10-K 1 fic_10k-2002.txt FIC 10-K FOR 2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2002 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 Boulevard, Building One, Austin, Texas 78730 (Address of Principal Executive Offices) (Zip Code) (512) 404-5050 (Registrant's Telephone Number, including area code) Securities Registered pursuant to Section 12(b) of the Act: None Securities Registered pursuant to Section 12(g) of the Act: Common Stock, $.20 par value (Title of Class) - 1 - 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 and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES [X] NO [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant on February 28, 2003, based on the closing sales price in the Nasdaq National Market ($14.80), was $118,977,156. The number of shares outstanding of Registrant's common stock on February 28, 2003 was 9,607,427. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement in connection with the 2003 Annual Meeting of Shareholders - Part III. - 2 - Forward-Looking Statements Except for historical factual information set forth in this Annual Report on Form 10-K, the statements, analyses, and other information contained in this report relating to trends in Financial Industries Corporation(the "Company" or "FIC")'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. - 3 - PART I Item 1. Business General Financial Industries Corporation ("FIC", the "Company" or the "Registrant") is a holding company primarily engaged in the life insurance business through its ownership of Family Life Insurance Company, ("Family Life") Investors Life Insurance Company of North America ("Investors Life"), and prior to February 19, 2002, Investors Life Insurance Company of Indiana ("Investors-IN"). FIC was organized as an Ohio corporation in 1968 and was reincorporated in Texas in 1980. Its executive offices are located at 6500 River Place Boulevard, Building One, Austin, Texas 78730. Through 1984, FIC's principal business was the sale and underwriting of life and health insurance, mainly in the midwestern and southwestern United States. During the period from 1985 to 1987, FIC acquired a 48.3% equity interest in InterContinental Life Corporation ("ILCO"). ILCO is a Texas corporation which, prior to May 18, 2001, was publicly traded and was engaged in the sale and underwriting of life insurance and annuities, through its subsidiaries, Investors Life and Investors-IN (which was merged into Investors Life on February 19, 2002 with Investors Life as the surviving entity). On May 18, 2001, FIC acquired the remaining shares of ILCO through a merger of a subsidiary of FIC with and into ILCO, whereby ILCO shareholders were issued 1.1 shares of FIC stock for each share of ILCO stock outstanding. See, "Acquisitions and Consolidations - Acquisition of ILCO." In June 1991, FIC purchased Family Life, a Washington based life insurance corporation, from Merrill Lynch Insurance Group, Inc. FIC and its insurance subsidiaries have substantially identical managements. Officers allocate their time among FIC and its subsidiaries in accordance with their comparative requirements. Acquisitions and Consolidations Strategy. FIC's business strategy has been and continues to be to grow internally and through acquisitions, while maintaining an emphasis on cost controls. Management believes that, under appropriate circumstances, it is more advantageous to acquire companies with books of in-force life insurance than to produce new business, because initial underwriting costs have already been incurred and mature business makes possible more predictable profit analysis. It is also management's belief that the current environment in the life insurance industry presents attractive opportunities for the Company to acquire life insurance companies and blocks of insurance policies that compliment or fit within the Company's existing marketing structure and product lines. The Company's objective is to improve the profitability of acquired businesses by consolidating and streamlining the administrative functions of these businesses, eliminating unprofitable products and distribution channels, applying its marketing expertise to the acquired company's markets and agents and benefiting from economies of scale. - 4 - Acquisition of Family Life. FIC acquired Family Life, a Washington based life insurance corporation, from Merrill Lynch Insurance Group, Inc. on June 12, 1991. Family Life's primary business is the underwriting and sale of mortgage protection life insurance to customers who are mortgage borrowers from financial institutions where Family Life has marketing relationships. Family Life distributes its insurance products primarily through a national career agency sales force. See "Business of Insurance Subsidiaries -- Family Life". Acquisition of ILCO. In January 1985, FIC acquired 26.53% of ILCO's common stock. During the period from 1985 to 1987, FIC acquired additional ILCO common stock resulting in an approximate 48% equity interest in ILCO. On May 18, 2001, pursuant to an Agreement and Plan of Merger, as amended (the "Merger Agreement"), dated as of January 17, 2001, among FIC, ILCO, and ILCO Acquisition Company, a Texas corporation and wholly-owned subsidiary of FIC ("Merger Sub"), Merger Sub was merged with and into ILCO (the "Merger"). ILCO was the surviving corporation of the Merger and became a wholly-owned subsidiary of FIC. In accordance with the Merger Agreement, FIC issued 1.1 shares of common stock, par value $0.20 per share ("FIC Common Stock"), for each share of common stock, par value $0.22 per share, of ILCO outstanding at the time of the Merger ("ILCO Common Stock"). In addition, each share of ILCO Common Stock issuable pursuant to outstanding options was assumed by FIC and became an option to acquire FIC Common Stock with the number of shares and exercise price adjusted for the exchange ratio in the Merger. ILCO's Acquisitions. Prior to May 18, 2001, ILCO made the following acquisitions: Standard Life Insurance Company. In November 1986, ILCO acquired Standard Life Insurance Company ("Standard Life"), headquartered in Jackson, Mississippi, for a gross purchase price of $54.5 million. Investors Life and Investors Life Insurance Company of California. In December 1988, ILCO, through Standard Life, purchased Investors Life Insurance Company of California ("Investors-CA") and Investors Life from CIGNA Corporation for a purchase price of $140 million. Meridian Life Insurance Company. In February 1995, ILCO, through Investors Life, purchased from Meridian Mutual Insurance Company the stock of Meridian Life Insurance Company, an Indianapolis-based life insurer, for a cash purchase price of $17.1 million. After the acquisition, Meridian Life changed its name to Investors Life Insurance Company of Indiana ("Investors-Indiana"). State Auto Life Insurance Company. In July 1997, ILCO and Investors-Indiana acquired State Auto Life Insurance Company, an Ohio domiciled life insurer, from State Automobile Mutual Insurance Company, for an adjusted cash purchase price of $11.8 million. Under the terms of the transaction, State Auto Life was merged into Investors-Indiana. - 5 - Grinnell Life Insurance Company. On June 30, 1998, ILCO, through a subsidiary, acquired Grinnell Life Insurance Company ("Grinnell Life") for an adjusted purchase price of $16.6 million. A portion of the purchase price ($12.37 million) was paid by way of a dividend to the seller immediately prior to the closing of the transaction; the balance of the purchase price was paid by ILCO's subsidiary. As part of the transaction, Grinnell Life was immediately merged with and into that subsidiary, with that subsidiary being the surviving entity. Consolidation of Acquired Companies. Merger of ILIC and Investors-Indiana. In December 1997, InterContinental Life Insurance Company ("ILIC"), a subsidiary of ILCO, transferred its domicile from New Jersey to Indiana. Following completion of the redomestication, ILIC and Investors-Indiana merged, with ILIC as the surviving entity in the merger process. Immediately after the merger, ILIC changed its name to Investors Life Insurance Company of Indiana. As used hereinafter, the phrase "Investors-IN" shall be used to refer to the merged entities. Mergers with Investors Life. Investors Life redomesticated from Pennsylvania to Washington in December of 1992. Investors-CA merged into Investors Life on December 31, 1992. Standard Life merged into Investors Life on June 29, 1993. On February 19, 2002, Investors-IN merged into Investors Life. In all such mergers, Investors Life was the surviving entity. FIC's management believes that the acquisitions and consolidations of its life insurance subsidiaries have achieved cost savings, such as reduced auditing expenses involved in auditing combined companies; the savings of expenses and time resulting from the combined company being examined by one state insurance department (Washington), rather than four (California, Pennsylvania, Mississippi and Indiana); the reduction in the number of tax returns and other annual filings with state insurance departments; and smaller annual fees to do business and reduced retaliatory premium taxes in most states. Business of Insurance Subsidiaries FIC's growth strategies include marketing and selling life insurance and annuity products through agents of its insurance subsidiaries, Family Life and Investors Life. Family Life. Family Life, which was organized in the State of Washington in 1949, specializes in providing mortgage protection life insurance to borrowers of financial institutions. Currently, Family Life has active relationships with 36 lenders that provide direct access to their customers. - 6 - Family Life's mortgage protection business consists of term and universal life insurance sold to homeowners and is designed to repay or reduce the mortgage balances of policyholders in the event of their death. This business is sold primarily to customers of independent financial institutions, often facilitated by a current list of borrowers provided by the financial institution. These policies often list the lending financial institution as the primary beneficiary of the life insurance policy. A key feature of the Family Life system is the ability to bill and collect premiums through the policyholder's monthly mortgage payments. This system enables Family Life to provide a convenient solution to the financial security needs of the under-served and under-protected low to moderate income homeowner market. In 2002, direct statutory premiums received on Family Life's insurance products totaled $36.4 million. This compares to $40.1 million in 2001 and $43.1 million in 2000. The reduction in premium is due to the normal runoff of the business. Family Life is licensed to sell annuity and life insurance products in 48 states and the District of Columbia (not licensed to sell in New York or New Hampshire). In 2002, premium income from these products was derived from all states in which Family Life is licensed, with over half of the amount derived from California (25%) and Texas (28%). Family Life's primary distribution channel is its exclusive force of approximately 200 career agents, who are organized into seven regions. The mortgage life insurance market has grown rapidly over the past few years and Family Life expects to maintain and expand its share of that market. Family Life believes that it is the only nation-wide agent-sold life insurance company operating through leads from financial institutions. Direct access to mortgage customers and the convenience of the insured making payments through their mortgage bill provides Family Life with a competitive advantage. The company is also in the process of upgrading its product portfolio to offer more competitive features and benefits, including an option to return premiums paid if the insured lives to the end of the term period. Going into 2003, the sales organization was restructured to lower overall acquisition costs in order to support more competitive products. In addition to its primary distribution channel, Family Life has expanded its system to: (1) provide a broader range of products; (2) generate direct mail mortgage leads; and (3) target higher income homeowners than its traditional market. This distribution strategy allows some Family Life agents to sell products of third-party life insurance companies that have entered into marketing relationships with an FIC subsidiary, ILG Sales Corporation. Investors Life. Investors Life is engaged primarily in administering existing portfolios of individual life insurance and annuity policies. Approximately 73% of the total collected premiums for 2002 were derived from renewal premiums on insurance and annuity policies sold by FIC's insurance subsidiaries prior to their acquisition by the Company. Investors Life is also engaged in marketing and underwriting individual life insurance and annuity products in 49 states (not licensed in New York), the District of Columbia and the U.S. Virgin Islands. These products are marketed through independent, non-exclusive general agents. - 7 - Products currently distributed by Investors Life include a new universal life insurance plan which is expected to rank favorably to similar products relative to guaranteed and current assumption cash values. Universal life insurance provides death benefit protection with flexible premium and coverage features, and the crediting of interest on cash values, at company-declared current interest rates. Under the flexible premium policies, policyholders may vary the amounts of their coverage (subject to minimum and maximum limits) as well as the date of payment and frequency of payments. In addition, Investors Life recently introduced a series of level term life products that feature competitive rates and a guaranteed return of premium option. The Company also offers fixed annuity products with competitive guarantees and several other universal life products. Direct statutory premiums received from all types of life insurance policies sold by Investors Life were $42.1 million in 2002, as compared to $45.0 million in 2001 and $46.3 million in 2000. Investors Life received reinsurance premiums from Family Life of $4.6 million in 2002, pursuant to the reinsurance agreement for universal life products written by Family Life. In 2002, premium income from all life insurance policies was derived from all states in which Investors Life is licensed, with significant amounts derived from Pennsylvania (14%), California (8%) and Ohio (8%). Direct deposits from the sale of fixed annuity products were $16.4 million in 2002, as compared to $12.3 million in 2001 and $10.6 million in 2000. Investors Life also received reinsurance premiums from Family Life of $1.3 million, pursuant to a reinsurance agreement for annuity products between the two companies. Investors Life also receives premium income from health insurance policies. In 2002, premium income from all such policies was $0.3 million, as compared to $0.6 million in 2001 and $0.7 million in 2000. Since 1997, substantially all of Investors Life's health insurance business has been reinsured with a third party reinsurer. Investors Life also sponsors a variable annuity separate account, which offers single premium and flexible premium policies. The policies provide for the contract owner to allocate premium payments among four different portfolios of Putnam Variable Trust (the "Putnam Fund"), a series fund which is managed by Putnam Investment Management, Inc. As of December 31, 2002, the assets held in the separate account were $28.0 million. During 2002, the premium received in connection with these variable annuity policies was $80,549, which was received from existing contract owners. Investors Life also maintains a closed variable annuity separate account, with approximately $11.9 million of assets as of December 31, 2002. The separate account was closed to new purchases in 1981 as a result of an IRS ruling that adversely affected the status of variable annuity separate accounts that invest in publicly-available mutual funds. The ruling did not adversely affect the status of in-force contracts. - 8 - For the past few years, Investors Life has been marketing a group deposit administration product, designed for use in connection with the funding of deferred compensation plans maintained by government employers under section 457 of the Internal Revenue Code. The company has established a marketing relationship with a third-party administrator based in San Antonio, Texas, which has established relationships with school districts in Texas. Group deposits under this program for the year 2000 totaled $1.5 million, deposits in 2001 totaled $0.24 million and deposits in 2002 totaled $0.35 million. At December 31, 2002, 16 school districts held plans with Investors Life. Investors Life, along with Family Life, participates in the distribution system involving third-party life insurance companies. The marketing arrangement makes available, to appointed agents of Investors Life, life insurance and annuity products not currently being offered by Investors Life. The underwriting risk on the products sold under this arrangement is assumed by the third-party insurer. The Company's appointed agents receive commissions on the sales of these products and the Company's marketing subsidiary receives an override commission. During 2002, Investors Life and Family Life received revenues of $1.2 million through this distribution system. At December 31, 2002, Investors Life and Family Life had relationships with 509 agents actively engaged in this marketing effort. Agency Operations The products of FIC's insurance subsidiaries are marketed and sold through two divisions: A. Investors Life Distribution System Investors Life contracts with independent non-exclusive agents, general agents and brokers nation-wide to sell its products. Such agents and brokers also sell insurance products for companies in competition with Investors Life. In order to attract agents and enhance the sale of its products, Investors Life pays competitive commission rates and provides other sales inducements. Investors Life is presently concentrating its efforts on the promotion and sale of fixed annuity products for retirement income. In addition, the company is also concentrating its efforts on the promotion and sale of universal life and term products related to mortgage protection. Marketing and sales for Investors Life is directed by the Executive Vice President of Marketing and Sales. The distribution system is organized into 13 regions, each of which has a Regional Vice President ("RVP") who is responsible for the recruitment and maintenance of the general agents and managing general agents for individual insurance sales within such region. In late 2002, Investors Life implemented a plan to restructure the compensation arrangements for RVPs, so as to minimize fixed costs and improve incentives for growth. Plans were also developed to put greater emphasis on recruiting Independent Marketing Organizations on a 100% variable cost basis. - 9 - B. Family Life Distribution System Family Life utilizes a nationwide exclusive agent force to sell its products. This agent force sells mortgage protection life insurance and annuity products. The products are sold primarily to lower income customers of client financial institutions, usually through a list of borrowers provided by the financial institution. Family Life works closely with the financial institutions to maintain and ensure that Family Life lead systems, which had been built from the loan portfolios of each active financial institution, operate effectively. Family Life agents make courtesy calls to borrowers of the financial institutions which are active on the Family Life lead system to offer the borrower the opportunity to purchase mortgage protection insurance (term or universal life insurance products). In advance of the passage of the Financial Services Modernization Act (the "Act") in 1999 (for a discussion of the provisions of this law, refer to the section entitled "Regulation"), Family Life established a task force to develop new lead sources for its agents. Although Family Life continues to focus on its traditional sales approach, it has established a supplemental leads program, whereby leads are obtained from public records (e.g. county loan records). Family Life has also developed a strategy to work with lenders as "setup only", whereby the mortgage institution does not furnish leads, but will collect and remit premiums. Finally, Family Life is developing new sales methods, including direct mailings and direct telephone leads. Sales and Marketing for Family Life is directed by the Executive Vice President of Marketing and Sales. Sales and marketing focuses on the development and maintenance of contractual agreements with the financial institutions which provide referrals to, and collect monthly premiums from, their borrowers for Family Life insurance plans. As of March, 2003, the Family Life distribution system consisted of seven regions, each directed by a Regional Vice President. Investment of Assets FIC has established and staffed an investment department, which manages portfolio investments and investment accounting functions for its life insurance subsidiaries. At December 31, 2002, invested assets totaled $761.2 million. The general investment objective of the Company emphasizes the selection of short to medium term high quality fixed income securities, rated Baa-3 (investment grade) or better by Moody's Investors Service, Inc. 64.9% of FIC's invested assets are in fixed maturity securities, available for sale. Our fixed maturity securities portfolio is predominately comprised of low risk, investment grade, available for sale publicly traded corporate securities, mortgage-backed securities, and United States Government bonds. All of FIC's invested assets are invested in the United States. The assets held by Family Life and Investors 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 Company determines the allocation of our assets primarily on the basis of cash flow and return requirements of our products and secondarily by the level of investment risk. - 10 - The Company's investment objectives include the making of selected investments in collateralized mortgage obligations. The Company has not invested in non-agency mortgage-backed securities, which have a greater credit risk than that of agency mortgage-backed securities. The other asset categories which comprise at least 5% of FIC's invested assets include investments in real estate, short-term investments, and policy loans. For a further discussion of FIC's invested assets see "Item 7 - Management Discussion and Analysis - Investments." Data Processing Since December 1994, the data processing needs of FIC's insurance subsidiaries have been provided to FIC's Austin, Texas and Seattle, Washington facilities by FIC Computer Services, Inc., a subsidiary of FIC. See "Item 13 - Certain Relationships and Related Transactions with Management." As the provider of data processing for the Company and its subsidiaries, FIC Computer Services, Inc. utilizes a centralized computer system to process policyholder records and financial information. In addition, the Company uses non-centralized computer terminals in connection with its operations. FIC expects to implement a number of technology projects during 2003 that are consistent with the Company's strategic direction aimed at improving operational efficiency and reducing expenses. It is estimated that the new technology investment will have a net savings of $1.8 million pre-tax or $1.2 million after tax over the next five years. These savings are based on a 30% growth assumption for new business sales. The three major projects scheduled for implementation this year are: (1) a new business and underwriting automation project that includes six initiatives to enhance the new business and underwriting environments, including: (a) automating the policy assembly process; (b) automating sales illustrations; (c) automating the underwriting and new business form letters; (d) automating underwriting requirements; (e) implementing a document imaging and workflow process; and (f) implementing an electronic policy application process for agents using electronic tablet PCs; (2) an interactive voice response system; and (3) migration to one new business system. The total cost of these technology improvements will be approximately $983,000 over five years, with $657,483 of the cost occurring in year one. Once these projects are completed, FIC believes that our operating units will have the ability to handle an increased workload from an acquisition of up to 100,000 policies, as well as handle a 30% increase in new sales growth, with little or no increase in current staffing levels. In addition to these projects, there are thirty-two technology initiatives that FIC is currently evaluating in order to further reduce expenses, improve productivity and improve service in the next few years. - 11 - Reinsurance and Reserves In accordance with general practices in the insurance industry, FIC's insurance subsidiaries limit the maximum net losses that may arise from large risks by reinsuring with other carriers. Such reinsurance provides for a portion of the mortality risk to be retained by FIC's insurance subsidiaries with the excess being ceded to a reinsurer at a premium set forth in a schedule based upon the age and risk classification of the insured. The reinsurance treaties provide for allowances that help Family Life and Investors Life offset the expense of writing new business. Investors Life generally retains the first $100,000 to $250,000 of risk on the life of any individual on its in-force block of life policies; however it has initiated raising this limit to $250,000 on most of these policies through recapture. On its in-force block of business, Family Life generally retains the first $200,000 of risk on the life of any one individual. On certain new products being written by Family Life (which amount to approximately one third of Family Life's new business), the entire amount of risk is reinsured on a percentage basis with Family Life retaining either 50% or 10% of the risk depending on the face amount of the policy. Although Family Life only retains as little as 10% of the risk, Family Life receives an allowance from the reinsurer on their portion of the premiums, which allows Family Life to profit on the 90% of the risk ceded to the reinsurer. This arrangement allows Family Life to price products more competitively and take certain underwriting risks which it could not take if it were retaining 100% of the risk. Family Life still reinsures all of its new business over $200,000, and Investors Life still reinsures all of its new business over $250,000. Family Life and Investors Life maintain bulk reinsurance treaties, under which they reinsured all of the mortality risks under accidental death benefit policies. The treaties were most recently renegotiated with the current reinsurer in 2002. In December 1997, FIC's life insurance subsidiaries entered into a reinsurance treaty under which all of the contractual obligations and risks under accident and health and disability income policies were assumed by a third party reinsurer. In 1995, Family Life (as the ceding company) entered into a reinsurance agreement with Investors Life (as the reinsuring company) pertaining to universal life insurance written by Family Life. The reinsurance agreement is on a co-insurance basis and applies to all covered business with effective dates on and after January 1, 1995. The agreement applies to only that portion of the face amount of the policy that is less than $200,000; face amounts of $200,000 or more are reinsured by Family Life with a third party reinsurer. In 1996, Family Life (as the ceding company) entered into a reinsurance agreement with Investors Life (as the reinsuring company), pertaining to annuity contracts written by Family Life. The agreement applies to contracts written on or after January 1, 1996. These reinsurance arrangements reflect management's plan to develop universal life and annuity business at Investors Life, with Family Life concentrating on the writing of term life insurance products. - 12 - Although reinsurance does not eliminate the exposure of FIC's insurance subsidiaries to losses from risks insured, the net liability of such subsidiaries will be limited to the portion of the risk retained, provided that the reinsurers meet their contractual obligations. FIC's insurance subsidiaries establish and carry as liabilities actuarially determined reserves that are calculated to meet the Company's future obligations. Reserves for life insurance policies are based on actuarially recognized methods using prescribed morbidity and mortality tables in general use in the United States modified to reflect the Company's actual experience when appropriate. These reserves are computed at amounts that, with additions from premiums to be received and with interest on such reserves compounded annually at certain assumed rates, are expected to be sufficient to meet the Company's policy obligations at their maturities or in the event of an insured's death. Investors Life Loans As part of the financing arrangement for the acquisition of Family Life Insurance Company, Family Life Corporation ("FLC"), a subsidiary of FIC, entered into a Senior Loan agreement under which $50 million was provided by a group of banks. The balance of the financing consisted of a $30 million subordinated note issued by FLC to Merrill Lynch Insurance Group, Inc. ("Merrill Lynch") and $14 million borrowed by another subsidiary of FIC from an affiliate of Merrill Lynch and evidenced by a senior subordinated note in the principal amount of $12 million and a junior subordinated note in the principal amount of $2 million and $25 million lent by two insurance company subsidiaries of ILCO. The latter amount was represented by a $22.5 million loan from Investors Life to FLC and a $2.5 million loan provided directly to FIC by Investors-CA (which was subsequently merged into Investors Life) (referred to as the "Investors Life Loans"). In addition to the interest provided under the Investors Life Loans, Investors Life and Investors-CA were granted by FIC non-transferable options to purchase, in the amounts proportionate to their respective loans, up to a total of 9.9% of shares of FIC's common stock at a price of $10.50 per share ($2.10 per share as adjusted for the five-for-one stock split in November 1996), equivalent to the then current market price, subject to adjustment to prevent dilution. The original provisions of the options provided for their expiration on June 12, 1998 if not previously exercised. As part of the May 18, 2001 merger of ILCO with FIC, the option agreement was amended to substitute the 9.9% provision for a fixed number of shares. The fixed number of shares, 500,411, is equivalent to the number of shares of FIC's common stock outstanding immediately prior to the Merger. In connection with the 1996 amendments to the subordinated notes, as described below, the expiration date of the options were extended to September 12, 2006. These notes were paid off to Investors Life in June 2001. - 13 - On July 30, 1993, the subordinated indebtedness owed to Merrill Lynch and its affiliate was prepaid. The primary source of the funds used to prepay the subordinated debt was new subordinated loans totaling $34.5 million that FLC and another subsidiary of FIC obtained from Investors Life (the "1993 Subordinated Loans"). The principal amount of the 1993 Subordinated Loans was to be paid in four equal annual installments in 2000, 2001, 2002 and 2003 and bears interest at an annual rate of 9%. The other terms of the 1993 Subordinated Loans are substantially the same as those of the $22.5 million subordinated loans that Investors Life had previously made to FLC. In June 1996, the provisions of the Investors Life Loans and the 1993 Subordinated Loans were modified. The 1993 Subordinated Loans were modified as follows: (a) the $30 million note was amended to provide for forty quarterly principal payments, in the amount of $163,540 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $1,336,458; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%, and (b) the $4.5 million note was amended to provide for forty quarterly principal payments, in the amount of $24,531 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $200,469; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%. As of December 31, 2002, the outstanding principal balance of the 1993 Subordinated Loans was $23.05 million. Since May 18, 2001, ILCO has been a wholly-owned subsidiary of FIC, and thus the 1993 Subordinated Loans are not an asset or liability on FIC's balance sheets, but still affect FIC's cash flow due to its debt servicing obligations. Regulation General. The Company and its insurance subsidiaries are subject to regulation and supervision at both the state and federal level, including regulation under federal and state securities laws and regulation by the states in which they are licensed to do business. The state insurance regulation is designed primarily to protect policy owners. Although the extent of regulation varies by state, the respective state insurance departments have broad administrative powers relating to the granting and revocation of licenses to transact business, licensing of agents, the regulation of trade practices and premium rates, the approval of form and content of financial statements and the type and character of investments. These laws and regulations require the Company's insurance subsidiaries to maintain certain minimum surplus levels and to file detailed periodic reports with the supervisory agencies in each of the states in which they do business and their business and accounts are subject to examination by such agencies at any time. The insurance laws and regulations of the domiciliary state of the Company's insurance subsidiaries require that such subsidiaries be examined at specified intervals. Both Investors Life and Family Life are domiciled in the state of Washington. - 14 - A number of states regulate the manner and extent to which insurance companies may test for acquired immune deficiency syndrome (AIDS) antibodies in connection with the underwriting of life insurance policies. To the extent permitted by law, the Company's insurance subsidiaries consider AIDS information in underwriting coverage and establishing premium rates. An evaluation of the financial impact of future AIDS claims is extremely difficult, due in part to insufficient and conflicting data regarding the incidence of the disease in the general population and the prognosis for the probable future course of the disease. Risk Based Capital Requirements. The National Association of Insurance Commissioners ("NAIC") has imposed Risk-Based Capital ("RBC") requirements to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with; (i) asset quality; (ii) mortality and morbidity; (iii) asset and liability matching; and (iv) other business factors. The RBC formula is intended to be used by insurance regulators as an early warning tool to discover potential weakly capitalized companies for the purpose of initiating regulatory action. The RBC requirements are not intended to be a basis for ranking the relative financial strength of insurance companies. The formula also defines a new minimum capital standard which will supplement the prevailing system of low fixed minimum capital and surplus requirements on a state-by-state basis. The RBC requirements provide for four different levels of regulatory attention in those states that adopt the NAIC regulations, depending on the ratio of the company's Total Adjusted Capital (which generally consist of its statutory capital, surplus and asset valuation reserve) to its Authorized Control Level RBC. A "Company Action Level Event" is triggered if a company's Total Adjusted Capital is less than 200% but greater than or equal to 150% of its Authorized Control Level RBC, or if a negative trend has occurred (as defined by the regulations) and Total Adjusted Capital is less than 250% but more than 200% of its Authorized Control Level RBC. When a Company Action Level Event occurs, the company must submit a comprehensive plan to the regulatory authority which discusses proposed corrective actions to improve its capital position. A "Regulatory Action Level Event" is triggered if a company's Total Adjusted Capital is less than 150% but greater than or equal to 100% of its Authorized Control Level RBC. When a Regulatory Action Level Event occurs, the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed. An "Authorized Control Level Event" is triggered if a company's Total Adjusted Capital is less than 100% but greater than or equal to 70% of its Authorized Control Level RBC, and the regulatory authority may take any action it deems necessary, including placing the company under regulatory control. A "Mandatory Control Level Event" is triggered if a company's total adjusted capital is less than 70% of its Authorized Control Level RBC, and the regulatory authority is mandated to place the company under its control. Calculations using the NAIC formula and the statutory financial statements of the Company's insurance subsidiaries as of December 31, 2002 indicate that the Total Adjusted Capital of each of the Company's insurance subsidiaries is above 420% of its respective Authorized Control Level RBC. - 15 - Solvency Laws Assessments. The solvency or guaranty laws of most states in which an insurance company does business may require that company to pay assessments (up to certain prescribed limits) to fund policyholder losses or liabilities of insurance companies that become insolvent. Recent insolvencies of insurance companies increase the possibility that such assessments may be required. