-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DufqtiHIEacKY5wD+/P+2T4X7pFSJV4DJIG37N3Jizc5VbhMhmTNdb6hod4Dpy9X XTogEgXHCJe+t+HsciEitQ== 0000035733-03-000042.txt : 20030515 0000035733-03-000042.hdr.sgml : 20030515 20030515174057 ACCESSION NUMBER: 0000035733-03-000042 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20030331 FILED AS OF DATE: 20030515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FINANCIAL INDUSTRIES CORP CENTRAL INDEX KEY: 0000035733 STANDARD INDUSTRIAL CLASSIFICATION: LIFE INSURANCE [6311] IRS NUMBER: 742126975 STATE OF INCORPORATION: TX FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-04690 FILM NUMBER: 03706470 BUSINESS ADDRESS: STREET 1: LEGAL DEPARTMENT STREET 2: 6500 RIVER PLACE BLVD., BUILDING ONE CITY: AUSTIN STATE: TX ZIP: 78730 BUSINESS PHONE: 512 404-5000 MAIL ADDRESS: STREET 1: 6500 RIVER PLACE BLVD., BUILDING ONE STREET 2: LEGAL DEPARTMENT CITY: AUSTIN STATE: TX ZIP: 78730 FORMER COMPANY: FORMER CONFORMED NAME: GOLDEN UNITED INVESTMENT CO STOCK PLAN DATE OF NAME CHANGE: 19731128 FORMER COMPANY: FORMER CONFORMED NAME: ILEX CORP DATE OF NAME CHANGE: 19730801 FORMER COMPANY: FORMER CONFORMED NAME: GOLDEN UNITED INVESTMENT CO DATE OF NAME CHANGE: 19730801 10-Q 1 fic1q2003.txt FIC 10-Q 1ST QUARTER 2003 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 2003 Commission File Number 0-4690 FINANCIAL INDUSTRIES CORPORATION (Exact Name of Registrant as specified in its charter) Texas 74-2126975 (State of Incorporation) (I.R.S. Employer Identification Number) 6500 River Place Blvd., Building One Austin, Texas 78730 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (512) 404-5000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X] NO Number of common shares outstanding, $0.20 par value, as of March 31, 2003: 9,605,939. - 1 - Forward-Looking Statements Except for historical factual information set forth in this Quarterly Report on Form 10-Q of Financial Industries Corporation (the "Company" or "FIC"), the statements, analyses, and other information contained in this report relating to trends in the Company's operations and financial results, the markets for the Company's products, the future development of the Company's business, and the contingencies and uncertainties to which the Company may be subject, as well as other statements including words such as "anticipate," "believe," "path," "estimate," "expect," "intend" and other similar expressions constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Such statements are made based upon management's current expectations and beliefs concerning the financial results, economic conditions and are subject to known and unknown risks, uncertainties and other factors contemplated by the forward-looking statements. Such factors include, among other things: (1) general economic conditions and other factors, including prevailing interest rate levels and stock market performance, which may affect the ability of FIC to sell its products, the market value of FIC's investments and the lapse rate and profitability of policies; (2) FIC's ability to achieve anticipated levels of operational efficiencies and cost-saving initiatives; (3) customer response to new products, distribution channels and marketing initiatives; (4) mortality, morbidity and other factors which may affect the profitability of FIC's insurance products; (5) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of FIC's products; (6) increasing competition in the sale of insurance and annuities; (7) regulatory changes or actions, including those relating to regulation of insurance products and insurance companies; (8) ratings assigned to FIC's insurance subsidiaries by independent rating organizations such as A.M. Best Company, which FIC believes are particularly important to the sale of annuity and other accumulation products; and (9) unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect FIC. - 2 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES INDEX Page No. Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets March 31, 2003 and December 31, 2002................................. 4 Consolidated Statements of Income For the three month periods ended March 31, 2003 and March 31, 2002 (as restated)..................... 6 Consolidated Statements of Cash Flows For the three month periods ended March 31, 2003 and March 31, 2002 (as restated)......................8 Notes to Consolidated Financial Statements...................................10 Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations......................19 Item 3. Quantitative and Qualitative Disclosures About Market Risk ...................................................34 Item 4. Controls and Procedures..............................................35 Part II Other Information...........................................................36 Signature Page..............................................................38 Certifications.............................................................. 39 - 3 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) March 31 December 31 2003 2002 (unaudited) Investments: Fixed maturities held to maturity, at amortized cost (market value approximates $22 and $1,069 at March 31, 2003 and December 31, 2002, respectively) $ 28 $ 1,090 Fixed maturities available for sale, at market value (amortized cost of $528,441 and $479,433 at March 31, 2003 and December 31, 2002, respectively) 538,927 493,827 Trading securities, at market value 20,075 0 Equity securities, at market value (cost approximates $6,348 and $6,381 at March 31, 2003 and December 31, 2002, respectively) 6,089 6,351 Policy loans 45,880 46,607 Mortgage loans 7 17 Invested real estate 74,867 75,393 Short-term investments 135,651 137,944 Total investments 821,524 761,229 Cash and cash equivalents 16,745 24,975 Accrued investment income 8,913 8,308 Agency advances and other receivables 20,524 19,728 Reinsurance receivables 12,668 12,330 Due and deferred premiums 11,534 11,981 Real estate occupied by Company 19,597 19,702 Property and equipment, net 1,454 1,367 Deferred policy acquisition costs 77,139 77,210 Present value of future profits of acquired businesses 23,507 23,796 Other assets 14,865 15,739 Separate account assets 326,649 334,637 Total Assets $ 1,355,119 $ 1,311,002 The accompanying notes are an integral part of these consolidated financial statements. - 4 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) March 31 December 31 2003 2002 (unaudited) LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Policy liabilities and contractholder deposit funds: Contractholder deposit funds $ 557,305 $ 557,466 Future policy benefits 170,067 172,008 