10-Q 1 a20011q.txt FIC10Q2001 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934 For the Quarterly Period Ended March 31, 2001 Commission File Number 0-4690 FINANCIAL INDUSTRIES CORPORATION (Exact Name of Registrant as specified in its charter) Texas 74-2126975 (State of Incorporation) (I.R.S. Employer Identification Number) 6500 River Place Blvd., Building One Austin, Texas 78730 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (512) 404-5000 Indicate by check mark whether the registrant (1) 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 (2) has been subject to such filing requirements for the past 90 days. YES X NO Number of common shares outstanding ($.20 par value) at end of period: 5,054,661. - 1 - Forward-Looking Statements Except for historical factual information set forth in this Form 10-Q, the statements, analyses, and other information contained in this report relating to trends in the Company's operations and financial results, the markets for the Company's products, the future development of the Company's business, and the contingencies and uncertainties to which the Company may be subject, as well as other statements including words such as "anticipate," "believe," "path," "estimate," "expect," "intend" and other similar expressions constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Such statements are made based upon management's current expectations and beliefs concerning the financial results, economic conditions and are subject to known and unknown risks, uncertainties and other factors contemplated by the forward-looking statements. Such factors include, among other things: (1) general economic conditions and other factors, including prevailing interest rate levels and stock market performance, which may affect the ability of FIC to sell its products, the market value of FIC's investments and the lapse rate and profitability of policies; (2) FIC's ability to achieve anticipated levels of operational efficiencies and cost-saving initiatives; (3) customer response to new products, distribution channels and marketing initiatives; (4) mortality, morbidity and other factors which may affect the profitability of FIC's insurance products; (5) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of FIC's products; (6) increasing competition in the sale of insurance and annuities; (7) regulatory changes or actions, including those relating to regulation of insurance products and insurance companies; (8) ratings assigned to FIC's insurance subsidiaries by independent rating organizations such as A.M. Best Company, which FIC believes are particularly important to the sale of annuity and other accumulation products; and (9) unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect FIC. - 2 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES INDEX Page No. Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets March 31, 2001 and December 31, 2000.......................... 4 Consolidated Statements of Income For the three month period ended March 31, 2001 and March 31, 2000............................. 6 Consolidated Statements of Cash Flows For the three month period ended March 31, 2001 and March 31, 2000............................. 8 Notes to Consolidated Financial Statements.............................10 Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations................12 Item 3. Quantitative and Qualitative Disclosures About Market Risk ............................................21 Part II Other Information.....................................................22 Signature Page........................................................25 - 3 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) March 31, December 31, 2001 2000 (unaudited) ASSETS Investments other than investments in affiliate: Fixed maturities available for sale at market value (amortized cost of $74,946 and $78,249 at March 31, 2001 and December 31, 2000, respectively) $ 77,340 $ 79,786 Equity securities at market (cost approximates $11 at March 31, 2001 and December 31, 2000) 4 4 Policy loans 3,746 3,699 Short-term investments 14,862 15,624 Total investments 95,952 99,113 Cash and cash equivalents 3,855 2,733 Investment in affiliate 79,559 79,105 Accrued investment income 1,348 1,172 Agency advances and other receivables 9,854 7,604 Reinsurance receivables 18,136 17,466 Due and deferred premiums 12,863 12,537 Property and equipment, net 1,318 1,318 Deferred policy acquisition costs 56,695 56,161 Present value of future profits of acquired business 18,602 19,440 Other assets 4,453 4,117 Total Assets $ 302,635 $ 300,766
The accompanying notes are an integral part of these consolidated financial statements - 4 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) March 31, December 31, 2001 2000 (unaudited) LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Policy liabilities and contract holder deposit funds: Future policy benefits $ 62,584 $ 62,462 Contract holder deposit funds 43,055 43,301 Unearned premiums -0- -0- Other policy claims and benefits payable 3,303 2,931 108,942 108,694 Subordinated notes payable to affiliate 33,812 35,349 Deferred federal income taxes 24,473 24,437 Other liabilities 5,491 3,734 Total Liabilities 172,718 172,214 Commitments and Contingencies Shareholders' equity: Common stock, $.20 par value, 10,000,000 shares authorized; 5,845,300 shares issued, 5,054,661 outstanding in 2001 and 2000 1,169 1,169 Additional paid-in capital 7,225 7,225 Accumulated other comprehensive income 3,320 2,107 Retained earnings 125,578 125,426 137,292 135,927 Common treasury stock, at cost, 790,639 shares in 2001 (7,375) (7,375) and 2000 Total Shareholders' Equity 129,917 128,552 Total Liabilities and Shareholders' Equity $ 302,635 $ 300,766
