<PAGE>
Financial Statements
Separate Account VUL
of
Integrity Life Insurance Company
DECEMBER 31, 1998
WITH REPORT OF INDEPENDENT AUDITORS
<PAGE>
Separate Account VUL
of
Integrity Life Insurance Company
Financial Statements
December 31, 1998
CONTENTS
<TABLE>
<S> <C>
Report of Independent Auditors...............................................1
Audited Financial Statements
Statement of Assets and Liabilities..........................................2
Statement of Operations......................................................3
Statements of Changes in Net Assets..........................................4
Notes to Financial Statements................................................6
</TABLE>
<PAGE>
Report of Independent Auditors
Policyholders
Separate Account VUL of Integrity Life Insurance Company
We have audited the accompanying statement of assets and liabilities of Separate
Account VUL of Integrity Life Insurance Company (comprising, respectively, the
Common Stock, Money Market, Balanced, Aggressive Stock, High Yield, and Global
Divisions) as of December 31, 1998, the related statement of operations for the
year then ended and statements of changes in net assets for the years ended
December 31, 1998 and 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. Our procedures included
confirmation of mutual fund shares owned in The Hudson River Trust (the "Trust")
as of December 31, 1998, by correspondence with the transfer agent of the Trust.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of each of the respective
divisions constituting Separate Account VUL of Integrity Life Insurance Company
at December 31, 1998, the results of their operations for the year then ended,
and changes in their net assets for the years ended December 31, 1998 and 1997,
in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Louisville, Kentucky
April 9, 1999
1
<PAGE>
Separate Account VUL of Integrity Life Insurance Company
Statement of Assets and Liabilities
December 31, 1998
<TABLE>
<CAPTION>
COMMMON MONEY AGGRESSIVE HIGH
STOCK MARKET BALANCED STOCK YIELD GLOBAL
DIVISION DIVISION DIVISION DIVISION DIVISION DIVISION TOTAL
-----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
ASSETS
Investments in The Hudson River Trust
at value (aggregate cost of $28,000,510) $ 19,182,954 $ 827,535 $ 6,082,232 $ 6,058,968 $ 379,952 $ 1,418,768 $ 33,950,409
LIABILITIES
Payable to the general account
of Integrity 901 55 422 3,154 311 274,789 279,632
-----------------------------------------------------------------------------------------
NET ASSETS $ 19,182,053 $ 827,480 $ 6,081,810 $ 6,055,814 $ 379,641 $ 1,143,979 $ 33,670,777
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
Unit value $ 644.97 $ 188.75 $ 339.69 $ 564.75 $ 285.23 $ 302.56
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
Units outstanding 29,741 4,384 17,904 10,723 1,331 3,781
-----------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
2
<PAGE>
Separate Account VUL of Integrity Life Insurance Company
Statement of Operations
Year Ended December 31, 1998
<TABLE>
<CAPTION>
COMMON MONEY AGGRESSIVE
STOCK MARKET BALANCED STOCK
DIVISION DIVISION DIVISION DIVISION
-------------------------------------------------------------------------
<S> <C> <C> <C> <C>
INVESTMENT INCOME
Reinvested dividends from
The Hudson River Trust $ 2,433,250 $ 40,455 $ 664,700 $ 324,427
EXPENSES
Mortality and expense risk and
administrative charges 95,418 4,684 32,272 34,702
-------------------------------------------------------------------------
NET INVESTMENT INCOME 2,337,832 35,771 632,428 289,725
REALIZED AND UNREALIZED GAIN (LOSS)
ON INVESTMENTS
Net realized gain on sales of investments 991,427 2,951 32,783 128,944
Net unrealized appreciation (depreciation)
of investments:
Beginning of period 4,340,259 6,697 283,082 411,740
End of period 5,377,215 6,813 536,967 (37,006)
-------------------------------------------------------------------------
Change in net unrealized appreciation/
depreciation during the period 1,036,956 116 253,885 (448,746)
-------------------------------------------------------------------------
NET REALIZED AND UNREALIZED GAIN (LOSS)
ON INVESTMENTS 2,028,383 3,067 286,668 (319,802)
-------------------------------------------------------------------------
NET INCREASE (DECREASE) IN NET ASSETS
RESULTING FROM OPERATIONS $ 4,366,215 $ 38,838 $ 919,096 $ (30,077)
-------------------------------------------------------------------------
-------------------------------------------------------------------------
<CAPTION>
HIGH
YIELD GLOBAL
DIVISION DIVISION TOTAL
---------------------------------------------------
<S> <C> <C> <C>
INVESTMENT INCOME
Reinvested dividends from
The Hudson River Trust $ 51,907 $ 104,633 $ 3,619,372
EXPENSES
Mortality and expense risk and
administrative charges 2,488 7,166 176,730
---------------------------------------------------
NET INVESTMENT INCOME 49,419 97,467 3,442,642
REALIZED AND UNREALIZED GAIN (LOSS)
ON INVESTMENTS
Net realized gain on sales of investments 1,387 52,225 1,209,717
Net unrealized appreciation (depreciation)
of investments:
Beginning of period 18,540 31,414 5,091,732
End of period (60,201) 126,111 5,949,899
---------------------------------------------------
Change in net unrealized appreciation/
depreciation during the period (78,741) 94,697 858,167
---------------------------------------------------
NET REALIZED AND UNREALIZED GAIN (LOSS)
ON INVESTMENTS (77,354) 146,922 2,067,884
---------------------------------------------------
NET INCREASE (DECREASE) IN NET ASSETS
RESULTING FROM OPERATIONS $ (27,935) $ 244,389 $ 5,510,526
---------------------------------------------------
---------------------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
3
<PAGE>
Separate Account VUL of Integrity Life Insurance Company
Statement of Changes in Net Assets
Year Ended December 31, 1997
<TABLE>
<CAPTION>
COMMON MONEY AGGRESSIVE
STOCK MARKET BALANCED STOCK
DIVISION DIVISION DIVISION DIVISION
-------------------------------------------------------------------------
<S> <C> <C> <C> <C>
INCREASE (DECREASE) IN NET ASSETS FROM
OPERATIONS
Net investment income $ 2,337,832 $ 35,771 $ 632,428 $ 289,725
Net realized gain on sales of investments 991,427 2,951 32,783 128,944
Change in net unrealized appreciation/
depreciation during the period 1,036,956 116 253,885 (448,746)
-------------------------------------------------------------------------
Net increase (decrease) in net assets
resulting from operations 4,366,215 38,838 919,096 (30,077)
INCREASE (DECREASE) IN NET ASSETS FROM POLICY
RELATED TRANSACTIONS
Contributions from policyholders 628,165 21,752 340,974 273,800
Policy terminations and benefits (2,171,915) (250,769) (862,809) (832,067)
Net transfers among investment divisions 3,993 100,085 (7,151) (48,261)
-------------------------------------------------------------------------
Net decrease in net assets from
policy related transactions (1,539,757) (128,932) (528,986) (606,528)
-------------------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS 2,826,458 (90,094) 390,110 (636,605)
Net Assets, beginning of year 16,355,595 917,574 5,691,700 6,692,419
-------------------------------------------------------------------------
NET ASSETS, END OF YEAR $ 19,182,053 $ 827,480 $ 6,081,810 $ 6,055,814
-------------------------------------------------------------------------
-------------------------------------------------------------------------
UNIT TRANSACTIONS
Contributions 1,136 118 1,098 492
Terminations and benefits (3,984) (1,366) (2,823) (1,464)
Net transfers (25) 542 (43) (118)
-------------------------------------------------------------------------
Net decrease in units (2,873) (706) (1,768) (1,090)
-------------------------------------------------------------------------
-------------------------------------------------------------------------
<CAPTION>
HIGH
YIELD GLOBAL
DIVISION DIVISION TOTAL
------------------------------------------------------
<S> <C> <C> <C>
INCREASE (DECREASE) IN NET ASSETS FROM
OPERATIONS
Net investment income $ 49,419 $ 97,467 $ 3,442,642
Net realized gain on sales of investments 1,387 52,225 1,209,717
Change in net unrealized appreciation/
depreciation during the period (78,741) 94,697 858,167
------------------------------------------------------
Net increase (decrease) in net assets
resulting from operations (27,935) 244,389 5,510,526
INCREASE (DECREASE) IN NET ASSETS FROM POLICY
RELATED TRANSACTIONS
Contributions from policyholders 20,956 75,058 1,360,705
Policy terminations and benefits (99,759) (171,612) (4,388,931)
Net transfers among investment divisions 35,609 (255,515) (171,240)
------------------------------------------------------
Net decrease in net assets from
policy related transactions (43,194) (352,069) (3,199,466)