Other policy claims and benefits payable 15,687 17,035 743,059 746,509 Deferred federal income taxes 22,743 25,814 Other liabilities 91,224 29,400 Separate account liabilities 326,649 334,637 Total Liabilities 1,183,675 1,136,360 Commitments and Contingencies Shareholders' equity: Common stock, $.20 par value, 25,000 shares authorized in 2003 and 2002, 11,858 and 11,856 shares issued in 2003 and 2002, 9,606 and 9,601 shares outstanding in 2003 and 2002 2,373 2,372 Additional paid-in capital 66,558 66,541 Accumulated other comprehensive income 2,971 4,949 Retained earnings 121,781 123,046 193,683 196,908 Common treasury stock, at cost, 2,252 and 2,255 shares in 2003 and 2002 (22,239) (22,266) Total Shareholders' Equity 171,444 174,642 Total Liabilities and Shareholders' Equity $ 1,355,119 $ 1,311,002 The accompanying notes are an integral part of these consolidated financial statements. - 5 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended March 31, 2003 2002 RESTATED Revenues: (unaudited) Premiums, net $ 7,939 $ 9,915 Earned insurance charges 10,608 10,825 Net investment income 9,043 10,434 Real estate income 288 613 Net realized investment gains 1,629 1 Other 259 452 29,766 32,240 Benefits and expenses: Policyholder benefits and expenses 9,843 10,868 Interest expense on contractholders deposit funds 7,339 7,985 Amortization of present value of future profits of acquired businesses 1,114 1,085 Amortization of deferred policy acquisition costs 2,632 2,009 Litigation settlement 2,915 0 Operating expenses 7,869 9,087 31,712 31,034 (Loss) income before federal income tax and cumulative effect of change in accounting principle (1,946) 1,206 Provision for federal income taxes (681) 624 (Loss) income before cumulative effect of change in accounting principle (1,265) 582 Cumulative effect of change in accounting principle 0 10,429 Net (Loss) Income $ (1,265) $ 11,011 The accompanying notes are an integral part of these consolidated statements. - 6 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended March 31, 2003 2002 RESTATED Net (Loss) Income Per Share (unaudited) Basic: Weighted average shares outstanding 9,602 9,500 Basic earnings per share: (Loss) income per share before cumulative effect of change in accounting principle $ (0.13) $ 0.06 Cumulative effect of change in accounting principle 0.00 1.10 Basic earnings per share $ (0.13) $ 1.16 Diluted: Common stock and common stock equivalents 9,602 9,575 Diluted earnings per share: (Loss) income per share before cumulative effect of change in accounting principle $ (0.13) $ 0.06 Cumulative effect of change in accounting principle 0.00 1.09 Diluted earnings per share $ (0.13) $ 1.15 The accompanying notes are an integral part of these consolidated financial statements. - 7 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Three Months Ended March 31, 2003 2002 RESTATED (unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Net (Loss) Income $ (1,265) $ 11,011 Adjustments to reconcile net income to net cash used in operating activities: Amortization of present value of future profits of acquired business 1,114 1,085 Amortization of deferred policy acquisition costs 2,632 2,009 Depreciation 855 554 Cumulative effect of change in accounting principle 0 (10,429) Realized gain on investments (1,629) (1) Changes in assets and liabilities: Increase in accrued investment income (605) 2,252) (Increase) decrease in agent advances and other receivables (1,134) 818 Decrease in due premiums 447 550 Increase in deferred policy acquisition costs (2,376) (2,335) Decrease (increase) in other assets 874 (3,478) Increase (decrease) in policy liabilities and accruals 271 (4,243) Increase in other liabilities 2,214 176 Decrease in deferred federal income taxes (1,991) (1,828) Net activity from trading securities (20,071) 0 Other, net 545 76 Net cash used in operating activities $ (20,121) $ (8,287) The accompanying notes are an integral part of these consolidated financial statements. - 8 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued (in thousands) Three Months Ended March 31, 2003 2002 RESTATED (unaudited) CASH FLOWS FROM INVESTING ACTIVITIES Fixed maturities purchased $ (127,344) $ (27,395) Real estate capitalized (84) (3,374) Change in policy loans 727 868 Proceeds from calls, maturities and sales of fixed maturities 140,712 31,276 Net decrease in short-term investments 2,293 10,020 Purchase and retirement of property and equipment (227) (87) Net cash provided by investing activities 16,077 11,308 CASH FLOW FROM FINANCING ACTIVITIES Cash dividends to shareholders (483) 0 Contractholder fund deposits 12,632 12,518 Contractholder fund withdrawals (16,353) (12,548) Issuance of capital stock 18 194 Purchase of treasury stock 0 (460) Net cash used in financing activities (4,186) (296) Net (decrease) increase in cash (8,230) 2,725 Cash and cash equivalents, beginning of year 24,975 7,094 Cash and cash equivalents, end of period $ 16,745 $ 9,819 The accompanying notes are an integral part of these consolidated financial statements. - 9 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The financial statements included herein have been presented to conform to the requirements of Form 10-Q. This presentation includes year end balance sheet data which was derived from audited financial statements. The notes to the financial statements do not necessarily include all disclosures required by generally accepted accounting principles (GAAP). The reader should refer to Form 10-K for the year ended December 31, 2002 previously filed with the Securities and Exchange Commission for financial statements prepared in accordance with GAAP. Management believes the financial statements reflect all adjustments necessary to present a fair statement of interim results. Certain prior year amounts have been reclassified to conform with current year presentation. The consolidated financial statements include the accounts of Financial Industries Corporation ("FIC") and its wholly-owned subsidiaries. All significant intercompany items and transactions have been eliminated. Other Comprehensive Income The following is a reconciliation of the change in accumulated other comprehensive income from December 31, 2002 to March 31, 2003 (in thousands): Net (unrealized) gain Total (loss) on accu- investments Net mulated in fixed apprecia- other maturities tion compre- available of equity hensive for sale securities Other Income Balance at December 31, 2002 $ 6,601 $ (20) $ (1,632) $ 4,949 Current Period Change (1,830) (148) 0 (1,978) Balance at March 31, 2003 $ 4,771 $ (168) $ (1,632) $ 2,971 - 10 - Earnings Per Share: The following table reflects the calculation