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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[x] QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended March 31, 2003
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-10890
HORACE MANN EDUCATORS CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 37-0911756
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1 Horace Mann Plaza, Springfield, Illinois 62715-0001
(Address of principal executive offices, including Zip Code)
Registrant's Telephone Number, Including Area Code: 217-789-2500
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
-----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes X No ____
-----
As of April 30, 2003, 42,701,528 shares of Common Stock, par value $0.001
per share, were outstanding, net of 17,503,371 shares of treasury stock.
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HORACE MANN EDUCATORS CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2003
INDEX
Page
----
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Independent Auditors' Review Report ......................................... 1
Consolidated Balance Sheets as of
March 31, 2003 and December 31, 2002 ...................................... 2
Consolidated Statements of Operations for the
Three Months Ended March 31, 2003 and 2002 ................................ 3
Consolidated Statements of Changes in Shareholders' Equity
for the Three Months Ended March 31, 2003 and 2002 ........................ 4
Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2003 and 2002 ................................ 5
Notes to Consolidated Financial Statements .................................. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ..................................... 13
Item 3. Quantitative and Qualitative Disclosures about Market Risk .................. 36
Item 4. Controls and Procedures ..................................................... 36
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders ......................... 36
Item 5. Other Information ........................................................... 36
Item 6. Exhibits and Reports on Form 8-K ............................................ 37
SIGNATURES .................................................................................... 38
CERTIFICATIONS ................................................................................ 39
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 March 31, 2003, and the related consolidated
statements of operations, changes in shareholders' equity, and cash flows for
the three-month periods ended March 31, 2003 and 2002. These consolidated
financial statements are the responsibility of the Company's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with auditing standards generally accepted in the United States of
America, the objective of which is the expression of an opinion regarding the
financial statements taken as a whole. Accordingly, we do not express such an
opinion.
Based on our review, we are not aware of any material modifications that
should be made to the consolidated financial statements referred to above for
them to be in conformity with accounting principles generally accepted in the
United States of America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of
Horace Mann Educators Corporation and subsidiaries as of December 31, 2002, and
the related consolidated statements of operations, changes in shareholders'
equity, and cash flows for the year then ended (not presented herein); and in
our report dated February 6, 2003, we expressed an unqualified opinion on those
consolidated financial statements.
/s/ KPMG LLP
KPMG LLP
Chicago, Illinois
May 1, 2003
1
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
March 31, December 31,
2003 2002
---------- ------------
ASSETS
Investments
Fixed maturities, available for sale, at fair value (amortized
cost, 2003, $2,922,360; 2002, $2,859,007) ......................... $3,072,537 $2,991,195
Short-term and other investments .................................... 119,514 135,431
Short-term investments, loaned securities collateral ................ 374,492 3,937
---------- ----------
Total investments ............................................... 3,566,543 3,130,563
Cash ................................................................... 30,908 60,162
Accrued investment income and premiums receivable ...................... 97,651 99,954
Deferred policy acquisition costs ...................................... 176,090 174,555
Goodwill ............................................................... 47,396 47,396
Value of acquired insurance in force ................................... 30,394 31,945
Other assets ........................................................... 99,575 113,244
Variable annuity assets ................................................ 859,241 854,470
---------- ----------
Total assets .................................................... $4,907,798 $4,512,289
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
Policy liabilities
Fixed annuity contract liabilities .................................. $1,421,904 $1,385,737
Interest-sensitive life contract liabilities ........................ 552,349 544,533
Unpaid claims and claim expenses .................................... 314,917 326,575
Future policy benefits .............................................. 180,252 180,577
Unearned premiums ................................................... 185,621 189,384
---------- ----------
Total policy liabilities ........................................ 2,655,043 2,626,806
Other policyholder funds ............................................... 124,098 125,108
Liability for securities lending agreements ............................ 374,492 3,937
Other liabilities ...................................................... 206,727 228,441
Short-term debt ........................................................ - -
Long-term debt ......................................................... 144,689 144,685
Variable annuity liabilities ........................................... 859,241 854,470
---------- ----------
Total liabilities ............................................... 4,364,290 3,983,447
---------- ----------
Preferred stock, $0.001 par value, shares authorized
1,000,000; none issued .............................................. - -
Common stock, $0.001 par value, shares authorized
75,000,000; shares issued, 2003, 60,204,899;
2002, 60,194,615 .................................................... 60 60
Additional paid-in capital ............................................. 342,963 342,749
Retained earnings ...................................................... 458,921 455,308
Accumulated other comprehensive income (loss), net of taxes:
Net unrealized gains on fixed
maturities and equity securities .................................. 91,406 80,567
Minimum pension liability adjustment ................................ (17,265) (17,265)
Treasury stock, at cost, 17,503,371 shares ............................. (332,577) (332,577)
---------- ----------
Total shareholders' equity ...................................... 543,508 528,842
---------- ----------
Total liabilities and shareholders' equity .................... $4,907,798 $4,512,289
========== ==========
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
March 31,
---------------------------
2003 2002
-------- --------
Insurance premiums written and contract deposits ............. $219,540 $211,748
======== ========
Revenues
Insurance premiums and contract charges earned ............ $158,318 $155,553
Net investment income ..................................... 47,521 49,685
Realized investment gains (losses) ........................ (4,748) 2,582
-------- --------
Total revenues .......................................... 201,091 207,820
-------- --------
Benefits, losses and expenses
Benefits, claims and settlement expenses .................. 110,877 110,816
Interest credited ......................................... 25,429 24,149
Policy acquisition expenses amortized ..................... 17,106 14,625
Operating expenses ........................................ 33,624 32,276
Amortization of intangible assets ......................... 1,625 1,294
Interest expense .......................................... 1,552 2,067
-------- --------
Total benefits, losses and expenses ..................... 190,213 185,227
-------- --------
Income before income taxes ................................... 10,878 22,593
Income tax expense ........................................... 2,779 7,022
-------- --------
Net income ................................................... $ 8,099 $ 15,571
======== ========
Net income per share
Basic ..................................................... $ 0.19 $ 0.38
======== ========
Diluted ................................................... $ 0.19 $ 0.38
======== ========
Weighted average number of shares
and equivalent shares (in thousands)
Basic ................................................... 42,700 40,780
Diluted ................................................. 42,869 41,231
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)
Three Months Ended
March 31,
------------------------------
2003 2002
---- ----
Common stock
Beginning balance .......................................... $ 60 $ 60
Options exercised, 2002, 68,465 shares; .................... - -
Conversion of Director Stock Plan units, 2003,
10,284 shares; 2002, 10,284 shares ....................... - -
---------- ----------
Ending balance ............................................. 60 60
---------- ----------
Additional paid-in capital
Beginning balance .......................................... 342,749 341,052
Options exercised and conversion
of Director Stock Plan units ............................. 214 1,354
---------- ----------
Ending balance ............................................. 342,963 342,406
---------- ----------
Retained earnings
Beginning balance .......................................... 455,308 461,139
Net income ................................................. 8,099 15,571
Cash dividends, 2003, $0.105 per share;
2002, $0.105 per share ................................... (4,486) (4,284)
---------- ----------
Ending balance ............................................. 458,921 472,426
---------- ----------
Accumulated other comprehensive income (loss), net of taxes:
Beginning balance .......................................... 63,302 14,898
Change in net unrealized gains (losses) on
fixed maturities and equity securities ................. 10,839 (33,151)
Increase in minimum pension liability adjustment ......... - (92)
---------- ----------
Ending balance ............................................. 74,141 (18,345)
---------- ----------
Treasury stock, at cost
Beginning and ending balance, 2003,
17,503,371 shares; 2002, 19,341,296 shares ............... (332,577) (357,959)
---------- ----------
Shareholders' equity at end of period ......................... $ 543,508 $ 438,588
========== ==========
Comprehensive income (loss)
Net income ................................................. $ 8,099 $ 15,571
Other comprehensive income (loss), net of taxes:
Change in net unrealized gains (losses)
on fixed maturities and equity securities .............. 10,839 (33,151)
Increase in minimum pension liability adjustment ......... - (92)
---------- ----------
Other comprehensive income ........................... 10,839 (33,243)
---------- ----------
Total .............................................. $ 18,938 $ (17,672)
========== ==========
See accompanying notes to consolidated financial statements.
4
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Three Months Ended
March 31,
------------------------------------
2003 2002
---- ----
Cash flows from operating activities
Premiums collected ......................................... $ 161,833 $ 164,686
Policyholder benefits paid ................................. (122,034) (121,842)
Policy acquisition and other operating expenses paid ....... (59,549) (55,186)
Federal income taxes paid .................................. (9,958) (2,032)
Investment income collected ................................ 49,513 52,991
Interest expense paid ...................................... (960) (3,316)
Other ...................................................... 142 (20)
---------- ----------
Net cash provided by operating activities .............. 18,987 35,281
---------- ----------
Cash flows used in investing activities
Fixed maturities
Purchases ................................................ (204,798) (433,944)
Sales .................................................... 91,999 393,132
Maturities ............................................... 34,187 19,602
Net cash provided by (used for)
short-term and other investments ......................... 15,242 (15,342)
---------- ----------
Net cash used in investing activities .................. (63,370) (36,552)
---------- ----------
Cash flows provided by financing activities
Dividends paid to shareholders ............................. (4,486) (4,284)
Exercise of stock options .................................. - 1,354
Annuity contracts, variable and fixed
Deposits ................................................. 64,262 63,349
Maturities and withdrawals ............................... (23,711) (41,124)
Net transfer to variable annuity assets .................. (19,786) (16,954)
Net decrease in life policy account balances ............... (1,150) (1,688)
---------- ----------
Net cash provided by financing activities .............. 15,129 653
---------- ----------
Net decrease in cash .......................................... (29,254) (618)
Cash at beginning of period ................................... 60,162 33,939
---------- ----------
Cash at end of period ......................................... $ 30,908 $ 33,321
========== ==========
See accompanying notes to consolidated financial statements.
5
HORACE MANN EDUCATORS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2003 and 2002
(Dollars in thousands, except per share data)
Note 1 - Basis of Presentation
The accompanying unaudited consolidated financial statements of Horace
Mann Educators Corporation ("HMEC"; and together with its subsidiaries, the
"Company") have been prepared in accordance with accounting principles generally
accepted in the United States of America ("GAAP") and with the rules and
regulations of the Securities and Exchange Commission. Certain information and
note disclosures normally included in financial statements prepared in
accordance with GAAP have been condensed or omitted. The Company believes that
these financial statements contain all adjustments (consisting of normal
recurring accruals) necessary to present fairly the Company's consolidated
financial position as of March 31, 2003 and the consolidated results of
operations, changes in shareholders' equity and cash flows for the three months
ended March 31, 2003 and 2002.
