<PAGE>
================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the period ended: March 31, 1996
Commission file number: 33-67268
-----------
ARM FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 61-1244251
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
239 S. FIFTH STREET, 12TH FLOOR
LOUISVILLE, KENTUCKY 40202
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (502) 582-7900
Indicate by check mark whether the registrant (i) 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 (ii) has been subject to such
filing requirements for the past 90 days. [X] Yes [_] No
As of March 31, 1996, 23,775 and 1,000 shares of the registrant's
Class A and Class B common stock, respectively, were outstanding, all of which
are privately owned and not traded on a public market.
================================================================================
<PAGE>
<TABLE>
<CAPTION>
TABLE OF CONTENTS
Item Page
- - ---- ----
PART I. FINANCIAL INFORMATION
<S> <C>
1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets--March 31, 1996
and December 31, 1995...................................... 3
Condensed Consolidated Statements of Operations--
Three Months Ended March 31, 1996 and 1995................. 5
Condensed Consolidated Statements of Cash Flows--
Three Months Ended March 31, 1996 and 1995................. 6
Notes to Condensed Consolidated Financial Statements......... 7
2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.......................... 11
PART II. OTHER INFORMATION
1. Legal Proceedings.............................................. 19
6. Exhibits and Reports on Form 8-K............................... 19
Signatures..................................................... 20
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
CARRYING AMOUNT FAIR VALUE
------------------------ -------------------------
MARCH 31, DECEMBER 31, MARCH 31, DECEMBER 31,
(In thousands) 1996 1995 1996 1995
- - ---------------------------------------------------------------------- -------------------------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
ASSETS
Cash and investments:
Fixed maturities available-for-sale, at
fair value (amortized cost: March 31,
1996-$2,642,375; December 31,
1995-$2,490,843) $2,627,945 $2,547,909 $2,627,945 $2,547,909
Equity securities, at fair value (cost:
March 31, 1996-$32,037;
December 31, 1995-$10,756) 32,360 11,751 32,360 11,751
Mortgage loans on real estate 42,933 43,943 42,933 43,943
Policy loans 119,499 117,528 119,499 117,528
Cash and cash equivalents 176,884 76,896 176,884 76,896
------------------------- -------------------------
Total cash and investments 2,999,621 2,798,027 2,999,621 2,798,027
Separate account assets 867,732 809,927 867,732 809,927
Accrued investment income 35,308 36,382 35,308 36,382
Value of insurance in force 62,725 51,051 111,386 98,977
Deferred policy acquisition costs 45,930 43,113 -- --
Goodwill 8,002 8,124 8,002 8,124
Deferred federal income taxes 40,481 19,776 46,586 48,642
Other assets 24,223 27,180 24,223 27,180
------------------------- -------------------------
Total assets $4,084,022 $3,793,580 $4,092,858 $3,827,259
========================= =========================
</TABLE>
3
<PAGE>
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (CONTINUED)
<TABLE>
<CAPTION>
CARRYING AMOUNT FAIR VALUE
------------------------ -------------------------
MARCH 31, DECEMBER 31, MARCH 31, DECEMBER 31,
(In thousands) 1996 1995 1996 1995
- - ----------------------------------------------------------------------- -------------------------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits $2,901,572 $2,708,260 $2,869,614 $2,742,209
Separate account customer deposits 866,620 808,345 866,620 808,345
Long-term debt 40,000 40,000 40,000 40,000
Payable for investment securities
purchased 95,757 8,538 95,757 8,538
Accounts payable and accrued expenses 11,797 15,496 11,797 15,496
Other liabilities 14,300 24,950 14,300 24,950
------------------------ -------------------------
Total liabilities 3,930,046 3,605,589 3,898,088 3,639,538
Contingencies
Shareholders' equity:
Preferred stock, $25.00 stated value 50,000 50,000
Class A common stock, $.01 par value,
23,775 and 23,770 shares issued,
respectively * *
Class B common stock, $.01 par value,
1,000 shares issued * *
Additional paid-in capital 124,456 124,425
Net unrealized gains (losses) on
available-for sale securities (8,813) 28,530
Retained-earnings deficit (11,667) (14,964)
------------------------
Total shareholders' equity 153,976 187,991 194,770 187,721
------------------------ -------------------------
Total liabilities and shareholders' equity $4,084,022 $3,793,580 $4,092,858 $3,827,259
========================= =========================
</TABLE>
* Less than $1,000.
See accompanying notes.