of basic and diluted earnings per share: March 31, 2003 2002 Restated (Amounts in thousands, except per share amounts) BASIC: Net (loss) income available to common shareholders (1,265) 11,011 Weighted average common shares outstanding 9,602 9,500 Basic earnings per share (0.13) 1.16 DILUTED: Net (loss) income available to common shareholders (1,265) 11,011 Weighted average common shares outstanding 9,602 9,500 Common stock options 0 318 Repurchase of treasury stock 0 (243) Common stock and common stock equivalents 9,602 9,575 Diluted earnings per share (0.13) 1.15 Options to purchase 206,650 shares of common stock at prices ranging from $8.18 to $14.30 were outstanding at March 31, 2003, 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. Stock Option Plans and Other Equity Incentive Plans 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. - 11 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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 three months ended March 31: 2003 2002 RESTATED Net (loss) income as reported $ (1,265) $ 11,011 Pro forma compensation expense, net of tax benefits 0 37 Pro forma net (loss) income $ (1,265) $ 10,974 Net (loss) income per share: Basic as reported $ (0.13) $ 1.16 Diluted as reported $ (0.13) $ 1.15 Basic - Pro Forma $ (0.13) $ 1.16 Diluted - Pro Forma $ (0.13) $ 1.15 Dividends Declared 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 Trading Securities FIC's trading securities consist of Collateralized Mortgage Obligations ("CMO's") of the type which are generally referred to as "inverse floaters" which have coupon rates that vary in an inverse relationship with a specified benchmark rate. The value of FIC's trading securities as of March 31, 2003 was $20.1 million. The change in the market value of trading securities during the period is included in net realized investment gains on the income statement. The change in market value included in income during the three months ended March 31, 2003 is $5,000. FIC did not have any trading securities at December 31, 2002. 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. - 12 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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. Among other changes, this Statement rescinds FASB Statement No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and SFAS Statement 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, the adoption of which did not materially 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. 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 SFAS No. 146 did not 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 prescribes a specific tabular format for the pro forma disclosures required by SFAS No. 123 and requires their disclosure in the "Summary of Significant Accounting Policies" or its equivalent. In addition, SFAS No. 148 requires inclusion of these pro forma disclosures 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. - 13 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". This statement amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," for decisions made (1) as part of the FASB's Derivatives Implementation Group process that effectively required amendments to SFAS No. 133, (2) in connection with other FASB projects dealing with financial instruments, and (3) in connection with implementation issues raised in relation to the application of the definition of a derivative. The adoption of SFAS No. 149 is not expected to materially affect FIC's results of operations, liquidity or financial position. - 14 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Restatement The financial statements as of and for the three month period ended March 31, 2002 have been restated. 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 and previously reported unaudited quarterly financial data were restated for the following items: 1. Family Life (a wholly owned subsidiary of the Company) 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 ha 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. - 15 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSULIDATED FINANCIAL STATEMENTS (UNAUDITED) 8. InterContinental Life Corporation ("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 upon FIC's acquisition of ILCO's remaining outstanding shares. ILCO's financial statements also 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. - 16 - FINANCIAL INDUSTRIES CORPORATION AN NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Net income for the three months ended March 31, 2002 was decreased from amounts previously reported by $5,873,000 as a result of the restatement, as follows (in thousands except per share data): Three Months Three Months Ended Ended March 31, 2002 March 31, 2002 As Previously As Restated Reported Net income before cumulative effect of change in accounting principle $ 1,157 $ 582 Cumulative effect of change in accounting principle $ 15,727 $ 10,429 Net income $ 16,884 $ 11,011 Basic earnings per share: Net income before cumulative effect of change in accounting principle $ 0.12 $ 0.06 Cumulative effect of change in accounting principle 1.66 1.10 Net income $ 1.78 $ 1.16 Diluted earnings per share: Net income before cumulative effect of change in accounting principle $ 0.12 $ 0.06 Cumulative effect of change in accounting principle 1.64 1.09 Net income $ 1.76 $ 1.15 - 17 - The change in net income for the three months ended March 31, 2002 was due to the following adjustments that increased (decreased) net income (in thousands): Three Months Ended March 31, 2002 Premiums $ 1 Policyholder benefits and expenses (584) Amortization of present value of future profits (15) Amortization of deferred policy acquisition costs (86) Provision for uncollectible receivables (200) Provision for deferred federal income taxes 309 Cumulative effect of change in accounting principle (5,298) Net income $ (5,873) - 18 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) A summary of the effects of the restatement on the Company's consolidated balance sheet as of March 31, 2002 is as follows (in thousands): As Previously As Reported Restated ASSETS Equity securities $ 48 $ 8,346 Invested real estate 64,029 67,049 Total Investments 739,454 750,772 Agency advances and other receivables 30,072 16,224 Property and equipment, net 3,576 798 Deferred policy acquisition costs 81,191 77,952 Present value of future profits of acquired businesses 30,590 29,854 Other assets 17,553 18,676 Separate account assets 388,480 380,714 Total Assets $ 1,359,257 $ 1,343,331 LIABILITIES AND SHAREHOLDERS' EQUITY Deferred federal income taxes 29,090 24,051 Other liabilities 9,283 17,322 Total liabilities 