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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 1996
Commission file number: 33-67268
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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.)
515 WEST MARKET STREET
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 September 30, 1996, 23,796 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.
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TABLE OF CONTENTS
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Item Page
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PART I. FINANCIAL INFORMATION
1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets--September 30, 1996
and December 31, 1995............................................ 3
Condensed Consolidated Statements of Operations--
Nine and Three Months Ended September 30, 1996 and 1995............ 5
Condensed Consolidated Statements of Cash Flows--
Nine Months Ended September 30, 1996 and 1995...................... 6
Notes to Condensed Consolidated Financial Statements................. 7
2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................................. 13
PART II. OTHER INFORMATION
1. Legal Proceedings...................................................... 27
6. Exhibits and Reports on Form 8-K....................................... 27
Signatures............................................................. 28
Exhibit Index.......................................................... 29
</TABLE>
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
CARRYING AMOUNT FAIR VALUE
--------------------------- ----------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, 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:
September 30, 1996-$3,019,164;
December 31, 1995-$2,490,843) $2,991,885 $2,547,909 $2,991,885 $2,547,909
Equity securities, at fair value (cost:
September 30, 1996-$31,438;
December 31, 1995-$10,756) 31,883 11,751 31,883 11,751
Mortgage loans on real estate 37,159 43,943 37,159 43,943
Policy loans 120,767 117,528 120,767 117,528
Cash and cash equivalents 49,808 76,896 49,808 76,896
------------------------- -------------------------
Total cash and investments 3,231,502 2,798,027 3,231,502 2,798,027
Assets held in separate accounts 1,001,068 809,927 1,001,068 809,927
Accrued investment income 37,302 36,382 37,302 36,382
Value of insurance in force 60,387 51,051 115,754 98,977
Deferred policy acquisition costs 54,231 43,113 -- --
Goodwill 7,758 8,124 7,758 8,124
Deferred federal income taxes 42,892 19,776 40,918 48,642
Other assets 23,461 27,180 23,461 27,180
------------------------- --------------------------
Total assets $4,458,601 $3,793,580 $4,457,763 $3,827,259
========================= =========================
</TABLE>
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (CONTINUED)
<TABLE>
<CAPTION>
CARRYING AMOUNT FAIR VALUE
---------------------------- ----------------------------
SEPTEMBER 30, DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
(In thousands) 1996 1995 1996 1995
- -------------------------------------------------------------------------- ----------------------------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Customer deposits $3,209,729 $2,708,260 $3,156,170 $2,742,209
Customer deposits in separate accounts 995,960 808,345 995,960 808,345
Long-term debt 40,000 40,000 40,000 40,000
Payable for investment securities
purchased 22,832 8,538 22,832 8,538
Accounts payable and accrued expenses 15,979 15,496 15,979 15,496
Other liabilities 17,957 24,950 17,957 24,950
---------------------------- ----------------------------
Total liabilities 4,302,457 3,605,589 4,248,898 3,639,538
Contingencies
Shareholders' equity:
Preferred stock, $25.00 stated value 50,000 50,000
Class A common stock, $.01 par value,
23,796 and 23,770 shares issued,
respectively * *
Class B common stock, $.01 par value,
1,000 shares issued * *
Additional paid-in capital 124,609 124,425
Net unrealized gains (losses) on
available-for-sale securities (14,750) 28,530
Retained-earnings deficit (3,715) (14,964)
----------------------------
Total shareholders' equity 156,144 187,991 208,865 187,721
---------------------------- ----------------------------
Total liabilities and shareholders' equity $4,458,601 $3,793,580 $4,457,763 $3,827,259
============================ ============================
</TABLE>
* Less than $1,000.
See accompanying notes.
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED THREE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(Dollars in thousands, except per share amounts) 1996 1995 1996 1995
- ------------------------------------------------------------------------- ---------------------
<S> <C> <C> <C> <C>
Investment income $ 183,203 $ 140,718 $ 65,340 $ 55,755
Interest credited on customer deposits (133,349) (105,455) (47,337) (41,173)
--------------------- ---------------------
Net investment spread 49,854 35,263 18,003 14,582
Fee income:
Variable annuity fees 7,783 5,104 2,686 1,946
Asset management fees 4,500 2,130 1,789 999
Other fee income 1,044 646 489 418
--------------------- ---------------------
Total fee income 13,327 7,880 4,964 3,363
Other income and expenses:
Surrender charges 3,912 2,182 1,022 1,067
Operating expenses (24,911) (16,315) (9,724) (5,946)
Commissions, net of deferrals (1,442) (847) (245) (357)
Interest expense on long-term debt (2,299) (2,568) (768) (895)
Amortization:
Deferred policy acquisition costs (4,599) (2,051) (1,494) (760)
Value of insurance in force (7,058) (4,902) (2,577) (2,416)
Acquisition-related deferred charges (377) (9,070) (126) (6,626)
Goodwill (366) (188) (122) (141)
Other, net (5,178) (1,876) (2,538) (1,466)
--------------------- ---------------------
Total other income and expenses (42,318) (35,635) (16,572) (17,540)
Realized investment gains (losses) (2,332) 876 (1,115) (1,818)
--------------------- ---------------------
Income (loss) before federal income taxes 18,531 8,384 5,280 (1,413)
Federal income tax benefit (expense) (3,719) (4,606) (956) 332
--------------------- ---------------------
Net income (loss) 14,812 3,778 4,324 (1,081)
Dividends on preferred stock (3,563) (3,563) (1,187) (1,187)
--------------------- ---------------------
Net income (loss) applicable to common
shareholders $ 11,249 $ 215 $ 3,137 $ (2,268)
===================== =====================
Net income (loss) per common share $ 453.94 $ 11.12 $ 126.51 $ (91.56)
===================== =====================
Average common shares outstanding 24,781 19,342 24,796 24,770
===================== =====================
</TABLE>
See accompanying notes.
