the standard,
FIC ceased negative goodwill amortization on January 1, 2002 and recognized the
unamortized balance of $10.4 million of negative goodwill acquired in the
Merger.
Investments. The Company's investments primarily consist of fixed maturity
securities, which include bonds, notes and redeemable preferred stocks. Fair
values of investments in fixed securities are based on quoted market prices or
dealer quotes. Fixed maturities classified as "available for sale" are reported
at fair value, with unrealized investment gains and losses, net of income taxes,
credited or charged directly to shareholder's equity. Securities classified as
trading are reported at fair value with changes in fair value credited or
charged directly to income. Generally accepted accounting principles require
that investments be written down to fair value when declines in value are
considered other than temporary. When such impairments occur, the decrease in
value is reported in net income as a realized investment loss and a new cost
basis is established.
Deferred Policy Acquisition Costs and Present Value of Future Profits of
Acquired Business. The costs of acquiring new business, including certain costs
of issuing policies and certain other variable selling expenses (principally
commissions), are included in deferred policy acquisition costs ("DAC"). DAC is
capitalized and then amortized to reflect an expense in relation to the
projected stream of profits (for universal life and annuity products) or to the
premium revenue (for traditional life products). Such projections require use of
certain assumptions, including interest margins, product loads, mortality rates,
persistency rates, and maintenance expense levels. Effective with respect to new
business issued on and after January 1, 2002, the Company has capitalized DAC
based on an updated analysis of its cost structure and assumptions as to product
performance. Management periodically reviews the assumptions associated with the
amortization models prospectively.
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Present value of future profits of acquired business ("PVFP") are the costs
associated with acquiring blocks of insurance from other companies or through
the acquisition of other companies. PVFP is capitalized and amortized in a
manner that matches these costs against the associated revenues.
For a further discussion of accounting standards, see New Accounting
Pronouncements beginning on page 12, herein.
Subsequent Events
As previously reported in its Annual Report on Form 10-K for the year ended
December 31, 2002, the Company filed a lawsuit against Roy F. Mitte ("Mitte"),
The Roy F. and Joann Cole Mitte Foundation (the "Foundation") and Joann Mitte
(collectively referred to as the "Defendants"). Mitte was the Chairman,
President and Chief Executive Officer of FIC until he was placed on
administrative leave in August, 2002. The administrative leave, and the
subsequent action by the Board of Directors in October, 2002 to terminate the
employment agreement between FIC and Mitte, resulted from an investigation
conducted by the FIC Audit Committee. Subsequent to the filing of the lawsuit,
Mr. Mitte filed a counterclaim against the Company alleging that the Company
breached the employment agreement between the Company and Mr. Mitte by refusing
to pay Mitte the severance benefits and compensation provided for under the
employment agreement and amendment thereto.
On May 15, 2003, the Company entered into a settlement agreement with the
Defendants and Scott Mitte (a director of the Company and the son of Roy Mitte)
(the "Mitte Parties"). Under the terms of the agreement the Mitte Parties
released the Company from any past, present or future claims which they may have
against the Company, including any claims which Roy Mitte may assert under the
employment agreement. In addition, the Company agreed to release the Mitte
Parties from any past, present or future claims which the Company may have
against the Mitte Parties.
The settlement provides for payments by the Company to Roy Mitte of $1 million
on June 1, 2003, $1 million on June 1, 2004 and $1 million on June 1, 2005, with
a provision for acceleration of payments in the event of a change in control.
The settlement agreement also includes provisions whereby, the Company agrees
(i) to use commercially reasonable efforts to locate a purchaser or purchasers
of specified installments over a two year period of the 1,552,206 shares of FIC
common stock owned by the Foundation during future periods set forth in the
settlement agreement, at a price of $14.64 per share, (ii) to purchase (or,
alternatively, locate a purchaser) on or before June 1, 2003 of the 39, 820
shares of FIC common stock owned by Roy Mitte and the 35,502 shares of common
stock held in the ESOP account of Roy Mitte, at a price of $14.64 per share. The
agreement also includes provisions related to the continuation of health
insurance of Roy and Joann Mitte and payment for the cancellation of options
held by Roy Mitte to purchase 6,600 shares of FIC common stock. The Company has
recognized a charge of $2.9 million (before tax) in the first quarter of 2003
for amounts to be paid under the settlement agreement, representing the
discounted amount of the non- interest bearing settlement.
