NOTE F—Business Segments

Torchmark is comprised of life insurance companies which primarily market individual life and supplemental health insurance products through niche distribution systems to middle income Americans. To a limited extent, the Company also markets fixed annuities. Torchmark’s core operations are insurance marketing and underwriting, and management of its investments. Insurance marketing and underwriting is segmented by the types of insurance products offered: life, health, and annuity. Management’s measure of profitability for each insurance segment is insurance underwriting margin, which is underwriting income before other income and insurance administrative expenses. It represents the profit margin on insurance products before administrative expenses, and is calculated by deducting net policy obligations (claims incurred and change in reserves), commissions and other acquisition expenses from premium revenue. Torchmark further views the profitability of each insurance product segment by the marketing groups that distribute the products of that segment: direct response, independent, or captive agencies.

The investment segment includes the management of the investment portfolio, debt, and cash flow. Management’s measure of profitability for this segment is excess investment income, which is the income earned on the investment portfolio less the required interest on net policy liabilities and financing costs. Financing costs include the interest on Torchmark’s debt. Other income and insurance administrative expense are classified in a separate “Other” segment.

The majority of the Company’s required interest on net policy liabilities (benefit reserves less the deferred acquisition cost asset) is not credited to policyholder accounts. Instead, it is an actuarial assumption for discounting cash flows in the computation of benefit reserves and the amortization of the deferred acquisition cost asset. Required interest related to the net policy liabilities is not included in the various insurance underwriting segments but is shown in the investment segment as a reduction to net investment income. We believe this presentation facilitates a more meaningful analysis of the Company’s underwriting and investment performance as the underwriting results are based on premiums, claims, and expenses and are not affected by unanticipated fluctuations in investment yields.

As noted, Torchmark’s “core operations” are insurance and investment management. The insurance segments issue policies for which premiums are collected for the eventual payment of policy benefits. In addition to policy benefits, operating expenses are incurred including acquisition costs, administrative expenses, and taxes. Because life and health contracts can be long term, premium receipts in excess current expenses are invested. Investment activities, conducted by the investment segment, focus on seeking quality investments with a yield and term appropriate to support the insurance product obligations. These investments generally consist of fixed maturities, and, over the long term, the expected yields are taken into account when setting insurance premium rates and product profitability expectations. As a result, fixed maturities are generally held for long periods to support the liabilities, and Torchmark generally expects to hold investments until maturity. Dispositions of investments occur from time to time, generally as a result of credit concerns, calls by issuers, or other factors usually beyond the control of management.

Dispositions are sometimes required in order to maintain the Company’s investment policies and objectives. Investments are also occasionally written down as a result of other-than-temporary impairment. Torchmark does not actively trade investments. As a result, realized gains and losses from the disposition and write down of investments are generally incidental to operations and are not considered a material factor in insurance pricing or product profitability. While from time to time these realized gains and losses could be significant to net income in the period in which they occur, they generally have a limited effect on the yield of the total investment portfolio. Further, because the proceeds of the disposals are reinvested in the portfolio, the disposals have little effect on the size of the portfolio and the income from the reinvestments is included in net investment income. Therefore, management removes realized investment gains and losses from results of core operations when evaluating the performance of the Company. For this reason, these gains and losses are excluded from Torchmark’s operating segments.

Torchmark accounts for its stock options and restricted stock under current accounting guidance requiring stock options and stock grants to be expensed based on fair value at the time of grant. Management considers stock compensation expense to be an expense of the Parent Company. Therefore, stock compensation expense is treated as a corporate expense in Torchmark’s segment analysis.

Torchmark provides coverage under the Medicare Part D prescription drug plan for Medicare beneficiaries. In accordance with GAAP, Part D premiums are recognized evenly throughout the year when they become due but benefit costs are recognized when the costs are incurred. Due to the design of the Part D product, premiums are evenly distributed throughout the year, but benefit costs are higher earlier in the year. As a result, under GAAP, benefit costs can exceed premiums in the first part of the year, but be less than premiums during the remainder of the year. In order to more closely match the benefit cost with the associated revenue for interim periods, Torchmark defers these excess benefits for segment reporting purposes. In addition, GAAP recognizes in each quarter a government risk-sharing premium adjustment consistent with the contract as if the quarter represented an entire contract period. These quarterly risk-sharing adjustments are removed in the segment analysis because the actual contract payments are based upon the experience of the full contract year, not the experience of interim periods. For the entire year, Torchmark expects its benefit ratio to be in line with pricing and does not expect to receive any government risk-sharing premium. For the full year of 2012, the total premiums and benefits were the same under this alternative method as they were under GAAP and are expected to be essentially the same in 2013. The Company’s presentation results in the underwriting margin percentage of each interim period reflecting the expected margin percentage for the full year.