The subsidiaries of HMEC sell and underwrite tax-qualified retirement
annuities and private passenger automobile, homeowners, and life insurance
products, primarily to educators and other employees of public schools and their
families. The Company's principal operating subsidiaries are Horace Mann Life
Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company,
Horace Mann Property & Casualty Insurance Company and Horace Mann Lloyds.
It is suggested that these financial statements be read in conjunction
with the financial statements and the related notes included in the Company's
Annual Report on Form 10-K for the year ended December 31, 2002.
The results of operations for the three months ended March 31, 2003 are
not necessarily indicative of the results to be expected for the full year.
6
Note 2 - Stock Based Compensation
The Company grants stock options to executive officers, other employees
and directors. The exercise price of the option is equal to the fair market
value of the Company's common stock on the date of grant. Additional information
regarding the Company's stock-based compensation plans is contained in Note 6 -
Shareholders' Equity and Stock Options of the Company's Annual Report on Form
10-K for the year ended December 31, 2002. The Company accounts for stock option
grants using the intrinsic value based method in accordance with Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees," and accordingly, recognizes no compensation expense for the stock
option grants.
Alternatively, Financial Accounting Standards Board ("FASB") Statement
of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation," allows companies to recognize compensation cost for stock-based
compensation plans, determined based on the fair value at the grant dates. If
the Company had applied this alternative accounting method, net income and net
income per share would have been reduced to the pro forma amounts indicated
below:
Three Months Ended
March 31,
------------------------------------
2003 2002
---- ----
Net income
As reported .......................................... $ 8,099 $ 15,571
Add: Stock-based compensation expense,
after tax, included in reported net income ...... - -
Deduct: Stock-based compensation expense,
after tax, determined under the fair value
based method for all awards (1) ................. 1,339 1,109
-------- --------
Pro forma ............................................ $ 6,760 $ 14,462
======== ========
Basic net income per share
As reported .......................................... $ 0.19 $ 0.38
Pro forma ............................................ $ 0.16 $ 0.35
Diluted net income per share
As reported .......................................... $ 0.19 $ 0.38
Pro forma ............................................ $ 0.16 $ 0.35
(1) The fair value of each option grant was estimated on the date of grant
using the Modified Roll-Geske option-pricing model with the following
weighted average assumptions for 2003 and 2002, respectively: risk-free
interest rates of 3.7% and 5.2%; dividend yield of 3.0% and 2.0%;
expected lives of 10 years; and volatility of 28.2% and 39.2%. These
expense amounts represent one-fourth of the full year expense reflecting
options vesting during the respective calendar year. The 2003 expense
includes vesting related to options granted through March 31, 2003. The
2002 expense includes vesting related to options granted through
December 31, 2002.
7
Note 3 - Restructuring Charges
Restructuring charges were incurred and separately identified in the
Statements of Operations for the years ended December 31, 2002, 2001 and 2000,
as described in Note 2 - Restructuring Charges of the Company's Annual Report on
Form 10-K for the year ended December 31, 2002.
The Company's Consolidated Balance Sheets at March 31, 2003 and December
31, 2002 did not reflect any accrued amounts due to the restructuring of its
Massachusetts automobile business recorded in 2001. The following table provides
information about the components of the other charges taken in 2002, 2001 and
2000, the balance of accrued amounts at December 31, 2002 and March 31, 2003,
and payment activity during the three months ended March 31, 2003.
Original Reserve at Reserve at
Pretax December 31, March 31,
Charge 2002 Payments 2003
-------- ------------ -------- ----------
Charges to earnings:
Property and Casualty
Claims Operations
Employee termination costs ........................ $2,542 $1,929 $728 $1,201
Additional defined benefit pension plan costs ..... 1,179 1,179 - 1,179
Termination of lease agreements ................... 502 425 94 331
------ ------ ---- ------
Subtotal ...................................... 4,223 3,533 822 2,711
------ ------ ---- ------
Printing Services Operations
Employee termination costs .......................... 409 38 34 4
Write-off of equipment .............................. 41 - - -
------ ------ ---- ------
Subtotal ...................................... 450 38 34 4
------ ------ ---- ------
Group Insurance and Credit Union Marketing Operations
Employee termination costs ........................ 1,827 291 50 241
Termination of lease agreements ................... 285 - - -
Write-off of capitalized software ................. 106 - - -
Other ............................................. 18 - - -
------ ------ ---- ------
Subtotal ...................................... 2,236 291 50 241
------ ------ ---- ------
Total ....................................... $6,909 $3,862 $906 $2,956
====== ====== ==== ======
8
Note 4 - Debt
Indebtedness outstanding was as follows:
March 31, December 31,
2003 2002
--------- ------------
Long-term debt:
1.425% Senior Convertible Notes due May 14,
2032. Aggregate principal amount of $244,500
less unaccrued discount of $128,362
(3.0% imputed rate) ................................... $116,138 $116,138
6 5/8% Senior Notes, due January 15, 2006.
Aggregate principal amount of $28,600 less
unaccrued discount of $49 and $53
(6.7% imputed rate) ................................... 28,551 28,547
-------- --------
Total ............................................... $144,689 $144,685
======== ========
Note 5 - Investments
The following table presents the composition and value of the Company's
fixed maturity securities portfolio by rating category. The Company has
classified the entire fixed maturity securities portfolio as available for sale,
which is carried at fair value.
Percent of Fair Value March 31, 2003
-------------------------------- -------------------------
Rating of Fixed March 31, December 31, Fair Amortized
Maturity Securities (1) 2003 2002 Value (2) Cost
----------------------- --------- ------------ ---------- -----------
AAA ....................... 40.3% 40.0% $1,238,195 $1,185,170
AA ........................ 7.0 6.8 214,664 203,247
A ......................... 25.1 24.9 771,853 718,903
BBB ....................... 23.1 23.7 710,279 676,148
BB ........................ 2.5 2.2 75,287 77,051
B ......................... 1.1 1.3 32,357 32,586
CCC or lower .............. 0.8 1.0 25,443 24,782
Not rated (3) ............. 0.1 0.1 4,459 4,473
----- ----- ---------- ----------
Total .................. 100.0% 100.0% $3,072,537 $2,922,360
===== ===== ========== ==========
(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) Fair values are based on quoted market prices, when available. Fair values
for private placements and certain other securities that are infrequently
traded are estimated with the assistance of the Company's investment
advisors utilizing recognized valuation methodology, including cash flow
modeling.
(3) This category includes $1 of publicly traded securities not currently rated
by S&P, Moody's or the National Association of Insurance Commissioners
("NAIC") and $4,458 of private placement securities not rated by either S&P
or Moody's. The NAIC has rated 97.0% of these private placement securities
as investment grade.
9
Note 5 - Investments-(Continued)
The Company reviews the fair value of all investments in its portfolio on a
monthly basis to assess whether an other-than-temporary decline in value has
occurred. These reviews, in conjunction with the Company's investment managers'
monthly credit reports and relevant factors such as (1) the financial condition
and near-term prospects of the issuer, (2) the Company's intent and ability to
retain the investment long enough to allow for the anticipated recovery in fair
value, (3) the stock price trend of the issuer, (4) the market leadership
position of the issuer, (5) the debt ratings of the issuer and (6) the cash
flows of the issuer, are all considered in the impairment assessment. A
write-down of an investment is recorded when a decline in the fair value of that
investment is deemed to be other-than-temporary, with a realized investment loss
reflected in the Statement of Operations for the period. As a result of these
reviews, the Company recorded pretax impairment charges of $6,117 for the three
months ended March 31, 2003.
The following table presents the expected maturity of the Company's fixed
maturity securities portfolio. Expected maturities differ from contractual
maturities based on assumptions regarding borrowers' utilization of the right to
call or prepay obligations with or without call or prepayment penalties.
Fair
Percent of Total Value
---------------------------------- -----------
March 31, December 31, March 31,
2003 2002 2003
----------- -------------- -----------
Due in 1 year or less ........................ 11.3% 12.8% $ 348,284
Due after 1 year through 5 years ............. 25.6 26.5 786,020
Due after 5 years through 10 years ........... 35.0 32.7 1,074,544
Due after 10 years through 20 years .......... 6.6 7.5 204,163
Due after 20 years ........................... 21.5 20.5 659,526
----- ----- ----------
Total ...................................... 100.0% 100.0% $3,072,537
===== ===== ==========
The Company's investment portfolio includes no derivative financial
instruments (futures, forwards, swaps, option contracts or other financial
instruments with similar characteristics).
The Company loans fixed income securities to third parties, primarily major
brokerage firms. As of March 31, 2003 and December 31, 2002, fixed maturities
with a fair value of $374,492 and $3,937, respectively, were on loan. Loans of
securities are required at all times to be secured by collateral from borrowers
at least equal to 100% of the market value of the securities loaned. The Company
maintains effective control over the loaned securities and therefore reports
them as Fixed Maturity Securities in the Consolidated Balance Sheets. SFAS No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities," as amended by SFAS No. 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,"
requires the securities lending collateral to be classified as investments with
a corresponding liability in the Company's Consolidated Balance Sheets.
10
Note 6 - Reinsurance
The Company recognizes the cost of reinsurance premiums over the contract
periods for such premiums in proportion to the insurance protection provided.