The accompanying notes are an integral part of these consolidated financial statements. - 5 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended March 31, 2000 2001 (unaudited) Revenues: Premiums $ 8,038 $ 8,401 Net investment income 1,631 1,740 Earned insurance charges 934 1,147 10,603 11,288 Benefits and expenses: Policyholder benefits and expenses 2,591 3,351 Interest expense on contract holders deposit funds 570 590 Amortization of present value of future profits of acquired businesses 838 1,016 Amortization of deferred policy acquisition costs 1,439 1,349 Operating expenses 3,140 2,947 Interest expense 427 528 9,005 9,781 Income before federal income tax and equity in net earnings of affiliates 1,598 1,507 Provision for federal income taxes 360 259 Income before equity in net earnings of affiliates 1,238 1,248 Equity in net earnings of affiliate, net of tax 845 966 Net Income $ 2,083 $ 2,214
The accompanying notes are an integral part of these consolidated statements. - 6 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended March 31, 2001 2000 (unaudited) Net Income Per Share Basic: Average weighted shares outstanding 5,055 5,055 Basic earnings per share $ 0.41 $ 0.44 Diluted: Common stock and common stock equivalents 5,183 5,167 Diluted earnings per share $ 0.40 $ 0.43
The accompanying notes are an integral part of these consolidated financial statements. - 7 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Three Months Ended March 31, 2001 2000 (unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 2,083 $ 2,214 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Amortization of present value of future profits of acquired business 838 1,016 Amortization of deferred policy acquisition costs 1,439 1,349 Equity in undistributed earnings of affiliate (1,361) (1,526) Changes in assets and liabilities: (Increase) decrease in accrued investment income (176) 49 Increase in agent advances and other receivables (2,920) (257) (Increase) decrease in due premiums (326) 137 Increase in deferred policy acquisition costs (1,973) (1,971) (Increase) decrease in other assets (336) 100 Increase (decrease) in policy liabilities and accruals 248 (220) Increase (decrease) in other liabilities 1,757 (465) (Decrease) increase in deferred federal income taxes 36 (47) Other, net (661) (140) Net cash (used in) provided by operating activities $ (1,352) $ 239
The accompanying notes are an integral part of these consolidated financial statements. - 8 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued (in thousands) Three Months Ended March 31, 2001 2000 (unaudited) CASH FLOWS FROM INVESTING ACTIVITIES Fixed maturities purchased $ (5,200) $ (1,462) Increase in policy loans (47) (3) Proceeds from calls and maturities of fixed maturities 8,496 232 Net increase (decrease) in short-term investments 762 2,712 Net cash provided by investing activities 4,011 1,479 CASH FLOW FROM FINANCING ACTIVITIES Repayment of subordinated notes payable (1,537) (1,537) Net cash used in financing activities (1,537) (1,537) Net increase in cash 1,122 181 Cash and cash equivalents, beginning of year 2,733 692 Cash and cash equivalents, end of period $ 3,855 $ 873
The accompanying notes are an integral part of these consolidated financial statements. - 9 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The financial statements included herein have been presented to conform to the requirements of Form 10-Q. This presentation includes year end balance sheet data which was derived from audited financial statements. The notes to the financial statements do not necessarily include all disclosures required by generally accepted accounting principles (GAAP). The reader should refer to Form 10-K for the year ended December 31, 2000 previously filed with the Securities and Exchange Commission for financial statements prepared in accordance with GAAP. Management believes the financial statements reflect all adjustments necessary to present a fair statement of interim results. Certain prior year amounts have been reclassified to conform with current year presentation. The consolidated financial statements include the accounts of Financial Industries Corporation ("FIC") and its wholly-owned subsidiaries. The investment of FIC in InterContinental Life Corporation ("ILCO") is presented using the equity method. All significant intercompany items and transactions have been eliminated. Other Comprehensive Income The following is a reconciliation of accumulated other comprehensive income from December 31, 2000 to March 31, 2001 (in thousands): Net unrealized Total gain on Net accumulated investments appreciation other in fixed maturities of equity comprehensive available for sale securities income Balance at December 31, 2000 $ 2,107 $ 0 $ 2,107 Current Period Change 1,213 0 1,213 Balance at March 31, 2001 $ 3,320 $ 0 $ 3,320
- 10 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Dividends Declared In March, 2001 FIC announced that its board approved the payment of an annual cash dividend in the amount of $0.41 per share. The dividend has been accrued in other liabilities on the consolidated balance sheet and was paid on April 12, 2001, to shareholders of record as of the close of business on March 19, 2001. New Accounting Pronouncements In June, 1998, the FASB issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133, as amended by FAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - An Amendment of FASB Statement No. 133", is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000 as amended by FAS No 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No 133". As the Company does not have significant investments in derivative financial instruments, the adoption of FAS 133 did not have a material impact on the Company's results of operations, liquidity or financial position. - 11 - Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operation Results of Operations - Three Months Ended March 31, 2001 and 2000 For the three-month period ended March 31, 2001, Financial Industries Corporation's ("FIC") net income was $2,083,000 (basic earnings of $0.41 