5
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995
<TABLE>
<CAPTION>
(In thousands) 1996 1995
- -------------------------------------------------------------------------------------------
<S> <C> <C>
Cash flows provided by operating activities $ 136,460 $ 100,174
Cash flows provided by (used in) investing activities:
Fixed maturity investments:
Purchases (2,471,399) (1,109,200)
Maturities and redemptions 189,135 119,205
Sales 1,773,723 909,202
Other investments:
Purchases (51,560) (7,772)
Maturities and redemptions 6,787 22,708
Sales 30,474 2,851
Policy loans, net (3,238) (4,184)
Purchase of assets held in separate accounts (192,883) (160,955)
Proceeds from sale of assets held in separate accounts 57,338 30,184
Cash and cash equivalents acquired in excess of purchase price
paid for substantially all assets of SBM Company -- 36,490
-------------------------
Cash flows used in investing activities (661,623) (161,471)
Cash flows provided by (used in) financing activities:
Proceeds from issuance of common stock -- 63,505
Stock issuance costs -- (2,000)
Amounts received from customers 835,379 266,709
Amounts paid to customers (329,052) (284,674)
Increase (decrease) in repurchase agreement liability (4,689) 17,709
Preferred stock dividends (3,563) (3,563)
-------------------------
Cash flows provided by financing activities 498,075 57,686
-------------------------
Net change in cash and cash equivalents (27,088) (3,611)
Cash and cash equivalents at beginning of period 76,896 45,855
-------------------------
Cash and cash equivalents at end of period $ 49,808 $ 42,244
=========================
</TABLE>
See accompanying notes.
6
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ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
SEPTEMBER 30, 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 nine month and three month periods ended
September 30, 1996 are not necessarily indicative of those to be expected for
the year ending 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
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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 seeks to reduce its exposure to changing interest rates through
the management of duration, convexity and cash flow characteristics of both
assets and liabilities while maintaining liquidity redundancies (i.e., sources
of liquidity in excess of projected liquidity needs). As a result, fair values
of the Company's assets and liabilities will tend to respond similarly to
changes in interest rates.
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.
Assets Held in Separate Accounts and Customer Deposits in Separate Accounts
Fair value of assets held in separate accounts is based on the quoted
market prices of the underlying mutual funds for assets invested in variable
options. The fair value of assets held in separate accounts invested in
guaranteed rate options is primarily based on quoted market prices of fixed
maturity securities. The fair value of customer deposits in separate accounts 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.
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Deferred Federal Income Taxes
The deferred federal income tax asset 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 single premium immediate annuity
contracts 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 single premium immediate
annuity contracts represents the fair values of those contracts as a whole which
implicitly eliminates the corresponding value of insurance in force. The fair
value amounts of the remaining customer deposits, primarily related to deferred
annuities, single premium endowment contracts, and guaranteed investment
contracts ("GICs"), 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 all customer
deposits, excluding those related to single premium immediate annuity contracts,
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 federal income tax assets.
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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>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------
(In thousands) 1996 1995
- -----------------------------------------------------------------------------------------
<S> <C> <C>
Insurance subsidiaries (statutory-basis)/1/ $29,187 $20,753
Non-insurance companies/2/ (1,153) 1,134
-----------------
Consolidated statutory-basis pretax operating income 28,034 21,887
Reconciling items:
Deferral of policy acquisition costs, net of amortization 10,770 12,289
Adjustments to customer deposits (51) (4,872)
Adjustments to invested asset carrying values at acquisition date (485) (353)
Amortization of value of insurance in force (7,058) (4,902)
Amortization of interest maintenance reserve (3,271) (2,912)
Amortization of goodwill (366) (188)
Amortization of acquisition-related deferred charges (377) (9,070)
Other acquisition-related expenses (1,847) --
Interest expense on long-term debt (2,299) (2,568)
Realized investment gains (losses) (2,332) 876
Federal income tax expense (3,719) (4,606)
Other (2,187) (1,803)
-----------------
Consolidated GAAP-basis net income $14,812 $ 3,778
=================
</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 gain (loss) excluding amortization of
acquisition-related deferred charges, certain other acquisition-related
expenses, interest expense on long-term debt, and realized investment gains
and losses.
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5. STOCK OPTIONS
The Company's Stock Option Plan adopted in December 1993, as amended, (the
"Plan") provides for granting of options to purchase up to 3,445 shares of Class
A common stock. A total of 2,680 options were outstanding as of September 30,
1996, of which 674 were exercisable. Each option has an exercise price set
initially at fair market value on the date of the grant, as determined by the
Board of Directors of the Company. Each option's exercise price will increase at
the end of every three month period following the date of grant at a rate of 12%
per annum, compounded annually, while the option remains issued but unexercised
(or if shorter, up to the date the Plan is terminated or there are certain
changes in the ownership of the Company).
The Company has elected to follow Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations in accounting for its employee stock options. Under the variable
plan accounting requirements of APB No. 25, no stock-based compensation expense
has been recognized through September 30, 1996 for the Plan.
6. SUBSEQUENT EVENTS
On October 3, 1996, the Company entered into an agreement to transfer its
responsibility for performing management and investment advisory services for
six mutual funds (the "State Bond Funds") to Federated Investors. Fee income of
$1.2 million was recorded with respect to the management of such funds for each
of the nine months ended September 30, 1996 and 1995. The State Bond Funds had
aggregate assets of $235.1 million at September 30, 1996. The management and
investment advisory responsibility for these funds was acquired by the Company
in June 1995 in conjunction with the acquisition of the assets and business
operations of the SBM Company ("SBM"). The consummation of the transaction is
subject to vote by the State Bond Funds' shareholders, which is scheduled to
take place on December 9, 1996, and to certain other conditions.