An analysis of the adjustments for the difference in the interim results as presented for segment purposes and GAAP for Medicare Part D is as follows.


	Six months ended
	June 30,
	2013			2012
Benefit costs deferred	$	29,945		$	32,640
Government risk-sharing premium adjustment		(14,895	)		(11,274	)

Pre-tax addition to segment interim period income	$	15,050		$	21,366

After tax amount	$	9,782		$	13,888

Torchmark has invested in various limited partnerships that provide investment returns through the provision of low-income housing tax credits and other related Federal income tax benefits to the Company. The investment returns from a portion of the interests are guaranteed by unrelated third-parties. Under GAAP, expenses associated with the amortization of the guaranteed interests are required to be reflected in income tax expense. In contrast, GAAP requires the expenses associated with the amortization of non-guaranteed interests to be reflected as a component of “Net investment income.” All of the investment returns from investing in these guaranteed and non-guaranteed limited partnerships interests are in the form of income tax benefits reflected in income tax expense. Management believes including the amortization

expense associated with the non-guaranteed as well as the guaranteed interests in income tax expense provides a more appropriate matching of the expense with the related income. For this reason, amortization expense of the non-guaranteed interests is included in “Income taxes” and not “Net investment income” for segment reporting purposes.

During the second quarter of 2013, Torchmark incurred two non-operating charges: (1) a state guaranty fund assessment in the amount of $1.2 million ($751 thousand after tax) and (2) a legal settlement related to a non-insurance matter in the amount of $500 thousand ($325 thousand after tax). The assessment related to Torchmark’s share of state guaranty fund assessments resulting from events in years prior to 2012. While these items are included in “Other operating expense” in the 2013 Consolidated Statement of Operations, the Company removes items related to prior years and non-operating items such as these from its segment analysis because management does not view such expenses as part of its core insurance operating results.

The following tables total the components of Torchmark’s operating segments and reconcile these operating results to its pretax income and each significant line item in its Consolidated Statements of Operations.


	For the six months ended June 30, 2013
	Life			Health			Annuity			Investment			Other & Corporate			Adjustments			Consolidated
Revenue:
Premium	$	945,923		$	589,560		$	287								$	14,895	⁽¹⁾	$	1,550,665
Net investment income										$	367,204						(12,401	)⁽⁴⁾		354,803
Other income													$	1,227			(146	)⁽³⁾		1,081

Total revenue		945,923			589,560			287			367,204			1,227			2,348			1,906,549
Expenses:
Policy benefits		615,990			409,043			21,524									29,945	⁽¹⁾		1,076,502
Required interest on:
Policy reserves		(251,356	)		(29,372	)		(29,105	)		309,833									0
Deferred acquisition costs		82,340			11,504			959			(94,803	)								0
Amortization of acquisition costs		162,534			36,785			4,883												204,202
Commissions, premium taxes, and non-deferred acquisition costs		67,575			45,240			30									(146	)⁽³⁾		112,699
Insurance administrative expense ⁽²⁾														88,062			1,155	⁽⁵⁾		89,217
Parent expense														4,927			500	⁽⁶⁾		5,427
Stock compensation expense														12,956						12,956
Interest expense											41,705									41,705

Total expenses		677,083			473,200			(1,709	)		256,735			105,945			31,454			1,542,708

Subtotal		268,840			116,360			1,996			110,469			(104,718	)		(29,106	)		363,841
Nonoperating items																	16,705	^(1,5,6)		16,705
Amortization of low-income housing																	12,401	⁽⁴⁾		12,401

Measure of segment profitability (pretax)	$	268,840		$	116,360		$	1,996		$	110,469		$	(104,718	)	$	0			392,947

Deduct applicable income taxes																				(128,632	)

Segment profits after tax																				264,315
Add back income taxes applicable to segment profitability																				128,632
Add (deduct) realized investment gains (losses)																				2,006
Deduct Part D adjustment ⁽¹⁾																				(15,050	)
Deduct amortization of low-income housing ⁽⁴⁾																				(12,401	)
Deduct Guaranty Fund Assessment ⁽⁵⁾																				(1,155	)
Deduct legal settlement expense ⁽⁶⁾																				(500	)

Pretax income from continuing operations per Consolidated Statement of Operations																			$	365,847

(1)	Medicare Part D items adjusted to GAAP from the segment analysis, which matches expected benefits with policy premium.