per common share, or diluted earnings of $0.40 per common share) as compared to $2,214,000 (basic earnings of $0.44 per common share, or diluted earnings of $0.43 per common share) in the first three months of 2000. Earnings per share are stated in accordance with the requirements of FAS No. 128, which establishes two measures of earnings per share: basic earnings per share and diluted earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect the potential dilution that would occur if securities or other contracts to issue common stock were converted or exercised. FIC's income from operations - as determined before federal income tax and equity in net earnings of its affiliate, InterContinental Life Corporation - for the three-month period ended March 31, 2001, was $1,598,000 (on revenues of $10,603,000), as compared to $1,507,000 (on revenues of $11,288,000), in the first three months of 2000. The operating strategy of the Company's management emphasizes several key objectives: expense management; marketing of competitively priced insurance products which are designed to generate an acceptable level of profitability; maintenance of a high quality portfolio of investment grade securities; and the provision of quality customer service. Revenues. Premiums for the first three months of 2001, net of reinsurance ceded, were $8.0 million, as compared to $8.4 million in the first three months of 2000. This source of revenues is related to Family Life's traditional life insurance book of business, primarily Family Life's term life insurance business. The decrease from March 31, 2000 to March 31, 2001 is attributable to the decrease in the traditional life insurance book of business from $5.76 billion at March 31, 2000 to $5.51 billion at March 31, 2001. The net investment income for the first three months of 2001 was $1.63 million as compared to $1.74 million in the same period of 2000. The net investment income decreased as compared to the same quarter for 2000 because there was a decline in the average interest rate earned on the investment portfolio of the Company. - 12 - Earned insurance charges for the first three months of 2001 were $0.93 million, as compared to $1.15 million in the same period of 2000. This source of revenue is related to Family Life's universal life insurance and annuity book of business. The decline in the level of earned insurance charges is attributable to a decrease in Family Life's universal life and annuity business. The face amount of in force universal life policies was $908 million at March 31, 2000 as compared to $897 million at March 31, 2001. Benefits and Expenses. Policyholder benefits and expenses were $2.6 million in the first quarter of 2001, as compared to $3.4 million in the first quarter of 2000. The change between the two periods is attributable to a decline in the amount of benefits paid during the first quarter of 2001 of $0.87 million. Interest expense on contract holders deposit funds was $0.57 million in the first quarter of 2001, as compared to $0.59 million in the same period of the year 2000. This expense's slight decrease is related to the small decrease in the level of contract holder deposit funds, which declined from $43.3 million at December 31, 2000 to $43.1 million at March 31, 2001. In the first three months of 2001, the amortization of present value of future profits of acquired business was $0.84 million as compared to $1.02 million in the first three months of 2000. These decreases in amortization were expected and should continue to decrease as the underlying asset, present value of future profits, decreases. The amortization of deferred policy acquisition costs was $1.44 million in the first three months of 2001, as compared to $1.35 million in the first three months of 2000. The increase in amortization is attributable to the capitalization of expenses incurred in connection with the writing of new business. The operating expenses for the first three months of 2001 were $3.14 million, as compared to $2.95 million in the first three months of 2000. The increase was due to a higher level of expenses over the current period versus the prior period's expenses. Interest expense for the first three months of 2001 was $0.43 million, as compared to $0.53 million in the first three months of 2000. The decrease in the amount of interest expenses from the first quarter of 2000 to the first quarter of 2001 is attributable to the scheduled reduction in the amount of outstanding indebtedness. - 13 - The provision for federal income taxes was $0.36 million in the first three months of 2001 as compared to $0.26 million in the first three months of 2000. The increase is due to the increase in income from operations. Equity in Net Income of InterContinental Life Corporation General For the three-month period ended March 31, 2001, the Company's equity in the net earnings of InterContinental Life Corporation ("ILCO"), net of federal income tax, was $845,000, as compared to $966,000 for the first three months of 2000. The decrease is attributable to the lower level of ILCO's earnings. FIC currently owns 3,591,534 shares of ILCO's common stock. In addition, Family Life currently owns 342,400 shares of ILCO common stock. As a result, FIC currently owns, directly and indirectly through Family Life, 3,933,934 shares (approximately 48.1%) of ILCO's common stock. FIC carries its investment in ILCO using the equity method of accounting. At March 31, 2001, FIC's investment in affiliate was valued at $79.56 million. The book value of ILCO's common stock at March 31, 2001 was $20.55 per share, which is substantially above the market value ($12.00) of ILCO's common stock on that same date. The applicable accounting standards permit FIC to carry its investment in ILCO on the equity method of accounting, without any adjustment to reflect the difference between book value and market value. Under certain circumstances, Accounting