On October 23, 1996, the Company filed a registration statement with the
Securities and Exchange Commission with respect to the public offering (the
"Offering") of a yet to be determined number of shares of Class A common stock,
par value $.01 per share (the "New Class A Common Stock"). The Company currently
intends to use the net proceeds of the Offering to strengthen the Company's
existing capital base, to repay certain outstanding indebtedness and for other
corporate purposes, which may include additions to working capital and
acquisitions. The Company's decision to proceed with the Offering is subject to
market and other conditions. Prior to the consummation of the Offering, the
Company expects to amend and restate its Certificate of Incorporation and By-
Laws to effectuate a recapitalization such that (i) the common equity of the
Company will consist of New Class A Common Stock and Class B Common Stock, par
value of $.01 per share (the "New Class B Common Stock" and, together with the
New Class A Common Stock, the "New Common Stock"), (ii) each outstanding share
of common stock of the Company will be converted into one share of New Class A
Common Stock, (iii) certain shares of the New Class A Common Stock owned by
private equity funds sponsored by Morgan Stanley Group, Inc. (the "Morgan
Stanley Stockholders," which at September 30, 1996 owned approximately 91% of
the outstanding voting stock of the Company) will be converted into New Class B
Common Stock such that, after giving effect to such conversion, but not giving
effect to the proposed Offering, the Morgan Stanley
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Stockholders will own, in the aggregate, 49% of the outstanding New Class A
Common Stock, and (iv) each share of New Class A Common Stock and New Class B
Common Stock will be split into an as yet to be determined number of shares of
New Class A Common Stock and New Class B Common Stock, respectively. Holders of
New Class B Common Stock will have no right to vote on matters submitted to a
vote of stockholders, except in certain circumstances. Shares of the New Class B
Common Stock will have no preemptive or other subscription rights and will be
convertible into an equal number of shares of New Class A Common Stock (1) at
the option of the holder thereof to the extent that, following such conversion,
the Morgan Stanley Stockholders will not, in the aggregate, own more than 49% of
the outstanding shares of New Class A Common Stock, and (2) automatically upon
the transfer of such shares by any Morgan Stanley Stockholder to a person that
is not a Morgan Stanley Stockholder or an affiliate of a Morgan Stanley
Stockholder. The registration statement has not yet become effective.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
GENERAL
The Company specializes in the asset accumulation business, providing
retail and institutional customers with products designed to serve the growing
retirement and long-term savings markets as well as providing other asset
management services. At September 30, 1996, the Company had over $7.0 billion of
assets under management.
The Company's revenues are derived from its spread-based business and its
fee-based business. The products and services of the spread-based and fee-based
businesses are sold in two principal markets, the retail and institutional
markets, through a broad spectrum of distribution channels. In the spread-based
line of business the Company earns a spread between what it earns 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 on and off
its balance sheet. The Company believes that market forces and population
demographics are producing and will continue to generate strong consumer demand
for long-term savings and retirement products, including variable and equity-
indexed annuity type products. Recent acquisitions by the Company have provided
it with the opportunity to leverage its resources and enter into new markets in
order to try to meet this demand. The Company continues to focus on the
development of its fee-based business to increase the size of this business
line, which is less capital intensive than the spread-based business and
provides the Company with diversified sources of income. Although the Company's
objective is to achieve a better business mix between its spread-based and fee-
based businesses, the business mix may vary from time to time, due to
opportunistic acquisitions.
The following discussion compares the Company's results of operations for
the nine and three months ended September 30, 1996 and 1995. As the Company
acquired substantially all the assets and business operations of SBM effective
May 31, 1995, the results of operations for the nine months ended September 30,
1996 include the acquired SBM operations for the entire period. Results of
operations for the nine months ended September 30, 1995 include only four months
of earnings related to acquired SBM operations. Therefore, results of the
current year to date period are not necessarily comparable with results of the
prior year to date period.
RESULTS OF OPERATIONS
Nine Months Ended September 30, 1996 and September 30, 1995
Net income during the nine months ended September 30, 1996 was $14.8
million compared to $3.8 million for the nine months ended September 30, 1995.
Operating earnings (net income applicable to common shareholders excluding
realized investment gains and losses net of taxes) were $12.8 million compared
to an operating loss of $0.4 million for the nine months ended September 30,
1996 and 1995, respectively. Operating earnings for the nine months ended
September 30, 1996 include net of tax charges of $1.3 million and $0.8 million
to increase the reserve for future guaranty fund assessments and for costs
associated with the evaluation of potential
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acquisition and financing transactions, respectively. The increase in operating
earnings was primarily attributable to an increase in net investment spread due
to ongoing asset/liability management and to deposit growth from the acquisition
of the SBM business operations and, to a lesser extent, additional sales of
spread-based products. In addition, fee income increased as a result of a
growing base of variable annuity deposits and institutional assets under
management. The increase in operating earnings was also attributable to a
decrease in amortization expenses resulting from a decrease in acquisition-
related deferred charges amortization. Such increases in operating earnings were
partially offset by an increase in operating expenses, which include the
aforementioned charges.
Annualized spread-based operating earnings were 0.95% and 0.87% of average
spread-based assets under management of $3.14 billion and $2.36 billion during
the nine months ended September 30, 1996 and 1995, respectively. This increase
in spread-based margins is primarily attributable to ongoing asset/liability
management, which generated higher net investment spreads. Annualized fee-based
operating earnings were 0.18% and 0.22% of average fee-based assets under
management of $3.09 billion and $1.68 billion during the nine months ended
September 30, 1996 and 1995, respectively. Fee-based margins for the 1996 period
were slightly lower compared to the corresponding prior period primarily from
the growth of institutional fee-based assets under management which generated
lower margins than the Company's variable annuity deposits. Certain expenses
including federal income taxes and unallocated corporate overhead are not
reflected in annualized spread-based and fee-based operating earnings.
