-----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, V1Jkvax3frG1TBduFUxN7lzXQAWyRnorYXDlNu8GE2EeaZhzbHPHYWo3oFUxVfr7 TD6eRgjCK2b4Vc3JjxtI3w== 0000050982-99-000035.txt : 19990402 0000050982-99-000035.hdr.sgml : 19990402 ACCESSION NUMBER: 0000050982-99-000035 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 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-K SEC ACT: SEC FILE NUMBER: 000-04690 FILM NUMBER: 99580654 BUSINESS ADDRESS: STREET 1: THE AUSTIN CENTER STREET 2: 701 BRAZOS 12TH FL CITY: AUSTIN STATE: TX ZIP: 78701 BUSINESS PHONE: 5124045050 MAIL ADDRESS: STREET 1: 701 BRAZOS 12TH FL CITY: AUSTIN STATE: TX ZIP: 78701 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-K 1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED) For the fiscal year ended December 31, 1998 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from to 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) 701 Brazos, Suite 1400, Austin, Texas 78701 (Address of Principal Executive Offices) (Zip Code) (512) 404-5050 (Registrant's Telephone Number) 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 The aggregate market value of the voting stock held by non-affiliates of the Registrant on March 15, 1999, based on the closing sales price in The Nasdaq Small-Cap Market ($13.75 per share), was $46,073,431. The number of shares outstanding of Registrant's common stock on March 15, 1999 was 5,054,661. 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. [ ] DOCUMENTS INCORPORATED BY REFERENCE: A. Reports on Form 10-K of InterContinental Life Corporation for the fiscal years ended December 31, 1998, 1997 and 1996 are hereby incorporated by reference. -2- 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 100% of Family Life Insurance Company ("Family Life") and its approximately 45% interest in InterContinental Life Corporation ("ILCO"). The Registrant was organized as an Ohio corporation in 1968 and was reincorporated in Texas in 1980. Its executive offices are located at 701 Brazos, Suite 1400, Austin, Texas 78701. Through 1984, FIC's principal business was the sale and underwriting of life and health insurance, mainly in the midwestern and southwestern United States. In 1985, FIC acquired control of ILCO. FIC, ILCO and their insurance subsidiaries have substantially identical managements. Officers allocate their time between FIC and ILCO in accordance with the comparative requirements of both companies and their subsidiaries. Roy F. Mitte, Chairman, President and Chief Executive Officer of FIC, ILCO and their insurance subsidiaries, is the owner, directly and beneficially, of approximately 29.54% of the outstanding shares of FIC's common stock. Acquisitions Strategy. The Company's 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 is generally less likely to terminate, making possible more predictable profit analysis. However, Family Life does continue to market those products that are profitable, as well as develop new products and streamline distribution channels. See "Agency Operations". It is also management's belief that the continuing consolidation in the life insurance industry presents attractive opportunities for the Company to acquire life insurance companies that complement 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 benefitting from economies of scale. FIC's ability to make future acquisitions will be dependent on its being able to obtain the necessary financing. In addition, since ILCO has the same acquisition strategy as FIC, a conflict of interest could arise in the future between FIC and ILCO with respect to acquisition opportunities. -3- Acquisition of ILCO. In January 1985, FIC acquired 26.53% of ILCO's Common Stock. FIC and Family Life subsequently acquired additional shares of ILCO's Common Stock and as of March 15, 1999, FIC owned, directly and indirectly through Family Life, approximately 45% of the outstanding shares of ILCO's Common Stock. Prior to September 30, 1998, FIC held options to acquire up to 1,702,155 additional shares of ILCO's Common Stock. The consideration for the options, which were granted in 1986, was FIC's granting to ILCO a loan in the principal amount of $1.2 million, FIC's agreement to guarantee future loan obligations of ILCO and FIC's agreement to guarantee ILCO's lease obligation on its headquarters building upon demand. As described under the heading "The ILCO Senior Loan", the Senior Loan of ILCO was fully repaid on September 30, 1998. Accordingly, FIC's rights under the 1986 option agreement expired on September 30, 1998. Acquisition of Family Life. FIC acquired Family Life from Merrill Lynch Insurance Group, Inc. on June 12, 1991. The consideration for the purchase was $114 million consisting of a cash payment of $70 million and $44 million of subordinated promissory notes issued by subsidiaries of FIC to the seller and its affiliates. 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 Family Life Insurance Company". ILCO's Acquisitions In November 1986, ILCO acquired Standard Life Insurance Company ("Standard Life"), headquartered in Jackson, Mississippi, for a gross purchase price of $54.5 million. A portion of the funds used by the new life insurance company formed by ILCO to make the acquisition ("New Standard") was the proceeds of a loan extended to the Company by a national bank in the principal amount of $15.0 million (the "Standard Term Loan"). This sum was, in turn, loaned by ILCO to New Standard, and the loan was evidenced by a surplus debenture. New Standard was merged into Standard Life in June 1988. In December 1988, ILCO, through Standard Life, purchased Investors Life Insurance Company of California ("Investors-CA") and Investors Life Insurance Company of North America ("Investors- NA") from CIGNA Corporation for a purchase price of $140 million. ILCO obtained the funds used for the acquisition from: (a) a Senior Loan in the amount of $125.0 million provided by six financial institutions, (b) a $10.0 million subordinated loan provided by two insurance and financial service organizations and (c) the sale of $5.0 million of Class A Preferred Stock to CIGNA and $15.0 million of Class B Preferred Stock to the subordinated lenders. Approximately $15.0 million of these funds were used to discharge the Standard Term Loan. The balance of these funds were loaned by ILCO to Standard Life. To evidence this indebtedness, Standard Life issued a $140.0 million surplus debenture to ILCO. In connection with the subordinated debt and preferred stock financing, ILCO issued detachable warrants entitling the holders to purchase 1,107,480 shares of ILCO's Common Stock at $3.33 per share. -4- In May 1990, ILCO effected an exchange agreement with the holders of its Class A Preferred Stock and its Class B Preferred Stock. Under the provisions of the exchange agreement, the holders of the Class A Preferred Stock received $5 million principal amount of a 13.25% 1998 Series Subordinate Notes, due November 1, 1998, together with a make whole amount equal to 13.25% of the then outstanding balance of the Note. The holders of the Class B Preferred Stock received $15 million principal amount of a 13.25% 1999 Series Subordinated Notes, due November 1, 1999. ILCO prepaid the subordinated debt and purchased the warrants in early 1993. See "The ILCO Senior Loan". In February, 1995, ILCO, through Investors-NA, 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"). 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. In connection with this transaction, the bank group participating in the ILCO Senior Loan agreed to defer payment of $4.5 million otherwise payable on April 1, 1997 under the terms of the ILCO Senior Loan, and to reduce the amount of the payment otherwise due on July 1, 1997 by $2.5 million. This deferral resulted in extending the maturity date of the Senior Loan to October 1, 1998. Under the terms of the transaction, State Auto Life was merged into Investors-Indiana. In December, 1997, InterContinental Life Insurance Company ("ILIC") transferred its domicile from New Jersey to Indiana. Following completion of the redomestication, ILIC merged with Investors-Indiana, 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. 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. Business of Family Life Insurance Company Family Life, which was organized in the State of Washington in 1949, specializes in providing mortgage protection life and accidental death insurance and annuity products to mortgage borrowers of financial institutions. Family Life has policies in force with customers of approximately 213 -5- financial institutions, of which approximately 60 actively provide Family Life with regular updating of their lists of borrowers. Family Life's mortgage protection business consists of term and universal life insurance sold to borrowers of mortgage debt, designed to repay the mortgages of policyholders in the event of their death. This business is sold to customers of client financial institutions, usually through a 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. An important feature of the Family Life product is the ability to bill and collect premiums through the policyholder's monthly mortgage payments. Family Life has annuity products and a variety of life insurance products, including decreasing term life insurance, universal life insurance, ten-year level term products, and a whole life insurance product. During 1998, 1997 and 1996, Family Life received statutory premium income from sales of its annuity products and various lines of insurance as follows: $0.1 million , $0.1 million and $0.2 million, respectively, from annuity products; $42.9 million, $45.6 million and $48.3 million, respectively, from individual life; $0.0 million, $0.3 million and $1.0 million, respectively, from individual accident and health; $314,846, $416,870 and $469,327, respectively, from group life and $158,622, $198,911 and $238,128, respectively, from group accident and health. Family Life is licensed to sell mortgage life insurance products in 49 states and the District of Columbia. In 1998, premium income from these products was derived from all states in which Family Life is licensed, with significant amounts derived from Texas (25%), California (24%), and Florida (5%). Family Life's primary distribution channel is its agency force of approximately 574 career agents (at December 31, 1998), who are organized into 24 regions. Most of the career agents sell mortgage life insurance products exclusively for Family Life. The mortgage life insurance business is very fragmented. Family Life believes that it is among the larger writers of agent sold mortgage life insurance in the United States and the only nation-wide agent-sold life insurance company operating through leads from financial institutions. Many of Family Life's competitors are life insurance companies with more resources than Family Life and whose mortgage life insurance business represents only a small portion of their total business. During 1998, Family Life expanded its distribution system, to recruit agents whose product portfolio includes a broader range of life and annuity products, in addition to the traditional mortgage protection life insurance products offered by Family Life. While Family Life's traditional sales force consists of agents who are contracted exclusively with the company, agents who participate in the expanded distribution system may have selling relationships with other insurers in addition to Family Life. During 1999, Family Life expects to recruit 20 to 30 agents for this marketing effort. -6- Consolidation and Administration Following the 1991 acquisition of Family Life by FIC, management integrated the sales, marketing, underwriting, accounting, contract and licensing, investments, personnel, data processing, home office support and other departments of Family Life and the life insurance subsidiaries of ILCO. Management believes this integration has resulted in cost savings for Family Life and ILCO's insurance subsidiaries. During 1992, ILCO's and FIC's insurance operations were centralized at their headquarters in Austin, Texas, with the exception of certain services performed in Seattle, Washington. Management believes that relocating administrative functions to Austin has reduced costs and improved the efficiency of the insurance companies' operations. At December 31, 1998, the number of employees within FIC and its subsidiaries, together with the employees of ILCO's insurance subsidiaries, was approximately 322 . Business of InterContinental Life Corporation ILCO was incorporated in 1969 under the laws of New Jersey. In June, 1997, ILCO transferred its domicile to the State of Texas. Its executive office is located at 701 Brazos, Suite 1400, Austin, Texas 78701. Operations. ILCO has developed management techniques to reduce operating expenses by centralizing, standardizing and more efficiently performing many functions common to most life insurance companies, such as underwriting and policy administration, accounting and financial reporting, marketing, regulatory compliance, actuarial services and asset management. ILCO has selectively recruited personnel in sales, marketing and various administrative departments. ILCO's centralized management techniques resulted in significant employee reductions and expense savings in the life insurance companies acquired by ILCO. During 1998, the general insurance expenses of ILCO's insurance subsidiaries were $15,172,682, as compared to $15,574,265 in 1997 and $12,008,163 in 1996. The level of expenses at the ILCO life companies for the year 1998 was affected by expenses incurred in connection with Year 2000 compliance, as well as the expenses incurred in connection with ILCO's acquisition of Grinnell Life Insurance Company. The increase in 1997, as compared to 1996, resulted primarily from expenses incurred in connection with ILCO's acquisition of State Auto Life in July, 1997 and expenses related to the modification of data processing systems for Year 2000 compliance. Management is committed to maintaining the general insurance expenses of ILCO's insurance subsidiaries at a level which will generate an acceptable level of profitability while maintaining the competitive pricing of their insurance products. -7- Principal Products. ILCO's insurance subsidiaries are engaged primarily in administering existing portfolios of individual life insurance and accident and health insurance policies and annuity products. Approximately 80.6% of the total collected premiums for 1998 were derived from renewal premiums on insurance policies and annuity products sold by ILCO's insurance subsidiaries prior to their acquisition by ILCO. ILCO's insurance subsidiaries are also engaged in marketing and underwriting individual life insurance and annuity products in 49 states and the District of Columbia. These products are marketed through independent, non-exclusive general agents. The products currently being distributed by ILCO's life subsidiaries include several versions of universal life insurance, which provide permanent life insurance which credit company-declared current interest rates. The universal life insurance portfolio of ILCO's insurance subsidiaries consists of flexible premium universal life insurance policies. 