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. 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, Medicare Part D, and annuity. Effective January 1, 2014, Torchmark reorganized its segment structure to separate its Medicare Part D health insurance business from its other health insurance activities as a stand-alone segment. Management has concluded that Medicare Part D meets the criteria of a distinct segment. Previously, Part D was included in the health segment. Prior periods’ segment results have been retrospectively adjusted for comparability. Premium income for Medicare Part D health insurance is included with the premium for other health products in the Consolidated Statements of Operations. Annuity revenue is classified as “Other premium.” 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 of 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 generally 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 2013, the total premiums and benefits were the same under this alternative method as they were under GAAP and are expected to be the same in 2014. 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,
	2014			2013
Benefit costs deferred	$	60,899		$	29,945
Government risk-sharing premium adjustment		(35,131	)		(14,895	)

Pre-tax addition to segment interim period income	$	25,768		$	15,050

After tax amount	$	16,749		$	9,782

The significant increases in the risk-sharing adjustments in 2014 were caused by the increase in volume of business and certain benefit design changes.

Additionally, management does not view the risk-sharing premium for Medicare Part D as a component of premium income, and accordingly adjusts health premium income in its segment analysis. A reconciliation of health premium included in the segment analysis with health premium as reported in the Consolidated Statements of Operations is presented in the following table.


	Six months ended
	June 30,
	2014		2013		% Change
Premium per segment analysis:
Medicare Part D premium	$	167,990	$	149,809		12
Other health premium		434,533		439,751		(1	)
Part D risk sharing adjustment		35,131		14,895		136

Health premium per Consolidated Statements of Operations	$	637,654	$	604,455		5

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. As described in Note G—New Unadopted Accounting Guidance, new accounting guidance related to low-income housing investments will conform more closely with Torchmark’s segment reporting once adopted in future periods.

During the first six months of 2014, Torchmark accrued for certain litigation cases in the net amount of $3.7 million ($2.4 million after tax) that were not directly related to its insurance operations. Additionally, Torchmark received $1.3 million ($853 thousand after tax) in settlement of litigation regarding investments. Also in the second quarter of 2014, the Company recorded $3.1 million in administrative settlements ($2.0 million after tax) related to benefits paid for deaths occurring in prior years where claims had not been filed. These administrative settlements are the result of the Company’s program of matching policyholder information against the Social Security death master file and obtaining due proof of loss. While more settlements under this program are expected during the next few months, the Company is not able to estimate the extent of such additional settlements at this time. These administrative settlements were included in “Policyholder benefits” in the Consolidated Statements of Operations in 2014.

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. With the exception of the administrative settlements above, all of these items are included in “Other operating expense” in the Consolidated Statements of Operations for the appropriate year. 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 ongoing 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.

Reconciliation of Segment Operating Information to the Consolidated Statement of Operations


	For the six months ended June 30, 2014
	Life			Health			Medicare Part D		Annuity			Investment			Other & Corporate			Adjustments			Consolidated
Revenue:
Premium	$	981,010		$	434,533		$	167,990	$	222								$	35,131	⁽¹⁾	$	1,618,886
Net investment income												$	377,981						(14,104	)⁽⁴⁾		363,877
Other income															$	1,266			(122	)⁽³⁾		1,144

Total revenue		981,010			434,533			167,990		222			377,981			1,266			20,905			1,983,907
Expenses:
Policy benefits		641,311			280,140			135,233		21,084									63,956	^(1,6)		1,141,724
Required interest on:
Policy reserves		(262,328	)		(31,758	)				(27,616	)		321,702									0
Deferred acquisition costs		83,633			11,223			354		764			(95,974	)								0
Amortization of acquisition costs		167,991			36,072			1,377		3,854												209,294
Commissions, premium taxes, and non-deferred acquisition costs		69,068			39,611			12,815		26									(122	)⁽³⁾		121,398
Insurance administrative expense ⁽²⁾																89,573			2,337	⁽⁵⁾		91,910
Parent expense																4,045						4,045
Stock compensation expense																17,401						17,401
Interest expense													38,086									38,086

Total expenses		699,675			335,288			149,779		(1,888	)		263,814			111,019			66,171			1,623,858

Subtotal		281,335			99,245			18,211		2,110			114,167			(109,753	)		(45,266	)		360,049
Nonoperating items																			31,162	^(1,5,6)		31,162
Amortization of low-income housing																			14,104	⁽⁴⁾		14,104

Measure of segment profitability (pretax)	$	281,335		$	99,245		$	18,211	$	2,110		$	114,167		$	(109,753	)	$	0			405,315

Deduct applicable income taxes																						(132,458	)

Segment profits after tax																						272,857
Add back income taxes applicable to segment profitability																						132,458
Add (deduct) realized investment gains (losses)																						17,196
Deduct Part D adjustment ⁽¹⁾																						(25,768	)
Deduct amortization of low-income housing ⁽⁴⁾																						(14,104	)
Deduct legal settlement expenses ⁽⁵⁾																						(2,337	)
Deduct administrative settlements ⁽⁶⁾																						(3,057	)

Pretax income per Consolidated Statement of Operations																					$	377,245

(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)	Legal settlement expenses.

(6)	Administrative settlements.

Reconciliation of Segment Operating Information to the Consolidated Statement of Operations *


	For the six months ended June 30, 2013
	Life			Health			Medicare Part D		Annuity			Investment			Other & Corporate			Adjustments			Consolidated
Revenue:
Premium	$	945,923		$	439,751		$	149,809	$	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			439,751			149,809		287			367,204			1,227			2,348			1,906,549
Expenses:
Policy benefits		615,990			283,852			125,191		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			11,169			335		959			(94,803	)								0
Amortization of acquisition costs		162,534			35,528			1,257		4,883												204,202
Commissions, premium taxes, and non-deferred acquisition costs		67,575			38,450			6,790		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			339,627			133,573		(1,709	)		256,735			105,945			31,454			1,542,708

Subtotal		268,840			100,124			16,236		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		$	100,124		$	16,236	$	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.

*	Retrospectively adjusted to give effect to the reorganization of segments described earlier in this Note.

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

Analysis of Profitability by Segment


	Six months ended June 30,						Increase (Decrease)
	2014			2013*			Amount			%
Life	$	281,335		$	268,840		$	12,495			5
Health		99,245			100,124			(879	)		(1	)
Medicare Part D		18,211			16,236			1,975			12
Annuity		2,110			1,996			114
Investment		114,167			110,469			3,698			3
Other and corporate:
Other income		1,266			1,227			39			3
Administrative expense		(89,573	)		(88,062	)		(1,511	)		2
Corporate		(21,446	)		(17,883	)		(3,563	)		20

Pretax total		405,315			392,947			12,368			3
Applicable taxes		(132,458	)		(128,632	)		(3,826	)		3

Total		272,857			264,315			8,542			3
Reconciling items, net of tax:
Realized gains (losses) - Investments		11,177			76			11,101
Part D adjustment		(16,749	)		(9,782	)		(6,967	)
Guaranty Fund assessment		0			(751	)		751
Administrative settlements		(1,987	)		0			(1,987	)
Legal settlement expense		(1,519	)		(325	)		(1,194	)

Net income	$	263,779		$	253,533		$	10,246			4

*	Retrospectively adjusted to give effect to the reorganization of segments described earlier in this Note.