Net investment spread, which is the difference between income earned on
investments and interest credited on customer deposits, increased to $49.9
million during the nine months ended September 30, 1996 from $35.3 million
during the nine months ended September 30, 1995. These amounts reflect the net
investment spread of 2.06% and 1.91% during the nine months ended September 30,
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 $183.2 million
during the nine months ended September 30, 1996 from $140.7 million during the
nine months ended September 30, 1995. These amounts represent annualized
investment yields of 7.74% and 7.88% on average cash and investments of $3.15
billion and $2.38 billion during the nine months ended September 30, 1996 and
1995, respectively. The decrease in annualized investment yields on cash and
investments primarily relates to a significant increase in sales of GICs, the
proceeds of which are invested in securities of shorter duration (which
generally have lower investment yields) than many of the Company's other
investments.
Interest credited on customer deposits increased to $133.3 million during
the nine months ended September 30, 1996 from $105.5 million during the nine
months ended September 30, 1995. These amounts represent annualized average
rates of interest credited on customer deposits of 5.68% and 5.97% on average
customer deposits of $3.13 billion and $2.35 billion during the nine months
ended September 30, 1996 and 1995, respectively. The decrease in annualized
average rates of interest credited on customer deposits resulted from the
Company's decision to reset crediting rates downward during the second half of
1995 consistent with an overall declining interest rate environment during that
period.
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Fee income increased to $13.3 million during the nine months ended
September 30, 1996 from $7.9 million during the nine months ended September 30,
1995. This increase is in part attributable to variable annuity fees which are
based on the market value of assets supporting the investment portfolio options
of variable annuity deposits in separate accounts. Variable annuity fees
increased to $7.8 million during the nine months ended September 30, 1996 from
$5.1 million during the nine months ended September 30, 1995 principally due to
asset growth from the receipt of variable annuity deposits and from a market-
driven increase in the value of existing variable annuity deposits invested in
mutual funds. Fee-based variable annuity deposits increased to $794.1 million at
September 30, 1996 from $558.1 million at September 30, 1995. In addition, asset
management fees earned by ARM Capital Advisors, Inc. ("ARM Capital Advisors") on
off-balance sheet assets managed for institutional clients and mutual funds
increased to $4.5 million during the nine months ended September 30, 1996 from
$2.1 million during the nine months ended September 30, 1995. This increase in
asset management fees reflects a significant increase in the average amount of
corresponding off-balance sheet assets managed due to new defined benefit
pension plan accounts. The average amount of off-balance sheet assets managed by
ARM Capital Advisors was $2.0 billion during the nine months ended September 30,
1996 compared to $1.0 billion during the nine months ended September 30, 1995.
Assets under management by type of product and service as of September 30,
1996 and December 31, 1995 were as follows:
<TABLE>
<CAPTION>
SEPTEMBER 30, 1996 DECEMBER 31, 1995
------------------------------ --------------------------------
PERCENT OF PERCENT OF
(Dollars in millions) AMOUNT TOTAL AMOUNT TOTAL
- ------------------------------------------------------------------------------------------------ --------------------------------
<S> <C> <C> <C> <C>
Spread-based:
Retail (fixed annuity, guaranteed rate option and face-
amount certificate deposits) $ 2,602.4 37% $2,716.2 50%
Institutional (GIC deposits) 769.7 11 143.2 3
------------------------------ --------------------------------
Total spread-based 3,372.1 48 2,859.4 53
Fee-based:
Retail (investment portfolio options of variable annuity
deposits and off-balance sheet mutual fund assets
managed) 1,029.2 15 845.7 16
Institutional (off-balance sheet assets managed for
institutional clients and deposits under marketing
partnerships) 2,539.7 36 1,598.0 29
------------------------------ --------------------------------
Total fee-based 3,568.9 51 2,443.7 45
Corporate and other (primarily cash and investments in
excess of customer deposits) 68.2 1 101.0 2
------------------------------ --------------------------------
Total assets under management $7,009.2 100% $5,404.1 100%
============================== ================================
</TABLE>
The increase in spread-based deposits was attributable to sales of GICs to
institutional customers. The increase in the fee-based line of business was
primarily attributable to deposits under new investment management 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 assets
under
15
<PAGE>
management and, additionally, to diversify its spread-based and fee-based
products and services and expand their associated channels of distribution.
Sales for spread-based products include premiums and deposits received
under products issued by the Company's insurance and face-amount certificate
subsidiaries. Sales for fee-based products and services include premiums and
deposits for the investment portfolio options of variable annuity products
issued by the Company's insurance subsidiaries and the amount of new off-balance
sheet assets managed by ARM Capital Advisors. Sales by market and type of
business for the nine months ended September 30, 1996 and 1995 were as follows:
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
(In millions) 1996 1995
- ------------------------------------------------------------------------------
<S> <C> <C>
Retail:
Spread-based $ 52.9 $ 72.8
Fee-based 174.3 120.4
-----------------------
Total retail 227.2 193.2
Institutional:
Spread-based 624.7 75.0
Fee-based 1,033.5 540.2
-----------------------
Total institutional 1,658.2 615.2
-----------------------
Total sales $1,885.4 $808.4
=======================
</TABLE>
The increase in retail sales was attributable to an increase in sales of
fee-based variable annuities due, in part, to the continuing strong stock market
returns during the first nine months of 1996 and marketing efforts. This
increase was partially offset by lower retail sales of spread-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 (the "yield curve") that was generally flatter during
the first half of 1996 relative to the first half of 1995. A flattened yield
curve tends to weaken sales of retail spread-based products due to increased
competition from short-term instruments such as bank certificates of deposit and
money market funds because the difference between short-term and intermediate-
term market interest rates decreases. The yield curve began to steepen during
the third quarter of 1996 which, when combined with increased marketing efforts,
produced an increase in sales of retail spread-based products during that
period. Sales of institutional spread-based products (i.e., GICs), which are
issued primarily through a joint venture with General American Life Insurance
Company, benefited from increased marketing efforts by the Company. The increase
in institutional fee-based sales was primarily attributable to deposits under
new defined benefit pension plan accounts managed by ARM Capital Advisors. The
Company's strategy is to broaden its mix of products, services and distribution
channels to enable it to achieve its target sales within different interest rate
environments.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $249.6 million and $223.4 million during the nine months ended
September 30, 1996 and 1995, respectively. Of these amounts, $81.1 million and
$37.6 million, respectively, can be attributed to
16
<PAGE>
fixed annuity business acquired from SBM. Surrender charge income increased to
$3.9 million during the nine months ended September 30, 1996 from $2.2 million
during the nine months ended September 30, 1995, due to higher average surrender
charges associated with SBM products compared to other products of the Company's
insurance subsidiaries and to the overall increase in the volume of surrenders.