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future premium taxes. The insurance companies record the expense for guaranty fund assessments in the period assessed. For the year ended December 31, 2002, Family Life received a credit on its guaranty fund assessments of $68,725, while Investors Life received a credit of $10,484. Those amounts are net of the amounts that can be offset against future premium taxes and, in the case of Family Life, the amount is also net of the amount that can be recovered from Merrill Lynch pursuant to the Stock Purchase Agreement between FIC and Merrill Lynch. The likelihood and amount of any other future assessments cannot be estimated and are beyond the control of FIC. Dividends. One source of cash for FLC to make payments of principal and interest on the 1993 Subordinated Loans is dividends paid to FLC by Family Life. Under current Washington law, any proposed payment of an "extraordinary dividend" requires a 30-day prior notice to the Washington Insurance Commissioner, during which period the Commissioner can approve the dividend, disapprove the dividend or fail to comment on the notice, in which case the dividend is deemed approved at the end of the 30-day period. An "extraordinary dividend" is a distribution which, together with dividends or distributions paid during the preceding twelve months, exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31st or (ii) the statutory net gain from operations for the preceding calendar year. Payment of a regular dividend requires that the insurer's earned surplus after dividends or distributions must be reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Family Life had earned surplus of $1.48 million and a net gain from operations of $0.13 million for 2002. Investors Life had earned surplus of $42.3 million and a net gain from operations of $3.0 million for 2002. Investors Life paid a dividend in 2002 to its parent corporation, InterContinental Life Corporation, in the amount of $8,556,104. Valuation Reserves. Life insurance companies are required to establish an Asset Valuation Reserve ("AVR") consisting of two components: (i) a "default component," which provides for future credit-related losses on fixed maturity investments, and (ii) an "equity component," which provides for losses on all types of equity investments, including equity securities and real estate. Insurers are also required to establish an Interest Maintenance Reserve ("IMR"), designed to defer realized capital gains and losses due to interest rate changes on fixed income investments and to amortize those gains and losses into future income. The IMR is required to be amortized into statutory earnings on a basis reflecting the remaining period to maturity of the fixed maturity securities sold. These reserves are required by state insurance regulatory authorities to be established as a liability on a life insurer's statutory financial statements, but do not affect the financial statements prepared in accordance with Generally Accepted Accounting Principles ("GAAP"). Since dividend payments are based upon statutory earnings, management believes that the combination of the AVR and IMR will affect statutory capital and surplus and therefore may reduce the ability of Investors Life and Family Life to pay dividends to FIC. - 16 - Insurance Holding Company Regulation. Family Life and Investors Life are subject to regulation under the insurance and insurance holding company statutes of the state of Washington. The insurance holding company laws and regulations vary from jurisdiction to jurisdiction, but generally require insurance and reinsurance subsidiaries of insurance holding companies to register with the applicable state regulatory authorities and to file with those authorities certain reports describing, among other information, their capital structure, ownership, financial condition, certain intercompany transactions and general business operations. The insurance holding company statutes also require prior regulatory agency approval, or in certain circumstances, prior notice of certain material intercompany transfers of assets as well as certain transactions between insurance companies, their parent companies and affiliates. Under the Washington Insurance Code, unless (i) certain filings are made with the Washington Department of Insurance, (ii) certain requirements are met, including a public hearing and (iii) approval or exemption is granted by the insurance commissioner, no person may acquire any voting security or security convertible into a voting security of an insurance holding company, such as the Company, which controls a Washington insurance company, or merge with such a holding company, if as a result of such transaction such person would "control" the insurance holding company. "Control" is presumed to exist if a person directly or indirectly owns or controls 10% or more or the voting securities of another person. The insurance holding company regulations generally apply only to insurers domiciled in a particular state. However, the regulations in certain states also provide that insurers that are "commercially domiciled" in that state are also subject to the provisions applicable to domiciled insurers. The test for determining whether an insurer is commercially domiciled is based on the percentage of premiums written in the state as compared to the amount of premiums written everywhere over a measuring period. The applicable percentage for California is 33%, while for Texas it is 30%. Currently, the insurance subsidiaries of FIC are not treated as commercially domiciled in any jurisdiction. Privacy Legislation. In July 2001, the Financial Services Modernization Act (referred to in this paragraph as the "Act") of 1999 became applicable to insurance companies. In general, the Act provides that financial institutions have certain obligations with respect to the maintenance of the privacy of customer information. In addition, the Act places new restrictions on disclosure of nonpublic personal information to third party institutions seeking to utilize such information in connection with the sale of products or services. A financial institution may disseminate certain types of customer information to nonaffiliated third parties if the institution provides clear and conspicuous disclosure of the institution's privacy policy and the customer authorizes the release of certain information to third parties. Where the customer permits the release of the information, the Act restricts disclosure of information that is non-public in nature but does not prohibit the release of information which can be obtained from public sources. Although FIC's insurance subsidiaries have not experienced any adverse effects to their business as a result of the Act to date, it is too early to assess the Act's long-range effects. - 17 - USA Patriot Act. Title III of the USA PATRIOT Act (Public Law 107-56) (referred to in this section as the "Act"), makes a number of amendments to the anti-money laundering provisions of the Bank Secrecy Act ("BSA"). The purpose of the amendments was to facilitate the prevention, detection and prosecution of international money laundering and the financing of terrorism. The Act requires every financial institution to establish an anti-money laundering program that includes: (1) the development of internal policies, procedures, and controls; (2) the designation of a compliance officer; (3) an ongoing employee training program; and (4) an independent audit function to test programs. In October, 2002, the Department of the Treasury (the "Treasury"), released an interim final rule that temporarily deferred the application of the Act to certain financial institutions, including insurance companies. Although Treasury has not yet issued final regulations pertaining to insurance companies, FIC and its insurance subsidiaries have taken preliminary steps to establish an anti-money laundering program. These steps include the appointment of a compliance officer and an internal auditor. In addition, a 'USA PATRIOT Act taskforce,' consisting of representatives of key departments of the Company, has been established to develop internal procedures, particularly in relation to the checking of names involved in certain transactions against the Specially Designated Nationals and Blocked Persons List prepared by Treasury's Office of Foreign Assets Control. Until Treasury issues final rules regarding the insurance industry's compliance with the anti-money laundering provisions of the Act, FIC's insurance subsidiaries believe that it is too early to predict the Act's long term effects on their business. Potential Federal Regulation. Although the federal government generally does not directly regulate the insurance industry, federal initiatives often have an impact on the business. Congress and certain federal agencies periodically investigate the condition of the insurance industry (encompassing both life and health and property and casualty insurance) in the United States in order to decide whether some form of federal role in the regulation of insurance companies would be appropriate. Further, since FIC is a publicly traded entity, it is subject to regulation by the Securities and Exchange Commission (SEC), as well as NASDAQ. Under SEC regulations, FIC is required to file forms under the Securities Act of 1933 and the Securities and Exchange Act of 1934 with respect to various aspects of its business. - 18 - Sarbanes-Oxley. On July 30, 2002, the Sarbanes-Oxley Act of 2002 ("SarbOx") was signed into law to address corporate and accounting fraud. SarbOx establishes a new accounting oversight board that will enforce auditing standards and restricts the scope of services that accounting firms may provide to their public company audit clients. Among other things, SarbOx also (i) requires chief executive officers and chief financial officers to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission (the "SEC"); (ii) imposes new disclosure requirements regarding internal controls, off-balance sheet transactions and pro forma (non-GAAP) disclosures; (iii) accelerates the time frame for reporting of insider transactions and periodic disclosures by public companies; and (iv) in the future, will require companies to disclose whether they have adopted a code of ethics for senior financial officers and whether the audit committee includes at least one "audit committee financial expert." SarbOx also requires that the SEC, based on certain enumerated factors, to regularly and systematically review corporate filings. To deter wrongdoing, SarbOx: (i) subjects bonuses issued to top executives to disgorgement if a restatement of a company's financial statements was due to corporate misconduct; (ii) prohibits an officer or director from misleading or coercing an auditor; (iii) prohibits insider trades during pension fund "blackout periods;" (iv) imposes new criminal penalties for fraud and other wrongful acts; and (v) extends the period during which certain securities fraud lawsuits can be brought against a company or its officers. As a publicly reporting company, we are subject to the requirements of SarbOx and are in the process of complying with, and establishing procedures for, compliance with SarbOx and related rules issued by the SEC and Nasdaq. At the present time, and subject to the final rules and regulations the SEC and Nasdaq may adopt, we anticipate that we will incur additional expense as a result of SarbOx, but we do not expect that such compliance will have a material impact on the Company's business. Federal Income Taxation. The Revenue Reconciliation Act of 1990 amended the Internal Revenue Code of 1986 to require a portion of the expenses incurred in selling insurance products to be deducted over a period of years, as opposed to an immediate deduction in the year incurred. Since this change only affects the timing of the deductions, it does not affect tax expense as shown on the Company's financial statements prepared in accordance with GAAP. For the years ended December 31, 2000, 2001 and 2002, the decreases in Family Life's current income tax provisions, utilizing the effective tax rates, due to this change were $177,038, $157,180, and $139,323 respectively. For the years ended December 31, 2000, 2001 and 2002, the decreases in the current income tax provisions of Investors Life due to this change were $8,368, $294,695, and $279,011 respectively. The change has a negative tax effect for statutory accounting purposes when the premium income of the Company's insurance subsidiaries increases, but has a positive tax effect when their premium income decreases. FIC files a consolidated federal income tax return with its subsidiaries, except for Investors Life (which files a separate return) and ILG Securities (which files its own federal income tax return). In accordance with the tax allocation agreements maintained by those FIC companies which file a consolidated return, federal income tax expense or benefit is allocated to each entity in the consolidated group as if such entity were filing a separate return. - 19 - Competition The financial services industry in general, and the market for life insurance and annuity products in particular, is highly competitive involving many companies. Agents placing insurance business with Family Life and Investors Life are compensated on a commission basis. However, some companies pay higher commissions and charge lower premium rates and many companies have more resources than FIC's insurance subsidiaries. In addition, consolidations of insurance and banking institutions, which is permitted under recently-enacted federal legislation, may adversely affect the ability of Family Life to expand its customer referral relationships with mortgage lending and servicing institutions. The Company believes it can compete effectively by focusing on markets where its approach to distribution and products provides competitive advantage. This includes the mortgage protection insurance market. Family Life's delivery system already provides an advantage in the lower income homeowner market. The company is also competing effectively for the middle income market through agreements to offer other insurance company products. In addition, the company is in the process of developing new mortgage related products with improved benefits and features. Another target market where the company believes it can compete effectively is in providing retirement income through fixed annuity products. Annuities currently available for sale consistently compare favorably to the industry with respect to agent commission levels and cash values on a guaranteed basis. The principal cost and competitive factors that affect the ability of FIC's insurance subsidiaries to sell their insurance products on a profitable basis are: (1) the general level of premium rates for comparable products; (2) the extent of individual policyholders services required to service each product category; (3) general interest rate levels; (4) competitive commission rates and related marketing costs; (5) legislative and regulatory requirements and restrictions; (6) the impact of competing insurance and other financial products; and (7) the condition of the regional and national economies. Employees of the Company At December 31, 2002, the number of employees within FIC and its subsidiaries was approximately 278 and the number of Regional Vice Presidents employed by the life insurance subsidiaries of FIC was 23. - 20 - Website Access Our website address is "www.ficgroup.com." Our filings with the Securities and Exchange Commission (SEC) are available at no cost on our website as soon as reasonably practicable after the filing of such reports with the SEC. Segment Information The principal operations of the Company's insurance subsidiaries are the underwriting of life insurance and annuities. Accordingly, no separate segment information is required to be provided by the Registrant for the three-year period ending December 31, 2002. Item 2. Properties FIC's home office is located at River Place Pointe, 6500 River Place Blvd., Building One, Austin, Texas. River Place Pointe was purchased by Investors Life in October 1998. It consists of 47.995 acres of land in Austin, Texas. The aggregate purchase price for these tracts was $8.1 million. The site development permit allowed for the construction of seven office buildings totaling 600,000 square feet, with associated parking, drives and related improvements. Construction on the first section of the project, which consists of four office buildings, an associated parking garage and related infrastructure was completed during 2000 and 2001. The second section of construction, which includes three more office buildings, an associated parking garage and related infrastructure, was completed in 2002. FIC and its insurance subsidiaries occupy the entire Building One of River Place Pointe, consisting of approximately 76,143 square feet of space and approximately 5,000 square feet of Building Four, for records storage. An associated facility of 10,000 square feet in Cedar Park, Texas, is leased to house the company's printing operations and warehouse storage. The monthly rental for the Cedar Park facility is $9,123. Family Life and Investors Life lease their home offices at the Sedgwick James Building, 2101 Fourth Avenue, in Seattle, Washington. The lease currently covers approximately 7,776 rentable square feet of office space for a term expiring on October 31, 2003. The base rental is approximately $17,934 per month, which includes Family Life's proportionate share of the building's operating expenses, including parking, utilities, property taxes, insurance, maintenance and management. Actual increases from those initial operating expenses during the lease term are passed on to Family Life on a proportionate basis. Additionally, Family Life and Investors Life lease 22,100 square feet of warehouse space at Segalle Business Park, Tukwila, Washington, for the storage of records. The monthly rental cost is $6,570 and the lease term expires on October 31, 2003. - 21 - ILCO leases a building located at 40 Parker Road, Elizabeth, New Jersey. This building, which was formerly ILCO's headquarters building, contains approximately 41,000 square feet of office space. The lease, which was signed in December 1985 and expires in December 2005, calls for a minimum base rental of $737,940 per annum. The lease provides that all costs including, but not limited to, those for maintenance, repairs, insurance and taxes be borne by ILCO. ILCO subleases this space to third parties. The Company believes that its properties and leased space are adequate to meet its foreseeable requirements. Item 3. 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 on the financial statements. Universal Life Litigation. On January 22, 2002, the Travis County District Court in Austin, Texas, denied certification to a proposed nationwide class of plaintiffs who purchased certain universal life insurance policies from INA Life Insurance Company (which was merged into Investors Life in 1992). The lawsuit, which was filed in 1996 as a "vanishing premium" life insurance litigation, initially alleged that the universal life insurance policies sold to plaintiffs by INA Life Insurance Company utilized unfair sales practices. In April 2001, the 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. Plaintiffs' Motion for Class Certification was denied in its entirety. 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. 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. - 22 - Litigation Relating to Former Chairman and CEO. In January, 2003, the Company filed a lawsuit in Federal District Court in Austin, Texas. The lawsuit names as defendants Roy F. Mitte ("Mitte"), The Roy F. and Joann Cole Mitte Foundation (the "Foundation") and Joann Mitte (collectively referred to as the "Defendants"). Mitte was the Chairman, President and Chief Executive Officer of FIC until he was placed on administrative leave in August, 2002. The administrative leave, and the subsequent action by the Board of Directors in October, 2002 to terminate the employment agreement between FIC and Mitte, resulted from an investigation conducted by the FIC Audit Committee. The investigation conducted by the Audit Committee determined that more than $540,000 in Mitte's personal expenses had been paid by Company funds without the knowledge or approval of the FIC's officers or directors. In addition, the investigation disclosed that Mitte had caused an unapproved transfer of $1 million from the Company to the Foundation, followed by an ineffective attempt to obtain an unanimous consent of the Board of Directors of the Company. The Board of Directors has never met to ratify or approve the donation. The Foundation is a shareholder of FIC. The Company's claims against Mitte seek the reimbursement of $540,000 of personal expenses which were paid by the Company for the benefit of Mitte over a period of years beginning in 1992. In addition, the suit demands that Mitte reimburse the Company for a payment which he caused to be made to the Foundation without proper authorization by the Board of Directors. On March 19, 2003, Mitte filed a counterclaim against the Company alleging that the Company breached the employment agreement between FIC and Mitte by refusing to pay Mitte the severance benefits and compensation provided for under the employment agreement and amendment thereto. The Company believes that it properly terminated the contract and intends to vigorously defend Mitte's counterclaim. The litigation is currently in the preliminary discovery stage. Other Litigation. Additionally, FIC's insurance 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. Management does 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. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted during the fourth quarter of the fiscal year ended December 31, 2002, to a vote of security holders. - 23 - PART II Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters A. Market Information FIC's common stock is traded on the Nasdaq National Market (Nasdaq symbol: FNIN). The following table sets forth the quarterly high and low closing prices for FIC common stock for 2002 and 2001. Quotations are furnished by the National Association of Securities Dealers Automated Quotation System ("Nasdaq"). Common Stock Prices High Low 2002 First Quarter $ 14.51 $13.30 Second Quarter 18.07 13.67 Third Quarter 17.55 14.60 Fourth Quarter 15.87 13.21 2001 First Quarter $ 14.75 $ 9.125 Second Quarter 16.90 11.90 Third Quarter 16.00 12.44 Fourth Quarter 14.90 13.00 B. Holders As of February 28, 2003 there were approximately 15,473 record holders of FIC common stock. C. Dividends In the year 2000, FIC paid a cash dividend in the amount of $0.18 per share, which was payable on April 12, 2000, to shareholders of record on April 5, 2000. In the year 2001, FIC paid three cash dividends. In March 2001, FIC announced that its board approved the payment of a cash dividend for the year in the amount of $0.41 per share. The dividend was paid on April 12, 2001, to shareholders of record as of the close of business on March 19, 2001. - 24 - In May 2001, FIC announced that its Board approved a dividend policy. The policy adopted by the Board anticipated that the Company would declare and pay, on a semi-annual basis, a dividend on the common stock of the Company so as to provide to shareholders with an annualized yield of approximately 3% of the market value (based on the Nasdaq National Market quotation system). Pursuant to the above-mentioned policy, in May 2001, FIC announced that its Board of Directors approved the payment of a semi-annual cash dividend in the amount of $0.25 per common share. The dividend was payable on July 2, 2001, to record holders as of the close of business on June 18, 2001. On November 27, 2001 a dividend in the amount of $0.21 per common share was approved. This dividend was payable on December 21, 2001 to record holders as of December 7, 2001. In May, 2002, the Board of FIC approved a cash dividend of $0.23 per common share payable on June 21, 2002 to record holders as of June 7, 2002. On December 13, 2002, the Board of Directors met to review and amend the previously-adopted dividend policy of the Company. The Board adopted a new policy whereby it anticipates the payment of a dividend on a semi-annual basis; however, the new policy is designed to reflect a dividend based on the results of operations, capital requirements and similar financial criteria of the Company, rather than on the market price of the common stock of the Company. Pursuant to the new policy, the Board declared a dividend of $0.05 per common share payable on January 24, 2003 to record holders as of January 3, 2003. The ability of an insurance holding company, such as FIC, to pay dividends to its shareholders may be limited by the company's ability to obtain revenue, in the form of dividends and other payments, from its subsidiaries. The right of FIC's insurance subsidiaries to pay dividends is restricted by the insurance laws of their domiciliary state. See Item 1. Business - Regulation - Dividends. Further, FLC, which holds all of the stock of Family Life, is restricted from paying dividends on its common stock by the provisions of the 1993 Subordinated Loans. See Item 1. Business - Senior Subordinated Loans. FIC (as the successor to the obligations of FLIIC) is also prohibited from paying dividends on its stock by the provisions of the $4.5 million subordinated note held by Investors Life. In order to provide for the payment of the cash dividends declared in 2001 and 2002, FIC received waivers from Investors Life on the above-described restrictions of the loan agreements, thereby permitting FIC to make the dividend payments to its shareholders. - 25 - Item 6. Selected Financial Data: (Registrant and its Consolidated Subsidiaries) (In thousands, except per share data) 2002 2001 2000 1999 1998 Restated Restated Restated Restated Total Revenues $118,715 $98,160 $44,418 $46,244 $52,293 (Loss) income before federal income tax, equity in net earnings of affiliates and cumulative change in accounting principle (8,358) 12,869 6,787 6,576 8,437 (Loss) income before equity in net earnings of affiliates and cumulative change in accounting principle (5,087) 8,792 5,396 5,555 6,257 Equity in net earnings of affiliate, net of tax 0 985 2,040 3,406 1,611 (Loss) income before cumulative change in accounting principle (5,087) 9,777 7,436 8,961 7,868 Cumulative change in accounting principle 10,429 0 0 0 0 Net Income $ 5,342 $ 9,777 $ 7,436 $ 8,961 $ 7,868
- 26 - Common Stock and Common Stock Equivalents 9,555 7,824 5,055 5,200 5,557 Net income per share $0.56 Basic $1.25 $1.47 $ 1.77 $1.46 Diluted $0.56 $1.24 $1.44 $ 1.72 $1.42 Total Assets $1,311,002 $1,363,857 $289,955 $288,292 $296,164 Long Term Obligations $0 $0 $35,349 $ 41,497 $ 47,645 Cash dividends paid per share $0.28 $0.87 $0.18 $0 $0
In 2002, net income and earnings per share were affected by the cumulative effect of a change in accounting principle of $10.4 million. This amount represents the excess of fair value of net assets acquired over cost as of the beginning of 2002 related to the merger of ILCO with and into a subsidiary of FIC on May 18, 2001. In the Company's filings for the quarters ended March 31, 2002, June 30, 2002 and September 30, 2002, the company reported a cumulative effect of a change in accounting principle of $15.7 million. Due to the restatements, as described below in Item 7, the Company has restated the amount of the excess of fair value of net assets over acquired cost to $10.4 million. The Company recorded this cumulative effect in conjunction with adopting Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations," in the first quarter of 2002, as required by SFAS 141. The results for the year ended December 31, 2001 were affected by the merger of ILCO with and into a subsidiary of FIC on May 18, 2001. For a description of the merger transaction, see "Item 7 - Management Discussion & Analysis - Transactions Affecting Comparability of Results of Operations." - 27 - Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Following is a discussion and analysis of the financial statements and other statistical data that management believes will enhance the understanding of FIC's financial condition and results of operations. This discussion should be read in conjunction with the financial statements beginning on page F-1. Forward-Looking Statements Except for historical factual information set forth in this Management's Discussion and Analysis, 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 effect 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 subsidiaries' 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 life 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. - 28 - Introduction As described in Note 2 to our accompanying consolidated financial statements included in Item 8 of this Annual Report on Form 10-K and beginning with the discussion on page F-21, we have restated our financial statements for the fiscal years ended December 31, 2001, and 2000. The financial information for all periods included in the following discussion gives effect to the restatement. For purposes of this Form 10-K and in accordance with rule 12b-15 under the Securities Exchange Act of 1934, as amended, each item of the Form 10-K for the years ended December 31, 2001 and 2000 as originally filed that were affected by the restatement has been amended to the extent affected and restated in its entirety. NO ATTEMPT HAS BEEN MADE IN THIS FORM 10-K TO MODIFY OR UPDATE OTHER DISCLOSURES AS PRESENTED IN THE ORIGINAL FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2001 OR 2000 EXCEPT AS REQUIRED TO REFLECT THE EFFECTS OF THIS RESTATEMENT. Restatement. In the fourth quarter of 2002, the Company identified uncollectible receivables for which adequate allowance had not been made and policyholder benefits and expenses that were understated due to an interface error between the policy administration system and the general ledger. The Company extended its investigation to determine the years affected and expanded the scope of its review to include other areas, including certain adjustments that were deemed not material in prior years. As a result of this review, the Consolidated Statements of Income for 2001 and 2000 and the Consolidated Balance Sheet for 2001 were restated as follows: - 29 - CONSOLIDATED STATEMENTS OF INCOME Year ended December 31, 2001 2000 Previously Previously Reported Restated Reported Restated Revenues: Premiums 35,886 35,887 33,149 33,149 Other 2,808 1,842 6 6 Total Revenues 99,125 98,160 44,418 44,418 Benefits and expenses: Policyholder benefits and expenses 27,702 30,149 13,453 13,453 Amortization of present value of future profits of acquired businesses 4,715 4,644 3,669 3,569 Amortization of deferred policy acquisition costs 6,800 6,767 5,329 5,340 Operating expenses 23,046 22,868 11,375 11,159 Total Expenses 83,126 85,291 37,936 37,631 Income before federal income tax and equity in net earnings of affiliates 15,999 12,869 6,482 6,787 Provision for federal income taxes: Current 3,937 3,937 1,521 1,521 Deferred 1,364 140 (237) (130) Income before equity in net earnings of affiliates 10,698 8,792 5,198 5,396 Equity in net earnings of affiliates, net of tax 1,316 985 3,581 2,040 Net Income $12,014 $ 9,777 $8,779 $7,436 Basic earnings per share $1.54 $1.25 $1.74 $1.47 Diluted earnings per share $1.52 $1.24 $1.70 $1.44