Amounts recoverable from reinsurers for unpaid claims and claim settlement
expenses, including estimated amounts for unsettled claims, claims incurred but
not reported and policy benefits, are estimated in a manner consistent with the
insurance liability associated with the policy. The effect of reinsurance on
premiums written and contract deposits; premiums and contract charges earned;
and benefits, claims and settlement expenses were as follows:
Gross
Amount Ceded Assumed Net
-------- ------- --------- ---------
Three months ended
March 31, 2003
-------------------
Premiums written
and contract deposits ......... $220,832 $5,068 $3,776 $219,540
Premiums and contract
charges earned ................ 159,799 5,091 3,610 158,318
Benefits, claims and
settlement expenses ........... 108,087 (933) 1,857 110,877
Three months ended
March 31, 2002
-------------------
Premiums written
and contract deposits ......... $211,173 $3,254 $3,829 $211,748
Premiums and contract
charges earned ................ 160,053 7,863 3,363 155,553
Benefits, claims and
settlement expenses ........... 116,030 9,416 4,202 110,816
11
Note 7 - Segment Information
The Company conducts and manages its business through four segments. The
three operating segments, representing the major lines of insurance business,
are: property and casualty insurance, principally personal lines automobile and
homeowners insurance; annuity products, principally individual, tax-qualified;
and life insurance. The Company does not allocate the impact of corporate level
transactions to the insurance segments, consistent with management's evaluation
of the results of those segments, but classifies those items in the fourth
segment, Corporate and Other. Historically, in addition to debt service and
realized investment gains and losses, such charges have included restructuring
charges, debt retirement costs, litigation charges and the provision for prior
years' taxes. Summarized financial information for these segments is as follows:
Three Months Ended
March 31,
---------------------
2003 2002
---- ----
Insurance premiums and contract charges earned
Property and casualty ............................................. $ 131,594 $ 128,004
Annuity ........................................................... 3,227 3,691
Life .............................................................. 23,808 24,180
Intersegment eliminations ......................................... (311) (322)
---------- ----------
Total .......................................................... $ 158,318 $ 155,553
========== ==========
Net investment income
Property and casualty ............................................. $ 8,232 $ 9,621
Annuity ........................................................... 26,490 27,328
Life .............................................................. 13,033 13,028
Corporate and other ............................................... 58 3
Intersegment eliminations ......................................... (292) (295)
---------- ----------
Total .......................................................... $ 47,521 $ 49,685
========== ==========
Net income
Property and casualty ............................................. $ 6,583 $ 7,217
Annuity ........................................................... 2,264 4,672
Life .............................................................. 3,825 3,825
Corporate and other ............................................... (4,573) (143)
---------- ----------
Total .......................................................... $ 8,099 $ 15,571
========== ==========
Amortization of intangible assets, pretax
(included in segment net income)
Value of acquired insurance in force
Annuity ........................................................ $ 1,211 $ 853
Life ........................................................... 414 441
---------- ----------
Total ........................................................ $ 1,625 $ 1,294
========== ==========
March 31, December 31,
2003 2002
----------- ------------
Assets
Property and casualty ............................................. $ 764,811 $ 773,362
Annuity ........................................................... 2,963,289 2,628,083
Life .............................................................. 1,110,433 1,036,078
Corporate and other ............................................... 101,697 112,102
Intersegment eliminations ......................................... (32,432) (37,336)
---------- ----------
Total .......................................................... $4,907,798 $4,512,289
========== ==========
12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollars in millions, except per share data)
Forward-looking Information
Statements made in the following discussion that state the Company's or
management's intentions, hopes, beliefs, expectations or predictions of future
events or the Company's future financial performance are forward-looking
statements and involve known and unknown risks, uncertainties and other factors.
It is important to note that the Company's actual results could differ
materially from those projected in such forward-looking statements due to, among
other risks and uncertainties inherent in the Company's business, the following
important factors:
. Changes in the composition of the Company's assets and liabilities.
. Fluctuations in the market value of securities in the Company's investment
portfolio and the related after-tax effect on the Company's shareholders'
equity and total capital through either realized or unrealized investment
losses. In addition, the impact of fluctuations in the financial markets on
the Company's defined benefit pension plan assets and the related after-tax
effect on the Company's operating expenses, shareholders' equity and total
capital.
. Prevailing interest rate levels, including the impact of interest rates on
(i) unrealized gains and losses in the Company's investment portfolio and
the related after-tax effect on the Company's shareholders' equity and
total capital, (ii) the book yield of the Company's investment portfolio
and (iii) the Company's ability to maintain appropriate interest rate
spreads over the fixed rates guaranteed in the Company's life and annuity
products.
. Defaults on interest or dividend payments in the Company's investment
portfolio due to credit issues and the resulting impact on investment
income.
. The impact of fluctuations in the capital markets on the Company's ability
to refinance outstanding indebtedness.
. The frequency and severity of catastrophes such as hurricanes, earthquakes
and storms and the ability of the Company to maintain a favorable
catastrophe reinsurance program.
. The collectibility of reinsurance receivables.
. Future property and casualty loss experience and its impact on estimated
claims and claim adjustment expenses for losses occurring in prior years.
. The cyclicality of the insurance industry.
. Business risks inherent in the Company's restructuring of its property and
casualty claims operation.
. The risk related to the Company's dated and complex information systems,
which are more prone to error than advanced technology systems.
. Disruptions of the general business climate, investments, capital markets
and consumer attitudes caused by geopolitical acts such as terrorism, war
or other similar events.
. The impact of a disaster or catastrophic event affecting the Company's
employees or its home office facilities and the Company's ability to
recover and resume its business operations on a timely basis.
13
. The Company's ability to develop and expand its agent force and its direct
product distribution systems, as well as the Company's ability to maintain
and secure product sponsorships by local, state and national education
associations.
. The competitive impact of new entrants such as mutual funds and banks into
the tax-deferred annuity products markets, and the Company's ability to
profitably expand its property and casualty business in highly competitive
environments.
. Changes in insurance regulations, including (i) those affecting the ability
of the Company's insurance subsidiaries to distribute cash to the holding
company and (ii) those impacting the Company's ability to profitably write
property and casualty insurance policies in one or more states.
. Changes in federal income tax laws and changes resulting from federal tax
audits affecting corporate tax rates or taxable income.
. Changes in federal and state laws and regulations which affect the relative
tax and other advantages of the Company's life and annuity products to
customers.
. The impact of fluctuations in the financial markets on the Company's
variable annuity fee revenues, valuations of deferred policy acquisition
costs and value of acquired insurance in force, and the level of guaranteed
minimum death benefit reserves.
. The Company's ability to maintain favorable claims-paying ability,
financial strength and debt ratings.
. Adverse changes in policyholder mortality and morbidity rates.
. The resolution of legal proceedings and related matters.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America ("GAAP") requires
the Company's management to make estimates and assumptions based on information
available at the time the financial statements are prepared. These estimates and
assumptions affect the reported amounts of the Company's assets, liabilities,
shareholders' equity and net income. Certain accounting estimates are
particularly sensitive because of their significance to the Company's financial
statements and because of the possibility that subsequent events and available
information may differ markedly from management's judgements at the time the
financial statements were prepared. Management has discussed with the Audit
Committee the quality, not just the acceptability, of the Company's accounting
principles as applied in its financial reporting. The discussions generally
included such matters as the consistency of the Company's accounting policies
and their application, and the clarity and completeness of the Company's
financial statements, which include related disclosures. For the Company, the
areas most subject to significant management judgements include: reserves for
property and casualty claims and claim settlement expenses, reserves for future
policy benefits, deferred policy acquisition costs, value of acquired insurance
in force, valuation of investments and valuation of assets and liabilities
related to the defined benefit pension plan.
Underwriting results of the property and casualty segment are significantly
influenced by estimates of the Company's ultimate liability for insured events.
Reserves for property and casualty claims include provisions for payments to be
made on reported claims, claims incurred but not yet reported and associated
settlement expenses. The process by which these reserves are established
requires reliance upon estimates based on known facts and on interpretations of
circumstances, including the Company's experience with similar cases and
historical trends involving claim payment patterns, claim payments, pending
levels of unpaid claims and product mix, as well as other factors including
court decisions, economic conditions and public attitudes. Adjustments may be
required as information develops which varies from experience, or, in some
14
cases, augments data which previously were not considered sufficient for use in
determining liabilities. The effects of these adjustments may be significant and
are charged or credited to income for the period in which the adjustments are
made. Due to the nature of the Company's personal lines business, the Company
has no exposure to claims for toxic waste cleanup, other environmental
remediation or asbestos-related illnesses other than claims under homeowners
insurance policies for environmentally related items such as toxic mold.
The Company completes a detailed study of property and casualty reserves
based on information available at the end of each quarter and year. Trends of
reported losses (paid amounts and case reserves on claims reported to the
Company) for each accident year are reviewed and ultimate loss costs for those
accident years are estimated. The Company engages an independent property and
casualty actuarial consulting firm to prepare an independent study of the
Company's property and casualty reserves twice a year - at June 30 and December
31.
Liabilities for future benefits on life and annuity policies are
established in amounts adequate to meet the estimated future obligations on
policies in force. Liabilities for future policy benefits on certain life
insurance policies are computed using the net level premium method and are based
on assumptions as to future investment yield, mortality and withdrawals.
Mortality and withdrawal assumptions for all policies have been based on
actuarial tables which are consistent with the Company's own experience.
Liabilities for future benefits on annuity contracts and certain long-duration
life insurance contracts are carried at accumulated policyholder values without
reduction for potential surrender or withdrawal charges. In the event actual
experience varies from the estimated liabilities, adjustments are charged or
credited to income for the period in which the adjustments are made.
The Company has established a guaranteed minimum death benefit ("GMDB")
reserve on variable annuity contracts and regularly monitors this reserve
considering fluctuations in the financial markets. At March 31, 2003 and
December 31, 2002, under GAAP, the GMDB reserve was $1.0 million and $0.8
million, respectively. The comparable reserve under statutory accounting
principles was $1.9 million and $1.6 million at the respective dates. The
Company has a relatively low exposure to GMDB because approximately 25% of
contract values have no guarantee; approximately 70% have only a return of
premium guarantee; and approximately 5% have a guarantee of premium at an annual
interest rate of 3% to 5%. The aggregate in-the-money death benefits under the
GMDB provision totaled $136 million and $115 million at March 31, 2003 and
December 31, 2002, respectively. Regarding the sensitivity of the GMDB reserve
to market fluctuations, an approximation for the impact on the GMDB is: for each
1 point of negative/positive market performance for the underlying mutual funds
of the Company's variable annuities, the GMDB reserve would currently
increase/decrease less than $0.1 million.
Policy acquisition costs, consisting of commissions, policy issuance and
other costs, which vary with and are primarily related to the production of
business, are capitalized and amortized on a basis consistent with the type of
insurance coverage. For investment (annuity) contracts, acquisition costs, and
also the value of annuity business acquired in the 1989 acquisition of the
Company ("Annuity VIF"), are amortized over 20 years in proportion to estimated
future gross profits. Capitalized acquisition costs for interest-sensitive life
contracts are also amortized over 20 years in proportion to estimated future
gross profits. The most significant assumptions that are involved in the
estimation of future gross profits include future financial market performance,
business surrender/lapse rates and the impact of realized investment gains and
losses. For the annuity segment, the Company amortizes policy acquisition costs
and the Annuity VIF utilizing a 10% reversion to the mean approach with a 200
basis point corridor around the mean. At March 31, 2003 and December 31, 2002,
capitalized annuity policy acquisition costs and the Annuity VIF
15
asset represented approximately 4% of the total annuity accumulated cash value.
In the event actual experience differs significantly from assumptions or
assumptions are significantly revised, the Company may be required to record a
material charge or credit to amortization expense for the period in which the
adjustment is made. As noted above, there are a number of assumptions involved
in the valuation of capitalized policy acquisition costs and the Annuity VIF.
Generally, if all other assumptions are met, with regard to financial market
performance assumptions for the underlying mutual funds of the Company's
variable annuities, a 1% deviation from the targeted financial market
performance would currently impact amortization between $0.1 million and $0.2
million depending on the magnitude and direction of the deviation.
The Company's methodology of assessing other-than-temporary impairments is
based on security-specific facts and circumstances as of the date of the
reporting period. Based on these facts, if management believes it is probable
that amounts due will not be collected according to the contractual terms of a
debt security, or if the Company does not have the ability or intent to hold a
security with an unrealized loss until it matures or recovers in value, an
other-than-temporary impairment shall be considered to have occurred. As a
general rule, if the fair value of a debt security has fallen below 80% of book
value for more than six months, this security will be reviewed for an
other-than-temporary impairment. Additionally, if events become known that call
into question whether the security issuer has the ability to honor its
contractual commitments, whether or not such security has been trading above an
80% fair value to book value relationship, such security holding will be
evaluated to determine whether or not such security has suffered an
other-than-temporary decline in value.