(2)	Administrative expense is not allocated to insurance segments.

(3)	Elimination of intersegment commission.

(4)	Amortization of low-income housing expense, considered a component of income tax expense in the segment analysis.

(5)	Guaranty Fund Assessment.

(6)	Legal settlement expense.

Reconciliation of Segment Operating Information to the Consolidated Statement of Operations


	For the six months ended June 30, 2012
	Life			Health			Annuity			Investment			Other & Corporate			Adjustments			Consolidated
Revenue:
Premium	$	902,828		$	509,676		$	279								$	11,274	⁽¹⁾	$	1,424,057
Net investment income										$	360,329						(11,032	)^(2,5)		349,297
Other income													$	865			(168	)⁽⁴⁾		697

Total revenue		902,828			509,676			279			360,329			865			74			1,774,051
Expenses:
Policy benefits		583,472			359,489			21,853									32,640	⁽¹⁾		997,454
Required interest on:
Policy reserves		(238,656	)		(18,700	)		(29,766	)		287,122									0
Deferred acquisition costs		81,814			9,196			1,177			(92,187	)								0
Amortization of acquisition costs		155,649			32,243			5,207												193,099
Commissions, premium taxes, and non-deferred acquisition costs		70,254			31,234			36									(168	)⁽⁴⁾		101,356
Insurance administrative expense ⁽³⁾														80,427						80,427
Parent expense														4,210						4,210
Stock compensation expense														11,237						11,237
Interest expense											39,188						132	⁽²⁾		39,320

Total expenses		652,533			413,462			(1,493	)		234,123			95,874			32,604			1,427,103

Subtotal		250,295			96,214			1,772			126,206			(95,009	)		(32,530	)		346,948
Nonoperating items																	21,366	⁽¹⁾		21,366
Amortization of low-income housing																	11,164	⁽⁵⁾		11,164

Measure of segment profitability (pretax)	$	250,295		$	96,214		$	1,772		$	126,206		$	(95,009	)	$	0			379,478

Deduct applicable income taxes																				(124,209	)

Segment profits after tax																				255,269
Add back income taxes applicable to segment profitability																				124,209
Add (deduct) realized investment gains (losses)																				9,667
Deduct Part D adjustment ⁽¹⁾																				(21,366	)
Deduct amortization of low-income housing ⁽⁵⁾																				(11,164	)

Pretax income from continuing operations per Consolidated Statement of Operations																			$	356,615

(1)	Medicare Part D items adjusted to GAAP from the segment analysis, which matches expected benefits with policy premium.

(2)	Reclassification of interest amount due to accounting rule requiring deconsolidation of Trust Preferred Securities. Management views the Trust Preferreds as consolidated debt.

(3)	Administrative expense is not allocated to insurance segments.

(4)	Elimination of intersegment commission.

(5)	Amortization of low-income housing expense, considered a component of income tax expense in the segment analysis.

The following table summarizes the measures of segment profitability for comparison. It also reconciles segment profits to net income.

Analysis of Profitability by Segment

(Dollar amounts in thousands)


	Six months ended June 30,						Increase (Decrease)
	2013			2012			Amount			%
Life insurance	$	268,840		$	250,295		$	18,545			7
Health insurance		116,360			96,214			20,146			21
Annuity		1,996			1,772			224
Investment		110,469			126,206			(15,737	)		(12	)
Other and corporate:
Other income		1,227			865			362			42
Administrative expense		(88,062	)		(80,427	)		(7,635	)		9
Corporate		(17,883	)		(15,447	)		(2,436	)		16

Pretax total		392,947			379,478			13,469			4
Applicable taxes		(128,632	)		(124,209	)		(4,423	)		4

Total		264,315			255,269			9,046			4
Reconciling items, net of tax:
Realized gains (losses) - Investments		76			6,284			(6,208	)
Part D adjustment		(9,782	)		(13,888	)		4,106
Guaranty Fund Assessment		(751	)		0			(751	)
Legal settlement expense		(325	)		0			(325	)

Net income	$	253,533		$	247,665		$	5,868			2