- 30 - CONSOLIDATED BALANCE SHEET As of December 31, 2001 Previously Reported Restated ASSETS Investments other than investments in affiliate: Equity securities, at market value (cost approximates $8,856 at December 31, 2001) $56 $8,279 Invested real estate 61,049 64,051 Total Investments 756,329 767,554 Agency advances and other receivables 30,324 17,309 Property and equipment, net 3,546 785 Deferred policy acquisition costs 80,290 77,137 Present value of future profits of acquired businesses 31,251 30,530 Other assets 14,074 15,198 Separate account assets 399,264 391,593 Total Assets $1,378,829 $1,363,857 LIABILITIES AND SHAREHOLDERS' EQUITY Deferred federal income taxes 31,920 27,197 Excess of net assets over acquired cost 15,847 10,429 Other liabilities 8,938 17,146 Total liabilities 1,199,353 1,197,420 Shareholders equity: Accumulated other comprehensive income 2,297 327 Retained earnings 131,462 120,393 Total Shareholders' Equity before Treasury Stock 201,373 188,334 Total Shareholders' Equity 179,476 166,437 Total Liabilities and Shareholders' Equity $1,378,829 $1,363,857 The consolidated statements of income for the years ended December 31, 2001 and 2000 were restated to reflect the following: o A reduction in other revenue in 2001 of $966,000 primarily related to a reclassification of negative goodwill amortization to operating expenses; o An increase in policyholder benefits and expenses in 2001 of $2.4 million related to certain death benefits and annuity benefits which were not recorded due to an interface error between the Company's policy administration system and its general ledger and a correction of an unreconciled difference between suspense account balances included in the Company's general ledger and those included in its policy administration system. - 31 - o Decreases in the expense related to amortization of present value of future profits of acquired business of $71,000 in 2001 and $100,000 in 2000 due to an adjustment in the calculation in this expense; o A decrease in the expense related to the amortization of deferred policy acquisition costs of $33,000 in 2001 and an increase of $11,000 in 2000 due to adjustments in assumptions to calculate amortization factors; o An decrease in operating expenses of $179,000 in 2001 and a decrease in operating expenses of $216,000 in 2000 due primarily to a reduction in rent expense from the recognition of a deferred gain related to an operating lease offset by expenses associated with uncollectible receivables, pension expenses and reductions in negative goodwill amortization; o A decrease in the provision for federal income taxes of $1.2 million in 2001 and an increase of $107,000 in 2000 due to the effect of the restatements on net income before federal income tax and equity in net earnings of affiliates; and o Decreases in the equity in net earnings of affiliate of $331,000 in 2001 and $1.5 million in 2000 due to adjustments that decreased ILCO's net income in 2001 and 2000. The consolidated balance sheet as of December 31, 2001 was restated to reflect the following: o An increase to assets of $8.2 million in FIC's investments in equity securities to properly reflect the market value of the Company's investment in the separate account; o An increase to invested real estate of $3.0 million primarily due to a reclassification of certain real estate expenditures that were classified as property and equipment; o A decrease in assets of $13.0 million in agency advances and other receivables primarily due to a write-off of uncollectible agent balances, a write-off of a reinsurance receivable, and a write-off of assets related to an interface error between the Company's policy administration system and its general ledger; o A decrease to property and equipment of $2.8 million primarily due to a reclassification of property and equipment to invested real estate and a write-off of assets that had not been depreciated since purchase; o A decrease in assets of $3.2 million in deferred policy acquisition costs due to a revision of the factors used to calculate Family Life's deferred policy acquisition costs; o A decrease in assets of $721,000 in present value of future profits of acquired businesses due to an adjustment in the calculation of this asset; - 32 - o An increase to assets of $1.1 million of other assets primarily related to the establishment of unrecorded pre-paid pension assets related to Family Life's and ILCO's pension plans; o A decrease in assets of $7.7 million of separate account assets due to a reclassification of separate account assets to equity securities; o A decrease in liabilities of $4.7 million related to deferred federal income taxes; o A decrease in liabilities of $5.4 million related to a reduction in excess of net assets over acquired cost related to ILCO goodwill; o An increase in liabilities of $8.2 million of other liabilities primarily related to an unreconciled difference between suspense account balances included in the Company's general ledger and those included in its policy administration system. o A decrease of $2.0 million of accumulated other comprehensive income due to the changes in the accounting treatment for the pre-paid pension asset and the separate account investment; and o A decrease in retained earnings of $11.1 million due to the restatements. Business Overview Financial Industries Corporation ("FIC" or the "Company") is a holding company engaged through its subsidiaries in the business of marketing, underwriting and distributing a broad range of life insurance and annuity products in 49 states, the District of Columbia and the U.S. Virgin Islands. The Company's revenues are derived principally from: * premiums on individual life insurance policies * product charges from universal life insurance products and annuities * net investment income and realized investment gains on assets In accordance with Generally Accepted Accounting Principles ("GAAP"), universal life insurance premiums and annuity deposits received are reflected on FIC's consolidated balance sheets as increases in liabilities for contract holder deposit funds and not as revenues. Expenses consist principally of insurance benefits provided to policyholders, interest credited on policyholder account balances, other operating costs and expenses, which include commissions and general business expenses, net of expenses deferred, amortization of present value of future profits of acquired businesses and amortization of deferred policy acquisition costs, and premium and income taxes. Surrender benefits paid relating to universal life insurance policies and annuities are reflected as decreases in liabilities for contract holder deposit funds and not as expenses. - 33 - The Company's profitability depends in large part upon: (1) the adequacy of our product pricing, which is primarily a function of competitive conditions, our ability to assess and manage trends in mortality and morbidity experience, our ability to generate investment earnings and our ability to maintain expenses in accordance with pricing assumptions; (2) the amount of assets under management; and (3) the maintenance of our target spreads between the rate of earnings on our investments and credited rates on policyholders' account balances. Transactions Affecting Comparability of Results of Operations On May 18, 2001, pursuant to an Agreement and Plan of Merger, as amended (the "Merger Agreement"), dated as of January 17, 2001, among FIC, InterContinental Life Corporation ("ILCO"), and ILCO Acquisition Company, a Texas corporation and wholly-owned subsidiary of FIC ("Merger Sub"), Merger Sub was merged with and into ILCO (the "Merger"). ILCO was the surviving corporation of the Merger and became a wholly-owned subsidiary of FIC. In accordance with the Merger Agreement, FIC issued 1.1 shares of common stock, par value $0.20 per share ("FIC Common Stock"), for each share of common stock, par value $0.22 per share, of ILCO outstanding at the time of the Merger ("ILCO Common Stock"). In addition, each share of ILCO Common Stock issuable pursuant to outstanding options was assumed by FIC and became an option to acquire FIC Common Stock with the number of shares and exercise price adjusted for the exchange ratio in the Merger. Prior to the merger, FIC owned approximately 48.1% of ILCO's common stock. Since ILCO was a wholly-owned subsidiary of FIC for the period from May 18, 2001 to December 31, 2001 and thereafter, the operations of ILCO are reported on a consolidated basis with FIC in the year end 2001 financial statements as well as for the year end 2002 financial statements. For the period from January 1, 2001 to May 17, 2001, and for the year ended December 31, 2000, FIC's net income includes its equity interest in the net income of ILCO, with such equity interest being based on FIC's percentage ownership of ILCO. In 2002, net income and earnings per share were affected by the cumulative effect of a change in accounting principle of $10.4 million. This amount represents the excess of fair value of net assets acquired over cost as of the beginning of 2002 related to the merger of ILCO with and into a subsidiary of FIC on May 18, 2001. In the Company's filings for the quarters ended March 31, 2002, June 30, 2002 and September 30, 2002, the company reported a cumulative effect of a change in accounting principle of $15.7 million. Due to the restatements, as described below in Item 7, the Company has restated the amount of the excess of fair value of net assets over acquired cost to $10.4 million. The Company recorded this cumulative effect in conjunction with adopting Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations," in the first quarter of 2002, as required by SFAS 141. Results of Operations - Three Years Ended December 31, 2002 For the year ended December 31, 2002, FIC's net income was $5,342,000 (basic and diluted earnings of $0.56 per common share) on revenues of $118,715,000 as compared to net income for the year ended December 31, 2001, which was $9,777,000 (basic earnings of $1.25 per common share or diluted earnings of $1.24 per common share) on revenues of $98,160,000 and net income for the year ended December 31, 2000, which was $7,436,000 (basic earnings of $1.47 per common share or diluted earnings of $1.44 per common share) on revenues of - 34 - $44,418,000. The net loss for the year ended December 31, 2002, before the cumulative effect of a change in accounting principle, was $5,087,000 (basic and diluted earnings of ($0.53) per common share). The per share results for the year ended December 31, 2002 were affected by the increase in the number of FIC's common shares outstanding due to the Merger. As of December 31, 2002, the number of FIC's weighted average common shares outstanding was 9,555,000, as compared to weighted average shares outstanding of 7,824,000 as of December 31, 2001. The December 31, 2001 weighted average shares outstanding takes into account the fact that additional shares were issued on May 18, 2001 due to the Merger and were outstanding only for the period from May 18, 2001 to December 31, 2001. Additionally, net income and earnings per share were affected by the cumulative effect of a change in accounting principle of $10.4 million, as described in "Transactions Affecting Comparability of Results of Operations." The decrease of $13.9 million in net income for the year 2002, before the cumulative effect of change in accounting principle, was primarily attributable to the following factors: (i) a decrease in investment income; (ii) a net realized loss on investments relating to impairments; (iii) an increase in death benefits; (iv) an increase in operating expenses and (v) decreases in premium income. The increase in net income for the year 2001 as compared to 2000 was primarily attributable to the Merger, which consolidated 100% of ILCO's net income subsequent to the May 18, 2001 Merger, with FIC's net income. Revenues. Premium revenues reported for traditional life insurance products are recognized when due. Premium income, net of reinsurance ceded, for the year 2002, was $35.7 million, as compared to $35.9 million for the year 2001 and $33.1 million for the year 2000. This source of revenues is related to the traditional life insurance book of business of FIC's insurance subsidiaries. For the year ended December 31, 2002, Investors Life contributed approximately $8.7 million and Family Life contributed approximately $27.0 million to premium income. The consolidation of ILCO's operations following the Merger contributed approximately $5 million and Family Life contributed approximately $31 million to premium income for the year ended December 31, 2001. At Family Life (which has been a subsidiary of FIC for all of the year-end periods covered by this report), first year net collected premiums for traditional life insurance products in 2002 were $2.6 million as compared to $3.4 million in 2001. The level of net collected premiums for traditional life insurance products at Family Life for the year 2002 was $23.7 million, as compared to $25.8 million for the year 2001 and $27.7 million for the year 2000. The decrease in renewal premium is attributable to the decrease in the traditional life insurance book of business. Income from universal life and annuity charges for the year ended December 31, 2002 was $42.0 million, as compared to $27.7 million for the year 2001 and $4.3 million in 2000. The increase from 2001 to 2002 was primarily attributable to the contribution of ILCO's operations for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. The consolidation of ILCO's operations following the Merger contributed approximately $24.0 million to - 35 - earned insurance charges for the year ended December 31, 2001. At Family Life, earned insurance charges declined from $3.4 million in the year 2001 to $2.8 million in the year 2002. The amount is consistently decreasing because Family Life reinsures all of its new universal life and annuity business with Investors Life and thus earned insurance charges received are attributable to a closed, decreasing book of business. At Investors Life, earned insurance charges decreased from $39.5 million in the year 2001 to $39.2 million in the year 2002. The face amount of in force universal life policies at Family Life was $721.1 million at December 31, 2001 as compared to $588.9 million at December 31, 2002. The face amount of in force universal life policies at Investors Life (including Investors-IN) was $4,676.9 million at December 31, 2001 as compared to $4,446.1 million at December 31, 2002. Net investment income for the year ended December 31, 2002 was $40.3 million as compared to $30.7 million for the year ended December 31, 2001 and $6.9 million for the year ended December 31, 2000. The increase in net investment income from year end 2001 to year end 2002 was attributable to the contribution of ILCO's operations for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. Approximately $24 million of the increase in net investment income for the year ended December 31, 2001 as compared to the year ended December 31, 2000 was attributable to the consolidation of ILCO's operations for the period from May 18, 2001 to December 31, 2001. At Investors Life net investment income decreased from $47.9 million in 2001 to $41.7 million in 2002. The decrease was primarily attributable to lower interest rates on short-term investments as well as the sale of investments to pay for the continued construction at River Place Pointe. See "Investments - Real Estate" for a description of the River Place Pointe investment. The level of net investment income contributed by the investment portfolio of Family Life for the year ended December 31, 2002 was $5.6 million. Net investment income at Family Life was adversely affected by the decline in the level of interest income received from fixed income and short-term investments. This decline is attributable to lower interest rates during the period. Real estate income is primarily earned from the leases on the buildings at River Place Pointe, an office complex in Austin, Texas, which is owned and being developed by Investors Life. Net real estate income was $2.6 million for the year ended December 31, 2002, as compared to $1.9 million for the year ended December 31, 2001. Investors Life's real estate income was included in FIC's income statements from May 18, 2001 through December 31, 2001 and for the year ended December 31, 2002. For the year ended December 31, 2000, FIC did not have any real estate income. For the year ended December 31, 2002, FIC had a $2.8 million realized loss on investments, compared to a $65,000 net realized gain in 2001 and $7,000 gain in 2000. The Company identified one bond at December 31, 2002, which was considered to be impaired and reduced its carrying value by $463,000. Also at December 31, 2002, the Company determined that its investment in its separate accounts was impaired and reduced its carrying value by $2.4 million. There were no impairments in the value of investments in 2001 and 2000 which were considered other than temporary. - 36 - Benefits and Expenses. Policyholder benefits and expenses were $48.2 million in 2002, as compared to $30.1 million in 2001 and $13.5 million in 2000. The increase of $18.1 million from year ended December 31, 2001 to December 31, 2002 was partly attributable to the inclusion of ILCO's expenses for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. The consolidation of ILCO's operations for the period from May 18, 2001 to December 31, 2001 contributed approximately $19 million to policyholder benefits and expenses for the year ended December 31, 2001. At ILCO's insurance subsidiaries, the level of policyholder benefits and expenses was $32.5 million in the year 2000, $32.4 million in the year 2001 and $37.3 million in the year 2002. The increase from 2001 to 2002 is attributable to increases in death benefit claims. At Family Life, the level of policyholder benefits and expenses decreased from $13.5 million for the year 2000 to $10.1 million for the year 2001 and increased to $10.7 million for the year 2002, which decreases are attributable to decreases in death benefit claims as well as decreases in reserves due to higher than expected lapse rates in Family Life's traditional life business. Interest expense on contract holders deposit funds was $29.7 million for the year 2002, as compared to $19.9 million for the year 2001 and $2.2 million for the year 2000. The increase from 2001 to 2002 was due to the inclusion of ILCO's expenses for the full year in 2002 as compared to the period from May 18 to December 31 in 2001. The increase from 2000 to 2001 is primarily attributable to $17.5 million of interest expense on contract holders deposit funds resulting from the consolidation of ILCO's operations following the Merger. This expense is related to payment of interest to policyholders for cash values accumulated in their accounts. The expense related to the amortization of present value of future profits of acquired businesses was $4.6 million for the year ended December 31, 2002, as compared to $4.6 million at December 31, 2001 and $3.6 million at December 31, 2000. The consolidation of ILCO's amortization expense with FIC's contributed approximately $1 million for the year ended December 31, 2001. The costs related to acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are deferred policy acquisition costs ("DAC"). The expense related to the amortization of DAC was $10.4 million for the year ended December 31, 2002, $6.8 million for the year ended December 31, 2001, and $5.3 million for the year ended December 31, 2000. A portion of the increase in this expense from 2001 to 2002 is attributable to the Merger. For the year ended December 31, 2002, the Company has capitalized DAC based on an updated analysis of its cost structure and assumptions as to product performance. For business written prior to January 1,2002, DAC was amortized using methods and practices which had been adopted at the time the products were introduced. For 2002, costs capitalized were approximately $3.3 million less than acquisition costs incurred as determined by the updated analysis. See "Critical Accounting Policies, Deferred Policies Acquisition Costs and Present Value of Future Profits of Acquired Business" herein for a further discussion of capitalization of expenses related to acquiring new business. - 37 - Operating expenses for 2002 were $34.2 million, as compared to $22.9 million in 2001 and $11.2 million in 2000. The consolidation of ILCO's operations contributed approximately $22.6 million to operating expenses for the year ended December 31, 2002 as compared to $11.0 million for the period from May 18, 2001 to December 31, 2001. The level of operating expenses for the year 2002 included: (i) expenses related to acquiring new business; (ii) $636,312 related to the repurchase of James M. Grace's employment contract; (iii) a transfer of funds of $1 million to the Roy F. and Joann Cole Mitte Foundation which was made in January, 2002, as compared to a $375,000 donation in 2001; (iv) $448,841 of costs incurred due to the investigation of the matters described in the Registrant's Current Report on Form 8-K filed with the Securities and Exchange Commission on August 15, 2002; and (v) a charge of $799,000 for uncollectible agent balances. For a further discussion of the repurchase of Mr. Grace's employment contract and the transfer of funds to the Mitte Foundation, see FIC's 10-K for the year ended December 31, 2001, dated April 1, 2002. The level of operating expenses for the year 2001 included certain non-recurring expenses related to the favorable resolution of the vanishing premium litigation (see "Item 3. Legal Proceedings - Universal Life Litigation") and the implementation of the correction procedure set forth by the Internal Revenue Service in Rev. Proc. 2001-42 for Modified Endowment Contracts. Interest expense for 2002 was $0, as compared to $0.9 million in 2001 and $1.9 million in 2000. The decrease in the amount of interest expenses from 2000 to 2001 is attributable to the scheduled reduction in the amount of outstanding indebtedness. This interest expense is related to the indebtedness owed to Investors Life by Family Life Corporation and FIC and for the year ended December 31, 2001 includes the amount of interest for the period from January 1, 2001 to May 18, 2001. The consolidation of ILCO's operations with those of FIC for periods following the May 18th Merger results in the elimination of this interest expense in the consolidated income statements of FIC and thus the post-Merger interest expense is $0. The provision for federal income taxes was ($3.3) million in 2002, as compared to $4.1 million in 2001 and $1.4 million in 2000. The decrease in taxes was due to the $21.2 million decrease in income (before federal income tax, equity in net earnings of affiliates and cumulative effect of change in accounting principle) for the year ended December 31, 2002 compared to the year ended December 31, 2001. The inclusion of ILCO's results for the period from May 18, 2001 to December 31, 2001 contributed approximately $2.6 million to the level of federal income taxes for the year 2001 as compared to 2000. Because of the Merger and subsequent consolidation of FIC and ILCO's provision for federal income taxes, FIC is not able to utilize the small company tax deduction, which provided lower tax rates. The increase in federal income taxes due to the loss of this deduction in 2001 was $343,227. Further, for the year ended December 31, 2000, FIC and ILCO each paid, and were each able to deduct $1 million of excess compensation. Due to the Merger, the Company incurred approximately $100,000 in additional federal income taxes in 2001 due to the non-deductibility of a portion of Roy F. Mitte's salary. However, since Mr. Mitte was not an executive with the Company on December 31, 2002, which is the relevant date for measuring deductibility of compensation under section 162(m) of the Code, his entire compensation for 2002 is deductible and thus the Company will not incur additional federal income taxes related to excess compensation in 2002. - 38 - Results of Operations - Three Months Ended December 31, 2002 as compared to the Three Months Ended December 31, 2001 For the three-month period ended December 31, 2002, FIC's net income before the cummulative effect of change in accounting principle was (5.8) million (basic and diluted earnings of (6.0 per common share) on revenues of $26.0 million as compared to the restated net income of $2.4 million (basic and diluted earnings of $0.25 per common share) on restated total revenues of $31.9 million in the last three months of 2001. The decrease in net income and total revenues from the three-month period ended December 31, 2001 to the same period in 2002 is attributable to (i) a decrease in investment income; (ii) a net realized loss on investments relating to impairments; (iii) an increase in death benefits; (iv) an increase in operating expenses. Liquidity and Capital Resources Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. FIC is an insurance holding company whose principal assets consist of the outstanding capital stock of its insurance subsidiaries - Family Life Insurance Company ("Family Life"), Investors Life Insurance Company of North America ("Investors Life"), and prior to February 19, 2002, Investors Life Insurance Company of Indiana ("Investors-IN"). Prior to the merger of FIC and ILCO on May 18, 2001, the principal assets of FIC consisted of the common stock of its insurance subsidiary, Family Life, and its equity ownership in ILCO. As a holding company, FIC's ability to meet its cash requirements, pay interest on any debt, pay expenses related to its affairs and pay dividends on its common stock substantially depends upon dividends from its subsidiaries. Prior to June 2001, the principal source of liquidity for FIC and its wholly-owned subsidiary, Family Life Corporation, consisted of the periodic payment of principal and interest by Family Life pursuant to the terms of the surplus debenture issued in connection with the Family Life acquisition from Merrill Lynch. The surplus debenture was completely paid off as of June 30, 2001. For periods subsequent to June 30, 2001, FIC's available source of liquidity will be 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 Family Life and Investors Life to pay shareholder dividends is and will continue to be subject to restrictions set forth in the insurance laws and regulations of Washington, their domiciliary state. Washington limits how and when Family Life and Investors Life can pay shareholder dividends by (a) including the "greater of" standard for payment of dividends to shareholders, (b) requiring that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and (c) requiring that cash dividends 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. In 2002, Investors Life paid a dividend to its parent corporation, ILCO, of $8,556,104 (based upon earned surplus of $48.4 million and net gain from operations of $8.56 million in the year 2001). ILCO, a holding company, does not have any restrictions on payments of dividends and paid a dividend of $8,556,104 to FIC in January, 2003. Investors Life had earned surplus of $42.3 million and a net gain from operations of $3.6 million for 2002 and Family Life had earned surplus of $1.5 million and a net gain from operations of $0.13 million in 2002. - 39 - Sources of cash for FIC's insurance subsidiaries consist of premium payments from policyholders and annuity holders, charges on policies and contracts, investment income, and proceeds from the sale of investment assets. These funds are applied primarily to provide for the payment of claims under insurance and annuity policies, payment of policy withdrawals, surrenders and loans, operating expenses, taxes, investments in portfolio securities, and shareholder dividends. FIC's cash and cash equivalents at December 31, 2002 was $25.0 million as compared to $7.1 million at December 31, 2001 and $2.7 million at December 31, 2000. The increase in cash and cash equivalents was primarily due to maturities and early redemptions of fixed income investments that occurred during December, 2002, resulting in an increased cash position pending reinvestment. The $4.4 million increase in cash and cash equivalents at December 31, 2001 from 2000 was due primarily to the Merger and the cash acquired in the purchase. FIC's net cash flow provided by operating activities was $7.6 million for the year 2002. In the year 2001, net cash flow used in by operating activities was ($2.7) million; net cash flow provided by operating activities was $0.3 million for the year 2000. The increase in cash used in operating activities of $10.3 million from 2002 to 2001 was attributable to a lower than expected level of surrenders of insurance and annuity policies which contributed to a smaller decrease in policy liabilities. Net cash flow provided by investing activities was $20.6 million in 2002, as compared to $15.4 million in 2001 and $9.1 million in 2000. The increase in cash provided by investing activities from 2001 to 2002 was primarily attributable to the increase in cash due to proceeds from the sales and maturities of fixed maturities. The increase in cash provided by investing activities from 2001 to 2000 was due to the purchase of ILCO, which provided $9.1 million, and a $14.8 million increase in proceeds from short-term investments. These amounts were offset by a ($18.1) million investment in real estate. Net cash flow used in financing activities was ($10.3) million in 2002, as compared to ($13.8) million in 2001 and ($7.3) million in 2000. Payment of cash dividends to stockholders attributed to $2.2 million of cash used in financing for 2002, as compared to $6.0 million in 2001 and $0.9 million in 2000; however, repayment of subordinated notes payable decreased from ($6.1) million in 2000 to ($1.5) million in 2001 and $0 in 2002 due to the Merger. In 2002, contractholder fund withdrawals exceeded deposits by $8.7 million, while in 2001 withdrawals exceeded deposits by $4.4 million. A primary liquidity consideration with respect to life insurance and annuity products is the risk of early policyholder and contractholder withdrawal. Deposit fund liabilities for universal life and annuity products as of December 31, 2002 were $557.5 million, as compared to $556.1 million at December 31, 2001. Individual life insurance policies are less susceptible to withdrawal than are annuity contracts because policyholders may incur surrender charges and undergo a new underwriting process in order to obtain a new insurance policy. At December 31, 2002, the bulk of the liabilities for contractholder deposit funds on FIC's balance sheet, $419.1 million, were related to insurance products, as compared to only $138.4 million of annuity product liabilities. - 40 - The cash requirements of FIC, and its holding company subsidiary, Family Life Corporation, consist primarily of its service of the indebtedness created in connection with FIC's ownership of Family Life. As of December 31, 2002, the investment portfolio of Investors Life included $23.05 million of notes receivable from affiliates, represented by (i) a loan of $30 million by Investors Life to Family Life Corporation made in July 1993, in connection with the prepayment of indebtedness which had been previously issued to Merrill Lynch as part of the 1991 acquisition of Family Life Insurance Company by a wholly-owned subsidiary of FIC, and (ii) a loan of $4.5 million by Investors Life to Family Life Insurance Investment Company made in July 1993, in connection with the same transaction described above. The provisions of the notes owned by Investors Life include the following provisions: (a) the $30 million note provides for quarterly principal payments, in the amount of $163,540 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $1,336,458; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%, and (b) the $4.5 million note provides for quarterly principal payments, in the amount of $24,531 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $200,469; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%. Due to the Merger, this indebtedness is not included as a liability on the consolidated financial statements of FIC. FIC's other liquidity requirements relate principally to the need for cash flow to meet operating expenses, as well as the liabilities associated with its insurance subsidiaries' various life insurance and annuity products. In 2002, management reviewed the Company's liquidity to determine whether the cash, cash equivalents and short term investments of the Company were sufficient to meet the Company's needs for cash for operations, capital requirements and commitments. Based on such review, management determined that it would be in the Company's best interest to reduce the amount of dividends paid to shareholders (see "Item 5- C. Dividends"), to discontinue donations to the Mitte Foundation and to streamline certain operations of the Company. Based on this review and the subsequent initiatives set forth by management, management believes that the cash, cash equivalents and short term investments of FIC and its subsidiaries 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. - 41 - Investments General The life insurance subsidiaries of FIC maintain a diversified portfolio of investments which is supervised by an in-house staff. Investment policies and significant individual investments are subject to approval by the board of directors of each of the life insurance subsidiaries, in accordance with applicable state insurance regulatory requirements. Management regularly monitors individual assets and the overall asset mix. In the first quarter of 2003, the Board of Directors of FIC enhanced its oversight responsibilities with respect to portfolio management by establishing an Investment Committee consisting of three independent directors. In addition to its responsibilities with respect to the review of investment guidelines, the FIC Investment Committee monitors internal controls pertaining to the purchase and sale of investments. Investment Strategy The assets of FIC's life insurance subsidiaries must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the 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 general investment objective of the Company emphasizes the selection of short to medium term high quality fixed income securities, rated Baa-3 (investment grade) or better by Moody's Investors Service, Inc. We determine the allocation of our assets primarily on the basis of cash flow and return requirements of our products and secondarily by the level of investment risk. Another key element of the Company's investment strategy is to avoid large exposure in other investment categories which the Company believes carry higher credit or liquidity risks, including private placements, partnerships and bank participations. These categories accounted for only $26,049 of invested assets at December 31, 2002 as compared to $45,479 at December 31, 2001. Overall Composition of Investments. The diversified portfolio of investments of FIC's life insurance subsidiaries includes public and private fixed maturity securities and real estate investments. All of FIC's invested assets are invested in the United States. Invested assets, excluding separate accounts, totaled $761.2 million and $767.6 million as of December 31, 2002 and December 31, 2001, respectively. - 42 - The following table summarizes invested assets by asset category, excluding separate account assets, as of December 31, 2002 and 2001: (in thousands) Invested Assets December 31, 2002 2001 (Restated) Carrying % of Carrying % of Value Total Value Total Fixed maturity securities available for sale: Public $493,827 64.9% $501,395 65.3% Private 0 0 Fixed maturity held to maturity Public 1,064 0.1 983 0.1 Private 26 * 46 * Equity securities 6,351 0.8 8,279 1.1 Policy loans 46,607 6.1 49,794 6.5 Mortgage loans 17 * 4,715 0.6 Invested Real estate 75,393 9.9 64,051 8.3 Short-term investments 137,944 18.1 138,291 18.0 Total invested assets 761,229 100% 767,554 100%