Policies issued by the Company's insurance subsidiaries include lapse protection
provisions that provide a deterrent against surrenders when interest rates rise.
These provisions can 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 nine months
ended September 30, 1995 and 1996 was generally 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. The Company has in place programs designed to
reduce surrender activity and improve persistency. During the nine months ended
September 30, 1996 and 1995, through one such program, $14.3 million and $35.8
million, respectively, of new annuity contracts were issued to customers that
had initiated a withdrawal request. The Company excludes this activity from its
net surrenders and sales disclosures because such amounts have no impact on net
cash flow. Other programs involve direct contact with customers and are designed
to inform customers of the financial strength of the Company and its insurance
subsidiaries and to describe other product offerings available.
Operating expenses increased to $24.9 million during the nine months ended
September 30, 1996 from $16.3 million during the nine months ended September 30,
1995. The increase was primarily attributable to (i) the inclusion of nine
months of incremental operating expenses related to the acquired SBM operations
in the 1996 results versus four months for the comparable 1995 period, (ii) the
expansion of distribution channels and (iii) charges of $1.6 million and $1.0
million to increase the reserve for anticipated future guaranty fund assessments
and for costs associated with the evaluation of potential acquisition and
financing transactions, respectively.
Commissions, net of deferrals, were $1.4 million and $0.8 million during
the nine months ended September 30, 1996 and 1995, respectively. The increase
was primarily attributable to the inclusion of nine months of renewal and
trailer commissions under certain fixed annuity contracts acquired in the SBM
acquisition in 1996 results versus four months for the comparable 1995 period.
Amortization of deferred policy acquisition costs related to operations was
$4.6 million and $2.1 million during the nine months ended September 30, 1996
and 1995, respectively. This increase was the result of growth in the deferred
policy acquisition cost asset as variable costs of selling and issuing the
Company's insurance subsidiaries' products (primarily first-year commissions)
are deferred and then amortized over the expected life of the contract.
Amortization of value of insurance in force related to operations increased
to $7.1 million during the nine months ended September 30, 1996 from $4.9
million during the nine months ended September 30, 1995. The increase was
primarily related to 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.
17
<PAGE>
Amortization of acquisition-related deferred charges was $0.4 million and
$9.1 million during the nine months ended September 30, 1996 and 1995,
respectively. The decrease was 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 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.
Other expenses, net increased $3.3 million during the nine months ended
September 30, 1996 compared to the same period in 1995. The increase was
primarily attributable to premiums paid or accrued in 1996 under reinsurance
agreements. Through these reinsurance agreements, one of which commenced
December 31, 1995, substantially all mortality risks associated with single
premium endowment contract deposits have been reinsured.
Realized investment losses, which are reported net of related amortization
of deferred policy acquisition costs and value of insurance in force, were $2.3
million during the nine months ended September 30, 1996 compared to realized
investment gains of $0.9 million during the nine months ended September 30,
1995. Such realized investment gains and losses were interest-rate related and
attributable to the ongoing 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 environments. The ongoing management of
securities is a significant component of the Company's asset/liability
management strategy. The ongoing portfolio management process involves
evaluating the various asset sectors (i.e., security types and industry classes)
and individual securities comprising the Company's investment portfolios and,
based on market yield rates, repositioning holdings from sectors perceived to be
relatively overvalued to sectors perceived to be undervalued with the aim of
improving cash flows. The Company endeavors to accomplish this repositioning
without materially changing the overall credit, asset duration, convexity, and
liquidity characteristics of its portfolios.
Federal income tax expense was $3.7 million and $4.6 million for the nine
months ended September 30, 1996 and 1995, respectively, reflecting effective tax
rates of 20.1% and 54.9%. The lower effective tax rate in 1996 resulted
primarily from the recognition of benefits associated with certain deferred tax
assets established in connection with the Company's acquisition of Integrity
Life Insurance Company and National Integrity Life Insurance Company
(collectively, the "Integrity Companies") on November 26, 1993 for which a full
valuation allowance was originally provided. These deferred tax benefits are
being recognized based on the taxable income generated by the Integrity
Companies' in the post-acquisition period and projections of future taxable
income.
Three Months Ended September 30, 1996 and September 30, 1995
Net income during the third quarter of 1996 was $4.3 million compared to a
net loss of $1.1 million for the third quarter of 1995, and operating earnings
for the same periods were $3.9 million and a loss of $1.1 million, respectively.
Operating earnings for the three months ended September 30, 1996 include net of
tax charges of $1.0 million and $0.8 million to increase the reserve for future
guaranty
18
<PAGE>
fund assessments and for costs associated with the evaluation of potential
acquisition and financing transactions, respectively. The increase in operating
earnings is attributable to an increase in net investment spread due to ongoing
asset/liability management and deposit growth from sales of spread-based
products. In addition, fee income increased as a result of a growing base of
variable annuity deposits and institutional assets under management. The
increase in operating earnings was also attributable to a decrease in
amortization expenses resulting from a decrease in acquisition-related deferred
charges amortization, partially offset by higher operating expenses which
include the aforementioned charges.