------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS (71,129) (107,680) 2,311,060
Net Assets, beginning of year 450,770 1,251,659 31,359,717
------------------------------------------------------
NET ASSETS, END OF YEAR $ 379,641 $ 1,143,979 $ 33,670,777
------------------------------------------------------
------------------------------------------------------
UNIT TRANSACTIONS
Contributions 69 224
Terminations and benefits (342) (506)
Net transfers 114 25
------------------------------------------------------
Net decrease in units (159) (257)
------------------------------------------------------
------------------------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
4
<PAGE>
Separate Account VUL of Integrity Life Insurance Company
Statement of Changes in Net Assets
Year Ended December 31, 1997
<TABLE>
<CAPTION>
COMMON MONEY AGGRESSIVE
STOCK MARKET BALANCED STOCK
DIVISION DIVISION DIVISION DIVISION
-------------------------------------------------------------------------
<S> <C> <C> <C> <C>
INCREASE (DECREASE) IN NET ASSETS FROM
OPERATIONS
Net investment income $ 1,231,101 $ 39,054 $ 428,871 $ 531,834
Net realized gain on sales of investments 1,013,552 2,615 137,227 235,552
Change in net unrealized appreciation/
depreciation during the period 1,597,649 (2,117) 177,960 (85,148)
-------------------------------------------------------------------------
Net increase in net assets resulting from
operations 3,842,302 39,552 744,058 682,238
INCREASE (DECREASE) IN NET ASSETS FROM POLICY
RELATED TRANSACTIONS
Contributions from policyholders 709,747 35,370 430,872 320,929
Policy terminations and benefits (2,154,973) (140,037) (901,177) (948,774)
Net transfers among investment divisions (23,918) 96,046 (10,426) (46,467)
-------------------------------------------------------------------------
Net decrease in net assets from
policy related transactions (1,469,144) (8,621) (480,731) (674,312)
-------------------------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS 2,373,158 30,931 263,327 7,926
Net assets, beginning of year 13,982,437 886,643 5,428,373 6,684,493
-------------------------------------------------------------------------
NET ASSETS, END OF YEAR $ 16,355,595 $ 917,574 $ 5,691,700 $ 6,692,419
-------------------------------------------------------------------------
-------------------------------------------------------------------------
UNIT TRANSACTIONS
Contributions 1,630 200 1,579 605
Terminations and benefits (4,823) (799) (3,335) (1,792)
Net transfers (5) 535 (17) 4
-------------------------------------------------------------------------
Net decrease in units (3,198) (64) (1,773) (1,183)
-------------------------------------------------------------------------
-------------------------------------------------------------------------
<CAPTION>
HIGH
YIELD GLOBAL
DIVISION DIVISION TOTAL
------------------------------------------------------
<S> <C> <C> <C>
INCREASE (DECREASE) IN NET ASSETS FROM
OPERATIONS
Net investment income $ 55,467 $ 97,135 $ 2,383,462
Net realized gain on sales of investments 5,932 112,601 1,507,479
Change in net unrealized appreciation/
depreciation during the period 12,297 (72,624) 1,628,017
------------------------------------------------------
Net increase in net assets resulting from
operations 73,696 137,112 5,518,958
INCREASE (DECREASE) IN NET ASSETS FROM POLICY
RELATED TRANSACTIONS
Contributions from policyholders 23,214 87,418 1,607,550
Policy terminations and benefits (114,746) (234,685) (4,494,392)
Net transfers among investment divisions 5,397 (4,872) 15,760
------------------------------------------------------
Net decrease in net assets from
policy related transactions (86,135) (152,139) (2,871,082)
------------------------------------------------------
INCREASE (DECREASE) IN NET ASSETS (12,439) (15,027) 2,647,876
Net assets, beginning of year 463,209 1,266,686 28,711,841
------------------------------------------------------
NET ASSETS, END OF YEAR $ 450,770 $ 1,251,659 $ 31,359,717
------------------------------------------------------
------------------------------------------------------
UNIT TRANSACTIONS
Contributions 83 294
Terminations and benefits (412) (802)
Net transfers 16 15
---------------------------------
Net decrease in units (313) (493)
---------------------------------
---------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
5
<PAGE>
Separate Account VUL
of
Integrity Life Insurance Company
Notes to Financial Statements
December 31, 1998
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND NATURE OF OPERATIONS
Integrity Life Insurance Company ("Integrity") established Separate Account VUL
(the "Separate Account") on May 14, 1986 for the purpose of issuing variable
life insurance policies ("policies"). The Separate Account is a unit investment
trust registered with the Securities and Exchange Commission under the
Investment Company Act of 1940, as amended. Variable life insurance policies
have not been offered by Integrity since 1990, but policies are still
outstanding. Net premiums may be received under existing policies. The
operations of the Separate Account are part of Integrity.
Integrity is an indirect wholly owned subsidiary of ARM Financial Group, Inc.
("ARM"). ARM specializes in the growing asset accumulation business with
particular emphasis on retirement savings and investment products.
Policyholders may allocate or transfer their account values to one or more of
the Separate Account's investment divisions or to a guaranteed interest division
provided by Integrity, or both. The Separate Account divisions invest in shares
of the corresponding portfolios of The Hudson River Trust (the "Trust"), a
mutual fund managed by Alliance Capital Management, L.P. The policyholder's
account value in a Separate Account division will vary depending on the
performance of the corresponding portfolio. The Separate Account currently has
six investment divisions available. The investment objective of each division
and its corresponding portfolio are the same. Set forth below is a summary of
the investment objectives of the portfolios of the Trust.
COMMON STOCK PORTFOLIO seeks to obtain long-term growth of capital and
increasing income. It invests primarily in common and preferred stocks and
other equity type instruments.
6
<PAGE>
Separate Account VUL
of
Integrity Life Insurance Company
Notes to Financial Statements (continued)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
MONEY MARKET PORTFOLIO seeks to obtain as high a level of current income as
is consistent with preserving capital and providing liquidity. It invests
primarily in high quality short-term money market instruments.
BALANCED PORTFOLIO seeks a high return through a combination of current
income and capital appreciation. It invests primarily in common stocks,
publicly-traded debt securities and high quality money market instruments.
AGGRESSIVE STOCK PORTFOLIO seeks to obtain long term growth of capital. It
invests primarily in common stocks and other equity-type securities issued
by medium and smaller sized companies with strong growth potential.
HIGH YIELD PORTFOLIO seeks a high return by maximizing current income and,
to the extent consistent with that objective, capital appreciation. It
invests primarily in a diversified mix of high yield, fixed income
securities involving greater volatility of price and risk of principal and
income than high quality fixed income securities.
GLOBAL PORTFOLIO seeks long term growth of capital as a fundamental
objective. It invests primarily in equity securities of non-United States
as well as United States companies.
The assets of the Separate Account are owned by Integrity. The portion of the
Separate Account's assets supporting the policies may not be used to satisfy
liabilities arising out of any other business of Integrity.
BASIS OF PRESENTATION
The accompanying financial statements have been prepared in accordance with
generally accepted accounting principles for unit investment trusts.
INVESTMENTS
Investments in shares of the Trust are valued at the net asset values of the
respective portfolios, which approximates fair value. The difference between
cost and fair value is reflected as unrealized appreciation and depreciation of
investments.
7
<PAGE>
Separate Account VUL
of
Integrity Life Insurance Company
Notes to Financial Statements (continued)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Dividends from income and capital gain distributions are recorded on the
ex-dividend date. Dividends and distributions from the Trust portfolios are
reinvested in the respective portfolios and are reflected in the unit value of
the divisions of the Separate Account.
Share transactions are recorded on the trade date. Realized gains and losses on
sales of Trust shares are determined based on the identified cost basis.