1,165,873 1,168,872 Accumulated other comprehensive income (441) (2,424) Retained earnings 148,345 131,403 Total shareholders' equity before treasury stock 215,741 196,816 Total shareholders' equity 193,384 174,459 Total liabilities and share- holders' equity $ 1,359,257 $ 1,343,331 - 19 - The consolidated balance sheet as of March 31, 2002 was restated to reflect the following: * An increase of $8.3 million in FIC's investments in equity securities to properly reflect the market value of the Company's investment in the separate account; * An increase $3.0 million in invested real estate primarily due to a reclassification of certain real estate expenditures that were classified as property and equipment; - 20 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) * A decrease of $13.8 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; * A decrease of $2.8 million in property and equipment primarily due to a reclassification of certain amounts classified as property and equipment to invested real estate and a write-off of assets that had not been depreciated since purchase; * A decrease 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; * A decrease of $736,000 in present value of future profits of acquired businesses due to an adjustment in the calculation of this asset; * An increase of $1.1 million in other assets primarily related to the establishment of unrecorded pre- paid pension assets related to Family Life's and ILCO's pension plans; * A decrease of $7.8 million in separate account assets due to a reclassification of separate account assets to equity securities; * A decrease of $5.0 million in the liability for deferred federal income taxes as a result of the restatement adjustments described herein; * An increase of $8.0 million in 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. * 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 * A decrease in retained earnings of $16.9 million due to the restatement adjustments described herein. - 21 - 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. 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 action 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. Subsequent Events As previously reported in its Annual Report on Form 10-K for the year ended December 31, 2002, the Company filed a lawsuit against 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. Subsequent to the filing of the lawsuit, Mr. Mitte filed a counterclaim against the Company alleging that the Company breached the employment agreement between the Company and Mr. Mitte by refusing to pay Mitte the severance benefits and compensation provided for under the employment agreement and amendment thereto. - 22 - On May 15, 2003, the Company entered into a settlement agreement with the Defendants and Scott Mitte (a director of the Company and the son of Roy Mitte) (the "Mitte Parties"). Under the terms of the agreement the Mitte Parties released the Company from any past, present or future claims which they may have against the Company, including any claims which Roy Mitte may assert under the employment agreement. In addition, the Company agreed to release the Mitte Parties from any past, present or future claims which the Company may have against the Mitte Parties. The settlement provides for payments by the Company to Roy Mitte of $1 million on June 1, 2003, $1 million on June 1, 2004 and $1 million on June 1, 2005, with a provision for acceleration of payments in the event of a change in control. The settlement agreement also includes provisions whereby, the Company agrees (i) to use commercially reasonable efforts to locate a purchaser or purchasers of specified installments over a two year period of the 1,552,206 shares of FIC common stock owned by the Foundation during future periods set forth in the settlement agreement, at a price of $14.64 per share, (ii) to purchase (or, alternatively, locate a purchaser) on or before June 1, 2003 of the 39, 820 shares of FIC common stock owned by Roy Mitte and the 35,502 shares of common stock held in the ESOP account of Roy Mitte, at a price of $14.64 per share. The agreement also includes provisions related to the continuation of health insurance of Roy and Joann Mitte and payment for the cancellation of options held by Roy Mitte to purchase 6,600 shares of FIC common stock. The Company has recognized a charge of $2.9 million (before tax) in the first quarter of 2003 for amounts to be paid under the settlement agreement, representing the discounted amount of the non-interest bearing settlement. As a condition of the obligations of the Company under the settlement agreement, the Mitte Parties agreed to grant a limited proxy to the persons named as proxies by FIC in any proxy statement filed by FIC with the SEC. With respect to the future shareholders meetings, the proxy may be voted "for" all nominees for the Board of Directors named on FIC's proxy statement, "against" any proposal by a person other than FIC for the removal of any members of the Board of Directors, "withheld" as to nominees for the Board of Directors proposed by any person other than FIC and "against" any proposal by any person other than FIC to amend the bylaws or articles of FIC. The proxy also extends to certain matters which may be proposed by FIC at the 2004 annual meeting of shareholders, or any later annual or special meeting, regarding changes in the ownership percentage required in order for a shareholder to call a special meeting of shareholders and the elimination of cumulative voting. The granting of the proxy is generally conditioned upon the performance of the scheduled purchases of the shares of FIC common stock owned by the Foundation. - 23 - Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations The following discussion addresses the financial condition of Financial Industries Corporation ("FIC") as of March 31, 2003, compared with December 31, 2002, and its results of operations for the three months ended March 31, 2003, compared with the same period last year. This discussion should be read in conjunction with Management's Discussion and Analysis included in FIC's 10-K for the year ended December 31, 2002, to which the reader is directed for additional information. Restatement In this Item 2, references to results for the quarter ended March 31, 2002 are to restated results. See the Notes to the Consolidated Financial Statements. Transactions Affecting Comparability of Results of Operations 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 InterContinental Life Corporation ("ILCO") with and into a subsidiary of FIC on May 18, 2001. 