* = less than 0.1% of total invested assets The decrease in invested assets is primarily attributable to a $7.6 million decrease in the market value of fixed maturities available for sale, a $1.9 million decrease in the market value of equity securities, a $3.2 million decrease in policy loans, and a $4.7 million decrease in mortgage loans. These amounts are offset by an $11.3 million increase in invested real estate. Fixed Maturity Securities. The Company's fixed maturity securities portfolio is predominately comprised of low risk, investment grade, available for sale publicly traded corporate securities, mortgage-backed securities and United States Government bonds. As of December 31, 2002, the market value of the fixed maturities available for sale segment was $493.8 million as compared to an amortized cost of $479.4 million or an unrealized gain of $14.4 million. The increase reflects unrealized gains on such investments related to changes in interest rates subsequent to the purchase of such investments. At December 31, 2001, the market value of the fixed - 43 - maturities available for sale segment was $501.4 million as compared to an amortized cost of $496.7 million. The lower level of assets held in the fixed maturities available for sale segment is attributable to the early redemption of longer- term fixed maturity investments by the issuer. The proceeds of these early redemptions were reinvested in short-term investments at the lower level of interest rates that prevailed throughout the year 2002. For the year 2003, the investment objectives of FIC's insurance subsidiaries include a strategy of reducing the concentration in short-term investments by making selected investments in medium-term fixed income investments, including CMO instruments. The investments of FIC's insurance subsidiaries in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $175.4 million, and mortgage-backed pass-through securities of $29.6 million, at December 31, 2002. Mortgage-backed pass-through securities, sequential CMO's and support bonds, which comprised approximately 57.8% of the book value of FIC's mortgage-backed securities at December 31, 2002, are sensitive to prepayment and extension risks. FIC's insurance subsidiaries 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 December 31, 2002, PAC and TAC instruments and scheduled bonds represented approximately 43.0% of the book value of FIC's mortgage-backed securities. Sequential and support classes represented approximately 10.4% of the book value of FIC's mortgage-backed securities at December 31, 2002. Previously, FIC's insurance subsidiaries have avoided investments in mortgage-backed securities with increased prepayment risk, such as interest-only stripped pass-through securities and inverse floater bonds. Beginning in December 2002, the insurance subsidiaries made selected investments in CMOs of the inverse floater category. Such instruments, which are subject to strict quantitative and qualitative standards, carry a higher current interest rate. Our investment guidelines do not permit the purchase of CMOs which are interest only or principal only instruments. 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 2003, the investment objectives of FIC's insurance subsidiaries include a strategy of reducing the concentration in short-term investments by making selected investments in a variety of medium-term CMO instruments. The securities valuation office (SVO) of the National Association of Insurance Commissioners evaluates all public and private bonds purchased as investments by insurance companies. The SVO assigns one of six investment categories to each security it reviews. Category 1 is the highest quality rating, and Category 6 is the lowest. As of December 31, 2002, the majority of our bonds are investment grade (Category 1 and 2). The Company's fixed maturities portfolio (including short-term investments), included only a non-material amount of debt securities which, in the annual statements of the companies as filed with state insurance departments, were designated by the SVO as "3" (medium quality) or below. - 44 - FIC's short-term investments consist primarily of U.S. Government bonds. The level of short-term investments at December 31, 2002 was $137.9 million, as compared to $138.3 million as of December 31, 2001. Equity Securities. FIC's equity securities consist primarily of its investment in the separate account. As of December 31, 2002, the market value of FIC's equity securities was $6.4 million compared to $8.3 million at December 31, 2001. The decrease from 2002 to 2001 is related to a decline in the value of the underlying funds in the separate account. Real Estate. Invested real estate at December 31, 2002 was $75.4 million, as compared to $64.1 million at December 31, 2001. The real estate investment is primarily related to the development of the River Place Pointe project ("River Place Pointe") by Investors Life, a subsidiary of ILCO. In October 1998, Investors Life purchased River Place Pointe, which consisted of two adjoining tracts of land located in Austin, Texas totaling 47.995 acres. The aggregate purchase price for these tracts was $8.1 million. Investors Life obtained a Site Development Permit for the tracts from the City of Austin allowing for the construction of seven office buildings totaling 600,000 square feet, with associated parking, drives and related improvements. Construction on the first section of the Project, which consists of four office buildings, an associated parking garage, and related infrastructure was completed during 2000 and 2001. Construction on the second section of the Project, which consists of three office buildings, an associated parking garage, and related infrastructure, was completed in 2002. As of December 31, 2002, Investors Life had invested $93.7 million in the construction of River Place Pointe, of which $19.7 million is recorded on FIC's balance sheet as real estate occupied by the Company. Investors Life paid $13.5 million during 2002 for the construction of the project. FIC and its insurance subsidiaries occupy all of Building One at River Place Pointe, consisting of approximately 76,143 square feet of space, and additionally occupies approximately 5,000 square feet of Building Four of River Place Pointe. As of December 31, 2002, 222,007 rentable square feet of office space was leased to third party tenants and 281,682 rentable square feet was available for lease. According to the Federal Deposit Insurance Corporation's ("FDIC") National Edition of Regional Outlook, Fourth Quarter, 2002 "the vacancy rate in Austin has risen almost fivefold in three years, the most dramatic increase in the country the Austin suburban (office) market reported an office vacancy rate of 27.2 percent as of September 30, 2002, the highest in the nation, with about 10 percent attributable to sublease space." The Company views the River Place Pointe investment as a long term commitment. Based on this assumption, the Company has examined future anticipated cash flow on the development and has determined that the investment is not impaired. - 45 - Mortgage Loans. As of December 31, 2002, $0.02 million was invested in mortgage loans as compared to $4.7 million at December 31, 2001. The Company does not make new mortgage loans on commercial properties. All of the Company's mortgage loans were made by its subsidiaries prior to their acquisition by the Company. At December 31, 2002, none of the mortgage loans held by the Company had defaulted as to principal or interest for more than 90 days, and none of the Company's mortgage loans were in foreclosure. The decrease in mortgage loans from 2001 to 2002 was due to the pay off of two mortgage loans during the third quarter of 2002. The Company participated with a third party in two mortgage loans in the state of New York - Champlain Centre Mall and Salmon Run Mall, with a total balance due of $4.60 million at June 30, 2002. On June 18, 2002, the Company agreed to a proposed payoff of these loans at a discount. The borrower paid off the loans in August, 2002, with a payment of $3.64 million. The Company reduced the carrying value of the two loans by $0.96 million as of June 30, 2002 as an impairment of an invested asset. Policy Loans. Policy loans totaled $46.6 million at December 31, 2002, as compared to $49.8 million at December 31, 2001. Critical Accounting Policies The financial statements contain a summary of FIC's critical accounting policies, including a discussion of recently-issued accounting pronouncements. Certain of these policies are considered to be important to the portrayal of FIC's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. These policies include valuation of: investments, deferred acquisition costs and present value of future profits, and future policy benefits. For the year 2001, the Company's critical accounting policies also included the purchase accounting for ILCO. Cumulative Effect of Accounting Changes. During the first quarter of 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations." SFAS No. 141 eliminates the practice of amortizing and deferring excess of fair value of net assets acquired over cost and requires unallocated negative goodwill to be recognized immediately. In accordance with the standard, FIC ceased negative goodwill amortization on January 1, 2002 and recognized the unamortized balance of $10.4 million of negative goodwill acquired in the Merger. Investments. The Company's investments primarily consist of fixed maturity securities, which include bonds, notes and redeemable preferred stocks. Fair values of investments in fixed securities are based on quoted market prices or dealer quotes. Fixed maturities are classified as "available for sale" and are reported at fair value, with unrealized investment gains and losses, net of income taxes, credited or charged directly to shareholder's equity. Generally accepted accounting principles require that investments be written down to fair value when declines in value are considered other than temporary. When such impairments occur, the decrease in value is reported in net income as a realized investment loss and a new cost basis is established. - 46 - Deferred Acquisition Costs and Present Value of Future Profits. The costs of acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are deferred policy acquisition costs ("DAC"). DAC is capitalized and then amortized to reflect an expense in relation to the projected stream of profits (for universal life and annuity products) or to the premium revenue (for traditional life products). Such projections require use of certain assumptions, including interest margins, product loads, mortality rates, persistency rates, and maintenance expense levels. Effective with respect to new business issued on and after January 1, 2002, the Company has capitalized DAC based on an updated analysis of its cost structure and assumptions as to product performance. For business written previously, DAC is amortized using previously established methods and practices. Management periodically reviews the assumptions associated with the amortization models prospectively. Present value of future profits of acquired business ("PVFP") are the costs associated with acquiring blocks of insurance from other companies or through the acquisition of other companies. PVFP is capitalized and amortized in a manner that matches these costs against the associated revenues. Future Policy Benefits. Future policy benefits comprise 15% of FIC's total liabilities at December 31, 2002. These liabilities are estimated using actuarial methods based on assumptions about premiums, interest yields, investment returns, expenses, mortality, morbidity, and persistency. These assumptions consider Company experience and industry standards. The assumptions vary by plan, age at issue, year of issue and duration. Purchase Accounting for ILCO. The acquisition of ILCO was accounted for as a purchase; accordingly, the results of ILCO's operations from May 18, 2001 to December 31, 2001 and for the entire year 2002 are included in FIC's consolidated results of operations at December 31, 2001 and 2002. For the period from January 1, 2001 to May 17, 2001, and for the year 2000, FIC's net income includes its equity interest in the net income of ILCO, with such equity interest being based on FIC's percentage ownership of ILCO. For a further discussion of accounting standards, see Note 1 to our audited consolidated financial statements, beginning on page F-13. - 47 - Subsequent Events Solomon Smith Barney Review In December 2002, the Company received an unsolicited indication of interest from the Pillar Foundation Group ("Pillar"). As previously publicly disclosed by the Company, the Company believes that the letters sent to FIC by Pillar did not constitute an offer. Rather, the letter stated that it was as an indication of interest to enter into a letter of intent at an undefined future time with respect to the acquisition of all or part of the outstanding common shares of FIC at a tentative valuation of $13 to $18 per share. Pillar did not indicate the source of funds for any such transaction, nor the structure or timing of any possible transaction. Furthermore, Pillar stated in the letter that any transaction would be subject to numerous due diligence and other identified and unnamed conditions, such as determination of a final price, regulatory and board approvals, and execution by sellers of a satisfactory stock purchase agreement. In fact, the letter did not state clearly whether Pillar intended to acquire shares from FIC or from other shareholders. In addition, Pillar did not have an established reputation in the insurance industry for consummating transactions of this magnitude and there was no evidence that it had the financial ability to do so. Because the valuation indicated by Pillar was below book value and because of the depressed state of the U.S. capital markets and poor general economic conditions, the Board of Directors concluded that it would not be in the best interest of the Company's shareholders to negotiate toward selling the Company for a depressed price in the existing economic conditions. Nevertheless, in the exercise of its fiduciary duties, on December 13, 2002, the Board of Directors unanimously approved the appointment of a Special Committee to review unsolicited indications of interest in the acquisition of the Company. On January 6, 2003, the Board of Directors unanimously approved a realignment of the Special Committee to include only independent directors and it authorized the Special Committee to select an investment banking firm to perform a valuation analysis of FIC and to explore strategic alternatives to improve shareholder value, including a sale of FIC. The Special Committee interviewed four firms and selected Salomon Smith Barney. Among the alternatives considered by the Special Committee were a sale of the company consistent with recent unsolicited indications of interest in FIC and various management alternatives, including an increased operating efficiency strategy, a growth through acquisitions strategy and a marketing alliances strategy. Through an exhaustive study of all business projections and financial assumptions, it was determined that pursuing any or all of the management plan was more advantageous to shareholder value than the sale, merger, or consolidation of the company at this time given current market conditions for sale transactions in the insurance industry and general economic conditions. The Special Committee ultimately determined, based in part on the analysis performed by Salomon Smith Barney, that it was in the best interest of FIC's shareholders at that time to allow FIC's new management to implement its business plan for FIC. The Board of Directors voted to accept the Special Committee's recommendation. - 48 - Proxy Contest On January 20, 2003, attorneys representing the Mitte Foundation sent a demand that the Company hold a special shareholders meeting for the purpose of removing all members of the board of directors and electing unidentified directors that would be proposed by the Mitte Foundation, Roy Mitte, Mr. Mitte's wife, Joann Cole Mitte, and Mr. Mitte's son, Scott Mitte (collectively, the "Mitte Family"). These attorneys informed the Company that they were prepared to pursue litigation if their demands were not met. The Mitte Foundation's demand, if granted by the Company or ordered by a court, would have required holding a shareholders' meeting without proxy materials of the Company or the dissemination to shareholders of all appropriate financial and other information concerning the Company's performance in 2002. Specifically, the federal securities laws require that each proxy statement furnished to shareholders by the Company must be accompanied or preceded by an annual report to shareholders which includes audited financial statements for the prior fiscal year. The Mitte Foundation demanded that the Company hold a special shareholders' meeting on February 4, 2003, only fifteen days after the date of the demand letter. The Company could not have prepared audited financial statements for fiscal year 2002 so soon after the fiscal year, nor was it otherwise required to file such financial statements by such time under the federal securities laws, which allow 90 days following the end of the fiscal year to prepare such information. As a result, the Company could not have disseminated proxy materials to its shareholders in compliance with the federal securities laws. Accordingly, in light of the Mitte Foundation's demand for a special meeting, the Company commenced litigation against Mr. Mitte, the Mitte Foundation, and Joann Cole Mitte which sought to delay the meeting, alleging, among other things, Mr. Mitte's violation of certain provisions of the securities laws as described below. The material allegations made by the Company against the Mitte Family are set out in detail in the Company's Original Complaint, filed on January 23, 2003 in the United States District Court for the Western District of Texas, Austin Division, Case No. A03-CA-033SS. The following allegations were made by the Company in the Complaint: o The Mitte Family omitted material information required to be disclosed under Section 13(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and the regulations issued thereunder, as well as violated the proxy solicitation rules contained in Regulation 14A of the Exchange Act; o Over a ten-year period, Roy Mitte caused FIC to pay, or to reimburse Mr. Mitte for, personal expenditures of Mr. Mitte or his family, in an amount exceeding $500,000; o In January 2002, Roy Mitte caused the transfer of $1,000,000 from FIC to the Mitte Foundation, in contravention of a promise made by Mr. Mitte to the Compensation Committee of the Board of Directors that no such transfers would be sought or made in 2002; and - 49 - o FIC has borne significant expenses that properly should have been paid or reimbursed by the Mitte Foundation. The following relief was sought by the Company: o A declaratory judgment that the Company may defer any shareholders' meeting until, among other things, the Company and Mitte could properly solicit proxies in compliance with the federal securities laws; o A preliminary injunction preventing, among other things, the Mitte Foundation from demanding that the Company notice a special shareholders' meeting; o A monetary judgment against Mr. Mitte for the amount of personal expenses which he improperly caused FIC to pay or reimburse him; o A monetary judgment against the Mitte Foundation in the amount of $1,000,000 and for all sums which FIC has improperly paid or borne on behalf of the Mitte Foundation; o A monetary judgment against Mr. Mitte in the amount of $1,000,000, in the event that the Mitte Foundation fails to repay this amount; and o Interest, attorneys' fees, and all other sums to which FIC proves itself justly entitled. On February 10, 2003, the Company entered into an agreement with the Foundation pursuant to which they agreed to withdraw their request for a special meeting in exchange for the Company's agreement that the 2003 Annual Meeting of Shareholders (the "Meeting") would be held May 9, 2003, with a record date of March 18, 2003. On March 19, 2003, Mr. Mitte filed a counterclaim against the Company alleging breach of contract with respect to the Company's failure to pay Mr. Mitte severance benefits and compensation that Mr. Mitte claims he is entitled to receive under his employment agreement with the Company. Mr. Mitte seeks actual damages, interest and attorney's fees and costs. The Company has not yet filed an answer to Mr. Mitte's counterclaim. Both the Mitte Family and the Company are currently engaged in discovery with respect to the pending litigation. . (See "Item 3. Litigation - Litigation Relating to Former Chairman and CEO"). On March 28, 2003, the Company filed its Preliminary Proxy with respect to the Meeting. Amendments to the Preliminary Proxy were filed on April 8, 2003 and April 14, 2003. More information regarding the proxy contest and the Meeting can be obtained therein by accessing the preliminary proxy on the SEC's website, www.sec.gov or the Investor Relations portion of the Company's website at www.ficgroup.com. - 50 - Item 7A. 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 sections entitled "Investment of Assets" in Item 1 of this report and the information set forth in Item 7, "Management's Discussion and Analysis of Financial Condition and Operations - Investments". 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. The Company does not use derivative financial instruments. Interest Rate Risk The Company manages the interest rate risk inherent in our assets relative to the interest rate risk inherent in our liabilities. Generally, we manage interest rate risk based on the application of a commonly used model. The model projects the impact of interest rate changes on a range of factors, including duration and potential prepayment. For example, 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 $16.6 million at December 31, 2002 and $24.6 million at December 31, 2001. For purposes of the foregoing estimate, fixed maturities, including fixed maturities available for sale, and short-term investments were taken into account. The market value of such assets was $632.8 million at December 31, 2002 and $640.7 million at December 31, 2001. The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $205.4 million at December 31, 2002 and $209.9 million at December 31, 2001. 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 $4.7 million at December 31, 2002 and $6.7 million at December 31, 2001. Separate account assets have not been included, since gains and losses on those assets generally accrue to the policyholders. The Company does not use derivative financial instruments to manager our exposure to fluctuations in interest rates. - 51 - 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. Item 8. Financial Statements and Supplementary Data The following Financial Statements of the Registrant have been filed as part of this report: 1. Report of PricewaterhouseCoopers LLP, Independent Accountants, dated April 17, 2003. 2. Consolidated Balance Sheet as of December 31, 2002 and Restated Consolidated Balance Sheet as of December 31, 2001. 3. Consolidated Statement of Income for the year ended December 31, 2002 and Restated Consolidated Statements of Income for the years ended December 31, 2001 and 2000. 4. Consolidated Statement of Changes in Shareholders' Equity for the year ended December 31, 2002, and Restated Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2001 and 2000. 5. Consolidated Statement of Cash Flows for the year ended December 31, 2002, and Restated Consolidated Statements of Cash Flows for the years ended December 31, 2001 and 2000. 6. Notes to Consolidated Financial Statements, as Restated. 7. Consolidated Financial Statement Schedules, as Restated. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure No independent accountant who audited the Registrant's financial statements has resigned or been dismissed during the two most recent fiscal years. - 52 - Part III Item 10. Directors and Executive Officers of the Registrant (a) Directors of the Registrant The names and ages of the current directors of the Registrant, their principal occupations or employment during the past five years and other data regarding them are set forth below. All of the directors, other than Eugene Payne and Richard A. Kosson, were elected at the 2002 annual shareholders meeting held in June 2002. Eugene Payne was appointed as a director in August 2002 and Richard A. Kosson was appointed as a director in December 2002, to fill vacancies created by resignations of two directors. The data supplied below is based on information provided by the directors, except to the extent that such data is known to the Registrant. Name Age Since Director and Other Information John D. Barnett 60 1991 Director of FIC since 1991. Vice President, Investments of Investment Professionals, Inc. from 1996 to present. Vice President, Investments of Prudential Securities from 1983 to 1996. Jeffrey H. Demgen 50 1995 Director of FIC since May 1995. Vice President of FIC since August 1996. Vice President and Director of ILCO since August 1996. Director of Family Life since October 1992. Executive Vice President of Family Life since August 1996. Senior Vice President of Family Life from October 1992 to August 1996. Executive Vice President and Director of Investors Life since August 1996. Senior Vice President and Director of Investors Life from October 1992 to June 1995. Theodore A. Fleron 63 1996 Vice President and Director of FIC since August 1996. Vice President and Director of ILCO since May 1991. Senior Vice President, General Counsel, and Director of Investors Life since July 1992 and Secretary since September 2001. Senior Vice President, General Counsel, Director and Assistant Secretary of Family Life since August 1996 and Secretary since September 2001. W. Lewis Gilcrease 71 2001 Director of FIC since June 2001 and from 1979 to July 1991. Director of ILCO from 1988 to May 2001. Dentist practicing in San Marcos, Texas. Chairman of the Strahan Foundation in support of athletics at Southwest Texas State University.
- 53 - Name Age Since Director and Other Information Richard A. Kosson 70 2002 Director of FIC since December 2002. Director of ILCO from 1981 to May 2001. Practicing CPA and Partner, Citrin Cooperman & Company, LLP. Past Chairman of the NJSCPA Insurance Trust. M. Scott Mitte 46 2000 Director of FIC since October 2000. Executive Director and Vice-President of the Roy F. and Joann Cole Mitte Foundation from 1999 to 2002. Roy F. Mitte 71 1976 Chairman of the Board, President and Chief Executive Office of FIC from 1976 to October 2002. Chairman of the Board, President and Chief Executive Officer of ILCO from 1985 to 2002. Chairman of the Board, President and Chief Executive Officer of Investors Life from December 1988 to 2002. Chairman of the Board, President and Chief Executive Officer of Family Life from June 1991 to 2002. Elizabeth T. Nash 53 2001 Director of FIC since June 2001. Director of ILCO from 1998 to May 2001. Member of the Texas State University System Foundation since 2000. President of Seton Hospital Development Board. Member of the Board of Regents, Texas State University System from 1993 through 1999, Chairman from 1997 to 1998, Vice-Chairman from 1996 to 1997. Board member of the Southwest Texas State University Development Foundation since 1987, Chairman from 1992 to 1997, Vice-Chairman from 1989 to 1992. Frank Parker 73 1994 Director of FIC since May 1994. Private investor. Prior to June 1998, President of Gateway Tugs, Inc. and Par-Tex Marine, Inc., both of which are located in Brownsville, Texas and were engaged in operating and chartering harbor and intracoastal tug boats. Eugene E. Payne 60 2002 Director of FIC since August 2002 and from 1992 to 2000. Presi- dent, Chairman and Chief Executive Officer of FIC since November 2002. Vice President of ILCO from December 1988 to 2000 and Dir- tor of ILCO from May 1989 to 2000. Chief Operations Officer of Investors Life and Family Life from 1991 to 2000. Chief Marketing Officer of Investors Life and Family Life from 1988 to 1991. Professor in the College of Business at Southwest Texas State University from 2000 to 2002.
- 54 - Name Age Since Director and Other Information Thomas C. Richmond 61 1996 Director of FIC since August 1996. Vice President and Secretary of FIC since September 2001. Director of ILCO from March 1994 to August 1996 and from December 2001 to present. Executive Vice President of Investors Life and Family Life since September 2001. Senior Vice President from January 1993 to September 2001 of Investors Life and Family Life. Vice President from March 1989 to January 1993 of Investors Life.