4
<PAGE>
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1996 AND 1995
<TABLE>
<CAPTION>
(In thousands, except per share data) 1996 1995
- - --------------------------------------------------------------------------
<S> <C> <C>
Investment income $ 55,193 $ 39,592
Interest credited on customer deposits (41,115) (30,149)
-------------------
Net investment spread 14,078 9,443
Fee income:
Variable annuity fees 2,362 1,474
Asset management fees 1,515 453
Other fee income 285 83
-------------------
Total fee income 4,162 2,010
Other income and expenses:
Surrender charges 1,570 566
Operating expenses (7,357) (5,132)
Commissions, net of deferrals (653) (191)
Interest expense on long-term debt (787) (976)
Amortization:
Deferred policy acquisition costs (1,687) (582)
Value of insurance in force (2,057) (1,005)
Acquisition-related deferred charges (126) (1,066)
Goodwill (122) --
Other, net (560) (186)
-------------------
Total other income and expenses (11,779) (8,572)
Realized investment losses, net (403) (2,511)
-------------------
Income before federal income taxes 6,058 370
Federal income tax expense (1,573) (196)
-------------------
Net income 4,485 174
Dividends on preferred stock (1,188) (1,188)
-------------------
Net income (loss) applicable to common shareholders $ 3,297 $ (1,014)
===================
Net income (loss) per common share $ 133.09 $ (67.60)
===================
Average common shares outstanding 24,773 15,000
===================
</TABLE>
See accompanying notes.
5
<PAGE>
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE THREE MONTHS ENDED MARCH 31, 1996 AND 1995
<TABLE>
<CAPTION>
(In thousands) 1996 1995
- - ------------------------------------------------------------------------------
<S> <C> <C>
CASH FLOWS PROVIDED BY OPERATING ACTIVITIES $ 36,533 $ 24,882
CASH FLOWS PROVIDED BY (USED IN) INVESTING ACTIVITIES:
Fixed maturity investments:
Purchases (767,864) (88,389)
Maturities and redemptions 46,702 16,343
Sales 663,577 81,591
Other investments:
Purchases (23,893) (5,746)
Maturities and redemptions 1,011 1,108
Sales 2,827 --
Policy loans, net (1,971) (1,550)
Purchase of separate account assets (59,616) (49,918)
Proceeds from sale of separate account assets 22,272 8,938
--------------------
Cash flows used in investing activities (116,955) (37,623)
CASH FLOWS PROVIDED BY (USED IN) FINANCING ACTIVITIES:
Amounts received from customers 309,293 58,012
Amounts paid to customers (115,687) (81,881)
Change in repurchase agreement liability (12,008) 16,966
Preferred stock dividends (1,188) (1,188)
--------------------
Cash flows provided by (used in) financing activities 180,410 (8,091)
--------------------
Net change in cash and cash equivalents 99,988 (20,832)
Cash and cash equivalents at beginning of period 76,896 45,855
--------------------
Cash and cash equivalents at end of period $ 176,884 $ 25,023
====================
</TABLE>
See accompanying notes.
6
<PAGE>
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
MARCH 31, 1996
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles
("GAAP") for interim financial information and with the instructions to Form 10-
Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by GAAP for complete financial statements. In
the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation have been included.
Operating results for the three months ended March 31, 1996 are not necessarily
indicative of those to be expected for the year ended December 31, 1996. For
further information, refer to the consolidated financial statements and
footnotes thereto included in the annual report on Form 10-K of ARM Financial
Group, Inc. (the "Company") for the year ended December 31, 1995.
Certain amounts from prior periods have been reclassified to conform to the
current period presentation. These reclassifications had no effect on previously
reported net income or shareholders' equity.
2. FAIR VALUE BALANCE SHEETS
The consolidated balance sheets include a dual presentation of carrying
amount and fair value balances. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in
Debt and Equity Securities", fixed maturities classified as available-for-sale
are reported at fair value in the carrying amount balance sheets; however,
corresponding customer deposits are reported at historical values. In contrast,
in the fair value balance sheets both assets and liabilities are reported at
fair value. As permitted by SFAS No. 107, "Disclosures About Fair Value of
Financial Instruments", the fair value balance sheets are presented as a
supplemental disclosure to provide a more meaningful picture of the Company's
financial position.
SFAS No. 107 requires disclosure of fair value information about all
financial instruments, including insurance liabilities classified as investment
contracts, unless specifically exempted. The accompanying fair value balance
sheets reflect fair values for those financial instruments specifically covered
by SFAS No. 107, along with fair value amounts for other assets and liabilities
for which disclosure is permitted but not required.
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
7
<PAGE>
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 the Company.
The Company's management of interest rate risk reduces its exposure to
changing interest rates through a close matching of duration, convexity and cash
flow characteristics of both assets and liabilities while maintaining liquidity
redundancies. As such, the Company believes that it will have only limited
volatility in its "fair value" adjusted shareholders' equity, although
volatility cannot be completely eliminated.