UNIT VALUE
Unit values for the Separate Account divisions are computed at the end of each
business day. The unit value is equal to the unit value for the preceding
business day multiplied by a net investment factor. This net investment factor
is determined based on the value of the underlying mutual fund portfolios of the
Separate Account, reinvested dividends and capital gains, new premium deposits
or withdrawals, and the daily asset charge for the mortality and expense risk
and administrative charges. Unit values are adjusted daily for all activity in
the Separate Account.
TAXES
Operations of the Separate Account are included in the income tax return of
Integrity, which is taxed as a life insurance company under the Internal Revenue
Code. The Separate Account will not be taxed as a regulated investment company
under Subchapter M of the Internal Revenue Code. Under the provisions of the
policies, Integrity has the right to charge the Separate Account for federal
income tax attributable to the Separate Account. No charge is currently being
made against the Separate Account for such tax since, under current tax law,
Integrity pays no tax on investment income and capital gains reflected in
variable life insurance policy reserves. However, Integrity retains the right to
charge for any federal income tax incurred which is attributable to the Separate
Account if the law is changed. Charges for state and local taxes, if any,
attributable to the Separate Account may also be made.
8
<PAGE>
Separate Account VUL
of
Integrity Life Insurance Company
Notes to Financial Statements (continued)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
2. INVESTMENTS
The aggregate cost of portfolio shares purchased and proceeds from portfolio
shares sold during the year ended December 31, 1998 and the cost of shares held
at December 31, 1998 for each division were as follows:
<TABLE>
<CAPTION>
DIVISION PURCHASES SALES COST
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Common Stock $ 3,046,767 $ 2,273,462 $ 13,805,739
Money Market 541,941 635,067 820,722
Balanced 927,373 827,537 5,545,265
Aggressive Stock 641,241 963,263 6,095,974
High Yield 151,032 144,485 440,153
Global 397,663 378,856 1,292,657
----------------
$ 28,000,510
----------------
----------------
</TABLE>
3. EXPENSES
Integrity assumes mortality and expense risks related to the operations of the
Separate Account and deducts a charge from the assets of the Separate Account at
an annual rate of 0.60% of policyholders' net assets to cover these risks.
Integrity makes deductions for administrative expenses and state premium taxes
from premiums before amounts are allocated to the Separate Account.
9
<PAGE>
4. YEAR 2000 (UNAUDITED)
ARM has undertaken a Year 2000 project that includes all of its subsidiaries,
including the Company. ARM's Year 2000 compliance project, as it relates to the
Company, is provided for under the Investment Services Agreement and
Administrative Services Agreement between ARM and the Company. The cost of ARM's
Year 2000 initiatives is not expected to be material to ARM's results of
operations or financial condition. Likewise, any cost to the Company related to
Year 2000 compliance is not expected to be material to the Company's results of
operations or financial condition.
ARM has completed the assessment phase of the project for all production
applications, hardware (personal computers and servers), system software,
vendors, and business partners. Although ARM is still receiving information from
a few vendors and business partners and assessing various logistic concerns with
its facilities, ARM's major production systems are substantially Year 2000
compliant. Where Year 2000 problems were found, the necessary upgrades and
repairs have begun and are scheduled for completion no later than May 31, 1999.
As well as assessing its facilities, ARM is also in the repair and certification
testing phase of its project. The testing phase will serve to verify the results
of repairs and assessments. Steps needed to correct any problems uncovered
during testing will begin immediately at that time. ARM's Year 2000 project is
well underway and because management believes that it will be Year 2000
compliant by May 31, 1999, it currently has no contingency plans for system
issues in place beyond its normal disaster recovery procedures. As a precaution,
ARM is developing a contingency and business resumption plan to address various
logistic concerns with its facilities. The contingency and business resumption
plan is scheduled for completion no later than September 30, 1999.
Although ARM anticipates no major interruption of business activities, that will
depend, in part, upon the activity of third parties. Even though ARM has
assessed and continues to assess third party issues, it has no direct ability to
influence the compliance actions of such parties. Accordingly, while ARM
believes its actions in this regard should have the effect of reducing Year 2000
risks, it is unable to eliminate them or to estimate the ultimate effect Year
2000 risks will have on the Company's operations.
10
<PAGE>
4. YEAR 2000 (UNAUDITED) (CONTINUED)
The estimated date on which ARM believes it will complete its Year 2000
compliance efforts, and the expenses related to ARM's Year 2000 compliance
efforts are based upon management's best estimates, which were based on
assumptions of future events, including the availability of certain resources,
third party modification plans and other factors. There can be no assurance that
these results and estimates will be achieved, and the actual results could
materially differ from those anticipated.
11
<PAGE>
Financial Statements
(Statutory Basis)
Integrity Life Insurance Company
YEARS ENDED DECEMBER 31, 1998 AND 1997
WITH REPORT OF INDEPENDENT AUDITORS
<PAGE>
Integrity Life Insurance Company
Financial Statements
(Statutory Basis)
Years Ended December 31, 1998 and 1997
CONTENTS
<TABLE>
<S> <C>
Report of Independent Auditors..........................................................................1
Audited Financial Statements
Balance Sheets (Statutory Basis)........................................................................3
Statements of Income (Statutory Basis)..................................................................5
Statements of Changes in Capital and Surplus (Statutory Basis)..........................................6
Statements of Cash Flows (Statutory Basis)..............................................................7
Notes to Financial Statements (Statutory Basis).........................................................9
</TABLE>
<PAGE>
Report of Independent Auditors
Board of Directors
Integrity Life Insurance Company
We have audited the accompanying statutory basis balance sheets of Integrity
Life Insurance Company as of December 31, 1998 and 1997, and the related
statutory basis statements of income, changes in capital and surplus, and cash
flows for the years then ended. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As described in Note 1 to the financial statements, the Company presents its
financial statements in conformity with accounting practices prescribed or
permitted by the Ohio Department of Insurance, which practices differ from
generally accepted accounting principles. The variances between such practices
and generally accepted accounting principles and the effects on the accompanying
financial statements are described in Note 1.
In our opinion, because of the effects of the matter described in the preceding
paragraph, the financial statements referred to above do not present fairly, in
conformity with generally accepted accounting principles, the financial position
of Integrity Life Insurance Company at December 31, 1998 and 1997, or the
results of its operations or its cash flows for the years then ended.
1
<PAGE>
However, in our opinion, the financial statements referred to above present
fairly, in all material respects, the financial position of Integrity Life
Insurance Company at December 31, 1998 and 1997, and the results of its
operations and its cash flows for the years then ended in conformity with
accounting practices prescribed or permitted by the Ohio Department of
Insurance.
/s/ Ernst & Young LLP
Louisville, Kentucky
February 9, 1999
2
<PAGE>
Integrity Life Insurance Company
Balance Sheets (Statutory Basis)
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
-------------------------
(In thousands)
<S> <C> <C>
ADMITTED ASSETS
Cash and invested assets:
Bonds $4,562,340 $3,444,659
Preferred stocks 32,704 58,369
Investment in common stock of subsidiary 59,503 54,028
Mortgage loans 11,719 13,186
Policy loans 102,305 99,531
Cash and short-term investments 412,074 201,242
Other invested assets 53,435 27,591
---------- ----------
Total cash and invested assets 5,234,080 3,898,606
Separate account assets 2,124,250 1,822,557
Accrued investment income 47,091 38,247
Reinsurance balances receivable 1,048 4,837
Other admitted assets 2,097 207
---------- ----------
Total admitted assets $7,408,566 $5,764,454
---------- ----------
---------- ----------
</TABLE>
3
<PAGE>
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
----------------------------
(In thousands)
<S> <C> <C>
LIABILITIES AND CAPITAL AND SURPLUS
Liabilities:
Policy and contract liabilities:
Life and annuity reserves $ 1,512,538 $ 1,603,893
Funding agreement and GIC deposit fund liabilities 3,508,124 2,039,202
Unpaid claims 120 207
Deposits on policies to be issued, net 83 (1,715)
----------- -----------
Total policy and contract liabilities 5,020,865 3,641,587
Separate account liabilities 2,101,750 1,798,069
Accounts payable and accrued expenses 3,502 2,538
Transfers to separate accounts due or accrued, net (59,632) (42,028)
Reinsurance balances payable 9,194 14,602
Federal income taxes 64 763
Asset valuation reserve 34,578 23,368
Interest maintenance reserve 38,637 42,272
Other liabilities 12,920 71,523
----------- -----------
Total liabilities 7,161,878 5,552,694
Capital and surplus:
Common stock, $2 par value, 1,500,000 shares
authorized, issued and outstanding 3,000 3,000
Paid-in surplus 122,006 113,109
Unassigned surplus 121,682 95,651
----------- -----------
Total capital and surplus 246,688 211,760
----------- -----------
Total liabilities and capital and surplus $ 7,408,566 $ 5,764,454
----------- -----------
----------- -----------
</TABLE>
See accompanying notes.