Principles Board Opinion 18 ("APB 18") and Staff Accounting Bulletin Topic 5.M ("SAB 5.M") require an adjustment to earnings where the value of an investment is deemed to have decreased on an other than a temporary basis. Application of the "other than temporary" provisions of APB 18 and SAB 5.M to FIC's investment in ILCO would potentially result in a charge to earnings in some future period. The amount of such charge would be based primarily upon the market price of ILCO's common stock, which ranged from $9.313 per share to $17.99 per share during the period from January 1, 2001 to May 14, 2001. Based on that range of market prices, the range of possible impairment charges which might result would be from $8.16 million to $39.76 million, net of tax. However, management believes that an adjustment to earnings is neither required nor appropriate under the provisions of APB 18 and SAB 5.M. In addition, management notes that FIC and ILCO are currently parties to an Agreement and Plan of Merger whereby ILCO would become a wholly-owned subsidiary of FIC. FIC believes that it is probable that the merger will be consummated. After the merger, FIC will include ILCO in its consolidated financial statements. FIC expects to recover the cost of its investment in ILCO from the realization of ILCO's net assets through consolidation. As of March 31, 2001, the market value of the fixed maturities available for sale segment was $427.36 million as compared to an amortized cost of $418.02 million, or an unrealized gain of $9.34 million. The increase reflects unrealized gains on such investments related to changes in interest rates subsequent to the purchase of such investments. Since FIC owns approximately 48.1% of the common stock of ILCO, such unrealized gains, net of tax, are reflected in FIC's investment in affiliate and accumulated other comprehensive income, and had the effect of increasing the reported value of such equity interest by approximately $1.9 million. The net of tax effect of this increase ($1.8 million at March 31, 2001) is included in "Accumulated other comprehensive income" on the Consolidated Balance Sheets and has been recorded as an increase in shareholders' equity. As required under the provisions of FAS No. 130, the determination of "Accumulated other comprehensive income" includes separate identification of the change in values which occurred during the current period. As of December 31, 2000, the market value of the fixed maturities available for sale segment was $440.7 million as compared to an amortized cost of $437.0 million, or an unrealized gain of $3.7 million. - 14 - Liquidity and Capital Resources of ILCO. Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. ILCO is a holding company whose principal assets consist of the common stock of Investors Life Insurance Company of North America ("Investors-NA") and its subsidiary - Investors Life Insurance Company of Indiana ("Investors-IN"). Historically, ILCO's principal cash flow sources have been from periodic payment of principal and interest by Investors-NA, pursuant to the terms of the Surplus Debentures. In addition to the need for cash flow to meet operating expenses, ILCO'S liquidity requirements relate principally to the liabilities associated with ILCO'S various life insurance and annuity products. ILCO'S product liabilities include the payment of benefits under life insurance and annuity products, as well as the payment of policy surrenders, withdrawals and policy loans. The Surplus Debentures were originally issued by Standard Life Insurance Company and their terms were previously approved by the Mississippi Insurance Commissioner. In connection with the 1993 merger of Standard Life into Investors-NA, the obligations of the Surplus Debentures were assumed by Investors-NA. As of June 30, 2000, the outstanding principal balance of the Surplus Debentures was completely paid off. For periods subsequent to June 30, 2000, ILCO's available source of liquidity is dividends paid to it from its subsidiaries. Applicable state insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of prescribed limitations without prior approval. The ability of Investors-NA to pay shareholder dividends is and will continue to be subject to restrictions set forth in the insurance laws and regulations of Washington, its domiciliary state. The Washington insurance law limits how and when Investors-NA can pay shareholder dividends by including the "greater of" standard for payment of dividends to shareholders, and requiring that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. Under the "greater of" standard, an insurer may pay a dividend in an amount equal to the greater of (i) 10% of the policyholder surplus or (ii) the insurer's net gain from operations for the previous year. As of March 31, 2001, Investors-NA had earned surplus of $60.7 million. Investors-IN is domiciled in the State of Indiana. Under the Indiana insurance code, a domestic insurer may make dividend distributions upon proper notice to the Department of Insurance, as long as the distribution is reasonable in relation to adequate levels of policyholder surplus and quality of earnings. Under Indiana law the dividend must be paid from earned surplus. Extraordinary dividend approval would be required where a dividend exceeds the greater of 10% of surplus or the net gain from operations for the prior fiscal year. Investors-IN had earned surplus of $23.4 million at March 31, 2001. The Form 10-Qs of ILCO for the three-month periods ended March 31, 2001 and March 31, 2000, set forth the business operations and financial results of ILCO and its life insurance subsidiaries. Such 10-Q reports of ILCO, including the discussion by ILCO's management under the caption "Management's Discussion and Analysis of Financial Conditions and Results of Operations" are incorporated herein by reference. - 15 - Liquidity and Capital Resources