The Company reviews the fair value of all investments in its portfolio on a
monthly basis to assess whether an other-than-temporary decline in value has
occurred. These reviews, in conjunction with the Company's investment managers'
monthly credit reports and relevant factors such as (1) the financial condition
and near-term prospects of the issuer, (2) the Company's intent and ability to
retain the investment long enough to allow for the anticipated recovery in fair
value, (3) the stock price trend of the issuer, (4) the market leadership
position of the issuer, (5) the debt ratings of the issuer and (6) the cash
flows of the issuer, are all considered in the impairment assessment. A
write-down of an investment is recorded when a decline in the fair value of that
investment is deemed to be other-than-temporary, with a realized investment loss
charged to income for the period.
A decline in fair value below amortized cost is not assumed to be
other-than-temporary for fixed maturity investments with unrealized losses due
to market conditions or industry-related events where there exists a reasonable
market recovery expectation and the Company has the intent and ability to hold
the investment until maturity or a market recovery is realized. An
other-than-temporary impairment loss will be recognized based upon all relevant
facts and circumstances for each investment, as appropriate, in accordance with
Securities and Exchange Commission Staff Accounting Bulletin ("SAB") No. 59,
"Accounting for Non-Current Marketable Equity Securities," Financial Accounting
Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS")
No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and
related guidance.
16
The Company's cost estimates for its defined benefit pension plan are
determined annually based on assumptions which include the discount rate,
expected return on plan assets and estimated lump sum distributions. Effective
April 1, 2002, participants stopped accruing benefits under the defined benefit
plan but continue to retain the benefits they had accrued to date. A discount
rate of 6.75% was used by the Company at December 31, 2002, which was based on
the average yield for long-term, high grade securities having maturities
generally consistent with the defined pension benefit payout period. To set its
discount rate, the Company looks to leading indicators, including Moody's Aa
long-term bond index. The expected annual return on plan assets assumed by the
Company at December 31, 2002 was 7.50%. Management believes that it has adopted
realistic assumptions for investment returns, discount rates and other key
factors used in the estimation of pension costs and asset values. To the extent
that actual experience differs from the Company's assumptions, subsequent
adjustments may be required, with the effects of those adjustments charged or
credited to income and/or shareholders' equity for the period in which the
adjustments are made.
Results of Operations
Insurance Premiums and Contract Charges
Insurance Premiums Written and Contract Deposits
Three Months Ended Growth Over
March 31, Prior Year
------------------------ ------------------
2003 2002 Percent Amount
-------- -------- ------- ------
Automobile and property (voluntary) ......... $128.5 $118.9 8.1% $ 9.6
Annuity deposits ............................ 64.3 63.3 1.6% 1.0
Life ........................................ 26.7 27.7 -3.6% (1.0)
------ ------ -----
Subtotal - core lines .............. 219.5 209.9 4.6% 9.6
Involuntary and other property & casualty ... 0.1 1.8 (1.7)
Excluding Massachusetts automobile ..... 0.1 0.4 (0.3)
Massachusetts automobile ............... - 1.4 (1.4)
------ ------ -----
Total .............................. $219.6 $211.7 3.7% $ 7.9
====== ====== =====
Total, excluding Massachusetts
automobile ....................... $219.6 $210.3 4.4% $ 9.3
====== ====== =====
17
Insurance Premiums and Contract Charges Earned
(Excludes annuity and life contract deposits)
Three Months Ended Growth Over
March 31, Prior Year
-------------------- -----------------
2003 2002 Percent Amount
-------- -------- ------- ------
Automobile and property (voluntary) ............ $129.4 $124.5 3.9% $ 4.9
Excluding Massachusetts automobile ........... 129.4 120.3 7.6% 9.1
Massachusetts automobile ..................... - 4.2 (4.2)
Annuity ........................................ 3.2 3.7 -13.5% (0.5)
Life ........................................... 23.5 23.9 -1.7% (0.4)
------ ------ -----
Subtotal - core lines ................. 156.1 152.1 2.6% 4.0
Subtotal - core lines, excluding
Massachusetts automobile ............ 156.1 147.9 5.5% 8.2
Involuntary and other property and casualty .... 2.2 3.5 (1.3)
Excluding Massachusetts automobile ........ 2.0 1.5 0.5
Massachusetts automobile .................. 0.2 2.0 (1.8)
------ ------ -----
Total ................................. $158.3 $155.6 1.7% $ 2.7
====== ====== =====
Total, excluding Massachusetts
automobile .......................... $158.1 $149.4 5.8% $ 8.7
====== ====== =====
The Company restructured its presence in the Massachusetts automobile
market and ceased writing automobile insurance policies in that state on
December 31, 2001. Through a marketing alliance with an unaffiliated company,
The Commerce Group, Inc. ("Commerce"), the Company's agents are authorized to
offer Massachusetts customers automobile insurance policies written by Commerce.
Horace Mann agents continue to write the Company's other products in
Massachusetts, including retirement annuities and property and life insurance.
Premiums written and contract deposits for the Company's core lines
increased 4.6% compared to the first quarter of 2002, primarily resulting from
rate increases in the property and automobile lines. Voluntary property and
casualty business, a component of the Company's core lines, represents policies
sold through the Company's marketing organization and issued under the Company's
underwriting guidelines.
The Company's exclusive agent force totaled 884 at March 31, 2003,
reflecting growth of 5.2% compared to a year earlier. Of the total, 387 agents
were in their first 24 months with the Company, an increase of 20.9% compared to
March 31, 2002, with new hires increasing 22.8% in the current period. The
number of experienced agents in the agent force, 497, was down 4.4% at March 31,
2003 compared to a year earlier, due primarily to terminations of
less-productive agents over the 12 months. Average agent productivity for all
lines of business combined declined 11.3% compared to the first quarter of 2002.
The impact of changes in the average experience level of the Company's agent
force, as well as severe weather in large geographic segments of the Company's
market (which resulted in lengthy school closings in January and February) and
client concerns regarding economic conditions, resulted in a slight decline in
total sales. Average agent productivity is measured as new sales premiums per
the average number of agents for the period.
18
In December 2001, the North Carolina Commissioner of Insurance (the
"Commissioner") ordered a 13% reduction in private passenger automobile
insurance premium rates to be effective in April 2002. The Commissioner's Order
was in response to a request from the North Carolina Rate Bureau (the "Bureau"),
which represents the insurance industry, to increase private passenger
automobile insurance rates by 5%. The Bureau voted to appeal the Commissioner's
Order in the state appellate court and raise rates while the case is being
heard. The difference between the rates ordered by the Commissioner and the
Bureau are anticipated to have an adverse impact of approximately $350 million
for the insurance industry. The difference in rates between the Commissioner and
the Bureau must be held in an escrow account pending the court's decision. If
the court should rule in favor of the Bureau, the insurers will be entitled to
the funds previously escrowed. If the court should rule in favor of the
Commissioner, the escrowed funds plus interest will be refunded to the
policyholders. Following the April 2002 effective date, this issue negatively
impacted the Company's earned premiums and pretax income by $1.8 million for the
twelve months ended December 31, 2002. The Company's 2003 earned premiums and
pretax income are expected to be negatively impacted by approximately $2.5
million as a result of this dispute over 2002 rates. A similar dispute between
the Commissioner and the Bureau is also in process regarding 2003 rates for
policies written or renewed January through June, which requires the Company to
escrow additional amounts and is expected to have a further adverse impact on
2003 results of approximately $0.6 million pretax. In April 2003, the
Commissioner and the Bureau reached an agreement regarding premium rates to be
effective in July 2003. Because of this agreement, the Company can cease adding
to the escrow for policies written or renewing after July 1, 2003. Escrowed
amounts established for the previous disputes will be maintained until final
resolution is reached. During the three months ended March 31, 2003, $0.9
million was escrowed due to the 2002 and 2003 rate disputes.
Growth in total voluntary automobile and homeowners premium written was
8.1% for the quarter ending March 31, 2003. Voluntary automobile insurance
premium written increased 6.4% ($5.9 million) compared to the first three months
of 2002, and homeowners premium increased 14.1% ($3.7 million). The increase in
property and casualty premiums resulted from the impact of rate increases on
average premium per policy. Average written premium was up 6% for voluntary
automobile and 16% for homeowners compared to the same period a year earlier,
while the average earned premium increased 6% for voluntary automobile and 13%
for homeowners. As of March 31, 2003, approved rate increases for the Company's
automobile and homeowners business were 7% and 19%, respectively. Many of the
Company's competitors are believed to have taken similar rate increases. Over
the prior 12 months and excluding an 18,000 unit decrease in Massachusetts,
automobile policies in force declined slightly compared to both March 31, 2002
and December 31, 2002, reflecting an increase in policies for educators which
was more than offset by a decrease in non-educator policies. There were no
Massachusetts voluntary automobile policies in force at March 31, 2003 and
December 31, 2002. Homeowners policies in force at March 31, 2003 were 8,000
less than at March 31, 2002 and 3,000 less than at December 31, 2002, reflecting
expected reductions. At March 31, 2003, there were 571,000 voluntary automobile
and 281,000 homeowners policies in force, for a total of 852,000.
Based on policies in force, the property and casualty 12-month retention
rate for new and renewal policies was 87%, 1 percentage point lower than the 12
months ended March 31, 2002, reflecting the anticipated reductions in homeowners
policies in force and the aggressive pricing and underwriting actions
implemented during the period. The Company plans additional rate increases in
2003, with primary emphasis on the homeowners line, which are expected to have a
continued adverse impact on retention of homeowners policies.
19
Involuntary property and casualty business includes allocations of
business from state mandatory insurance facilities and assigned risk business.
The first quarter 2003 decline in involuntary and other property and casualty
premiums written versus the prior year was primarily attributable to a decrease
in Massachusetts mandatory automobile insurance facility business.
Compared to the first three months of 2002, new annuity deposits
increased 1.6%, primarily reflecting a 10.5% increase in single premium and
rollover deposits. New scheduled annuity deposits decreased 2.9% in the first
quarter of 2003 compared to a year earlier. New deposits to fixed accounts were
15.2%, or $5.3 million, higher than in the first three months of 2002 and new
deposits to variable accounts decreased 15.1%, or $4.3 million, compared to a
year earlier. The Company offers a dollar cost averaging program for amounts
systematically transferred from the fixed investment return option to the
variable investment return options over 3-month, 6-month or 12-month periods.