4
<PAGE>
Integrity Life Insurance Company
Statements of Income (Statutory Basis)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997
-------------------------
(In thousands)
<S> <C> <C>
PREMIUMS AND OTHER REVENUES:
Premiums and annuity considerations $ 7,313 $ 13,386
Deposit-type funds 1,868,553 2,191,350
Net investment income 321,469 239,514
Amortization of the interest maintenance reserve 2,243 2,561
Income from separate account seed money investment -- 469
Other revenues 20,409 16,988
---------- ----------
Total premiums and other revenues 2,219,987 2,464,268
Benefits paid or provided:
Death benefits 5,528 5,136
Annuity benefits 240,573 136,630
Surrender benefits 297,863 408,615
Interest on funds left on deposit 162,137 84,652
Payments on supplementary contracts 10,982 10,659
Increase in reserves and deposit fund liabilities 1,216,263 945,161
---------- ----------
Total benefits paid or provided 1,933,346 1,590,853
---------- ----------
Insurance and other expenses:
Commissions 31,144 29,189
General expenses 23,542 15,869
Taxes, licenses and fees 1,483 1,111
Net transfers to separate accounts 186,486 785,374
Other expenses 1,710 3,354
---------- ----------
Total insurance and other expenses 244,365 834,897
---------- ----------
Gain from operations before federal income taxes and
net realized capital gains 42,276 38,518
---------- ----------
Federal income tax expense 5,456 2,871
---------- ----------
Gain from operations before net realized capital gains 36,820 35,647
Net realized capital gains, excluding realized capital
gains (losses), net of tax, transferred to the interest
maintenance reserve (1998-$(1,392); 1997-$6,239) 945 2,512
---------- ----------
Net income $ 37,765 $ 38,159
---------- ----------
---------- ----------
</TABLE>
See accompanying notes.
5
<PAGE>
Integrity Life Insurance Company
Statements of Changes in Capital and Surplus (Statutory Basis)
Years Ended December 31, 1998 and 1997
<TABLE>
<CAPTION>
TOTAL
COMMON PAID-IN UNASSIGNED CAPITAL AND
STOCK SURPLUS SURPLUS SURPLUS
----------------------------------------------------------------------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Balance, January 1, 1997 $ 3,000 $ 87,535 $ 73,299 $ 163,834
Net income 38,159 38,159
Net change in unrealized gain
of subsidiary 5,756 5,756
Increase in asset valuation reserve (9,563) (9,563)
Capital contribution, net 25,574 25,574
Dividends to shareholder (12,000) (12,000)
-------- --------- --------- ---------
Balance, December 31, 1997 3,000 113,109 95,651 211,760
Net income 37,765 37,765
Net change in unrealized gain
of subsidiary 5,475 5,475
Net change in nonadmitted
assets and related items 1 1
Increase in asset valuation reserve (11,210) (11,210)
Capital contribution 8,897 8,897
Dividends to shareholder (6,000) (6,000)
-------- --------- --------- ---------
Balance, December 31, 1998 $ 3,000 $ 122,006 $ 121,682 $ 246,688
-------- --------- --------- ---------
-------- --------- --------- ---------
</TABLE>
SEE ACCOMPANYING NOTES.
6
<PAGE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997
----------------------------
(In thousands)
<S> <C> <C>
OPERATIONS:
Premiums, policy proceeds, and other
considerations received $ 1,875,866 $ 2,204,736
Net investment income received 315,760 230,747
Commission and expense allowances received
on reinsurance ceded 904 3,838
Benefits paid (555,176) (561,208)
Insurance expenses paid (55,204) (46,819)
Other income received net of other expenses paid 17,100 9,092
Net transfers to separate accounts (204,091) (789,869)
Federal income taxes paid (1,814) (5,501)
--------- ---------
Net cash provided by operations 1,393,345 1,045,016
INVESTMENT ACTIVITIES:
Proceeds from sales, maturities, or repayments
of investments:
Bonds 4,854,879 3,407,120
Preferred stocks 86,730 87,435
Mortgage loans 1,467 19,760
Real estate -- 359
Other invested assets 63,054 10,216
Net gains (losses) on cash and short-term investments 580 (24)
Miscellaneous proceeds 1,050 3,436
--------- ---------
Total investment proceeds 5,007,760 3,528,302
Benefits recovered (taxes paid) on capital gains (3,264) 175
--------- ---------
Net proceeds from sales, maturities, or repayments
of investments 5,004,496 3,528,477
</TABLE>
7
<PAGE>
Integrity Life Insurance Company
Statements of Cash Flows (Statutory Basis) (continued)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997
---------------------------
(In thousands)
<S> <C> <C>
Cost of investments acquired:
Bonds 5,980,098 4,376,185
Preferred and common stocks 60,158 101,175
Other invested assets 85,759 31,931
Miscellaneous applications 2,731 --
---------- ---------
Total cost of investments acquired 6,128,746 4,509,291
Net increase in policy loans and premium notes 2,773 1,320
---------- ---------
Net cash used in investment activities (1,127,023) (982,134)
FINANCING AND MISCELLANEOUS ACTIVITIES:
Other cash provided:
Capital and surplus paid-in 8,897 40,000
Other sources 7,631 52,548
---------- ---------
Total other cash provided 16,528 92,548
Other cash applied:
Dividends to shareholder 6,000 12,000
Other applications, net 66,018 29,197
---------- ---------
Total other cash applied 72,018 41,197
---------- ---------
Net cash provided by (used in) financing and
miscellaneous activities (55,490) 51,351
---------- ---------
Net increase in cash and short-term investments 210,832 114,233
Cash and short-term investments at beginning of year 201,242 87,009
---------- ---------
Cash and short-term investments at end of year $ 412,074 $ 201,242
---------- ---------
---------- ---------
</TABLE>
See accompanying notes.
8
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)
December 31, 1998
1. ORGANIZATION AND ACCOUNTING POLICIES
ORGANIZATION
Integrity Life Insurance Company (the "Company") is an indirect wholly owned
subsidiary of ARM Financial Group, Inc. ("ARM"). ARM acquired the Company and
its wholly owned insurance subsidiary, National Integrity Life Insurance Company
("National Integrity"), on November 26, 1993 from The National Mutual Life
Association of Australasia Limited. The Company is domiciled in the state of
Ohio. The Company, currently licensed in 46 states and the District of Columbia,
and National Integrity specialize in the growing asset accumulation business
with particular emphasis on retirement savings and investment products.
In June 1997, ARM completed an initial public offering of 9.2 million shares of
its common stock of which 5.75 million shares were sold by ARM for net proceeds
of $78.8 million. The remaining 3.45 million shares were sold by certain private
equity funds sponsored by Morgan Stanley Dean Witter & Co. ("Morgan Stanley
Stockholders"). On June 30, 1997, ARM used a portion of such net proceeds to
make a $40 million capital contribution to the Company, thereby strengthening
the Company's capital base to provide for future growth. Simultaneously, the
Company paid a $14.4 million dividend of bonds held by the Company to ARM for a
net capital contribution of $25.6 million.
In May 1998, ARM completed a secondary public offering of approximately 12.4
million shares of common stock held by the Morgan Stanley Stockholders. As a
result of the secondary public offering, the Morgan Stanley Stockholders no
longer own any shares of ARM's outstanding stock.