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. In the first quarter of 2003, net income was affected by a $2.9 million expense related to the settlement of the litigation between FIC, and Roy F. Mitte (the former Chairman and Chief Executive Officer of the Company), and the Roy F. and Joann Cole Mitte Foundation (see "Subsequent Events", herein, for a further description of this settlement, referred to as the "Mitte Settlement"). Results of Operations - Three Months Ended March 31, 2003 and 2002 For the three-month period ended March 31, 2003, FIC's net loss was ($1.3) million (basic and diluted loss of ($0.13) per common share) on revenues of $29.8 million as compared to net income of $11.0 million (basic earnings of $1.16 per common share, or diluted earnings of $1.15 per common share) on revenues of $32.2 million in the first three months of 2002. Net income for the first three months of 2002, before the cumulative effect of change in accounting principle, was $0.6 million (basic and diluted earnings of $0.06 per common share). - 24 - Revenues. Premium revenues reported for traditional life insurance products are recognized when due. Premium income for the first three months of 2003, net of reinsurance ceded, was $7.9 million, as compared to $9.9 million in the first three months of 2002. This source of revenues is related to the traditional life insurance book of business of FIC's insurance subsidiaries. The level of net collected premiums for traditional life insurance products at Family Life for the three months ending March 31, 2003 was $5.8 million, as compared to $7.4 million in the same period in 2002. The decrease in net collected premium is attributable to the decrease in the traditional life insurance book of business. Income from universal life and annuity charges for the first three months of 2003 was $10.6 million, as compared to $10.8 million in the same period of 2002. The face amount of in force universal life policies was $5,210 million at March 31, 2002 as compared to $4,897 million at March 31, 2003. Net investment income for the first three months of 2003 was $9.0 million as compared to $10.4 million in the same period of 2002. Net investment income 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. Real estate income was $288,000 for the three-month period ended March 31, 2003, as compared to $613,000 for the same period in 2002. The decrease in real estate income from the three months ended March 31, 2002 to the same period ended March 31, 2003 is due to the completion of the remainder of the buildings in River Place Pointe and the related expenses and depreciation of those buildings. Net realized investment gains were $1.6 million in the first three months of 2003, as compared to $0.001 million in the first three months of 2002. Benefits and Expenses. Policyholder benefits and expenses were $9.8 million in the first three months of 2003, as compared to $10.9 million in the first three months of 2002. The decrease in policyholder benefits and expenses was primarily attributable to a decrease in reserves of $1.8 million offset by an increase in death benefits of $0.8 million. Interest expense on contract holders deposit funds was $7.3 million in the first three months of 2003, as compared to $8.0 million in the same period of the year 2002. This expense is related to payment of interest to policyholders for cash values accumulated in their accounts. This decrease was due primary to the lowering of credited rates on these accounts - 25 - 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 $2.6 million in the first three months of 2003, as compared to $2.0 million in the first three months of 2002. The amount not capitalized was recorded as an expense in the first quarter. See "Critical Accounting Policies, Deferred Policy 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. In the first three months of 2003, the expense related to the amortization of present value of future profits of acquired business was $1.1 million as compared to $1.1 million in the first three months of 2002. Operating expenses for the first three months of 2003 were $10.8 million, as compared to $9.1 million in the first three months of 2002. The level of operating expenses for the three month period ending March 31, 2003 included: (i) expenses related to acquiring new business; (ii) $2.9 million related to the Mitte Settlement (see "Subsequent Events" for a further discussion of the Mitte Settlement); (iii) legal expenses related to litigation and proxy matters; and (iv) fees paid to Salomon Smith Barney related to the matter set forth in the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission on January 28, 2003. The provision for federal income taxes was ($0.7) million in the first three months of 2003 as compared to $0.6 million in the first three months of 2002. The decrease was due to the decrease in income for the three month period ended March 31, 2003 compared to the same period in 2002. 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") and Investors Life Insurance Company of North America ("Investors Life"). 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. 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. Neither Investors Life nor Family Life paid any dividends during the first quarter of 2003. For the three month period ended March 31, 2003, Investors Life had earned surplus of $26.2 million and a net loss from operations of $0.6 million, and Family Life ad earned surplus of $2.2 million and a net gain from operations of $0.1 million. - 26 - 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 March 31, 2003 was $16.7 million as compared to $25.0 million at December 31, 2002. The $8.3 million decrease in cash and cash equivalents at March 31, 2003 from December 31, 2002 was due primarily to reinvestment of cash into purchases of intermediate-and long-term bonds. Cash and cash equivalents at March 31, 2002 was $9.8 million. The increase in cash from March 31, 2002 to March 31, 2003 was primarily attributable to maturities and early redemptions of fixed income investments which resulted in an increased cash position pending reinvestments. FIC's net cash flow used in operating activities was $20.1 million for the three month period ending March 31, 2003, as compared to $8.3 million used in operating activities for the same period in the year 2002. The increase in cash used in operating activities of $11.8 million from 2002 to 2003 was primarily attributable to $20.1 million of net activity from trading securities in the three-month period ending March 31, 2003, which was offset by changes in other assets and policy liabilities and accruals. Net cash flow provided by investing activities was $16.1 million in the three month period ending March 31, 2003, as compared to $11.3 million provided by investing activities in the same period of 2002. The $4.8 million increase in cash provided by investing activities in 2003 from 2002 was due primarily to proceeds from calls, maturities and sales of fixed maturities. Net cash flow used in financing activities was $4.2 million in the first three months of 2003, as compared to $0.3 million in the first three months of 2002. The increase in cash used in financing activities of $3.9 million is attributable to a dividend to shareholders of $0.5 million, as well as an increase of contractholder fund withdrawals of $3.8 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 March 31, 2003 were $557.3 million, as compared to $557.5 million at March 31, 2002. 