(b) Executive Officers of the Registrant The following table sets forth the names and ages of the persons who currently serve as the Company's executive officers together with all positions and offices held by them with the Company. Officers are elected to serve at the will of the Board of Directors or until their successors have been elected and qualified. Name Age Positions and Offices Eugene E. Payne 60 Chairman of the Board, President and Chief Executive Officer George M. Wise, III. 42 Vice President & Chief Financial Officer Jeffrey H. Demgen 50 Vice President & Chief Marketing Officer Thomas C. Richmond 61 Vice President & Chief Operating Officer Theodore A. Fleron 63 Vice President, Secretary & General Counsel Eugene E. Payne is Chairman, President and Chief Executive Officer of FIC, a position he has held since November, 2002. He joined FIC in 1989 and served for twelve years in an executive capacity in every major business area, including chief operations officer and chief marketing officer. In 2000, Dr. Payne elected early retirement from FIC and taught management strategy and entrepreneurship as chairman of the management department at Southwest Texas State University's College of Business. He returned to FIC as Interim Chairman in August, 2002 and was elected to his current positions in November, 2002. He also served as a director of FIC from 1992 to 2000 and as a director of ILCO (currently a wholly-owned subsidiary of FIC) from 1989 to 2000 - 55 - George M. Wise, III, is Vice President and Chief Financial Officer, a position he has held since November 2002. Previously, he was President and Consulting Actuary for Wise, Mitchell & Associates, Ltd., from December 2001 to November, 2002. From January 1998 to December, 2001, he was President and Consulting Actuary for Wise & Associates, Inc. In his capacity as a consulting actuary, Mr. Wise managed actuarial consulting firms which provided actuarial and insurance consulting services to life and health insurance companies. Jeffrey H. Demgen has been Vice President of FIC since August 1996 and Chief Marketing Officer since 1996. He was elected as a director of FIC in May 1995. Mr. Demgen is not standing for re-election to the FIC Board at the Annual Meeting. Mr. Demgen has served as a director and vice president of ILCO since August 1996 and has served as a director and in various management capacities with FIC's life insurance subsidiaries since 1992. Thomas C. Richmond has been Vice President of FIC since September 2001 and Chief Operating Officer since 2001. He became a director of FIC in August 1996. Mr. Richmond is not standing for re-election to the FIC Board at the annual Meeting. He has served as a director of ILCO from March 1994 to August 1996 and from December 2001 to present. He has also served in various management capacities with FIC's life insurance subsidiaries since 1989. Theodore A. Fleron, has been Vice President, General Counsel of FIC since 1996, Secretary of FIC since December, 2002 and has been a director since 1996. He is also a director of the life insurance subsidiaries of FIC and serves as Senior Vice President, General Counsel and Secretary of those companies. Mr. Fleron has been associated with FIC since December 1989 and has been involved in all aspects of FIC's legal matters, including corporate and federal securities, insurance regulation and litigation. Previously, he was associated with CIGNA Corporation and its predecessor, INA Corporation, from 1974 to 1989, where he served as Senior Counsel in the Law Department. (c) Identification of certain significant employees Not applicable. (d) Family relationships M. Scott Mitte is Roy F. Mitte's son. (e) Business experience The business experience of the executive officers has been outlined in Item 10 (b). (f) Involvement in Certain Legal Proceedings None. - 56 - (g) Beneficial Ownership Reporting Compliance The information set forth under the caption "Beneficial Ownership Reporting Compliance" in the Proxy Statement distributed to shareholders in connection with FIC's 2003 Annual Meeting of Shareholders (the "Proxy Statement"), which is to be filed by FIC after the date this Report on Form 10-K is filed, is hereby incorporated by reference. Item 11. Executive Compensation Composition of Board The business of FIC is managed under the direction of its board of directors. The board of directors currently consists of eleven directors, five of whom are independent directors. Summary Compensation Table The information set forth under the caption "Summary Compensation Table" in the Proxy Statement is hereby incorporated by reference. Option Vesting Upon a Change of Control in 2002 The information set forth under the caption "Options Vesting Upon a Change of Control in 2002" in the Proxy Statement is hereby incorporated by reference. Stock Appreciation Rights Granted in 2002 The information set forth under the caption "Stock Appreciation Rights Granted in 2002" in the Proxy Statement is hereby incorporated by reference. Option/SAR Grants in Last Fiscal Year The information set forth under the caption "Option/SAR Grants in Last Fiscal Year" in the Proxy Statement is hereby incorporated by reference. Aggregated Option/SAR Exercises in 2002 and 2002 Option/SAR Values The information set forth under the caption "Aggregated Option/SAR Exercises in 2002 and 2002 Option/SAR Values" in the Proxy Statement is hereby incorporated by reference. Defined Benefit Plan The information set forth under the caption "Defined Benefit Plan" in the Proxy Statement is hereby incorporated by reference. - 57 - Employment Agreements and Change In Control Arrangements The information set forth under the caption "Employment Agreements and Change in Control Arrangements" in the Proxy Statement is hereby incorporated by reference. Compensation of Directors The information set forth under the caption "Compensation of Directors" in the Proxy Statement is hereby incorporated by reference. Compensation Committee Interlocks and Insider Participation The information set forth under the caption "Compensation Committee Interlocks and Insider Participation" in the Proxy Statement is hereby incorporated by reference. Compensation Committee Report on Executive Compensation The information set forth under the caption "Compensation Committee Report on Executive Compensation" in the Proxy Statement is hereby incorporated by reference. Performance Graph The information set forth under the caption "Performance Graph" in the Proxy Statement is hereby incorporated by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters. The following table presents information as of February 28, 2003 as to all persons who, to the knowledge of the Registrant, were the beneficial owners of five percent (5%) or more of the common stock of the Registrant. - 58 - Amount and Nature Name and Address of of Beneficial Percent Beneficial Owner Ownership of Class(4) Roy F. and Joann Cole Mitte Foundation 6836 Bee Caves Road, Suite 262 Austin, Texas 78746 1,552,206 (1) 16.16 % Roy F. Mitte 3701 Westlake Drive Austin, Texas 78746 1,594,326 (1)(2) 16.59 % Family Life Insurance Company 6500 River Place Blvd. Austin, Texas 78730 648,640 6.32 %(3) Investors Life Insurance Company of North America 6500 River Place Blvd. Austin, Texas 78730 1,427,073 (4) 12.93 %(5) Fidelity Management & Research Company 82 Devonshire Street Boston, MA 02109 1,307,020 (6) 13.60% Wellington Management Company, LLP 75 State Street Boston, MA 02109 656,800 (7) 6.84% (1) As reported on a Schedule 13D/A filed by the Roy F. and Joann Cole Mitte Foundation on February 13, 2003. According to the 13D/A filing, The Foundation is a not-for-profit corporation organized under the laws of the State of Texas, and exempt from federal income tax under Section 501(a) of the Internal Revenue Code of 1986, as amended, as an organization described in Section 501(c)(3). (2) Includes 35,520 shares allocated to Mr. Mitte's account under the Employee Stock Purchase Plan and 6,600 shares which may be acquired pursuant to options which are exercisable within 60 days. For purposes of this table, Mr. Mitte is deemed to have beneficial ownership of the shares owned by the Foundation. - 59 - (3) Assumes that outstanding stock options or warrants held by non-affiliated persons have not been exercised and that outstanding stock options held by Family Life Insurance Company have been exercised. (4) Of such shares, 926,662 shares are owned by Investors Life Insurance Company of North America ("Investors Life") and 500,411 shares are issuable upon exercise of an option held by Investors Life. All shares are held as treasury shares. (5) Assumes that outstanding stock options or warrants held by non-affiliated persons have not been exercised and that outstanding stock options held by Investors Life have been exercised. (6) As reported to the Company on a Schedule 13G filed on June 11, 2001, by FMR Corporation, the parent company of Fidelity Management & Research Company ("Fidelity") and Fidelity Management Trust Company. The Company also notes that Fidelity filed a Schedule 13G/A on February 13, 2001, reporting that the beneficial ownership of Fidelity Low Price Stock Fund, an investment company registered under the Investment Company Act of 1940, was 340,000 shares. According to the Schedule 13G filings, as amended, Fidelity acts as investment advisor to the Fidelity Low Priced Stock Fund, and the Fund is the beneficial owner of 340,000 shares of FIC common stock. (7) As reported on a Schedule 13G filed by Wellington Management Company, LLP ("WMC") on February 12, 2003. According to the Schedule 13G filing, WMC acts as investment advisor to certain clients of WMC and such clients have the right to receive, or the power to direct the receipt of, dividends from, or the proceeds from the sale of, such securities. The filing further states that no such client is known to have such right or power with respect to more than five percent of the common stock of the Company. The following table contains information as of February 28, 2003 as to the Common Stock of FIC beneficially owned by (1) each director, (2) each of the named executive officers, and (c) the directors and executive officers as a group. In general, "beneficial ownership" refers to shares that a director or executive officer has the power to vote, or the power to dispose of, and stock options that are currently exercisable or become exercisable within 60 days of February 28, 2003. The information contained in the table has been obtained by the Company from each director and executive officer, except for the information known to the Company. - 60 - Amount and Nature of Percent of Name Beneficial Ownership (1)(2) Class Non-Employee Directors: John Barnett 2,000 * W. Lewis Gilcrease -0- * Richard A. Kosson 1,940 * Michael Scott Mitte 64 (2) * Elizabeth T. Nash 220 * Frank Parker 12,000 * Employee Directors: Roy F. Mitte 1,594,326 (1)(2)(3) 16.59% Named Executive Officers: Jeffrey H. Demgen 14,459 (2)(3) * Theodore A. Fleron 21,040 (2)(3) * Eugene E. Payne -0- * Thomas C. Richmond 18,868 (2)(3) * George M. Wise, III 500 * Total of Directors and Officers As a Group 1,665,417 17.30% * Less than 1%. (1) As reported on a Schedule 13D/A filed by the Roy F. and Joann Cole Mitte Foundation on February 13, 2003. According to the 13D/A filing, The Foundation is a not-for-profit corporation organized under the laws of the State of Texas, and exempt from federal income tax under Section 501(a) of the Internal Revenue Code of 1986, as amended, as an organization described in Section 501(c)(3). For purposes of this table, Mr. Mitte is deemed to have beneficial ownership of the shares owned by the Foundation. (2) Includes shares beneficially acquired through participation in the Company's 401K Plan and/or the Employee Stock Purchase Plan, which are group plans for eligible employees. (3) Include shares issuable upon exercise of options granted under the Stock Option Plan to executive officers and directors who are also employees of the Company or its subsidiaries, to the extent that such options are exercisable within 60 days of February 28, 2003, as follows: Mr. Demgen - 4,400 shares; Mr. Fleron - 4,400 shares; Mr. Mitte - 6,600 shares; and Mr. Richmond - 4,400 shares. - 61 - The following table contains information regarding FIC's equity compensation plans as of December 31, 2002: (a) (b) (c) Number of securities remaining available Number of securi- Weighted-average for future issuance ties to be issued exercise price under equity upon exercise of of outstanding compensation plans outstanding options options, warrants (excluding securities warrants and rights and rights reflected in column (a) Plan Category Equity compensation plans approved by security holders 208,850 (1) $9.51 231,000 Equity compensation plans not approved by security holders 0 0 0 Total 208,850 $9.51 231,000
(1) Shares available to be exercised, as of December 31, 2002, by certain officers of FIC and its life insurance subsidiaries pursuant to the InterContinental Life Corporation 1999 Stock Option Plan. On May 18, 2001, each share of ILCO Common Stock issuable pursuant to outstanding options was assumed by FIC and became an option to acquire FIC Common Stock with the number of shares and exercise price adjusted for the exchange ratio in the Merger. Item 13. Certain Relationships and Related Transactions The information set forth under the caption "Certain Relationships and Related Transactions" in the Proxy Statement is hereby incorporated by reference. Item 14. Controls and Procedures (a) The chief executive officer and chief financial officer of the Company have evaluated the effectiveness of the Company's disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934 as of a date within 90 days prior to the filing date of this report. Based on that evaluation, such officers have concluded that the Company's disclosure controls and procedures, as modified following implementation of the procedures described in paragraph (b), below, are effective to ensure that material information relating to the Company and its subsidiaries is made known to such officers in a timely manner for inclusion in the Company's periodic filings with the SEC. (b) The financial statements for the year ended December 31, 2002, were prepared under the general direction of the chief financial officer of the Company (who joined the Company in November, 2002, and was appointed as Vice President and Chief Financial Officer November 15, 2002). In connection with the preparation of such financial statements, the Company identified certain accounting errors which occurred in the year 2002, as well as prior periods. The identification and correction of these accounting errors are accounted for in the financial statements for the year ended December 31, 2002 and the related restatements for the years ended December 31, 2001 and December 31, 2000. The effect upon the financial statements for the years 2001 and 2000 resulting from the correction of these errors is described in this annual Report under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations - Restatement". As part of their evaluation of the Company's disclosure controls and procedures, the chief executive officer and the chief financial officer determined that certain procedures, as described below, needed to be established or modified in order to ensure that material information relating to the Company and its subsidiaries are included properly in the Company's financial filings with the SEC: - 62 - 1. For the year ended December, 31, 2002, the determination of the amount of uncollectible agent debit balances was made in accordance with a newly-established procedure which measures various factors (including the current level of production of the applicable agent and the persistency rate of that agent's book of business with the company) pertinent to the probability that the receivable will be realized. The Company believes that, if the current procedures had been in place with respect to years prior to 2002, the amount of agent debit balance receivables included in the financial statements for such prior years would have approximated the restated amounts shown in this Annual Report for such prior years. 2. In connection with the implementation of a modification to the mechanical interface system between the Company's policy administration system and the general ledger system used to record consolidated transactions for GAAP reporting purposes, the Company determined that the manual review procedures which it utilized in connection with the preparation of the financial statements for prior periods was not correctly identifying all of the transactions at the policy administration system level that were not correctly feeding to the general ledger system. Following implementation of the modification of the mechanical interface system, the Company identified transactions in addition to those which were reported in its Form 10-Q for the period ended September 30, 2002 and its Form 10-Q/A for the period ended June 30, 2002. A description of the financial effect of the identification and correction of the accounting errors is included in this Annual Report under the caption "Management's Discussion and analysis of Financial Condition and results of Operations - Restatement". The Company believes that the implementation of the modifications to the mechanical interface system will eliminate these accounting errors in connection with the preparation of financial statements for future periods. 3. The restatement of the consolidated balance sheet as of December 31, 2001 includes an increase of approximately $8 million in other liabilities resulting from a review of suspense account entries at the general ledger level. The Company has determined that certain suspense account entries had not been correctly reconciled with respect to prior periods due to the lack of a systematic review and reconciliation of such entries. In order to assure the proper reconciliation of suspense account entries in the future, the Company has reassigned responsibility for such reconciliation to a separate unit, the Financial Controls Department, with reconciliations to be completed on a quarterly basis. - 63 - Except as described above, there were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their most recent evaluation by the Company's chief executive officer and chief financial officer. Part IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents have been filed as part of this report: 1. Financial Statements (See Item 8) The following consolidated financial statements of Financial Industries Corporation and Subsidiaries are included in Item 8: Report of Independent Accountants Consolidated Balance Sheets, December 31, 2002 and 2001 (Restated) Consolidated Statements of Income, for years ended December 31, 2002, 2001 (Restated and 2000 (Restated) Consolidated Statements of Changes in Shareholders' Equity, for the years ended December 31, 2002, 2001 (Restated) and 2000 (Restated) Consolidated Statement of Cash Flows, for the years ended December 31, 2002, 2001 (Restated) and 2000 (Restated) Notes to Consolidated Financial Statements 2. The following consolidated financial statement schedules of Financial Industries Corporation and Subsidiaries are included: Schedule I-Summary of Investments Other Than Investments in Related Parties Schedule II - Condensed Financial Statements of Registrant Schedule IV - Reinsurance All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore, have been omitted. - 64 - 3. Exhibits filed with this report or incorporated herein by reference are as listed in the Index to Exhibits beginning on Page 71. (b) Reports on Form 8-K Registrant filed the following reports on Form 8-K during the fourth quarter of 2002: 1. On November 6, 2002, FIC filed a Current Report on Form 8-K in connection with (a) the appointment of Dr. Eugene Payne as President, Chief Executive Officer and Chairman of FIC; and (b) the termination of the employment agreement between FIC and the former President, Chief Executive Officer and Chairman, Roy F. Mitte. A press release is attached to the Form 8-K. 2. On November 18, 2002, FIC filed a Current Report on Form 8-K in connection with (a) earnings for the nine-month period ended September 30, 2002; (b) restated earnings for the six-month period ended June 30, 2002; and (c) the appointment of George M. Wise, III as the Chief Financial Officer of the Company. Two press releases are attached to the Form 8-K. 3. On December 12, 2002, FIC filed a Current Report on Form 8-K in connection with the receipt of an unsolicited letter from Pillar Foundation Group regarding their interest in acquiring all or part of FIC's outstanding common stock. A press release is attached to the Form 8-K. 4. On December 16, 2002, FIC filed a Current Report on Form 8-K in connection with (a) the resignation of two employee directors; (b) declaration of a cash dividend; and (c) steps the Company has taken to move sales acquisition costs in line with product pricing. A press release is attached to the Form 8-K. (c) Exhibits: The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed in the Index of Exhibits to this Annual Report on Form 10-K. - 65 - SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) 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 (Registrant) By: /s/ Eugene E. Payne Eugene E. Payne, Chairman of the Board, President and Chief Executive Officer By: /s/ George M. Wise, III George M. Wise, III Chief Financial Officer By: /s/ Nigel S. Walker Nigel S. Walker Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons, a majority of the Board of Directors of the Registrant, on behalf of the Registrant and in the capacities indicated on April 17, 2003. /s/ Eugene E. Payne /s/ John D. Barnett Eugene E. Payne, Director John D. Barnett, Director /s/ Jeffrey H. Demgen /s/ Theodore A. Fleron Jeffrey H. Demgen, Director Theodore A. Fleron, Director /s/ W. Lewis Gilcrease /s/ Richard A. Kosson W. Lewis Gilcrease, Director Richard A. Kosson, Director /s/ Elizabeth Nash /s/ Frank Parker Elizabeth Nash, Director Frank Parker, Director /s/ Thomas C. Richmond Thomas C. Richmond, Director - 66 - CERTIFICATION I, Eugene E. Payne, Chief Executive Officer of Financial Industries Corporation ("FIC"), certify that: 1. I have reviewed this annual report on Form 10-K of FIC; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report; 4. The Registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and - 67 - 6. The Registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: April 17, 2003 By: /s/ Eugene E. Payne Eugene E. Payne Chief Executive Officer - 68 - CERTIFICATION I, George M. Wise, III, Chief Financial Officer of Financial Industries Corporation ("FIC"), certify that: 1. I have reviewed this annual report on Form 10-K of FIC; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report; 4. The Registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and - 69 - 6. The Registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: April 17, 2003 By: /s/ George M. Wise, III George M. Wise, III Chief Financial Officer - 70 - EXHIBIT INDEX Exhibit Page No. No. Description of Exhibit 2.1 Agreement and Plan of Merger dated as of January 18, 2001, by and among FIC, ILCO and ILCO Acqui- sition Corp. (1) 3.1 Articles of Incorporation of FIC (2) 3.2 Certificate of Amendment to the Articles of In- corporation of FIC, dated November 12, 1996 (3) 3.3 Bylaws of FIC (2) 3.4 Amendment to Bylaws of FIC dated February 29, 1992 (10) 3.5 Amendment to Bylaws of FIC dated June 16, 1992 (10) 3.6 Amendment to Articles of Incorporation of FIC dated May 18, 2001 (13) 10.01 Stock Purchase Agreement, dated as of March 19, 1991, as amended, by and among Merrill Lynch Insurance Group, Inc., Family Life Insurance Company, Family Life Corporation, Family Life Insurance Investment Company and FIC (4) 10.02 Note, dated June 12, 1991, in the original principal amount of $2.5 million made by FIC in favor of Investors Life Insurance Company of California (Investors-CA) and transferred to Investors Life Insurance Company of North America (Investors Life) in connection with the merger as of December 31, 1992 of Investors-CA into Investors Life (4) 10.03 Credit Agreement, dated as of June 12, 1991, among Family Life Corporation, the Lenders named therein and the Agent named therein (4) 10.04 Note, dated June 12, 1991, in the original principal amount of $22.5 million made by Family Life Corporation in favor of Investors Life (4) 10.05 Note, dated June 12, 1991, in the original principal amount of $2.5 million made by FIC in favor of Investors Life Insurance Company of California (4) 10.06 Option Agreement, dated as of June 12, 1991, among FIC, Investors Life Insurance Company of North America and Investors Life Insurance Company of California.(4) 10.07 Surplus Debenture, dated as of June 12, 1991, in the original principal amount of $97.5 million made by Family Life Insurance Company in favor of Family Life Corporation (4) 10.08 Note, dated July 30, 1993, in the original principal amount amount of $30 million made by Family Life Corporation in favor of Investors Life Insurance Company of North America (5) - 71 - Exhibit Page No. No. Description of Exhibit 10.09 Note, dated July 30, 1993, in the original principal amount of $4.5 million made by Family Life Insurance Investment Company in favor of Investors Life Insurance Company of North America (5) 10.10 Amendment No. 1 to Note, dated July 30, 1993, between Family Life Corporation and Investors Life Insurance Company of North America (5) 10.11 Amendment No. 1 to Note, dated July 30, 1993, between Family Life Insurance Company and Family Life Corporation (5) 10.12 Guaranty Agreement, dated July 30, 1993, between FIC and Investors Life Insurance Company of North America (5) 10.13 Guaranty Agreement, dated July 30, 1993, between FIC and Investors Life Insurance Company of North America.(5) 10.14 Data Processing Agreement, dated as of November 30, 1994 between ILCO and FIC Computer Services, Inc.(6) 10.15 Data Processing Agreement, dated as of November 30, 1994 between Investors Life Insurance Company of North America and FIC Computer Services, Inc (6) 10.16 Data Processing Agreement, dated as of November 30, 1994 Between Family Life Insurance Company and FIC Computer Services, Inc.(6) 10.17 Amendment No. 2, dated December 12, 1996, effective June 12, 1996, to the note dated June 12, 1991 in the original principal amount of $22.5 million made by Family Life Corporation in favor of Investors Life Insurance Company of North America (7) 10.18 Amendment No. 1, dated December 12, 1996, effective June 12, 1996, to the note dated June 12, 1991 in the original principal amount of $2.5 million made by FIC in favor of Investors Life Insurance Company of California (7) 10.19 Amendment No. 1, dated December 12, 1996, effective June 12, 1996, to the note dated June 12, 1991 in the original principal amount of $2.5 million made by FIC in favor of Investors Life Insurance Company of North America (7) 10.20 Amendment No. 1, dated December 12, 1996, effective June 12, 1996, to the note dated July 30, 1993 in the original principal amount of $30 million made by FIC in favor of Investors Life Insurance Company of North America (7) - 72 - Exhibit Page No. No. Description of Exhibit 10.21 Amendment No. 1, dated December 12, 1996, effective June 12, 1996, to the note dated July 30, 1993 in the original principal amount of $4.5 million made by Family Life Insurance Investment Company in favor of Investors Life Insurance Company of North America (7) 10.22 Amendment Agreement, dated December 12, 1996, amending the Option Agreement among FIC, Investors Life Insurance Company of North America and Investors Life Insurance Company of California (7) 10.23 Assignment Agreement, dated December 23, 1998, between Family Life Insurance Investment Company and FIC (8) 10.24 Amendment dated as of April 4, 2001 to Employment Agreement between the Registrant and Roy F. Mitte (11) 10.25 Amended and Restated Stock Option Grant Agreement (13) 10.26 Employment Agreement of James M. Grace dated January 8, 2001 (12) 10.27 Employment Agreement between Registrant and Jeffrey H. Demgen dated as of May 1, 2002 and ratified by the Board of Directors on August 17, 2002, as amended on August 19, 2002 (14) 10.28 Employment Agreement between Registrant and Thomas C. Richmond dated as of May 1, 2002 and ratified by the Board of Directors on August 17, 2002 (14) 10.29 Employment Agreement between Registrant and Hans Annarino dated as of May 1, 2002 and ratified by the Board of Directors on August 17, 2002 (14) 10.30 Employment Agreement between Registrant and Theodore A. Fleron dated as of March 22, 2002 and ratified by the Board of Directors on August 17, 2002 (14) 10.31 Employment Agreement between Registrant and Dr. Eugene E. Payne dated as of November 4, 2002 and ratified by the Board of Directors on November 4, 2002 (15) 10.32 Financial Industries Corporation Equity Incentive Plan, dated November 4, 2002 (15) 10.33 Employment Agreement between Registrant and George M. Wise, III dated as of December 13, 2002 and ratified by the Board of Directors on December 13, 2002* 10.34 Employment Agreement between Registrant and Theodore A. Fleron dated as of December 13, 2002 and ratified by the Board of Directors on December 13, 2002, superceding Exhibit 10.30* - 73 - Exhibit Page No. No. Description of Exhibit 10.35 Employment Agreement between Registrant and Thomas C. Richmond dated as of December 13, 2002 and ratified by the Board of Directors on December 13, 2002, superceding Exhibit 10.28* 21.1 Ex - 75 Subsidiaries of Registrant* 23.1 Ex - 76 Consent of Independent Accountants* 99.1 Ex - 77 Certification dated April 17, 2003, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 * * Filed herewith. (1) Incorporated be reference to the Exhibits filed with FIC's Current Report on Form 8-K dated January 22, 2001. (2) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for 1985. (3) Incorporated by reference to the Exhibits filed with FIC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1996. (4) Incorporated by reference to the Exhibits filed with FIC's Current Report on Form 8-K dated June 25, 1991. (5) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for 1993. (6) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for 1994. (7) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for 1996. (8) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for 1998. (9) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for 1999. (10) Incorporated by reference to the Exhibits filed with FIC's S-4 filed on February 1, 2001. (11) Incorporated by reference to the Exhibits filed with FIC's 10K/A filed on April 5, 2001. (12) Incorporated by reference to the Exhibits filed with ILCO's 10K/A filed on April 3, 2001. (13) Incorporated by reference to the Exhibits filed with FIC's Annual Report on Form 10-K for the year ended December 31, 2001. (14) Incorporated by reference to the Exhibits filed with FIC's Quarterly Report on Form 10-Q filed on August 26, 2002, for the six-month period ended June 30, 2002. (15) Incorporated by reference to the Exhibits filed with FIC's Quarterly Report on Form 10-Q filed on November 14, 2002, for the nine-month period ended September 30, 2002. - 74 - EXHIBIT 21.1 SUBSIDIARIES OF REGISTRANT Actuarial Risk Consultants, Inc. Family Life Corporation Family Life Insurance Company Financial Industries Service Corporation Financial Industries Securities Corporation Financial Industries Service Corporation of Mississippi, Inc. Financial Industries Sales Corporation of Southern California, Inc. FIC Realty Services, Inc. FIC Property Management, Inc. FIC Computer Services, Inc. ILCO Acquisition Company InterContinental Life Corporation Investors Life Insurance Company of North America ILG Sales Corporation ILG Securities Corporation InterContinental Growth Plans, Inc. InterContinental Life Agency, Inc. - 75 - EXHIBIT 23. 1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-63046) of Financial Industries Corporation of our report dated April 16, 2003 appearing on page F-2 of this Form 10-K. PricewaterhouseCoopers LLP Dallas, Texas April 16, 2003 - 76 - EXHIBIT 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Financial Industries Corporation ("FIC") on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), we Eugene E. Payne, Chief Executive Officer, and George M. Wise, III, Chief Financial Officer, certify pursuant to 18 U.S.C. SECTION 1350, as adopted pursuant to SECTION 906 of the Sarbanes-Oxley Act of 2002, that to our knowledge and belief: 1. The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of FIC. /s/ Eugene E. Payne /s/ George M. Wise, III ______________________________ ______________________________ Eugene E. Payne George M. Wise, III Chief Executive Officer Chief Financial Officer Date: April 17, 2003 - 77 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES FORM 10-K--ITEM 15 (a) (1) and (2) LIST OF FINANCIAL STATEMENTS TABLE OF CONTENTS (1) The following consolidated financial statements of Financial Industries Corporation and Subsidiaries are included in Item 8: Report of Independent Accountants.......................................F-2 Consolidated Balance Sheets, December 31, 2002 and 2001, as restated................................F-3 Consolidated Statements of Income for the years ended December 31, 2002, 2001 and 2000, as restated..............F-5 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 2002, 2001 and 2000, as restated.................... .....F-7 Consolidated Statements of Cash Flows for the years ended December 2002, 2001 and 2000, as restated.............F-10 Notes to Consolidated Financial Statements, as restated................F-13 (2) The following consolidated financial statement schedules of Financial Industries Corporation and Subsidiaries are included: Schedule I - Summary of Investments - Other Than Investments in Related Parties...................................F-54 Schedule II - Condensed Financial Information of Registrant, as restated...........................................................F-55 Schedule III - Supplementary Insurance Information, as restated........F-58 Schedule IV - Reinsurance, as restated.................................F-59 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore, have been omitted. F-1 REPORT OF INDEPENDENT ACCOUNTANTS To The Board of Directors and Shareholders of Financial Industries Corporation: In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 15(a)(1) on page F-1 present fairly, in all material respect, the financial position of Financial Industries Corporation and its subsidiaries (the "Company") at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a) (2) on page F-1 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 2, the Company has restated its financial statements for the years ended December 31, 2001 and 2000. As discussed in Note 1, during 2002 the Company adopted Statement of Financial Accounting Standards No. 141, "Business Combinations." PricewaterhouseCoopers LLP Dallas, Texas April 17, 2003 F-2 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2002 2001 RESTATED ASSETS (in thousands) Investments other than investments in affiliate: Fixed maturities held to maturity, at amortized cost (market value approximates $1,069 and $1,028 at December 31, 2002 and 2001) $ 1,090 $ 1,029 Fixed maturities available for sale, at market value (amortized cost of $479,433 and $496,704 at December 31, 2002 and 2001) 493,827 501,395 Equity securities, at market value (cost approximates $6,381 and $8,856 December 31, 2002 and December 31, 2001) 6,351 8,279 Policy loans 46,607 49,794 Mortgage loans 17 4,715 Invested real estate 75,393 64,051 Short-term investments 137,944 138,291 Total investments 761,229 767,554 Cash and cash equivalents 24,975 7,094 Accrued investment income 8,308 8,483 Agency advances and other receivables 19,728 17,309 Reinsurance receivables 12,330 14,709 Due and deferred premiums 11,981 13,411 Real estate held for use 19,702 20,054 Property and equipment, net 1,367 785 Deferred policy acquisition costs 77,210 77,137 Present value of future profits of acquired businesses 23,796 30,530 Other assets 15,739 15,198 Separate account assets 334,637 391,593 Total Assets $1,311,002 $1,363,857