The following methods and assumptions were used in estimating fair values:
Fixed Maturities and Equity Securities
Fair values for fixed maturities and equity securities are based on quoted
market prices, where available. For fixed maturities for which a quoted market
price is not available, fair values are estimated using internally calculated
estimates or quoted market prices of comparable instruments.
Mortgage Loans on Real Estate
Pursuant to the terms of the acquisition of certain of the Company's
insurance operations, payments of principal and interest on substantially its
entire current mortgage loan portfolio are guaranteed by The National Mutual
Life Association of Australasia Limited ("National Mutual"). Principal received
in excess of statutory book value is to be returned to National Mutual.
Accordingly, book value is deemed to be fair value for these mortgage loans.
Policy Loans
The carrying amount of policy loans approximates their fair value.
Cash and Cash Equivalents and Accrued Investment Income
The carrying amount of cash and cash equivalents and accrued investment
income approximates their fair value given the short-term nature of these
assets.
Separate Account Assets and Separate Account Customer Deposits
Fair value of separate account assets is based on the quoted market prices
of the underlying mutual funds for assets invested in variable options. The fair
value of separate account assets invested in guaranteed rate options is
primarily based on quoted market prices of fixed maturity securities. The fair
value of separate account customer deposits is based on the account values of
the underlying policies, plus or minus market value adjustments applicable to
certain customers who are guaranteed a fixed rate of return.
Goodwill
The carrying amount of goodwill approximates fair value.
8
<PAGE>
Deferred Federal Income Taxes
Deferred federal income tax assets and related valuation allowance were
adjusted for federal income tax which may be incurred as a result of the
differences between the estimated fair values and carrying amounts of the assets
and liabilities.
Customer Deposits and Value of Insurance In Force
The fair value of customer deposits for structured settlements and
immediate annuities is based on discounted cash flow calculations using a
current market yield rate for assets with similar durations (i.e., indexed to
the U.S. Treasury yield curve). The fair value of customer deposits for
structured settlements and immediate annuities represents the fair values of
those insurance policies as a whole which implicitly eliminates the
corresponding value of insurance in force. The fair value amounts of the
remaining customer deposits, primarily deferred annuities, single premium
endowments, and guaranteed investment contracts, represent the account values of
the underlying contracts before applicable surrender charges. The fair value of
the value of insurance in force represents the estimated present value of future
profits for accumulation business, including variable annuities, assuming a
discount rate of 13%. Deferred policy acquisition costs do not appear on the
fair value presentation because those values are implicitly considered in the
determination of the fair value of the corresponding customer deposits and value
of insurance in force.
Long-Term Debt
The carrying amount of long-term debt approximates fair value.
Other Assets and Liabilities
The fair values of other assets and liabilities are reported at their
financial statement carrying amounts.
3. FEDERAL INCOME TAXES
Federal income taxes are different from the amount determined by
multiplying pretax earnings by the expected federal income tax rate of 35%. The
differences are primarily attributable to changes in valuation allowances
related to deferred tax assets.
9
<PAGE>
4. STATUTORY INFORMATION
Following is a reconciliation of income based on statutory accounting
practices prescribed or permitted by insurance regulatory authorities for the
Company's insurance subsidiaries with net income reported in the accompanying
condensed consolidated statements of operations:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
(In thousands) 1996 1995
- - -----------------------------------------------------------------------------------------------
<S> <C> <C>
Insurance subsidiaries (statutory-basis)/(1)/ $ 8,258 $ 6,459
Non-insurance companies/(2)/ (241) (607)
------------------
Consolidated statutory-basis pretax operating income 8,017 5,852
Reconciling items:
Deferred policy acquisition costs, net of amortization 3,148 3,492
Adjustments to customer deposits 146 (1,999)
Adjustments to invested asset carrying values at acquisition date (158) (160)
Amortization of value of insurance in force (2,057) (1,005)
Amortization of interest maintenance reserve (1,112) (985)
Amortization of goodwill (122) --
Other (488) (272)
------------------
GAAP-basis pretax operating income 7,374 4,923
Amortization of acquisition-related deferred charges (126) (1,066)
Interest expense on long-term debt (787) (976)
Realized investment losses, net (403) (2,511)
Federal income tax expense (1,573) (196)
------------------
GAAP-basis net income $ 4,485 $ 174
==================
</TABLE>
- - ----------
/(1)/ Insurance company general account and separate account statutory-
basis pretax income excluding realized gains and losses as reported
to insurance regulatory authorities.
/(2)/ Non-insurance company pretax loss excluding amortization of
acquisition-related deferred charges, interest expense on long-term
debt, and realized investment gains and losses, net.