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 March 31, 2003, the bulk of the liabilities for contractholder deposit funds on FIC's balance sheet, $415.9 million, were related to insurance products, as compared to only $141.4 million of annuity product liabilities. - 27 - 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 March 31, 2003, the investment portfolio of Investors Life included $21.5 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 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 $1,336,458; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note is 9%, and (b) the $4.5 million note provides for quarterly principal payments, in the amount of $200,469; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note is 9%. Due to the merger of InterContinental Life Corporation (which owns 100% of the outstanding stock of Investors Life) with a subsidiary of FIC on May 18, 2001, 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 has reduced the amount of dividends paid to shareholders, discontinued donations to the Roy F. and Joann Cole Mitte Foundation, and implemented plans to streamline the operations of the Company. Because of such review and 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. Investments As of March 31, 2003, FIC's invested assets, excluding separate accounts, $821.5 million, compared to $761.2 million at December 31, 2002. The increase is primarily attributable to a $20 million increase in trading securities and an increase in fixed maturities available for sale of $45.1 million. There are no significant differences between the portfolio composition as of March 31, 2003 as compared to December 31, 2002 other than the addition of trading securities, which compromise 2.44% of the investment portfolio at March 31, 2003 as compared to 0% at December 31, 2003. - 28 - The assets held by 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. FIC 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. 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 $22,094 of invested assets as of March 31, 2003 and $26,049 of invested assets at December 31, 2002. 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 March 31, 2003, the market value of fixed maturities available for sale was $538.9 million as compared to an amortized cost of $528.4 million or an unrealized gain of $10.5 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, 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. The investments of FIC's insurance subsidiaries in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $223.2 million as of March 31, 2003 as compared to $175.4 million at December 31, 2002, and mortgage-backed pass-through securities of $66.8 million as of March 31, 2003 and $29.6 million at December 31, 2002. Mortgage-backed pass- through securities, sequential CMO's and support bonds, which comprised approximately 52.9% of the book value of FIC's mortgage-backed securities at March 31, 2003, 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 March 31, 2003, PAC and TAC instruments and scheduled bonds represented approximately 32.8% of the book value of FIC's mortgage-backed securities. Sequential and support classes represented approximately 14.3% of the book value of FIC's mortgage-backed securities at March 31, 2003. Additionally, the insurance subsidiaries make 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 - 29 - which varies in an inverse relationship with a specified benchmark interest rate. The 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 March 31, 2003, 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. Trading Securities FIC's trading securities consist of CMOs of the type which are generally referred to as "inverse floaters" which have coupon rates that vary in an inverse relationship with a specified benchmark rate. The value of FIC's trading securities as of March 31, 2003 was $20.1 million. The change in the market value of trading securities during the period is included in net realized investment gains on the income statement. The change in market value included in income during the three months ended March 31, 2003 is $5,000. FIC did not have any trading securities at December 31, 2002. Equity Securities FIC's equity securities consist primarily of its investment in the separate account of Investors Life. As of March 31, 2003, the market value of FIC's equity securities was $6.1 million, as compared to $6.4 million at December 31, 2002. The decrease is related to a decline in the value of the underlying funds in the separate account. Policy Loans Policy loans totaled $45.9 million at March 31, 2003, as compared to $46.6 million at December 31, 2002. - 30 - Mortgage Loans As of March 31, 2003, $7,000 was invested in mortgage loans, as compared to $17,000 at December 31, 2002. The Company does not make new mortgage loans on commercial properties. Real Estate Invested real estate at March 31, 2003 was $74.9 million as compared to $75.4 million at December 31, 2002. The real estate investment is primarily related to the development of the River Place Pointe project ("River Place Pointe") by Investors Life. 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 March 31, 2003, Investors Life had invested $93.8 million in the construction of River Place Pointe, of which $19.6 million is recorded on FIC's balance sheet as real estate occupied by the Company. As of March 31, 2003, 226,039.5 rentable square feet of office space was leased to third party tenants and 273,497 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 Austin office market vacancy rate (including sublease space available) was 27.2% as of September 30, 2002, the highest in the nation. 