The accompanying notes are an integral part of these consolidated financial statements F-3 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, continued December 31, 2002 2001 RESTATED LIABILITIES AND SHAREHOLDERS' EQUITY (in thousands) Liabilities: Policy liabilities and contract holder deposit funds: Contractholder deposit funds $ 557,466 $ 556,117 Future policy benefits 172,008 180,953 Other policy claims and benefits payable 17,035 13,985 746,509 751,055 Deferred federal income taxes 25,814 27,197 Excess of net assets acquired over cost 0 10,429 Other liabilities 29,400 17,146 Separate account liabilities 334,637 391,593 Total Liabilities 1,136,360 1,197,420 Commitments and Contingencies (Notes 11 and 13) Shareholders' equity: Common stock, $.20 par value, 25,000,000 shares authorized in 2002 and 2001, 11,856,196 and 11,736,546 shares issued in 2002 and 2001, 9,600,827 and 9,498,847 outstanding in 2002 and 2001 2,372 2,348 Additional paid-in capital 66,541 65,558 Accumulated other comprehensive income 4,949 327 Deferred compensation 0 (292) Retained earnings 123,046 120,393 Total shareholders' equity before treasury stock 196,908 188,334 Common treasury stock, at cost, 2,255,369 and 2,237,699 shares at 2002 and 2001 (22,266) (21,897) Total Shareholders' Equity 174,642 166,437 Total Liabilities and Shareholders' Equity $1,311,002 $1,363,857
The accompanying notes are an integral part of these consolidated financial statements. F-4 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 2002 2001 2000 RESTATED RESTATED Revenues: (in thousands) Premiums, net $ 35,672 $ 35,887 $ 33,149 Earned insurance charges 41,981 27,710 4,323 Net investment income 40,296 30,719 6,933 Real estate income, net 2,593 1,937 0 Net realized (loss) gain on investments (2,845) 65 7 Other 1,018 1,842 6 118,715 98,160 44,418 Benefits and expenses: Policyholder benefits and expenses 48,165 30,149 13,453 Interest expense on contractholder deposit funds 29,711 19,936 2,211 Amortization of present value of future profits of acquired businesses 4,593 4,644 3,569 Amortization of deferred policy acquisition costs 10,427 6,767 5,340 Operating expenses 34,177 22,868 11,159 Interest expense 0 927 1,899 127,073 85,291 37,631 (Loss) income before federal income tax, equity in net earnings of affiliates and cumulative effect of change in accounting principle (8,358) 12,869 6,787 Provision (benefit) for federal income taxes: Current 270 3,937 1,521 Deferred (3,541) 140 (130) (Loss) income before equity in net earnings of affiliates and cumulative effect of change in accounting principle (5,087) 8,792 5,396 Equity in net earnings of affiliate, net of tax 0 985 2,040 Net (loss) income before cumulative effect of change in accounting principle (5,087) 9,777 7,436 Cumulative effect of change in accounting principle 10,429 0 0 Net Income $ 5,342 $ 9,777 $ 7,436
The accompanying notes are an integral part of these consolidated statements. F-5 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME, Continued (in thousands except per share data) Years Ended December 31, 2002 2001 2000 RESTATED RESTATED Net Income Per Share (Note 14) Basic: Average weighted shares outstanding 9,555 7,824 5,055 Basic earnings per share: Net (loss) income before cumulative effect of change in accounting principle $ (0.53) $ 1.25 $ 1.47 Cumulative effect of change in accounting principle 1.09 0 0 Net income $ 0.56 $ 1.25 $ 1.47 Diluted: Common stock and common stock equivalents 9,555 7,898 5,163 Diluted earnings per share: Net (loss) income before cumulative effect of change in accounting principle $ (0.53) $ 1.24 $ 1.44 Cumulative effect of change in accounting principle 1.09 0 0 Net income $ 0.56 $ 1.24 $ 1.44
The accompanying notes are an integral part of these consolidated financial statements. F-6 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (in thousands) Common Stock Additional Paid-in Shares Amount Capital Balance at December 31, 1999: As previously reported 5,845 $ 1,169 $ 7,225 Prior period adjustment (Note 2) As restated 5,845 1,169 7,225 Comprehensive Income (Loss): Net Income, as restated Other Comprehensive Income (Loss): Change in net unrealized loss on investments in fixed maturities available for sale, net of tax Change in net unrealized appreciation of equity securities, net of tax, as restated Total Comprehensive Income (Loss), as restated Cash Dividends to Shareholders ($0.18 per share) Balance at December 31, 2000, as restated 5,845 1,169 7,225 Comprehensive Income (Loss): Net Income, as restated Other Comprehensive Income (Loss): Change in net unrealized gain on investments in fixed maturities available for sale, net of tax Change in net unrealized appreciation of equity securities, net of tax, as restated Minimum pension liability, net of tax, as restated Total Comprehensive Income (Loss), as restated Stock options exercised 47 10 374 Treasury stock purchased Issuance of shares in exchange for acquired company 5,844 1,169 57,959 Stock based compensation Cash Dividends to Shareholders ($0.87 per share) Balance at December 31, 2001, as restated 11,736 2,348 65,558 Comprehensive Income (Loss): Net Income Other Comprehensive Income (Loss): Change in net unrealized gain on investments in fixed maturities available for sale, net of tax Change in net unrealized depreciation of equity securities, net of tax Minimum pension liability, net of tax Total Comprehensive Income (Loss) Stock options exercised 120 24 983 Treasury stock purchased Stock based compensation Cash Dividends to Shareholders ($0.28 per share) Balance at December 31, 2002 11,856 $ 2,372 $ 66,541
The accompanying notes are an integral part of these consolidated financial statements. F-7 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY, Continued (in thousands) Net Unrealized Gain (Loss) on Net Unrealized Investments in Total Appreciation Fixed Accumulated (Depreciation) Maturities Other of Equity Available for Comprehensive Securities Sale Other Income (Loss) Balance at December 31, 1999: As previously reported $ 0 $ (2,454) $ 0 $ (2,454) Prior period adjustment (Note 2) 1,417 1,417 As restated 1,417 (2,454) 0 (1,037) Comprehensive Income (Loss): Net Income, as restated Other Comprehensive Income (Loss): Change in net unrealized loss on investments in fixed maturities available for sale, net of tax 3,591 3,591 Change in net unrealized appreciation of equity securities, net of tax, as restated (606) (606) Total Comprehensive Income (Loss), as restated (606) 3,591 0 2,985 Cash dividends to Shareholders ($0.18 per share) Balance at December 31, 2000, as restated 811 1,137 0 1,948 Comprehensive Income (Loss): Net Income, as restated Other Comprehensive Income (Loss): Change in net unrealized gain on investments in fixed maturities available for sale, net of tax 798 798 Change in net unrealized appreciation of equity securities, net of tax, as restated (1,184) (1,184) Minimum pension liability, net of tax, as restated (1,235) (1,235) Total Comprehensive Income (Loss), as restated (1,184) 798 (1,235) (1,621) Stock options exercised Treasury stock purchased Issuance of shares in exchange for acquired company Stock based compensation Cash dividends to Shareholders ($0.87 per share) Balance at December 31, 2001, as restated (373) 1,935 (1,235) 327 Comprehensive Income (Loss): Net Income Other Comprehensive Income (Loss): Change in net unrealized gain on investments in fixed maturities available for sale, net of tax 4,666 4,666 Change in net unrealized depreciation of equity securities, net of tax 353 353 Minimum pension liability, net of tax (397) (397) Total Comprehensive Income (Loss) 353 4,666 (397) 4,622 Stock options exercised Treasury stock purchased Stock based compensation Cash Dividends to Shareholders ($0.28 per share) Balance at December 31, 2002 $ (20) $ 6,601 $ (1,632) $ 4,949
The accompanying notes are an integral part of these consolidated financial statements. F-8 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY, Continued (in thousands) Total Deferred Retained Treasury Shareholders' Compensation Earnings Stock Equity Balance at December 31, 1999: As previously reported $ 0 $ 117,552 $ (7,375) $ 116,117 Prior period adjustment (Note 2) (7,489) (6,072) As restated 0 110,063 (7,375) 110,045 Comprehensive Income (Loss): Net Income, as restated 7,436 7,436 Other Comprehensive Income (Loss): Change in net unrealized loss on investments in fixed maturities available for sale, net of tax 3,591 Change in net unrealized appreciation of equity securities, net of tax, as restated (606) Total Comprehensive Income (Loss), as restated 0 7,436 0 10,421 Cash Dividends to Shareholders ($0.18 per share) (905) (905) Balance at December 31, 2000, as restated 0 116,594 (7,375) 119,561 Comprehensive Income (Loss): Net Income, as restated 9,777 9,777 Other Comprehensive Income (Loss): Change in net unrealized gain on investments in fixed maturities available for sale, net of tax 798 Change in net unrealized appreciation of equity securities, net of tax, as restated (1,184) Mininum pension liability, net of tax, as restated (1,235) Total Comprehensive Income (Loss), as restated 0 9,777 0 8,156 Stock options exercised 384 Treasury Stock purchased (2,248) (2,248) Issuance of shares in exchange for acquired company (12,274) 46,854 Stock based compensation (292) (292) Cash Dividends to Shareholders ($0.87 per share) (5,978) (5,978) Balance at December 31, 2001, as restated (292) 120,393 (21,897) 166,437 Comprehensive Income (Loss): Net Income 5,342 5,342 Other Comprehensive Income (Loss): Change in net unrealized gain on investments in fixed maturities available for sale, net of tax 4,666 Change in net unrealized depreciation of equity securities, net of tax 353 Mininum pension liability, net of tax (397) Total Comprehensive Income (Loss) 0 5,342 0 9,964 Stock options exercised 1,007 Treasury stock purchased (369) (369) Stock based compensation 292 292 Cash Dividends to Shareholders ($0.28 per share) (2,689) (2,689) Balance at December 31, 2002 $ 0 $ 123,046 $ (22,266) $ 174,642
The accompanying notes are an integral part of these consolidated financial statements. F-9 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2002 2001 2000 CASH FLOWS FROM OPERATING RESTATED RESTATED ACTIVITIES (in thousands) Net Income $ 5,342 $ 9,777 $ 7,436 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Amortization of present value of future profits of acquired business 4,593 4,644 3,569 Amortization of deferred policy acquisition costs 10,427 6,767 5,340 Amortization of negative goodwill 0 (671) 0 Realized loss (gain) on investments 2,845 (65) (7) Depreciation 3,089 878 0 Cumulative effect of change in accounting principle (10,429) 0 0 Equity in undistributed earnings of affiliate 0 ( 985) (2,040) Changes in assets and liabilities: Decrease in accrued investment income 175 1,047 8 (Increase) decrease in agency advances and other receivables (2,419) 28,545 (564) Decrease (increase) in reinsurance receivables 2,379 0 (2,618) Decrease (increase) in due and deferred premiums 1,430 (874) (145) Increase in deferred policy acquisition costs (10,728) (11,825) (9,000) (Increase) decrease in other assets (541) 308 772 (Increase) decrease in policy liabilities and accruals 4,171 (18,672) 211 Increase (decrease) in other liabilities 2,070 (6,107) (848) Decrease in deferred federal income taxes (4,084) (6,413) (1,256) Other, net 761 (3,621) (575) Net cash provided by (used in) operating activities $ 7,559 $ (2,733) $ 283
The accompanying notes are an integral part of these consolidated financial statements. F-10 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued Year Ended December 31, 2002 2001 2000 RESTATED RESTATED CASH FLOWS FROM INVESTING ACTIVITIES (in thousands) Fixed maturities purchased (214,747) (116,978) (11,724) Real estate capital expenditures (13,515) (18,994) 0 Proceeds from sales and maturities of fixed maturities 242,656 116,181 11,664 Proceeds from payments received on mortgage loans 3,743 91 0 Net decrease in short-term investments 347 23,976 9,215 Net decrease (increase) in policy loans 3,187 1,946 (104) Cash acquired in purchase of insurance holding company 0 9,085 0 Purchase and retirement of property and equipment (1,064) 138 37 Net cash provided by investing activities 20,607 15,445 9,088 CASH FLOW FROM FINANCING ACTIVITIES Repayment of subordinated notes payable 0 (1,537) (6,148) Cash dividends to shareholders (2,206) (5,978) (905) Issuance of capital stock 1,007 384 0 Contractholder fund deposits 55,368 23,285 4,978 Contractholder fund withdrawals (64,085) (27,723) (5,255) Purchase of treasury stock (369) (2,248) 0 Net cash used in financing activities (10,285) (13,817) (7,330) Net increase in cash 17,881 4,361 2,041 Cash and cash equivalents, beginning of year 7,094 2,733 692 Cash and cash equivalents, end of year $ 24,975 $ 7,094 $ 2,733 Supplemental Cash Flow Disclosures: Income taxes paid $ 3,335 $ 7,104 $ 1,200 Interest paid $ 0 $ 725 $ 2,073
The accompanying notes are an integral part of these consolidated financial statements. F-11 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued Supplemental Schedule of Non-Cash Investing Activities: The Company purchased the outstanding capital stock of a life insurance holding company in the second quarter of 2001 for purchase price of approximately $49.1 million. The consolidated statements of cash flows reflect the impact of this acquisition. This purchase resulted in the Company receiving assets and assuming liabilities as follows (in thousands): 2001 RESTATED Assets $ 709,497 Liabilities $ 707,444 The accompanying notes are an integral part of these consolidated financial statements. F-12 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Summary of Significant Accounting Policies Organization Financial Industries Corporation ("FIC" or the "Company") is principally engaged, through its subsidiaries, in acquiring and administering existing portfolios of individual life insurance and annuity products. The Company's insurance subsidiaries are also engaged in the business of marketing and underwriting individual life insurance, disability insurance and annuity products in 49 states, the District of Columbia and the U.S. Virgin Islands. Such products are marketed through both captive and independent agency systems. Principles of Consolidation The consolidated financial statements include the accounts of FIC and its wholly-owned subsidiaries. All material intercompany balances and transactions have been eliminated. The more significant subsidiaries are: Family Life Corporation ("FLC"), Family Life Insurance Company ("Family Life"), FIC Realty Services, Inc. ("FIC Realty") and FIC Property Management, Inc. ("FIC-Property"). Effective on May 18, 2001, the consolidated financial statements also include the accounts of InterContinental Life Corporation ("ILCO"), Investors Life Insurance Company of North America ("Investors Life"), Investors Life Insurance Company of Indiana ("Investors-IN") and ILG Sales Corp, all which were accounted for under the equity method of accounting prior to the acquisition of the remaining outstanding shares. On February 18, 2002, Investors-IN was merged into Investors Life with Investors Life as the surviving entity. Basis of Presentation The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which differ from statutory accounting principles required by regulatory authorities for the Company's insurance subsidiaries. The following accounting policies describe the accounting principles used in the preparation of the consolidated financial statements. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results will differ from those estimates. Investments The Company's general investment philosophy is to hold fixed maturity securities until maturity. However, fixed maturities may be sold prior to their maturity dates in response to changing market conditions, duration of liabilities, liquidity factors, interest rate movements and other investment factors. Accordingly, substantially all the Companies fixed maturity investments are classified as available for sale and are carried at market value. Unrealized gains and losses on securities available for sale are not recognized in earnings but are reported as a separate component of equity in accumulated other comprehensive income, net of effect on other balance sheet accounts and related income taxes. F-13 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued While collateralized mortgage obligations ("CMOs") are carried at market value, premiums and discounts on CMOs are amortized over stated maturity of the CMOs, with consideration given to estimates of prepayments in the amortization of those premiums and discounts. Equity securities are classified as available for sale and are carried at market value. Equity securities include investments in the Company's own separate accounts, which are carried at estimated fair value. Unrealized gains and losses on equity securities, net of deferred income taxes, if applicable, are reflected directly in shareholders' equity as a component of accumulated other comprehensive income. Mortgage loans and policy loans are recorded at unpaid balances. Short-term investments are carried at cost, which approximates market value, and generally consist of those fixed maturities and other investments with maturities of less than one year from the date of purchase. Securities pledged as collateral for repurchase agreements are held by the Company's investment custodian until maturity of the repurchase agreement. Provisions of the agreement and procedures adopted by the Company ensure that the market value of the collateral, including accrued interest thereon, is sufficient in the event of default by the counterparty. Realized gains and losses on disposal of investments are included in net income. The cost of investments sold is determined on the specific identification basis, except for stocks, for which the first-in, first-out method is employed. Costs of debt securities and equity securities are adjusted for impairments, which are declines in value that are considered to be other than temporary. When impairment of the value of an investment is considered other than temporary, the decrease in value is reported in net income as a realized investment loss and a new cost basis is established. In evaluating whether a decline in value is other than temporary, the Company considers several factors including, but not limited to, the following: (1) whether the decline is substantial; (2) the duration; (3) the reasons for the decline in value (credit event, interest related or market fluctuations); (4) the Company's ability and intent to hold the investments for a period of time to allow for a recovery of value; and (5) the financial condition of and near term prospects of the issuer. Invested Real Estate Invested real estate is stated at cost less accumulated depreciation. Depreciation is provided using straight-line and accelerated methods over estimated useful lives of 5 to 40 years. Real estate income is reported net of expenses incurred to operate the properties and depreciation expenses. F-14 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The Company's management reviews the performance of real estate investments on an on-going basis for impairment as well as when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Management indentifies properties it intends to sell and properties it intends to hold for use. Currently management intends to hold for use all invested real estate. For each asset held for use, the Company applies a probability-weighted estimation approach to recovery of the carrying amount of the asset to determine if the sum of expected future cash flows (undiscounted and without interest charges) of the asset exceeds it carrying amount. If the sum of expected future cash flows (undiscounted and without interest charges) is less than the net book value of the asset, the excess of the net book value over the Company's estimate of fair value of the asset is charged to current earnings. The Company's estimate of fair value of the asset then becomes the new cost basis of the asset and this new cost basis is then depreciated over the asset's remaining life. Based on the application of the above policy, the Company has determined that no impairment is considered to exist with respect to its invested real estate as of December 31, 2002 and 2001. Cash and Cash Equivalents Generally, cash includes cash on hand and on deposit in non-interest bearing accounts. Short term investments with maturities of three months or less at the time of purchase are reported as cash equivalents. Property and Equipment Property and equipment is stated at cost less accumulated depreciation. Depreciation is provided using straight-line and accelerated methods over estimated useful lives of 3 to 8 years. Maintenance and repairs are charged to expense when incurred. Deferred Policy Acquisition Costs The cost of acquiring new business, principally first year commissions and certain expenses of the policy issuance and underwriting departments, which vary with and are primarily related to the production of new business, have been deferred to the extent recoverable. Acquisition costs related to traditional life insurance products are deferred and amortized to expense using actuarial methods that include the same assumptions used to estimate future policy benefits. Acquisition costs related to interest sensitive products are deferred and amortized in proportion to the ratio of estimated annual gross profits to total estimated gross profits over the expected lives of the contracts. Recoverability of deferred acquisition costs is evaluated periodically. Present Value of Future Profits on Acquired Businesses The present value of future profits of acquired traditional life business is amortized over the premium paying period of the related policies in proportion to the ratio of the annual premium revenue to total anticipated premium revenue applicable to such policies. Interest on the unamortized balance is accreted at rates from 7.0% to 11.0%. F-15 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued For interest-sensitive products, these costs are amortized in relation to the present value, using the current credited interest rate, of expected gross profits of the policies over the anticipated coverage period. Retrospective adjustments of these amounts for interest sensitive products are made periodically upon the revision of estimates of current or future gross profits to be realized from a group of policies. Recoverability of present value of future profits is evaluated periodically by comparing the current estimate of future profits to the unamortized asset balances. Real Estate Held for Use Real estate held for use represents real estate occupied by the Company and is carried at cost less accumulated depreciation. Depreciation is provided using straight-line over estimated useful lives of 40 years. Accumulated depreciation on real estate occupied by Company is $1,073,738 and $639,736 as of December 31, 2002 and 2001, respectively. Separate Accounts Separate account assets and liabilities, carried at market value, represent policyholder funds maintained in accounts having specific investment objectives. The net investment income, gains and losses of these accounts, less applicable contract charges, generally accrue directly to the policyholders and are not included in the Company's statement of income, with the exception of the gains and losses in the Company's seed money in the separate accounts, which are included in other income in the income statement. Solvency Laws Assessments The solvency or guaranty laws of most states in which the Company's insurance subsidiaries do business may require the Company's insurance subsidiaries to pay assessments (up to certain prescribed limits) to fund policyholder losses or liabilities of insurance companies that become insolvent. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength, and in certain instances, may be offset against future premium taxes. The Company's insurance subsidiaries expense for guaranty fund assessment from states which do not allow premium tax offsets was not material. Policy Liabilities and Contractholder Deposit Funds Liabilities for future policy benefits related to traditional life products are accrued as premium revenue is recognized. The liabilities are computed using the net level premium method, or an equivalent actuarial method, based upon industry and Company experience of investment yields, mortality and withdrawals, including provisions for possible adverse deviation. F-16 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Contract holder deposit funds represent liabilities for universal life and annuity products. These liabilities consist of deposits received from customers and are accumulated at actual credited interest rates on their fund balances less charges for expenses and mortality. Excess of Net Assets Acquired Over Cost The excess of net assets acquired over cost, or negative goodwill, is presented net of accumulated amortization. Prior to January 1, 2002, the excess of net assets acquired over cost was amortized generally in accordance with expected revenues of the related policies. During the first quarter of 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations." SFAS No. 141 eliminates the practice of amortizing and deferring excess of fair value of net assets acquired over cost and requires unallocated negative goodwill to be recognized immediately. In accordance with the standard, FIC ceased negative goodwill amortization on January 1, 2002 and recognized the unamortized balance of $10.4 million of negative goodwill acquired in the acquisition of ILCO as a cumulative effect of a change in accounting principle. Other Policy Claims and Benefits Payable The liability for other policy claims and benefits payable represents management's estimate of ultimate unpaid losses on claims and other miscellaneous liabilities to policyholders. Estimated unpaid losses on claims are comprised of losses on claims that have been reported but not yet paid and claims that have been incurred but not reported. The liability for other policy claims and benefits payable is subject to the impact of changes in claim severity, frequency and other factors. Although there is considerable variability inherent in such estimates, management believes that the liability recorded is adequate. Federal Income Taxes The Company computes deferred income taxes utilizing the asset and liability method. Under this method, balance sheet amounts for deferred income taxes are computed based on the tax effect of the differences between the financial reporting and federal income tax bases of assets and liabilities using the tax rates which are expected to be in effect when these differences are anticipated to reverse. Revenue Recognition Premiums on traditional life and health products are recognized as revenue when due. Benefits and expenses are associated with earned premiums, so as to result in recognition of net profits over the lives of the contracts. Proceeds from investment-related products and universal life products are recorded as liabilities when received. Revenues for investment-related and universal life products consist of net investment income, mortality charges, administration charges and surrender charges. F-17 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Stock Option Plans and Other Equity Incentive Plans The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25") and related Interpretations in accounting for its stock option plans, which are described more fully in Note 10. No compensation cost has been recognized by the Company in the accompanying income statement for its stock option plans, with the exception of the amortization of deferred compensation costs related to the acquisition of ILCO. During 2002, the remaining deferred compensation costs were amortized as the related stock options became fully vested in accordance with their original contractual terms. The Company follows the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock Based Compensation - Transition and Disclosure." SFAS No. 123 allows companies to follow existing accounting rules (APB 25) provided that pro forma disclosures are made of what net income and earnings per share would have been had the company recognized expense for stock-based awards based on their fair value at date of grant. The fair value disclosure assumes that fair value of option grants were calculated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: 2002 2001 Expected dividend yield 1.0% 3.0 % Expected volatility 37% 45 - 52% Risk-free interest rate 2.23 - 2.72% 3.11 - 4.72% Expected holding period - years 1 2 - 4 For purpose of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. Pro forma income information is as follows (in thousands except for net income per share) for the year ended December 31: 2002 2001 RESTATED Net income as reported $ 5,342 $ 9,777 Pro forma compensation expense, net of tax benefits 560 74 Pro forma net income $ 4,782 $ 9,703 Net income per share: Basic as reported $ 0.56 $ 1.25 Diluted as reported $ 0.56 $ 1.24 Basic - Pro Forma $ 0.50 $ 1.24 Diluted - Pro Forma $ 0.50 $ 1.23 No FIC options were granted during the year ended December 31, 2000. F-18 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued When stock appreciation rights are granted, the Company recognizes compensation expense equal to the amount by which the quoted market price of the Company's common stock exceeds the exercise price at the measurement date. Compensation expense is accrued as a charge to expense over the period or periods the employee performs the related services. Compensation accrued during the service period is adjusted in subsequent periods up to the measurement date for changes, either increases or decreases, in the quoted market value of the shares of the enterprise's stock covered by the grant, but shall not be adjusted below zero. The offsetting adjustment is made to compensation expense of the period in which changes in the market value occur. Net Income Per Share Net income per share is calculated based on two methods: 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 reflects the potential dilution that could occur if securities or other contracts to issue common stock were converted or exercised. The computation of diluted earnings per share does not assume conversion, exercise or contingent issuance of securities that would result in an increase in earnings per share amounts or a decrease in loss per share amounts (antidilution). Both methods are presented on the face of the accompanying consolidated statements of income. New Accounting Pronouncements During 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 143 ("SFAS 143"), "Accounting for Asset Retirement Obligations", which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, the adoption of which did not materially affect FIC's results of operations, liquidity or financial position. In May 2002, the FASB issued SFAS No. 145, "Rescission of FAS Nos. 4, 44, and 64, Amendment of SFAS No.13, and Technical Corrections," as of April 2002. This Statement rescinds FASB Statement No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS No.145 is effective for financial statements issued for fiscal years beginning after May 15, 2002, and is not expected to affect FIC's results of operations, liquidity or financial position. The American Institute of Certified Public Accountants ("AICPA") also recently issued Statement of Position No. 01-06 ("SOP 01-06") "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others." The guidance in SOP 01-06 relating to financing and lending activities is explicitly applicable to insurance companies. SOP 01-06 reconciles and conforms the accounting and financial reporting guidance presently contained in other accounting guidance. SOP 01-06 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The Company's accounting practices for its lending activities are already consistent with the guidance contained in SOP 01-06. The adoption of SOP 01-06 did not have a significant effect on the Company's financial statements. F-19 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," which addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force ("EITF") Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002, the adoption of which is not expected to materially affect FIC's results of operations, liquidity or financial position. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure." The statement amends SFAS No.123 to provide alternative methods of transition for voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS No. 148 improves the prominence and clarity of the pro forma disclosures required by SFAS No. 123 by prescribing a specific tabular format and by requiring disclosure in the "Summary of Significant Accounting Policies" or its equivalent. In addition, SFAS No. 148 improves the timeliness of those disclosures by requiring their inclusion in financial reports for interim periods. SFAS No. 148 is effective for financial statements for fiscal years ending after December 15, 2002. FIC continues to account for its stock option plans under APB 25 and related interpretations as allowed by this statement. FIC has adopted the disclosure provisions of SFAS No. 148. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 are effective for years ending after December 15, 2002. FIN 45 did not have a material effect on the Company. In January 2003, the FASB issued Interpretation No. 46 "Consolidation of Variable Interest Entities, an interpretation of ARB 51" ("FIN 46"). The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights ("variable interest entities" or "VIEs") and how to determine when and which business enterprise should consolidate the VIE (the "primary beneficiary"). This new model for consolidation applies to an entity which either (1) the equity investors (if any) do not have a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity's activities without receiving additional subordinated financial support from other parties. In addition, FIN 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. FIN 46 is not expected to have a material effect on the Company. F-20 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Reclassification Certain prior years' amounts have been reclassified to conform with the 2002 presentation. 