10
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
The following discussion compares the Company's results of operations for
the three months ended March 31, 1996 and 1995. The results of operations for
the three months ended March 31, 1996 include the effects of the business
operations of SBM Company ("SBM") acquired effective May 31, 1995. Therefore,
current period results of operations are not necessarily comparable with the
prior period.
Three Months Ended March 31, 1996 Compared with Three Months Ended March
31, 1995
Net income during the first quarter of 1996 was $4.5 million compared to
$0.2 million for the first quarter of 1995. The increase in net income is
primarily attributable to a $2.5 million increase in pretax operating income
and a $2.1 million decrease in realized investment losses, net of related
amortization adjustments.
Operating earnings (net income excluding realized investment gains and
losses and related amortization of value of insurance in force and deferred
policy acquisition costs, net of taxes) was $3.6 million and $0.6 million for
the first quarter of 1996 and 1995, respectively. The increase in operating
earnings is primarily attributable to an increase in net investment spread due
to on-going asset/liability management and deposit growth from the acquisition
of the SBM business operations and internally developed risk-based business. In
addition, fee income increased resulting from a growing base of variable
annuity deposits and institutional assets under management. Such increases in
revenues were partially offset by an increase in operating expenses and
amortization expense.
Net investment spread, which is the difference between income earned on
investments and interest credited on customer deposits, increased to $14.1
million in the first quarter of 1996 from $9.4 million in the first quarter of
1995. These amounts reflect the net investment spread of 1.93% and 1.74% in the
first quarter of 1996 and 1995, respectively, between the Company's annualized
investment yield on average cash and investments and the annualized average
rate credited on customer deposits. The Company's investment income increased
to $55.2 million in the first quarter of 1996 from $39.6 million in the first
quarter of 1995. These amounts represent annualized investment yields of 7.55%
and 7.81% on average cash and investments of $2.92 billion and $2.03 billion
during the first quarter of 1996 and 1995, respectively. The decrease in
annualized investment yields on cash and investments primarily relates to
significant sales of guaranteed investment contracts ("GICs"), the proceeds of
which are invested in securities of shorter duration than many of the Company's
other investments. Additionally, a lower overall interest rate environment
since the first quarter of 1995 resulted in lower yields on investments from
new sales of the Company's other risk-based products.
Interest credited on customer deposits increased to $41.1 million in the
first quarter of 1996 from $30.1 million in the first quarter of 1995. These
amounts represent annualized average rates of interest credited on customer
deposits of 5.62% and 6.07% on average customer deposits of $2.92
11
<PAGE>
billion and $1.99 billion during the first quarter of 1996 and 1995,
respectively. The decrease in annualized average rates of interest credited on
customer deposits reflects lower renewal rates declared during 1995 as a result
of the lower overall interest rate environment throughout 1995, as well as the
addition of guaranteed investment contract deposits during the last half of 1995
and through March 31, 1996.
Fee income, primarily variable annuity and asset management fees, increased
to $4.2 million in the first quarter of 1996 from $2.0 million in the first
quarter of 1995. This increase is in part attributable to variable annuity fees
which are based on the market value of assets supporting the mutual fund options
of variable annuity customer deposits in separate accounts. Variable annuity
fees increased to $2.4 million in the first quarter of 1996 from $1.5 million in
the first quarter of 1995 principally due to asset growth from the receipt of
variable annuity deposits and from increased market values. In addition, asset
management fees earned by ARM Capital Advisors, Inc. ("ARM Capital Advisors") on
off-balance sheet assets in private accounts and mutual funds increased to $1.5
million in the first quarter of 1996 from $0.5 million in the first quarter of
1995, reflecting a significant increase in the average fair value of off-balance
sheet assets managed, from $0.8 billion during the first quarter of 1995 to $1.7
billion in the first quarter of 1996.
The Company classifies its products and services as either risk-based or
fee-based and manages these two distinct lines of business separately. The
products and services comprising the risk-based and fee-based lines of business
are sold through two principal distribution channels: retail and institutional.
In the risk-based line of business the Company earns a spread between what is
earned on invested assets and what is credited to customer accounts. In the fee-
based line of business the Company receives a fee for managing customers'
deposits.
