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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X]QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
[ ]TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________ to ___________
Commission file number 1-10890
HORACE MANN EDUCATORS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 37-0911756
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1 Horace Mann Plaza, Springfield, Illinois 62715-0001
(Address of principal executive offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: 217-789-2500
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ___
As of July 31, 2002, 40,848,319 shares of Common Stock, par value $0.001
per share, were outstanding, net of 19,341,296 shares of treasury stock.
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[SEAL]
HORACE MANN EDUCATORS CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2002
INDEX
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Independent Auditors' Review Report................................... 1
Consolidated Balance Sheets as of
June 30, 2002 and December 31, 2001.................................. 2
Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 2002 and 2001.................... 3
Consolidated Statements of Changes in Shareholders' Equity
for the Six Months Ended June 30, 2002 and 2001...................... 4
Consolidated Statements of Cash Flows for the
Three and Six Months Ended June 30, 2002 and 2001.................... 5
Notes to Consolidated Financial Statements............................ 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................... 21
Item 3. Quantitative and Qualitative Disclosures about Market Risk......... 46
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders................ 46
Item 6. Exhibits and Reports on Form 8-K................................... 47
SIGNATURES........................................................................... 48
[SEAL]
INDEPENDENT AUDITORS' REVIEW REPORT
The Board of Directors and Shareholders
Horace Mann Educators Corporation:
We have reviewed the consolidated balance sheet of Horace Mann Educators
Corporation and subsidiaries as of June 30, 2002, and the related consolidated
statements of operations and cash flows for the three-month and six-month
periods ended June 30, 2002 and 2001, and the related consolidated statements of
changes in shareholders' equity for the six-month periods ended June 30, 2002
and 2001. These consolidated financial statements are the responsibility of the
Company's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with auditing standards generally accepted in the United States of
America, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such an
opinion.
Based on our review, we are not aware of any material modifications that
should be made to the consolidated financial statements referred to above for
them to be in conformity with accounting principles generally accepted in the
United States of America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of
Horace Mann Educators Corporation and subsidiaries as of December 31, 2001, and
the related consolidated statements of operations, changes in shareholders'
equity, and cash flows for the year then ended (not presented herein); and in
our report dated February 7, 2002, we expressed an unqualified opinion on those
consolidated financial statements.
As discussed in note 5 to the consolidated financial statements, as of
January 1, 2002 the Company adopted the provisions of Statement of Financial
Accounting Standards No. 142, "Goodwill and Intangible Assets."
/s/ KPMG LLP
KPMG LLP
Chicago, Illinois
August 5, 2002
[SEAL]
1
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
JUNE 30, DECEMBER 31,
2002 2001
----------- ------------
ASSETS
Investments
Fixed maturities, available for sale, at fair value (amortized
cost, 2002, $2,686,345; 2001, $2,726,831) .......................... $ 2,714,475 $ 2,769,867
Short-term and other investments .................................... 167,231 107,445
Short-term investments, loaned securities collateral ................ 448,074 98,369
----------- ------------
Total investments ................................................ 3,329,780 2,975,681
Cash .................................................................. 20,858 33,939
Accrued investment income and premiums receivable ..................... 95,203 112,746
Deferred policy acquisition costs ..................................... 170,074 157,776
Goodwill .............................................................. 47,396 47,396
Value of acquired insurance in force .................................. 35,797 38,393
Other assets .......................................................... 205,044 114,665
Variable annuity assets ............................................... 952,647 1,008,430
----------- ------------
Total assets ..................................................... $ 4,856,799 $ 4,489,026
=========== ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Policy liabilities
Fixed annuity contract liabilities .................................. $ 1,311,526 $ 1,278,137
Interest-sensitive life contract liabilities ........................ 530,738 518,455
Unpaid claims and claim expenses .................................... 318,538 314,295
Future policy benefits .............................................. 181,890 179,109
Unearned premiums ................................................... 175,864 185,569
----------- ------------
Total policy liabilities ......................................... 2,518,556 2,475,565
Other policyholder funds .............................................. 123,451 123,434
Liability for securities lending agreements ........................... 448,074 98,369
Other liabilities ..................................................... 161,708 171,271
Short-term debt ....................................................... - 53,000
Long-term debt ........................................................ 212,821 99,767
Variable annuity liabilities .......................................... 952,647 1,008,430
----------- ------------
Total liabilities ................................................ 4,417,257 4,029,836
----------- ------------
Preferred stock, $0.001 par value, shares authorized
1,000,000; none issued ............................................... - -
Common stock, $0.001 par value, shares authorized
75,000,000; shares issued, 2002, 60,189,615;
2001, 60,076,921 ..................................................... 60 60
Additional paid-in capital ............................................ 342,230 341,052
Retained earnings ..................................................... 448,844 461,139
Accumulated other comprehensive income (loss), net of taxes:
Net unrealized gains on fixed
maturities and equity securities ................................... 17,897 26,336
Minimum pension liability adjustment ................................ (11,530) (11,438)
Treasury stock, at cost, 19,341,296 shares ............................ (357,959) (357,959)
----------- ------------
Total shareholders' equity ....................................... 439,542 459,190
----------- ------------
Total liabilities and shareholders' equity .................... $ 4,856,799 $ 4,489,026
=========== ============
[SEAL]
See accompanying notes to consolidated financial statements.
2
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2002 2001 2002 2001
--------- --------- --------- ---------
Insurance premiums written
and contract deposits ............................ $ 218,600 $ 218,225 $ 430,348 $ 425,997
========= ========= ========= =========
Revenues
Insurance premiums and
contract charges earned ......................... $ 154,333 $ 151,990 $ 309,886 $ 301,907
Net investment income ............................ 50,350 49,835 100,035 98,598
Realized investment losses ....................... (41,277) (5,719) (38,695) (1,035)
--------- --------- --------- ---------
Total revenues .................................. 163,406 196,106 371,226 399,470
--------- --------- --------- ---------
Benefits, losses and expenses
Benefits, claims and settlement expenses ......... 115,967 134,813 226,783 242,590
Interest credited ................................ 24,441 24,508 48,590 48,317
Policy acquisition expenses amortized ............ 14,301 13,256 28,926 27,314
Operating expenses ............................... 31,714 26,798 63,990 56,292
Amortization of intangible assets ................ 1,383 1,770 2,677 3,677
Interest expense ................................. 2,364 2,323 4,431 4,847
Debt retirement costs ............................ 2,316 - 2,316 -
Litigation charges ............................... 1,581 - 1,581 -
Restructuring reserve adjustment ................. - (175) - (175)
--------- --------- --------- ---------
Total benefits, losses and expenses ............. 194,067 203,293 379,294 382,862
--------- --------- --------- ---------
Income (loss) before income taxes ................. (30,661) (7,187) (8,068) 16,608
Income tax expense (benefit) ...................... (11,374) (2,261) (4,352) 4,836
--------- --------- --------- ---------
Net income (loss) ................................. $ (19,287) $ (4,926) $ (3,716) $ 11,772
========= ========= ========= =========
Net income (loss) per share
Basic ............................................ $ (0.47) $ (0.12) $ (0.09) $ 0.29
========= ========= ========= =========
Diluted .......................................... $ (0.47) $ (0.12) $ (0.09) $ 0.29
========= ========= ========= =========
Weighted average number of shares
and equivalent shares (in thousands)
Basic ........................................... 40,838 40,554 40,809 40,539
Diluted ......................................... 41,294 40,874 41,272 40,800
[SEAL]
See accompanying notes to consolidated financial statements.
3
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SIX MONTHS ENDED
JUNE 30,
-----------------------
2002 2001
---------- ----------
Common stock
Beginning balance ............................................ $ 60 $ 60
Options exercised, 2002, 102,410 shares;
2001, 64,575 shares ......................................... - -
Conversion of Director Stock Plan units,
2002, 10,284 shares; 2001, 10,293 shares .................... - -
---------- ----------
Ending balance ............................................... 60 60
---------- ----------
Additional paid-in capital
Beginning balance ............................................ 341,052 338,243
Options exercised and conversion of
Director Stock Plan units ................................... 2,116 964
Catastrophe-linked equity put option premium ................. (938) (475)
---------- ----------
Ending balance ............................................... 342,230 338,732
---------- ----------
Retained earnings
Beginning balance ............................................ 461,139 452,624
Net income (loss) ............................................ (3,716) 11,772
Cash dividends, 2002, $0.21 per share;
2001, $0.21 per share ....................................... (8,579) (8,518)
---------- ----------
Ending balance ............................................... 448,844 455,878
---------- ----------
Accumulated other comprehensive income (loss), net of taxes:
Beginning balance ............................................ 14,898 (4,975)
Change in net unrealized gains (losses) on
fixed maturities and equity securities ..................... (8,439) 12,514
Increase in minimum pension liability adjustment ............ (92) -
---------- ----------
Ending balance ............................................... 6,367 7,539
---------- ----------
Treasury stock, at cost
Beginning and ending balance,
2002 and 2001, 19,341,296 shares ............................ (357,959) (357,959)
---------- ----------
Shareholders' equity at end of period ......................... $ 439,542 $ 444,250
========== ==========
Comprehensive income (loss)
Net income (loss) ............................................ $ (3,716) $ 11,772
Other comprehensive income (loss), net of taxes:
Change in net unrealized gains (losses)
on fixed maturities and equity securities .................. (8,439) 12,514
Increase in minimum pension liability adjustment ............ (92) -
---------- ----------
Other comprehensive income (loss) ........................ (8,531) 12,514
---------- ----------
Total .................................................. $ (12,247) $ 24,286
========== ==========
[SEAL]
See accompanying notes to consolidated financial statements.
4
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------ ------------------------
2002 2001 2002 2001
----------- ----------- ----------- -----------
Cash flows from operating activities
Premiums collected ................................... $ 165,576 $ 154,669 $ 330,262 $ 316,458
Policyholder benefits paid ........................... (118,327) (116,557) (240,169) (240,035)
Policy acquisition and
other operating expenses paid ....................... (50,016) (45,286) (105,202) (92,100)
Federal income taxes paid ............................ (8,818) - (10,850) -
Investment income collected .......................... 48,469 45,161 101,460 94,599
Interest expense paid ................................ (1,941) (6) (5,257) (4,154)
Other ................................................ (3,396) (867) (3,416) (1,154)
----------- ----------- ----------- -----------
Net cash provided by operating activities ......... 31,547 37,114 66,828 73,614
----------- ----------- ----------- -----------
Cash flows used in investing activities
Fixed maturities
Purchases .......................................... (417,486) (330,303) (851,430) (688,388)
Sales .............................................. 290,686 208,151 683,818 470,932
Maturities ......................................... 79,612 70,217 99,214 136,916
Net cash received from (used for) short-term
and other investments ............................... (45,730) 14,180 (61,072) 7,086
----------- ----------- ----------- -----------
Net cash used in investing activities ............. (92,918) (37,755) (129,470) (73,454)
----------- ----------- ----------- -----------
Cash flows provided by (used in) financing activities
Dividends paid to shareholders ....................... (4,295) (4,261) (8,579) (8,518)
Principal repayments on Bank Credit Facility ......... (53,000) - (53,000) -
Exercise of stock options ............................ 762 874 2,116 964
Catastrophe-linked equity put option premium ......... (938) (238) (938) (475)
Proceeds from issuance of
Convertible Notes ................................... 163,013 - 163,013 -
Retirement of Senior Notes ........................... (56,941) - (56,941) -
Annuity contracts, variable and fixed
Deposits ............................................ 65,090 61,697 128,439 120,649
Maturities and withdrawals .......................... (45,770) (40,094) (86,894) (93,879)
Net transfer to variable annuity assets ............. (17,250) (15,641) (34,204) (19,125)
Net decrease in life policy account balances ......... (1,763) (1,210) (3,451) (2,286)
----------- ----------- ----------- -----------
Net cash provided by (used in)
financing activities ............................. 48,908 1,127 49,561 (2,670)
----------- ----------- ----------- -----------
Net increase (decrease) in cash ....................... (12,463) 486 (13,081) (2,510)
Cash at beginning of period ........................... 33,321 18,145 33,939 21,141
----------- ----------- ----------- -----------
Cash at end of period ................................. $ 20,858 $ 18,631 $ 20,858 $ 18,631
=========== =========== =========== ===========
[SEAL]
See accompanying notes to consolidated financial statements.
5
HORACE MANN EDUCATORS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2002 AND 2001
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Note 1 - Basis of Presentation
The accompanying unaudited consolidated financial statements of Horace Mann
Educators Corporation ("HMEC"; and together with its subsidiaries, the
"Company") have been prepared in accordance with the rules and regulations of
the Securities and Exchange Commission. Certain information and note disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted. The Company believes that these financial statements
contain all adjustments (consisting of normal recurring accruals) necessary to
present fairly the Company's consolidated financial position as of June 30, 2002
and December 31, 2001 and the consolidated results of operations, changes in
shareholders' equity and cash flows for the three and six months ended June 30,
2002 and 2001.
The subsidiaries of HMEC sell and underwrite tax-qualified retirement
annuities and private passenger automobile, homeowners, and life insurance
products, primarily to educators and other employees of public schools and their
families. The Company's principal operating subsidiaries are Horace Mann Life
Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company,
Horace Mann Property & Casualty Insurance Company and Horace Mann Lloyds.
It is suggested that these financial statements be read in conjunction with
the financial statements and the related notes included in the Company's Annual
Report on Form 10-K for the year ended December 31, 2001.
The results of operations for the three and six months ended June 30, 2002
are not necessarily indicative of the results to be expected for the full year.
Note 2 - Restructuring Charges
Restructuring charges were incurred and separately identified in the
Statements of Operations for the years ended December 31, 2001 and 2000.
Massachusetts Automobile Business
In October 2001, the Company recorded restructuring charges of $7,290
pretax ($4,738, or $0.12 per share, after tax) reflecting a change in the
Company's presence in the Massachusetts automobile market. On October 18, 2001,
Horace Mann announced that it had formed a marketing alliance with The Commerce
Group, Inc. ("Commerce") for the sale of automobile insurance in the state of
Massachusetts. Through this alliance, and by January 1, 2002, Horace Mann began
providing its Massachusetts customers with Commerce automobile insurance
policies, while continuing to write other Horace Mann products, including
property and life insurance and retirement annuities.