Severe weather during January and February, which resulted in numerous
school closings, and clients' concerns about the economy negatively impacted new
sales of annuity contracts for the first quarter of 2003. Annualized new annuity
sales by Horace Mann agents decreased 10.4% compared to the first three months
of 2002 while total annualized annuity sales decreased only 1.1% for the same
period, reflecting the positive impact of Horace Mann's growing independent
agent distribution initiative.
In 2001, the Company began building a nationwide network of independent
agents who will comprise a second distribution channel for the Company's 403(b)
tax-qualified annuity products. The independent agent distribution channel,
which included 230 authorized agents at March 31, 2003, generated $2.5 million
in annualized Horace Mann annuity contract deposits during the first quarter of
2003 and $10.5 million for the full year 2002. A significant portion of the 2002
amount was produced as a result of Horace Mann being named as one of four
providers for fixed and variable annuity options to Chicago, Illinois public
school employees and the Company's partnering with an independent broker/dealer
having two decades of experience in providing retirement planning services to
Chicago Public School employees.
Fixed accumulated cash value was $1.5 billion at March 31, 2003, $127.7
million, or 9.0% more than a year earlier. Fixed accumulated cash value
retention for the 12 months ended March 31, 2003 was 94.2%, comparable to the
prior year. Variable accumulated deposit retention of 91.9% for the twelve
months ended March 31, 2003, impacted by financial market performance, decreased
1.1% percentage points compared to a year earlier. Variable accumulated funds on
deposit at March 31, 2003 were $0.9 billion, a $176.7 million, or 17.1%,
decrease from the prior year also reflecting the impact of financial market
values. The number of annuity contracts outstanding increased 5.0%, or 7,000
contracts, compared to March 31, 2002.
For the three months ended March 31, 2003, annuity segment contract
charges earned decreased 13.5%, or $0.5 million compared to the same period a
year earlier. In the current period, declines in market valuations negatively
impacted fees earned on variable accumulated balances.
20
Life segment premiums and contract deposits for the first three months
of 2003 were 3.6% lower than a year earlier, reflecting a decline in new
business and business retention. The life insurance in force lapse ratio of 9.1%
for the twelve months ended March 31, 2003 was comparable to the same period
last year. The lapse ratio for the term portion of the business improved
slightly compared to the prior year, while the lapse ratio for the whole life
portion of the business increased slightly.
Consistent with the Company's Value Proposition and overall strategy to
meet a broader array of consumer financial needs, the product portfolio that the
Company's agents can offer is being expanded through two new marketing
alliances. The first is with Jefferson Pilot Financial for universal life
insurance. Jefferson Pilot was a leading issuer of universal life policies in
the U.S. for 2002. The second alliance is with American Funds for retail mutual
funds. Both product rollouts began in the second quarter of 2003 and are
expected to enable the Company to reach more educators while deepening
relationships with existing clients.
Net Investment Income
Pretax investment income of $47.5 million for the three months ended
March 31, 2003 decreased 4.4%, or $2.2 million, (3.0%, or $1.0 million, after
tax) compared to the prior year as lost income related to investment credit
issues and a decline in the portfolio yield offset growth in the size of the
investment portfolio. Average investments (excluding the securities lending
collateral) increased 6.9% over the past 12 months. The average pretax yield on
the investment portfolio was 6.3% (4.3% after tax) for the first three months of
2003 compared to a pretax yield of 7.0% (4.7% after tax) a year earlier.
Throughout 2003, investment income is expected to continue to be under pressure
due to investment credit issues and lower interest rates.
Realized Investment Gains and Losses
Net realized investment losses were $4.7 million for the three months
ended March 31, 2003 compared to realized investment gains of $2.6 million in
the prior year. For the current quarter, the Company recorded fixed income
security impairment charges totaling $6.1 million, $3.0 million related to one
of the Company's collateralized debt obligation ("CDO") securities and the
remaining $3.1 million primarily related to two airline industry issuers. The
first quarter of 2002 included impairment charges of $9.9 million related to
fixed income securities issued by two telecommunications companies and a
realized investment loss of $2.0 million from the Company's sale of all of its
holdings in securities issued by Kmart Corporation. Net realized investment
losses and gains for the respective periods also reflected gains realized from
ongoing investment portfolio management activity.
21
Management believes that there may be further investment impairments in
2003 if current economic and financial conditions persist. The table below
presents the Company's fixed maturity securities portfolio as of March 31, 2003
by major asset class, including the ten largest sectors of the Company's
corporate bond holdings.
Pretax
Number of Fair Amortized Unrealized
Issuers Value Cost Gain (Loss)
--------- --------- ------------ -----------
Corporate bonds
Banking and Finance ................... 28 $ 274.5 $ 249.3 $ 25.2
Energy ................................ 28 202.9 186.2 16.7
Utilities ............................. 19 138.7 135.3 3.4
Food and Beverage ..................... 15 118.8 113.3 5.5
Telecommunications .................... 17 117.7 105.5 12.2
Automobiles ........................... 5 69.3 71.2 (1.9)
Broadcasting and Media ................ 19 74.0 69.9 4.1
Industry, Manufacturing ............... 8 66.6 65.2 1.4
Transportation ........................ 12 61.8 60.3 1.5
Health Care, Pharmacy ................. 14 56.7 54.2 2.5
All Other Corporates (1) .............. 71 445.7 420.6 25.1
--- --------- --------- -------
Total corporate bonds .............. 236 1,626.7 1,531.0 95.7
Mortgage-backed securities
Government ............................ 450 618.0 594.5 23.5
Other ................................. 27 66.9 62.3 4.6
Municipal bonds ......................... 163 405.5 385.7 19.8
Government bonds
U.S. .................................. 5 210.2 201.1 9.1
Foreign ............................... 4 16.2 13.1 3.1
Collateralized debt obligations (2) ..... 11 81.7 85.2 (3.5)
Asset-backed securities ................. 12 47.3 49.5 (2.2)
--- --------- --------- -------
Total fixed maturity securities .... 908 $ 3,072.5 $ 2,922.4 $ 150.1
=== ========= ========= =======
_________________
(1) The All Other Corporates category contains 16 additional industry
classifications. Real estate, retail, chemicals, defense, paper,
insurance and cable represented $296.8 million of fair value at
March 31, 2003, with the remaining 9 classifications each representing
less than $30 million of the fair value at March 31, 2003.
(2) Each of the securities was rated investment grade by Standard and
Poor's Corporation and/or Moody's Investors Service, Inc., at
March 31, 2003.
The corporate bond securities impaired in the first quarter of 2003 were
issued by Northwest Airlines, Delta Air Lines and UnumProvident, an insurance
carrier. As of March 31, 2003, the Northwest and Delta holdings represented the
only remaining exposure to the airline sector in the Company's investment
portfolio with a fair value of $3.7 million. In addition, one CDO security was
impaired in the current quarter. As discussed below, the Company consolidated
the management of its fixed maturity securities portfolio in March 2003. As part
of the transition to a single manager, BlackRock, Inc., completed a
comprehensive appraisal and evaluation of the transferred CDO holdings, which
resulted in the first quarter impairment. Securities issued by two companies in
the telecommunications sector (NTL and Diamond Cable) were impaired in the first
quarter of 2002. In each of the periods, the impaired securities were marked to
fair value, and the write-downs were recorded as realized investment losses in
the Statement of Operations. These
22
impairments were deemed to be other-than-temporary for one or more of the
following reasons: the recovery of full value was not likely, the issuer
defaulted or was likely to default due to the need to restructure its debt, or
the Company had an intent to sell the security in the near future.
At March 31, 2003, the Company's diversified fixed maturity portfolio
consisted of 1,138 investment positions and totaled approximately $3.1 billion
in fair value. The portfolio was 95.5% investment grade, based on fair value,
with an average quality rating of A+. At March 31, 2003, the portfolio had
approximately $21 million pretax of total gross unrealized losses related to 93
positions. At December 31, 2002, the total pretax gross unrealized losses were
approximately $27 million related to 137 positions. The following table provides
information regarding fixed maturity securities that had an unrealized loss at
March 31, 2003, including the length of time that the securities have
continuously been in an unrealized loss position.
Investment Positions With Unrealized Losses Segmented by Quality
and Period of Continuous Unrealized Loss
As of March 31, 2003
Pretax
Number of Fair Amortized Unrealized
Positions Value Cost Loss
--------- ------- --------- ----------
Investment grade
6 Months or less ........................ 39 $220.5 $224.8 $ (4.3)
7 through 12 months ..................... 12 44.0 47.6 (3.6)
13 through 24 months .................... 5 23.5 27.1 (3.6)
25 through 36 months .................... - - - -
37 through 48 months .................... - - - -
Greater than 48 months .................. 4 14.1 15.2 (1.1)
-- ------ ------ ------
Total ................................ 60 $302.1 $314.7 $(12.6)
== ====== ====== ======
Non-investment grade
6 Months or less ........................ 5 $ 6.5 $ 6.7 $ (0.2)
7 through 12 months ..................... 8 2.9 3.0 (0.1)
13 through 24 months .................... 5 11.2 12.6 (1.4)
25 through 36 months .................... 1 5.5 6.1 (0.6)
37 through 48 months .................... 5 11.5 12.1 (0.6)
Greater than 48 months .................. 3 18.1 23.5 (5.4)
-- ------ ------ ------
Total ................................ 27 $ 55.7 $ 64.0 $ (8.3)
== ====== ====== ======
Not rated
Total, all 7 through 12 months ....... 6 $ 2.6 $ 2.6 *
== ====== ====== ======
Grand total ........................ 93 $360.4 $381.3 $(20.9)
== ====== ====== ======
_____________
* Less than $0.1 million
23
Of the securities with unrealized losses, only two issuers had pretax
unrealized losses greater than $2 million and were trading below 80% of book
value at March 31, 2003. The Company views the decrease in value of these two
securities as temporary, expects recovery in fair value, anticipates continued
payments under the terms of the securities, and has the intent and ability to
hold these securities until maturity or a recovery in fair value occurs.
Therefore, no impairment of these securities was recorded at March 31, 2003.
Future changes in circumstances related to these securities could require
subsequent impairment of their value.
Historically, the Company's investment guidelines have limited single
corporate issuer exposure to 1% of invested assets. Effective in the third
quarter of 2002, the Company revised its guidelines to limit the single
corporate issuer exposure to 4.0% (after tax) of shareholders' equity for "AA"
or "AAA" rated securities, 2.5% (after tax) of shareholders' equity for "A"
rated securities, 2.0% (after tax) of shareholders' equity for "BBB" rated
securities, and 1.0% (after tax) of shareholders' equity for non-investment
grade securities. The change in the investment guidelines was immediately
effective for new purchases of securities. It is anticipated that the existing
portfolio will be brought into compliance with the new guidelines by the end of
2003. Additional sub-sector limitations were also developed as part of the
revised guidelines.