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. Direct statutory premiums received from all types of universal life products were $38.9 million in 1998, as compared to $40.6 million in 1997 and $40.6 million in 1996. Investors-NA received reinsurance premiums from Family Life of $2.5 million in 1998, pursuant to the reinsurance agreement for universal life products written by Family Life. In 1998, premium income from all life insurance products was derived from all states in which ILCO's insurance subsidiaries are licensed, with significant amounts derived from Pennsylvania (14%), Ohio (8%) and New Jersey (8%). Two of ILCO's insurance subsidiaries receive premium income from health insurance policies. In 1998, premium income from all health insurance policies was $1.0 million, as compared to $0.9 million in each of 1997 and 1996. As described below, the health insurance business of ILCO's subsidiaries is 100% reinsured with a third party reinsurer. In December, 1997, ILCO'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 insurance policies were assumed by a third party reinsurer. The transfer is effective as of July 1, 1997. The decision to dispose of this book of business was based on ILCO's analysis that the business was not generating targeted profit objectives and that the products were not part of the core business of ILCO's subsidiaries. The sale permits the companies to focus on its primary business - life insurance and annuity sales. In connection with the transaction, the total amount of net reserves transferred by the ILCO subsidiaries was $6,327,504. In addition to the transfer of reserves, ILCO's life companies paid the reinsurer $1,037,150 in connection with the transaction, which amount was accounted for as an expense for the year ended December 31, 1997. In 1997, the transferred business generated approximately $791,000 in annualized premiums for ILCO's life subsidiaries. Investors-NA 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 -8- four different portfolios of Putnam Variable Trust (the "Putnam Fund"), a series fund which is managed by Putnam Investment Management, Inc. Prior to April, 1995, the underlying investment vehicle for the variable annuity contracts was the CIGNA Annuity Funds Group. A substitution of the Putnam Fund for the CIGNA Funds was completed in April, 1995. The plan of substitution was approved by the Securities and Exchange Commission. Following such approval, the plan was submitted to policyholders for approval, which was obtained. As of December 31, 1998, the assets held in the separate account were $51.3 million. During 1998, the premium income realized in connection with these variable annuity policies was $156,419, which was received from existing contract owners. Investors-NA also maintains a closed variable annuity separate account, with approximately $21.6 million of assets as of December 31, 1998. The separate account was closed to new purchases in 1981 as a result of an IRS ruling which adversely affected the status of variable annuity separate accounts which invest in publicly-available mutual funds. The ruling did not adversely affect the status of in-force contracts. During 1997, ILCO's life company subsidiaries expanded their marketing efforts in the fixed annuity market. Direct deposits from the sale of fixed annuity products were $6.14 million in 1998, as compared to $3.5 million in 1997, and $1.7 million in 1996. Investors-NA also received reinsurance premiums from Family Life of $1.7 million in 1998, pursuant to a reinsurance agreement for annuity products between Investors-NA and Family Life Insurance Company. Merger of Insurance Subsidiaries. Investors-NA redomesticated from Pennsylvania to Washington in December of 1992. Investors-CA merged into Investors-NA on December 31, 1992. Standard Life merged into Investors-NA on June 29, 1993. The mergers have achieved cost savings, such as reduced auditing expenses involved in auditing one combined company; the savings of expenses and time resulting from the combined company being examined by one state insurance department (Washington), rather than three (California, Pennsylvania and Mississippi); the reduction in the number of tax returns and other annual filings with 45 states; and smaller annual fees to do business and reduced retaliatory premium taxes in most states. In December, 1997, ILIC transferred its domicile from New Jersey to Indiana. Following completion of the redomestication, ILIC merged with Investors-Indiana, 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. As a result of the merger, Investors-IN is licensed in 44 states. As of December 31, 1998, it had assets of $188.1 million and capital and surplus of $23.1 million. ILCO's management believes that these acquisitions and consolidations have caused a reduction in expense and have further strengthened the financial condition of the combined companies. -9- Investment of Assets The assets held by Family Life and ILCO's life insurance subsidiaries must comply with applicable state insurance laws and regulations pertaining to life insurance companies. The investment portfolios of Family Life and ILCO's life insurance subsidiaries are tailored by their managements to reflect the nature of the insurance obligations, business needs, regulatory requirements and tax considerations relating to the underlying insurance business with respect to such assets. This is particularly the case with respect to interest-sensitive life insurance products, where the investment emphasis is to obtain a targeted margin of profit over the rate of interest credited to policyholders, while endeavoring to minimize the portfolio's exposure to changing interest rates. To reduce the exposure to such rate changes, portfolio investments are selected so that diversity, maturity and liquidity factors approximate the duration of associated policyholder liabilities. The investment objective of Family Life and ILCO's insurance subsidiaries 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. At December 31, 1998, only 1.5 % of ILCO's total assets were invested in mortgage loans or real estate. Non-affiliated corporate debt securities that were non-investment grade represented 0.6% of ILCO's total assets at December 31, 1998. ILCO had investments in debt securities of affiliated companies aggregating approximately $47.6 million as of December 31, 1998. Family Life does not have investments in mortgage loans, real estate, non-investment grade debt securities or affiliates' debt securities. The investments of Family Life and ILCO's insurance subsidiaries in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $28.0 million and $212.1 million, respectively, and mortgage-backed pass-through securities of $5.1 million and $32.1 million, respectively, at December 31, 1998. Mortgage-backed pass-through securities, sequential CMO's and support bonds, which comprised approximately 39.9 % of the book value of FIC's mortgage-backed securities and 42.6% of the book value of ILCO's mortgage-backed securities at December 31, 1998, are sensitive to prepayment and extension risks. ILCO and FIC have reduced the risk of prepayment associated with mortgage-backed securities by investing in planned amortization class ("PAC"), target amortization class ("TAC") instruments, accretion directed bonds 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, 1998, PAC and TAC instruments and accretion directed and scheduled bonds represented approximately 60.1% of the book value of FIC's mortgage-backed securities and approximately 37.8% of the book value of ILCO's mortgage-backed securities. Sequential and support classes represented approximately 24.5% of the book value of FIC's mortgage-backed securities and approximately 34.6% of the book value of ILCO's mortgage-backed securities at December 31, 1998. In addition, FIC and ILCO limit the risk of prepayment of CMOs by not paying a premium for any CMOs. ILCO and FIC do not invest in mortgage-backed securities with increased prepayment risk, such as interest-only stripped pass-through securities and inverse floater bonds. Neither FIC nor ILCO had any z-accrual bonds as of December 31, 1998. The prepayment risk that certain mortgage-backed securities are subject to is prevalent in periods of declining interest -10- 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. Neither FIC nor ILCO made additional investments in CMOs during 1998 and the current investment objectives of both FIC and ILCO do not contemplate additions to the portfolio of CMO investments during 1999. FIC and ILCO do not invest in non-agency mortgage-backed securities, which have a greater credit risk than that of agency mortgage-backed securities. ILCO and FIC do not make new mortgage loans on commercial properties. Substantially all of ILCO's mortgage loans were made by its subsidiaries prior to their acquisition by ILCO. At December 31, 1998, 0.8% of the total book value of mortgage loans held by ILCO had defaulted as to principal or interest for more than 90 days, and none of ILCO's mortgage loans were in foreclosure. During 1998, none of ILCO's mortgage loans were converted to foreclosed real estate or were restructured while ILCO owned them. Family Life does not have any mortgage loans. Another key element of FIC's and ILCO's investment strategy is to avoid large exposure in other investment categories which management believes carry higher credit or liquidity risks, including private placements, partnerships and bank participations. These categories accounted for approximately 0.4% of ILCO's invested assets and none of FIC's invested assets at December 31, 1998. A subsidiary of ILCO, Investors-NA, was the owner and developer of Bridgepoint Square Offices. Following the completion of the construction, the project consisted of four office buildings, with a total rentable space of approximately 364,000 square feet, and two parking garages. Investors-NA purchased the 20 acre tract of land for this complex in January, 1995. At that time, the tract included one completed and fully leased office building, an adjacent parking garage, and sites for three more office buildings and another parking garage. Investors-NA completed construction of the three remaining office buildings and parking garage in 1997. See Item 2. Properties. In May 1996, Family Life Insurance Company ("FLIC"), an indirect, 100% owned subsidiary of FIC, purchased a 7.1 acre tract adjacent to the original Bridgepoint Square tract. This second tract contained one building site and one garage site. In January, 1997, FLIC began construction on a four-story office building, with rentable space of approximately 76,793 square feet, and the parking garage, with 350 parking spaces. In May, 1997, the entire rentable space in the building was leased to a major tenant in the technology business. Construction of the parking garage and the building shell was completed in October, 1997. In November, 1997, Investors-NA and Family Life entered into a sale agreement with an independent third party for the sale of their respective interests in Bridgepoint Square Offices. The transaction, which closed on December 5,1997, was for an aggregate price of $78 million. The sale -11- resulted in a net pre-tax profit to Investors-NA of approximately $14.0 million, and a net pre-tax profit to Family Life of approximately $4.5 million. See Item 2. Properties. In October, 1998, Investors-NA purchased 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-NA has obtained approval of a site plan development proposal for these tracts. The development permit provides for the construction of seven office buildings totaling 600,000 square feet, with associated parking, drives and related improvements. The initial phase of the project ("Phase One") will consist of two office buildings, associated parking and the infrastructure for the entire project. Construction on Phase One began during the first quarter of 1999. FIC and ILCO have established and staffed an investment department, which manages portfolio investments and investment accounting functions for their life insurance subsidiaries. Agency Operations The products of FIC's and ILCO's insurance subsidiaries are marketed and sold through two divisions: A. Investors Life Distribution System The Investors Life Distribution System sells a wide range of life insurance and annuity products through an independent, non-exclusive general agent sales distribution system. The products sold are issued by subsidiary companies of ILCO. All marketing and sales for the Company are directed by the Executive Vice President of Marketing and Sales. The Senior Vice President for Investors Sales directs Regional Vice Presidents who are responsible for the recruitment of general agents and managing general agents for individual insurance sales in the Investors Life Distribution System. B. Family Life Distribution System This nationwide system sells Family Life's products through an exclusive agent force. This agent force sells mortgage protection life insurance and annuity products. The products are sold primarily to middle-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 insure that Family Life lead systems, which had been built from the loan portfolios of each active financial institution, operate at a level that favors both parties. 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). -12- During 1998, Family Life expanded its distribution system, to recruit agents whose product portfolio includes a broader range of life and annuity products, in addition to the traditional mortgage protection life insurance products offered by Family Life. While Family Life's exclusive sales force consists of agents who are contracted exclusively with the company, agents who participate in the expanded distribution system may have selling relationships with other insurers in addition to Family Life. During 1999, Family Life expects to recruit 20-30 agents for this marketing effort. Sales and Marketing for Family Life is directed by the Executive Vice President of Marketing and Sales. Reporting to the Executive Vice President, the Senior Vice President of Marketing heads the Family Life marketing organization which is focused 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. The Senior Vice President for Family Life Sales directs 24 Regional Vice Presidents. The Family Life distribution system consists of 155 District Sales Managers, and 574 active career agents. Data Processing The data processing needs of FIC's and ILCO's insurance subsidiaries are provided to ILCO's and 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 and affiliates, 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. The software programs used by these systems will be affected by what is referred to as the "Year 2000 problem" or "Y2K problem". This refers to the limitations of the programming code in certain existing software programs to recognize date sensitive information as the year 2000 approaches. Unless modified prior to the year 2000, such systems may not properly recognize such information and could generate erroneous data or cause a system to fail to operate properly. In response to the potential operations and policy administration problems caused by the computer calendar change on January 1, 2000, the management of the Company instructed FIC Computer Services, Inc. to analyze its system capabilities and the operational requirements of the Company and its respective subsidiaries and affiliates with respect to the Y2K problem. In 1996, FIC Computer Services, Inc. conducted the analysis of all of the Company's systems. After reviewing that analysis, the Company determined that a plan should be devised to prevent the data processing errors that may be encountered due to the Y2K problem. In November, 1996, a three-year plan outlining a proposed solution (the "Plan") was established and approved by the Company to ensure that all of the data processing systems would be Y2K compliant or converted onto Y2K compliant systems. The Company began the major work under this Plan in 1997 and it is scheduled to be completed by the Fall of 1999. -13- The Company established this Plan because FIC Computer Services, Inc.'s analysis revealed that those systems that are not converted or modified into Y2K compliant systems, may produce policy administration errors as a result of the calendar change, requiring that the life insurance subsidiaries manually administer those policies. This would result in a material increase in administrative costs incurred by the life insurance subsidiaries of both ILCO and FIC. The Company's analysis also indicated that, in addition to potential policy administration errors in the life insurance subsidiaries, any machine which contains a microchip is subject to error due to the Y2K problem. Such an occurrence could not only create errors in the Company's internal systems, but those of the Company's suppliers and service