[SEAL]
6
Note 2 - Restructuring Charges-(Continued)
The Company's Consolidated Balance Sheets at June 30, 2002 and December 31,
2001 did not reflect any accrued amounts due to the restructure of its
Massachusetts automobile business.
The Company expects that this transaction will have a positive impact on
operating income of approximately $0.10 per share in 2003 and beyond. The
improvement in 2002 earnings will be somewhat less reflecting the run-off of
current policies in force. The Company plans to utilize the benefits of this
transaction to invest in its marketing, customer service and technology
infrastructures. The Company's Massachusetts automobile business represented
premiums written and earned of approximately $14,000 and $27,000 for the six
months ended June 30, 2001 and the twelve months ended December 31, 2001,
respectively. In 2002, premiums written for the voluntary portion of this
business have been reduced to zero, and premiums earned will be reduced
significantly throughout the year reflecting run-off of the policies in force at
December 31, 2001. For the full year 2001, claims and settlement expenses in
Massachusetts for voluntary automobile business were $9,137 and for involuntary
residual market business were $11,455. Claims and settlement expenses in 2002
will reflect run-off of the business and a decline in exposure to loss with
expiration of all of the policies written by the Company by December 31, 2002.
Printing Services, Group Insurance and Credit Union Marketing Operations
In November 2001, the Company recorded restructuring charges of $450 pretax
($293, less than $0.01 per share, after tax) reflecting the decision to close
its on site printing services operations based on a cost benefit analysis.
Employee termination costs, for termination of 13 individuals by December 31,
2001, which represented severance, vacation buy-out and related payroll taxes
represented $409 of the total charge. The eliminated positions encompass
management, technical and clerical responsibilities. The remaining $41 was
attributable primarily to the write-off of equipment related to this function.
In December 2000, the Company recorded restructuring charges of $2,236
pretax ($1,453, or $0.04 per share, after tax) reflecting two changes in the
Company's operations. Specifically, the Company restructured the operations of
its group insurance business, thereby eliminating 39 jobs, and its credit union
marketing group, eliminating 20 additional positions. The changes will improve
business results and more closely align these functions with the Company's
strategic direction. Employee termination costs, for termination of an estimated
50 individuals, represented severance, vacation buy-out and related payroll
taxes. The eliminated positions encompass management, professional and clerical
responsibilities. By December 31, 2001, 39 individuals had been terminated with
two additional terminations scheduled in 2002. Termination of lease agreements
represented office space used by the credit union marketing group. The remaining
charge was attributable primarily to the write-off of software related to these
two areas.
[SEAL]
7
Note 2 - Restructuring Charges-(Continued)
The following table provides information about the components of the
charges taken in December 2001 and 2000, the balance of accrued amounts at
December 31, 2001 and June 30, 2002, and payment activity during the six months
ended June 30, 2002.
Original Reserve at Reserve at
Pretax December 31, June 30,
Charge 2001 Payments Adjustments 2002
-------- -------------- ---------- ------------ --------------
Charges to earnings:
Printing Services Operations
Employee termination
costs......................... $ 409 $ 396 $ 215 $ - $ 181
Write-off of equipment......... 41 - - - -
-------- ------- ------- ------- -------
Subtotal.................. 450 396 215 - 181
-------- ------- ------- ------- -------
Group Insurance and
Credit Union Marketing
Operations
Employee termination
costs........................ 1,827 636 243 - 393
Termination of lease
agreements................... 285 - - - -
Write-off of capitalized
software..................... 106 - - - -
Other......................... 18 - - - -
-------- ------- ------- ------- -------
Subtotal.................. 2,236 636 243 - 393
-------- ------- ------- ------- -------
Total.................... $ 2,686 $ 1,032 $ 458 $ - $ 574
======== ======= ======= ======= =======
Note 3 - Debt
Indebtedness outstanding was as follows:
June 30, December 31,
2002 2001
----------- --------------
Short-term debt:
Bank Credit Facility ............................... $ - $ 53,000
Long-term debt:
1.425% Senior Convertible Notes, due May 14, 2032.
Aggregate principal amount less
unaccrued discount of $185,587
(3.0% imputed rate) ............................... 167,913 -
6 5/8% Senior Notes, due January 15, 2006.
Aggregate principal amount less unaccrued
discount of $92 and $233 (6.7% imputed rate) 44,908 99,767
----------- --------------
Total ........................................... $ 212,821 $ 152,767
=========== ==============
[SEAL]
8
Note 3 - Debt-(Continued)
Credit Agreement with Financial Institutions ("Bank Credit Facility")
On May 29, 2002, the Company entered into a new Bank Credit Agreement which
provides for unsecured borrowings of up to $25,000, with a provision that allows
the commitment amount to be increased to $35,000 (the "Current Bank Credit
Facility"). The Current Bank Credit Facility expires on May 31, 2005. Interest
accrues at varying spreads relative to corporate or eurodollar base rates and is
payable monthly or quarterly depending on the applicable base rate. No amounts
had been borrowed under the Current Bank Credit Facility and no balance was
outstanding at June 30, 2002. The unused portion of the Current Bank Credit
Facility is subject to a variable commitment fee which was 0.20% on an annual
basis at June 30, 2002. An amendment to the previous Bank Credit Agreement was
made prior to December 31, 2001, which extended the maturity from December 31,
2001 to June 30, 2002. The previous Bank Credit Agreement was terminated when
the Company entered into the Current Bank Credit Facility. The $53,000 balance
outstanding under the previous Bank Credit Agreement was repaid in full on May
14, 2002 utilizing a portion of the proceeds from the issuance of the
Convertible Notes as described below.
1.425% Senior Convertible Notes ("Convertible Notes")
On May 14, 2002, the Company issued $353,500 aggregate principal amount of
1.425% senior convertible notes due in 2032 at a discount of 52.5% resulting in
an effective yield of 3.0%. The net proceeds from the sale of the Convertible
Notes have been used to repay the balance outstanding under the previous Bank
Credit Agreement and repurchase a portion of the outstanding Senior Notes, as
described below, and will be used for general corporate purposes and potentially
to further reduce corporate indebtedness. Interest on the Convertible Notes is
payable semi-annually at a rate of 1.425% beginning November 14, 2002 until May
14, 2007. After that date, cash interest will not be paid on the Convertible
Notes prior to maturity unless contingent cash interest becomes payable.
Contingent cash interest becomes payable if the average market price of a
Convertible Note for a five trading day measurement period preceding the
applicable six-month period equals 120% or more of the sum of the Convertible
Note's issue price, accrued original issue discount and accrued cash interest,
if any, for such Convertible Note. The contingent cash interest payable per
Convertible Note with respect to any quarterly period within any six-month
period will equal the then applicable conversion rate multiplied by the greater
of (i) $0.105 or (ii) any regular cash dividends paid by the Company per share
on HMEC's common stock during that quarterly period. The Convertible Notes will
be convertible at the option of the holders, if the conditions for conversion
are satisfied, into shares of HMEC's common stock at a conversion price of
$26.74. Holders may also surrender Convertible Notes for conversion during any
period in which the credit rating assigned to the Convertible Notes is Ba2 or
lower by Moody's or BB+ or lower by S&P, the Convertible Notes are no longer
rated by either Moody's or S&P, or the credit rating assigned to the Convertible
Notes has been suspended or withdrawn by either Moody's or S&P. The Convertible
Notes will cease to be convertible pursuant to this credit rating criteria
during any period or periods in which all of the credit ratings are increased
above such levels. The Convertible Notes are redeemable by HMEC in whole or in
part, at any time on or after May 14, 2007, at redemption prices equal to the
sum of the issue price plus accrued original issue discount and accrued cash
interest, if any, on the applicable redemption date. The
[SEAL]
9
Note 3 - Debt-(Continued)
holders of the Convertible Notes may require HMEC to purchase all or a portion
of their Convertible Notes on either May 14, 2007, 2012, 2017, 2022, or 2027 at
stated prices plus accrued cash interest, if any, to the purchase date. HMEC may
pay the purchase price in cash or shares of HMEC common stock or in a
combination of cash and shares of HMEC common stock. The Convertible Notes were
privately offered only to qualified institutional buyers under Rule 144A under
the Securities Act of 1933 and outside the United States of America ("U.S.") to
non-U.S. persons under Regulation S under the Securities Act of 1933, and may
not be offered or sold in the U.S. absent registration or an applicable
exemption from registration requirements. HMEC intends to file a registration
statement with the Securities and Exchange Commission related to the Convertible
Notes prior to September 30, 2002.
6 5/8% Senior Notes ("Senior Notes")
On May 30, 2002, the Company repurchased $55,000 aggregate principal amount
of its outstanding Senior Notes utilizing a portion of the proceeds from the
issuance of the Convertible Notes, as described above. The aggregate cost of the
repurchase was $56,838. The retirement of these Senior Notes resulted in a
pretax charge to income for the six months ended June 30, 2002 of $2,316, which
equated to $1,505 or $0.04 per share after tax.
Note 4 - Investments
The following table presents the composition and value of the Company's
fixed maturity securities portfolio by rating category. The Company has
classified the entire fixed maturity securities portfolio as available for sale,
which is carried at fair value.
Percent of
Carrying Value June 30, 2002
------------------------ ---------------------------
Rating of Fixed June 30, December 31, Carrying Amortized
Maturity Securities(1) 2002 2001 Value Cost
---------------------- --------- ------------- ----------- -------------
AAA......................... 39.5% 36.7% $ 1,071,145 $ 1,036,400
AA.......................... 6.5 6.3 178,048 170,096
A........................... 21.8 20.8 592,338 578,283
BBB......................... 27.7 31.6 750,875 760,885
BB.......................... 1.8 1.5 47,835 57,661
B........................... 1.7 2.1 46,141 53,055
CCC or lower................ 0.8 0.8 22,336 24,390
Not rated(2)................ 0.2 0.2 5,757 5,575
----- ----- ----------- -------------
Total...................... 100.0% 100.0% $ 2,714,475 $ 2,686,345
===== ===== =========== =============
(1) Ratings are as assigned primarily by Standard & Poor's Corporation ("S&P")
when available, with remaining ratings as assigned on an equivalent basis
by Moody's Investors Service, Inc. ("Moody's"). Ratings for publicly traded
securities are determined when the securities are acquired and are updated
monthly to reflect any changes in ratings.
(2) This category includes $196 of publicly traded securities not currently
rated by S&P or Moody's and $5,561 of private placement securities not
rated by either S&P or Moody's. The National Association of Insurance
Commissioners ("NAIC") has rated 92.5% of these private placements as
investment grade.
[SEAL]
10
Note 4 - Investments-(Continued)
The following table presents a maturity schedule of the Company's fixed
maturity securities. Expected maturities will differ from contractual maturities
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.
Percent Carrying
of Total Value
-------------------------- ------------
June 30, December 31, June 30,
Scheduled Maturity 2002 2001 2002
------------------ ---------- ------------- ------------
Due in 1 year or less...................... 4.2% 4.0% $ 114,108
Due after 1 year through 5 years........... 21.2 23.0 574,582
Due after 5 years through 10 years......... 28.0 29.9 759,235
Due after 10 years through 20 years........ 15.1 14.8 410,256
Due after 20 years......................... 31.5 28.3 856,294
----- ----- ------------
Total..................................... 100.0% 100.0% $ 2,714,475
===== ===== ============
The Company's investment portfolio includes no derivative financial
instruments (futures, forwards, swaps, option contracts or other financial
instruments with similar characteristics).
The Company reviews the fair value of the investment portfolio on a monthly
basis to determine if there are any securities that have fallen below 80% of
book value. This review, in conjunction with the Company's investment managers'
monthly credit reports and current market data, is the basis for determining if
a security has suffered an other-than-temporary decline in value. A write-down
is recorded when such decline in value is deemed to be other-than-temporary,
with the realized investment loss reflected in the Statement of Operations for
the period. In 2002, as a result of these reviews, the Company recorded pretax
impairment charges of $9,876 and $28,111 for the three months ended March 31,
and June 30, respectively.
Management believes that there may be further investment impairments during
the remainder of 2002 if current economic and financial conditions persist. At
June 30, 2002, the Company's investment portfolio had a total of 40 fixed income
securities issued by telecommunications companies, with an amortized cost of
$270,100 and an after-tax unrealized loss of approximately $20,000.
The Company lends fixed income securities to third parties, primarily major
brokerage firms. As of June 30, 2002 and December 31, 2001, fixed maturities
with a fair value of $448,074 and $98,369, respectively, were on loan. The
Company separately maintains a minimum of 100% of the value of the loaned
securities as collateral for each loan. Securities lending collateral is
classified as investments with a corresponding liability in the Company's
Consolidated Balance Sheet, in accordance with the applicable accounting
guidance.
[SEAL]
11
Note 5 - Goodwill and Other Acquired Intangible Assets
When the Company was acquired in 1989, intangible assets were recorded in
the application of purchase accounting to recognize the value of acquired
insurance in force and goodwill. In addition, goodwill was recorded in 1994
related to the purchase of Horace Mann Property & Casualty Insurance Company
(formerly Allegiance Insurance Company). The value of acquired insurance in
force is being amortized over the following periods utilizing the indicated
methods for life and annuity, respectively, as follows: 20 years, in proportion
to coverage provided; 20 years, in proportion to estimated gross profits.
Goodwill was amortized over 40 years on a straight-line basis through December
31, 2001.
Effective January 1, 2002, the Company adopted Financial Accounting
Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS")
No. 142, "Goodwill and Other Intangible Assets". The Company's value of acquired
insurance in force is an intangible asset with a definite life and will continue
to be amortized under the provisions of SFAS No. 142. Goodwill will remain on
the balance sheet and not be amortized. SFAS No. 142 establishes a new method of
testing goodwill for impairment. On an annual basis, and when there is reason to
suspect that its value may have been diminished or impaired, the goodwill asset
must be tested for impairment. The amount of goodwill determined to be impaired
will be expensed to current operations. As of June 30, 2002, the Company
completed the allocation of goodwill by business segment and the initial
impairment testing procedures which resulted in no impairment loss.