FIC is a holding company whose principal assets consist of the common stock of Family Life and its equity ownership in ILCO. FIC's primary sources of capital consist of cash flow from operations of its subsidiaries and the proceeds from bank and institutional borrowings. The cash requirements of FIC and its subsidiaries consist primarily of its service of the indebtedness created in connection with its ownership of Family Life. As of March 31, 2001, the outstanding balance of such indebtedness was $33.8 million on the Subordinated Notes granted by Investors-NA. The principal source of liquidity for FIC's subsidiaries consists of the periodic payment of principal and interest by Family Life pursuant to the terms of a Surplus Debenture. The terms of the Surplus Debenture were previously approved by the Washington Insurance Commissioner. Under the provisions of the Surplus Debenture and current law, no prior approval of the Washington Insurance Department is required for Family Life to pay interest or principal on the Surplus Debenture; provided that, after giving effect to such payments, the statutory surplus of Family Life is in excess of 6% of assets (the "surplus floor"). However, Family Life has voluntarily agreed with the Washington Insurance Commissioner that it will provide at least five days advance notice of payments which it will make under the surplus debenture. As of March 31, 2001, the statutory capital and surplus of Family Life was $26.1 million, an amount substantially in excess of the surplus floor. As of March 31, 2001, the principal balance of the Surplus Debenture was $3.9 million. The funds required by Family Life to meet its obligations under the terms of the Surplus Debenture are generated primarily from premium payments from policyholders, investment income and the proceeds from the sale and redemption of portfolio investments. Washington's insurance code includes the "greater of" standard for dividends but has requirements that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. Family Life does not presently have earned surplus as defined by the regulations adopted by the Washington Insurance Commissioner and, therefore, is not permitted to pay cash dividends. However, since the new law applies only to dividend payments, the ability of Family Life to make principal and interest payments under the Surplus Debenture is not affected. The Company does not anticipate that, for the foreseeable future, Family Life will have any difficulty in making payments to Family Life Corporation in amounts sufficient to enable Family Life Corporation to service indebtedness, either by payments of principal and interest by Family Life on the Surplus Debenture or partial redemptions by Family Life of its redeemable preferred stock. The sources of funds for Family Life consist of premium payments from policyholders, investment income and the proceeds from the sale and redemption of portfolio investments. These funds are applied primarily to provide for the payment of claims under insurance and annuity policies, operating expenses, taxes, investments in portfolio securities, shareholder dividends and payments under the provisions of the Surplus Debenture. - 16 - FIC's net cash flow (used in) provided by operating activities was $(1.35) million in the first three months of 2001, as compared to $0.24 million in the first three months of 2000. Net cash flow used in financing activities was $1.54 million in the first three months of 2001, as compared to $1.54 million in the first three months of 2000. The decrease in cash flow provided by operating activities for the quarter ended March 31, 2001 was affected by an increase in agency advances and other receivables as well as an increase in other liabilities related to the dividend payable to FIC shareholders. Net cash flow provided by investing activities was $4.01 million for the three months ended March 31, 2001, as compared to $1.48 million for the same period in 2000. The increase in cash flow from investing activities was primarily attributable to cash received from the redemption or maturity of investments which cash was used in operations and financing activities. The guaranty commitments of FIC under the loans incurred in connection with the acquisition of Family Life (after taking into account the repayments and new loans which occurred in July, 1993) relate to: (i) the $22.5 million note issued by Family Life Corporation to Investors Life Insurance Company of North America and (ii) the $34.5 million loaned by Investors-NA to two subsidiaries of FIC. Management believes that its cash, cash equivalents and short term investments are sufficient to meet the needs of its business and to satisfy debt service. There are no trends, commitments or capital asset requirements that are expected to have an adverse effect on the liquidity of FIC. Investments. As of March 31, 2001, the Company's investment assets totaled $95.95 million, as compared to $99.11 million as of December 31, 2000. The decrease was primarily attributable to cash received from the redemption or maturity of investments which cash was used in operations and financing activities. As of March 31, 2001, the market value of the fixed maturities available for sale segment was $77.34 as compared to an amortized value of $74.95 million or an unrealized gain of $2.39 million. The increase reflects unrealized gains on such investments related to changes in interest rates subsequent to the purchase of such investments. The net of tax effect of this increase ($1.55 million at March 31, 2001) has been recorded as an increase in shareholders' equity. As required under the provisions of FAS No. 130, the determination of "Accumulated other comprehensive income" includes separate identification of the change in values which occurred during the current period. -17- The level of short-term investments at March 31, 2001 was $14.86 million, as