providers. In order to prepare for this contingency, the Plan called for the acquisition of new mainframe hardware and software, and the modification and conversion of our telephones, voice mail and desk-top personal computers. The Plan calls for an upgrade of the Family Life's administrative systems by changing individual lines of computer code in order to modify current operating software such that it will become Y2K compliant. The administrative systems which are not modified will be converted onto the Company's CK/4 System, a system designed to be Y2K compliant according to the representations of the vendor. Under the Plan, FIC Computer Services, Inc. will utilize its own personnel, acquire Y2K compliant operating software, and engage the assistance of outside consultants to facilitate the systems conversions and modifications. The Company is in the process of this systems conversion and anticipates that the project will be completed in advance of the year 2000. The Company has increased the budget for the implementation and completion of the Plan from the prior years estimate. As of December 31, 1997, the Company had budgeted approximately $330,000 for implementing the Plan. Based on its current analysis, the Company expects that the cost of implementing and completing the Plan will result in an after-tax expense of approximately $898,000 for the three-year (1997 - 1999) conversion period. For the twelve month period ended December 31, 1998, the Company has incurred an after tax expense of approximately $289,000 in connection with the completion of the Plan. Between January 1, 1997 and December 31, 1998, the Company has expended approximately 60.3 % of the three-year expected after-tax cost discussed above. In the event that the Plan does not achieve full compliance by the target dates, or if unforeseen matters involving Y2K appear at later dates, the Company will utilize the staff of FIC Computer Services, Inc. to identify and resolve such issues as and if they arise. In order to continuously evaluate the effectiveness of the modifications and conversions made to the various systems, FIC Computer Services, Inc. has acquired testing software to simulate dates on or after January 1, 2000. Additionally, FIC Computer Services, Inc. runs the systems through model office cycles and also conducts visual inspections of screen displays to determine whether the systems are functioning in a Y2K compliant manner. The system which administers a material number of policies for Family Life will be modified rather than converted. The modification of the PMS system (administering approximately 122,000 policies -14- for Family Life) was completed in March, 1998. The conversion of the Cypros AP system (administering approximately 19,550 active policies for Family Life) is scheduled for completion at the end of September, 1999. A non-material number of Family Life policies are administered by systems which also administer policies for ILCO and its subsidiaries. With regard to ILCO and its subsidiaries, the ALIS system (administering approximately 42,280 policies for Investors-NA) was converted to CK/4 in February of 1998. The conversion of the Life 70 system (administering approximately 16,120 active policies for Investors-IN) is scheduled for completion in May, 1999. The modification of the Lifecomm-B system which is responsible for the 18,000 policies assumed after the acquisition of State Auto Life originally scheduled for completion in April, 1999, was completed in February, 1999. The conversion of the Lifecomm-A system (administering approximately 62,410 active policies for Investors-NA) is now scheduled for completion in September of 1999. The various software applications described above are licensed to the Company or its affiliates under agreements which permit the Company's and ILCO's subsidiaries to process business on its computer systems utilizing such software. In 1997, FIC Computer Services, Inc. purchased new mainframe hardware and accompanying operating software, which the vendor has represented to be Y2K compliant. FIC Computer Services, Inc. has completed the installation and testing of such new mainframe hardware and software for compliance with the requirements of the Year 2000 conversion. In addition, FIC Computer Services has purchased certain third-party software which is run on the mainframe. This software has been represented by the vendor as being in compliance with Year 2000 requirements. Testing is currently being done on such third-party software, which testing is expected to be completed by September 1, 1999. The telephone system, which includes both PBX and voice mail systems, has been tested by the maintenance provider for that system and the Company has received assurances that the telephone system is Y2K compliant. With respect to non-centralized systems (i.e., desktop computers), the Company has obtained updated software releases and new hardware designed to be Y2K compliant according to the representations of the vendors. The Company expects that the effort needed to correct for Y2K problems on such systems will be less time intensive than the effort needed to achieve compliance for its centralized systems. The installation of such new PC hardware and software was commenced in early 1999 and is expected to be completed by September 1, 1999. The Company also faces the risk that one or more of its external suppliers of goods or services ("third party providers") will not be in a position to properly interact with the Company due to the inability of such third party provider to resolve its own Y2K issues. Pursuant to the Plan, the Company has completed an inventory of its third party provider relationships. In order to assess the Y2K readiness of such third party providers, the Company has developed and forwarded a detailed questionnaire to such providers. As the responses to the questionnaires are received, the Company will evaluate the overall Y2K readiness of its third party provider relationships. However, the -15- Company does not have sufficient information at the current time to determine whether the computer systems of its third party providers will be in compliance with the Y2K requirements as the year 2000 approaches. In the event that a major administrative system fails to operate properly due to the Y2K problem, or the Company does not complete the necessary systems conversions prior to January 1, 2000, the Company has developed a plan to respond to such a contingency. FIC Computer Services has assigned certain personnel to be members of an emergency response team to resolve Y2K operations problems. Additionally, insurance policies would be administered manually if the necessary systems conversions were not completed prior to January 1, 2000, or subsequent Y2K operations problems persist. Manual policy administration would require additional personnel. If substantial additional personnel become necessary for manual policy administration, the training and salary expenses of such personnel could materially affect the Company's business and results of operations. Competition There are many life and health insurance companies in the United States. Agents placing insurance business with Family Life and ILCO's insurance subsidiaries are compensated on a commission basis. However, some companies pay higher commissions and charge lower premium rates and many companies have more substantial resources than Family Life and ILCO's insurance subsidiaries. The principal cost and competitive factors that affect the ability of Family Life and ILCO'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. Reinsurance and Reserves In accordance with general practices in the insurance industry, Family Life and ILCO'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 Family Life and the ILCO 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 ILCO's insurance subsidiaries offset the expense of writing new business. Family Life generally retains the first $200,000 of risk on the life of any one individual. Investors-IN generally retains the first $60,000 to $100,000 of risk on the life of any individual, depending on the type of coverage being written. Investors-NA generally retains the first $250,000 of risk on the life of any individual. -16- Family Life maintains a bulk reinsurance treaty, under which it reinsured all of its risks under accidental death benefit policies. The treaty was most recently renegotiated with the current reinsurer in January, 1997. As discussed above (see "Principal Products"), in December, 1997, FLIC and ILCO'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 connection with the transaction, the total amount of net reserves transferred by the FLIC was $852,688. In addition to the transfer of reserves, FLIC paid the reinsurer $100,000 in connection with the transaction, which amount was accounted for as an expense for the year ended December 31, 1997. In 1997, the accident and health business generated approximately $735,000 in annualized premiums. In 1995, Family Life (as the ceding company) entered into a reinsurance agreement with Investors- NA (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 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 (as the ceding company) entered into a reinsurance agreement with Investors-NA (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-NA, with Family Life concentrating on the writing of term life insurance products. Although reinsurance does not eliminate the exposure of FIC's and ILCO'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. ILCO's insurance subsidiaries and Family Life carry reserves on their books to meet future obligations under their outstanding insurance policies. Such reserves are believed to be sufficient to meet policy obligations as they mature and are calculated using assumptions for interest, mortality, expenses and withdrawals in effect at the time the policies were issued. Acquisition of Family Life In June, 1991, FIC purchased Family Life, a Washington based life insurance corporation, from Merrill Lynch Insurance Group, Inc. ("Merrill Lynch"). The business of Family Life, as reconstituted for sale, consists principally of the underwriting and sale of life insurance to mortgage borrowers through lending institutions. -17- The consideration for the purchase was $114 million consisting of a cash payment of $70 million and $44 million of subordinated promissory notes issued by subsidiaries of FIC to the seller and its affiliates. To effectuate the transaction, FIC organized two downstream holding companies: Family Life Corporation ("FLC"), and Family Life Insurance Investment Corporation ("FLIIC"). FLIIC was organized as a wholly-owned subsidiary of FIC and, in turn, was issued all of the outstanding shares of FLC. FLC purchased 250,000 shares of common stock, being all of the outstanding shares, of Family Life from Merrill Lynch for an $84 million cash payment (including $14 million that had been borrowed by FLIIC from an affiliate of Merrill Lynch) and a $30 million senior subordinated note. 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 and $14 million principal value of newly issued preferred shares. As part of the financing arrangement, FLC entered into a Senior Loan agreement under which $50 million was provided by a group of banks (the "Family Life Senior Loan"). The balance of the financing consisted of a $30 million subordinated note issued by FLC to Merrill Lynch and $14 million borrowed by FLIIC from an affiliate of Merrill Lynch and evidenced by a subordinated note in the principal amount of $12 million and a subordinated note in the principal amount of $2 million (collectively, the "Merrill Lynch Subordinated Loans") and $25 million lent by two insurance company subsidiaries of ILCO (the "Investors Life Subordinated Loans"). The latter amount was represented by a $22.5 million loan from Investors-NA to FLC and a $2.5 million loan provided directly to FIC by Investors-CA. In addition to the interest provided under the Investors Life Subordinated Loans, Investors-NA and Investors-CA were granted by FIC non-transferable options to purchase, in amounts proportionate to their respective loans, up to a total of 9.9 percent of shares of FIC common stock at a price of $10.50 per share, 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 $34.5 million subordinated loans obtained from Investors-NA, the expiration date of the options was extended to September 12, 2006. For a discussion of the 1996 amendments, please refer to Item 13, Certain Relationships and Related Transactions with Management, above. Of the total $119 million of cash borrowed and notes issued by FIC and its subsidiaries for purposes of the transaction, $114 million constituted the purchase price for Family Life and $5 million was used to pay transaction costs, for working capital and for other related purposes. In connection with the several loans effected for purposes of the transaction, various creditors priorities and normal borrower requirements and restrictions were established and FIC issued its direct guaranty of the respective loans, subject to certain priorities, to the various lending banks, Merrill Lynch and its affiliates, and Investors-NA and Investors-CA. The outstanding shares of common stock of Family -18- Life were also pledged as collateral to the bank lenders and, upon repayment of the bank loan, to Merrill Lynch. The transaction was structured to conform to the requirements of Section 338(h)(10) of the Internal Revenue Code. On July 30, 1993, the Merrill Lynch Subordinated Loans were prepaid. $38 million plus accrued interest was paid to retire the indebtedness, which had a principal balance of approximately $50 million on July 30, 1993. The primary source of the funds used to prepay the Merrill Lynch Subordinated Loans was new subordinated loans totaling $34.5 million that were obtained from Investors-NA. See "The Family Life Refinancing." Family Life Senior and Subordinated Loans Senior Loan. The Senior Loan obligations of FLC were completely paid off on April 17, 1996. During the period that the Senior Loan was in effect, it was a secured and guaranteed five year term loan in the initial principal amount of $50 million. Upon the retirement of the Senior Loan, certain of its provisions were automatically incorporated into the Investors Life Subordinated Loans which are described in the following section. Those provisions include specified events of default, including, but not limited to, failure to pay principal, interest, commitment fees or other amounts payable when due, failure to maintain certain financial covenants, violation of covenants (including covenants with respect to the maintenance of a minimum net worth), material misrepresentations, defaults under other indebtedness, the loss of any license of an insurance subsidiary of FLC which would have a material adverse effect on FLC, defaults under the FIC guaranty agreement, a fine in an amount in excess of $100,000 imposed upon any insurance subsidiary of FLC by any state insurance regulatory agency, changes in ownership or control of FIC by its controlling person, Roy F. Mitte, or in ILCO by FIC and the occurrence of certain events of bankruptcy. In addition, the security interests furnished to the lenders under the Senior Loan were transferred to Investors-NA. The security interests include all of the issued and outstanding shares of preferred stock and common stock of FLC and Family Life and the $97.5 million surplus debenture of Family Life. Investors Life Subordinated Loans. The $22.5 million subordinated senior note issued by FLC to Investors-NA was originally scheduled to mature on June 12, 1998, with principal payments in four equal semi-annual principal installments of $5,625,000 each on December 12, 1996, June 12, 1997, December 12, 1997 and June 12, 1998. Interest is payable semi-annually, at the rate of 11% per annum. Effective as of June 12, 1996, the note was amended to provide for twenty quarterly principal payments, in the amount of $1,125,000 each, to commence on December 12, 1996. The final quarterly