The allocation of goodwill by segment was as follows:
Balance as of
January 1, 2002
and June 30, 2002
-----------------
Annuity............................... $ 28,025
Life.................................. 9,911
Property and casualty................. 9,460
---------
Total............................... $ 47,396
=========
[SEAL]
12
Note 5 - Goodwill and Other Acquired Intangible Assets-(Continued)
Net income (loss) and net income (loss) per share exclusive of goodwill
amortization expense for the three and six months ended June 30, 2002 and 2001
were as follows:
Three Months Ended Six Months Ended
June 30, June 30,
--------------------------- ---------------------------
2002 2001 2002 2001
------------ ------------ ------------ ------------
Reported net income (loss) .............. $ (19,287) $ (4,926) $ (3,716) $ 11,772
Add back: Goodwill amortization ........ - 404 - 809
------------ ------------ ------------ ------------
Adjusted net income (loss) ............. $ (19,287) $ (4,522) $ (3,716) $ 12,581
============ ============ ============ ============
Reported net income (loss)
per share-basic ........................ $ (0.47) $ (0.12) $ (0.09) $ 0.29
Add back: Goodwill amortization ........ - 0.01 - 0.02
------------ ------------ ------------ ------------
Adjusted net income (loss)
per share-basic ....................... $ (0.47) $ (0.11) $ (0.09) $ 0.31
============ ============ ============ ============
Reported net income (loss)
per share-diluted ...................... $ (0.47) $ (0.12) $ (0.09) $ 0.29
Add back: Goodwill amortization ........ - 0.01 - 0.02
------------ ------------ ------------ ------------
Adjusted net income (loss)
per share-diluted ..................... $ (0.47) $ (0.11) $ (0.09) $ 0.31
============ ============ ============ ============
Net income and net income per share exclusive of goodwill amortization
expense for the years ended December 31, 2001, 2000 and 1999 were as follows:
Year Ended December 31,
------------------------------
2001 2000 1999
-------- -------- --------
Reported net income .................. $ 25,587 $ 20,841 $ 44,505
Add back: Goodwill amortization ...... 1,618 1,618 1,618
-------- -------- --------
Adjusted net income ................. $ 27,205 $ 22,459 $ 46,123
======== ======== ========
Reported net income per share-basic .. $ 0.63 $ 0.51 $ 1.08
Add back: Goodwill amortization ...... 0.04 0.04 0.04
-------- -------- --------
Adjusted net income per share-basic . $ 0.67 $ 0.55 $ 1.12
======== ======== ========
Reported net income per share-diluted $ 0.63 $ 0.51 $ 1.07
Add back: Goodwill amortization ...... 0.04 0.04 0.04
-------- -------- --------
Adjusted net income per share-diluted $ 0.67 $ 0.55 $ 1.11
======== ======== ========
[SEAL]
13
Note 5 - Goodwill and Other Acquired Intangible Assets-(Continued)
For the amortization of the value of acquired insurance in force, the
Company periodically reviews its estimates of future gross profits. The most
significant assumptions that are involved in the estimation of future gross
profits include future market performance, business surrender/lapse rates and
the impact of realized investment gains and losses. In the event actual
experience differs significantly from assumptions or assumptions are
significantly revised, the Company may be required to record a material charge
or credit to amortization expense for the period in which the adjustment is
made.
The value of acquired insurance in force for investment contracts (those
issued prior to August 29, 1989) is adjusted for the impact on estimated future
gross profits as if net unrealized investment gains and losses had been realized
at the balance sheet date. The impact of this adjustment is included in net
unrealized gains and losses within shareholders' equity.
The balances of value of acquired insurance in force by segment at June 30,
2002 and December 31, 2001 were as follows:
June 30, 2002 December 31, 2001
------------------------------------- --------------------------------------
Accumulated Net Accumulated Net
Cost Amortization Balance Cost Amortization Balance
--------- -------------- --------- --------- -------------- ---------
Value of acquired
insurance in force
Life.................... $ 48,746 $ 39,033 $ 9,713 $ 48,746 $ 38,151 $ 10,595
Annuity................. 87,553 61,042 26,511 87,553 59,247 28,306
--------- --------- --------- --------- --------- ---------
Subtotal............... $ 136,299 $ 100,075 36,224 $ 136,299 $ 97,398 38,901
========= ========= --------- ========= ========= ---------
Impact of
unrealized gains and
losses................. (427) (508)
--------- ---------
Total................. $ 35,797 $ 38,393
========= =========
Scheduled amortization of the December 31, 2001 balances of value of
acquired insurance in force by segment over the next five years is as follows:
Year Ended December 31,
------------------------------------------------
2002 2003 2004 2005 2006
-------- -------- -------- -------- --------
Scheduled amortization of:
Value of acquired insurance in force
Life................................... $ 1,726 $ 1,625 $ 1,537 $ 1,460 $ 1,394
Annuity................................ 3,779 3,785 3,917 4,037 4,140
-------- -------- -------- -------- --------
Total................................. $ 5,505 $ 5,410 $ 5,454 $ 5,497 $ 5,534
======== ======== ======== ======== ========
[SEAL]
14
Note 6 - Shareholders' Equity
Share Repurchase Programs
The Company has not repurchased shares of its common stock under its stock
repurchase program since the third quarter of 2000, consistent with management's
stated intention to utilize excess capital to support the Company's strategic
growth initiatives. Since early 1997, 8,165,100 shares, or 17% of the shares
outstanding on December 31, 1996, have been repurchased at an aggregate cost of
$203,657, equal to an average cost of $24.94 per share. Including shares
repurchased in 1995, the Company has repurchased 33% of the shares outstanding
on December 31, 1994. The repurchase of shares was financed through use of cash
and, when necessary, its Bank Credit Facility. However, the Company has not
utilized its Bank Credit Facility for share repurchases since the second quarter
of 1999. As of June 30, 2002, $96,343 remained authorized for future share
repurchases.
[SEAL]
15
Note 7 - Reinsurance
The Company recognizes the cost of reinsurance premiums over the contract
periods for such premiums in proportion to the insurance protection provided.
Amounts recoverable from reinsurers for unpaid claims and claim settlement
expenses, including estimated amounts for unsettled claims, claims incurred but
not reported and policy benefits, are estimated in a manner consistent with the
insurance liability associated with the policy. The effect of reinsurance on
premiums written and contract deposits; premiums and contract charges earned;
and benefits, claims and settlement expenses were as follows:
Ceded to Assumed
Gross Other from State
Amount Companies Facilities Net
--------- ----------- ------------ -----------
Three months ended
June 30, 2002
------------------
Premiums written
and contract deposits................. $ 223,879 $ 6,340 $ 1,061 $ 218,600
Premiums and contract
charges earned........................ 161,088 10,005 3,250 154,333
Benefits, claims and
settlement expenses................... 121,454 9,174 3,687 115,967
Three months ended
June 30, 2001
------------------
Premiums written
and contract deposits................. $ 221,166 $ 6,825 $ 3,884 $ 218,225
Premiums and contract
charges earned........................ 154,573 6,614 4,031 151,990
Benefits, claims and
settlement expenses................... 130,774 1,371 5,410 134,813
Six months ended
June 30, 2002
----------------
Premiums written
and contract deposits................. $ 435,052 $ 9,594 $ 4,890 $ 430,348
Premiums and contract
charges earned........................ 321,141 17,868 6,613 309,886
Benefits, claims and
settlement expenses................... 237,484 18,590 7,889 226,783
Six months ended
June 30, 2001
----------------
Premiums written
and contract deposits................. $ 431,234 $ 12,975 $ 7,738 $ 425,997
Premiums and contract
charges earned........................ 307,147 13,274 8,034 301,907
Benefits, claims and
settlement expenses................... 242,048 9,161 9,703 242,590
[SEAL]
16
Note 7 - Reinsurance-(Continued)
The Company maintains an excess and catastrophe treaty reinsurance program.
The Company reinsures 95% of catastrophe losses above a retention of $8,500 per
occurrence up to $80,000 per occurrence. In addition, the Company's predominant
insurance subsidiary for property and casualty business written in Florida
reinsures 90% of hurricane losses in that state above a retention of $11,000 up
to $47,400 with the Florida Hurricane Catastrophe Fund, based on the Fund's
financial resources. Through December 31, 2001, these catastrophe reinsurance
programs were augmented by a $100,000 equity put and reinsurance agreement. This
equity put provided an option to sell shares of the Company's convertible
preferred stock with a floating rate dividend at a pre-negotiated price in the
event losses from catastrophes exceeded the catastrophe reinsurance program
coverage limit. Before tax benefits, the equity put provided a source of capital
for up to $154,000 of catastrophe losses above the reinsurance coverage limit.
Effective May 7, 2002, the Company entered into a replacement equity put
and reinsurance agreement with a subsidiary of Swiss Reinsurance Company. The
Swiss Re Group is rated "A++ (Superior)" by A.M. Best. Under the 36-month
agreement, the equity put coverage of $75,000 provides a source of capital for
up to $115,000 of pretax catastrophe losses above the reinsurance coverage
limit. The Company also has the option, in place of the equity put, to require a
Swiss Re Group member to issue a 10% quota share reinsurance coverage of all of
the Company's property and casualty book of business. Annual fees related to
this equity put option, which are charged directly to additional paid-in
capital, increased to 145 basis points in 2002 from 95 basis points in 2001
under the prior agreement; however, in 2002 the agreement is effective only for
the last eight months of the year. The agreement contains certain conditions to
Horace Mann's exercise of the equity put option including: (i) the Company's
shareholders' equity, adjusted to exclude goodwill, can not be less than
$215,000 after recording the first triggering event; (ii) the Company's total
debt as a percentage of capital can not be more than 47.5% prior to recording
the triggering event; and (iii) the Company's S&P financial strength rating can
not be below "BBB" prior to a triggering event. The Company's S&P financial
strength rating was "A+" at June 30, 2002.
For liability coverages, including the educator excess professional
liability policy, the Company reinsures each loss above a retention of $500 up
to $20,000. The Company also reinsures each property loss above a retention of
$250 up to $2,500, including catastrophe losses that in the aggregate are less
than the retention levels above.
The maximum individual life insurance risk retained by the Company is $200
on any individual life and $125 is retained on each group life policy. Excess
amounts are reinsured.
[SEAL]
17
Note 8 - Contingencies
Lawsuits and Legal Proceedings
In June 2002, the Company recorded a pretax charge of $1,581, which equated
to $1,028 or $0.02 per share after tax, representing the Company's best estimate
of the costs of resolving class action lawsuits related to diminished value
brought against the Company. While the actual costs incurred by the Company to
resolve these issues could be either less or more than the liability established
at June 30, 2002, management believes that, based on facts and circumstances
available at this time, the amount recorded will be adequate to resolve the
matters.
There are various other lawsuits and legal proceedings against the Company.
Management and legal counsel are of the opinion that the ultimate disposition of
such other litigation will have no material adverse effect on the Company's
financial position or results of operations.
Assessments for Insolvencies of Unaffiliated Insurance Companies
The Company is also contingently liable for possible assessments under
regulatory requirements pertaining to potential insolvencies of unaffiliated
insurance companies. Liabilities, which are established based upon regulatory
guidance, have generally been insignificant.
[SEAL]
18
Note 9 - Segment Information
The Company conducts and manages its business through four segments. The
three operating segments representing the major lines of insurance business are:
property and casualty insurance, principally personal lines automobile and
homeowners insurance; individual annuity products, principally tax-qualified;
and life insurance. The fourth segment, Corporate and Other, includes primarily
debt service and realized investment gains and losses. Summarized financial
information for these segments is as follows:
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
2002 2001 2002 2001
---------- ---------- ---------- ----------
Insurance premiums and contract charges earned
Property and casualty ................................ $ 128,651 $ 124,917 $ 256,655 $ 248,100
Annuity .............................................. 3,729 3,733 7,420 7,519
Life ................................................. 22,277 23,660 46,457 46,927
Intersegment eliminations ............................ (324) (320) (646) (639)
---------- ---------- ---------- ----------
Total ............................................ $ 154,333 $ 151,990 $ 309,886 $ 301,907
========== ========== ========== ==========
Net investment income
Property and casualty ................................ $ 8,748 $ 9,156 $ 18,369 $ 18,183
Annuity .............................................. 27,583 26,837 54,911 53,496
Life ................................................. 14,171 14,168 27,199 27,528
Corporate and other .................................. 142 24 145 75
Intersegment eliminations ............................ (294) (350) (589) (684)
---------- ---------- ---------- ----------
Total ............................................ $ 50,350 $ 49,835 $ 100,035 $ 98,598
========== ========== ========== ==========
Net income (loss)
Operating income (loss)
Property and casualty ............................... $ 3,222 $ (9,669) $ 10,439 $ (1,805)
Annuity ............................................. 4,519 5,181 9,191 9,410
Life ................................................ 4,373 5,374 8,198 9,325
Corporate and other, including interest expense ..... (2,038) (2,208) (3,859) (4,599)
---------- ---------- ---------- ----------
Total operating income (loss) ...................... 10,076 (1,322) 23,969 12,331
Realized investment losses, after tax ................ (26,830) (3,718) (25,152) (673)
Debt retirement costs, after tax ..................... (1,505) - (1,505) -
Litigation charges, after tax ........................ (1,028) - (1,028) -
Restructuring reserve adjustment, after tax .......... - 114 - 114
---------- ---------- ---------- ----------
Total ............................................ $ (19,287) $ (4,926) $ (3,716) $ 11,772
========== ========== ========== ==========
Amortization of intangible assets
Value of acquired insurance in force
Annuity ............................................. $ 942 $ 895 $ 1,795 $ 1,926
Life ................................................ 441 471 882 942
---------- ---------- ---------- ----------
Subtotal ......................................... 1,383 1,366 2,677 2,868
Goodwill (See Note 5) ................................ - 404 - 809
---------- ---------- ---------- ----------
Total ............................................ $ 1,383 $ 1,770 $ 2,677 $ 3,677
========== ========== ========== ==========
June 30, December 31,
2002 2001
------------ -------------
Assets
Property and casualty........................... $ 745,958 $ 738,638
Annuity......................................... 2,863,731 2,674,524
Life............................................ 1,141,848 1,007,345
Corporate and other............................. 152,143 105,215
Intersegment eliminations....................... (46,881) (36,696)
------------ -------------
Total.......................................... $ 4,856,799 $ 4,489,026
============ =============
[SEAL]
19
Note 10 - Subsequent Event - Restructure of Property and Casualty Claims
Operations
In July 2002, the Company announced the restructuring of its property and
casualty claims operations. The Company expects to realize operating and cost
efficiencies and also improve customer service by consolidating claims office
locations throughout the United States into 6 offices compared to the current
17, implementing a new claims administration system, and performing certain
claims reporting and adjusting functions internally versus utilizing external
service providers. The Company expects that these claims actions will have a
positive impact on earnings in 2003 and beyond. In addition to the cost
efficiencies anticipated from the new claims environment, the restructuring is
expected to have a favorable impact on automobile and homeowners claim severity.