BASIS OF PRESENTATION
The accompanying financial statements of the Company have been prepared in
conformity with accounting practices prescribed or permitted by the Ohio
Department of Insurance. Such practices vary from generally accepted accounting
principles ("GAAP"). The more significant variances from GAAP are as follows:
9
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
1. ORGANIZATION AND ACCOUNTING POLICIES (CONTINUED)
INVESTMENTS
Investments in bonds and preferred stocks are reported at amortized cost or
fair value based on the National Association of Insurance Commissioners'
("NAIC") rating; for GAAP, such fixed maturity investments are designated
at purchase as held-to-maturity, trading or available-for-sale.
Held-to-maturity fixed investments are reported at amortized cost, and the
remaining fixed maturity investments are reported at fair value with
unrealized holding gains and losses reported in operations for those
designated as trading and as a separate component of shareholder's equity
for those designated as available-for-sale. In addition, fair values of
certain investments in bonds and stocks are based on values specified by
the NAIC, rather than on actual or estimated fair values used for GAAP.
Realized gains and losses are reported in income net of income tax and
transfers to the interest maintenance reserve. Changes between cost and
admitted investment asset amounts are credited or charged directly to
unassigned surplus rather than to a separate surplus account. The Asset
Valuation Reserve is determined by an NAIC prescribed formula and is
reported as a liability rather than unassigned surplus. Under a formula
prescribed by the NAIC, the Company defers the portion of realized gains
and losses on sales of fixed income investments, principally bonds and
mortgage loans, attributable to changes in the general level of interest
rates and amortizes those deferrals over the remaining period to maturity
of the individual security sold using the seriatim method. The net deferral
is reported as the Interest Maintenance Reserve in the accompanying balance
sheets. Under GAAP, realized gains and losses are reported in the income
statement on a pretax basis in the period that the asset giving rise to the
gain or loss is sold and include provisions when there has been a decline
in asset values deemed other than temporary.
SUBSIDIARY
The accounts and operations of the Company's subsidiary are not
consolidated with the accounts and operations of the Company as would be
required under GAAP.
10
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
1. ORGANIZATION AND ACCOUNTING POLICIES (CONTINUED)
POLICY ACQUISITION COSTS
Costs of acquiring and renewing business are expensed when incurred.
Under GAAP, acquisition costs related to investment-type products, to
the extent recoverable from future gross profits, are amortized
generally in proportion to the emergence of gross profits over the
estimated term of the underlying policies.
NONADMITTED ASSETS
Certain assets designated as "nonadmitted," principally receivables
greater than 90 days past due, are excluded from the accompanying
balance sheets and are charged directly to unassigned surplus.
PREMIUMS AND BENEFITS
Revenues include premiums and deposits received and benefits include
death benefits paid and the change in policy reserves. Under GAAP, such
premiums and deposits received are accounted for as a deposit liability
and therefore not recognized as premium revenue; benefits paid equal to
the policy account value are accounted for as a return of deposit
instead of benefit expense.
BENEFIT RESERVES
Certain policy reserves are calculated using statutorily prescribed
interest and mortality assumptions rather than on expected experience or
actual account balances as would be required under GAAP.
FEDERAL INCOME TAXES
Deferred federal income taxes are not provided for differences between
the financial statement amounts and tax bases of assets and liabilities.
11
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
1. ORGANIZATION AND ACCOUNTING POLICIES (CONTINUED)
STATEMENT OF CASH FLOWS
Cash and short-term investments in the statement of cash flows represent
cash balances and investments with initial maturities of one year or
less. Under GAAP, the corresponding captions of cash and cash
equivalents include cash balances and investments with initial
maturities of three months or less.
The effects of the foregoing variances from GAAP on the accompanying statutory
basis financial statements are as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997
----------------------------
(In thousands)
<S> <C> <C>
Net income as reported in the accompanying
statutory basis financial statements $ 37,765 $ 38,159
Deferred policy acquisition costs, net of amortization 22,694 19,174
Adjustments to customer deposits (7,082) (10,224)
Adjustments to invested asset carrying values
at acquisition date (226) (69)
Amortization of value of insurance in force (5,426) (8,423)
Amortization of interest maintenance reserve (2,243) (2,561)
Adjustments for realized investment gains (losses) (4,043) 217
Adjustments for federal income tax expense (4,623) (4,419)
Investment in subsidiary 11,561 6,009
Eliminate dividend income from subsidiary (2,771) -
Other 2,237 3,300
--------- ---------
Net income, GAAP basis $ 47,843 $ 41,163
--------- ---------
--------- ---------
</TABLE>
12
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
1. ORGANIZATION AND ACCOUNTING POLICIES (CONTINUED)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997
----------------------------
(In thousands)
<S> <C> <C>
Capital and surplus as reported in the accompanying
statutory basis financial statements $ 246,688 $ 211,760
Adjustments to customer deposits (165,471) (150,973)
Adjustments to invested asset carrying values at
acquisition date 436 (2,342)
Asset valuation reserve and interest maintenance reserve 73,215 65,481
Value of insurance in force 27,097 35,924
Goodwill 2,968 3,997
Deferred policy acquisition costs 79,679 54,175
Adjustments to investment in subsidiary
excluding net unrealized gains (losses) 25,497 22,182
Net unrealized gains (losses) on available-for-sale securities (123,124) 21,317
Other 29,517 28,596
--------- ---------
Shareholder's equity, GAAP basis $ 196,502 $ 290,117
--------- ---------
--------- ---------
</TABLE>
Other significant accounting practices are as follows:
INVESTMENTS
Bonds, preferred stocks, common stocks, and short-term investments are stated at
values prescribed by the NAIC, as follows:
Bonds and short-term investments are reported at cost or amortized cost.
The discount or premium on bonds is amortized using the interest method.
For loan-backed bonds and structured securities, anticipated prepayments
are considered when determining the amortization of discount or premium.
Prepayment assumptions for loan-backed bonds and structured securities are
obtained from broker-dealer survey values or internal estimates. These
assumptions are consistent with the current interest rate and economic
environment. The retrospective adjustment method is used to value all such
securities.
13
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
1. ORGANIZATION AND ACCOUNTING POLICIES (CONTINUED)
Preferred stocks are reported at cost.
The Company's investment in its insurance subsidiary is reported at the
equity in the underlying statutory basis of National Integrity's net
assets. Changes in the admitted asset carrying amount of the investment are
credited or charged directly to unassigned surplus.
Short-term investments includes investments with maturities of less than
one year at the date of acquisition.
Mortgage loans and policy loans are reported at unpaid principal balances.
Realized capital gains and losses are determined using the average cost method.
BENEFITS
Life and annuity reserves are developed by actuarial methods and are determined
based on published tables using statutorily specified interest rates and
valuation methods that will provide, in the aggregate, reserves that are greater
than or equal to the minimum or guaranteed policy cash values or the amounts
required by the Ohio Department of Insurance. The Company waives deduction of
deferred fractional premiums upon the death of life and annuity policy insureds
and does not return any premium beyond the date of death. Surrender values on
policies do not exceed the corresponding benefit reserve. Policies issued
subject to multiple table substandard extra premiums are valued on the standard
reserve basis which recognizes the non-level incidence of the excess mortality
costs. Additional reserves are established when the results of cash flow testing
under various interest rate scenarios indicate the need for such reserves.
Tabular interest, tabular less actual reserve released, and tabular cost have
been determined by formula as prescribed by the NAIC.
Interest on funds left on deposit represents interest credited on funding
agreements and GIC deposit fund liabilities. Interest credited on all other life
and annuity reserves is included as a component of annuity or surrender
benefits.
14
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
1. ORGANIZATION AND ACCOUNTING POLICIES (CONTINUED)
REINSURANCE
Reinsurance premiums, benefits and expenses are accounted for on bases
consistent with those used in accounting for the original policies issued and
the terms of the reinsurance contracts. Premiums, benefits and expenses, and the
reserves for policy and contract liabilities are reported net, rather than
gross, of reinsured amounts.