principal payment is due on September 12, 2001. The interest rate on the note remains at 11%. The $2.5 million subordinated note issued by FIC to Investors-CA initially provided for interest, payable semi-annually, at the rate of 12% per annum, and its principal was due and payable in full at maturity on June 12, 1998 (the "FIC Note"). As a result of the merger of Investors-CA into -19- Investors-NA, the FIC Note is now owned by Investors-NA. Prior to June 12, 1996, accrued interest on the FIC Note was paid by delivery of additional notes of FIC having terms identical to such original note, including the payment of interest (the "PIK Notes"). Interest payable on and after June 12, 1996 on all of the FIC Note is to be paid in cash. Effective as of June 12, 1996, the FIC Note was amended to provide that the principal balance of the note is to be repaid in twenty quarterly installments of $125,000 each, commencing December 12, 1996 with the final payment due on September 12, 2001. With respect to the PIK Notes, the amendment provided that the principal balance of the notes ($1,977,119) is to be paid in twenty quarterly principal payments, in the amount of $98,855.95 each, commencing December 12, 1996 with the final payment due on September 12, 2001. The interest rate on both the FIC Note and the PIK Notes remained at 12%. The obligors are allowed to prepay the Investors Life Subordinated Loans, in whole or in part, without premium or penalty. During the time that the Senior Loan was outstanding, the Investors Life Subordinated Loans were subordinated to the Senior Loan and constitute a second lien on the pledged collateral subject to the first lien of the Senior Loan. Repayment of FLC's $22.5 million note is also guaranteed by FIC. The Investors Life Subordinated Loan documents specify events of default, including, but not limited to, failure to pay principal, interest or other amounts payable with respect to the Investors Life Subordinated Loan documents when due, violation of covenants in the Investors Life Subordinated Loan documents (including covenants with respect to the maintenance of a minimum net worth), material misrepresentations, defaults under other indebtedness, and the occurrence of certain events of bankruptcy. The Investors Life Subordinated Loan documents also contain various specified negative, affirmative and financial covenants to be performed or observed by FLC, FIC and their subsidiaries. During the period the Senior Loan was outstanding, the covenants in effect under the Investors Life Subordinated Loan documents were less restrictive than the covenants under the Senior Loan documents but become generally equivalent to the Senior Loan restrictions upon the termination of the Senior Loan. On July 30, 1993, Investors-NA loaned $34.5 million to FLC and FLIIC in the form of subordinated notes in connection with the prepayment of the Merrill Lynch Subordinated Loans. See "The Family Life Refinancing." As of December 31, 1998 the outstanding principal balance of the Investors Life Subordinated Loans, including the loans made by Investors-NA in 1993 was $47.65 million. Options. In addition to the interest provided under the Investors Life Subordinated Loans, Investors- NA and Investors-CA were granted by FIC non-transferable options to purchase, in amounts proportionate to their respective loans, up to a total of 9.9 percent of shares of FIC common stock 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 -20- terms of the option provided for their expiration on June 12, 1998, if not previously exercised. In connection with the 1996 amendments to the $34.5 million subordinated loans obtained from Investors-NA, the expiration date of the options was extended to September 12, 2006. The Family Life Refinancing. In July, 1993, the Merrill Lynch Subordinated Loans were prepaid. $38 million plus accrued interest was paid to retire the indebtedness, which had a principal balance of approximately $50 million on July 30, 1993. The primary source of the funds used to prepay the Merrill Lynch Subordinated Loans was new subordinated loans totaling $34.5 million that were obtained from Investors-NA. Prior to the 1996 amendments described below, the principal amount of the new subordinated debt was payable in four equal annual installments in 2000, 2001, 2002 and 2003. The interest rate is 9%. The other terms of the 1993 notes are substantially the same as those of the $22.5 million subordinated loan that Investors-NA had previously made to FLC and that continue to be outstanding. The $34.5 million of new subordinated loans consist of a $30 million loan to FLC and a $4.5 million loan to FLIIC. The debt restructuring reduced the total indebtedness of FLC and FLIIC by approximately $15 million. The transaction resulted in a pre-tax gain of approximately $12 million for the Company in the third quarter of 1993, and the Company estimates that the restructuring of this subordinated debt will result in aggregate interest savings to FLC and FLIIC of approximately $40 million over the next ten years. In recognition of this reduced interest requirement, the interest rate on the surplus debenture of Family Life held by FLC was reduced from 12.5% to 9%. As of June 12, 1996, the provisions of the notes from Investors-NA to FIC, FLC and FLIIC were modified as follows: (a) the $22.5 million note was amended to provide for twenty quarterly principal payments, in the amount of $1,125,000 each, to commence on December 12, 1996; the final quarterly principal payment is due on September 12, 2001; the interest rate on the note remains at 11%, (b) 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%, (c) 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%, (d) the $2.5 million note was amended to provide that the principal balance of the note is to be repaid in twenty quarterly installments of $125,000 each, commencing December 12, 1996 with the final payment due on September 12, 2001; the rate of interest remains at 12%, (e) the Master PIK note, which was issued to provide for the payment in kind of interest due under the terms of the $2.5 million note prior to June 12, 1996, was amended to provide that the principal balance of the note ($1,977,119) is to be paid in twenty quarterly principal payments, in the amount of $98,855.95 each, to commence -21- December 12, 1996 with the final payment due on September 12, 2001; the interest rate on the note remains at 12%. 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. ILCO's Senior Loan ILCO's Senior Loan was fully repaid as of September 30, 1998. During the period that the ILCO Senior Loan was outstanding, FIC guaranteed obligations under the loan documents. The Senior Loan of ILCO was originally arranged in connection with the 1988 acquisition of Investors-NA and Investors-CA. In January, 1993, ILCO refinanced its Senior Loan. That transaction was done in connection with the prepayment of the subordinated indebtedness and the purchase of warrants which had been issued as part of the financing of the 1988 acquisitions. The terms of the amended and restated credit facility were substantially the same as the terms and provisions of the 1988 Senior Loan. The maturity date, which had been December 31, 1996, was extended to July 1, 1998 for the Senior Loan. The average interest rate paid by ILCO on its Senior Loan was approximately 7.76% during 1996, 7.68% during 1997 and 7.63% during 1998. In February, 1995, ILCO borrowed an additional $15 million under the Senior Loan to help finance the acquisition of Meridian Life Insurance Company, and the maturity date of the Senior Loan was further extended to July 1, 1999. As of December 31, 1995, the outstanding principal balance of ILCO's Senior Loan obligations was $59.4 million. In January, 1996, ILCO made a scheduled payment of $4.5 million under its Senior Loan. In March, 1996, ILCO made the scheduled payments for April 1st and July 1st, totaling $9 million. At that same time, ILCO made a payment of $941,000, an additional payment under the terms of the loan applied to the principal balance. On April 1, 1996, an optional principal payment in the amount of $15 million was made, which resulted in advancing the scheduled payoff date of the Senior Loan to April 1, 1998. In July, 1996, ILCO made the principal payment for October 1st ($4.5 million), plus an optional principal payment of $0.5 million. In connection with ILCO's acquisition of State Auto Life Insurance Company in July, 1997, ILCO's Senior Loan agreement was modified to extend the maturity date to October 1, 1998. As of December 31, 1997, the outstanding principal balance of ILCO's senior loan obligations was $11.0 million, which reflected the prepayment by the Company of the payment originally scheduled for January 1, 1998. A regular payment, in the amount of $3.7 million, was made on April 1, 1998 and a prepayment of the July 1, 1998 installment, in the amount of $3.7 million, was made on June 30, 1998. The outstanding principal balance of ILCO's senior loan obligations was $3.6 million at June 30, 1998. The final installment on the senior loan obligation scheduled for October 1, 1998, was prepaid on September 30, 1998. As a result, the senior loan obligation of ILCO was fully discharged effective September 30, 1998. -22- Regulation General. ILCO's insurance subsidiaries and Family Life are subject to regulation and supervision by the states in which they are licensed to do business. Such 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 Family Life and ILCO'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 states of FIC's and ILCO's insurance subsidiaries require that such subsidiaries be examined at specified intervals. Family Life is domiciled in the State of Washington. Investors-NA and Investors-IN are domiciled in the states of Washington and Indiana, respectively. In December 1992, Investors-NA redomesticated from Pennsylvania to Washington, and Investors-CA merged into Investors-NA. In June, 1993, Standard Life merged into Investors-NA. Prior to December, 1997, Investors-IN was domiciled in the State of New Jersey. In December, 1997, Investors-IN transferred its domicile to the State of Indiana. 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, Family Life and ILCO's insurance subsidiaries consider AIDS information in underwriting coverages 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. Effective for the 1993 calendar year, the National Association of Insurance Commissioners ("NAIC") has adopted 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 states will use the RBC formula 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. In addition, the formula 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 consists of its statutory capital, surplus and asset valuation reserve) to its Authorized -23- 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 Family Life and ILCO's insurance subsidiaries as of December 31, 1998 indicate that the Total Adjusted Capital of each of FIC's and ILCO's insurance subsidiaries is above 640% of its respective Authorized Control Level RBC. 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. The net amounts of such assessments for Family Life and ILCO's insurance subsidiaries were approximately ($15,237) and $7,016, respectively, in the year ended December 31, 1998. 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. See "Acquisition of Family Life." The likelihood and amount of any other future assessments cannot be estimated and are beyond the control of FIC and ILCO. Surplus Debentures and Dividends. The principal sources of cash for FLC to make payments of principal and interest on the Family Life Senior Loan are payments under the surplus debenture of Family Life Insurance Company (a Washington-domiciled insurer) and dividends paid by Family Life. Under current Washington law, any proposed payment of a dividend or 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 31 or (ii) statutory net gain from operations for the preceding calendar year is an "extraordinary dividend" and may not be paid until -24- either it has been approved, or a 60-day waiting period shall have passed during which it has not been disapproved, by the Washington Insurance Commissioner. In 1993, Washington amended its insurance code to retain the above-described "greater of" standard for dividends, but enacted requirements that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. Family Life does not presently have earned surplus as defined by the regulations adopted by the Washington Insurance Commissioner and, therefore, is not presently permitted to pay cash dividends. However, since this law applies only to dividend payments, the ability of Family Life to make principal and interest payments under the surplus debenture is not affected. Principal and interest payments on the surplus debenture have provided sufficient funds to meet debt service obligations of FLC. Under the provisions of the surplus debenture and current law, Family Life can pay interest and principal on the surplus debenture without having to obtain the prior approval of the Washington Insurance Commissioner; provided that, after giving effect to the payment of interest or principal on the surplus debenture, the statutory capital and surplus of Family Life exceeds 6% of its assets. Pursuant to the surplus debenture, Family Life paid principal and interest in 1996, 1997 and 1998 totaling $13,526,338, $11,903,287 and $11,564,978, respectively. Family Life does give five-days prior notification to the Washington Insurance Department of each proposed payment on the surplus debenture in accordance with an agreement between Family Life and the Department. The Company does not anticipate that Family Life will have any difficulty in making principal and interest payments on the surplus debenture in the amounts necessary to enable FLC to service its indebtedness for the foreseeable future. Valuation Reserves. Commencing in 1992, the Mandatory Securities Valuation Reserve ("MSVR") required by the NAIC for life insurance companies was replaced by a mandatory Asset Valuation Reserve ("AVR") which is expanded to cover mortgage loans, real estate and other investments. During 1997, a change in the NAIC's AVR procedures resulted in a one-time reduction in the amount of the reserves held by Family Life, with a corresponding one-time increase in the amount of surplus, in the amount of $320,000. A new mandatory 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, is also effective for 1992. Previously, realized capital gains attributable to interest rate changes were credited to the MSVR and had the effect of reducing Family Life's required MSVR contributions. Effective in 1992, such realized capital gains are credited to the IMR. The combination of the AVR and IMR will affect statutory capital and surplus and may reduce the ability of Family Life to pay dividends and make payments on the surplus debenture. Insurance Holding Company Regulation. Family Life is subject to regulation under the insurance and insurance holding company statutes 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 -25- 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. 