Net investment spread increased to $18.0 million in the third quarter of
1996 from $14.6 million in the third quarter of 1995. These amounts reflect the
net investment spread of 2.10% and 2.01% in the third quarters 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 $65.3 million in the third quarter
of 1996 from $55.8 million in the third quarter of 1995. These amounts represent
annualized investment yields of 7.83% and 7.86% on average cash and investments
of $3.34 billion and $2.84 billion during the third quarters of 1996 and 1995,
respectively. The decrease in annualized investment yields on cash and
investments primarily relates to the significant increase in sales of GICs, the
proceeds of which are invested in securities of shorter duration than many of
the Company's other investments.
Interest credited on customer deposits increased to $47.3 million in the
third quarter of 1996 from $41.2 million in the third quarter of 1995. These
amounts represent annualized average rates of interest credited on customer
deposits of 5.73% and 5.85% on average customer deposits of $3.30 billion and
$2.82 billion during the third quarters of 1996 and 1995, respectively.
Fee income increased to $5.0 million in the third quarter of 1996 from $3.4
million in the third quarter of 1995. Variable annuity fees increased to $2.7
million in the third quarter of 1996 from $1.9 million in the third quarter of
1995 principally due to asset growth from the receipt of variable annuity
deposits and from a market-driven increase in the value of existing variable
annuity deposits invested in mutual funds. In addition, asset management fees
earned by ARM Capital Advisors on off-balance sheet assets managed for
institutional clients and mutual funds increased to $1.8 million in the third
quarter of 1996 from $1.0 million in the third quarter of 1995. This increase in
asset management fees reflects a significant increase in the average amount of
corresponding off-balance sheet assets managed due to new defined benefit
pension plan accounts. The average amount of off-balance sheet assets managed by
ARM Capital Advisors was $2.3 billion during the third quarter of 1996 compared
to $1.2 billion in the third quarter of 1995.
19
<PAGE>
<TABLE>
<CAPTION>
Sales by market and type of business for the three months ended September
30, 1996 and 1995 were as follows:
THREE MONTHS ENDED
SEPTEMBER 30,
------------------
(In millions) 1996 1995
- ------------------------------------------------------------------------------
<S> <C> <C>
Retail:
Spread-based $ 21.7 $ 8.8
Fee-based 46.8 55.0
--------------------
Total retail 68.5 63.8
Institutional:
Spread-based 183.4 50.0
Fee-based 211.1 189.6
--------------------
Total institutional 394.5 239.6
--------------------
Total sales $ 463.0 $ 303.4
====================
</TABLE>
The increase in retail sales was attributable to an increase in sales of
spread-based fixed annuity products and the Company's new equity-indexed annuity
product, partially offset by a decrease in sales of fee-based variable annuity
products. The increase in spread-based fixed annuities is due to the steepening
of the yield curve which makes these products more attractive to customers and
to increased marketing efforts. Sales of the Company's institutional spread-
based products increased significantly due to increased marketing efforts by the
Company.
Net surrenders of annuity products issued by the Company's insurance
subsidiaries were $76.2 million and $70.0 million in the third quarters of 1996
and 1995, respectively. Of these amounts, $26.7 million and $29.5 million,
respectively, can be attributed to fixed annuity business acquired from SBM.
Surrender charge income was essentially unchanged for the three months ended
September 30, 1996 and 1995.
Operating expenses increased to $9.7 million in the third quarter of 1996
from $5.9 million in the third quarter of 1995. The increase was primarily
attributable to costs associated with the expansion of distribution channels and
to charges of $1.2 million and $1.0 million to increase the reserve for
anticipated future guaranty fund assessments and for costs associated with the
evaluation of potential acquisition and financing transactions, respectively.
Amortization of deferred policy acquisition costs related to operations was
$1.5 million and $0.8 million during the three months ended September 30, 1996
and 1995, respectively. This increase is the result of growth in the deferred
policy acquisition cost asset as variable costs of selling and issuing the
Company's insurance subsidiaries' products are deferred and then amortized over
the expected life of the contract.
Amortization of acquisition-related deferred charges was $0.1 million and
$6.6 million in the third quarters of 1996 and 1995, respectively. The decrease
was 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 determined that changes
20
<PAGE>
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.
Other expenses, net increased $1.1 million during the three months ended
September 30, 1996 compared to the same period in 1995. The increase was
attributable to premiums paid or accrued in 1996 under reinsurance agreements.
Through these reinsurance agreements, one of which commenced December 31, 1995,
substantially all mortality risks associated with single premium endowment
contract deposits have been reinsured.
Realized investment losses were $1.1 million and $1.8 million for the three
months ended September 30, 1996 and 1995, respectively. Such realized investment
losses were interest-rate related and attributable to the ongoing management of
the Company's fixed maturity securities classified as available-for-sale.
Federal income tax expense was $1.0 million for the three months ended
September 30, 1996 compared to a benefit of $0.3 million for the three months
ended September 30, 1995, reflecting effective tax rates of 18.1% and 23.5%.
ASSET PORTFOLIO REVIEW
The Company primarily invests in securities with fixed maturities with the
objective of providing reasonable returns while limiting credit and liquidity
risks. At amortized cost, fixed maturities at September 30, 1996 totaled $3.0
billion, compared with $2.5 billion at December 31, 1995, representing
approximately 92% and 90%, respectively, of total cash and investments. The
increase in investments in fixed maturities primarily resulted from the
investment of the proceeds from sales of GIC products.