SEPARATE ACCOUNTS
Separate account assets and liabilities reported in the accompanying financial
statements represent funds that are separately administered, principally for
variable annuity contracts and institutional funding agreements. Separate
account assets are reported at fair value. Surrender charges collectible by the
general account in the event of variable annuity contract surrenders are
reported as a negative liability rather than an asset pursuant to prescribed
NAIC accounting practices. Policy related activity involving cashflows, such as
premiums and benefits, are reported in the accompanying statements of income in
separate line items combined with related general account amounts. Investment
income and interest credited on deposits held in guaranteed separate accounts
are included in the accompanying statements of income as a net amount included
in net transfers to (from) separate accounts. The Company receives
administrative fees for managing the nonguaranteed separate accounts and other
fees for assuming mortality and certain expense risks. Such fees are included in
other revenues.
USE OF ESTIMATES
The preparation of financial statements in compliance with statutory accounting
practices requires management to make estimates and assumptions that affect
amounts reported in the financial statements and accompanying notes. Actual
results could differ from those estimates.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the
presentation of the 1998 financial statements. These reclassifications had no
effect on previously reported net income or surplus.
15
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
2. PERMITTED STATUTORY ACCOUNTING PRACTICES
The Company's statutory basis financial statements are prepared in accordance
with accounting practices prescribed or permitted by the Ohio Department of
Insurance. "Prescribed" statutory accounting practices include state laws,
regulations, and general administrative rules, as well as a variety of
publications of the NAIC. "Permitted" statutory accounting practices encompass
all accounting practices that are not prescribed; such practices may differ from
state to state, may differ from company to company within a state, and may
change in the future. In 1998, both the NAIC and the Ohio Department of
Insurance adopted codified statutory accounting principles ("Codification") with
an effective date of January 1, 2001. Codification will likely change, to some
extent, prescribed statutory accounting practices and may result in changes to
the accounting practices that the Company uses to prepare its statutory-basis
financial statements. The Company has not yet determined the impact of
Codification to its statutory-basis financial statements.
3. INVESTMENTS
The cost or amortized cost and the fair value of investments in bonds are
summarized as follows:
<TABLE>
<CAPTION>
Cost or Gross Gross
Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
--------------------------------------------------------------------
(In thousands)
<S> <C> <C> <C> <C>
At December 31, 1998:
Mortgage-backed securities $ 1,969,989 $ - $ - $ 1,969,989
Corporate securities 1,803,209 5,445 53,873 1,754,781
Asset-backed securities 497,116 - - 497,116
U.S. Treasury securities and
obligations of U.S. government
agencies 258,659 206 741 258,124
Foreign governments 29,412 - 999 28,413
States and political
subdivisions 3,955 158 - 4,113
------------- ------------- ------------- -------------
Total bonds $ 4,562,340 $ 5,809 $ 55,613 $ 4,512,536
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
</TABLE>
16
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
3. INVESTMENTS (CONTINUED)
<TABLE>
<CAPTION>
Cost or Gross Gross
Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
--------------------------------------------------------------------
(In thousands)
At December 31, 1997:
<S> <C> <C> <C> <C>
Mortgage-backed securities $ 1,606,968 $ - $ - $ 1,606,968
Corporate securities 1,132,531 13,329 7,533 1,138,327
Asset-backed securities 374,841 - - 374,841
U. S. Treasury securities and
obligations of U.S. government
agencies 276,801 714 7 277,508
Foreign governments 49,513 121 437 49,197
States and political subdivisions
4,005 160 - 4,165
------------- ------------- ------------- -------------
Total bonds $ 3,444,659 $ 14,324 $ 7,977 $ 3,451,006
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
</TABLE>
Fair values are based on published quotations of the Securities Valuation Office
of the NAIC. Fair values generally represent quoted market value prices for
securities traded in the public marketplace, or analytically determined values
using bid or closing prices for securities not traded in the public marketplace.
However, for certain investments for which the NAIC does not provide a value,
the Company uses the amortized cost amount as a substitute for fair value in
accordance with prescribed guidance. As of December 31, 1998 and 1997, the fair
value of investments in bonds includes $3.8 billion and $2.9 billion,
respectively, of bonds that were valued at amortized cost.
17
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
3. INVESTMENTS (CONTINUED)
A summary of the cost or amortized cost and fair value of the Company's
investments in bonds at December 31, 1998, by contractual maturity, is as
follows:
<TABLE>
<CAPTION>
Cost or
Amortized Fair
Cost Value
------------------------------------
(In thousands)
Years to maturity:
<S> <C> <C>
One or less $ 22,292 $ 22,254
After one through five 131,959 129,762
After five through ten 338,367 326,435
After ten 1,602,617 1,566,980
Asset-backed securities 497,116 497,116
Mortgage-backed securities 1,969,989 1,969,989
------------- -------------
Total $ 4,562,340 $ 4,512,536
------------- -------------
------------- -------------
</TABLE>
The expected maturities in the foregoing table may differ from the contractual
maturities because certain borrowers have the right to call or prepay
obligations with or without call or prepayment penalties and because
asset-backed and mortgage-backed securities (including floating-rate securities)
provide for periodic payments throughout their life.
Proceeds from the sales of investments in bonds during 1998 and 1997 were $4.1
billion and $2.9 billion; gross gains of $26.5 million and $34.9 million, and
gross losses of $26.8 million and $26.9 million were realized on those sales,
respectively.
At December 31, 1998 and 1997, bonds with an admitted asset value of $7,521,000
and $7,664,000, respectively, were on deposit with state insurance departments
to satisfy regulatory requirements.
18
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
3. INVESTMENTS (CONTINUED)
Unrealized gains and losses on investment in subsidiary are reported directly in
surplus and do not affect operations. The gross unrealized gains and losses on,
and the cost and fair value of, the investment are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross
Cost Unrealized Unrealized
Gains Losses Fair Value
------------------------------------------------------------------
(In thousands)
<S> <C> <C> <C> <C>
At December 31, 1998:
Subsidiary $ 17,823 $ 41,680 $ - $ 59,503
--------- --------- ------- ---------
--------- --------- ------- ---------
At December 31, 1997:
Subsidiary $ 17,823 $ 36,205 $ - $ 54,028
--------- --------- ------- ---------
--------- --------- ------- ---------
</TABLE>
The Company's mortgage loan portfolio is primarily comprised of agricultural
loans. The Company made no new investments in mortgage loans during 1998. The
maximum percentage of any one loan to the value of the security at the time of
the loan exclusive of any purchase money mortgages was 75%. Fire insurance is
required on all properties covered by mortgage loans. As of December 31, 1998,
the Company held no mortgages with interest more than one year past due. During
1998, no interest rates of outstanding mortgage loans were reduced. No amounts
have been advanced by the Company.
19
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
3. INVESTMENTS (CONTINUED)
Major categories of the Company's net investment income are summarized as
follows:
<TABLE>
<CAPTION>
Year Ended December 31,
1998 1997
-------------------------------
(In thousands)
Income:
<S> <C> <C>
Bonds $ 299,122 $ 216,166
Preferred stocks 3,226 6,042
Dividend from subsidiary 2,771 -
Mortgage loans 1,100 5,619
Real estate - 158
Policy loans 7,544 6,842
Cash and short-term investments 15,335 7,072
Other investment income 2,091 880
------------- -------------
Total investment income 331,189 242,779
Investment expenses (2,807) (3,265)
Interest expense on repurchase agreements (6,913) -
------------- -------------
Net investment income $ 321,469 $ 239,514
------------- -------------
------------- -------------
</TABLE>
4. DERIVATIVE INSTRUMENTS
The Company offers equity-indexed products through its separate accounts that
meet consumer demand for equity investments with downside protection. In
connection with this product the Company acquired 356 S&P 500 futures contracts
during 1998. The Company acquired the futures through the use of a margin
account whereby the Company maintains a minimum cash balance of approximately
$10,000 per contract. Should the S&P 500 fall below the level determined at the
acquisition date, the Company would be required to add additional cash to the
margin account based on the change in the S&P 500's market value. Should the S&P
500 increase from its level at the inception of the contract, cash would be
added by the counterparty to the margin account. Unrealized market value gains
on the futures are recorded in the separate accounts statement of operations to
hedge against the Company's obligation to pay equity-indexed returns to
policyholders. As of December 31, 1998, outstanding futures had unrealized gains
of approximately $5.8 million.