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As a condition of the obligations of the Company under the settlement agreement,
the Mitte Parties agreed to grant a limited proxy to the persons named as
proxies by FIC in any proxy statement filed by FIC with the SEC. With respect to
the future shareholders meetings, the proxy may be voted "for" all nominees for
the Board of Directors named on FIC's proxy statement, "against" any proposal by
a person other than FIC for the removal of any members of the Board of
Directors, "withheld" as to nominees for the Board of Directors proposed by any
person other than FIC and "against" any proposal by any person other than FIC to
amend the bylaws or articles of FIC. The proxy also extends to certain matters
which may be proposed by FIC at the 2004 annual meeting of shareholders, or any
later annual or special meeting, regarding changes in the ownership percentage
required in order for a shareholder to call a special meeting of shareholders
and the elimination of cumulative voting. The granting of the proxy is generally
conditioned upon the performance of the scheduled purchases of the shares of FIC
common stock owned by the Foundation.
A copy of the settlement agreement is attached hereto as an exhibit.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
General. FIC's principal assets are financial instruments, which are subject to
market risks. Market risk is the risk of loss arising from adverse changes in
market rates, principally interest rates on fixed rate investments. For a
discussion of the Company's investment portfolio and the management of that
portfolio to reflect the nature of the underlying insurance obligations of the
Company's insurance subsidiaries, please refer to the information set forth in
"Management's Discussion and Analysis of Financial Condition and Operations -
Investments".
The following is a discussion of the Company's primary market risk sensitive
instruments. It should be noted that this discussion has been developed using
estimates and assumptions. Actual results may differ materially from those
described below. Further, the following discussion does not take into account
actions that could be taken by management in response to the assumed changes in
market rates. In addition, the discussion does not take into account other types
of risks that may be involved in the business operations of the Company, such as
the reinsurance recoveries on reinsurance treaties with third party insurers.
The primary market risk to the Company's investment portfolio is interest rate
risk. The Company's investment portfolio includes $20.1 million of "inverse
floater" CMOs. These contain a derivative which is "embedded" in the financial
instrument. Changes in the market value of the entire securities, including the
embedded derivatives, are recorded in the income statement each period as these
securities have been classified as trading securities.
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Interest Rate Risk The Company manages the interest rate risk inherent in
our assets relative to the interest rate risk inherent in our liabilities.
Generally, we manage interest rate risk based on the application of a commonly
used model. The model projects the impact of interest rate changes on a range of
factors, including duration and potential prepayment. For example, assuming an
immediate increase of 100 basis points in interest rates, the net hypothetical
loss in fair market value related to the financial instruments segment of the
Company's balance sheet is estimated to be $24.4 million at March 31, 2003 and
$16.6 million at December 31, 2002. For purposes of the foregoing estimate,
fixed maturities, including fixed maturities available for sale and trading
securities, and short-term investments were taken into account. The market value
of such assets was $694.7 million at March 31, 2003 and $632.8 million at
December 31, 2002.
The fixed income investments of the Company include certain mortgage-backed
securities. The market value of such securities was $290.0 million at March 31,
2003 and $205.4 million at December 31, 2002. Assuming an immediate increase of
100 basis points in interest rates, the net hypothetical loss in the fair market
value related to such mortgage-backed securities is estimated to be $9.9 million
at March 31, 2003 and $4.7 million at December 31, 2002.
Separate account assets have not been included, since gains and losses on those
assets generally accrue to the policyholders.
The Company generally does not use derivative financial instruments to manage
our exposure to fluctuations in interest rates. However, the Company's
investments in inverse floater CMO's at March 31, 2003 described above have a
coupon rate which varies in an inverse relationship with a specified benchmark
rate.
The hypothetical effect of the interest rate risk on fair values was estimated
by applying a commonly used model. The model projects the impact of interest
rate changes on a range of factors, including duration and potential prepayment.
Item 4. Controls and Procedures
The chief executive officer and chief financial officer of the Company have
evaluated the effectiveness of the Company's disclosure controls and procedures
pursuant to Rule 13a-14 under the Securities Exchange Act of 1934 as of a date
within 90 days prior to the filing date of this report. Based on that
evaluation, such officers have concluded that the Company's disclosure controls
and procedures are effective to ensure that material information relating to the
Company and its subsidiaries is made known to such officers in a timely manner
for inclusion in the Company's periodic filings with the SEC.