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 are investigating the current 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. Congress is currently conducting a variety of hearings relating in general to the solvency of insurers. It is not possible to predict the outcome of any such congressional activity nor the potential effects thereof on Family Life. Congressional initiatives directed at repeal of the McCarran-Ferguson Act (which exempts the "business of insurance" from most federal laws, including the antitrust laws, to the extent it is subject to state regulation) and judicial decisions narrowing the definition of "business of insurance" for McCarran-Ferguson Act purposes may limit the ability of insurance companies in general to share information with respect to rate-setting, underwriting and claims management practices. Current and proposed federal measures which may also significantly affect the insurance industry include minimum solvency requirements and removal of barriers preventing banks from engaging in the insurance 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. However, the change will increase the tax for statutory accounting purposes in the first few years, which will reduce statutory surplus and, accordingly, may decrease the amount of cash dividends that Family Life can pay. For the years ended December 31, 1996, 1997 and 1998, the increases (decreases) in Family Life's current income tax provisions, utilizing the effective tax rates, due to this change were $183,358, $136,000 and $89,034, -26- respectively. The change has a negative tax effect for statutory accounting purposes when Family Life's premium income increases, but has a positive tax effect when its premium income decreases. Item 2. Properties The Registrant's headquarters are currently located at Austin Centre, 701 Brazos, Suite 1400, Austin, Texas. A subsidiary of ILCO, Investors-NA, purchased Austin Centre, an office-hotel property in downtown Austin in August 1991 for a purchase price of $31,275,000 from an unrelated seller that had previously acquired the property through foreclosure. Austin Centre covers a full city block and is a sixteen story mixed use development consisting of 343,664 square feet of office/retail space (predominately office space), a 314 room hotel and 61 luxury apartments, all united by a 200 foot high glass atrium. The project was completed in October 1986. In September 1995, Investors-NA entered into a contract to sell Austin Centre to an Austin-based real estate investment firm for a purchase price of $62.675 million, less $1 million to be paid to a capital reserve account for the purchaser. The sale was consummated on March 29, 1996. A portion of the sale proceeds equal to the amount that Investors-NA presently had invested in Austin Centre were retained and reinvested by Investors-NA. The balance of the net proceeds of the sale were used to reduce ILCO's bank indebtedness by approximately $15 million. Following the sale of the Austin Centre, the Company and its affiliates continued to occupy three floors of the office space, under a lease arrangement. The current lease, which was entered into in May, 1997, is for a five (5) year term ending in October, 2002, with options to renew for three successive five (5) year terms thereafter. In January, 1995, ILCO, through Investors-NA, purchased, as an investment property, an office building project known as Bridgepoint Office Square in Austin, Texas for a cash purchase price of $9.75 million. The property consists of 20 acres of land with four office building sites and two parking structure sites. The first phase of development of the property was completed in 1986 and consists of a five-story office building with 83,474 square feet of rentable space and a 550-car parking garage. In the fourth quarter of 1995, construction began on the second office building, containing approximately 109,000 rentable square feet, and the other parking garage containing approximately 871 spaces. That phase of the project was completed in September, 1996. In March, 1996, construction commenced on the third office building, with approximately 79,000 rentable square feet of office space and was completed in December, 1996. Construction began on the fourth building in July 1996, and was completed in July, 1997. The fourth building contains approximately 92,459 rentable square feet. On May 3, 1996, Family Life purchased a tract of land adjoining the Bridgepoint Office Square tract for a cash purchase price of $1.3 million. The property consists of 7.1 acres of land with one office building site and one parking structure site. Family Life began construction of the fifth building -27- (known as "Bridgepoint Five") on the new site in January 1997. In May, 1997, the entire rentable space (approximately 76,793 rentable square feet) contained in the building was leased to a major tenant in the technology business. Construction of the parking garage and the building shell was completed in October, 1997. On November 24, 1997, Investors-NA and Family Life entered into a contract with Health and Retirement Properties Trust, a Maryland real estate investment trust (the "Purchaser") to sell their respective interests in the Bridgepoint Square Office complex. The aggregate purchase price for the project was $78,000,000. The transaction closed on December 5, 1997. The purchase price was allocated approximately 78.5% to Investors-NA and 21.5% to Family Life. The sale of Bridgepoint Office Square resulted in a net profit to Investors-NA of approximately $14.0 million ($9.1 million after tax) that is included in ILCO's fourth quarter earnings for the year 1997. For Family Life, the sale resulted in a net profit of approximately $4.5 million ($3.2 million after tax) that is included in FIC's fourth quarter earnings for the year 1997. Family Life leases its 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 in October, 2001. The base rental is approximately $11,200 per month, which includes Family Life's proportionate share of the building's operating expenses, including 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. 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. ILCO and Investors-NA are defendants in a lawsuit which was filed in October, 1996, in Travis County, Texas. CIGNA Corporation, an unrelated company, is also a named defendant in the lawsuit. The named plaintiffs in the suit (a husband and wife), allege that the universal life insurance policies sold to them by INA Life Insurance Company (a company which was merged into Investors- NA in 1992) utilized unfair sales practices. The named plaintiffs seek reformation of the life insurance contracts and an unspecified amount of damages. The named plaintiffs also seek a class action as to similarly situated individuals. No certification of a class has been granted as of the date hereof. ILCO believes that the suit is without merit and intends to vigorously defend this matter. In August, 1997, another individual filed a similar action in Travis County, Texas against the corporate entities identified above. The lawsuit involves the same type of policy and includes -28- allegations which are substantially identical to the allegations in the first action. The named plaintiff also seeks class certification. ILCO believes that the court would consider class certification with respect to only one of these actions. ILCO also believes that this action is without merit and intends to vigorously defend this matter. 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, 1998 to a vote of security holders. -29- PART II Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters A. Market Information The following table sets forth the quarterly high and low sales prices for FIC Common Stock in The Nasdaq Small-Cap Market for 1998 and 1997. The quotations set forth in the table have been adjusted to give retroactive effect to the five-for-one stock split which was effective November 12, 1996. FIC's NASDAQ trading symbol is FNIN. Common Stock Prices High Low 1998 First Quarter $ 21.25 $ 16.375 Second Quarter 20.50 17.75 Third Quarter 20.25 12.50 Fourth Quarter 19.50 13.625 1997 First Quarter $ 13.25 $ 10.75 Second Quarter 13.25 11.00 Third Quarter 16.25 11.625 Fourth Quarter 20.25 14.75 B. Stockholders As of March 15, 1999 there were approximately 15,650 record holders of FIC Common Stock. C. Dividends FIC has not paid a dividend since 1976 and does not expect to pay a dividend during 1999. 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 operating insurance subsidiary or subsidiaries. The right of Family Life to pay dividends is restricted by the insurance laws of its domiciliary state. See Item 1. Business - - Regulation Surplus Debenture and Dividends. However, FIC does not directly own Family Life's stock but, instead, indirectly owns that stock through a downstream holding company, Family Life Corporation ("FLC"). FLC, which holds all of the stock of Family Life, is prohibited from paying dividends on its common stock by the provisions of the notes from Investors-NA. FIC (as the successor to the obligations of FLIIC under the provisions of the $4.5 million subordinated note held by Investors- NA) the immediate parent of FLC and the directly-owned subsidiary of FIC, is prohibited from paying dividends on its stock by the provisions of the $4.5 million subordinated note. The ability of ILCO to pay dividends to FIC and the other shareholders of ILCO is affected by the receipt of dividends and other payments from its insurance subsidiaries. Item 6. Selected Financial Data: (Registrant and its Consolidated Subsidiaries) (In thousands, except per share data) 1998 1997 1996 1995 1994 Operating Revenues $53,607 $63,343 $59,928 $61,541 $68,524 Income (loss) before federal income tax, equity in net earnings of affiliates 8,973 13,411 9,791 10,394 10,610 Income before equity in net earnings of affiliates 6,605 9,870 7,145 7,966 8,264 Equity in net earnings of affiliate, net of tax 2,613 6,458 9,012 2,051 1,690 Net Income $ 9,218 $ 16,328 $ 16,157 $ 10,017 $ 9,954 Common Stock Equivalents 5,557 5,589 5,568 5,540 5,530 Net income per share Basic $ 1.71 $ 3.01 $ 2.98 $ 1.85 $ 1.83 Diluted $ 1.66 $ 2.92 $ 2.90 $ 1.81 $ 1.80 Total Assets $301,738 $304,324 $287,730 $287,678 $253,100 Long Term Obligations $ 47,645 $ 53,792 $ 59,940 $ 67,989 $ 77,819
-30- Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations For the year ended December 31, 1998, FIC's net income was $9,218,000 (basic earnings of $1.71 per common share or diluted earnings of $1.66 per common share), as compared to $16,328,000 (basic earnings of $3.01 per common share or diluted earnings of $2.92 per common share) for the year ended December 31, 1997 and $16,157,000 (basic earnings of $2.98 per common share or diluted earnings of $2.90 per common share), for the year ended December 31, 1996. Earnings per share are stated in accordance with the requirements of Financial Accounting Standard (FAS) No. 128, which establishes two measures of earnings per share: basic earnings per share and diluted earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect the potential dilution that would occur if securities or other contracts to issue common stock were converted or exercised. For the year 1996, earnings per share have been restated to reflect the effect of FAS No. 128. Results of Operations Net income from continuing operations (excluding the gain resulting from Family Life's sale of its interest in Bridgepoint Square Offices in 1997, ILCO's sale of its interest in Bridgepoint Square Offices in 1997, and ILCO's sale of the Austin Centre in 1996, as described below) was $9,218,000 (basic earnings of $1.71 per common share or diluted earnings of $1.66 per common share) for the year ended December 31, 1998, $9,300,000 (basic earnings of $1.71 per common share or diluted earnings of $1.66 per common share) for the year ended December 31, 1997 and $9,487,000 (basic earnings of $1.75 per common share or diluted earnings of $1.70 per common share) for the year ended December 31, 1996. Net income for the year ended December 31, 1997 includes $3.2 million ($0.57 per common share) resulting from Family Life's sale of its interest in Bridgepoint Square Offices. Family Life purchased undeveloped land at the Bridgepoint site in May, 1996, for a cash purchase price of $1.3 million. The property consists of 7.1 acres of land with one office building site and one parking structure site. Family Life began construction of the building (known as "Bridgepoint Five") in January 1997. In May, 1997, the entire rentable space (approximately 76,793 rentable square feet) contained in the building was leased to a major tenant in the technology business. Construction of the parking garage and the building shell was completed in October, 1997. In November, 1997, Family Life entered into a contract to sell its interest in the Bridgepoint Square Office complex. The sale also included the adjacent properties developed by ILCO's subsidiary, Investors-NA. The aggregate purchase price for the project was $78 million. The transaction closed on December 5, 1997. The purchase price was allocated approximately 78.5% to Investors-NA and 21.5% to Family Life. The sale resulted in a net profit to Family Life of approximately $4.5 million ($3.2 million after tax) that is included in FIC's earnings for the year 1997. -31- FIC's net income is affected by its equity interest in InterContinental Life Corporation ("ILCO") and ILCO's insurance subsidiaries. Net income for the year ended December 31, 1997 includes $3.8 million ($0.68 per common share on a diluted basis) resulting from ILCO's sale of its interest in Bridgepoint Square Offices. Net income for the year ended December 31, 1996 includes $7.1 million resulting from ILCO's sale of the Austin Centre, a hotel/office complex, located in Austin, Texas. The statutory earnings of Family Life as required to be reported to insurance regulatory authorities before interest expense, capital gains and losses, and federal income taxes were $12,930,000 at December 31, 1998, as compared to $13,625,000 at December 31, 1997 and $12,734,000 at December 31, 1996. These statutory earnings are the source to provide for the repayment of the indebtedness incurred in connection with the acquisition of Family Life. The decline in long-term interest rates during 1998, which was related to general economic conditions, had a positive effect upon the market value of the fixed maturities available for sale segment of the Company's portfolio. As of December 31, 1998, the market value of the fixed maturities available for sale segment was $79.4 million as compared to an amortized value of $76.73 million, or an unrealized gain $2.67 million. The net of tax effect of this increase has been recorded as an increase in shareholders' equity. There is no assurance that this unrealized gain may be realized in the future. For the year ended December 31, 1998, FIC's income from operations, before federal income tax and equity in net earnings of affiliate, was $8,973,000 (on revenues of $53,607,000), as compared to $13,411,000 (on revenues of $63,343,000) in the year 1997 and $9,791,000 (on revenues of $59,928,000) for the year 1996. Premiums for the year 1998, net of reinsurance ceded, were $38.4 million, as compared to $40.2 million in 1997 and $43.3 million in 1996. Policyholder benefits and expenses were $16.3 million in 1998, as compared to $19.9 million in 1997 and $22.1 million in 1996. Equity in Net Income of InterContinental Life Corporation General: Prior to the acquisition of Family Life in June of 1991, FIC's primary involvement in the life insurance business was through its equity interest in ILCO. The Company's equity in the net earnings of ILCO, net of federal income tax, was $2,613,000 , as compared to $6,458,000 for the year 1997 and $9,012,000 for the year 1996. The decrease in 1997, as compared to 1996 is primarily attributable to the effect, in 1996, of ILCO's net income resulting from the sale of the Austin Centre property. FIC currently owns 1,795,146 shares of ILCO's common stock. In addition, Family Life currently owns 171,200 shares of ILCO common stock. As a result, FIC currently owns, directly and -32- indirectly through Family Life, 1,966,346 shares (approximately 45%) of ILCO's common stock. Prior to September 30, 1998, FIC held options to acquire 1,702,155 shares of ILCO's common stock. Under the terms of the option agreement, such options continued in effect only as long as FIC guaranteed certain indebtedness of ILCO. Since the Senior Loan of ILCO was fully repaid on September 30, 1998, FIC's rights under the 1986 option agreement expired on September 30, 1998. The decline in long-term interest rates during 1998, which was related to general economic conditions, had a positive effect upon the market value of the fixed maturities available for sale segment of ILCO's investment portfolio. As of December 31, 1998, the market value of the fixed maturities available for sale segment