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. Short-term investments FIC's short-term investments consist primarily of U.S. Government bonds. The level of short-term investments at March 31, 2003 was $135.7 million, as compared to $137.9 million as of December 31, 2002. - 31 - 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 and deferred acquisition costs and present value of future profits. For the year 2002, the Company's critical accounting policies also included the cumulative effect of accounting changes regarding the goodwill acquired from the merger with 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 net assets acquired over costs 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 classified as "available for sale" are reported at fair value, with unrealized investment gains and losses, net of income taxes, credited or charged directly to shareholder's equity. Securities classified as trading are reported at fair value with changes in fair value credited or charged directly to income. 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. Deferred Policy Acquisition Costs and Present Value of Future Profits of Acquired Business. The costs of acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are included in 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. Management periodically reviews the assumptions associated with the amortization models prospectively. - 32 - 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. For a further discussion of accounting standards, see New Accounting Pronouncements beginning on page 12, herein. Subsequent Events As previously reported in its Annual Report on Form 10-K for the year ended December 31, 2002, the Company filed a lawsuit against 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. Subsequent to the filing of the lawsuit, Mr. Mitte filed a counterclaim against the Company alleging that the Company breached the employment agreement between the Company and Mr. Mitte by refusing to pay Mitte the severance benefits and compensation provided for under the employment agreement and amendment thereto. On May 15, 2003, the Company entered into a settlement agreement with the Defendants and Scott Mitte (a director of the Company and the son of Roy Mitte) (the "Mitte Parties"). Under the terms of the agreement the Mitte Parties released the Company from any past, present or future claims which they may have against the Company, including any claims which Roy Mitte may assert under the employment agreement. In addition, the Company agreed to release the Mitte Parties from any past, present or future claims which the Company may have against the Mitte Parties. The settlement provides for payments by the Company to Roy Mitte of $1 million on June 1, 2003, $1 million on June 1, 2004 and $1 million on June 1, 2005, with a provision for acceleration of payments in the event of a change in control. The settlement agreement also includes provisions whereby, the Company agrees (i) to use commercially reasonable efforts to locate a purchaser or purchasers of specified installments over a two year period of the 1,552,206 shares of FIC common stock owned by the Foundation during future periods set forth in the settlement agreement, at a price of $14.64 per share, (ii) to purchase (or, alternatively, locate a purchaser) on or before June 1, 2003 of the 39, 820 shares of FIC common stock owned by Roy Mitte and the 35,502 shares of common stock held in the ESOP account of Roy Mitte, at a price of $14.64 per share. The agreement also includes provisions related to the continuation of health insurance of Roy and Joann Mitte and payment for the cancellation of options held by Roy Mitte to purchase 6,600 shares of FIC common stock. The Company has recognized a charge of $2.9 million (before tax) in the first quarter of 2003 for amounts to be paid under the settlement agreement, representing the discounted amount of the non- interest bearing settlement. - 33 - As a condition of the obligations of the Company under the settlement agreement, the Mitte Parties agreed to grant a limited proxy to the persons named as proxies by FIC in any proxy statement filed by FIC with the SEC. With respect to the future shareholders meetings, the proxy may be voted "for" all nominees for the Board of Directors named on FIC's proxy statement, "against" any proposal by a person other than FIC for the removal of any members of the Board of Directors, "withheld" as to nominees for the Board of Directors proposed by any person other than FIC and "against" any proposal by any person other than FIC to amend the bylaws or articles of FIC. The proxy also extends to certain matters which may be proposed by FIC at the 2004 annual meeting of shareholders, or any later annual or special meeting, regarding changes in the ownership percentage required in order for a shareholder to call a special meeting of shareholders and the elimination of cumulative voting. The granting of the proxy is generally conditioned upon the performance of the scheduled purchases of the shares of FIC common stock owned by the Foundation. A copy of the settlement agreement is attached hereto as an exhibit. Item 3. Quantitative and Qualitative Disclosures About Market Risk General. FIC's principal assets are financial instruments, which are subject to market risks. Market risk is the risk of loss arising from adverse changes in market rates, principally interest rates on fixed rate investments. For a discussion of the Company's investment portfolio and the management of that portfolio to reflect the nature of the underlying insurance obligations of the Company's insurance subsidiaries, please refer to the information set forth in "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 that 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 that 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's investment portfolio includes $20.1 million of "inverse floater" CMOs. These contain a derivative which is "embedded" in the financial instrument. Changes in the market value of the entire securities, including the embedded derivatives, are recorded in the income statement each period as these securities have been classified as trading securities. - 34 - 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 $24.4 million at March 31, 2003 and $16.6 million at December 31, 2002. For purposes of the foregoing estimate, fixed maturities, including fixed maturities available for sale and trading securities, and short-term investments were taken into account. The market value of such assets was $694.7 million at March 31, 2003 and $632.8 million at December 31, 2002. The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $290.0 million at March 31, 2003 and $205.4 million at December 31, 2002. 