compared to $15.62 as of December 31, 2000. The slight decrease is within the expected levels of short-term investments. The assets held by Family Life must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the Company's emphasis is to obtain targeted profit margins, while minimizing the exposure to changing interest rates. This objective is implemented by selecting primarily short- to medium-term, investment grade fixed income securities. In making such portfolio selections, the Company generally does not select new investments which are commonly referred to as "high yield" or "non-investment grade". The fixed maturities portfolio of Family Life, as of March 31, 2001, consisted solely of fixed maturities investments which, in the annual statement of the company, as filed with state insurance departments, were designated under the National Association of Insurance Commissioners ("NAIC") rating system as a "1" (highest quality). The investments of Family Life and ILCO's insurance subsidiaries in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $19 million and $173 million, respectively, and mortgage-backed pass-through securities of $8 million and $39.4 million, respectively, at March 31, 2001. Mortgage-backed pass-through securities, sequential CMO's and support bonds, which comprised approximately 54.4% of the book value of FIC's mortgage-backed securities and 56.2% of the book value of ILCO's mortgage-backed securities at March 31, 2001, are sensitive to prepayment and extension risks. ILCO and FIC have reduced the risk of prepayment associated with mortgage- backed securities by investing in planned amortization class ("PAC"), target amortization class ("TAC") instruments and scheduled bonds. These investments are designed to amortize in a predictable manner by shifting the risk of prepayment of the underlying collateral to other investors in other tranches ("support classes") of the CMO. At March 31, 2001, PAC and TAC instruments and scheduled bonds represented approximately 45.6% of the book value of FIC's mortgage-backed securities and approximately 43.8% of the book value of ILCO's mortgage-backed securities. Sequential and support classes represented approximately 24.8% of the book value of FIC's mortgage-backed securities and approximately 37.7% of the book value of ILCO's mortgage-backed securities at March 31, 2001. In addition, FIC and ILCO limit the risk of prepayment of CMOs by not paying a premium for any CMOs. ILCO and FIC do not invest in mortgage-backed securities with increased prepayment risk, such as interest-only stripped pass-through securities and inverse floater bonds. Neither FIC nor ILCO had any z-accrual bonds as of March 31, 2001. The prepayment risk that certain mortgage-backed securities are subject to is prevalent in periods of declining interest rates, when mortgages may be repaid more rapidly than scheduled as individuals refinance higher rate mortgages to take advantage of the lower current rates. As a result, holders of mortgage-backed securities may receive large prepayments on their investments which cannot be reinvested at an interest rate comparable to the rate on the prepaying mortgages. For the year 2001, the investment objectives of FIC and ILCO include the making of selected investments in CMOs. Management believes that the absence of "high-yield" or "non-investment grade" investments (as defined above) in the portfolios of its life insurance subsidiary enhances the ability of the Company to service its debt, to provide security to its policyholders and to credit relatively consistent rates of return to its policyholders. - 18 - Accounting Developments In June, 1998, the FASB issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133, as amended by FAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - An Amendment of FASB Statement No. 133", is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000 as amended by FAS No 137 "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No 133". As the Company does not have significant investments in derivative financial instruments, the adoption of FAS 133 did not have a material impact on the Company's results of operations, liquidity or financial position. Other Developments Agreement and Plan of Merger. On January 17, 2001, FIC entered into an Agreement and Plan of Merger (the "Agreement") with ILCO and ILCO Acquisition Company ("ILCO Acquisition"), a Texas corporation and wholly-owned subsidiary of FIC. In general, the Agreement provides that, following the approval of the Agreement by the shareholders of ILCO and the approval of the issuance of shares of FIC common stock and amendment to FIC's articles of incorporation by the shareholders of FIC and the satisfaction or waiver of the other conditions to the merger: (1) ILCO Acquisition will merge with and into ILCO; and (2) ILCO Acquisition will cease to exist and ILCO will continue as the surviving corporation and as a wholly-owned subsidiary of FIC following the merger. Upon the consummation of the merger: (1) each share of ILCO common stock issued and outstanding immediately prior to the merger, other than shares of ILCO common stock held as treasury shares by ILCO (but excluding shares of ILCO common stock held by any of ILCO's subsidiaries, whether or not treated as treasury shares of ILCO on a consolidated basis under generally accepted accounting principles) or shares of ILCO common stock held by FIC, will be converted into the right to receive 1.1 shares of FIC common stock. However, in the event of any change in FIC common stock and/or ILCO common stock prior to the merger, such as a stock split, stock dividend, subdivision, reclassification, recapitalization, combination, exchange of shares or the like, the number and class of shares of FIC common stock to be issued and delivered in the merger in exchange for each outstanding share of ILCO common stock will be adjusted so as to maintain the