Approximately 135 employees with management, professional and clerical
responsibilities will be impacted by the office consolidations. Charges for
employee termination costs, representing severance, vacation buy-out, related
payroll taxes and the impact of accelerated retirements on the Company's defined
benefit pension plan, and other costs related to the office closures totaling
approximately $2,500 after tax, or 6 cents per share, will be reflected as a
non-operating restructuring charge in the Company's financial statements for the
third quarter of 2002.
[SEAL]
20
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
FORWARD-LOOKING INFORMATION
Statements made in the following discussion that state the Company's or
management's intentions, hopes, beliefs, expectations or predictions of future
events or the Company's future financial performance are forward-looking
statements and involve known and unknown risks, uncertainties and other factors.
It is important to note that the Company's actual results could differ
materially from those projected in such forward-looking statements due to, among
other risks and uncertainties inherent in the Company's business, the following
important factors:
. Changes in the composition of the Company's assets and liabilities through
acquisitions or divestitures.
. Fluctuations in the market value of securities within the Company's
investment portfolio due to credit issues and the related after-tax effect
on the Company's shareholders' equity and total capital through either
realized or unrealized investment losses.
. Prevailing interest rate levels, including the impact of interest rates on
(i) unrealized gains and losses on the Company's investment portfolio and
the related after-tax effect on the Company's shareholders' equity and
total capital and (ii) the book yield of the Company's investment
portfolio.
. The success of the Company's overall investment strategy which is subject
to market value risk, reinvestment risk and liquidity risk.
. The impact of fluctuations in the capital markets on the Company's ability
to refinance outstanding indebtedness or repurchase shares of the Company's
outstanding common stock.
. The frequency and severity of catastrophes such as hurricanes, earthquakes
and storms, the ability of the Company to maintain a favorable catastrophe
reinsurance program, and the collectibility of reinsurance receivables.
. Future property and casualty loss experience and its impact on estimated
claims and claim adjustment expenses for losses occurring in prior years.
. The cyclicality of the insurance industry.
. The Company's ability to develop and expand its agency force and its direct
product distribution systems, as well as the Company's ability to maintain
and secure product sponsorships by local, state and national education
associations.
. The competitive impact of new entrants such as mutual funds and banks into
the tax-deferred annuity products markets, and the Company's ability to
profitably expand its property and casualty business in highly competitive
environments.
. Changes in insurance regulations, including (i) those affecting the ability
of the Company's insurance subsidiaries to distribute cash to the holding
company and (ii) those impacting the Company's ability to profitably write
property and casualty insurance policies in one or more states.
. Changes in federal income tax laws and changes resulting from federal tax
audits affecting corporate tax rates or taxable income, and regulations
changing the relative tax advantages of the Company's life and annuity
products to customers.
[SEAL]
21
. The impact of fluctuations in the financial markets on the Company's
variable annuity fee revenues, valuations of deferred policy acquisition
costs and value of acquired insurance in force, and the level of guaranteed
minimum death benefit reserves.
. The Company's ability to maintain favorable claims-paying ability,
financial strength and debt ratings.
. Adverse changes in policyholder mortality and morbidity rates.
. The resolution of legal proceedings and related matters.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP") requires
the Company's management to make estimates and assumptions based on information
available at the time the financial statements are prepared. These estimates and
assumptions affect the reported amounts of the Company's assets, liabilities,
shareholders' equity and net income. Certain accounting estimates are
particularly sensitive because of their significance to the Company's financial
statements and because of the possibility that subsequent events and available
information may differ markedly from management's judgements at the time the
financial statements were prepared. For the Company, the areas most subject to
significant management judgements include: reserves for property and casualty
claims and claim settlement expenses, reserves for future policy benefits,
deferred policy acquisition costs, value of acquired insurance in force and
valuation of investments. Additional information regarding the accounting
policies for each of these areas is provided within the relevant topics in
"Results of Operations," as well as in the Notes to Consolidated Financial
Statements in the Company's Annual Report for 2001 on Form 10-K.
THE HORACE MANN VALUE PROPOSITION
The Horace Mann Value Proposition articulates the Company's overarching
strategy and business purpose: Provide lifelong financial well-being for
educators and their families through personalized service, advice, and a full
range of tailored insurance and financial products.
In 2000, the Company's management announced steps to focus on the Company's
core business and accelerate growth of the Company's revenues and profits. These
initiatives are intended to:
. Grow and strengthen the agency force and make the Company's agents more
productive by improving the products, tools and support the Company
provides to them;
. Expand the Company's penetration of targeted geographic areas and new
segments of the educator market;
. Broaden the Company's distribution options to complement and extend the
reach of the Company's agency force;
. Increase cross-selling and improve retention in the existing book of
business; and
. Make the Company's products more responsive to customer needs and
preferences and expand the Company's product lines within the personal
financial services segment.
During the fourth quarter of 2000, management began implementing specific
plans that address the initiatives above. New compensation and evaluation
systems were implemented during 2001 to improve the performance of the Company's
agents and agency managers. The Company has begun targeting high-priority
geographic markets with dedicated staff teams. New
[SEAL]
22
approaches to customer service are being developed and tested that will free
agents to spend more time selling. Additional distribution options are being
initiated to capitalize fully on the value of the Company's payroll deduction
slots in schools across the country. And, the Company will increase its use of
technology to improve the efficiency of its agency force and its administrative
operations.
RESULTS OF OPERATIONS
Insurance Premiums and Contract Charges
Insurance Premiums Written and Contract Deposits
Six Months Ended Growth Over
June 30, Prior Year
----------------- -----------------
2002 2001 Percent Amount
------- ------- ------- -------
Automobile and property (voluntary) .............. $ 246.3 $ 241.3 2.1% $ 5.0
Excluding Massachusetts automobile .............. 246.3 231.1 6.6% 15.2
Massachusetts automobile ........................ - 10.2 -100.0% (10.2)
Annuity deposits ................................. 128.4 120.6 6.5% 7.8
Life ............................................. 55.0 58.5 -6.0% (3.5)
------- ------- -------
Subtotal - core lines ...................... 429.7 420.4 2.2% 9.3
Subtotal - core lines, excluding
Massachusetts automobile .................. 429.7 410.2 4.8% 19.5
Involuntary and other
property & casualty ............................. 0.6 5.6 (5.0)
Excluding Massachusetts
automobile .................................... (0.6) 2.3 (2.9)
Massachusetts automobile ....................... 1.2 3.3 -63.6% (2.1)
------- ------- -------
Total ...................................... $ 430.3 $ 426.0 1.0% $ 4.3
======= ======= =======
Total, excluding Massachusetts
automobile ................................ $ 429.1 $ 412.5 4.0% $ 16.6
======= ======= =======
[SEAL]
23
Insurance Premiums and Contract Charges Earned
(Excludes annuity and life contract deposits)
Six Months Ended Growth Over
June 30, Prior Year
------------------- -------------------
2002 2001 Percent Amount
-------- -------- -------- --------
Automobile and property (voluntary) .............. $ 250.2 $ 238.7 4.8% $ 11.5
Excluding Massachusetts automobile .............. 242.8 228.8 6.1% 14.0
Massachusetts automobile ........................ 7.4 9.9 -25.3% (2.5)
Annuity .......................................... 7.4 7.5 -1.3% (0.1)
Life ............................................. 45.9 46.3 -0.9% (0.4)
-------- -------- --------
Subtotal - core lines ......................... 303.5 292.5 3.8% 11.0
Subtotal - core lines, excluding
Massachusetts automobile .................... 296.1 282.6 4.8% 13.5
Involuntary and other
property & casualty ............................. 6.4 9.4 -31.9% (3.0)
Excluding Massachusetts
automobile .................................... 2.8 5.4 -48.1% (2.6)
Massachusetts automobile ....................... 3.6 4.0 -10.0% (0.4)
-------- -------- --------
Total ......................................... $ 309.9 $ 301.9 2.6% $ 8.0
======== ======== ========
Total, excluding Massachusetts
automobile ................................... $ 298.9 $ 288.0 3.8% $ 10.9
======== ======== ========
As previously disclosed, the Company restructured its presence in the
Massachusetts automobile market and ceased writing automobile insurance policies
in that state on December 31, 2001. Through a marketing alliance with The
Commerce Group, Inc. ("Commerce"), the Company now offers Massachusetts
customers Commerce automobile insurance policies while continuing to write other
Horace Mann products, including retirement annuities and property and life
insurance.
Premiums written and contract deposits for the Company's core lines
increased 4.8% compared to the prior year, excluding Massachusetts voluntary
automobile premiums written in the first six months of 2001. The growth resulted
from continued strong gains in the annuity segment, growth in the Company's
automobile business and rate increases in the property line.
Average agent productivity for all lines of business combined increased
9.1% compared to the first half of 2001, offsetting a 4.5% decline in the total
agent count. The Company is seeing stabilization in the total number of agents
due to recent improvements in agent retention as well as a 15.7% increase in new
hires for the first six months of 2002, compared to the same period last year.
Management anticipates ending 2002 with approximately 940 agents. At June 30,
2002, the Company's exclusive agency force totaled 836. Of those, 324 were in
their first 24 months with the Company, an increase of 27.6%, compared to June
30, 2001. The number of experienced agents in the agency force, 512, was down
17.6% at June 30, 2002, compared to a year earlier, due primarily to
terminations of less-productive agents over the prior 12 months. This, and the
strong improvement in productivity levels of agents hired in the last 12 months,
has driven the overall average agent productivity increase. Average agent
productivity is measured as new sales premiums per the average number of agents
for the period.
[SEAL]
24
In 2001, the Company modified its agent compensation and reward structure,
in order to provide an incentive for agent performance that is more closely
aligned with the Company's objectives. The revised structure continues the
historical focus on profitability but places a greater emphasis on individual
agent productivity, new premium growth, growth in educator and cross-sold
business, and business retention. The Company's agency manager compensation
structure was similarly modified, and the agency management team was
strengthened through the promotions of several of the Company's most experienced
and capable agents. The number of new agents hired during 2001 was comparable to
the prior period and the number of new hires for the first half of 2002 was
higher than a year earlier, in spite of the Company's implementation of more
stringent agent selection criteria to improve agent productivity and retention.
The new compensation plan for agency managers became effective January 1, 2001.
The new compensation plan for all agents was implemented on August 1, 2001, and
there were approximately 800 agents at the time of implementation. Also in 2001,
the Company implemented enhanced agent training programs to help new agents
achieve production targets more rapidly and help experienced agents sharpen and
strengthen their skills and began providing agents with additional tools and
support programs to help them make a successful transition to their new role
under the Company's Value Proposition. Management believes these actions, along
with other strategic initiatives, will continue to have a positive impact on
agent productivity in the future.
In December 2001, the North Carolina Commissioner of Insurance (the
"Commissioner") ordered a 13% reduction in private passenger automobile
insurance premium rates to be effective in April 2002. The Commissioner's Order
was in response to a request from the North Carolina Rate Bureau (the "Bureau"),
which represents the insurance industry, to increase private passenger
automobile insurance rates by 5%. The Bureau has voted to appeal the
Commissioner's Order in the state appellate court and raise rates while the case
is being heard. The difference between the rates ordered by the Commissioner and
the Bureau would have an adverse impact of approximately $350 million for the
insurance industry. The Company's full year earned premiums would be negatively
impacted by approximately $2 million and $3 million in 2002 and 2003,
respectively. In addition, the difference in rates between the Commissioner and
the Bureau must be held in an escrow account pending the court's decision. If
the court should rule in favor of the Bureau, the insurers will be entitled to
the funds previously escrowed. If the court should rule in favor of the
Commissioner, the escrowed funds plus interest will be refunded to the
policyholders. Following the April 2002 effective date, this issue negatively
impacted the Company's premiums earned and pretax results by $0.3 million for
the six months ended June 30, 2002.
Growth in total voluntary automobile and homeowners premium written was
6.6% for the first six months of 2002, excluding Massachusetts voluntary
automobile written premiums of $10.2 million from the prior year. The average
premium written per policy increased for both automobile and homeowners
insurance, compared to a year earlier, and the number of automobile policies
also increased. Voluntary automobile insurance premium written, excluding
Massachusetts, increased 7.0% ($12.1 million) compared to the first six months
of 2001, and homeowners premium increased 5.3% ($3.1 million). The property and
casualty increase in premiums written resulted from growth in average premium
per policy of 6% for automobile and 12% for homeowners, compared to a year
earlier, as the growing impact of rate actions continue to flow through policy
renewals and new business. Compared to the first six months of 2001, average
earned premiums increased 4% for voluntary automobile and 10% for homeowners,
reflecting the positive impact of rate increases. Over the prior 12 months and
excluding an 11,000 unit decrease in Massachusetts automobile, unit growth was
0.2%, or 2,000, driven by a 6,000 unit
[SEAL]
25
increase in automobile. Homeowners units were 4,000 less than 12 months earlier
and 5,000 units less than at December 31, 2001 reflecting planned reductions. At
June 30, 2002, there were 586,000 voluntary automobile and 287,000 homeowners
policies in force for a total of 873,000, including 12,000 Massachusetts
voluntary automobile units which will run off over the remaining months of 2002.