was $450.15 million as compared to an amortized cost of $435.13 million, or an unrealized gain of $15.02 million. There is no assurance that this unrealized gain will be realized by ILCO in the future. Since FIC owns approximately 45% of the common stock of ILCO, such unrealized gains, net of tax, are reflected in FIC's equity interest in ILCO, and had the effect of increasing the reported value of such equity interest by approximately $4.08 million. ILCO's results for 1998 include, for the period beginning on June 30, 1998, the operations of Grinnell Life Insurance Company. Grinnell Life was acquired on June 30, 1998, through a subsidiary of ILCO, 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. Liquidity and Capital Resources of ILCO: ILCO is a holding company whose principal assets consist of the common stock of Investors-NA and its subsidiary, Investors Life Insurance Company of Indiana (formerly InterContinental Life Insurance Company). ILCO's primary source of funds consists of payments under the surplus debentures from Investors-NA. As of December 31, 1997, the outstanding principal balance of ILCO's senior loan obligations was $11.0 million, which reflected the prepayment by the Company of the payment originally scheduled for January 1, 1998. A regular payment, in the amount of $3.7 million, was made on April 1, 1998 and a prepayment of the July 1, 1998 installment, in the amount of $3.7 million, was made on June 30, 1998. The outstanding principal balance of ILCO's senior loan obligations was $3.6 million at June 30, 1998. The final installment on the senior loan obligation scheduled for October 1, 1998, was prepaid on September 30, 1998. As a result, the senior loan obligation of ILCO was fully discharged effective September 30, 1998. ILCO's principal source of liquidity consists of the periodic payment of principal and interest by Investors-NA, pursuant to the terms of the Surplus Debentures. The Surplus Debentures were originally issued by Standard Life Insurance Company and their terms were previously approved by -33- the Mississippi Insurance Commissioner. Upon the merger of Standard Life into Investors-NA, the obligations of the Surplus Debentures were assumed by Investors-NA. As of December 31, 1998, the outstanding principal balance of the Surplus Debentures was $4.5 million and $11.4 million, respectively. Since Investors-NA is domiciled in the State of Washington, the provisions of Washington insurance law apply to the Surplus Debentures. Under the provisions of the Surplus Debentures and current law, no prior approval of the Washington Insurance Commissioner is required for Investors-NA to pay interest or principal on the Surplus Debentures; provided that, after giving effect to such payments, the statutory surplus of Investors-NA is in excess of $10 million (the "surplus floor"). However, Investors-NA has voluntarily agreed with the Washington Insurance Commissioner that it will provide at least five days advance notice of payments which it will make under the surplus debenture. As of December 31, 1998, the statutory surplus of Investors-NA was $68.2 million, an amount substantially in excess of the surplus floor. The funds required by Investors-NA to meet its obligations to the Company under the terms of the Surplus Debentures are derived from operating income generated from insurance and investment operations. In addition to the payments under the terms of the Surplus Debentures, ILCO has received dividends from its life insurance subsidiaries. Washington's insurance code includes the "greater of" standard for payment of dividends to shareholders, but has a requirement that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. As of December 31, 1998, Investors-NA had earned surplus of $39.3 million. Since the law applies only to dividend payments, the ability of Investors-NA to make principal and interest payments under the Surplus Debentures is not affected. ILCO does not anticipate that Investors-NA will have any difficulty in making principal and interest payments on the Surplus Debentures for the foreseeable future. Investors-IN, formerly known as ILIC, is domiciled in the State of Indiana. The transfer of domicile from New Jersey to Indiana was effective December 15, 1997. Under the Indiana insurance code, a domestic insurer may make dividend distributions upon proper notice to the Department of Insurance, as long as the distribution is reasonable in relation to adequate levels of policyholder surplus and quality of earnings. Under Indiana law the dividend must be paid from earned surplus. Extraordinary dividend approval would be required where a dividend exceeds the greater of 10% of surplus or the net gain from operations for the prior fiscal year. Investors-IN had earned surplus of $18.1 million at December 31, 1998. The Form 10-Ks of ILCO for the years ended December 31, 1998, 1997 and 1996, set forth the business operations and financial results of ILCO and its life insurance subsidiaries. Such 10-K reports of ILCO, including the discussion by ILCO's management under the caption "Management's Discussion and Analysis of Financial Conditions and Results of Operations" are incorporated herein by reference. -34- Liquidity and Capital Resources FIC is a holding company whose principal assets consist of the common stock of Family Life and its equity ownership in ILCO. FIC's primary sources of capital consists of cash flow from operations of its subsidiaries and the proceeds from bank and institutional borrowings. The principal source of liquidity for FIC's subsidiaries consists of the periodic payment of principal and interest by Family Life pursuant to the terms of a Surplus Debenture. The terms of the Surplus Debenture were previously approved by the Washington Insurance Commissioner. Under the provisions of the Surplus Debenture and current law, no prior approval of the Washington Insurance Department is required for Family Life to pay interest or principal on the Surplus Debenture; provided that, after giving effect to such payments, the statutory surplus of Family Life is in excess of 6% of assets (the "surplus floor"). However, Family Life has voluntarily agreed with the Washington Insurance Commissioner that it will provide at least five days advance notice of payments which it will make under the surplus debenture. As of December 31, 1998, the statutory capital and surplus of Family Life was $30.3 million, an amount substantially in excess of the surplus floor. During 1998, Family Life made principal payments of $9.0 million and interest payments of $2.6 million to Family Life Corporation under the Surplus Debenture. As of December 31, 1998, the principal balance of the Surplus Debenture was $22.9 million. The funds required by Family Life to meet its obligations under the terms of the Surplus Debenture are generated primarily from premium payments from policyholders, investment income and the proceeds from the sale and redemption of portfolio investments. Washington's insurance code includes the "greater of" standard for dividends but has requirements that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. Family Life does not presently have earned surplus as defined by the regulations adopted by the Washington Insurance Commissioner and, therefore, is not permitted to pay cash dividends. However, since the new law applies only to dividend payments, the ability of Family Life to make principal and interest payments under the Surplus Debenture is not affected. The Company does not anticipate that Family Life will have any difficulty in making principal and interest payments on the Surplus Debenture in the amounts necessary to enable Family Life Corporation to service its indebtedness for the foreseeable future. The sources of funds for Family Life consist of premium payments from policyholders, investment income and the proceeds from the sale and redemption of portfolio investments. These funds are applied primarily to provide for the payment of claims under insurance and annuity policies, operating expenses, taxes, investments in portfolio securities, shareholder dividends and payments under the provisions of the Surplus Debenture. FIC's net cash flow provided by operating activities was $6.0 million in 1998, as compared to $4.2 million in 1997 and $9.7 million in 1996. Net cash flow used in financing activities was $13.10 million in 1998, as compared to $6.15 million in 1997 and $8.05 million in 1996. -35- The guaranty commitments of FIC under the loans incurred in connection with the acquisition of Family Life (after taking into account the repayments and new loans which occurred in July, 1993) relate to: (i) the $22.5 million note issued by Family Life Corporation to Investors Life Insurance Company of North America, and (ii) the $34.5 million loaned by Investors-NA to two subsidiaries of FIC. Management believes that its cash, cash equivalents and short term investments are sufficient to meet the needs of its business and to satisfy debt service. Investments As of December 31, 1998, the Company's investment assets totaled $110.2 million, as compared to $119.1 million as of December 31, 1997. The level of short-term investments at the end of 1998 was $27.6 million, as compared to $34.5 million as of December 31, 1997. The fixed maturities available for sale portion represents $79.4 million of investment assets as of December 31, 1998, as compared to $81.9 million at the end of 1997. The amortized cost of fixed maturities available for sale as of December 31, 1998 was $76.73 million representing a net unrealized gain of $2.67 million. This unrealized gain principally reflects changes in interest rates from the date the respective investments were purchased. To reduce the exposure to interest rate changes, portfolio investments are selected so that diversity, maturity and liquidity factors approximate the duration of associated policyholder liabilities. The assets held by Family Life must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the Company's emphasis is to obtain targeted profit margins, while minimizing the exposure to changing interest rates. This objective is implemented by selecting primarily short- to medium-term, investment grade fixed income securities. In making such portfolio selections, the Company generally does not select new investments which are commonly referred to as "high yield" or "non-investment grade". The fixed maturities portfolio of Family Life, as of December 31, 1998, consisted solely of fixed maturities investments which, in the annual statements of the companies, as filed with state insurance departments, were designated under the National Association of Insurance Commissioners ("NAIC") rating system as a "1" (highest quality). Management believes that the absence of "high-yield" or "non-investment grade" investments (as defined above) in the portfolios of its life insurance subsidiary enhances the ability of the Company to service its debt, provide security to its policyholders and to credit relatively consistent rates of return to its policyholders. -36- Y2K Compliance The Company and its subsidiaries utilize 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. The software programs used in connection with these systems will be affected by what is referred to as the "Y2K date problem". This refers to the limitations of the programming code in certain existing software programs to recognize date sensitive information as the year 2000 approaches. Unless modified prior to the year 2000, such systems may not properly recognize such information and could generate erroneous data or cause a system to fail to operate properly. The Company has evaluated its centralized computer systems and has developed a plan to reach Y2K compliance. A central feature of the plan is to convert most of the centralized systems to a common system which is already in compliance with Y2K requirements. The Company is in the process of this systems conversion and anticipates that the project will be completed in advance of the year 2000. The Company has increased the budget for the implementation and completion of the Plan from the prior years estimate. As of December 31, 1997, the Company had budgeted approximately $330,000 for implementing the Plan. Based on its current analysis, the Company expects that the cost of implementing and completing the Plan will result in an after-tax expense of approximately $898,000 for the three-year (1997 - 1999) conversion period. For the twelve month period ended December 31, 1998, the Company has incurred an after tax expense of approximately $289,000 in connection with the completion of the Plan. Between January 1, 1997 and December 31, 1998, the Company has expended approximately 60.3 % of the three-year expected after-tax cost discussed above. The Plan calls for an upgrade of the Family Life's administrative systems by changing individual lines of computer code in order to modify current operating software such that it will become Y2K compliant. This process includes approximately 29 sub-systems which provide data input to the main systems. The administrative systems which are not modified will be converted onto the Company's CK/4 System, a system designed to be Y2K compliant according to the representations of the vendor. The systems which administer a substantial number of Family Life policies will be modified rather than converted. The modification of the PMS system (administering approximately 122,000 policies for Family Life) was completed in March, 1998. The conversion of the Cypros AP system (administering approximately 19,600 active policies for Family Life) is scheduled for completion at the end of September, 1999. A small number of Family Life policies are administered by systems which also administer policies for ILCO and its subsidiaries. With regard to ILCO and its subsidiaries, the ALIS system (administering approximately 49,280 active policies for Investors-NA at the time of conversion) was converted to CK/4 in January of 1998. The conversion of the Life 70 system (administering approximately 16,120 active policies for Investors-IN) is scheduled for completion in April, 1999. The modification of the Lifecomm-B system which is responsible for the 18,000 active policies assumed after ILCO's acquisition of State Auto Life is also scheduled for completion in April, 1999. -37- The conversion of the Lifecomm-A system (administering approximately 62,400 active policies for Investors-NA) is now scheduled for completion in September of 1999. The Company also faces the risk that one or more of its external suppliers of goods or services ("third party providers") will not be in a position to properly interact with the Company due to the inability of such third party provider to resolve its own Y2K issues. The Company has completed an inventory of its third party provider relationships. In order to assess the Y2K readiness of such third party providers, the Company has developed and forwarded a detailed questionnaire to such providers. As the responses to the questionnaires are received, the Company will evaluate the overall Y2K readiness of its third party provider relationships. However, the Company does not have sufficient information at the current time to determine whether the computer systems of its third party providers will be in compliance with the Y2K requirements as the year 2000 approaches. In 1997, FIC Computer Services - a subsidiary of FIC which provides data processing services for the Company and its affiliates - purchased new mainframe hardware and accompanying operating software, which the vendor has represented to be Y2K compliant. This hardware and software was tested in 1998. The telephone system has been tested by the maintenance provider for that system and the Company has received assurances that the telephone system is Y2K compliant. With respect to non-centralized systems (i.e., desktop computers), the Company has obtained updated software releases and new hardware designed to be Y2K compliant according to the representations of the vendors. The Company expects that the effort