Customer deposits and funds under management by line of business as of
March 31, 1996 and December 31, 1995 were as follows:
<TABLE>
<CAPTION>
1996 1995
-------------------------------------------------------
PERCENTAGE PERCENTAGE
(Dollars in millions) AMOUNT OF TOTAL AMOUNT OF TOTAL
- - ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Risk-based:
Retail (fixed annuity, guaranteed rate option and face
amount certificate deposits) $ 2,662.7 44% $ 2,716.2 50%
Institutional (guaranteed investment contract deposits) 383.3 7 143.2 3
----------------------------------------------------
Total risk-based 3,046.0 51 2,859.4 53
Fee-based:
Retail (mutual fund options of variable annuity deposits
and off-balance sheet mutual fund assets) 914.0 15 845.7 16
Institutional (off-balance sheet assets managed in
private accounts and deposits under
marketing partnerships) 1,989.3 33 1,598.0 29
----------------------------------------------------
Total fee-based 2,903.3 48 2,443.7 45
Corporate and other (primarily cash and
investments in excess of customer deposits) 52.8 1 101.0 2
----------------------------------------------------
Total customer deposits and funds under management $ 6,002.1 100% $ 5,404.1 100%
====================================================
</TABLE>
12
<PAGE>
The increase in risk-based deposits was attributable to sales of GICs. The
increase in the fee-based line of business is primarily attributable to deposits
under new investment management and investment advisory contracts managed by ARM
Capital Advisors. The Company continues to develop its fee-based line of
business, as reflected in its growth as a percentage of total customer deposits
and funds under management. Additionally, the Company has diversified and
expanded in terms of products and services offered and the distribution channels
through which such products and services are marketed.
Sales for risk-based business include premiums and deposits received under
products issued by the Company's insurance and face-amount certificate
subsidiaries. Sales for fee-based business represent premiums and deposits for
the mutual fund options of variable annuity products issued by the Company's
insurance subsidiaries, the amount of new off-balance sheet assets which are
managed by ARM Capital Advisors, and off-balance sheet deposits with the State
Bond group of mutual funds. Sales by line of business and distribution channel
for the three months ended March 31, 1996 and 1995 were as follows:
<TABLE>
<CAPTION>
(In millions) 1996 1995
- - ----------------------------------------------------
<S> <C> <C>
Retail
Risk-based $ 11.9 $ 30.1
Fee-based 60.8 27.0
--------------
Total retail 72.7 57.1
Institutional
Risk-based 239.6 --
Fee-based 429.8 56.5
--------------
Total institutional 669.4 56.5
--------------
Total sales $742.1 $113.6
==============
</TABLE>
The increase in retail sales is primarily attributable to sales of fee-
based mutual fund options of variable annuities. This increase was somewhat
offset by lower retail sales of risk-based fixed annuity products due to greater
industry-wide competition from banks and other financial services institutions
for savings products primarily as a result of a U.S. Treasury yield curve that
was flatter during the first quarter of 1996 relative to the first quarter of
1995. A flattened yield curve tends to weaken sales of risk-based retail
products due to increased competition from bank certificates of deposit and
money market fund offerings. However, the same flattened yield curve benefited
sales of risk-based institutional products (i.e., GICs), which accumulate
interest based on short-term rates. The Company's GIC business is issued mainly
through a marketing partnership with another insurance company. The increase in
fee-based institutional sales is primarily attributable to deposits in private
accounts by new customers of ARM Capital Advisors. The retail and institutional
sales results during contrasting interest rate environments during the first
quarters of 1995 and 1996
13
<PAGE>
demonstrate the benefits the Company has derived from diversification of
products and services and distribution.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $88.3 million in the first quarter of 1996 compared to $65.5
million in the first quarter of 1995. This increase is associated with the fixed
annuity business acquired with the SBM companies. The increase in net surrenders
resulted in an increase in surrender charge income to $1.6 million in the first
quarter of 1996 from $0.6 million in the first quarter of 1995. Policies issued
by the Company's insurance subsidiaries include lapse protection provisions that
provide a cushion against excess surrenders when interest rates rise. These
provisions include surrender charges and market value adjustments on annuity
withdrawals. During the period that surrender charges are assessable, generally
the first five to seven years after a policy is issued, surrenders are
relatively low. The surrender and withdrawal activity during the first quarters
of 1995 and 1996 was expected by the Company due to the level of customer
deposits written several years ago that were subject to declining or expiring
surrender charges, and the Company's strategy of maintaining investment spreads.
During the third quarter of 1994, and continuing to-date, the Company began
implementing programs designed to reduce surrender activity. These programs
involve direct contact with customers and are designed to inform customers of
the financial strength of the Company and its insurance subsidiaries and
describe other product offerings available.
Operating expenses increased to $7.4 million in the first quarter of 1996
from $5.1 million in the first quarter of 1995. The increase is primarily
attributable to incremental expenses incurred in connection with the operations
of the acquired SBM business operations, as well as the expansion of
distribution channels.