Based on policies in force, the property and casualty 12-month retention
rate for new and renewal policies was 88%, equal to the 12 months ended June 30,
2001 despite implemented rate increases over the period. The Company plans
additional rate increases in the remainder of 2002 and beyond, with primary
emphasis on the homeowners line, which are expected to have a continued adverse
impact on retention of homeowners policies in force. The Company has implemented
tiered rating systems for automobile and homeowners business based on customers'
credit ratings, which management expects will have a positive impact on both
loss ratios and business growth in the educator market. Tiered rating, together
with price increases implemented and planned, are expected to return the Company
to rate adequacy, with average premium growth keeping pace with average loss
experience over time. For 2002, the Company is targeting combined ratios of
approximately 96% for voluntary automobile and 108% for homeowners, as a result
of the impact of rate actions coupled with other initiatives described under
"Results of Operations -- Benefits, Claims and Settlement Expenses."
The decline in premiums written for involuntary and other property and
casualty was primarily attributable to a decrease in state mandatory automobile
insurance facility business assumed in the first half of 2002, compared to the
same period last year.
Growth in annuity contract deposits for the six months ended June 30, 2002
reflected new business growth and better retention of existing business. In
September 2000, the Company more than tripled the number of choices available to
its customers by introducing 21 new investment options in its tax-deferred
annuity product line. At the same time, the Company provided its agents with
proprietary asset allocation software that helps agents assist educator
customers in selecting the best retirement investment programs for their
individual needs and circumstances. The fourth quarter of 2000 was the first
full quarter with the expanded investment options.
Compared to the first six months of 2001, new annuity deposits increased
6.5%, reflecting a 10.9% increase in scheduled deposits received partially
offset by a 1.9% decrease in single premium and rollover deposits. New deposits
to fixed annuities were 13.3%, or $7.8 million, higher than in the first six
months of 2001, while new deposits to variable annuities were equal to a year
ago. The Company offers a dollar cost averaging program for amounts
systematically transferred from the fixed annuity option to the variable mutual
fund investment options over 3-month, 6-month or 12-month periods.
In January 2002, the Company announced that it had been selected as one of
four providers of fixed and variable annuities to Chicago, Illinois, public
school employees. Beginning April 1, 2002, the Company is partnering with an
independent broker/dealer, which has been providing retirement planning services
to Chicago Public School employees for more than two decades, to pursue this
opportunity to bolster business growth in the annuity segment. The Chicago
Public Schools is the third-largest school district in the United States of
America. For the three months ended June 30, 2002, approximately 1,500 new
flexible premium contracts were sold through this partnership representing over
$6 million in contract deposits on an annual basis, $1.5 million of which were
received in the current period.
[SEAL]
26
Variable annuity accumulated funds on deposit at June 30, 2002 were $1.0
billion, $59.0 million less than a year earlier, a 5.8% decrease including the
impact of financial market values. Variable annuity accumulated deposit
retention improved 4.2 percentage points over the 12 months to 92.8%, reflecting
ongoing improvement following the Company's expansion of variable investment
options and implementation of proprietary asset allocation software. Fixed
annuity cash value retention for the 12 months ended June 30, 2002 was 94.0%,
2.9 percentage points better than the same period last year. Fixed annuity
accumulated cash value was $1.4 billion at June 30, 2002, $61.3 million, or 4.5%
more than a year earlier. The number of annuity contracts outstanding increased
7.5%, or 10,000 contracts, compared to June 30, 2001.
In 2000, the Company took actions to increase the variable annuity options
available to customers, as described above, and also took steps to improve the
returns of its proprietary mutual funds. For the six months ended June 30, 2002,
the amount of variable annuity surrenders was 13% lower than for the same period
last year. The amount of fixed annuity surrenders decreased 11% compared to the
first six months of 2001.
For the six months ended June 30, 2002, annuity segment contract charges
earned decreased 1.3%, or $0.1 million, compared to the same period last year.
Improvements in retention of variable and fixed accumulated values, as described
above, resulted in a decline in surrender fees earned. In the current period,
declines in market valuations also negatively impacted fees earned on variable
annuity balances.
Life segment premiums and contract deposits for the first six months of
2002 were 6.0% lower than a year earlier, due to a decrease in both new business
and interest-sensitive life product deposits. The life insurance in force lapse
ratio was 9.2% for the twelve months ended June 30, 2002, compared to 8.6% for
the same period last year. The lapse ratios for the term portion and the whole
life portion of the business were each comparable to the prior year, with the
overall lapse ratio increasing as a result of a shift in the mix of business.
Net Investment Income
Investment income of $100.0 million for the first six months of 2002
increased 1.4%, or $1.4 million, (0.8%, or $0.5 million, after tax) compared to
the prior year due primarily to growth in the size of the investment portfolio.
Average investments (excluding the securities lending collateral) increased 3.5%
over the past 12 months. The average pretax yield on the investment portfolio
was 7.0% (4.7% after tax) for the first six months of 2002, compared to a pretax
yield of 7.2% (4.8% after tax) last year. Looking to the second half of 2002,
investment income will be under pressure due to investment credit issues,
described under "Results of Operations -- Realized Investment Gains and Losses"
below, and current reinvestment returns available.
Realized Investment Gains and Losses
Net realized investment losses were $38.7 million and $1.0 million for the
six months ended June 30, 2002 and 2001, respectively. In the second quarter of
2002, $41.3 million of realized investment losses were recorded which included a
loss of $19.4 million related to the sale and impairment of securities issued by
WorldCom, Inc. Additionally, impairment losses of $21.2 million were recognized
in the second quarter of 2002 relating primarily to holdings of fixed income
securities of other companies in the communications sector. The first quarter of
2002 included impairment charges of $9.9 million related to fixed income
securities issued by two
[SEAL]
27
telecommunications companies and a realized investment loss of $2.0 million from
the Company's sale of all of its holdings in securities issued by Kmart
Corporation. Partially offsetting these losses for the six months were gains
realized from ongoing investment portfolio management activity. The net realized
losses in 2001 primarily resulted from the second quarter sale and impairment of
two fixed income securities for credit-related reasons offsetting the first
quarter full repayment of an impaired commercial mortgage loan and the release
of a related reserve for uncollectible mortgages.
Management believes that there may be further investment impairments during
the remainder of 2002 if current economic and financial conditions persist. At
June 30, 2002, the Company's investment portfolio had a total of 40 fixed income
securities issued by telecommunications companies, with an amortized cost of
$270 million and an after-tax unrealized loss of approximately $20 million.
The Company reviews the fair value of the entire investment portfolio on a
monthly basis to determine if there are any securities that have fallen below
80% of book value. This review, in conjunction with the Company's investment
managers' monthly credit reports and current market data, is the basis for
determining if a security has suffered an other-than-temporary decline in value.
A write-down is recorded when such decline in value is deemed to be
other-than-temporary, with the realized investment loss reflected in the
Statement of Operations for the period.
Historically, the Company's investment guidelines have limited single
corporate issuer exposure to 1% of invested assets. Based on current financial
market conditions, the Company is revising the guidelines to limit the single
corporate issuer exposure to 2%, after tax, of shareholders' equity. The change
in the investment guidelines will be effective immediately for new purchases of
securities while the existing portfolio will be addressed over the next 18
months. Revised sector limitations are also being developed as part of the
strengthened investment guidelines. Management believes that, while the
turbulence in the financial market is likely to continue in the near term, it is
not expected to represent a material threat to the Company's financial
condition.
[SEAL]
28
Benefits, Claims and Settlement Expenses
Six Months Ended Growth Over
June 30, Prior Year
----------------- -----------------
2002 2001 Percent Amount
------- ------- ------- -------
Property and casualty ...................... $ 204.5 $ 219.8 -7.0% $ (15.3)
Annuity .................................... 0.6 0.4 50.0% 0.2
Life ....................................... 21.7 22.4 -3.1% (0.7)
------- ------- -------
Total .................................... $ 226.8 $ 242.6 -6.5% $ (15.8)
======= ======= =======
Property and casualty
statutory loss ratio:
Before catastrophe losses ............... 78.8% 84.9% -6.1%
After catastrophe losses ................ 80.5% 88.6% -8.1%
Impact of litigation charges (a) ........ 0.6% - 0.6%
----------
(a) Under statutory accounting practices, the $1.6 million litigation
charge is reflected in property and casualty claims and settlement
expenses. On a GAAP basis, this item is reported separately in the
Statement of Operations as litigation charges in the Corporate and
Other segment.
In the first six months of 2002, the Company's benefits, claims and
settlement expenses reflected improvements in both the voluntary automobile and
the homeowners loss ratios excluding catastrophe losses and the impact of
litigation charges, as a result of favorable weather, loss containment
initiatives and the favorable impact of the Company's restructuring of its
Massachusetts automobile business. In the first half of 2001, the Company's
benefits, claims and settlement expenses were affected adversely by
strengthening of prior years' reserves for property and casualty claims and by a
high level of non-catastrophe weather-related losses.
Underwriting results of the property and casualty segment are significantly
influenced by estimates of the Company's ultimate liability for insured events.
Reserves for property and casualty claims include provisions for payments to be
made on reported claims, claims incurred but not yet reported and associated
settlement expenses. The process by which these reserves are established
requires reliance upon estimates based on known facts and on interpretations of
circumstances, including the Company's experience with similar cases and
historical trends involving claim payment patterns, claim payments, pending
levels of unpaid claims and product mix, as well as other factors including
court decisions, economic conditions and public attitudes. As information
develops which varies from experience, provides additional data or, in some
cases, augments data which previously were not considered sufficient for use in
determining liabilities, adjustments may be required. The effects of these
adjustments may be significant and are charged or credited to income for the
period in which the adjustments are made.
Excluding the $1.6 million provision for the costs of resolving class
action lawsuits related to diminished value brought against the Company, net
development of reserves for property and casualty claims occurring in prior
years, excluding involuntary business, had no impact in the first six months of
2002, compared to reserve strengthening of $10.6 million for the same period in
2001. Total reserves for property and casualty claims occurring in prior years,
including involuntary business and the $1.6 million provision in 2002 for class
action litigation, were
[SEAL]
29
strengthened $2.5 million in the current period, compared to $11.0 million for
the six months ended June 30, 2001. The reserve strengthening in 2001 was
recorded in the three months ended June 30. The Company's property and casualty
net reserves were $273.5 million and $271.6 million at June 30, 2002 and 2001,
respectively.
Non-catastrophe weather-related losses in the first and second quarters of
2001 were notably greater than historical experience. The statutory
non-catastrophe property loss ratio by quarter and for the full years 2001, 2000
and 1999 was as follows:
2002 2001 2000 1999
------- ------- ------- -------
Non-catastrophe property
loss ratio for the:
Quarter ended March 31 .................. 78.5% 85.1% 79.0% 81.9%
Quarter ended June 30 ................... 75.4% 99.4% 91.4% 72.8%
Quarter ended September 30 .............. 99.7% 82.8% 78.1%
Quarter ended December 31 ............... 82.8% 80.7% 53.3%
Year ended December 31 .................. 91.5% 83.4% 71.0%
After determining that the increase in non-catastrophe property losses
experienced in the early months of 2000 was due to underlying loss trends,
rather than the normal cyclicality of the property business, management began
and has continued to implement pricing, underwriting and loss control
initiatives. The Company's actions have had a positive impact on the property
loss ratio in the first half of 2002, accompanied by an expected decline in
homeowners policies in force. Management expects that the full impact of these
changes will be realized later in 2002 and beyond. In light of experience and
competitive actions in 2001, the Company is continuing to aggressively increase
homeowners rates. The Company has also initiated further tightening of
underwriting guidelines, expanded reunderwriting of existing policies,
implemented coverage and policy form restrictions in all states where permitted,
and limited new homeowners business to educators in certain areas. In addition,
due to the claims experience in the fourth quarter of 2001, the Company is
conducting a program to reinspect a significant portion of its property book of
business. The Company also is strengthening its homeowners policies' contract
language to further protect the Company against water damage and mold claims.
The Company has also begun the process of redesigning its claim handling
procedures in order to better control loss costs. (See also "Results of
Operations -- Subsequent Event - Restructure of Property and Casualty Claims
Operations.") Management anticipates that these actions will enable the Company
to improve the profitability of its existing book of homeowners business and
attract new business that meets its profitability standards.
For the first six months of 2002, incurred catastrophe losses for all lines
were $4.3 million, compared to $9.2 million for the same period last year.
Incurred catastrophe losses in the first half of 2001 included a net benefit of
$1.4 million due to favorable development of reserves for 2000 catastrophe
losses.
[SEAL]
30
The voluntary automobile loss ratio excluding catastrophe losses was 78.0%
for the first six months of 2002, including 0.9 percentage points due to the
aforementioned class action lawsuits, compared to 77.7% for the same period last
year. The increase in average voluntary automobile premium per policy in the
first six months of 2002 nearly kept pace with the increase in average current
accident year loss costs.
The annuity benefits in the first six months of 2002 and 2001 represented
mortality charges for annuity contracts on payout status. In addition, the
guaranteed minimum death benefit reserve on variable annuity contracts was
increased $0.3 million in the six months ended June 30, 2002, as a result of
fluctuations in the financial markets.
Life mortality experience in the current period was comparable to a year
earlier.
Liabilities for future benefits on life and annuity policies are
established in amounts adequate to meet the estimated future obligations on
policies in force. Liabilities for future policy benefits on certain life
insurance policies are computed using the net level premium method and are based
on assumptions as to future investment yield, mortality and withdrawals.
Mortality and withdrawal assumptions for all policies have been based on various
actuarial tables which are consistent with the Company's own experience.
Liabilities for future benefits on annuity contracts and certain long-duration
life insurance contracts are carried at accumulated policyholder values without
reduction for potential surrender or withdrawal charges. In the event actual
experience varies from the estimated liabilities, adjustments are charged or
credited to income for the period in which the adjustments are made.