21
<PAGE>
<TABLE>
<CAPTION>
The Company's cash and investments as of September 30, 1996 are detailed as
follows:
AMORTIZED COST
--------------------
PERCENT OF ESTIMATED
(Dollars in millions) AMOUNT TOTAL FAIR VALUE
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Fixed maturities:
Corporate securities $ 1,079.3 33% $ 1,052.2
U.S. Treasury securities and obligations of
U.S. government agencies 158.7 5 158.1
Other government securities 106.4 3 115.8
Asset-backed securities 257.7 8 255.7
Mortgage-backed securities ("MBSs"):
Agency pass-throughs 166.5 5 166.9
Collateralized mortgage obligations ("CMOs"):
Agency 420.6 13 417.1
Non-agency 814.2 25 808.5
Interest only 15.8 -- 17.6
-------------------------------------
Total fixed maturities 3,019.2 92 2,991.9
Equity securities (i.e., non-redeemable
preferred stock) 31.4 1 31.8
Mortgage loans on real estate 37.2 1 37.2
Policy loans 120.8 4 120.8
Cash and cash equivalents 49.8 2 49.8
-------------------------------------
Total cash and investments $ 3,258.4 100% $ 3,231.5
=====================================
</TABLE>
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 prioritized 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.
MBSs are subject to risks associated with prepayments of the underlying
mortgage loans. Prepayments cause these securities to have actual maturities
different from those projected at the time of purchase. Securities that have an
amortized cost that is greater than par (i.e., purchased at a premium) 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 (i.e., purchased at a discount) 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 may be 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
22
<PAGE>
of the securities in the overall securitization structure. The Company has gross
unamortized premiums and unaccreted discounts of MBSs of $28.7 million and $48.2
million, respectively, at September 30, 1996. Although the interest rate
environment has experienced significant volatility during 1995 and the first
nine months of 1996, prepayments and extensions of cash flows from MBSs have not
materially affected investment income of the Company.
The Company also manages prepayment exposure on CMO holdings by
diversifying not only 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
and monitored giving full consideration to the collateral characteristics such
as weighted average coupon rate, weighted average maturity and the prepayment
history of the specific loan pool.
Total cash and investments were 93% investment grade or equivalent as of
September 30, 1996 and December 31, 1995. Investment grade securities are those
classified as 1 or 2 by the National Association of Insurance Commissioners
("NAIC") or, where such classifications are not available, having a rating on
the scale used by Standard & Poor's Corporation ("S&P") of BBB- or above. Yields
available on non-investment grade securities are generally higher than are
available on investment grade securities. However, credit risk is greater with
respect to such non-investment grade securities. 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 in total represent less than 0.1% of cash and investments as
of September 30, 1996.
At September 30, 1996, the ratings assigned by the NAIC and comparable S&P
ratings on the Company's fixed maturity portfolio, and the percentage of total
fixed maturity investments classified in each category were as follows:
<TABLE>
<CAPTION>
AMORTIZED COST
---------------------
PERCENT OF ESTIMATED
NAIC Designation (Comparable S&P Rating) (Dollars in millions) AMOUNT TOTAL FAIR VALUE
- -----------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
1 (AAA,AA,A) $ 2,080.7 69% $ 2,063.5
2 (BBB) 712.7 24 703.7
3 (BB) 142.5 5 142.3
4 (B) 83.3 2 82.4
5 (CCC,CC,C) -- -- --
6 (CI,D) --
-------------------------------------
Total fixed maturities $ 3,019.2 100% $ 2,991.9
=====================================
</TABLE>
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
23
<PAGE>
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 general decline in interest rates during 1995 and subsequent rise in
interest rates during the first nine months of 1996 resulted in unrealized
losses on available-for-sale securities which totaled $14.8 million (net of $4.1
million of related adjustments to deferred policy acquisition costs and value of
insurance in force and $8.0 million of deferred income taxes) at September 30,
1996, compared to unrealized gains of $28.5 million (net of $14.2 million of
related amortization of deferred policy acquisition costs and value of insurance
in force and $15.4 million of deferred income taxes) at December 31, 1995. This
change in net unrealized gains and losses on available-for-sale securities for
the nine months ended September 30, 1996 decreased reported shareholders' equity
by $43.3 million as compared to an increase of $133.5 million for the year ended
December 31, 1995. 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 assets and all liabilities are carried at historical values. At
September 30, 1996 and December 31, 1995, shareholders' equity excluding the
effects of SFAS No. 115 was $170.9 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
which 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 general rise in interest rates during
the first nine months of 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% and 2% of total cash and
investments at September 30, 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 the Company with respect to
principal (up to 100% of the investments' year-end 1992 statutory book value)
and interest with respect to approximately 99% of these loans at September 30,
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.
Assets held in separate accounts at September 30, 1996 totaled $1.0
billion, compared to $.8 billion at December 31, 1995. The increase was
primarily attributable to the receipt of variable annuity deposits and from a
market-driven increase in the value of existing variable annuity deposits
invested in mutual funds.
24
<PAGE>
LIQUIDITY AND FINANCIAL RESOURCES
Holding Company Operations
The Company's principal need for liquidity has historically consisted 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 ongoing 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. During
the first nine months of 1996, the Company received dividends of $14.0 million
from Integrity Life Insurance Company ("Integrity"). The amount remaining in
1996 that Integrity can distribute to the Company in the form of dividends is
limited to $3.6 million without prior approval of the Ohio Insurance Director.
The Company had cash and unaffiliated investments of $5.4 million at September
30, 1996. In addition, $20.0 million was available on unused bank lines of
credit at September 30, 1996.
Insurance Subsidiaries Operations
The sources of liquidity of the Company's insurance subsidiaries are
investment income and proceeds from maturities and redemptions of investments.
The principal uses of such funds are benefits, withdrawals and loans associated
with the various customer deposits, commissions, operating expenses and the
purchase of new investments.