20
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
4. DERIVATIVE INSTRUMENTS (CONTINUED)
During 1998, the Company purchased an interest rate cap for $5,225,000 and sold
an interest rate floor for $1,425,000, each having a contractrual notional
amount of $1.0 billion. The objective for holding these instruments is to limit
exposure to volatility of interest credited payments for variable rate
institutional spread deposits. Both the purchase price of the cap and the
proceeds from the floor will be amortized into operations using the interest
method over the lives of the cap and floor, respectively. Payments received from
the cap or made on the floor are recorded in the statement of operations as an
offset to interest on contract or policy funds.
The Company holds institutional spread deposits in its general account. The
Company uses interest rate swaps to reduce the interest rate exposure arising
from mismatches between the assets and liabilities related to the deposits. The
Company agreed to exchange with other parties a fixed-rate of interest it
receives on certain investment securities for floating-rate interest amounts
calculated by reference to agreed-upon notional principal amounts. On certain
contracts entered into during 1998, the Company received $1,138,750 of
consideration as part of the swaps that will be amortized into operating
earnings over the life of the swaps. A single net payment is made by one
counterparty at each date. The Company has approximately $346 million of
notional principal contracts outstanding in the general account at December 31,
1998.
During 1998, the Company entered into total yield swap transactions with two
affiliates of the Company, 312 Certificate Company ("312CC") and 212 Certificate
Company ("212CC"). 312CC and 212CC were established as special purpose entities
to offer privately placed certificates. These swaps are considered off-balance
sheet items.
The swap transactions generally provide that the Company pays an amount that
approximates the interest credited to be paid to certificate holders plus
outside credit enhancement fees and receives the book income of the 312CC and
212CC investment portfolios, less investment advisory expenses. The Company
accounts for the swap activity in its guaranteed separate account. During 1998,
the Company recorded approximately $962,000 and $414,000 of net investment
income from 312CC and 212CC, respectively, in its separate account summary of
operations.
21
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
4. DERIVATIVE INSTRUMENTS (CONTINUED)
The 312CC swap transaction provides that the Company increase the fair market
value of the 312CC investment portfolio to equal the account value of the
certificate ("account value") if the ratio of the investment portfolio fair
value to account value is less than 97%. The 212CC swap transaction provides
that the Company maintains the fair value of the 212CC investment portfolio to
be no less than 97% of the account value. However, from time to time ARM may
make capital contributions to 312CC and 212CC as necessary to maintain the fair
value of the investment portfolios at or near account value. Such infusions
would serve to mitigate the Company's obligation to make the above payments
under the swaps. During 1998, ARM made a $6 million capital contribution to
312CC.
Certain events may cause the 312CC and 212CC certificates to be paid prior to
their stated maturity dates. If such an event occurs and the fair value of the
312CC or 212CC investment portfolio is less than account value, the swap
transactions provide that the Company contribute the difference.
The Company is exposed to credit-related losses in the event of nonperformance
by counterparties to the financial instruments, but does not expect any
counterparties to fail to meet their obligations given their high credit
ratings.
5. REINSURANCE
Consistent with prudent business practices and the general practice of the
insurance industry, the Company reinsures risks under certain of its insurance
products with other insurance companies through reinsurance agreements. Through
these reinsurance agreements, substantially all mortality risks associated with
single premium endowment and variable annuity deposits and substantially all
risks associated with variable life business have been reinsured with
non-affiliated insurance companies. A contingent liability exists with respect
to insurance ceded which would become a liability should the reinsurer be unable
to meet the obligations assumed under these reinsurance agreements.
22
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
5. REINSURANCE (CONTINUED)
The effect of reinsurance on premiums, annuity considerations and deposit-type
funds is as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
1998 1997
----------------------------
(In thousands)
<S> <C> <C>
Direct premiums and amounts assessed
against policyholders $ 421,637 $ 1,005,583
Reinsurance assumed 1,474,079 1,217,681
Reinsurance ceded (19,850) (18,528)
---------- -----------
Net premiums, annuity considerations and
deposit-type funds $ 1,875,866 $ 2,204,736
----------- -----------
----------- -----------
</TABLE>
In 1998 and 1997, the Company assumed $1.5 billion and $1.1 billion,
respectively, in funding agreement and GIC deposits through a 50% coinsurance
agreement with General American Life Insurance Company.
6. FEDERAL INCOME TAXES
The Company files a consolidated return with National Integrity. The method of
allocation between the companies is based on separate return calculations with
current benefit being given for the use of National Integrity's losses and
credits in the consolidated return.
Income before income taxes differs from taxable income principally due to value
of insurance in force, interest maintenance reserves, and differences in policy
and contract liabilities and investment income for tax and financial reporting
purposes.
The prior year tax provision was calculated including a consolidated net
operating loss carryover benefit of $12.4 million.
23
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
7. SURPLUS
The ability of the Company to pay dividends is limited by state insurance laws.
Under Ohio insurance laws, the Company may pay dividends, without the approval
of the Ohio Director of Insurance, only from earned surplus and those dividends
may not exceed (when added to other dividends paid in the proceeding 12 months)
the greater of (i) 10% of the Company's statutory capital and surplus as of the
preceding December 31, or (ii) the Company's statutory net income for the
preceding year. The maximum dividend payments that may be made by the Company to
ARM during 1999 are $37.8 million.
Under New York insurance laws, National Integrity may pay dividends to the
Company only out of its earnings and surplus, subject to at least thirty days
prior notice to the New York Insurance Superintendent and no disapproval from
the Superintendent prior to the date of such dividend. The Superintendent may
disapprove a proposed dividend if the Superintendent finds that the financial
condition of National Integrity does not warrant such distribution. During 1998,
the Company received dividends of $2.8 million from National Integrity.
The NAIC's Risk-Based Capital ("RBC") requirements attempt to evaluate the
adequacy of a life insurance company's adjusted statutory capital and surplus in
relation to investment, insurance and other business risks. The RBC formula is
used by the states as an early warning tool to identify possible
under-capitalized companies for the purpose of initiating regulatory action and
is not designed to be a basis for ranking the financial strength of insurance
companies. In addition, the formula defines a new minimum capital standard which
supplements the previous system of low fixed minimum capital and surplus
requirements. The RBC requirements provide for four different levels of
regulatory attention depending on the ratio of the company's adjusted capital
and surplus to its RBC. As of December 31, 1998 and 1997, the adjusted capital
and surplus of the Company is substantially in excess of the minimum level of
RBC that would require regulatory response.
24
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
8. ANNUITY RESERVES
At December 31, 1998 and 1997, the Company's general and separate account
annuity reserves and deposit fund liabilities that are subject to discretionary
withdrawal (with adjustment), subject to discretionary withdrawal without
adjustment, and not subject to discretionary withdrawal provisions are
summarized as follows:
<TABLE>
<CAPTION>
Amount Percent
----------------------------
(In thousands)
<S> <C> <C>
At December 31, 1998:
Subject to discretionary withdrawal (with adjustment):
With market value adjustment $ 404,623 6.0%
At book value less surrender charge of 5% or more 215,430 3.2
At market value 1,019,880 15.1
---------- ----------
Total with adjustment or at market value 1,639,933 24.3
Subject to discretionary withdrawal (without adjustment)
at book value with minimal or no charge or adjustment 4,500,408 66.7
Not subject to discretionary withdrawal 607,460 9.0
---------- ----------
Total annuity reserves and deposit fund liabilities (before
reinsurance) 6,747,801 100.0%
----------
----------
Less reinsurance ceded (28,045)
----------
Net annuity reserves and deposit fund liabilities $6,719,756
----------
----------
At December 31, 1997:
Subject to discretionary withdrawal (with adjustment):
With market value adjustment $ 348,451 7.0%
At book value less surrender charge of 5% or more 235,360 4.7
At market value 711,105 14.3
---------- ----------
Total with adjustment or at market value 1,294,916 26.0
Subject to discretionary withdrawal (without adjustment)
at book value with minimal or no charge or adjustment 3,095,701 62.1
Not subject to discretionary withdrawal 594,781 11.9
---------- ----------
Total annuity reserves and deposit fund liabilities (before
reinsurance) 4,985,398 100.0%
----------
----------
Less reinsurance ceded (34,721)
----------
Net annuity reserves and deposit fund liabilities $4,950,677
----------
----------
</TABLE>
25
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
9. SEPARATE ACCOUNTS
The Company's guaranteed separate accounts include indexed products (i.e.,
equity-indexed annuities and an institutional funding agreement) and non-indexed
products and options (i.e., guaranteed rate options and systematic transfer
options). The guaranteed rate options are sold as a fixed annuity product or as
an investment option within the Company's variable annuity products. The
Company's equity-indexed annuities provide participation in the S&P 500 Price
Index.