As disclosed in the Company's Annual Report on Form 10-K for 2001, early in
that year management discovered some deficiencies in the tax compliance testing
procedures associated with certain of the Company's life insurance policies that
could jeopardize the tax status of some of those life policies. Deficiencies in
the Company's computer-based monitoring of premiums, combined with the
complexity of certain of the Company's life insurance products, resulted in the
acceptance of too much premium for certain policies under the applicable tax
test the Company was using. As a result of this discovery, the Company retained
outside experts to assist with the investigation and remedy of this issue. The
deficiencies in the testing procedures were identified and corrected. Such a
problem is not uncommon in the life insurance industry and will be cured using
standard Internal Revenue Service ("IRS") procedures that have been established
specifically to address this type of situation. The Company recorded $2.0
million of policyholder benefits in the Corporate and Other segment in the
fourth quarter of 2001, as well as $1.0 million of operating expense, which
represented the Company's current best estimate of the costs to the Company to
resolve these problems. In the second quarter of 2002, management further
refined its analysis and confirmed that the charge recorded in the fourth
quarter of 2001 continues to be its best estimate of the costs to the Company to
resolve these problems.
As a result of the tax status issue described above, the complexity of the
Company's product underlying the policies in question, and the complexity of
administering that product and other life products offered by the Company,
management is re-examining its life product portfolio and related administrative
system.
[SEAL]
31
Interest Credited to Policyholders
Six Months Ended Growth Over
June 30, Prior Year
----------------- -----------------
2002 2001 Percent Amount
------- ------- ------- -------
Annuity.................................. $ 33.5 $ 34.1 -1.8% $ (0.6)
Life..................................... 15.1 14.2 6.3% 0.9
------- ------- -------
Total.................................. $ 48.6 $ 48.3 0.6% $ 0.3
======= ======= =======
The fixed annuity average annual interest rate credited decreased to 4.9%
for the six months ended June 30, 2002, compared to 5.2% for the same period
last year. Partially offsetting the decline in the rate credited, the average
accumulated fixed deposits increased 4.6% for the first six months of 2002,
compared to the same period in 2001. Life insurance interest credited increased
as a result of continued growth in interest-sensitive life insurance reserves.
Operating Expenses
For the first six months of 2002, operating expenses increased $7.6
million, or 13.5%, compared to last year. The higher level of company-wide
expense was due primarily to $2.9 million of transition costs related to changes
in the Company's pension plan and elimination of the provision for 2001 employee
incentive compensation in the second quarter of 2001 as a consequence of the
Company's earnings reported in the first half of 2001. The increase in these
company-wide expenses impacted each of the Company's insurance segments.
In 2001, the Company determined that it would freeze its defined benefit
pension plan and move to a defined contribution structure. This change is
expected to reduce the Company's pension expense by approximately $2 million to
$3 million per year beginning in 2004. Costs of transitioning to the new
structure, based upon assumptions of future events, are estimated to be
approximately $5.5 million and $2 million for the full years 2002 and 2003,
respectively, largely from provisions that are expected to be triggered as a
result of the higher retirement rate currently being experienced by the Company,
coupled with more retirees choosing lump sum distributions. To the extent that
actual experience differs from the Company's assumptions, adjustments may be
required with the effects of these adjustments charged or credited to income for
the period in which the adjustments are made. Effective January 1, 2002, the
Company also implemented changes to its employee medical plans to mitigate that
cost.
The total corporate expense ratio on a statutory accounting basis was 24.0%
for the six months ended June 30, 2002, 2.1 percentage points higher than the
same period in 2001, reflecting the expense items discussed above. The property
and casualty statutory expense ratio, the 16th lowest of the 100 largest
property and casualty insurance groups for 2000 (the most recent industry
ranking available), was 23.2% for the six months ended June 30, 2002, compared
to 20.6% last year. The property and casualty expense ratio reflected that
segment's portion of the increase in company-wide operating expenses as well as
an increase in automobile new business commissions.
[SEAL]
32
Amortization of Policy Acquisition Expenses and Intangible Assets
For the first six months of 2002, the combined amortization of policy
acquisition expenses and intangible assets was $31.6 million, compared to the
$31.0 million recorded for the same period in 2001.
Amortization of intangible assets decreased to $2.7 million for the six
months ended June 30, 2002, compared to $3.7 million for the same period in
2001. The decline primarily reflected the elimination of amortization of
goodwill as the result of the adoption of Financial Accounting Standards Board
("FASB") Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill
and Other Intangible Assets." Amortization of goodwill was $0.8 million and $1.6
million for the six months ended June 30, 2001 and the year ended December 31,
2001, respectively. In addition, the June 2002 valuation of annuity value of
business acquired in the 1989 acquisition of the Company ("Annuity VIF")
resulted in a $0.1 million reduction in amortization scheduled for the six
months. The valuation identified an increase in amortization due to lower than
expected market performance offset by the impact of realized investment losses.
Policy acquisition expenses amortized for the six months ended June 30,
2002 of $28.9 million were $1.6 million more than the same period last year
primarily related to the property and casualty segment. Over the past 12 months,
this segment has experienced accelerated growth in business and the acquisition
cost amortization period matches the terms of the insurance policies (six and
twelve months). The increase in amortization for the property and casualty
segment was partially offset by a $1.0 million reduction in amortization for the
annuity and life segments combined as a result of the current year valuation.
The favorable impact of realized investment losses in the valuation was only
partially offset by lower than expected market performance in the annuity
segment.
Policy acquisition costs, consisting of commissions, premium taxes and
other costs, which vary with and are primarily related to the production of
business are capitalized and amortized on a basis consistent with the type of
insurance coverage. For investment (annuity) contracts, acquisition costs, and
also the value of annuity business acquired in the 1989 acquisition of the
Company, are amortized over 20 years in proportion to estimated future gross
profits. Capitalized acquisition costs for interest-sensitive life contracts are
also amortized over 20 years in proportion to estimated future gross profits.
The most significant assumptions that are involved in the estimation of future
gross profits include future market performance, business surrender/lapse rates
and the impact of realized investment gains and losses. In the event actual
experience differs significantly from assumptions or assumptions are
significantly revised, the Company may be required to record a material charge
or credit to amortization expense for the period in which the adjustment is
made.
Income Tax Expense
The effective income tax rate on income including realized investment gains
and losses was a benefit of 54.3% for the six months ended June 30, 2002,
compared to a tax of 28.9% for the same period last year.
[SEAL]
33
Income from investments in tax-advantaged securities reduced the effective
income tax rate 20.7 and 12.4 percentage points for the six months ended June
30, 2002, and 2001, respectively. While the amount of income from tax-advantaged
securities in the current year was slightly less than in the first half of 2001,
the reduced level of income before income taxes in the current period resulted
in this having a more significant impact on the effective income tax rate.
The effective income tax rate on operating income, as defined below, before
income taxes was 30.6% for the six months ended June 30, 2002, comparable to the
effective income tax rate of 29.4% on the same basis for the prior year.
Operating Income (Loss)
The Company defines operating income as net income before the after-tax
impact of realized investment gains and losses and non-recurring items.
Non-recurring items included debt retirement costs and class action litigation
charges in the first half of 2002 as well as a restructuring reserve adjustment
in the same period a year earlier.
Compared to the first half of 2001, current period operating income
benefitted from mild weather, the impact of property and casualty rate increases
on earned premiums, the positive impact of the Company's restructuring of its
Massachusetts automobile business, and the discontinuance of goodwill
amortization with the adoption of SFAS No. 142 on January 1, 2002.
These positive prior year comparisons were partially offset by an increase
in company-wide operating expenses due to (1) transition costs related to
changes in the Company's retirement plans, which are expected to have a
favorable long-term impact on employee benefit costs, and (2) elimination of the
provision for 2001 employee incentive compensation in the second quarter of last
year. Operating income in the first six months of 2001 was adversely affected by
strengthening of prior years' property and casualty reserves.
Consistent with previous indications, at the time of this Report on Form
10-Q management anticipates that 2002 full year operating income will be within
a range of $1.15 to $1.25 per share. However, the recent turmoil in the
financial markets will put pressure on earnings. In the second half of 2002,
management anticipates lower investment income due to investment credit issues
and tightening margins on variable annuities resulting from declining market
valuations. As described throughout this discussion of Results of Operations,
certain of the Company's significant accounting measurements require the use of
estimates and assumptions. As additional information becomes available,
adjustments may be required. Those adjustments are charged or credited to income
for the period in which the adjustments are made.
[SEAL]
34
Operating income (loss) by segment was as follows:
Six Months Ended Growth Over
June 30, Prior Year
----------------- -----------------
2002 2001 Percent Amount
------- ------- ------- -------
Property & casualty
Before catastrophe losses ..................... $ 13.3 $ 4.1 $ 9.2
Catastrophe losses, after tax ................. (2.8) (6.0) 3.2
------- ------- -------
Total including catastrophe losses ......... 10.5 (1.9) 12.4
Annuity ......................................... 9.2 9.4 -2.1% (0.2)
Life ........................................... 8.2 9.4 -12.8% (1.2)
Corporate and other expense ..................... (1.0) (1.5) 0.5
Interest expense, after tax ..................... (2.9) (3.1) 0.2
------- ------- -------
Total ...................................... $ 24.0 $ 12.3 95.1% $ 11.7
======= ======= =======
Total before catastrophe losses ............ $ 26.8 $ 18.3 46.4% $ 8.5
======= ======= =======
Property and casualty statutory combined ratio:
Before catastrophe losses ..................... 102.0% 105.5% -3.5%
After catastrophe losses ...................... 103.7% 109.2% -5.5%
Impact of litigation charges .................. 0.6% - 0.6%
Property and casualty segment operating income of $10.5 million for the
first six months of 2002 increased $12.4 million compared to the same period
last year. Excluding the $1.0 million after-tax provision for class action
litigation, development of prior years' reserves decreased operating income $0.6
million after tax for the first half of 2002. For the first six months of 2001,
the Company strengthened prior years' reserves by $7.2 million after tax, all
recorded in the three months ended June 30. Compared to a year earlier, 2002
property and casualty segment operating income reflected favorable weather,
partially offset by increases in claim adjustment expenses and company-wide
operating expenses.
For the first six months of 2002, the Company's increase in average
voluntary automobile insurance premium per policy nearly kept pace with the
increase in average loss costs for the current accident year. The Company has
implemented tiered rating systems based on customers' credit ratings for
automobile and homeowners business, which management expects will have a
positive impact on both loss ratios and business growth for these products in
the Company's target market. The Company is continuing to approach the pricing
and underwriting of its homeowners products aggressively, to accelerate margin
recovery. And, due to homeowners loss experience in the fourth quarter of 2001,
the Company identified additional initiatives. Actions include further
tightening of underwriting guidelines, expanded reunderwriting of existing
policies, coverage and policy form restrictions in all states where permitted,
limited coverage of new homeowners business to educators in certain areas,
reinspection of the homeowners book of business and redesign of the Company's
claim handling procedures. (See also "Results of Operations -- Subsequent Event
- - Restructure of Property and Casualty Claims Operations.")
The property and casualty statutory combined ratio was 103.7% for the first
six months of 2002, compared to 109.2% for the same period in 2001. The
statutory loss ratio for the segment improved compared to the prior year;
however, the statutory expense ratio increased 2.6 percentage points, primarily
reflecting this segment's portion of the increase in company-wide operating
expenses as well as an increase in automobile new business commissions.
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Annuity segment operating income in the first six months of 2002 was only
slightly less than the prior year. Improvement in the net interest margin was
offset primarily by the increase in company-wide operating expenses. Valuation
of annuity segment deferred acquisition costs and value of acquired insurance in
force at June 30, 2002, including lower than expected market appreciation offset
by the impact of realized investment losses, resulted in an after-tax reduction
in amortization of $0.4 million for the six months. Similar valuations a year
earlier reduced after-tax amortization $0.1 million for the six months. Variable
annuity fee income for the current period was comparable to the first six months
of 2001. Variable annuity accumulated funds on deposit were $1.0 billion at June
30, 2002, $59.0 million, or 5.8%, less than 12 months earlier. Fixed annuity
accumulated cash value of $1.4 billion was $61.3 million, or 4.5%, greater than
June 30, 2001.
Life segment operating income decreased $1.2 million compared to the first
six months of 2001 as a result of this segment's portion of the increase in
company-wide operating expenses and pressure on the interest margin. Mortality
experience on ordinary life business was comparable to the first half of 2001.
Valuation of life segment deferred acquisition costs at June 30, 2002 resulted
in a reduction in amortization of $0.4 million after tax due to the impact of
realized investment losses.
The reduction in the operating loss for the corporate and other segment
compared to the first six months of 2001 primarily reflected the change in
accounting, which was effective January 1, 2002, that eliminated goodwill
amortization. For the six months ended June 30, 2001, amortization of goodwill
was $0.8 million, or 2 cent per share.
Net Income (Loss)
Net Income (Loss) Per Share, Diluted
Six Months Ended Growth Over
June 30, Prior Year
----------------- -----------------
2002 2001 Percent Amount
------- ------- ------- -------
Operating income ................................ $ 0.58 $ 0.30 93.3% $ 0.28
Realized investment losses ...................... (0.61) (0.01) (0.60)
Debt retirement costs ........................... (0.04) - (0.04)
Litigation charges .............................. (0.02) - (0.02)
Restructuring reserve adjustment ................ - - -
------- ------- -------
Net income (loss) .......................... $ (0.09) $ 0.29 $ (0.38)
======= ======= =======
Net income (loss), includes net realized investment gains and losses and
non-recurring items reflected in the Corporate and Other segment. For the six
months ended June 30, 2002, the Company reported a net loss of $3.7 million, or
$0.09 per share, including after-tax realized investment losses of $25.2
million, or $0.61 per share. For the first half of 2001, net income was $11.8
million, or $0.29 per share, including after-tax realized investment losses of
$0.6 million, or $0.01 per share. After-tax realized investment losses are
described in "Results of Operations -- Realized Investment Gains and Losses."
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In addition to the changes in after-tax realized investment losses and
operating income, the Company recorded non-recurring items in the first six
months of both 2002 and 2001.
In May 2002, the Company used a portion of the proceeds from the sale of
its Convertible Notes to repay the balance outstanding under the previous Bank
Credit Agreement and repurchase $55.0 million of its outstanding Senior Notes.
The debt retirement resulted in an after-tax charge of $1.5 million, or $0.04
per share, which was reflected in current period net income.