Amortization of value of insurance in force increased to $2.1 million in
the first quarter of 1996 from $1.0 million in the first quarter of 1995
reflecting amortization of the value of insurance in force established as an
asset by the Company on May 31, 1995 in connection with the acquisition of SBM's
insurance subsidiary.
Amortization of acquisition-related deferred charges was $0.1 million in
the first quarter of 1996 compared to $1.1 million in the first quarter of 1995.
The decrease is primarily attributable to the accelerated amortization during
the third quarter of 1995 of certain costs and charges deferred during 1993 and
1994. During the third quarter of 1995, Company management evaluated and
determined that changes in facts and circumstances had resulted in a change in
their original estimate of the periods benefited by these costs and charges. As
a result of this change in estimate, the remaining unamortized balances of these
deferred costs and charges were fully amortized as of September 30, 1995,
resulting in lower amortization in future periods.
Realized investment gains were $0.9 million (a $0.3 million loss, net of
related amortization and tax) in the first quarter of 1996 compared to realized
investment losses of $2.5 million ($1.6 million, net of tax) in the first
quarter of 1995. Such realized investment gains and losses were primarily
interest-rate related and attributable to the on-going management of the
Company's fixed maturity securities classified as available-for-sale which can
result in period-to-period swings in realized investment gains and losses since
securities are sold during both rising and falling interest rate
14
<PAGE>
environments. The on-going management of securities is a significant component
of the Company's asset/liability management strategy. The on-going portfolio
management process involves evaluating the various asset sectors and individual
securities comprising the Company's investment portfolios and, based on market
yield rates, repositioning holdings in relatively overvalued sectors to
undervalued ones with the aim of improving cash flows. The Company's goal is to
accomplish this repositioning without materially changing the overall credit,
asset duration and convexity characteristics of its portfolios.
ASSET PORTFOLIO REVIEW
The Company primarily invests in securities with fixed maturities with the
objective of providing reasonable returns while limiting liquidity and credit
risks. Fixed maturities at March 31, 1996 totaled $2.6 billion, compared with
$2.5 billion at December 31, 1995 (at amortized cost), representing
approximately 87% and 90%, respectively, of total cash and investments. The
increase primarily resulted from sales of GICs. Fixed maturities were 91.6% and
92.3% investment grade as of March 31, 1996 and December 31, 1995, respectively.
Investment grade securities are those classified as 1 or 2 by the National
Association of Insurance Commissioners or, where such classifications are not
available, having a rating on the scale used by Standard & Poor's Corporation of
BBB- or above. The Company attempts to reduce the risks associated with non-
investment grade securities by limiting the exposure to any one issuer and by
closely monitoring the creditworthiness of such issuers. Additionally, the
Company's investment portfolio has minimal exposure to real estate, non-
indemnified mortgage loans and common equity securities, which represent less
than 1% of cash and investments as of March 31, 1996. As of March 31, 1996, the
book value of securities in the Company's investment portfolios which had
defaulted on principal or interest payments was zero.
The Company's fixed maturities portfolio as of March 31, 1996 and December
31, 1995 (at amortized cost) is detailed as follows:
<TABLE>
<CAPTION>
1996 1995
--------------------------------------------
PERCENT OF PERCENT OF
(Dollars in millions) AMOUNT TOTAL AMOUNT TOTAL
- - -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Corporate securities $1,008.3 38% $ 951.9 38%
U.S. Treasury securities and obligations of U.S.
government agencies 118.9 4 248.8 10
Other government securities 95.6 4 90.5 3
Asset-backed securities 242.5 9 150.7 6
Mortgage-backed securities ("MBSs"):
Agency pass-throughs 116.6 4 153.5 6
Collateralized mortgage obligations ("CMOs"):
Agency 438.9 17 500.5 20
Non-agency 603.9 23 394.1 16
Principal only and residual 17.7 1 0.8 1
----------------------------------------------
Total fixed maturities $2,642.4 100% $2,490.8 100%
==============================================
</TABLE>
15
<PAGE>
Agency pass-through certificates are MBSs which represent an undivided
interest in a specific pool of residential mortgages. The payment of principal
and interest is guaranteed by the U.S. government or U.S. government agencies.
CMOs are pools of mortgages that are segregated into sections, or tranches,
which provide sequential retirement of bonds rather than a pro rata share of
principal return in the pass-through structure. The underlying mortgages of
agency CMOs are guaranteed by the U.S. government or U.S. government agencies.
The Company manages prepayment exposure on CMO holdings by diversifying not only
within the more stable CMO tranches, but across alternative collateral classes
such as commercial mortgages and Federal Housing Administration project loans,
which are generally less volatile than agency-backed, residential mortgages.
Additionally, prepayment sensitivity is evaluated in light of collateral
characteristics such as weighted average coupon rate, weighted average maturity
and the prepayment history of the specific loan pool.