needed to correct for Y2K problems on such systems will be less time intensive than the effort needed to achieve compliance for its centralized systems. The installation of such new PC hardware and software was commenced in early 1999 and is expected to be completed by September 1, 1999. In the event that a major administrative system fails to operate properly due to the Y2K problem, or the Company does not complete the necessary systems conversions prior to January 1, 2000, the Company has developed a plan to respond to such a contingency. FIC Computer Services has assigned certain personnel to be members of an emergency response team to resolve Y2K operations problems. Additionally, insurance policies would be administered manually if the necessary systems conversions were not completed prior to January 1, 2000, or subsequent Y2K operations problems persist. Manual policy administration would require additional personnel. If substantial additional personnel become necessary for manual policy administration, the training and salary expenses of such personnel could materially affect the Company's business and results of operations. The Company is not able to estimate the likelihood that manual administration will be needed or the amount of any expense which it would incur in connection with such manual administration. Cautionary Statements for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995 -38- Except for historical factual information set forth in this Management's Discussion and Analysis, certain statements made in this report are forward looking and contain information about financial results, economic conditions, Y2K risks and other risks and known uncertainties. The Company cautions the reader that actual results could differ materially from those anticipated by the Company, depending upon the eventual outcome of certain factors, including: (1) heightened competition for new business, (2) significant changes in interest rates, (3) adverse regulatory changes affecting the business of insurance and (4) adverse changes in the Y2K readiness of the Company or its significant third party providers. Accounting Developments In February 1997, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard (FAS) No. 128, "Earnings Per Share," which revises the standards for computing earnings per share previously prescribed by APB Opinion No. 15, "Earnings Per Share." The Statement establishes two measures of earnings per share: basic earnings per share and diluted earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were converted or exercised. The Statement requires dual presentation of basic and diluted earnings per share on the face of the income statement for all entities with potential dilutive securities outstanding. The Statement also requires a reconciliation of the numerator and denominator of the basic earnings per share computation to the numerator and denominator of the diluted earnings per share computation. The Statement is effective for interim and annual periods ending after December 15, 1997. Earlier application is not permitted. However, a company may disclose pro forma earnings per share amounts that would have resulted if it had applied the Statement in an earlier period. The Company adopted FAS 128 in its annual financial statements for the year ended December 31, 1997. In June, 1997, the FASB issued FAS No. 130, "Reporting Comprehensive Income", which establishes standards for reporting and display of comprehensive income and its components in a financial statement with the same prominence as other financial statements. Comprehensive income is defined as net income adjusted for changes in stockholders' equity resulting from events other than net income or transactions related to an entity's capital instruments. The Company adopted FAS 130 effective January 1, 1998, with reclassification of financial statements for earlier years. In June, 1997, the FASB issued FAS No. 131, "Disclosure About Segments of an Enterprise and Related Information", which establishes standards for reporting information about operating segments. Generally, FAS No. 131 requires that financial information be reported on the basis that it is used internally for evaluating performance. The Company adopted FAS No. 131 effective January 1, 1998 and comparative information for earlier years has been restated. This statement does -39- not need to be applied to interim financial statements in the initial year of application. The adoption of FAS No. 131 did not impact upon the Company's reporting of financial information. In February, 1998, the FASB issued FAS No. 132, "Employers' Disclosures About Pensions and Other Postretirement Benefits", which revises current disclosure requirements for employers' pension and other retiree benefits. FAS No. 132 does not change the measurement or recognition of pension or other postretirement benefit plans. The Company adopted FAS No. 132 effective January 1, 1998, with the effect of such adoption to be reflected in year-end financial statements. The adoption of FAS No. 132 did not have a material impact on the Company's results of operations, liquidity or financial position. In December, 1997, the Accounting Standards Executive Committee issued Statement of Position ("SOP") 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments", which provides guidance on accounting for insurance-related assessments. The Company is required to adopt SOP 97-3, effective January 1, 1999. Previously issued financial statements should not be restated unless the SOP is adopted prior to the effective date and during an interim period. The adoption of SOP 97-3 is not expected to have a material impact on the Company's results of operations, liquidity or financial position. In June, 1998, the FASB issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133 is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 1999. As the Company does not have significant investments in derivative financial instruments, the adoption of FAS 133 does not have a material impact on the Company's results of operations, liquidity or financial position. 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 "Acquisition of ILCO" and "Investment of Assets" in Item I of this report and 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 which could be taken by management in response to the assumed changes in -40- market rates. In addition, the discussion does not take into account other types of risks which may be involved in the business operations of the Company, such as the reinsurance recoveries on reinsurance treaties with third party insurers. The primary market risk to the Company's investment portfolio is interest rate risk. Since the Company own approximately 45% of the common stock of ILCO, the interest rate risk of ILCO's fixed income portfolio has an effect on the value of FIC's "investment in affiliate". The Company does not use derivative financial instruments. Interest Rate Risk: (a) FIC's Fixed Income Investments: Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in fair market value related to the financial instruments segment of the Company's balance sheet is estimated to be $2.5 million at December 31, 1998 and $3.5 million at December 31, 1997. For purposes of the foregoing estimate, the following categories of the Company's fixed income investments were taken into account: (i) fixed maturities, including fixed maturities available for sale, and (ii) short-term investments. The market value of such assets was $107.0 million at December 31, 1998 and $116.3 million at December 31, 1997. The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $33.9 million at December 31, 1998 and $40.2 million at December 31, 1997. 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 $1.2 million at December 31, 1998 and $1.8 million at December 31, 1997. (b) FIC's Investment in Affiliate: The value of FIC's investment in affiliate is affected by the amount of unrealized gains and losses, net of tax, in the investment portfolio of its affiliate, ILCO. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in value, net of tax, related to the Company's investment in affiliate is estimated to be $4.6 million at December 31, 1998 and $7.0 million at December 31, 1997. 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. -41- 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 March 26, 1999. 2. Consolidated Balance Sheets, as of December 31, 1998 and December 31, 1997. 3. Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996. 4. Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996. 5. Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996. 6. Notes to Consolidated Financial Statements. 7. Consolidated Financial Statement Schedules. 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. -42- 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 were elected at the 1998 annual shareholders meeting. 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. 55 1991 Vice President-Investments, Investment Barnett Professionals, Inc. Since August 1996. Vice President-Investments of Prudential Securities from April 1983 to July 1996. Joseph F. 60 1992 Vice President of FIC from February Crowe 29, 1992 to January 3, 1997, when he retired from active service with the Company. Director of FIC since February 29, 1992. Vice President of ILCO from May 1991 to January 1997. Director of ILCO from May 1991 to October 1997. Executive Vice President of Investors Life Insurance Company of North America Family Life Insurance Company and InterContinental Life Insurance Company form June 1991 to January 1997. Director of Investors Life Insurance Company of North America, Family Life Insurance Company and InterContinental Life Insurance Company from June 1991 to January 1997. Executive Vice President of Investors Life Insurance Company of Indiana form February 1995 to January 1997. Director of Investors Life Insurance Company of Indiana from February 1995 to January 1997. From December 1986 to March 1991, Executive Vice President of Personal Financial Security Division of Aetna Life & Casualty Company. -43- Jeffrey H. 46 1995 Director of FIC since May 1995. Vice Demgen President of FIC since August 1996. Vice President and Director of ILCO since August 1996. Director of Family Life Insurance Company since October 1992. Executive Vice President of Family Life Insurance Company since August 1996. Senior Vice President of Family Life Insurance Company from October 1992 to August 1996. Executive Vice President and Director of Investors Life Insurance Company of North America since August 1996. Senior Vice President and Director of Investors Life Insurance Company of North America from October 1992 to June 1995. Executive Vice President of Investors-IN (formerly known as InterContinental Life Insurance Company) since August 1996. Executive Vice President and Director of Investors Life Insurance Company of Indiana from August 1996 to December 1997. Senior Vice President of United Insurance Company of America from September 1984 to July 1992. Theodore A. 59 1996 Vice President and Director of FIC Fleron since August 1996. Vice President and Director of ILCO since May 1991. Assistant Secretary of ILCO since June 1990. Senior Vice President, General Counsel, Assistant Secretary and Director of Investors Life Insurance Company of North America and Investors IN, formerly known as InterContinental Life Insurance Company since July 1992 Vice President, General Counsel, Assistant Secretary and Director of Investors Life Insurance Company of North America and Investors-IN, formerly known as InterContinental Life Insurance Company from January 1989 to July 1992. Senior Vice President, General Counsel, Director and Assistant Secretary of Investors Life Insurance Company of Indiana from June 1995 to December 1997. Senior Vice President, General Counsel Director and Assistant Secretary of Family Life Insurance Company since August 1996. -44- James M. 55 1976 Vice President,Treasurer and Director Grace of FIC. Vice President and Treasurer of ILCO since January 1985. Executive Vice President,Treasurer and Director of Investors-IN, formerly known as InterContinental Life Insurance Company since 1989. Director, Executive Vice President and Treasurer of Investors Life Insurance Company of North America since 1989. Executive Vice President, Treasurer and Director of Family Life Insurance Company since June 1991. Director, Executive Vice President and Treasurer of Investors Life Insurance Company of Indiana from February 1995 to December 1997. Dale E. Mitte 64 1994 Director since January 1994. Senior Vice President, Chief Underwriter and Director from January 1993 to March 5 1999 of Investors Life Insurance Company of North America and Investors-IN, formerly known as InterContinental Life Insurance Company. Vice President, Chief Underwriter and Director from December 1988 to January 1993 of Investors Life Insurance Company of North America and Investors- IN, formerly known as InterContinental Life Insurance Company. Director from June 1991 to April 1992 and Vice President and Chief Underwriter from June 1991 to March 5, 1999 of Family Life Insurance Company. Director, Senior Vice President and Chief Underwriter of Investors Life Insurance Company of Indiana from June 1995 to December 1997. -45- Roy F. Mitte 67 1976 Chairman of the Board, President and Chief Executive Officer of FIC. Chairman of the Board, President and Chief Executive Officer of ILCO and Investors-IN, formerly known as InterContinental Life Insurance Company since January 1985. President of ILCO since April 1985. Chairman of the Board, President and Chief Executive Officer of Investors Life Insurance Company of North America since December 1988. Chairman of the Board, President and Chief Executive Officer of Family Life Insurance Company since June 1991. Chairman of the Board, President and Chief Executive Officer of Investors Life Insurance Company of Indiana from February 1995 to December 1997. Chairman, ILG Securities Corporation since December 1988. Frank Parker 70 1994 President, Gateway Tugs, Inc., which is located in Brownsville, Texas and is engaged in operating and chartering harbor and intracoastal tug boats, for more than the last five years. Eugene E. Payne 56 1992 Vice President, Secretary and Director of FIC. Vice President of ILCO since December 1988 and Secretary and Director of ILCO since May 1989. Executive Vice President, Secretary and Director of Investors Life Insurance Company of North America since December 1988. Executive Vice President since December 1988 and Director since May 1989 of Investors-IN, formerly known as InterContinental Life Insurance Company. Executive Vice President, Secretary and Director of Family Life Insurance Company since June 1991. Director, Executive Vice President and Secretary of Investors Life Insurance Company of Indiana from February 1995 to December 1997. -46- Thomas C. 56 1996 Director of FIC since August 1996. Richmond Director of ILCO from March 1994 to August 1996. Director from March 1989 to February 1990, Senior Vice President since January 1993 and Vice President from March 1989 to January 1993 of Investors Life Insurance Company of North America and Investors-IN, formerly known as InterContinental Life Insurance Company. Senior Vice President of Family Life Insurance Company since June 1991. Senior Vice President of Investors Life Insurance Company of Indiana from June 1995 to December 1997. Jerome H. 62 1998 President and Professor of Chemistry, Supple Southwest Texas State University since April 1989. Director of FIC since 1998. The incumbent directors have been nominated for submission to vote of the shareholders for reelection at the 1999 annual shareholders' meeting. (b) Executive Officers of the Registrant The following table sets forth the names and ages of the persons who served as the Registrant's Executive Officers during 1998 together with all positions and offices held by them with the Registrant. 