2. Restatement In the fourth quarter of 2002, the Company identified uncollectible receivables for which adequate allowance had not been made and policyholder benefits and expenses that were understated due to an interface error between the policy administration system and the general ledger. The Company extended its investigation to determine the years affected and expanded the scope of its review to include other areas, including certain adjustments that were deemed not material in prior years. As a result of this review, the financial statements for 2001 and 2000 were restated for the following items. Previously reported unaudited quarterly financial data was also restated as discussed in Note 16. 1. Family Life did not properly apply the accounting requirements of SFAS No. 87, "Employers' Accounting for Pensions," in accounting for its defined benefit pension plan. The Company had accounted for its pension expense on a cash basis. As a result, the Company had not properly recognized pension expense or benefit and had not recorded a prepaid pension asset in years prior to January 1, 2000. 2. Agency advances and other receivables had not been analyzed for collectibility and contained balances pertaining to agents that should have been written off. 3. Depreciation on certain property and equipment had not been recorded since purchase. 4. Certain lease incentives had been recognized in income as received in 1997 instead of being deferred and recognized over the lease period. Further, certain other lease termination benefits had been deferred instead of being recognized in income in the period the lease was terminated. 5. Deferred acquisition cost amortization for traditional life policies issued prior to January 1, 2002 had been calculated using amortization factors which did not properly take into account the pattern of commission expense recognized on these policies, which understated amortization of these costs in early years of the policies and overstated amortization of these costs in later years of the policies. Also, deferred acquisition cost amortization for universal life policies issued prior to January 1, 2002 was based on undiscounted estimates of future gross profits, which overstated amortization of these costs. 6. Present value of future profits amortization had not reflected certain adjustments that reduced the present value of future profits asset. 7. Certain death benefit and annuity benefit expenses incurred during the years ended 1999, 2000, 2001 and 2002 were not recorded due to an interface error between the Company's policy administration system and its general ledger. F-21 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 8. ILCO's financial statements also required adjustment. ILCO had been accounted for as an investment of the Company under the equity method of accounting prior to May 18, 2001 and consolidated after that date. ILCO's financial statements required adjustment for the following items: a. ILCO had not recorded dividend and capital gain distributions prior to 1998 on its investment in one of its variable annuity separate accounts (which understated ILCO January 1, 2000 retained earnings) and had not recorded unrealized gains or losses to adjust the carrying value of its investment in the separate account to market value (which understated ILCO January 1, 2000 accumulated other comprehensive income). b. Agency advances and other receivables and other assets had not been analyzed for recoverability and contained balances that should have been written off. c. Certain adjustments to reinsurance recoverables that related to periods prior to January 1, 2000 were recorded during 2000. d. ILCO did not properly apply the accounting requirements of SFAS No. 87, "Employers' Accounting for Pensions," in accounting for its defined benefit pension plan. ILCO had accounted for its pension expense on a cash basis. As a result, the Company had not properly recognized pension expense or benefit and had not recorded a prepaid pension asset in years prior to January 1, 2000. e. Certain lease incentives had been recognized in income as received in 1997 instead of being deferred and recognized over the lease period. Further, certain other lease termination benefits had been deferred instead of being recognized in income in the period the lease was terminated. f. An unreconciled difference between suspense account balances included in the Company's general ledger and those included in its policy administration system resulted in an unsupported net asset (included in other liabilities on the consolidated balance sheet) that should have been written off. 9. The negative goodwill recognized as a result of the Company's acquisition of the remaining common shares of ILCO on May 18, 2001 and related amortization of negative goodwill in 2001 was adjusted to reflect the impact on ILCO of the above items. 10. Deferred federal income tax balances were adjusted for the above items. F-22 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Net income for 2001 was decreased from amounts previously reported by $2,237,000 and net income for 2000 was decreased by $1,343,000 as a result of the restatement, as follows (in thousands except per share data): 2001 2000 As 2001 As 2000 Previously As Previously As Reported Restated Reported Restated Income before federal income tax and equity in net earnings of affiliates $ 15,999 $ 12,869 $ 6,482 $ 6,787 Income before equity in net earnings of affiliates 10,698 8,792 5,198 5,396 Equity in net earnings of affiliate, net of tax 1,316 985 3,581 2,040 Net income $ 12,014 $ 9,777 $ 8,779 $ 7,436 Basic earnings per share $ 1.54 $ 1.25 $ 1.74 $ 1.47 Diluted earnings per share $ 1.52 $ 1.24 $ 1.70 $ 1.44
The change in net income for each year was due to the following adjustments that increased (decreased) net income for the years ended December 31, 2001 and 2000 (in thousands): 2001 2000 Premiums $ 1 $ 0 Negative goodwill amortization (296) 0 Policyholder benefits and expenses (2,447) 0 Amortization of present value of future profits 71 100 Amortization of deferred policy acquisition costs 33 (11) Provision for uncollectible receivables (401) (155) Pension expense (91) (132) Rent expense 0 503 Provision for deferred federal income taxes 1,224 (107) Equity in net earnings of affiliate (ILCO), net of tax (331) (1,541) Net income $ (2,237) $ (1,343) F-23 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The decrease of $331,000 in 2001 and $1,541,000 in 2000 in the Company's equity in net earnings of affiliate, net of tax, was due to the following adjustments that increased (decreased) the Company's equity in ILCO's net income for the year ended December 31, 2001 and 2000 (in thousands): 2001 2000 Premiums and policyholder benefits ceded to reinsurers $ 0 $ ( 204) Policyholder benefits and expenses (358) (1,727) Pension expense 0 (9) Rent expense 0 277 Provision for deferred federal income taxes 26 122 Equity in net earnings of affiliate, net of tax $ (331) $ (1,541) The Company accounted for its investment in ILCO under the equity method of accounting prior to its acquisition of ILCO's remaining outstanding common shares on May 18, 2001. The Company owned approximately 48% of ILCO's common shares during the period from January 1, 2001 to May 18, 2001 and during the year ended December 31, 2000. The above adjustments to equity in net earnings of affiliate, net of tax, are therefore equal to approximately 48% of the related adjustments to ILCO's net income for the period from January 1, 2001 to May 18, 2001 and during the year ended December 31, 2000, prior to related tax effects. The above adjustments decreased ILCO's net income for the period January 1, 2001 through May 18, 2001 by $484,000 and decreased ILCO's reported net income of $12.1 million for the year ended December 31, 2000 by $2.3 million (Note 5). Total shareholders equity at January 1, 2000 was decreased by $6,072,000, from $116.1 million to $110.3 million. The decrease in total shareholders' equity was due to a decrease of $7,489,000 in retained earnings as of January 1, 2000, offset by an increase in accumulated other comprehensive income of $1,417,000 as of January 1, 2000. The effects of the restatement on the Company's retained earnings, accumulated other comprehensive income and total shareholders' equity were as follows as of January 1, 2000 (in thousands): January 1, 2000 As Previously January 1, 2002 Reported As Restated Retained earnings $ 117,552 $ 110,063 Accumulated other comprehensive income $ (2,454) $ (1,037) Total shareholders' equity $ 116,117 $ 110,045 The change in the Company's retained earnings, accumulated other comprehensive income and total shareholders' equity at January 1, 2000 was due to the following adjustments that increased (decreased) retained earnings, accumulated other comprehensive income and total shareholders' equity at January 1, 2000 (in thousands): F-24 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued January January 1, 2000 1, 2000 Accumulated Total January 1, 2000 Other Share- Retained Comprehensive holders' Earnings Income Equity Agency advances and other receivables $ (2,273) $ 0 $ (2,273) Property and equipment, net (1,247) 0 (1,247) Deferred policy acquisition costs (3,243) 0 (3,243) Present value of future profits 87 0 87 Prepaid pension asset 707 0 707 Deferred rent revenue (350) 0 (350) Deferred federal income taxes 2,212 0 2,212 Investment in affiliate (ILCO) (3,382) 1,417 (1,965) Total $ (7,489) $ 1,417 $(6,072,000)
Investment in affiliate (ILCO) was deceased by $1,965,000 (of which $3,382,000 decreased retained earnings and $1,417,000 increased accumulated other comprehensive income) due to the following adjustments that increased (decreased) the Company's equity in ILCO's retained earnings, accumulated other comprehensive income and total shareholders' equity at January 1, 2000 (in thousands): January 1 January 1, 2000 2000 January 1, Accumulated Total 2000 Other Share- Retained Comprehensive holders' Earnings Income Equity Equity securities $ 1,124 $ 2,180 $ 3,304 Agency advances and other receivables (2,105) 0 (2,105) Reinsurance 204 204 receivables 0 Prepaid pension asset 2,343 0 2,343 Other assets (374) 0 (374) Deferred rent revenue (238) 0 (238) Other liabilities (3,427) 0 (3,427) Deferred federal income taxes (909) (763) (1,672) Investment in affiliate $ (3,382) $ 1,417 $ (1,965)
F-25 FINANICAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The Company accounted for its investment in ILCO under the equity method of accounting prior to its acquisition of ILCO's remaining outstanding common shares on May 18, 2001. The Company owned approximately 48% of ILCO's common shares at January 1, 2000. The above adjustments to investment in affiliate are therefore equal to approximately 48% of the related adjustments to ILCO's retained earnings, accumulated other comprehensive income and total shareholders' equity at January 1, 2000, prior to related tax effects. The above adjustments decreased ILCO's reported retained earnings of $151.9 million at January 1, 2000 by $7.1 million, increased ILCO's reported accumulated other comprehensive income (loss) of ($3.7 million) at January 1, 2000 by $3.0 million and decreased ILCO's reported total shareholders' equity of $151.7 million by $4.1 million. 3. Investments Fixed Maturities Investments in fixed maturities by category at December 31, 2002 and 2001, respectively, were as follows (in thousands): Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Fixed maturities available for sale as of December 31, 2002: U.S. treasury securities and obligations of U.S. government agencies and corporations $ 25,325 $ 3,809 $ 428 $ 28,706 States, municipalities and political subdivisions 6,060 331 0 6,391 Corporate securities 248,424 5,335 445 253,314 Mortgage-backed securities 199,624 6,743 951 205,416 Total fixed maturities available for sale 479,433 16,218 1,824 493,827 Fixed maturities held to maturity: Corporate securities 1,090 3 24 1,069 Total fixed maturities $ 480,523 $ 16,221 $ 1,848 $ 494,896
F-26 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value Fixed maturities available for sale as of December 31, 2001: U.S. Treasury securities and obligations of U.S. government agencies and corporations $ 22,992 $ 2,307 $ 14 $ 25,285 States, municipalities and political subdivisions 8,072 292 0 8,364 Corporate securities 261,812 718 4,674 257,856 Mortgage-backed securities 203,828 6,123 61 209,890 Total fixed maturities available for sale 496,704 9,440 4,749 501,395 Fixed maturities held to maturity: Corporate securities 1,029 0 1 1,028 Total fixed maturities available for sale $ 497,733 $ 9,440 $ 4,750 $ 502,423
The amortized values and market values of fixed maturities at December 31, 2002 are shown below by contractual maturity. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Fixed Maturities Available for Sale Amortized Market Value Value (in thousands) Due in one year or less $ 9,735 $ 9,657 Due after one year through five years 25,222 27,250 Due after five years through ten years 27,837 29,827 Due after ten years 217,014 221,677 Mortgage-backed securities 199,625 205,416 Total fixed maturities available for sale $ 479,433 $ 493,827 F-27 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANICAL STATEMENT, Continued Fixed maturities held to maturity mature after ten years. Proceeds from sales of investments in fixed maturities during 2002, 2001 and 2000 were $72,799,651, $41,700,711 and $1,050,000, respectively. On these sales, there were gains of $1,077,281 and losses of $99,425 in 2002, gains of $217,459 and losses of $201,655 in 2001 and gains of $1,575 and losses of $0 in 2000. The net change in unrealized investment gains (losses) represents a component of accumulated other comprehensive income for the years ended December 31, 2002, 2001 and 2000. The following is a summary of the change in unrealized investment gains (losses), net of the effect on other balance sheet accounts and related deferred income taxes, that are reflected in accumulated other comprehensive income for the periods presented. The unrealized gains and losses include the Company's portion of its percentage ownership of ILCO prior to May 18, 2001. The amount included in the total below is $5,554,000 for 2000. Change in Unrealized Gains (Losses) on Investments 2002 2001 2000 RESTATED RESTATED (in thousands) Fixed maturities $ 9,703 $ 1,449 $ 7,017 Equity securities 543 (1,822) (932) Gross unrealized gains (losses) 10,246 (373) 6,085 Effect on other balance sheet accounts (2,526) (221) (1,492) Deferred federal income taxes (2,701) 208 (1,608) Net change in unrealized gains (losses) on investments $ 5,019 $ (386) $ 2,985 The following table sets forth the reclassification adjustments required for the years ended December 31, 2002, 2001 and 2000: 2002 2001 2000 RESTATED RESTATED (in thousands) Reclassification Adjustments Unrealized holding gains (losses) on investments arising during the period, net of tax $ 3,170 $ (344) $ 2,990 Reclassification adjustments for (gains) losses included in net income, net of tax 1,849 (42) (5) Unrealized gains (losses) on investments, net of reclassification adjustment, net of tax $ 5,019 $ (386) $ 2,985 F-28 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The Company's insurance subsidiaries are required to maintain assets on deposit with state regulatory authorities. Such assets are included in fixed maturities and have an aggregate fair value of $12,024,359 and $16,363,363 at December 31, 2002 and 2001, respectively. Net Investment Income The components of net investment income are summarized as follows: Year ended December 31, 2002 2001 2000 (in thousands) Fixed maturities $ 32,934 $ 23,878 $ 5,493 Other, including short-term investments and policy loans 7,464 7,268 1,483 Gross investment income 40,398 31,146 6,976 Investment expenses (102) (427) (43) Net investment income $ 40,296 $ 30,719 $ 6,933 Other than temporary impairments The Company identified one bond at December 31, 2002, which was considered to be impaired and reduced its carrying value by $463,000. Also at December 31, 2002, the Company determined that its investment in its separate accounts was impaired and reduced its carrying value by $2.4 million. There were no impairments in the value of investments in 2001 or 2000 which were considered other than temporary. Mortgage loans The Company participated with a third party in two mortgage loans in New York state, Champlain Centre Mall and Salmon Run Mall, with a total balance due of $4.60 million at June 30, 2002. On June 18, 2002, the Company agreed to a proposed payoff of these loans at a discount. The borrower paid off the loans in August, 2002 with a payment of $3.64 million. The Company reduced the carrying value of the two loans by $0.96 million as of June 30, 2002 as an impairment of an invested asset. The impairment loss is included in realized losses on investments in the income statement. Invested real estate Investors Life purchased property known as River Place Pointe in October 1998. It consists of 47.995 acres of land in Austin, Texas. The aggregate purchase price for these tracts was $8.1 million. The site development permit allowed for the construction of seven office buildings totaling 600,000 square feet, with associated parking, drives and related improvements. Construction on the first section of the project, which consisted of four office buildings, an associated parking garage, and related infrastructure was completed during 2000 and 2001. The second section of construction, which included three more office buildings, an associated parking garage, and related infrastructure, was completed by the end of 2002. FIC and its insurance subsidiaries occupy Building One of River F-29 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Place Pointe, consisting of approximately 76,143 square feet of space and approximately 5,000 square feet of Building Four. Approximately 222,007 sq. ft. of the remaining 320,691 sq. ft. from Buildings Two, Three and Four is leased to third parties. The remaining buildings are not leased. At December 31, 2002 invested real estate includes approximately $73.98 million relating to the River Place Pointe property, not including $19.70 million reported as real estate occupied by Company. Real estate income as of December 31, 2002 and 2001 was $2.59 million and $1.94 million, net of real estate expenses of $4.1 million and $1.58 million, respectively. Accumulated depreciation on invested real estate as of December 31, 2002 is $2.1 million. Non-income producing investments The Company has no non-income producing investments as of December 31, 2002, 2001 and 2000, other than non-leased buildings of the River Place Pointe real estate investment. 4. Disclosure about Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments at December 31, 2002 are as follows: Carrying Amount Fair Value (in thousands) Financial assets: Fixed maturities $ 494,917 $ 494,896 Equity securities 6,351 6,351 Policy loans 46,607 46,607 Mortgage loans 17 17 Short-term investments 137,944 137,944 Separate account assets 334,637 334,637 Cash and cash equivalents 24,975 24,975 Financial liabilities: Separate account liabilities 334,637 334,637 Deferred annuities 123,527 119,993 Supplemental contracts 13,936 13,525 The following methods and assumptions were used to estimate the fair value of each class of financial instruments: F-30 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Fixed Maturities Fair values are based on quoted market prices or dealer quotes. Policy Loans Policy loans are, generally, issued with coupon rates below market rates and are considered early payment of the life benefit. As such, the carrying amount of these financial instruments is a reasonable estimate of their fair value. Mortgage loans The fair value of mortgage loans is estimated using a discounted cash flow analysis using rates for BBB-rated bonds with similar coupon rates and maturities. Separate account assets and liabilities Separate account assets and liabilities represent the market value of policyholder funds maintained in accounts having specific investment objectives. Cash and short-term investments The carrying amount of these instruments approximates market value. Deferred annuities and supplemental contracts The fair value of deferred annuities is estimated using cash surrender values. Fair values for supplemental contracts is estimated using a discounted cash flow analysis, based on interest rates currently offered on similar products. 5. Investment in InterContinental Life Corporation Prior to the acquisition of ILCO on May 18, 2001, FIC carried its investment in ILCO on the equity method of accounting. For the period from January 1, 2001 to May 17, 2001, FIC's net income includes its equity interest in the net income of ILCO, with such equity interest being based on FIC's percentage ownership of ILCO. ILCO is primarily engaged in the sale and administration of life insurance products through its insurance subsidiary, Investors Life. Summarized financial information for ILCO for the period from January 1, 2001 to May 17, 2001 and the year ended December 31, 2000 is set forth below, (in thousands): F-31 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued January 1 to May 18, 2001 January 1 to 2000 As Previously May 18, 2001 As Previously 2000 Reported As Restated Reported As Restated Results of Operations: Premium income $ 3,834 $ 3,835 $ 10,873 $ 9,875 Net investment income $ 19,288 $ 19,288 $ 50,893 $ 50,893 Earned insurance charges $ 15,386 $ 15,386 $ 38,500 $ 38,500 Benefits and expenses $ 32,296 $ 33,042 $ 84,669 $ 87,137 Net income $ 4,493 $ 4,009 $ 12,066 $ 9,813 Basic earnings per share $ 0.54 $ 0.48 $ 1.45 $ 1.18 Diluted earnings per share $ 0.54 $ 0.48 $ 1.45 $ 1.18
The amount of net realized gains (losses) included in net earnings of ILCO is $(3,000) for the year ended December 31, 2000 and $100,000 for the period from January 1, 2001 to May 17, 2001. On May 18, 2001, ILCO Acquisition Company ("ILCO Acquisition"), a Texas corporation and wholly-owned subsidiary of FIC, merged with and into ILCO. As a result of the merger, ILCO Acquisition subsequently ceased to exist, and ILCO continued as the surviving corporation, as a wholly-owned subsidiary of FIC. 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, were converted into the right to receive 1.1 shares of FIC common stock. In addition, each option to purchase ILCO common stock was assumed by FIC and became an option to purchase FIC common stock with the number of shares and the exercise price adjusted for the exchange ratio in the merger. The consideration for the transaction was $49.1 million, represented by the issuance of 4.7 million shares of FIC stock, at $10 per share, to ILCO shareholders and other direct costs of the merger. The $10 per share price was calculated based on the average price of FIC common stock on the two days immediately preceding and following the date of the merger agreement between FIC and ILCO. Prior to the merger, FIC owned approximately 48.1% of ILCO's common stock. The acquisition of ILCO was accounted for as a purchase; accordingly, the results of ILCO's operations are included in the consolidated results of operations from the date of the acquisition to December 31, 2001. Assets acquired and liabilities assumed were recorded at their fair values as of the acquisition date. The allocation of the purchase price to the net assets acquired over costs resulted in excess of net assets acquired of approximately $11.3 million after reduction of certain non current, non financial assets as required by GAAP. FIC amortized $684,000 of excess of net assets acquired over cost in 2001, which amount is included in operating expenses in the consolidated statement of income. This allocation is based on an analysis, as of May 18, 2001, of the acquired book of business. F-32 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The pro forma unaudited results of operations for the twelve months ended December 31, 2001 and 2000, assuming the ILCO acquisition had been consummated as of the beginning of the respective periods, are as follows: Twelve Months Ended December 31 (UNAUDITED) (In thousands, except per share data) 2001 2000 RESTATED RESTATED Total Revenues $ 136,225 $ 143,522 Net Income $ 9,633 $ 16,371 Net Income per share: Basic $ 1.00 $ 1.68 Diluted $ 0.99 $ 1.65 6. Present Value of Future Profits of Acquired Businesses An analysis of the present value of future profits follows: 2002 2001 RESTATED (in thousands) Balance at beginning of year $ 30,530 $ 19,627 Present value of acquired business from consolidation of acquired company 0 16,816 Effect of unrealized gain on investments (2,141) (1,269) Accretion of interest 2,385 2,305 Amortization during the period (6,978) (6,949) Present value of future profits at December 31 $ 23,796 $ 30,530 Anticipated amortization of the present value of future profits net of interest accretion for each of the next five years is as follows (in thousands): 2003 $ 4,365 2004 $ 3,563 2005 $ 3,007 2006 $ 2,525 2007 $ 2,203 F-33 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued At purchase, the present value of future profits was calculated using a discount rate of approximately 15%. Interest is accreted on the unamortized portion at approximately 7.0% to 11.0%. 7. Income Taxes The Company files a consolidated federal income tax return with its subsidiaries, except for Investors Life, Investors-IN and ILG Securities, which file separate returns. In accordance with the Company's tax allocation agreement, federal income tax expense or benefit is allocated to each member of the consolidated group as if each member were filing a separate return. The U.S. federal income tax provision (benefit) charged to continuing operations was as follows: 2002 2001 2000 RESTATED RESTATED (in thousands) Current $ 270 $ 3,937 $ 1,521 Deferred (3,541) 140 (130) Total provision for income tax $ (3,271) $ 4,077 $ 1,391 The provision for income taxes is less than the amount of income tax determined by applying the U.S. statutory income tax rate of 35% to pre-tax income from continuing operations as a result of the following differences: 2002 2001 2000 RESTATED RESTATED (in thousands) Income taxes at the statutory rate $ (2,925) $ 4,508 $ 2,375 Increase (decrease) in taxes resulting from: Small life insurance company deduction 0 (104) (382) Dividends received deduction (15) (429) (477) Tax rate differential 0 0 (65) Non-deductible compensation (346) 443 16 Other items, net 15 (341) (76) Total provision for income taxes $ (3,271) $ 4,077 $ 1,391 Provision has not been made for state and foreign income tax expense since this expense is minimal. Premium taxes are paid to various states where premium revenue is earned. Premium taxes are included in the statement of income as operating expenses. F-34 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Deferred taxes are recorded for temporary differences between the financial reporting bases and the federal income tax bases of the Company's assets and liabilities. The sources of these differences and the estimated tax effect of each are as follows: 2002 2001 RESTATED Deferred tax liability: (in thousands) Excess pension benefit $ 1,778 $ 1,777 Deferred policy acquisition costs 20,957 20,286 Present value of future profits 7,174 9,050 Deferred and uncollected premium 6,002 6,955 Reinsurance recoverable 3,116 3,925 Unrealized (depreciation) appreciation on marketable securities 4,876 1,642 Other taxable temporary differences 2,795 3,100 Total deferred tax liability 46,698 46,735 Deferred tax asset: Policy reserves 10,871 11,716 Net operating loss carry forward 4,083 3,263 Alternative minimum tax credit 346 347 Uncollected agent balances 1,306 1,076 Other receivables 2,308 2,308 Charitable contribution carryforward 424 0 Accrued liabilities 1,546 828 Total deferred tax assets, net 20,884 19,538 Net deferred tax liability $ 25,814 $ 27,197 An additional deferred federal income tax charge of $3,234,000 and $159,000 for 2002 and 2001, respectively, has been provided on the unrealized appreciation (depreciation) of marketable securities and is included in the balance of the deferred tax liability. This increase or decrease in deferred tax liability has been recorded as a reduction or increase to the equity adjustment due to the net change in unrealized appreciation or depreciation and has not been reflected in the deferred income tax expense, included in net income from operations. F-35 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued As a result of the acquisition of ILCO, the bases of ILCO's assets and liabilities were adjusted as described more fully in Note 5 of these financial statements. The adjustments to asset bases for financial reporting purposes results in adjustments that reduce the taxable temporary differences between financial reporting and tax purposes. As such, the Company's deferred tax liability was reduced by approximately $13.8 million. This adjustment was also reflected in the recorded financial reporting bases in assets acquired. Under the provisions of pre-1984 life insurance company income tax regulations, a portion of "gain from operations" of Investors Life was not subject to current taxation but was accumulated, for tax purposes, in special tax memorandum accounts designated as "policyholders' surplus accounts." Subject to certain limitations,"policyholders' surplus" is not taxed until distributed or the insurance company no longer qualifies to be taxed as a life insurance company. The accumulation in this account for Investors Life at December 31, 2002 was $12,582,000. Federal income tax of $4,404,000 would be due if the entire balance is distributed at a tax rate of 35%. The Company does not anticipate any transactions that would cause any part of the policyholders' surplus accounts to become taxable and, accordingly, deferred taxes have not been provided on such amounts. At December 31, 2002, Investors Life has approximately $173,000,000, in the aggregate in its shareholders' surplus account from which distributions could be made without incurring any federal tax liability. At December 31, 2002, the Company and its non-life wholly-owned subsidiaries have net operating loss carry forwards of approximately $11.7 million, which will begin to expire in 2008. Family Life is eligible for a special deduction allowed to small life insurance companies equal to 60 percent of tentative life insurance company taxable income, subject to certain limitations, for years 1999 through 2001. Under current law, FIC's insurance subsidiaries are no longer eligible for this special deduction subsequent to 2001. 8. Reinsurance Family Life and Investors Life reinsure portions of certain policies they write, thereby providing greater diversification of risk and minimizing exposure on larger policies. Generally, the reinsurer receives a proportionate part of the premiums less commissions and is liable for a corresponding part of benefit payments. The Company's retention on any one individual ranges from $0 to $250,000 depending on the risk. Policy liabilities and contract holder deposit funds are reported in the consolidated financial statements before considering the effect of reinsurance ceded. The insurance subsidiaries remain liable to the extent the reinsurance companies are unable to meet their obligation under the reinsurance agreements. F-36 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The components of reinsurance receivables as presented in the consolidated financial statements are as follows: December 31, 2002 2001 (in thousands) Future policy benefits $ 6,366 $ 8,263 Unearned premiums 658 937 Other policy claims and benefits payable 5,306 5,509 $ 12,330 $ 14,709 The amounts in the consolidated statements of income have been reduced by reinsurance ceded as follows: For the years ended 2002 2001 2000 (in thousands) Premiums $ 3,232 $ 2,414 $ 839 Policyholder benefits and expenses $ 3,754 $ 3,389 $ 1,515 Estimated amounts recoverable from reinsurers on paid claims are $1,987,883 and $2,486,455 in 2002 and 2001, respectively. These amounts are included in reinsurance receivables in the consolidated financial statements at December 31, 2002 and 2001. 9. Shareholders' Equity The Company's ability to pay dividends to its shareholders is affected, in part, by receipt of dividends from Family Life and Investors Life. Family Life and Investors Life are domiciled in the state of Washington. Under current Washington law any proposed payment of dividends or distribution by the insurance subsidiary which, together with dividends or distributions paid during the preceding twelve months, exceeds the greater of (i) 10% of statutory surplus as of the preceding December 31 or (ii) statutory net gain from operations, is called an "extraordinary dividend" and may not be paid until either it has been approved, or a waiting period shall have passed during which it has not been disapproved, by the insurance commissioner. Effective July 25, 1993, Washington amended its insurance code to retain the "greater of" standard but enacted requirements that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that dividends may be paid only from earned surplus. As of December 31, 2001, Family Life and Investors Life have earned surplus as defined by the regulations adopted by the Washington Insurance Commissioner and, therefore, are presently permitted to pay cash dividends. In December 2002, Investors Life paid a cash dividend to ILCO of $8,556,104. F-37 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Capital and surplus of Family Life as reported to insurance regulators and as determined in accordance with statutory accounting practices prescribed or permitted by the state of Washington aggregates approximately $24,673,837 and $23,520,637 at December 31, 2002 and 2001, respectively. Statutory net income aggregated approximately $131,314, $4,419,303 and $5,024,926 for the years ended December 31, 2002, 2001 and 2000, respectively. Capital and surplus of Investors Life as reported to insurance regulators and as determined in accordance with statutory accounting practices prescribed or permitted by the state of Washington aggregates approximately $55,819,415 and $63,837,560 at December 31, 2002 and 2001, respectively. Statutory net income aggregated approximately $2,996,204, $8,325,275 and $11,082,693 for the years ended December 31, 2002, 2001 and 2000, respectively. The effect on the statutory capital and surplus and statutory net income amounts of the restatement adjustments described in Note 2 will be reflected, to the extent applicable, in Family Life's and Investor Life's next statutory filings. The Company employed no permitted statutory accounting practices that individually or in the aggregate materially affected statutory surplus or risk-based capital of its insurance subsidiaries at December 31, 2002 or 2001. In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which replaced the current Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The Codification provides guidance for areas where statutory accounting has been silent and changes current statutory accounting in some areas, e.g. deferred income taxes are recorded. The Company implemented the changes from Codification in the first quarter of 2001 for all its insurance subsidiaries. The primary change as a result of Codification for each insurance subsidiary related to the recognition of deferred taxes. The effect of the accounting change was $3,005,586, $870,069 and $3,088,332 at January 1, 2001 for Investors Life, Investors-IN and Family Life, respectively, as a result of Codification and resulted in a corresponding increase in statutory surplus for each insurance subsidiary. 