The Company's investments are managed by outside managers and advisors
which follow the investment guidelines established by the Company. In
conjunction with the review of investment guidelines, the Company also
periodically reviews its overall investment program and the performance of its
investment managers. Effective in March 2003, the Company consolidated the
management of its fixed maturity securities portfolio with BlackRock, with the
exception of a small portion allocated to a specialty high-yield manager.
BlackRock has managed a portion of the Company's fixed maturity securities
portfolio since 1994.
Benefits, Claims and Settlement Expenses
Three Months Ended Growth Over
March 31, Prior Year
------------------------ -----------------
2003 2002 Percent Amount
---- ---- ------- ------
Property and casualty ................................ $ 99.3 $ 100.0 -0.7% $(0.7)
Annuity .............................................. 0.5 0.1 0.4
Life ................................................. 11.1 10.7 3.7% 0.4
------- ------- -----
Total .............................................. $ 110.9 $ 110.8 0.1% $ 0.1
======= ======= =====
Property and casualty statutory loss ratio:
Before catastrophe losses ......................... 73.6% 77.9% -4.3%
After catastrophe losses .......................... 75.2% 78.1% -2.9%
24
In the first three months of 2003, the Company's benefits, claims and
settlement expenses reflected improvement in the homeowners statutory loss
ratio, including catastrophe and other weather-related losses, as a result of
loss containment initiatives and the favorable impact of rate increases on
earned premiums. The voluntary automobile statutory loss ratio for the current
period was slightly higher compared to the first quarter of 2002. Favorable
voluntary automobile current accident year loss experience was offset by adverse
development of prior years' reserves, as described below. Compared to the first
three months of 2002, a higher level of weather-related losses represented an
increase in the property and casualty statutory loss ratio of approximately 2
percentage points in the current period.
Excluding involuntary business, net adverse development of reserves for
property and casualty claims occurring in prior years was $3.8 million for the
first three months of 2003, primarily related to automobile liability loss
reserves from accident years 2001 and prior, compared to favorable reserve
development of $0.4 million in the prior year. Total reserves for property and
casualty claims occurring in prior years, including involuntary business, were
increased $4.3 million in the current year compared to an increase of $0.1
million for the three months ended March 31, 2002. The Company's property and
casualty reserves were $276 million and $270 million at March 31, 2003 and 2002,
respectively, net of anticipated reinsurance recoverables.
Over the 12 months ended March 31, 2003, the Company made changes in its
property and casualty claims function including hiring of new management,
implementing improved processes and physical consolidation of the previous 17
branch offices into 6 regional claims offices, which began in late-November 2002
and was completed in the first quarter of 2003. As part of the reorganization of
the claims function, all open claim files were reviewed by the new team,
including an updated assessment of reserves on older cases. In the first quarter
of 2003, these reassessments resulted in a re-estimated ultimate liability for
claims from accident years 2001, 2000 and 1999 and prior that was higher than
the amount previously established. Installation and implementation of the new
claims administration system, including related process changes, are planned for
the last half of 2003.
The following table quantifies the amount of first quarter 2003
adverse/(favorable) development for each line of business and the accident years
to which the re-estimates relate:
Other
Voluntary Total Property &
Total Automobile Property Casualty
--------- -------------- ---------- -------------
Three months ended
March 31, 2003
------------------------
Accident Years:
2002 ..................... $ 0.8 $ 1.1 $ (0.9) $ 0.6
2001 ..................... 1.4 1.7 0.6 (0.9)
2000 & Prior ............. 2.1 2.8 (0.1) (0.6)
----- ----- ------ ------
Total ............. $ 4.3 $ 5.6 $ (0.4) $ (0.9)
===== ===== ====== ======
25
For the first three months of 2003, incurred catastrophe losses for all
lines were $2.1 million compared to $0.2 million for the same period in the
prior year.
Despite a higher level of weather-related losses, the property statutory
loss ratio of 74.1% for the first quarter of 2003 improved 4.5 percentage points
from the same period in 2002, reflecting an increase in average premium per
policy and the positive effects of loss containment initiatives.
The voluntary automobile statutory loss ratio excluding catastrophe losses
was 75.7% for the first quarter of 2003 compared to 75.3% for the same period
last year. The statutory loss ratio in the current period included 5.8
percentage points due to adverse development of prior years' reserves compared
to minimal impact a year earlier. The increase in average voluntary automobile
premium per policy in 2003 exceeded the increase in average current accident
year loss costs.
The annuity benefits in the first three months of 2003 and 2002 reflected
mortality charges for annuity contracts on payout status. In addition, annuity
benefits in 2003 included an increase of $0.2 million in the GMDB reserve on
variable annuity contracts due to fluctuations in the financial markets.
Life mortality costs in the current period were slightly higher compared to
a year earlier.
As disclosed in the Company's Annual Report on Form 10-K for 2002, early in
2001 management discovered deficiencies in the tax compliance testing procedures
associated with certain of the Company's life insurance policies that could
jeopardize the tax status of some of those life policies. Deficiencies in the
Company's computer-based monitoring of premiums, combined with the complexity of
certain of the Company's life insurance products, resulted in the acceptance of
too much premium for certain policies under the applicable tax test the Company
was using. As a result of this discovery, the Company retained outside experts
to assist with the investigation and remediation of this issue. The deficiencies
in the testing procedures related to compliance with Internal Revenue Code
("IRC") Section 7702 (Definition of Life Insurance) were identified and
corrected. Such a problem is not uncommon in the life insurance industry and is
expected to be cured using Internal Revenue Service ("IRS") procedures that have
been established to address this type of situation. The Company recorded $2.0
million of policyholder benefits in the Corporate and Other segment in the
fourth quarter of 2001, as well as $1.0 million of operating expense, which
represented the Company's current best estimate of the costs to the Company to
resolve these problems. In the second, third and fourth quarters of 2002 and in
the first quarter of 2003, 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. In October 2002,
the Company filed documents with the IRS under the established procedures to
specifically address issues related to IRC Section 7702. The Company is also in
the process of identifying and correcting any related deficiencies and
quantifying any potential exposure associated with IRC Section 7702A (Modified
Endowment Contracts). The Company expects to make any subsequent IRS filings
determined to be required under Section 7702A by the end of 2003.
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-evaluating its life product portfolio and related
administrative system.
26
Interest Credited to Policyholders
Three Months Ended Growth Over
March 31, Prior Year
---------------------- --------------------
2003 2002 Percent Amount
---- ---- ------- ------
Annuity ................. $17.7 $16.9 4.7% $0.8
Life .................... 7.7 7.2 6.9% 0.5
----- ----- ----
Total ................. $25.4 $24.1 5.4% $1.3
===== ===== ====
The increase in annuity segment interest credited reflected an 8.6%
increase in average accumulated fixed deposits partially offset by a decline in
the average annual interest rate credited of 20 basis points compared to the
first three months of 2002. Life insurance interest credited increased as a
result of the growth in interest-sensitive life insurance reserves.
Operating Expenses
For the first three months of 2003, operating expenses increased $1.2
million, or 3.7%, compared to the prior year. The current period included an
increase in investments in technology and property and casualty underwriting
initiatives.
In 2001, the Company determined that it would freeze its defined benefit
pension plan in 2002 and move to a defined contribution structure. Costs of
transitioning to the new structure, based upon assumptions of future events,
were $6.2 million in 2002 and are currently estimated to be approximately $6.5
million for 2003. These costs are largely as a result of settlement accounting
provisions that are expected to be triggered as a result of the higher
retirement rate currently being experienced by the Company, coupled with more
retirees choosing lump sum distributions, and the impact of declines in the
market value of the pension plan's assets.
The Company's policy with respect to funding the defined benefit pension
plan is to contribute amounts which are actuarially determined to provide the
plan with sufficient assets to meet future benefit payments consistent with the
funding requirements of federal laws and regulations. In 2002, the Company
contributed $7.9 million to the defined benefit pension plan, which was greater
than the $1.8 million actuarially-determined required minimum amount, reflecting
a degree of conservatism which the Company believes to be appropriate in light
of the current volatility in the financial markets. Based on assumptions at the
time of this Report on Form 10-Q, the Company anticipates contributing
approximately $9.0 million to the defined benefit pension plan in 2003, an
amount which is also anticipated to be in excess of the required minimum amount.
For the defined benefit pension plan, investments have been set aside in a trust
fund.
The property and casualty statutory expense ratio was 24.3% for the three
months ended March 31, 2003, comparable to the full year 2002 result but 2
percentage points higher than the first quarter a year ago. The increase
compared to the first quarter of 2002 primarily reflected (1) an increase in
automobile new business commissions, (2) investments in technology and
underwriting initiatives and (3) the required statutory classification of
escrowed North Carolina rate dispute amounts.
27
Amortization of Policy Acquisition Expenses and Intangible Assets
For the first three months of 2003, the combined amortization of policy
acquisition expenses and intangible assets was $18.7 million compared to $15.9
million recorded for the same period in 2002.
Amortization of intangible assets was $1.6 million for the three months
ended March 31, 2003 compared to $1.3 million for the same period in 2002. The
increase reflects the March 2003 valuation of annuity value of business acquired
in the 1989 acquisition of the Company ("Annuity VIF"), which resulted in an
increase in amortization of $0.3 million for the current period due to lower
than expected financial market appreciation. A similar valuation in March 2002
resulted in a decrease in amortization of $0.1 million.
Policy acquisition expenses amortized for the three months ended March 31,
2003 of $17.1 million were $2.5 million more than the prior year, primarily
related to the property and casualty segment. Over the past 12 months, this
segment has experienced accelerated growth in new business and the acquisition
cost amortization period matches the terms of the insurance policies (six and
twelve months). The increase in amortization for the property and casualty
segment was augmented by a $0.7 million increase in amortization for the annuity
and life segments combined, primarily as a result of the current year valuation
compared to the impact of the 2002 valuation. In the current period, the
favorable impact of realized investment losses in the valuation was offset by
lower than expected financial market performance for the annuity segment. For
the annuity segment, the current year valuation increased amortization $0.7
million compared to a decrease of $0.1 million in 2002. The current year
valuation reduced amortization $0.2 million for the life segment compared to no
impact in the prior year.
Income Tax Expense
The effective income tax rate on income, including realized investment
gains and losses, was 25.7% for the three months ended March 31, 2003 compared
to 31.0% a year earlier.
Income from investments in tax-advantaged securities reduced the effective
income tax rate 10.8 and 3.7 percentage points for the three months ended March
31, 2003 and 2002, respectively. While the amount of income from tax-advantaged
securities in the current year increased marginally compared to the prior year,
the reduced level of income before income taxes in the current period resulted
in this having a more significant impact on the effective income tax rate.
Net Income
For the three months ended March 31, 2003, net income benefited from the
impact of property and casualty rate increases on earned premiums, with the
growth in average premium per policy outpacing current accident year loss costs,
underwriting initiatives and the Company's restructuring of its Massachusetts
automobile business.