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 $9.9 million at March 31, 2003 and $4.7 million at December 31, 2002. Separate account assets have not been included, since gains and losses on those assets generally accrue to the policyholders. The Company generally does not use derivative financial instruments to manage our exposure to fluctuations in interest rates. However, the Company's investments in inverse floater CMO's at March 31, 2003 described above have a coupon rate which varies in an inverse relationship with a specified benchmark rate. 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 4. Controls and Procedures 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 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. - 35 - 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 II. Other Information Item 1. Legal Proceedings The Company and its subsidiaries are defendants in certain legal actions related to the normal business operations of the Company. Management believes that the resolution of such legal actions will not have a material impact on the financial statements. Litigation Relating to the FIC/ ILCO Merger. There have been no material developments since the Company's filing of its Annual Report on Form 10-K for the year ended December 31, 2002. Litigation Relating to Former Chairman and CEO. For an update of material developments which have occurred since the Company's filing of its Annual Report on Form 10-K for the year ended December 31, 2002, see "Part I. - Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations - Subsequent Events". 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 2. Changes in Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None - 36 - Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the first quarter of 2003. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 99.1 Certification of Chief Executive Officer of FIC pursuant to 18 U.S.C. Section 1350. 99.2 Certification of Chief Financial Officer of FIC pursuant to 18 U.S.C. Section 1350. 10.1 Compromise Settlement Agreement and Mutual Release in the litigation entitled Financial Industries Corporation v. The Roy F. and Joann Cole Mitte Foundation, Roy F. Mitte, and Joann Cole Mitte, Civil Action No. A03 CA 033 SS, in the United States District Court for the Western District of Texas, Austin Division. (b) Reports on Form 8-K (i) On January 28, 2003, the Registrant filed a Current Report on Form 8-K. The current report referred to a press release issued January 27, 2002 by the Company, which announced that the Company had retained Salomon Smith Barney to explore strategic alternatives for the Company, including continuing the business plan of new management, consideration of a proposal to purchase some or all of FIC's outstanding stock, the sale, merger or consolidation of the Company, or any other alternatives that Salomon believed should be considered. (ii) On February 3, 2003, the Registrant filed a Current Report on Form 8-K. The current report referred to a press release issued January 31, 2002 by the Company, which announced plans to implement new technology projects. - 37 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FINANCIAL INDUSTRIES CORPORATION /s/ Eugene E. Payne _____________________________________ Eugene E. Payne President and Chief Executive Officer /s/ George M. Wise, III _____________________________________ George M. Wise, III Chief Financial Officer Date: May 15, 2003 - 38 - CERTIFICATION I, Eugene E. Payne, Chief Executive Officer of Financial Industries Corporation ("FIC"), certify that: 1. I have reviewed this quarterly report on Form 10-Q of FIC; 2. Based on my knowledge, this quarterly 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 quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly 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 quarterly 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 quarterly 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 quarterly report (the "Evaluation Date"); and c) presented in this quarterly 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): - 39 - 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 6. The Registrant's other certifying officers and I have indicated in this quarterly report whether or not 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: May 15, 2003 By:/s/ Eugene E. Payne ________________________________ Eugene E. Payne Chief Executive Officer - 40 - CERTIFICATION I, George M. Wise, III, Chief Financial Officer of Financial Industries Corporation ("FIC"), certify that: 1. I have reviewed this quarterly report on Form 10-Q of FIC; 2. Based on my knowledge, this quarterly 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 quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly 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 quarterly 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 quarterly 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 quarterly report (the "Evaluation Date"); and c) presented in this quarterly 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): - 41 - 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 6. The Registrant's other certifying officers and I have indicated in this quarterly report whether or not 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: May 15, 2003 By: /s/ George M. Wise, III _____________________________ George M. Wise, III Chief Financial Officer - 42 - EX-99.A9 3 eep906cert-2003.txt EUGENE E. PAYNE'S 906 CERTIFICATION EXHIBIT 99.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER OF FINANCIAL INDUSTRIES CORPORATION 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 Quarterly Report of Financial Industries Corporation ("FIC") on Form 10- Q for the quarter ended March 31, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Eugene E. Payne, Chief Executive 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 the best of my 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 _____________________________ Eugene E. Payne Chief Executive Officer Date: May 15, 2003 EX-99.A9 4 gmw906cert-2003.txt GEORGE M. WISE, III 906 CERTIFICATION EXHIBIT 99.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER OF FINANCIAL INDUSTRIES CORPORATION 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 Quarterly Report of Financial Industries Corporation ("FIC") on Form 10- Q for the quarter ended March 31, 2003, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, 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 the best of my 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/ George M. Wise, III _____________________________ George M. Wise, III Chief Financial Officer Date: May 15, 2003 -----END PRIVACY-ENHANCED MESSAGE-----