10. Retirement Plans and Employee Stock Plans Retirement Plans A. Family Life Family Life has a non-contributory defined benefit pension plan ("Family Life Pension Plan"), which covers employees who have completed one year or more of service. Under the Family Life Pension Plan, benefits are payable upon retirement based on earnings and years of credited service. a. The Normal Retirement Date for all employees is the first day of the month coinciding with or next following the later of attainment of age 65 or the completion of five years of service, but not later than age 70. b. The Normal Retirement Benefit is the actuarial equivalent of a life annuity, payable monthly, with the first payment commencing on the Normal Retirement Date. The life annuity is equal to the sum of (1) plus (2): F-38 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (1) Annual Past Service Benefit: 1.17% of the first $10,000 of Average Final Earnings plus 1 1/2% of the excess of Average Final Earnings over $10,000, all multiplied by the participant's Credited Past Service. For these purposes, "credited past service" is service prior to April 1, 1967, with respect to employees who were plan participants on December 31, 1975. (2) Annual Future Service Benefit: 1.5578% of the first $10,000 of Average Final Earnings plus 2% of the excess of Average Final Earnings over $10,000, all multiplied by the participant's Credited Future Service. c. Effective April 1, 1997, the Family Life Pension Plan was amended to provide that the accrual rate for future service is 1.57% of Final Average Earnings multiplied by Credited Service after March 31, 1997, less 0.65% of Final Average Earnings up to Covered Compensation. With respect to service prior to April 1, 1997, the accrual rate desribed in paragraph (b), above, is applicable, with Average Final Earnings taking into account a participant's earnings subsequent to April 1, 1997. Average Final Earnings are the highest average Considered Earnings during any five consecutive years while an active participant. Total Credited Past Service plus Credited Future Service is limited to 40 years. The pension costs for the Family Life Pension Plan includes the following components: 2002 2001 2000 (in thousands) Service cost for benefits earned during the year $ 66 $ 66 $ 61 Interest cost on projected benefit obligation 541 490 472 Expected return on plan assets (321) (414) (401) Pension expense $ 286 $ 142 $ 132 F-39 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The following summarizes the funded status of the Family Life Pension Plan at December 31: 2002 2001 (in thousands) Change in benefit obligation: Benefit obligation at beginning of year $ 7,222 $ 6,841 Service cost 66 66 Interest cost 541 490 Benefits paid (451) (175) Loss due to change in assumptions 1,077 0 Benefit obligation at end of year $ 8,455 $ 7,222 Change in plan assets: Fair value of plan assets at beginning of year $ 6,570 $ 6,394 Actual return on plan assets 365 344 Employer contributions 141 7 Benefits paid (451) (175) Fair value of plan assets at end of year $ 6,625 $ 6,570 Funded Status: Funded status at end of year $ (352) $ 1,684 Unrecognized actuarial net gain (145) (135) Additional minimum liability (611) (1,901) Accrued pension expense at end of year $ (1,108) $ (352) The significant assumptions for the plans are as follows: The discount rate for projected benefit obligations was 6.75%, 7.25% and 7.25% for the years ended December 31, 2002, 2001 and 2000, respectively. The assumed long-term rate of compensation increases was 5.0% for the years ended December 31, 2002, 2001 and 2000. The assumed long-term rate of return on plan assets was 8.0% for the years ended December 31, 2002, 2001 and 2000. F-40 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued B. ILCO ILCO maintains a retirement plan ("ILCO Pension Plan") covering substantially all employees of the Company and its subsidiaries. The ILCO Pension Plan is a non-contributory, defined benefit pension plan, which covers each eligible employee who has attained 21 years of age and has completed one year or more of service. Each participating subsidiary company contributes an amount necessary (as actuarially determined) to fund the benefits provided for its participating employees. The ILCO Pension Plan's basic retirement income benefit at normal retirement age is 1.57% of the participant's average annual earnings less 0.65% of the participant's final average earnings up to covered compensation multiplied by the number of his/her years of credited service. For participants who previously participated in the ILCO Pension Plan maintained by ILCO for the benefit of former employees of the IIP Division of CIGNA Corporation (the IIP Plan), the benefit formula described above applies to service subsequent to May 31, 1996. With respect to service prior to that date, the benefit formula provided by the IIP Plan is applicable, with certain exceptions applicable to former IIP employees who are classified as highly compensated employees. Former eligible IIP employees commenced participation automatically. The ILCO Pension Plan also provides for early retirement, postponed retirement and disability benefits to eligible employees. Participant benefits become fully vested upon completion of five years of service, as defined, or attainment of normal retirement age, if earlier. The pension benefit (costs) for the ILCO Pension Plan includes the following components: 2002 2001 (In thousands) Service cost for benefits earned during the period $ 544 $ 465 Interest cost on projected benefit obligation 1,023 965 Expected return on plan assets (1,267) (1,327) Amortization of unrecognized prior service cost 0 (11) Pension expense $ 300 $ 92 F-41 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The following summarizes the funded status of the ILCO Pension Plan at December 31: 2002 2001 (in thousands) Change in benefit obligation: Benefit obligation at beginning of period $ 14,492 $ 13,552 Service cost 544 465 Interest cost 1,023 965 Benefits paid (603) (490) Loss due to change in assumptions 916 0 Benefit Obligation at end of year $ 16,372 $ 14,492 Change in plan assets: Fair value of plan assets at beginning of year $ 17,293 $ 16,835 Actual return on plan assets 1,124 948 Benefits paid (603) (490) Fair value of plan assets at end of year $ 17,814 $ 17,293 Funded Status: Funded status at end of year $ 4,771 $ 4,863 Unrecognized prior service cost (300) (92) Unrecognized actuarial net loss 0 0 Prepaid pension expense at end of year $ 4,471 $ 4,771 The significant assumptions for the ILCO Pension Plan are as follows: The discount rate for projected benefit obligations was 6.75% and 7.25% in 2002 and 2001, respectively. The assumed long-term rate of compensation increases was 5.0% for 2002 and 2001. The assumed long-term rate of return on plan assets was 8.0% for 2002 and 2001. There were no assumed expenses as a percentage for 2002 and 2001. F-42 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Savings and Investment Plan ILCO maintains a Savings and Investment ("401(k) Plan") that allows eligible employees who have met a one-year service requirement to make contributions to the 401(k) Plan on a tax-deferred basis. A 401(k) Plan participant may elect to contribute up to 16% of eligible earnings on a tax deferred basis, subject to certain limitations applicable to "highly compensated employees" as defined in the Internal Revenue Code. 401(k) Plan participants may allocate contributions, and earnings thereon, between investment options selected by participants. The Account Balance of each Participant attributable to employee contributions is 100% vested at all times. During 1995, the 401(k) Plan was amended to allow for the addition of Family Life as a participating employer, thus allowing Family Life employees to participate in the 401(k) Plan. In 1997, the 401(k) Plan was amended to provide for a matching contribution. The match, which was in the form of shares of ILCO common stock, prior to the acquisition of the remaining outstanding common stock of ILCO by FIC on May 18, 2001, and is in the form of FIC common stock thereafter, is equal to 100% of an eligible participant's elective deferral contributions, as defined in the 401(k) Plan, not to exceed a maximum percentage of the participant's plan compensation. Initially, the maximum percentage was 1%. Effective January 1, 2000, the 401(k) Plan was amended to increase the maximum percentage to 2%. Allocations are made on a quarterly basis to the account of participants who have at least 250 hours of service in that quarter. The total costs recognized by the Company relating to the 401(k) Plan was $90,985 and $95,878 for 2002 and 2001. In 2001, the 401(k) Plan was amended and restated to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001. ILCO maintained an Employee Stock Ownership Plan ("ESOP Plan") and a related trust for the benefit of its employees and Family Life employees. The ESOP Plan generally covered employees who had attained the age of 21 and had completed one year of service. Vesting of benefits to employees was based on number of years of service. Effective May 1, 1998, the 401(k) Plan was amended to provide for the merger of the ESOP Plan into the 401(k) Plan. In connection with the merger, certain features under the ESOP Plan were preserved for the benefit of employees previously participating in the ESOP Plan with regard to all benefits accrued under the ESOP Plan through the date of merger. The merger was effected on December 26, 2001. No contributions were made to the ESOP Plan in 2001. At December 31, 2002, the 401(k) Plan had a total of 514,469 shares of FIC stock, which are allocated to participants. 401(k) Plan shares are treated as issued and outstanding in calculating the Company's earnings per share. Dividends to shareholders in the 401(k) Plan are treated by the Company as dividends to outside shareholders and are a direct charge to retained earnings. F-43 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Stock Option Plans A. ILCO Stock Option Plan Under ILCO's 1999 Non-qualified Stock Option Plan (the "ILCO Stock Option Plan") options to purchase shares of ILCO's common stock were granted to certain employees of ILCO, its subsidiaries and affiliates. The ILCO Stock Option Plan became effective on May 18, 1999 (the "Effective Date"). The exercise price of the options is equal to 100% of the fair market value on the date of grant, but in no case less than $7.50 per share ($6.818 per share as adjusted for the exchange ratio in the merger). A portion of the options become exercisable on the next anniversary of the Effective Date following the date of grant. No options may be exercised after the sixth anniversary of the Effective Date. All options must be exercised in one year from the date the options become exercisable. The number of options that become exercisable on each anniversary of the Effective Date, prior to the sixth anniversary, is equal to 100% of the total options granted divided by the number of years between the next anniversary of the Effective Date following the date of grant and the sixth anniversary of the Effective Date. Subsequent to May 18, 2001, each share of ILCO common stock issuable pursuant to outstanding options was assumed by the Company and became an option to acquire FIC common stock. The number of shares and the exercise price were adjusted for the exchange ratio in the merger (see Note 5). The related charge was included in equity as deferred compensation. The weighted average information for 2001 below is calculated from the date of merger, May 18, 2001, to December 31, 2001. After the merger in 2001, 22,000 options were granted at prices ranging from $13.00 to $14.30. 26,400 options were cancelled and 47,150 options were exercised. In 2002, 33,000 options were granted at prices ranging from $13.42 to $14.00, 42,350 were cancelled and 119,650 were exercised. The following table summarizes activity under ILCO's Stock Option Plan for the year ended December 31, 2002 and 2001: Weighted Weighted 2002 Average 2001 Average Options Exercise Options Exercise (000's) Price (000's) Price Outstanding on May 18, 2001 and beginning of year 338 $ 8.76 389 $ 8.38 Granted 33 13.74 22 13.65 Exercised (120) 8.56 (47) 8.21 Cancelled (42) 9.52 (26) 8.18 Outstanding at end of year 209 $ 9.51 338 $ 8.76 Options exercisable at end of year 209 $ 9.51 50 $ 8.54 Weighted average fair value of options granted during the year $ 2.09 $ 2.54 F-44 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANICAL STATEMENTS, Continued B. FIC Stock Option Plan In 1984, the Company's shareholders adopted a qualified stock option plan for officers and key employees. The aggregate amount of the common shares on which options may be granted is limited to 200,000 shares. The option price will not be less than 100% of the fair market price of the optioned shares on the date the option is granted. As of December 31, 2002, no options had been granted under the FIC Stock Option Plan. C. Stock Appreciation Rights Granted in 2002 On November 4, 2002, FIC adopted an Equity Incentive Plan (the "Plan"). The purpose of the Plan is to provide motivation to key employees of the Company and its subsidiaries to put forth maximum efforts toward the continued growth, profitability, and success of the Company and its subsidiaries by providing incentives to such key employees through performance-related incentives, including, but not limited to, the performance of the Common Stock of the Company. Toward this objective, stock appreciation rights or performance units may be granted to key employees of the Company and its subsidiaries on the terms and subject to the conditions set forth in the Plan. On November 4, 2002, the Company granted stock appreciation rights ("SARs") with respect to 30,000 shares of the Common Stock of the Company, pursuant to terms and provisions of the Plan. The exercise price of each unit is $14.11, which was 100% of the Fair Market Value of the Common Stock of the Company on the date of such grant. 11. Leases The Company and its subsidiaries occupy office facilities under lease agreements which expire at various dates through 2005. Certain office space leases may be renewed at the option of the Company. Rent expense in 2002, 2001 and 2000 was $2,844,186, $1,695,425 and $184,840 respectively. Minimum annual rentals are as follows: (in thousands) 2003 $ 1,216 2004 941 2005 842 2006 96 2007 24 Thereafter 0 Total $ 3,119 12. Related Party Transactions Prior to May 18, 2001, FIC owned 48.1% of ILCO's common stock. Significant related party transactions are as follows: F-45 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued In 1989, as part of the purchase of Family Life from Merrill Lynch Insurance Group, Inc. ("Merrill Lynch"), FIC organized two downstream holding companies: Family Life Insurance Investment Corporation ("FLIIC") and Family Life Corporation ("FLC"). FLIIC was organized as a wholly-owned subsidiary of FIC and, in turn, was issued all of the outstanding shares of FLC. FLC purchased all of the outstanding shares of Family Life from Merrill Lynch. A portion of the consideration for the purchase consisted of a $30 million senior subordinated note (the "Merrill Lynch Loan"). Following the purchase of the Family Life shares by FLC, Family Life issued 250,000 previously unissued shares of its common stock to FLC for a $2.5 million cash payment and immediately thereafter redeemed from FLC 250,000 shares of its common stock that had been purchased by FLC from Merrill Lynch. The consideration paid to FLC by Family Life for said redeemed shares consisted of $2.5 million cash, a newly issued surplus debenture (an instrument having certain restrictions on payment for the protection of policyholders) in the principal amount of $97.5 million (the "Family Life Surplus Debenture") and $14 million principal value of newly issued preferred shares. Another part of the financing arrangement to purchase Family Life included FLC borrowing $25 million from Investors Life (the "Investors Life Loans"). This amount was represented by a $22.5 million loan from Investors Life to FLC and a $2.5 million loan provided directly to FIC by Investors-CA (which was subsequently merged into Investors Life). In addition to the interest provided under the Investors Life Loans, Investors Life was granted non-transferable options to purchase FIC common stock, up to a total of 9.9 % of shares of FIC common stock (currently 500,411 shares) at a price of $2.10 per share (as adjusted to reflect the five-for-one stock split in November 1996), equivalent to the then current market price, subject to adjustment to prevent dilution. The initial terms of the option provided for their expiration on June 12, 1998, if not previously exercised. In connection with the 1996 amendments to the Investors Life Loans, the expiration date of the options was extended to September 12, 2006. On June 12, 1996, the Investors Life Loans were amended to provide for twenty quarterly principal payments, commencing on December 12, 1996. Additionally, prior to such date, accrued interest on the $2.5 million subordinated note issued by FIC to Investors-CA was paid by delivery of additional notes of FIC having terms identical to the original note, including the payment of interest. The Investors Life Loans were paid in full as of September 12, 2001; however, because of the 1993 Subordinated Loans, described in "Family Life Refinancing" below, the options of Investors Life to purchase FIC common stock did not expire with the repayment of the Investors Life Loans. In 1993, Investors Life loaned an additional $34.5 million to FLC and FLIIC in the form of subordinated notes so that FLC and FLIIC could prepay the Merrill Lynch Loan (the "1993 Subordinated Loans"). The 1993 Subordinated Loans consisted of a $30 million loan to FLC and a $4.5 million loan to FLIIC. On June 12, 1996, the 1993 Subordinated Loans were also amended as follows: (a) the $30 million note was amended to provide for forty quarterly principal payments in the amount of $163,540 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $1,336,458; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remained at 9%, and (b) the $4.5 million note was amended to provide for forty quarterly principal payments in the amount of $24,531 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $200,469; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remained at 9%. F-46 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued In December 1998, FLIIC was dissolved. In connection with the dissolution, all of the assets and liabilities of FLIIC became the obligations of FLIIC's sole shareholder, FIC. Accordingly, the obligations under the provisions of the $4.5 million note described above are now the obligations of FIC. As of December 31, 2002, the outstanding principal balance of the 1993 Subordinated Loans was $23.05 million. In 1995, Family Life entered into a reinsurance agreement with Investors Life pertaining to universal life insurance written by Family Life. The reinsurance agreement is on a co-insurance basis and applies to all covered business with effective dates on and after January 1, 1995. The agreement applies to only that portion of the face amount of the policy which is less than $200,000; face amounts of $200,000 or more are reinsured by Family Life with a third party reinsurer. In 1996, Family Life entered into a reinsurance agreement with Investors Life, pertaining to annuity contracts written by Family Life. The agreement applies to contracts written on or after January 1, 1996. On January 8, 2001, the Company donated $375,000 to the Roy F. and Joann Cole Mitte Foundation (the "Foundation"). The Foundation is a charitable entity exempt from federal income tax under section 501(a) of the Code as an organization described in section 501(c)(3) of the Code, and owns 16.31% of the outstanding shares of FIC's common stock. The sole members of the Foundation are Roy F. Mitte, former Chairman, President and Chief Executive Officer of FIC, ILCO and their insurance subsidiaries and his wife, Joann Cole Mitte. On January 2, 2002, FIC made a transfer of $1,000,000 to the Foundation. This transfer is the subject of ongoing litigation between the Company and the former Chairman, President and CEO, as described in Note 13. 13. Commitments and Contingencies 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 matters will not have a material impact on the financial statements. F-47 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Universal Life Litigation. On January 22, 2002, the Travis County District Court in Austin, Texas, denied certification to a proposed nationwide class of plaintiffs who purchased certain universal life insurance policies from INA Life Insurance Company (which was merged into Investors Life in 1992). The lawsuit, which was filed in 1996 as a "vanishing premium" life insurance litigation, initially alleged that the universal life insurance policies sold to plaintiffs by INA Life Insurance Company utilized unfair sales practices. In April 2001, the 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. Plaintiffs' Motion for Class Certification was denied in its entirety. 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. 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. Litigation Relating to Former Chairman and CEO. In January, 2003, the Company filed a lawsuit in Federal District Court in Austin, Texas. The lawsuit names as defendants Roy F. Mitte ("Mitte"), The Roy F. and Joann Cole Mitte Foundation (the "Foundation") and Joann Mitte (collectively referred to as the "Defendants"). Mitte was the Chairman, President and Chief Executive Officer of FIC until he was placed on administrative leave in August, 2002. The administrative leave, and the subsequent action by the Board of Directors in October, 2002 to terminate the employment agreement between FIC and Mitte, resulted from an investigation conducted by the FIC Audit Committee. The investigation conducted by the Audit Committee determined that more than $540,000 in Mitte's personal expenses had been paid by Company funds without the knowledge or approval of the FIC's officers or directors. In addition, the investigation disclosed that Mitte had caused an unapproved transfer of $1 million from the Company to the Foundation, followed by an ineffective attempt to obtain an unanimous consent of the Board of Directors of the Company. The Board of Directors has never met to ratify or approve the donation. The Foundation is a shareholder of FIC. The Company's claims against Mitte seek the reimbursement of $540,000 of personal expenses which were paid by the Company for the benefit of Mitte over a period of years beginning in 1992. In addition, the suit demands that Mitte reimburse the Company for a payment which he caused to be made to the Foundation without proper authorization by the Board of Directors. On March 19, 2003, Mitte filed a counterclaim against the Company alleging that the Company breached the employment agreement between FIC and Mitte by refusing to pay Mitte the severance benefits and compensation provided for under the employment agreement and amendment thereto. The Company believes that it properly terminated the contract and intends to vigorously defend Mitte's counterclaim. F-48 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The litigation is currently in the preliminary discovery stage. Other Litigation. Additionally, FIC's insurance 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. Management does 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. 14. Net Income Per Share The following table reflects the calculation of basic and diluted earnings per share: December 31, 2002 2001 2000 RESTATED RESTATED (Amounts in thousands, except per share amounts) Basic: Net income available to common shareholders $ 5,342 $ 9,777 $ 7,436 Weighted average common shares outstanding 9,555 7,824 5,055 Basic earnings per share $ 0.56 $ 1.25 $ 1.47 Diluted: Net income available to common shareholders $ 5,342 $ 9,777 $ 7,436 Weighted average common shares outstanding 9,555 7,824 5,055 Common stock options 0 224 258 Effect of shares ILCO owns of FIC 0 0 (91) Repurchase of treasury stock 0 (150) (59) Common stock and common stock equivalents 9,555 7,898 5,163 Diluted earnings per share $ 0.56 $ 1.24 $ 1.44
Options to purchase 208,850 shares of common stock at prices ranging from $8.18 to $14.30 were outstanding at December 31, 2002, but were not included in the computation of diluted earnings per share because the inclusion would result in an antidilutive effect in periods where a loss from continuing operations was incurred. F-49 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 15. Business Concentration One of the Company's insurance subsidiaries, Family Life, provides mortgage protection life, disability and accidental death insurance to mortgage borrowers of financial institutions. For marketing purposes, a significant number of these financial institutions provide Family Life with customer lists. In 2002, premium income from these products was derived from 48 states with concentrations of approximately 25% and 28% in California and Texas, respectively. In 2001, these amounts were 25% and 27%, respectively. In 2002 and 2001, premium income from Investors Life's life insurance products was derived from all states in which Investors Life is licensed, with significant amounts derived from Pennsylvania (14% and 14%), California (8% and 8%), and Ohio (8% and 8%). 16. Quarterly Financial Data (unaudited) Previously reported unaudited quarterly financial data has been restated for the effects of the adjustments described in Note 2 to the extent applicable, as follows (in thousands, except per share data): Three Months Three Months Ended Ended March 31, March 31, 2002 2001 2002 2001 AS PREVIOUSLY FILED AS RESTATED Total revenues $32,239 $10,603 $32,240 $10,603 Net income before cumulative effect of change in accounting principle $ 1,157 $ 2,083 $ 582 $ 1,873 Cumulative effect of change in accounting principle 15,727 0 10,429 0 Net income $16,884 $ 2,083 $11,011 $ 1,873 Basic earnings per share: Net income before cumulative effect of change in accounting principle $ 0.12 $ 0.41 $ 0.06 $ 0.37 Cumulative effect of change in accounting principle 1.66 0 1.10 0 Net income $ 1.78 $ 0.41 $ 1.16 $ 0.37 Diluted earnings per share: Net income before cumulative effect of change in accounting principle $ 0.12 $ 0.40 $ 0.06 $ 0.36 Cumulative effect of change in accounting principle 1.64 0 1.09 0 Net income $ 1.76 $ 0.40 $ 1.15 $ 0.36
F-50 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Quarterly Financial Data (unaudited) (continued) (in thousands, except per share data) Three Months Three Months Ended Ended June 30, June 30, 2002 2001 2002 2001 AS PREVIOUSLY FILED AS RESTATED Total revenues $ 30,002 $ 22,114 $ 30,003 $ 22,114 Net income before cumulative effect of change in accounting principle $ 215 $ 2,766 $ (247) $ 2,359 Cumulative effect of change in accounting principle 0 0 0 0 Net income $ 215 $ 2,766 $ (247) $ 2,359 Basic earnings per share: Net income before cumulative effect of change in accounting principle $ 0.02 $ 0.38 $ (0.03) $ 0.33 Cumulative effect of change in accounting principle 0 0 0 0 Net income $ 0.02 $ 0.38 $ (0.03) $ 0.33 Diluted earnings per share: Net income before cumulative effect of change in accounting principle $ 0.02 $ 0.38 $ (0.03) $ 0.33 Cumulative effect of change in accounting principle 0 0 0 0 Net income $ 0.02 $ 0.38 $ (0.03) $ 0.33
F-51 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Quarterly Financial Data (unaudited) (continued) (in thousands, except per share data) Three Months Three Months Ended Ended September 30, September 30, 2002 2001 2002 2001 AS PREVIOUSLY FILED AS RESTATED Total revenues $ 30,519 $ 33,965 $ 30,520 $ 33,506 Net income before cumulative effect of change in accounting principle $ 899 $ 3,806 $ 377 $ 3,007 Cumulative effect of change in accounting principle 0 0 0 0 Net income $ 899 $ 3,806 $ 377 $ 3,007 Basic earnings per share: Net income before cumulative effect of change in accounting principle $ 0.09 $ 0.40 $ 0.04 $ 0.32 Cumulative effect of change in accounting principle 0 0 0 0 Net income $ 0.09 $ 0.40 $ 0.04 $ 0.32 Diluted earnings per share: Net income before cumulative effect of change in accounting principle $ 0.09 $ 0.40 $ 0.04 $ 0.32 Cumulative effect of change in accounting principle 0 0 0 0 Net income $ 0.09 $ 0.40 $ 0.04 $ 0.32
F-52 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Quarterly Financial Data (unaudited) (continued) (in thousands, except per share data) Three Months Ended Three Months Ended December 31, 2002 December 31, 2001 AS AS PREVIOUSLY RESTATED FILED Total revenues $25,953 $32,443 $ 31,937 Net income before cumulative effect of change in accounting principle $(5,800) $ 3,359 $ 2,403 Cumulative effect of change in accounting principle 0 0 0 Net income $(5,800) $ 3,359 $ 2,403 Basic earnings per share: Net income before cumulative effect of change in accounting principle $ (0.60) $ 0.35 $ 0.25 Cumulative effect of change in accounting principle 0 0 0 Net income $ (0.60) $ 0.35 $ 0.25 Diluted earnings per share: Net income before cumulative effect of change in accounting principle $ (0.60) $ 0.35 $ 0.25 Cumulative effect of change in accounting principle 0 0 0 Net income $ (0.60) $ 0.35 $ 0.25 F-53 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 2002 (in thousands) Amount Shown on Amortized Fair Balance Type of Investment Cost Value Sheet Fixed Maturities Available for Sale: Bonds: United States Government and government agencies and authorities $ 25,325 $ 28,706 $ 28,706 States, municipalities and political subdivisions 6,060 6,391 6,391 Corporate securities 248,424 253,314 253,314 Mortgage-backed securities 199,624 205,416 205,416 Total fixed maturities available for sale 479,433 493,827 493,827 Fixed maturities held to maturity 1,090 1,069 1,090 Total fixed maturities 480,523 494,896 494,917 Equity securities: Common Stocks: Industrial and miscellaneous other 59 29 29 Seed money investment in Separate Accounts 6,322 6,322 6,322 Total equity securities 6,381 6,351 6,351 Policy loans 46,607 46,607 46,607 Short-term investments 137,944 137,944 137,944 Total investments $ 671,455 $ 685,798 $ 685,819 F-54 FINANCIAL INDUSTRIES CORPORATION (PARENT COMPANY) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS December 31, 2002 2001 RESTATED ASSETS (in thousands) Cash and cash equivalents $ 383 $ 684 Short-term investments 0 1,300 Long-term bonds 16 16 Investments in subsidiaries* 210,180 198,195 Property, plant and equipment, net 69 69 Other assets 964 965 Accounts receivable 398 95 Total assets $ 212,010 $ 201,324 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Subordinated notes payable $ 3,007 $ 3,809 Other liabilities and intercompany payables 16,218 12,935 Total liabilities 19,225 16,744 Shareholders' equity Common stock, $.20 par value, 25,000,000 authorized; 11,856,196 and 11,736,546 shares issued in 2002 and 2001, 9,600,827 and 9,498,847 shares outstanding in 2002 and 2001 2,372 2,348 Additional paid-in capital 66,541 65,558 Accumulated other comprehensive income 4,949 327 Deferred compensation 0 (292) Retained earnings (including $134,396 and $126,998 of undistributed earnings of subsidiaries at December 31, 2002 and 2001) 123,046 120,393 Total shareholders' equity before treasury stock 196,908 188,334 Common treasury stock, at cost, 625,695 and 608,025 shares in 2002 and 2001, respectively (4,123) (3,754) Total shareholders' equity 192,785 184,580 Total liabilities and shareholders' equity $ 212,010 $ 201,324 * $210,180 and $198,195 are eliminated in consolidation in 2002 and 2001, respectively. F-55 FINANCIAL INDUSTRIES CORPORATION (PARENT COMPANY) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT, STATEMENTS OF INCOME FOR THE YEARS ENDED December 31, (in thousands) 2002 2001 2000 RESTATED RESTATED Income $ 12 $ 67 $ 26 Expenses: Operating expenses 1,756 790 147 Interest expense 312 400 515 2,068 1,190 662 Loss from operations (2,056) (1,123) (636) Equity in undistributed earnings from subsidiaries 7,398 10,900 8,072 Net income $ 5,342 $ 9,777 $ 7,436 F-56 FINANCIAL INDUSTRIES CORPORATION (PARENT COMPANY) SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED December 31, (in thousands) 2002 2001 2002 CASH FLOWS FROM OPERATING ACTIVITIES RESTATED RESTATED Net income $ 5,342 $ 9,777 $ 7,436 Adjustments to reconcile net income to net cash used in operating activities: (Increase) decrease in accounts receivables (303) 487 (482) Increase in investment in subsidiaries* (11,985) (65,973) (11,269) Decrease (increase) in other assets 1 (258) (34) Increase in other liabilities and intercompany payables 3,283 6,258 916 Other 4,431 59,305 4,597 Net cash provided by operating activities 769 9,596 1,164 CASH FLOWS FROM FINANCING ACTIVITIES Net change in short-term investments 1,300 (1,150) 887 Change in subordinated notes payable to Investors Life (802) (946) (993) Cash dividend to shareholders (2,206) (5,978) (905) Purchase of treasury stock (369) (1,445) 0 Issuance of capital stock 1,007 384 0 Net cash used in financing activities (1,070) (9,135) (1,011) (Decrease) increase in cash (301) 461 153 Cash and cash equivalents, beginning of year 684 223 70 Cash and cash equivalents, end of year $ 383 $ 684 $ 223 *Eliminated in consolidation F-57 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION December 31, 2002 (in thousands) Future policy Deferred benefits, Other Policy Policy losses,claims Claims and Acquisition and loss Benefits Premium Costs expenses (1) Payable Revenue 2002 $ 77,210 $ 729,474 $ 17,035 $ 35,672 2001, As restated $ 77,137 $ 737,070 $ 13,985 $ 35,887 2000, As restated $ 52,907 $ 105,763 $ 2,931 $ 33,149 Benefits, Amortization claims, of Deferred Net losses and Policy Other Investment Settlement Acquisition Operating Income expenses (2) Costs Expenses 2002 $ 42,889 $ 77,876 $ 10,427 $ 34,177 2001, As restated $ 32,656 $ 50,085 $ 6,767 $ 22,856 2000, As restated $ 6,933 $ 15,664 $ 5,340 $ 11,159 (1) Includes contractholder funds (2) Includes interest expense on contractholder funds F-58 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SCHEDULE IV-REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 and 2000 (in thousands) Percentage Gross Ceded to Assumed of Amount Direct Other From Other Assumed Amount Companies Companies Net Amount To Net 2002 Life Insurance in-force $10,736,157 $1,274,843 $ 0 $ 9,461,314 0.00% Premium: Life insurance $ 38,402 $ 2,783 $ 0 $ 35,619 0.00% Accident & health insurance 502 449 0 53 0.00% Total Premium $ 38,904 $ 3,232 $ 0 $ 35,672 0.00% 2001, as restated Life Insurance in- force $12,107,319 $1,074,286 $ 0 $11,033,033 0.00% Premium: Life insurance $ 37,619 $ 1,821 $ 7 $ 35,805 0.02% Accident & health insurance 675 593 0 82 0.00% Total Premium $ 38,294 $ 2,414 $ 7 $ 35,887 0.02% 2000, as restated Life insurance in- force $ 7,006,301 $ 552,467 $ 5,067 $ 6,458,901 0.08% Premium: Life insurance $ 33,499 $ 448 $ 51 $ 33,102 0.15% Accident & health insurance 438 391 0 47 0.00% Total Premium $ 33,937 $ 839 $ 51 $ 33,149 0.15%
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