The Company develops cash flow projections under a variety of interest rate
scenarios generated by the Company. The Company attempts to structure asset
portfolios 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 without exposure to material realized losses during
a higher interest rate environment. These other liquid assets include cash and
cash equivalents and high-grade floating-rate securities held by both the
Company and its insurance subsidiaries. The Company also has $20 million
available on unused bank lines of credit as mentioned above.
During the nine months ended September 30, 1996 and 1995, the Company met
its liquidity needs entirely by cash flows from operating activities and
principal payments and redemptions of investments. At September 30, 1996, cash
and cash equivalents totaled $49.8 million compared to $76.9 million at December
31, 1995. 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.
25
<PAGE>
The Company generated cash flows of $136.5 million and $100.2 million from
operating activities during the nine months ended September 30, 1996 and 1995,
respectively. These cash flows resulted principally from investment income, less
commissions and operating expenses. Proceeds from sales, maturities and
redemptions of investments generated $2.0 billion and $1.1 billion in cash flows
during the nine months ended September 30, 1996 and 1995, respectively, which
were offset by purchases of investments of $2.5 billion and $1.1 billion,
respectively. An increase in investment purchases and sales activity during the
first nine months of 1996 compared to 1995 reflects the Company's ongoing
management of its fixed maturity portfolio which has increased in size due to
sales of spread-based products and the acquisition of the SBM businesses.
FORWARD-LOOKING STATEMENTS
The statement of the Company's belief as to the stimulation of future
demand for long-term savings and retirement products, including variable and
equity-indexed annuity type products, under the heading "General" is a forward-
looking statement. Factors that could cause actual results to differ materially
from this forward-looking statement include, but are not limited to, a change in
population demographics, development of alternative investment products, a
change in economic conditions, and changes in current federal income tax laws.
26
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
As a consequence of the acquisition of State Bond and Mortgage Life
Insurance Company ("SBM Life") on June 14, 1995, and SBM Life's merger with and
into Integrity on December 31, 1995, Integrity became a party to a marketing
agreement (the "Agreement") with Multico Marketing Corporation ("Multico"). In
reliance upon the Agreement, Integrity eliminated commissions to Multico on new
product sales on a prospective basis effective July 1, 1995. Multico filed a
lawsuit in the United States District Court for the Western District of Kentucky
against Integrity on February 23, 1996, alleging breach of contract and breach
of the covenant of good faith and fair dealing, and seeking a trial by jury and
damages of approximately $61 million (the "Multico Action"). Integrity filed a
counterclaim against Multico seeking a declaration that Integrity's actions in
revising commissions did not constitute a breach of contract, and recovery of
commissions, fees, trailers, overwrites and bonuses paid to Multico in the
amount of approximately $9.3 million. Discovery is proceeding between the
parties. On May 23, 1996, Integrity filed a motion for summary judgement in the
litigation. While the Company believes that the Multico Action is without merit,
there can be no assurance that Integrity will prevail in the litigation.
Except for the Multico lawsuit discussed above, the Company and its
subsidiaries are currently involved only in routine legal and administrative
proceedings incidental to the conduct of their businesses. The Company believes
that none 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 filed no reports on Form 8-K during the three months ended
September 30, 1996.
Exhibits
See Exhibit Index on page 29 of this report.
27
<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 November 13, 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)
28
<PAGE>
<TABLE>
<CAPTION>
ARM FINANCIAL GROUP, INC. AND SUBSIDIARIES
EXHIBIT INDEX
==============================================================================
EXHIBIT
NUMBER DESCRIPTION
- ------------------------------------------------------------------------------
<S> <C>
2 Subscription Agreement dated as of July 1, 1996 between ARM Financial
Group, Inc. and Warren M. Foss. *
10.1 Assignment and Assumption Agreement dated as of June 28, 1996 between
Northwestern National Life Insurance Company and ARM Financial Group,
Inc. *
10.2 Employment Agreement dated as of July 1, 1996 between ARM Financial
Group, Inc. and John Franco. *
10.3 Employment Agreement dated as of July 1, 1996 between ARM Financial
Group, Inc. and Martin H. Ruby. *
10.4 Employment Agreement dated as of July 1, 1996 between ARM Financial
Group, Inc. and David E. Ferguson. *
10.5 Employment Agreement dated as of July 1, 1996 between ARM Financial
Group, Inc. and John R. Lindholm. *
27 Financial Data Schedule (filed herewith).
</TABLE>
- -----------------
* Incorporated by reference to the Registration Statement on Form S-1 of
the Registrant, filed on October 23, 1996.
29
<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 NINE MONTHS ENDED SEPTEMBER 30, 1996 AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> SEP-30-1996
<DEBT-HELD-FOR-SALE> 2,991,885
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 31,883
<MORTGAGE> 37,159
<REAL-ESTATE> 0
<TOTAL-INVEST> 3,181,694
<CASH> 49,808
<RECOVER-REINSURE> 0
<DEFERRED-ACQUISITION> 54,231
<TOTAL-ASSETS> 4,458,601
<POLICY-LOSSES> 3,209,729
<UNEARNED-PREMIUMS> 0
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 40,000
<COMMON> 0
0
50,000
<OTHER-SE> 106,144
<TOTAL-LIABILITY-AND-EQUITY> 4,458,601
0
<INVESTMENT-INCOME> 183,203
<INVESTMENT-GAINS> (2,332)
<OTHER-INCOME> 17,239
<BENEFITS> 133,349
<UNDERWRITING-AMORTIZATION> 4,599
<UNDERWRITING-OTHER> 26,353
<INCOME-PRETAX> 18,531
<INCOME-TAX> 3,719
<INCOME-CONTINUING> 14,812
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 14,812
<EPS-PRIMARY> 453.94
<EPS-DILUTED> 453.94
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