In June 2002, the Company recorded an after-tax charge of $1.0 million, or
$0.02 per share, to net income, representing the Company's best estimate of the
costs of resolving class action lawsuits related to diminished value brought
against the Company. While the actual costs incurred by the Company to resolve
these issues could be either less or more than the liability established in the
current period, management believes that, based on facts and circumstances
available at this time, the amount recorded will be adequate to resolve the
matters.
In the first six months of 2001, the Company recorded an after-tax
reduction to restructuring reserves of $0.1 million, less than $0.01 per share.
Return on shareholders' equity was 10% based on operating income and 2%
based on net income for the 12 months ended June 30, 2002.
Subsequent Event - Restructure of Property and Casualty Claims Operations
In July 2002, the Company announced the restructuring of its property and
casualty claims operations. The Company expects to realize operating and cost
efficiencies and also improve customer service by consolidating claims office
locations throughout the United States into 6 offices compared to the current
17, implementing a new claims administration system, and performing certain
claims reporting and adjusting functions internally versus utilizing external
service providers. The Company expects that these claims actions will have a
positive impact on earnings in 2003 and beyond. In addition to the cost
efficiencies anticipated from the new claims environment, the restructuring is
expected to have a favorable impact on automobile and homeowners claim severity.
Approximately 135 employees with management, professional and clerical
responsibilities will be impacted by the office consolidations. Charges for
employee termination costs, representing severance, vacation buy-out, related
payroll taxes and the impact of accelerated retirements on the Company's defined
benefit pension plan, and other costs related to the office closures totaling
approximately $2.5 million after tax, or $0.06 per share, will be reflected as a
non-operating restructuring charge in the Company's financial statements for the
third quarter of 2002.
LIQUIDITY AND FINANCIAL RESOURCES
Special Purpose Entities
At June 30, 2002 and 2001, the Company did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or for other contractually narrow or limited purposes.
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As such, the Company is not exposed to any financing, liquidity, market or
credit risk that could arise if the Company had engaged in such relationships.
Related Party Transactions
The Company does not have any contracts or other transactions with related
parties that are required to be reported under the applicable securities laws
and regulations.
Ariel Capital Management, Inc., HMEC's largest shareholder with 23% of the
common shares outstanding per their SEC filing on Form 13F as of June 30, 2002,
is the investment adviser for two of the mutual funds offered to the Company's
annuity customers. In addition, T. Rowe Price Associates, Inc., HMEC's second
largest shareholder with 8% of the common shares outstanding per their SEC
filing on Form 13F as of March 31, 2002, is the investment advisor for two of
the mutual funds offered to the Company's annuity customers.
Investments
The Company's investment strategy emphasizes investment grade, publicly
traded fixed income securities. At June 30, 2002, fixed income securities
represented 94.2% of investments excluding the securities lending collateral. Of
the fixed income investment portfolio, 95.5% was investment grade and 99.8% was
publicly traded. The average quality of the total fixed income portfolio was A+
at June 30, 2002.
The duration of the investment portfolio is managed to provide cash flow to
satisfy policyholder liabilities as they become due. The average option adjusted
duration of total investments was 4.4 years at June 30, 2002 and 5.0 years at
December 31, 2001. The Company has included in its annuity products substantial
surrender penalties to reduce the likelihood of unexpected increases in policy
or contract surrenders. All annuities issued since 1982, and approximately 79%
of all outstanding fixed annuity accumulated cash values, are subject in most
cases to substantial early withdrawal penalties.
Additional discussion of the Company's investment guidelines is included in
"Results of Operations -- Realized Investment Gains and Losses."
Cash Flow
The short-term liquidity requirements of the Company, within a 12-month
operating cycle, are for the timely payment of claims and benefits to
policyholders, operating expenses, interest payments and federal income taxes.
Cash flow in excess of these amounts has been used to fund business growth,
retire short-term debt, pay dividends to shareholders and repurchase shares of
the Company's common stock. Long-term liquidity requirements, beyond one year,
are principally for the payment of future insurance policy claims and benefits
and retirement of long-term notes.
Operating Activities
As a holding company, HMEC conducts its principal operations in the
personal lines segment of the property and casualty and life insurance
industries through its subsidiaries. HMEC's insurance subsidiaries generate cash
flow from premium and investment income,
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generally well in excess of their immediate needs for policy obligations,
operating expenses and other cash requirements. Cash provided by operating
activities primarily reflects net cash generated by the insurance subsidiaries.
Net cash provided by operating activities was $6.8 million less than the first
six months of 2001 due primarily to an increase in federal income taxes paid in
the current year.
The Company has entered into various operating lease agreements, primarily
for computer equipment, computer software and real estate (agency and claims
offices across the country and portions of the home office complex). These
leases have varying commitment periods with most in the 1 to 3 year range.
Operating cash flow reflects payments on these leases of approximately $4
million for both the six months ended June 30, 2002 and 2001. It is anticipated
that the Company's payments under operating leases for the full year 2002 will
be comparable to prior years' payments of approximately $8 million. The Company
does not have any other arrangements that expose it to material liability that
are not recorded in the financial statements.
Payment of principal and interest on debt, fees related to the
catastrophe-linked equity put option and reinsurance agreement, dividends to
shareholders and parent company operating expenses, as well as the share
repurchase program, are dependent upon the ability of the insurance subsidiaries
to pay cash dividends or make other cash payments to HMEC, including tax
payments pursuant to tax sharing agreements. The insurance subsidiaries are
subject to various regulatory restrictions which limit the amount of annual
dividends or other distributions, including loans or cash advances, available to
HMEC without prior approval of the insurance regulatory authorities. Dividends
which may be paid by the insurance subsidiaries to HMEC during 2002 without
prior approval are approximately $40 million, of which $5 million had been paid
as of June 30, 2002. Although regulatory restrictions exist, dividend
availability from subsidiaries has been, and is expected to be, adequate for
HMEC's capital needs.
Investing Activities
HMEC's insurance subsidiaries maintain significant investments in fixed
maturity securities to meet future contractual obligations to policyholders. In
conjunction with its management of liquidity and other asset/liability
management objectives, the Company, from time to time, will sell fixed maturity
securities prior to maturity and reinvest the proceeds in other investments with
different interest rates, maturities or credit characteristics. Accordingly, the
Company has classified the entire fixed maturity securities portfolio as
available for sale.
Financing Activities
Financing activities include primarily payment of dividends, the receipt
and withdrawal of funds by annuity contractholders, repurchases of the Company's
common stock, and borrowings and repayments under the Company's debt facilities.
Fees related to the catastrophe-linked equity put option and reinsurance
agreement, which augments its other reinsurance program, have been charged
directly to additional paid-in capital.
In May 2002, the Company issued $353.5 million aggregate principal amount
of 1.425% Senior Convertible Notes ("Convertible Notes"), which will mature on
May 14, 2032, at a discount of 52.5%. As of June 30, 2002, proceeds from the
sale of the Convertible Notes have been used to repay the $53.0 million balance
outstanding under the previous Bank Credit Agreement on May 14, 2002 and
repurchase $55.0 million aggregate principal amount of the Company's outstanding
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6 5/8% Senior Notes due January 15, 2006 on May 30, 2002 at an aggregate cost of
$56.8 million. The remaining proceeds will be used for general corporate
purposes and potentially to further reduce corporate indebtedness. (See also
"Liquidity and Financial Resources -- Capital Resources" for additional
description of the Convertible Notes.)
For the first six months ended June 30, 2002, receipts from annuity
contracts increased 6.5%. Annuity contract maturities and withdrawals decreased
$7.0 million, or 7.5%, compared to the same period last year including decreases
of 10.7% and 13.0% in surrenders of variable and fixed annuities, respectively.
Reflecting continued improvement in recent quarterly trends, cash value
retention for variable and fixed annuities was 92.8% and 94.0%, respectively,
for the 12 month period ended June 30, 2002. Net transfers to variable annuity
assets increased $15.1 million compared to the same period last year reflecting
the Company's expansion of its variable investment options.
The Company has not repurchased shares of its common stock under its stock
repurchase program since the third quarter of 2000, consistent with management's
stated intention to utilize excess capital to support the Company's strategic
growth initiatives. Historically, the repurchase of shares was financed through
use of cash and, when necessary, its Bank Credit Facility. However, the Company
has not utilized its Bank Credit Facility for share repurchases since the second
quarter of 1999. As of June 30, 2002, $96.3 million remained authorized for
future share repurchases.
Capital Resources
The Company has determined the amount of capital which is needed to
adequately fund and support business growth, primarily based on risk-based
capital formulas including those developed by the National Association of
Insurance Commissioners ("NAIC"). Historically, the Company's insurance
subsidiaries have generated capital in excess of such needed capital. These
excess amounts have been paid to HMEC through dividends. HMEC has then utilized
these dividends and its access to the capital markets to service and retire
long-term debt, increase and pay dividends to its shareholders, fund growth
initiatives, repurchase shares of its common stock and for other corporate
purposes. Management anticipates that the Company's sources of capital will
continue to generate capital in excess of the needs for business growth, debt
interest payments and shareholder dividends.
The total capital of the Company was $652.3 million at June 30, 2002,
including $212.8 million of long-term debt and no short-term debt outstanding.
Total debt represented 32.6% of capital (33.5% excluding unrealized investment
gains and losses) at June 30, 2002, which exceeded the Company's long-term
operating target of approximately 25%. The Company anticipates additional
reductions in long-term debt prior to December 31, 2002 utilizing a portion of
the remaining proceeds from the issuance of the Convertible Notes (discussed
below). Upon completion of the anticipated additional reductions in long-term
debt, the Company's debt is expected to represent less than 30% of total
capital.
Shareholders' equity was $439.5 million at June 30, 2002, including an
unrealized gain in the Company's investment portfolio of $17.9 million after
taxes and the related impact on deferred policy acquisition costs and the value
of acquired insurance in force associated with annuity and interest-sensitive
life policies. The market value of the Company's common stock and the market
value per share were $762.6 million and $18.67, respectively, at June 30, 2002.
Book value per share was $10.76 at June 30, 2002, $10.32 excluding investment
fair value adjustments. At June
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30, 2001, book value per share was $10.94, $10.73 excluding investment fair
value adjustments. The decrease over the 12 months included the effects of
realized and unrealized investment gains and losses and an increase in the
Company's minimum pension liability recorded at December 31, 2001.
On May 14, 2002, the Company issued $353.5 million aggregate principal
amount of 1.425% senior convertible notes due in 2032 ("Convertible Notes") at a
discount of 52.5% resulting in an effective yield of 3.0%. The net proceeds from
the sale of the Convertible Notes have been used to repay the balance
outstanding under the previous Bank Credit Agreement and repurchase a portion of
the outstanding Senior Notes, as described below, and will be used for general
corporate purposes and potentially to further reduce corporate indebtedness.
Interest on the Convertible Notes is payable semi-annually at a rate of 1.425%
beginning November 14, 2002 until May 14, 2007. After that date, cash interest
will not be paid on the Convertible Notes prior to maturity unless contingent
cash interest becomes payable. Contingent cash interest becomes payable if the
average market price of a Convertible Note for a five trading day measurement
period preceding the applicable six-month period equals 120% or more of the sum
of the Convertible Note's issue price, accrued original issue discount and
accrued cash interest, if any, for such Convertible Note. The contingent cash
interest payable per Convertible Note with respect to any quarterly period
within any six-month period will equal the then applicable conversion rate
multiplied by the greater of (i) $0.105 or (ii) any regular cash dividends paid
by the Company per share on HMEC's common stock during that quarterly period.
The Convertible Notes will be convertible at the option of the holders, if the
conditions for conversion are satisfied, into shares of HMEC's common stock at a
conversion price of $26.74. Holders may also surrender Convertible Notes for
conversion during any period in which the credit rating assigned to the
Convertible Notes is Ba2 or lower by Moody's or BB+ or lower by S&P, the
Convertible Notes are no longer rated by either Moody's or S&P, or the credit
rating assigned to the Convertible Notes has been suspended or withdrawn by
either Moody's or S&P. The Convertible Notes will cease to be convertible
pursuant to this credit rating criteria during any period or periods in which
all of the credit ratings are increased above such levels. The Convertible Notes
are redeemable by HMEC in whole or in part, at any time on or after May 14,
2007, at redemption prices equal to the sum of the issue price plus accrued
original issue discount and accrued cash interest, if any, on the applicable
redemption date. The holders of the Convertible Notes may require HMEC to
purchase all or a portion of their Convertible Notes on either May 14, 2007,
2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any,
to the purchase date. HMEC may pay the purchase price in cash or shares of HMEC
common stock or in a combination of cash and shares of HMEC common stock. The
Convertible Notes were privately offered only to qualified institutional buyers
under Rule 144A under the Securities Act of 1933 and outside the United States
of America ("U.S.") to non-U.S. persons under Regulation S under the Securities
Act of 1933, and may not be offered or sold in the U.S. absent registration or
an applicable exemption from registration requirements. The Convertible Notes
have an investment grade rating from S&P (BBB+), Moody's (Baa2) and A.M. Best
(bbb+). S&P and A.M. Best have indicated the outlook for their rating is
"Stable." On July 25, 2002, Moody's affirmed its Baa2 rating, but revised the
outlook for the rating to "Negative" from "Stable." This change in outlook was
the result of the Company's second quarter 2002 investment losses stemming from
the impact on the financial markets from the announced SEC investigation into
the accounting practices of WorldCom, Inc. Moody's announcement indicated that
material adverse deviations from the Company's expected level of capital growth
and earnings could trigger a subsequent ratings downgrade. HMEC intends to file
a registration statement with the Securities and Exchange Commission related to
the Convertible Notes prior to September 30, 2002.
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In January 1996, the Company issued $100.0 million aggregate principal
amount of 6 5/8% Senior Notes ("Senior Notes") at a discount of 0.5% which will
mature on January 15, 2006. On May 30, 2002, the Company repurchased $55.0
million aggregate principal amount of its outstanding Senior Notes utilizing a
portion of the proceeds from the issuance of the Convertible Notes, as described
above. Interest on the Senior Notes is payable semi-annually. The Senior Notes
are redeemable in whole or in part, at any time at the Company's option. The
Senior Notes have an investment grade rating from Standard & Poor's Corporation
("S&P") (BBB+), Fitch, Inc. ("Fitch") (A-), Moody's Investors Service, Inc.