These positive prior year comparisons were offset by adverse development of
property and casualty prior years' reserves, which resulted in an after-tax
charge of $2.8 million for the quarter. Current period net income was also
negatively impacted by (1) decreases in investment income related to investment
credit issues and declining interest rates, (2) tightening margins on variable
annuities resulting from adverse financial market conditions, (3) heavier
weather-related losses than a year ago and (4) investment impairment charges.
28
Net income by segment was as follows:
Three Months Ended Growth Over
March 31, Prior Year
----------------------- --------------------
2003 2002 Percent Amount
---- ---- ------- ------
Property & casualty
Before catastrophe losses .......................... $ 8.0 $ 7.3 9.6% $ 0.7
Catastrophe losses, after tax ...................... (1.4) (0.1) (1.3)
-------- --------
Total including catastrophe costs ............. 6.6 7.2 -8.3% (0.6)
Annuity .............................................. 2.3 4.7 -51.1% (2.4)
Life ................................................. 3.8 3.8 - -
Corporate and other (1) .............................. (4.6) (0.1) (4.5)
-------- -------- --------
Total ......................................... $ 8.1 $ 15.6 -48.1% $ (7.5)
======== ======== ========
Property and casualty statutory combined ratio:
Before catastrophe losses ....................... 97.9% 100.2% -2.3%
After catastrophe losses ........................ 99.5% 100.4% -0.9%
- ---------------
(1) The Corporate and Other segment includes interest expense on debt,
realized investment gains and losses and other non-operating,
reconciling items to net income. The Company does not allocate the
impact of corporate level transactions to the insurance segments
consistent with management's evaluation of the results of those
segments.
Adverse development of prior years' reserves decreased property and
casualty net income $2.8 million after tax in the first quarter of 2003 compared
to no material impact a year earlier. Compared to the prior year, the higher
level of weather-related losses in the first quarter of 2003 represented an
increase in the Company's property and casualty statutory combined ratio of
approximately 2 percentage points.
For the first three months of 2003, the Company's increase in average
voluntary automobile insurance premium per policy exceeded the increase in
average current accident year loss costs. The Company is continuing to approach
the pricing and underwriting of its property and casualty products aggressively
- -- most notably the homeowners line -- to accelerate margin recovery.
The property and casualty statutory combined ratio improved 0.9
percentage points compared to the first three months of 2002. Adverse
development of prior years' reserves represented 3.3 percentage points of the
statutory combined ratio in the current period compared to 0.1 percentage points
in the prior year. In spite of the increased reserve strengthening, the
statutory loss ratio for the segment improved 2.9 percentage points compared to
the prior year. However, the statutory expense ratio increased 2.0 percentage
points, primarily reflecting an increase in automobile new business commissions,
investments in technology and underwriting initiatives and the required
statutory classification of escrowed North Carolina rate dispute amounts.
Annuity segment net income in the first three months of 2003 decreased
compared to the prior year. Current year income was adversely impacted by an
after-tax reduction in the net interest margin of $1.1 million, primarily
reflecting lower investment income resulting from investment credit issues and
declining interest rates. In addition, as discussed above, valuation of annuity
segment deferred acquisition costs and value of acquired insurance in force at
March 31, 2003 resulted in an after-tax charge of $0.6 million. Similar
valuations a year earlier decreased
29
after-tax amortization $0.1 million for the first quarter. An increase in the
GMDB reserves reduced current year net income by $0.2 million compared to no
impact a year earlier. Fee income related to variable annuity deposits decreased
compared to the prior year, primarily as a result of adverse financial market
conditions.
Life segment net income was equal to the first three months of 2002.
Valuation of life segment deferred acquisition costs at March 31, 2003 resulted
in a reduction in amortization of $0.1 million after tax due to the impact of
realized investment losses. In the prior year, a similar valuation resulted in
no adjustment. Mortality experience on ordinary life business was slightly
higher compared to a year earlier.
The increase in the net loss for the corporate and other segment
compared to last year primarily reflected realized investment losses, including
impairment charges, compared to realized investment gains in the first three
months of 2002. Interest expense on the Company's outstanding debt decreased
compared to the prior year, reflecting refinancing transactions completed in the
last eight months of 2002.
Return on shareholders' equity based on net income was less than 1% for
the 12 months ended March 31, 2003.
Operating Income
Operating income is a non-GAAP financial measure defined by the Company
as net income before the after-tax impact of realized investment gains and
losses and non-operating items. There were no non-operating items in the first
quarters of 2003 and 2002. A reconciliation of operating income to GAAP net
income is provided below. Management utilizes the operating income measure in
comparing core operating performance across reporting periods but acknowledges
that its definition of operating income may not be comparable to other
companies.
Reconciliations of Operating Income to GAAP Net Income
Three Months Ended Growth Over
March 31, Prior Year
----------------------- --------------------
2003 2002 Percent Amount
---- ---- ------- ------
Operating income ..................................... $ 11.2 $ 13.9 -19.4% $ (2.7)
Realized investment gains (losses), after-tax ........ (3.1) 1.7 (4.8)
-------- -------- --------
Net income ...................................... $ 8.1 $ 15.6 -48.1% $ (7.5)
======== ======== ========
Per share, diluted:
Operating income ................................... $ 0.26 $ 0.34 -23.5% $ (0.08)
Realized investment gains (losses), after tax ...... (0.07) 0.04 (0.11)
-------- -------- --------
Net income .................................... $ 0.19 $ 0.38 -50.0% $ (0.19)
======== ======== ========
At the time of this Quarterly Report on Form 10-Q, and consistent with
disclosure in the Company's Annual Report on Form 10-K for 2002, management
anticipates that 2003 full year operating income will be within a range of $1.25
to $1.35 per share. This projection includes an approximate $0.09 reduction in
per share operating earnings as a result of the Company's capital transactions
completed in the fourth quarter of 2002. This projection also reflects
management's
30
anticipation of continued improvement in the property and casualty statutory
combined ratio mitigated by compression in the Company's annuity margins and
pressure on investment income. As described in "Critical Accounting Policies,"
certain of the Company's significant accounting measurements require the use of
estimates and assumptions. As additional information becomes available,
adjustments may be required. Those adjustments are charged or credited to income
for the period in which the adjustments are made and may impact actual results
compared to management's current estimate. A projection of net income is not
accessible on a forward-looking basis because it is not possible to provide a
reliable forecast of realized investment gains and losses, which can vary
substantially from one period to another and may have a significant impact on
net income. At the time of this Quarterly Report on Form 10-Q, any other
reconciling items to net income are assumed to be zero in 2003.
Liquidity and Financial Resources
Special Purpose Entities
At March 31, 2003 and 2002, the Company did not have any relationships
with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or for other contractually narrow or limited purposes. As such, the Company is
not exposed to any financing, liquidity, market or credit risk that could arise
if the Company had engaged in such relationships.
Related Party Transactions
The Company does not have any contracts or other transactions with
related parties that are required to be reported under the applicable securities
laws and regulations.
Ariel Capital Management, Inc., HMEC's largest shareholder with 25% of
the common shares outstanding per their SEC filing on Form 13F as of December
31, 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
third largest shareholder with 8% of the common shares outstanding per their SEC
filing on Form 13F as of December 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 March 31, 2003, fixed income securities
represented 96.3% of investments excluding the securities lending collateral. Of
the fixed income investment portfolio, 95.5% was investment grade and 99.9% was
publicly traded. The average quality of the total fixed income portfolio was A+
at March 31, 2003.
The duration of the investment portfolio is managed to provide cash flow
to satisfy policyholder liabilities as they become due. The average option
adjusted duration of total investments was 5.3 years at March 31, 2003 and 4.8
years at December 31, 2002. The Company has included in its annuity products
substantial surrender penalties to reduce the likelihood of unexpected increases
in policy or contract surrenders. All annuities issued since 1982, and
approximately 79% of all outstanding fixed annuity accumulated cash values, are
subject in most cases to substantial early withdrawal penalties.
31
Additional discussion of the Company's investment guidelines is included
in "Results of Operations -- Realized Investment Gains and Losses."
Cash Flow
The short-term liquidity requirements of the Company, within a 12-month
operating cycle, are for the timely payment of claims and benefits to
policyholders, operating expenses, interest payments and federal income taxes.
Cash flow in excess of these amounts has been used to fund business growth,
retire short-term debt, pay dividends to shareholders and repurchase shares of
the Company's common stock. Long-term liquidity requirements, beyond one year,
are principally for the payment of future insurance policy claims and benefits
and retirement of long-term debt.
Operating Activities
As a holding company, HMEC conducts its principal operations in the
personal lines segment of the property and casualty and life insurance
industries through its subsidiaries. HMEC's insurance subsidiaries generate cash
flow from premium and investment income, generally well in excess of their
immediate needs for policy obligations, operating expenses and other cash
requirements. Cash provided by operating activities primarily reflects net cash
generated by the insurance subsidiaries. For the first three months of 2003, net
cash provided by operating activities declined compared to the prior year,
primarily reflecting an increase in federal income taxes paid.
Payment of principal and interest on debt, fees related to the
catastrophe-linked equity put option and reinsurance agreement, dividends to
shareholders and parent company operating expenses, as well as the share
repurchase program, are dependent upon the ability of the insurance subsidiaries
to pay cash dividends or make other cash payments to HMEC, including tax
payments pursuant to tax sharing agreements. The insurance subsidiaries are
subject to various regulatory restrictions which limit the amount of annual
dividends or other distributions, including loans or cash advances, available to
HMEC without prior approval of the insurance regulatory authorities. Dividends
which may be paid by the insurance subsidiaries to HMEC during 2003 without
prior approval are approximately $43 million, of which none had been paid as of
March 31, 2003. 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, repayments and repurchases related to the
Company's debt facilities. Fees related to the catastrophe-linked equity put
option and reinsurance agreement, which augments its traditional reinsurance
program, have been charged directly to additional paid-in capital.
32
For the three months ended March 31, 2003, receipts from annuity
contracts increased 1.6%. Annuity contract maturities and withdrawals decreased
$17.4 million, or 42.3%, compared to the same period last year, including a
decrease of 6% in surrenders of variable annuity deposits nearly offset by a 6%
increase in surrenders of fixed annuity deposits. Cash value retentions for
variable and fixed annuity options were 91.9% and 94.2%, respectively, for the
12 month period ended March 31, 2003. Net transfers to variable annuity
accumulated cash values increased $2.8 million compared to the same period last
year.
Contractual Obligations
Payments Due By Period
As of December 31, 2002
----------------------------------------------------------
More Than
Less Than 1 - 3 Years 3 - 5 Years 5 Years
1 Year (2004 and (2006 and (2008 and
Total (2003) 2005) 2007) beyond)
------ --------- ----------- ----------- ---------
Long-Term Debt Obligations (1):
Convertible Notes Due 2032 .............. $260.2 $3.5 $ 7.0 $ 5.2 $244.5
Senior Notes Due 2006 ................... 35.2 1.9 3.8 29.5 -
------ ---- ----- ----- ------
Total ................................ $295.4 $5.4 $10.8 $34.7 $244.5
====== ==== ===== ===== ======
- -------------------
(1) Includes principal and interest.