MBSs are subject to risks associated with variable prepayments of the
underlying mortgage loans. Prepayments cause these securities to have actual
maturities different from those expected at the time of purchase. Securities
that have an amortized cost that is greater than par that are backed by
mortgages that prepay faster than expected will incur a reduction in yield or a
loss, versus an increase in yield or a gain if the mortgages prepay slower than
expected. Those securities that have an amortized cost that is less than par
that are backed by mortgages that prepay faster than expected will generate an
increase in yield or a gain, versus a decrease in yield or a loss if the
mortgages prepay slower than expected. The reduction or increase in yields is
partially offset as funds from prepayments are reinvested at current interest
rates. The degree to which a security is susceptible to either gains or losses
is influenced by the difference between its amortized cost and par, the relative
sensitivity of the underlying mortgages backing the assets to prepayments in a
changing interest rate environment and the repayment priority of the securities
in the overall securitization structure. Although the interest rate environment
has experienced significant volatility during 1995 and the first quarter of
1996, prepayments and extensions of cash flows from MBSs have not materially
affected investment income of the Company.
As of January 1, 1994, the Company adopted SFAS No. 115, "Accounting for
Certain Investments in Debt and Equity Securities". The Company classifies its
entire fixed maturities portfolio as available-for-sale. Fixed maturities
classified as available-for-sale are carried at fair value and changes in fair
value, net of related value of insurance in force and deferred policy
acquisition cost amortization and deferred income taxes, are charged or credited
directly to shareholders' equity.
The decline in rates during 1995 and subsequent rise in interest rates
during the first quarter of 1996 resulted in unrealized losses on available-for-
sale securities which totaled $8.8 million (net of $0.6 million of related
amortization and $4.7 million in deferred income taxes) at March 31, 1996,
compared to unrealized gains of $28.5 million (net of $14.2 million of related
amortization and $15.4 million in deferred income taxes) at December 31, 1995.
This change in net unrealized gains and losses on available-for-sale securities
for the three months ended March 31, 1996 resulted in a decrease in
shareholders' equity of $37.3 million. This volatility in reported shareholders'
equity occurs as a result of SFAS No. 115 which requires some assets to be
carried at fair value while other
16
<PAGE>
assets are carried at historical cost and all liabilities are carried at
historical values. At March 31, 1996 and December 31, 1995, shareholders' equity
before the effects of SFAS No. 115 was $162.8 million and $159.5 million,
respectively.
The Company manages assets and liabilities in a closely integrated manner,
with the aim of reducing the volatility of investment spreads during a changing
interest rate environment. As a result, adjusting shareholders' equity for
changes in the fair value of the Company's fixed maturities and equity
securities without reflecting offsetting changes in the value of the Company's
liabilities or other assets creates volatility in reported shareholders' equity
but does not reflect the underlying economics of the Company's business. The
Company's accompanying consolidated financial statements include fair value
balance sheets which demonstrate that the rise in interest rates during 1996 did
not have a material effect on the financial position of the Company when all
assets and liabilities are adjusted to fair values.
Mortgage loans on real estate represented 1.4% and 1.6% of total cash and
investments at March 31, 1996 and December 31, 1995, respectively. Pursuant to
the terms of the acquisition of certain of the Company's insurance operations,
National Mutual has indemnified principal (up to 100% of the investments' year-
end 1992 statutory book value) and interest with respect to approximately 99% of
these loans at March 31, 1996. In support of its indemnification obligations,
National Mutual placed $23.0 million into escrow in favor of the Company's
insurance subsidiaries, which will remain available until the subject commercial
and agricultural loans have been paid in full.
Separate account assets at March 31, 1996 totaled $867.7 million, compared
to $809.9 million at December 31, 1995. The $57.8 million increase primarily
resulted from sales of mutual fund options of variable annuity contracts.
LIQUIDITY AND FINANCIAL RESOURCES
Holding Company Operations
The Company's principal need for liquidity consists of debt service
obligations under its bank financing agreement, dividend payments on its
preferred stock and operating expenses not absorbed by management fees charged
to its subsidiaries. The Company is dependent on dividends or other
distributions from its insurance subsidiaries and fee income generated by ARM
Capital Advisors, its asset management subsidiary, and other non-insurance
operations to meet on-going cash needs, including amounts required to pay
dividends on its preferred stock.
The ability of the Company's insurance subsidiaries to pay dividends and
enter into agreements with affiliates is limited by state insurance laws. In
March 1996, the Company received dividends of $6.0 million from Integrity Life
Insurance Company. The amount remaining in 1996 that the Company's insurance
subsidiaries can transfer in the form of dividends to the holding company is
limited to $11.6 million. The Company had cash and unaffiliated investments of
$6.2 million at March 31, 1996. In addition, $20.0 million was available on
unused bank lines of credit at March 31, 1996.