relative proportionate interests of the holders of ILCO common stock and FIC common stock; (2) each share of ILCO common stock, series A preferred stock and series B preferred stock of ILCO, in each case which is held as treasury shares by ILCO prior to the merger (excluding shares of ILCO common stock held by any of ILCO's subsidiaries, whether or not treated as treasury shares of ILCO on a consolidated basis under generally accepted accounting principles), and each share of ILCO common stock which is held by FIC (excluding any shares of ILCO common stock owned by any of FIC's subsidiaries) prior to the merger, will be cancelled and retired; (3) each share of common stock of ILCO Acquisition issued and outstanding immediately prior to the merger will be converted into one share of common stock of ILCO and such shares will represent all of the issued and outstanding capital stock of ILCO following the merger; and (4) shares of FIC common stock outstanding immediately prior to the merger (including shares of FIC common stock held by any subsidiary of FIC or ILCO) will remain outstanding and will be unaffected by the merger. No fractional shares of FIC common stock will be issued in the merger. A holder of ILCO common stock who would otherwise be entitled to receive fractional shares of FIC common stock as a result of the merger will receive, in lieu of fractional shares, cash in an amount equal to the average closing price per share of FIC common stock for the 30 trading days immediately prior to the merger multiplied by the fraction to which the holder would otherwise be entitled. FIC will make available to First Union National Bank, as exchange agent, from time to time sufficient cash amounts to satisfy payment for fractional shares and First Union will distribute such proceeds, without interest, to the holders of the fractional interests. - 19 - The consummation of the merger remains subject to regulatory approval, as well as to the various conditions precedent set forth in the Agreement, including the approval of certain matters by the shareholders of FIC and ILCO. A Special Meeting of the shareholders of each of FIC and ILCO is scheduled for May 18, 2001. For a more detailed description of the Agreement, see the complete copy of the Agreement, attached as an annex to the S-4 filed by FIC with the Securities and Exchange Commission on February 1, 2001, as amended by the S-4/A filed on March 13, 2001 and the S-4/A filed on April 3, 2001. NASDAQ Listing On January 24, 2001, FIC submitted an application to have its common stock traded on the NASDAQ National Market under the symbol FNIN. Previously, the common stock of FIC was traded on the NASDAQ Small-Cap Market. The application was approved and the common stock of FIC commenced trading on the NASDAQ National Market on April 9, 2001. Unsolicited Verbal Inquiries Concerning Possible Purchase of Post-Merger Company On March 8, 2001, FIC announced that it has received unsolicited verbal indications of interest from a few companies that may be interested in acquiring FIC after completion of the merger with ILCO. The press release did not state any price ranges or other material terms. In conjunction with such indications of interest, FIC has retained Philo Smith Capital Corporation as its financial advisor to explore the possibility of a post-merger sale of FIC with these companies and to further solicit indications of interest from other companies that may have similar interests. As indicated on the Form 424B3 filed with the Securities and Exchange Commission on May 9, 2001, FIC has received one indication of interest that it intends to pursue through further discussions with the third party submitting such indication of interest. However, FIC has still not determined whether it will sell the company, and no price or material terms on which it would agree to sell the company have been determined by the board of directors of FIC or agreed upon with any third party. - 20 - Dividends Declared In March, 2001 FIC announced that its board approved the payment of an annual cash dividend in the amount of $0.41 per share. The dividend has been accrued in other liabilities on the consolidated balance sheet and was paid on April 12, 2001, to shareholders of record as of the close of business on March 19, 2001. Item 3. Quantitative and Qualitative Disclosures About Market Risk General. FIC's principal assets are financial instruments, which are subject to market risks. Market risk is the risk of loss arising from adverse changes in market rates, principally interest rates on fixed rate investments. For a discussion of the Company's investment portfolio and the management of that portfolio to reflect the nature of the underlying insurance obligations of the Company's insurance subsidiaries, please refer to the information set forth in Item 2 "Management's Discussion and Analysis of Financial Conditions and Results of Operation - Investments" of this report. The following is a discussion of the Company's primary market risk sensitive instruments. It should be noted that this discussion has been developed using estimates and assumptions. Actual results may differ materially from those described below. Further, the following discussion does not take into account actions which could be taken by management in response to the assumed changes in market rates. In addition, the discussion does not take into account other types of risks which may be involved in the business operations of the Company, such as the reinsurance recoveries on reinsurance treaties with third party insurers. The primary market risk to the Company's investment portfolio is interest rate risk. Since the Company owns approximately 48.1% of the common stock of ILCO, the interest rate risk of ILCO's fixed income portfolio has an effect on the value of FIC's 'investment in affiliate'. The Company does not use derivative financial instruments. - 21 - Interest Rate Risk. (a) FIC's Fixed Income Investments Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in fair market value related to the financial instruments segment of the Company's balance sheet is estimated to be $2.6 million at March 31, 2001 and $3.4 million at December 31, 2000. For purposes of the foregoing estimate, the following categories of the Company's fixed income investments were taken into account: (i) fixed maturities, including fixed maturities available for sale and (ii) short-term investments. The market value of such assets was $92.2 million at March 31, 2001 and $95.4 million at December 31, 2000. The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $27.9 million at March 31, 2001 and $28.1 million at December 31, 2000. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in the fair market value related to such mortgage-backed securities is estimated to be $0.9 million at March 31, 2001 and $1.5 million at December 31, 2000. (b) FIC's Investment in Affiliate The value of FIC's investment in affiliate is affected by the amount of unrealized gains and losses, net of tax, in the investment portfolio of its affiliate, ILCO. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in value, net of tax, related to the Company's investment in affiliate is estimated to be $5.6 million at March 31, 2001 and $6.2 million at December 31, 2000. The hypothetical effect of the interest rate risk on fair values was estimated by applying a commonly used model. The model projects the impact of interest rate changes on a range of factors, including duration and potential prepayment. Part II. Other Information Item 1. Legal Proceedings The Company and its subsidiaries are defendants in certain legal actions related to the normal business operations of the Company. Management believes that the resolution of such legal actions will not have a material impact upon the financial statements. - 22 - Universal Life Litigation: ILCO and Investors-NA are defendants in a lawsuit which was filed in October, 1996, in Travis County, Texas. CIGNA Corporation, an unrelated Company, is also a named defendant in the lawsuit. The named plaintiffs in the suit (a husband and wife), allege that the universal life insurance policies sold to them by INA Life Insurance Company (a company which was merged into Investors-NA in 1992) utilized unfair sales practices. The named plaintiffs seek reformation of the life insurance contracts and an unspecified amount of damages. The named plaintiffs also seek a class action as to similarly situated individuals. In April, 2001, the named plaintiffs filed an amended complaint, so as to include various post-sale allegations, including allegations related to the manner in which increases in the cost of insurance were applied, the allocation of portfolio yields to the universal life policies and changes in the spread between the earned rate and the credited rate. The Company filed a motion to strike the amended Complaint, which motion was denied by the Court. No certification of a class has been granted as of the date hereof. The Company believes that the suit is without merit and intends to vigorously defend this matter. Litigation Relating to the FIC/ ILCO Merger: On the day that FIC and ILCO each publicly announced the formation of a special committee to evaluate a potential merger, two class action lawsuits were filed against ILCO, FIC and the officers and directors of ILCO. The actions allege that a cash consideration in the proposed merger is unfair to the shareholders of ILCO, that it would prevent the ILCO shareholders from realizing the true value of ILCO, and that FIC and the named officers and directors had material conflicts of interest in approving the transaction. In their initial pleadings, the plaintiffs sought certification of the cases as class actions and the named plaintiffs as class representatives, and among other relief, requested that the merger be enjoined (or, if consummated, rescinded and set aside) and that the defendants account to the class members for their damages. Recently, the plaintiffs initiated discovery in this matter. The defendants believe that the lawsuits are without merit and intend to vigorously contest the lawsuits. Management is unable to determine the impact, if any, that the lawsuits may have on the results of operations of the Company. Other Litigation: Additionally, FIC and its subsidiaries are regularly involved in litigation, both as a defendant and as plaintiff. The litigation naming the insurance subsidiaries as defendant ordinarily involves our activities as a provider of insurance protection products. We do not believe that such litigation, either individually or in the aggregate, will have a material adverse effect on the Company's business, financial condition or results of operations. - 23 - Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Form 10-K Annual Report of Registrant for the year ended December 31, 2000 heretofore filed by Registrant with the Securities and Exchange Commission, which is hereby incorporated by reference. (b) Reports on Form 8-K On January 22, 2001, the Registrant filed a report on Form 8-K. The report pertained to the announcement by the Registrant that it had entered into a definitive agreement whereby it would acquire the remaining common shares (approximately 52%) of InterContinental Life Corporation ("ILCO") which it does not currently own. The terms and provisions of the transaction are set forth in an Agreement and Plan of Merger dated as of January 17, 2001, among the Registrant, ILCO and ILCO Acquisition Company. A copy of the Agreement and Plan of Merger is attached to the Report of Form 8-K. - 24 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SUBSIDIARIES SIGNATURE 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. FINANCIAL INDUSTRIES CORPORATION /s/ James M. Grace James M. Grace, Treasurer Date: May 15, 2001 - 25 -