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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 most recent evaluation by the Company's chief executive officer and chief
financial officer.
Part II. Other Information
Item 1. Legal Proceedings
The Company and its subsidiaries are defendants in certain legal actions related
to the normal business operations of the Company. Management believes that the
resolution of such legal actions will not have a material impact on the
financial statements.
Litigation Relating to the FIC/ ILCO Merger. There have been no material
developments since the Company's filing of its Annual Report on Form 10-K for
the year ended December 31, 2002.
Litigation Relating to Former Chairman and CEO. For an update of material
developments which have occurred since the Company's filing of its Annual Report
on Form 10-K for the year ended December 31, 2002, see "Part I. - Item 2.
Management's Discussion and Analysis of Financial Conditions and Results of
Operations - Subsequent Events".
Other Litigation. Additionally, FIC's insurance subsidiaries are regularly
involved in litigation, both as a defendant and as plaintiff. The litigation
naming the insurance subsidiaries as defendant ordinarily involves our
activities as a provider of insurance protection products. Management does not
believe that such litigation, either individually or in the aggregate, will have
a material adverse effect on the Company's business, financial condition or
results of operations.
Item 2. Changes in Securities and Use of Proceeds
None
Item 3. Defaults Upon Senior Securities
None
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Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during
the first quarter of 2003.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
99.1 Certification of Chief Executive Officer of FIC pursuant to
18 U.S.C. Section 1350.
99.2 Certification of Chief Financial Officer of FIC pursuant to
18 U.S.C. Section 1350.
10.1 Compromise Settlement Agreement and Mutual Release in the
litigation entitled Financial Industries Corporation v. The
Roy F. and Joann Cole Mitte Foundation, Roy F. Mitte, and
Joann Cole Mitte, Civil Action No. A03 CA 033 SS, in the
United States District Court for the Western District of
Texas, Austin Division.
(b) Reports on Form 8-K
(i) On January 28, 2003, the Registrant filed a Current Report
on Form 8-K. The current report referred to a press release
issued January 27, 2002 by the Company, which announced that
the Company had retained Salomon Smith Barney to explore
strategic alternatives for the Company, including continuing
the business plan of new management, consideration of a
proposal to purchase some or all of FIC's outstanding stock,
the sale, merger or consolidation of the Company, or any
other alternatives that Salomon believed should be
considered.
(ii) On February 3, 2003, the Registrant filed a Current Report
on Form 8-K. The current report referred to a press release
issued January 31, 2002 by the Company, which announced
plans to implement new technology projects.
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FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES
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.
FINANCIAL INDUSTRIES CORPORATION
/s/ Eugene E. Payne
_____________________________________
Eugene E. Payne
President and Chief Executive Officer
/s/ George M. Wise, III
_____________________________________
George M. Wise, III
Chief Financial Officer
Date: May 15, 2003
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CERTIFICATION
I, Eugene E. Payne, Chief Executive Officer of Financial Industries Corporation
("FIC"), certify that:
1. I have reviewed this quarterly report on Form 10-Q of FIC;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the Registrant as of, and for, the periods presented in
this quarterly report;
4. The Registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the Registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The Registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Registrant's auditors and the
audit committee of Registrant's board of directors (or persons
performing the equivalent function):
- 39 -
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Registrant's
ability to record, process, summarize and report financial data
and have identified for the Registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's
internal controls; and
6. The Registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 15, 2003 By:/s/ Eugene E. Payne
________________________________
Eugene E. Payne
Chief Executive Officer
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CERTIFICATION
I, George M. Wise, III, Chief Financial Officer of Financial Industries
Corporation ("FIC"), certify that:
1. I have reviewed this quarterly report on Form 10-Q of FIC;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the Registrant as of, and for, the periods presented in
this quarterly report;
4. The Registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant
and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
b) evaluated the effectiveness of the Registrant's disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The Registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Registrant's auditors and the
audit committee of Registrant's board of directors (or persons
performing the equivalent function):
- 41 -
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Registrant's
ability to record, process, summarize and report financial data
and have identified for the Registrant's auditors any material
weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the Registrant's
internal controls; and
6. The Registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Date: May 15, 2003 By: /s/ George M. Wise, III
_____________________________
George M. Wise, III
Chief Financial Officer
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