17
<PAGE>
Insurance Subsidiaries Operations
The liquidity requirements of the Company's insurance subsidiaries relate
to their payment of benefits, withdrawals and loans associated with the various
long-term savings and retirement products as well as for commissions and
operating expenses. The principal sources for such liquidity are investment
income and proceeds from maturities and redemptions of investments.
The Company develops cash flow projections under a variety of interest rate
scenarios developed by the Company. Asset portfolios are structured so that the
interest and principal payments, along with other fee income, are more than
sufficient to cover the cash outflows for benefits, withdrawals, and expenses
under the expected scenarios developed by the Company. In addition, the Company
maintains other liquid assets and aims to meet unexpected cash requirements
(with the projected cash inflows and liquid assets being approximately double
the expected cash outflows) without exposure to realized losses during a higher
interest rate environment. These other liquid assets include cash and cash
equivalents, high-grade floating-rate securities and bank lines of credit of
both the Company and its insurance subsidiaries.
During the quarters ended March 31, 1996 and 1995, the Company met its
liquidity needs entirely by cash flows from operating activities. At March 31,
1996, cash and cash equivalents totaled $176.9 million compared to $76.9 million
at December 31, 1995. Cash and cash equivalents at March 31, 1996 includes
approximately $96 million of cash in course of settlement related to securities
purchased. The Company's aim is to manage its cash and cash equivalents position
so as to satisfy short-term liquidity needs. In connection with this management
of cash and cash equivalents, the Company may invest idle cash in short duration
fixed maturities to capture additional yield when short-term liquidity
requirements permit.
Cash flows of $36.5 million and $24.9 million were generated from operating
activities during the quarters ended March 31, 1996 and 1995, respectively.
These cash flows resulted principally from investment income, less commissions
and operating expenses. Proceeds from sales, redemptions and maturities of
investments generated $714.1 million and $99.0 million in cash flows during
quarters ended March 31, 1996 and 1995, respectively, which were offset by
purchases of investments of $791.8 million and $94.1 million, respectively.
Purchases and sales of investments during the first quarter of 1996 reflect the
Company's on-going management of its fixed maturity investments which have
increased in size, due to the acquisition of the SBM businesses, from the first
quarter of 1995.
18
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is currently involved in no material legal or administrative
proceedings. The Company's subsidiaries are currently involved only in routine
legal and administrative proceedings incidental to the conduct of their
businesses. The Company does not believe that any of these proceedings will have
a material adverse effect on the financial condition or results of operations of
the Company or its subsidiaries.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Reports on Form 8-K
The Company did not file any reports on Form 8-K during the three months
ended March 31, 1996.
Exhibits
27 Financial Data Schedule (electronic filing only).
19
<PAGE>
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, on May 10, 1996.
ARM FINANCIAL GROUP, INC.
By: /s/ EDWARD L. ZEMAN
-------------------------------
Edward L. Zeman
Executive Vice President-Chief
Financial Officer
(Principal Financial Officer)
By: /s/ BARRY G. WARD
------------------------------------
Barry G. Ward
Controller (Principal Accounting
Officer)
20
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE BALANCE
SHEET AND STATEMENT OF OPERATIONS OF ARM FINANCIAL GROUP, INC.'S FORM 10-Q FOR
THE QUARTER ENDED MARCH 31, 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-END> MAR-31-1996
<DEBT-HELD-FOR-SALE> 2,627,945
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 32,360
<MORTGAGE> 42,933
<REAL-ESTATE> 0
<TOTAL-INVEST> 2,822,737
<CASH> 176,884
<RECOVER-REINSURE> 0
<DEFERRED-ACQUISITION> 45,930
<TOTAL-ASSETS> 4,084,022
<POLICY-LOSSES> 2,901,572
<UNEARNED-PREMIUMS> 0
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 40,000
<COMMON> 0
0
50,000
<OTHER-SE> 103,976
<TOTAL-LIABILITY-AND-EQUITY> 4,084,022
0
<INVESTMENT-INCOME> 55,193
<INVESTMENT-GAINS> (403)
<OTHER-INCOME> 4,162
<BENEFITS> 41,115
<UNDERWRITING-AMORTIZATION> 1,687
<UNDERWRITING-OTHER> 8,010
<INCOME-PRETAX> 6,058
<INCOME-TAX> 1,573
<INCOME-CONTINUING> 4,485
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 4,485
<EPS-PRIMARY> 133.09
<EPS-DILUTED> 133.09
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