The Company's nonguaranteed separate accounts primarily include variable
annuities. The net investment experience of variable annuities is credited
directly to the policyholder and can be positive or negative. Assets held in
separate accounts are carried at estimated fair values. Information regarding
the separate accounts of the Company as of and for the year ended December 31,
1998 is as follows:
<TABLE>
<CAPTION>
Separate Accounts With
Guarantees
---------------------------------
Nonindexed Nonguaranteed
Guaranteed Separate
Indexed More Than 4% Accounts Total
---------------------------------------------------------------------
(In thousands)
<S> <C> <C> <C> <C>
Premiums, deposits and other
considerations $ 33,456 $ 132,280 $ 185,181 $ 350,917
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Reserves for separate accounts with
assets at fair value $ 587,033 $ 409,143 $ 1,053,699 $ 2,049,875
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
Reserves for separate accounts
by withdrawal characteristics:
Subject to discretionary withdrawal
(with adjustment):
With market adjustment $ 45,784 $ 358,839 $ - $ 404,623
At book value without market
value adjustment and with
current surrender charge of
5% or more - 50,304 - 50,304
At market value - - 1,053,699 1,053,699
------------- ------------- ------------- -------------
Total with adjustment or at market
value 45,784 409,143 1,053,699 1,508,626
Not subject to discretionary
withdrawal 541,249 - - 541,249
------------- ------------- ------------- -------------
Total separate accounts reserves $ 587,033 $ 409,143 $ 1,053,699 $ 2,049,875
------------- ------------- ------------- -------------
------------- ------------- ------------- -------------
</TABLE>
26
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
9. SEPARATE ACCOUNTS (CONTINUED)
A reconciliation of the amounts transferred to and from the separate accounts
for the years ended December 31, 1998 and 1997 is presented below:
<TABLE>
<CAPTION>
1998 1997
----------------------------
(In thousands)
<S> <C> <C>
Transfers as reported in the Summary of Operations
of the Separate Accounts Statement:
Transfers to separate accounts $ 350,917 $ 874,585
Transfers from separate accounts (166,508) (91,038)
--------- ---------
Net transfers to separate accounts 184,409 783,547
Reconciling adjustments:
Policy deductions and other expense reported as
other revenues 2,077 1,827
--------- ---------
Transfers as reported in the Summary of Operations
of the Life, Accident and Health Annual Statement $ 186,486 $ 785,374
--------- ---------
--------- ---------
</TABLE>
10. FAIR VALUES OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures About
Fair Value of Financial Instruments," requires disclosure of fair value
information about all financial instruments, including insurance liabilities
classified as investment contracts, unless specifically exempted. The fair value
of a financial instrument is the amount at which the instrument could be
exchanged in a current transaction between willing parties, other than in a
forced or liquidation sale. In cases where quoted market prices are not
available, fair values are based on estimates using present value or other
valuation techniques. Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows. Accordingly, the aggregate fair value amounts presented do not
necessarily represent the underlying value of such instruments. For financial
instruments not separately disclosed below, the carrying amount is a reasonable
estimate of fair value.
27
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
10. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
-----------------------------------------------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
-----------------------------------------------------------------------
(In thousands)
Assets:
<S> <C> <C> <C> <C>
Bonds $ 4,562,340 $ 4,390,941 $ 3,444,659 $ 3,484,364
Preferred stocks 32,704 32,643 58,369 59,964
Mortgage loans 11,719 11,719 13,186 13,186
Cash and short-term investments 412,074 412,074 201,242 201,242
Liabilities:
Life and annuity reserves for
investment-type contracts and deposit
fund liabilities $ 4,705,091 $ 4,669,365 $ 3,320,869 $ 3,379,388
Separate accounts annuity reserves
2,016,056 2,001,161 1,630,787 1,607,081
</TABLE>
BONDS AND PREFERRED STOCKS
Fair values for bonds and preferred stocks are based on quoted market prices
where available. For bonds and preferred stocks for which a quoted market price
is not available, fair values are estimated using internally calculated
estimates or quoted market prices of comparable investments.
MORTGAGE LOANS AND CASH AND SHORT-TERM INVESTMENTS
The carrying amount of mortgage loans and cash and short-term investments
approximates their fair value.
LIFE AND ANNUITY RESERVES FOR INVESTMENT-TYPE CONTRACTS AND DEPOSIT FUND
LIABILITIES
The fair value of single premium immediate annuity reserves are based on
discounted cash flow calculations using a market yield rate for assets with
similar durations. The fair value amount of institutional deposits represents
the estimated present value of cash flows using current market rates and the
duration of the liabilities. The fair value amounts of deposit fund
28
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
10. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
liabilities and the remaining annuity reserves are primarily based on the cash
surrender values of the underlying contracts.
SEPARATE ACCOUNTS ANNUITY RESERVES
The fair value of separate accounts annuity reserves for investment-type
products equals the cash surrender values.
11. RELATED PARTY TRANSACTIONS
Effective January 1, 1995, the Company entered into an Administrative Services
and an Investment Services Agreement with ARM. ARM performs certain
administrative and special services for the Company to assist with its business
operations. The services include policyholder services; accounting, tax and
auditing; underwriting; marketing and product development; functional support
services; payroll functions; personnel functions; administrative support
services; and investment functions. During 1998 and 1997, the Company was
charged $27.2 million and $19.3 million, respectively, for these services in
accordance with the requirements of applicable insurance law and regulations.
12. YEAR 2000 (UNAUDITED)
ARM has undertaken a Year 2000 project that includes all of its subsidiaries,
including the Company. ARM's Year 2000 compliance project, as it relates to the
Company, is provided for under the Investment Services Agreement and
Administrative Services Agreement between ARM and the Company. The cost of ARM's
Year 2000 initiatives is not expected to be material to ARM's results of
operations or financial condition. Likewise, any cost to the Company related to
Year 2000 compliance is not expected to be material to the Company's results of
operations or financial condition.
ARM has completed the assessment phase of the project for all production
applications, hardware (personal computers and servers), system software,
vendors, and business partners. Although ARM is still receiving information from
a few vendors and business partners and assessing various logistic concerns with
its facilities, ARM's major production systems are substantially Year 2000
compliant. Where Year 2000 problems were found, the necessary upgrades and
repairs have begun and are scheduled for completion no later than May 31, 1999.
29
<PAGE>
Integrity Life Insurance Company
Notes to Financial Statements (Statutory Basis)(continued)
12. YEAR 2000 (UNAUDITED) (CONTINUED)
As well as assessing its facilities, ARM is also in the repair and certification
testing phase of its project. The testing phase will serve to verify the results
of repairs and assessments. Steps needed to correct any problems uncovered
during testing will begin immediately at that time. ARM's Year 2000 project is
well underway and because management believes that it will be Year 2000
compliant by May 31, 1999, it currently has no contingency plans for system
issues in place beyond its normal disaster recovery procedures. As a precaution,
ARM is developing a contingency and business resumption plan to address various
logistic concerns with its facilities. The contingency and business resumption
plan is scheduled for completion no later than September 30, 1999.
Although ARM anticipates no major interruption of business activities, that will
depend, in part, upon the activity of third parties. Even though ARM has
assessed and continues to assess third party issues, it has no direct ability to
influence the compliance actions of such parties. Accordingly, while ARM
believes its actions in this regard should have the effect of reducing Year 2000
risks, it is unable to eliminate them or to estimate the ultimate effect Year
2000 risks will have on the Company's operations.
The estimated date on which ARM believes it will complete its Year 2000
compliance efforts, and the expenses related to ARM's Year 2000 compliance
efforts are based upon management's best estimates, which were based on
assumptions of future events, including the availability of certain resources,
third party modification plans and other factors. There can be no assurance that
these results and estimates will be achieved, and the actual results could
materially differ from those anticipated.