("Moody's") (Baa2), and A.M. Best Company, Inc. ("A.M. Best") (bbb+). S&P, Fitch
and A.M. Best have indicated the outlook for their rating is "Stable." On July
25, 2002, Moody's affirmed its Baa2 rating, but revised the outlook for the
rating to "Negative" from "Stable", as described above in the paragraph
regarding the Convertible Notes. The Senior Notes are traded on the New York
Stock Exchange (HMN 6 5/8).
As of December 31, 2001, the Company had short-term debt of $53.0 million
outstanding under the previous Bank Credit Agreement. The $53.0 million balance
outstanding under the previous Bank Credit Agreement was repaid in full on May
14, 2002 utilizing a portion of the proceeds from the issuance of the
Convertible Notes, as described above. On May 29, 2002, the Company entered into
a new Bank Credit Agreement which provides for unsecured borrowings of up to
$25.0 million, with a provision that allows the commitment amount to be
increased to $35.0 million (the "Current Bank Credit Facility"). The Current
Bank Credit Facility expires on May 31, 2005. Interest accrues at varying
spreads relative to corporate or eurodollar base rates and is payable monthly or
quarterly depending on the applicable base rate. No amounts had been borrowed
under the Current Bank Credit Facility and no balance was outstanding at June
30, 2002. The unused portion of the Current Bank Credit Facility is subject to a
variable commitment fee which was 0.20% on an annual basis at June 30, 2002.
The Company's ratio of earnings to fixed charges for the six months ended
June 30, 2002 was 0x, reflecting the impact of $38.7 million pretax of realized
investment losses recognized during the period, compared to 4.5x for the same
period in 2001.
Total shareholder dividends were $8.6 million for the six months ended June
30, 2002. In February 2002 and May 2002, the Board of Directors announced
regular quarterly dividends of $0.105 per share.
The Company maintains an excess and catastrophe treaty reinsurance program.
The Company reinsures 95% of catastrophe losses above a retention of $8.5
million per occurrence up to $80 million per occurrence. In addition, the
Company's predominant insurance subsidiary for property and casualty business
written in Florida reinsures 90% of hurricane losses in that state above a
retention of $11.0 million up to $47.4 million with the Florida Hurricane
Catastrophe Fund, based on the Fund's financial resources. Through December 31,
2001, these catastrophe reinsurance programs were augmented by a $100 million
equity put and reinsurance agreement. This equity put provided an option to sell
shares of the Company's convertible preferred stock with a floating rate
dividend at a pre-negotiated price in the event losses from catastrophes
exceeded the catastrophe reinsurance program coverage limit. Before tax
benefits, the equity put provided a source of capital for up to $154 million of
catastrophe losses above the reinsurance coverage limit.
Effective May 7, 2002, the Company entered into a replacement equity put
and reinsurance agreement with a subsidiary of Swiss Reinsurance Company. The
Swiss Re Group is rated "A++
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(Superior)" by A.M. Best. Under the 36-month agreement, the equity put coverage
of $75.0 million provides a source of capital for up to $115.0 million of pretax
catastrophe losses above the reinsurance coverage limit. The Company also has
the option, in place of the equity put, to require a Swiss Re Group member to
issue a 10% quota share reinsurance coverage of all of the Company's property
and casualty book of business. Annual fees related to this equity put option,
which are charged directly to additional paid-in capital, increased to 145 basis
points in 2002 from 95 basis points in 2001 under the prior agreement; however,
in 2002 the agreement is effective only for the last eight months of the year.
The agreement contains certain conditions to Horace Mann's exercise of the
equity put option including: (i) the Company's shareholders' equity, adjusted to
exclude goodwill, can not be less than $215.0 million after recording the first
triggering event; (ii) the Company's total debt as a percentage of capital can
not be more than 47.5% prior to recording the triggering event; and (iii) the
Company's S&P financial strength rating can not be below "BBB" prior to a
triggering event. The Company's S&P financial strength rating was "A+" at June
30, 2002.
For liability coverages, including the educator excess professional
liability policy, the Company reinsures each loss above a retention of $500
thousand up to $20 million. The Company also reinsures each property loss above
a retention of $250 thousand up to $2.5 million in 2001 and 2002, including
catastrophe losses that in the aggregate are less than the retention levels
above.
The cost of the Company's catastrophe reinsurance coverage program for the
full year 2002 increased approximately 50%, or $2.0 million, compared to full
year 2001 as a result of the effects on the reinsurance market of the September
11, 2001 terrorist attacks. However the impact on the Company was mitigated due
to the fact that 38% of the Company's catastrophe coverage is under a three-year
contract from January 1, 2001 through December 31, 2003. The cost of the
Company's entire property and casualty reinsurance program for the full year
2002 increased approximately 35%, or $2.5 million, compared to full year 2001.
INSURANCE FINANCIAL RATINGS AND IMSA CERTIFICATION
The Company's principal insurance subsidiaries are rated by various rating
agencies. Additional information regarding the rating processes and ratings
definitions for each agency is included in the Company's Annual Report on Form
10-K for the year ended December 31, 2001 in "Business -- Insurance Financial
Ratings and IMSA Certification." Each of the ratings below is unchanged from
December 31, 2001 with the exception of A.M. Best's rating for the Company's
property and casualty subsidiaries and Moody's outlook for the Company's
financial strength ratings.
On May 9, 2002 following its annual review of Horace Mann's ratings, A.M.
Best Company, Inc. ("A.M. Best") announced that it was affirming the "A
(Excellent)" financial strength rating of the Company's principal life insurance
subsidiary. A.M. Best downgraded the financial strength ratings of the Company's
property and casualty subsidiaries one notch from "A+ (Superior)" to "A
(Excellent)" reflecting capitalization of these subsidiaries being below A.M.
Best's standard for the Superior rating and the impact on earnings in 2000 and
2001 of prior years' reserve strengthening. A.M. Best has identified the outlook
for the ratings as "Stable."
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As affirmed on May 2, 2002, each of HMEC's principal insurance subsidiaries
is rated "A+ (Strong)" for financial strength by Standard & Poor's Corporation
("S&P") with a ratings outlook of "Stable", with the exception of Horace Mann
Lloyds which is not yet rated by S&P.
Each of HMEC's principal insurance subsidiaries is rated "AA- (Very
Strong)" for financial strength by Fitch, Inc. ("Fitch") with a rating outlook
of "Stable".
Moody's Investors Service, Inc. ("Moody's") has assigned a financial
strength rating of "A2 (Good)" to each of HMEC's principal subsidiaries, with
the exception of Horace Mann Lloyds which is not yet rated by Moody's. On July
25, 2002, Moody's affirmed these ratings, but revised the outlook for the
ratings to "Negative" from "Stable." This change in outlook was the result of
the Company's second quarter 2002 investment losses stemming from the impact on
the financial markets from the announced SEC investigation into the accounting
practices of WorldCom, Inc. Moody's announcement indicated that material adverse
deviations from the Company's expected level of capital growth and earnings
could trigger a subsequent ratings downgrade.
As of 2001, Horace Mann is one of only two insurance groups that have been
named to The Ward's Financial Group's ("Wards") Top 50 for both its property and
casualty and life subsidiaries in each of the last eight years. Identified
annually, the Top 50 represent benchmark groups of 50 life insurance companies
and 50 property and casualty insurance companies that, over the prior five
years, have in Ward's opinion excelled at balancing safety, consistency and
performance.
In July 2001, Horace Mann Life Insurance Company, the Company's principal
life insurance subsidiary, earned membership in the Insurance Marketplace
Standards Association ("IMSA"). HMLIC is an IMSA member for three years, after
which it must demonstrate continuous improvement and repeat the self- and
independent assessment process to retain its membership. As of June 30, 2002,
fewer than 250 companies had earned IMSA membership.
MARKET VALUE RISK
Market value risk is the risk that the Company's invested assets will
decrease in value. This decrease in value may be due to a change in (1) the
yields realized on the Company's assets and prevailing market yields for similar
assets, (2) an unfavorable change in the liquidity of the investment, (3) an
unfavorable change in the financial prospects of the issuer of the investment,
or (4) a downgrade in the credit rating of the issuer of the investment. See
also "Results of Operations -- Realized Investment Gains and Losses."
Significant changes in interest rates expose the Company to the risk of
experiencing losses or earning a reduced level of income based on the difference
between the interest rates earned on the Company's investments and the credited
interest rates on the Company's insurance liabilities.
The Company manages its market value risk by coordinating the projected
cash outflows of assets with the projected cash outflows of liabilities. For all
its assets and liabilities, the Company seeks to maintain reasonable durations,
consistent with the maximization of income without sacrificing investment
quality while providing for liquidity and diversification. The investment risk
associated with variable annuity products and the underlying mutual funds is
assumed by those contractholders, and not by the Company.
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A more detailed description of the Company's exposure to market value risks
and the management of those risks is presented in the Company's 2001 Form 10-K
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Market Risk."
RECENT ACCOUNTING CHANGES
SFAS No. 143
In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 143, "Accounting for
Asset Retirement Obligations," effective for fiscal years beginning after June
15, 2002. The accounting practices in this statement apply to legal obligations
associated with the retirement of long-lived assets that result from the
acquisition, construction, development and (or) the normal operation of a
long-lived asset. This statement will not have a material impact on the Company
because it does not own a significant amount of property and equipment.
SFAS No. 145
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections," effective for fiscal years beginning after May 15, 2002. Under
SFAS No. 4, all gains and losses from the extinguishment of debt, exclusive of
an exception identified in SFAS No. 64, were required to be aggregated and, if
material, classified as an extraordinary item, net of related income tax effect.
With adoption of SFAS No. 145, gains and losses from extinguishment of debt
should be classified as extraordinary only if they meet the criteria of
Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations
- - Reporting the Effects of Disposal of a Segment of a Business, Extraordinary,
Unusual and Infrequently Occurring Events and Transactions." Applying the
provisions of Opinion No. 30 will distinguish transactions that are part of an
entity's recurring operations from those that are unusual or infrequent or that
meet the criteria for classification as an extraordinary item. In the six months
ended June 30, 2002, the Company recorded a charge for the extinguishment of
debt and did not report this charge as an extraordinary item.
SFAS No. 44 was not applicable to the Company. Although the evaluation of
the impact of the remaining provisions of SFAS No. 145 is not yet complete, at
this time management anticipates that the impact will not be material.
SFAS No. 146
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," effective for exit or disposal
activities that are initiated after December 31, 2002. This statement 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)." The principal difference
between SFAS No. 146 and EITF No. 94-3 relates to the requirements for
recognition of a liability for a cost associated with an exit or disposal
activity. SFAS No. 146 requires that such liability be recognized when the
liability is incurred. Under EITF No. 94-3, a liability for defined exit costs
was recognized at the date of an entity's commitment to an exit plan. Management
anticipates that the impact of this statement will not be material.
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45
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by Item 305 of Regulation S-K is contained in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" contained in this Form 10-Q.
PART II: OTHER INFORMATION
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company's Annual Meeting of Shareholders was held on May 14, 2002.
The results of the matters submitted to a vote of security holders are shown in
the table below.
Votes Votes
For Against Abstentions
----------- --------- ------------
Votes representing 36,788,830 shares of
Common Stock were represented and cast
regarding Proposal 1.
Election of the following nominees to hold
the office of Director until the next Annual
Meeting of Shareholders and until their
respective successors have been duly
elected and qualified:
William W. Abbott 35,923,225 865,605 -
Mary H. Futrell 28,051,523 8,737,307 -
Donald E. Kiernan 34,872,475 1,916,355 -
Louis G. Lower II 35,924,425 864,405 -
Joseph J. Melone 29,068,830 7,720,000 -
Jeffrey L. Morby 28,112,853 8,675,977 -
Shaun F. O'Malley 36,064,675 724,155 -
Charles A. Parker 36,064,675 724,155 -
William J. Schoen 36,064,675 724,155 -
Votes representing 33,941,411 shares of
Common Stock were represented and cast
regarding Proposal 2.
Approval of the Company's 2002 Incentive
Compensation Plan. 28,218,350 4,690,942 582,119
[SEAL]
46
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
Exhibit
No. Description
------- -----------
(a) The following items are filed as Exhibits. Management contracts
and compensatory plans are indicated by an asterisk (*).
(4) Instruments defining the rights of security holders,
including indentures:
4.1 Indenture dated as of May 14, 2002, between HMEC and
JPMorgan Chase Bank as trustee, with regard to HMEC's
1.425% Senior Convertible Notes Due 2032
(10) Material contracts:
10.1 Credit Agreement dated as of May 29, 2002 (the "Bank
Credit Facility") among HMEC, certain financial
institutions named therein and Bank of America, N.A.,
as administrative agent (the "Agent").
10.2* Horace Mann Educators Corporation 2002 Incentive
Compensation Plan.
10.2(a)* Specimen Employee Stock Option Agreement under the
Horace Mann Educators Corporation 2002 Incentive
Compensation Plan.
10.2(b) Specimen Regular Employee Stock Option Agreement
under the Horace Mann Educators Corporation 2002
Incentive Compensation Plan.
10.2(c)* Specimen Director Stock Option Agreement under the
Horace Mann Educators Corporation 2002 Incentive
Compensation Plan.
(11) Statement re computation of per share earnings.
(15) KPMG LLP letter regarding unaudited interim financial
information.
(99) Additional exhibits:
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, Louis G. Lower II, Chief Executive
Officer of Horace Mann Educators Corporation.
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002, Peter H. Heckman, Chief Financial
Officer of Horace Mann Educators Corporation.
(b) No reports on Form 8-K were filed by the Company during the second
quarter of 2002.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HORACE MANN EDUCATORS CORPORATION
(Registrant)
Date August 13, 2002 /s/ Louis G. Lower II
--------------- -----------------------------------------
Louis G. Lower II
President and Chief Executive Officer
Date August 13, 2002 /s/ Peter H. Heckman
--------------- -----------------------------------------
Peter H. Heckman
Executive Vice President
and Chief Financial Officer
Date August 13, 2002 /s/ Bret A. Conklin
--------------- -----------------------------------------
Bret A. Conklin
Senior Vice President
and Controller
[SEAL]
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