The Company has entered into various operating lease agreements,
primarily for computer equipment, computer software and real estate (agency and
claims offices across the country and portions of the home office complex).
These leases have varying commitment periods with most in the 1 to 3 year range.
Payments on these leases were approximately $3 million and $2 million for the
three months ended March 31, 2003 and 2002, respectively. It is anticipated that
the Company's payments under operating leases for the full year 2003 will be
comparable to payments in 2002 of approximately $8 million. The Company does not
have any other arrangements that expose it to material liability that are not
recorded in the financial statements.
Capital Resources
The Company has determined the amount of capital which is needed to
adequately fund and support business growth, primarily based on risk-based
capital formulas including those developed by the National Association of
Insurance Commissioners ("NAIC"). Historically, the Company's insurance
subsidiaries have generated capital in excess of such needed capital. These
excess amounts have been paid to HMEC through dividends. HMEC has then utilized
these dividends and its access to the capital markets to service and retire
long-term debt, increase and pay dividends to its shareholders, fund growth
initiatives, repurchase shares of its common stock and for other corporate
purposes. Management anticipates that the Company's sources of capital will
continue to generate capital in excess of its needs for business growth, debt
interest payments and shareholder dividends.
The total capital of the Company was $688.2 million at March 31, 2003,
including $144.7 million of long-term debt and no short-term debt outstanding.
Total debt represented 21.0% of capital (24.2% excluding unrealized investment
gains and losses) at March 31, 2003, below the Company's long-term target of
25%.
33
Shareholders' equity was $543.5 million at March 31, 2003, including an
unrealized gain in the Company's investment portfolio of $91.4 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 $560.2 million and $13.12, respectively, at March 31, 2003.
Book value per share was $12.73 at March 31, 2003, $10.59 excluding investment
fair value adjustments.
On May 14, 2002, the Company issued $353.5 million aggregate principal
amount of 1.425% senior convertible notes due in 2032 ("Convertible Notes") at a
discount of 52.5% resulting in an effective yield of 3.0%. The Convertible Notes
were privately offered only to qualified institutional buyers under Rule 144A
under the Securities Act of 1933 and outside the United States of America
("U.S.") to non-U.S. persons under Regulation S under the Securities Act of
1933. A Securities and Exchange Commission registration statement registering
the Convertible Notes was declared effective on November 4, 2002. Prior to
December 31, 2002, the Company repurchased $109.0 million aggregate principal
amount, $51.8 million carrying value, of the outstanding Convertible Notes. At
March 31, 2003, $244.5 million aggregate principal amount, $116.1 million
carrying value, of the Convertible Notes were outstanding. The Convertible Notes
are traded in the open market (HMN 1.425).
In January 1996, the Company issued $100.0 million aggregate principal
amount of 6 5/8% Senior Notes ("Senior Notes") at a discount of 0.5% which will
mature on January 15, 2006. In 2002, the Company repurchased $71.4 million
aggregate principal amount of its outstanding Senior Notes utilizing a portion
of the proceeds from the issuance of the Convertible Notes. At March 31, 2003,
$28.6 million aggregate principal amount of Senior Notes were outstanding. The
Senior Notes are traded on the New York Stock Exchange (HMN 6 5/8).
As of March 31, 2003 and December 31, 2002, the Company had no amounts
outstanding under its Bank Credit Agreement. The Bank Credit Agreement provides
for unsecured borrowings of up to $25.0 million, with a provision that allows
the commitment amount to be increased to $35.0 million (the "Bank Credit
Facility"). The Bank Credit Facility expires on May 31, 2005. Interest accrues
at varying spreads relative to corporate or eurodollar base rates and is payable
monthly or quarterly depending on the applicable base rate. The unused portion
of the Bank Credit Facility is subject to a variable commitment fee, which was
0.20% on an annual basis at March 31, 2003.
The Company's ratio of earnings to fixed charges for the three months
ended March 31, 2003 was 7.8x, reflecting the impact of $4.7 million of pretax
realized investment losses recognized during the period, compared to 11.8x for
the same period in 2002.
Total shareholder dividends were $4.5 million for the three months ended
March 31, 2003. In February 2003, the Board of Directors announced regular
quarterly dividends of $0.105 per share.
Descriptions of the Company's material property and casualty reinsurance
programs and a life reinsurance agreement with Sun Life Reinsurance Company
Limited are contained in the Company's Annual Report on Form 10-K for 2002
within "Management's Discussion and Analysis of Financial Condition and Results
of Operations--Liquidity and Financial Resources--Capital Resources." There have
been no material changes to the Company's reinsurance coverage as of the time of
this Quarterly Report on Form-10-Q.
34
Market Value Risk
Market value risk, the Company's primary market risk exposure, is the
risk that the Company's invested assets will decrease in value. This decrease in
value may be due to a change in (1) the yields realized on the Company's assets
and prevailing market yields for similar assets, (2) an unfavorable change in
the liquidity of the investment, (3) an unfavorable change in the financial
prospects of the issuer of the investment, or (4) a downgrade in the credit
rating of the issuer of the investment. See also "Results of Operations --
Realized Investment Gains and Losses."
Significant changes in interest rates expose the Company to the risk of
experiencing losses or earning a reduced level of income based on the difference
between the interest rates earned on the Company's investments and the credited
interest rates on the Company's insurance liabilities.
The Company manages its market value risk by coordinating the projected
cash outflows of assets with the projected cash outflows of liabilities. For all
its assets and liabilities, the Company seeks to maintain reasonable durations,
consistent with the maximization of income without sacrificing investment
quality, while providing for liquidity and diversification. The investment risk
associated with variable annuity deposits and the underlying mutual funds is
assumed by those contractholders, and not by the Company. Certain fees that the
Company earns from variable annuity deposits are based on the market value of
the funds deposited.
A more detailed description of the Company's exposure to market value
risks and the management of those risks is presented in the Company's Annual
Report on Form 10-K for 2002 "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Market Value Risk."
Information Systems Risk
The Company administers its insurance business with information systems
that are dated and complex, and require extensive manual input, calculation and
control procedures. These systems are more prone to error than more advanced
technology systems. To address these issues, over the past two years the Company
has enhanced its existing systems and technology infrastructure and begun
installing new systems, including a new general ledger and financial reporting
system which was implemented in the second quarter of 2003. In the meantime,
enhanced checks and control procedures have been established to review the
output of existing information systems, including periodic internal and external
third party reviews. Nevertheless, there are risks that inaccuracies in the
processing of data may occur which might not be identified by those procedures
and checks.
Business Continuity Risk
Given the events of September 11, 2001, the continuing threat of
terrorism and the current geopolitical climate, the Company has undertaken a
reassessment of its business continuity plans. While current contingency plans
are felt to be adequate to restore some of the more critical business processes
and the Company is aggressively working to strengthen its continuity plans, in
the current environment there is believed to exist a higher than acceptable
level of risk that the Company's ability to recover and resume most or all of
its key business operations on a timely basis would be compromised.
35
Item 3: Quantitative and Qualitative Disclosures About Market Risk
The information required by Item 305 of Regulation S-K is contained in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" contained in this Quarterly Report on Form 10-Q.
Item 4: Controls and Procedures
Within the 90 days prior to the date of this report, the Company carried
out an evaluation, under the supervision and with the participation of the
Company's management, including the Company's Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures pursuant to Exchange Act Rule
13a-14 and 15d-14. Based upon that evaluation, the Chief Executive Officer and
Chief Financial Officer concluded that the Company's disclosure controls and
procedures are effective in timely alerting them to material information
relating to the Company (including its consolidated subsidiaries) required to be
included in the Company's periodic Securities and Exchange Commission filings.
No significant deficiencies or material weaknesses in the Company's disclosure
controls and procedures were identified in the evaluation and therefore, no
corrective actions were taken. There were no significant changes in the
Company's internal controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation.
PART II: OTHER INFORMATION
Item 4: Submission of Matters to a Vote of Security Holders
None.
Item 5: Other Information
In compliance with Section 202 of the Sarbanes-Oxley Act of 2002, the
Audit Committee of the Board of Directors of Horace Mann Educators Corporation
has preapproved the continuing provision of certain non-audit services by KPMG
LLP, Horace Mann Educators Corporation's independent auditor. Such services
consist of audit-related services, primarily related to statutory regulatory
requirements and SEC registration statement review services, and
non-audit-related services, related to tax consultation and employee compliance
affirmations.
The Audit Committee has determined that the services provided by KPMG
LLP under non-audit services are compatible with maintaining the auditor's
independence.
36
Item 6: Exhibits and Reports on Form 8-K
Exhibit
No. Description
------- -----------
(a) The following items are filed as Exhibits.
(11) Statement re computation of per share earnings.
(15) KPMG LLP letter regarding unaudited interim financial information.
(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) During the first quarter of 2003, HMEC filed one Current Report on Form
8-K with the SEC, containing an Item 5 Other Events and an Item 7
Financial Statements and Exhibits, as follows:
1. Dated February 6, 2003, regarding the Company's press release
reporting its financial results for the three and twelve month
periods ended December 31, 2002.
37
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 May 14, 2003 /s/ Louis G. Lower II
------------------------- -----------------------------------
Louis G. Lower II
President and Chief Executive Officer
Date May 14, 2003 /s/ Peter H. Heckman
------------------------- -----------------------------------
Peter H. Heckman
Executive Vice President
and Chief Financial Officer
Date May 14, 2003 /s/ Bret A. Conklin
------------------------- -----------------------------------
Bret A. Conklin
Senior Vice President
and Controller
38
Certifications
Chief Executive Officer Certification pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
I, Louis G. Lower II, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Horace Mann
Educators Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 13, 2003 /s/ Louis G. Lower II
------------------------- -----------------------------------
Louis G. Lower II
Chief Executive Officer
39
Chief Financial Officer Certification pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002
I, Peter H. Heckman, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Horace Mann Educators
Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly
report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 12, 2003 /s/ Peter H. Heckman
------------------------- -----------------------------------
Peter H. Heckman
Chief Financial Officer
40
================================================================================
HORACE MANN EDUCATORS CORPORATION
EXHIBITS
To
FORM 10-Q
For the Quarter Ended March 31, 2003
VOLUME 1 OF 1
================================================================================
The following items are filed as Exhibits to Horace Mann Educators
Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31,
2003. Management contracts and compensatory plans are indicated by an
asterisk(*).
EXHIBIT INDEX
Exhibit
No. Description
- ------- -----------
(11) Statement re computation of per share earnings.
(15) KPMG LLP letter regarding unaudited interim financial information.
(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.