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 Roy F. Mitte 67 Chairman of the Board, President and Chief Executive Officer James M. Grace 55 Vice President and Treasurer Eugene E. Payne 56 Vice President and Secretary Jeffrey H. Demgen 46 Vice President In May 1991, Roy F. Mitte suffered a stroke, resulting in partial paralysis affecting his speech and mobility. Mr. Mitte continues to make the requisite decisions in his capacity as Chief Executive Officer, although his ability to communicate and his mobility are impaired. -47- (c) Identification of certain significant employees Not applicable. (d) Family relationships Dale E. Mitte is Roy F. Mitte's brother. (e) Business experience All of the executive officers of the Company are members of the Board of Directors, and their business experience has been outlined in Item 10 (a). (f) Compliance with Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of beneficial ownership on Form 3 and changes in beneficial ownership on Form 4 and 5 with the Securities and Exchange Commission. Officers, directors and greater than ten-percent shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on review of the copies of such forms furnished to the Company, or written representations that no Form 5's were required, the Company believes that during the period from January 1, 1998 through December 31, 1998, all Section 16(a) filing requirements applicable to its officers, directors and greater than ten-percent beneficial owners were complied with. -48- Item 11. Executive Compensation Summary Compensation Table The following table sets forth information concerning the compensation of the Company's Chief Executive Officer and each of the three other persons who were serving as executive officers of the Company at the end of 1998 and received cash compensation exceeding $100,000 during 1998: Annual Compensation Long Term Name and Compensation Awards All Other Principal Stock Options Compensa- Position Year Salary(1) Bonus(4) Other(2) (Shares) tion Roy F. Mitte, Chairman, President and 1998 $ 503,500 $2,500,000 -0- -0- -0- Chief Executive 1997 $ 503,500 $1,500,000 -0- -0- -0- Officer 1996 $ 503,500 -0- -0- -0- $2,446,3973 James M. Grace, Vice 1998 195,000 25,000 -0- -0- -0- President and 1997 195,000 40,000 -0- -0- -0- Treasurer 1996 195,000 15,000 -0- -0- -0- Eugene E. Payne, Vice 1998 195,000 20,000 -0- -0- -0- President and 1997 195,000 40,000 -0- -0- -0- Secretary 1996 195,000 15,000 -0- -0- -0- Jeffrey H. 1998 $ 145,384 $ 15,000 -0- -0- -0- Demgen, Vice 1997 $ 117,884 $ 30,000 -0- -0- -0- President7 1996 $ 102,500 $ 7,500 -0- -0- -0-
(1) The salaries and bonuses set forth in the table were paid by ILCO, except that FIC and/or Family Life authorized payment of a portion of Mr. Mitte's salary in each of 1996, 1997 and 1998. The executive officers of FIC have also been executive officers of Family Life, the insurance subsidiary of FIC, and ILCO and its insurance subsidiaries. FIC and/or Family Life reimbursed ILCO (or, in the case of Mr. Mitte, authorized payment of) the following amounts as FIC's or Family Life's share of the executive officers' cash compensation and bonus for 1996, 1997 and 1998: (i) Mr. Mitte: $216,857, $999,746 and $1,111,821, respectively;(ii) Mr. Grace: $83,987, $68,150 and $64,152, respectively; (iii) Dr. Payne: $83,987, $68,150 and $61,447, respectively; and (iv) Mr. Demgen: $46,125 and $66,548 and $72,173 1996, 1997 and 1998, respectively. -49- Mr. Mitte and FIC are parties to an employment agreement, providing for the employment of Mr. Mitte as Chairman, President and Chief Executive Officer of the Company. The agreement, which was initially effective February 25, 1982, provides for five-year terms and for automatic renewals for successive five-year periods, unless otherwise terminated in accordance with the terms of the agreement. The agreement provides that the level of compensation will be fixed each year by agreement, but not less than $120,000 per year. In addition, the agreement provides that Mr. Mitte is entitled to reimbursement for reasonable business expenses and to participate in all fringe benefit plans and arrangements available generally to employees of the Company. (2) Does not include the value of perquisites and other personal benefits because the aggregate amount of any such compensation does not exceed the lesser of $50,000 or 10 percent of the total amount of annual salary and bonus for any named individual. (3) During 1996, ILCO paid Mr. Mitte: (i) $1,862,000 for the cancellation in 1996 of options to purchase 121,500 shares of the Company's common stock, plus interest at the rate of 8% per year on such amount for a one year period (for a total of $2,011,737); (ii) $120,700 for the federal income tax reimbursement relating to the cancellation in 1995 of options to purchase 50,000 shares of the Company's common stock; and (iii) $313,960 for the federal income tax reimbursement relating to the 1996 options cancellation described above in this footnote. (4) The data in this column represents the amount of annual bonus awarded. The bonuses for Mr. Grace, Dr. Payne and Mr. Demgen for the year 1997 represent amounts paid in 1997, but include the bonuses awarded with respect to the years 1996 and 1997. Dr. Payne elected to defer the amounts shown for 1997 and 1998 into the Company's Non-Qualified Deferred Compensation Plan. The Plan was established in 1997 to permit Mr. Grace and Dr. Payne to defer a portion of their compensation. Under the provisions of the Plan, contributions are invested on a money purchase basis and plan benefits are based on the value of the account at retirement or other distribution. In accordance with applicable tax law requirements, amounts allocated to the Plan are subject to the claims of general creditors of the Company. Compensation of Directors Directors who are not officers or employees of the Company are paid a $5,000 annual fee, and are compensated $1,000 for each regular or special meeting of the Board of Directors which they attend in person. Members of Compensation Committee The Compensation Committee makes recommendations to the Board of Directors with respect to the Chief Executive Officer's compensation. The members of the Compensation Committee are John D. Barnett, Frank Parker, and Jerome H. Supple. -50- Compensation Committee Interlocks and Insider Participation Roy F. Mitte determines the compensation of all executive officers of FIC, other than the Chief Executive Officer. Mr. Mitte is the Chairman of the Board, President and Chief Executive Officer of FIC and ILCO. He also determines the compensation of all executive officers of ILCO, other than the Chief Executive Officer. Item 12. Security Ownership of Certain Beneficial Owners and Management The following table presents information as of March 15, 1999 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. Amount and Nature Name and Address of of Beneficial Percent Beneficial Owner Ownership of Class Roy F. Mitte, Chairman of the Board, President and Chief Executive Officer, 701 Brazos Suite 1400, Austin, Texas 78701 1,493,216 29.54% Family Life Insurance Company 701 Brazos Street Suite 1400 Austin, Texas 78701 272,000 5.38% InterContinental Life Corporation 701 Brazos Suite 1400, Austin, Texas 78701 690,161 (1, 3) 13.65% (2) Investors Life Insurance Company of North America 701 Brazos Suite 1400 Austin, Texas 78701 690,161 (1, 3) 13.65% (2) -51- Heartland Advisors, Inc. 790 North Milwaukee St. Milwaukee, WI 53202 438,500 8.68% (4) (1) Of such shares, 145,500 shares are owned by Investors-NA, 44,250 shares are owned by Investors-IN, and 500,411 shares are issuable upon exercise of an option held by Investors- NA. Investors-NA is a direct subsidiary of ILCO. Investors-IN is a direct subsidiary of Investors-NA. (2) Assumes that outstanding stock options or warrants held by other persons have not been exercised. (3) See Item 1. Business-Acquisition of Family Life for a description of the options granted to Investors-NA. (4) As reported to the Company on a Schedule 13(G) filed by Heartland Advisors, Inc. ("Heartland"). According to the Schedule 13(G), the shares are held for various investment advisory accounts and the interest of one such account (Heartland Value Fund, a registered investment company) is more than 5% of the common stock of FIC. A Schedule 13(G) was filed on January 27, 1998, reporting beneficial ownership of 320,400 shares. A Schedule 13(G)/A was filed on January 21, 1999, reporting beneficial ownership of an additional 118,100 shares. The following table contains information as of March 15, 1999 as to the Common Stock of the Registrant beneficially owned by each director, nominee and executive officer and by all executive officers and directors of the Registrant as a group. The information contained in the table has been obtained by the Registrant from each director and executive officer, except for the information known to the Registrant. Except as indicated in the notes to the table, each beneficial owner has sole voting power and sole investment power as to the shares listed opposite his name. Amount and Nature of Percent of Name Beneficial Ownership Class John Barnett 2,000 * Joseph F. Crowe -0- (2) Jeffrey H. Demgen -0- (2) Theodore A. Fleron -0- James M. Grace 5,600 (2) * Dale E. Mitte 2,000 * Roy F. Mitte 1,493,216 (1,2) 29.54% -52- Frank Parker 10,000 * Eugene E. Payne -0- * Thomas C. Richmond 1,100 * Jerome H. Supple 200 * All Executive Officers, and Directors as a group (11 persons) 1,514,116 (1,2) 29.95 % (1) As of March 15, 1999, Mr. Mitte, jointly with his wife Joann, owns 1,493,216 common shares of Financial Industries Corporation ("FIC"). The holdings of Mr. Mitte of FIC's common stock constitutes 29.54% of the outstanding common stock of the Company. In addition, Mr. Mitte holds the position of Chairman, President and Chief Executive Officer of ILCO. (2) No executive officer or director holds any options to acquire FIC Common Stock. Messrs. Roy Mitte, Grace, Payne and Demgen are executive officers and/or directors of ILCO and beneficially owned approximately 47.12 % of the outstanding shares of ILCO common stock as of March 15, 1999. Since FIC beneficially owns 44.74 % of ILCO's Common Stock, Mr. Roy Mitte's personal holdings are combined with FIC's holdings in determining the percentage of ILCO Common Stock beneficially owned by Mr. Mitte. ILCO beneficially owned 690,161 shares of FIC Common Stock (13.65% of the outstanding shares) as of March 15, 1999. * Less than 1%. Item 13. Certain Relationships and Related Transactions (a) Prior to the repayment of the ILCO Senior Loan on September 30, 1998, the obligations of ILCO under the Senior Loan were guaranteed by FIC. FIC presently owns 1,966,346 shares of ILCO's Common Stock, constituting 44.74% of such shares outstanding. (b) Roy F. Mitte serves as Chairman, President and Chief Executive Officer of both FIC and ILCO. James M. Grace serves as Vice President, Treasurer and Director of both companies; Dr. Payne serves as Vice President, Secretary and Director of both companies; Messrs. Demgen and Fleron serve as Vice Presidents and Directors of both companies. Mr. Roy Mitte holds beneficial ownership of 29.54% of the outstanding shares of the Company (see "Security Ownership of Certain Beneficial Owners"). (c) 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 -53- 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, Ins. ("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-NA to FLC and a $2.5 million loan provided directly to FIC by Investors-CA. In addition to the interest provided under those loans, Investors-NA 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 percent 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. 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. On July 30,1993,the subordinated indebtedness owed to Merrill Lynch and its affiliate was prepaid. The Company paid $38 million plus accrued interest to retire the indebtedness, which had a principal balance of approximately $50 million on July 30, 1993. 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-NA. The principal amount of the new subordinated debt is payable 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 new debt are substantially the same as those of the $22.5 million subordinated loans that Investors-NA had previously made to FLC and that continue to be outstanding. In June, 1996, the provisions of the notes from Investors-NA to FIC, Family Life Corporation ("FLC") and Family Life Insurance Investment Company ("FLIIC") were modified as follows: (a) the $22.5 million note was amended to provide for twenty quarterly principal payments, in the amount of $1,125,000 each, to commence on December 12, 1996; the final quarterly principal payment is due on September 12, 2001; the interest rate on the note remains at 11%, (b) 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%, (c) 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%, (d) the $2.5 million note was amended to provide that the principal balance of the note is to be repaid in twenty quarterly installments of -54- $125,000 each, commencing December 12, 1996 with the final payment due on September 12, 2001; the rate of interest remains at 12%, (e) the Master PIK note, which was issued to provide for the payment in kind of interest due under the terms of the $2.5 million note prior to June 12, 1996, was amended to provide that the principal balance of the note ($1,977,119) is to be paid in twenty quarterly principal payments, in the amount of $98,855.95 each, to commence December 12, 1996 with the final payment due on September 12, 2001; the interest rate on the note remains at 12%. 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. (d) The data processing needs of ILCO's and FIC's insurance subsidiaries are provided to ILCO's and FIC's insurance subsidiaries by FIC Computer Services, Inc. ("FIC Computer"), a subsidiary of FIC. Under the provisions of the data processing agreement FIC Computer provides data processing services to each subsidiary for fees equal to such subsidiary's proportionate share of FIC Computer's actual costs of providing those services to all of the subsidiaries. Family Life paid $1,610,397 and ILCO's insurance subsidiaries paid $2,818,095 to FIC Computer for data processing services provided during 1998. (e) In 1995, Family Life entered into a reinsurance agreement with Investors-NA 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. (f) In 1996, Family Life entered into a reinsurance agreement with Investors-NA, pertaining to annuity contracts written by Family Life. The agreement applies to contracts written on or after January 1, 1996. (g) In November, 1998, FIC purchased 101,304 shares of FIC's common stock from the Roy F. and Joann Cole Mitte Foundation (the "Foundation"), a Texas non-profit corporation which is controlled by Mr. Mitte and his wife, at a price of $18.625 per share (or a total purchase price of $1,886,787). At the same time, Family Life purchased 272,000 shares of FIC's common stock from the Foundation at a price of $18.625 per share (or a total purchase price of $5,066,000). Mr. Mitte and his wife had previously donated the shares to the Foundation. The Foundation obtained a private letter ruling from the Internal Revenue Service, in which the IRS ruled that the sale of the FIC common stock to the Company would not constitute a direct or indirect act of self-dealing between the Foundation and the Company. The transaction was reviewed by a Special Committee of the Board of Directors, -55- consisting of two outside directors. In addition, the Company obtained a favorable fairness opinion from an independent investment banking firm. (h) Mr. Crowe retired from active service with the Company in January, 1997 and served on the ILCO Board until October, 1997; he continues to serve on the Board of Directors of FIC. Following Mr. Crowe's retirement, the Company entered into a consulting agreement with him. Under the terms of the agreement, Mr. Crowe is to be available for periodic consultation on actuarial matters related to the operations of the life insurance companies. The agreement provide of a payment of $25,000 per year for a period of five-years. -56- Part IV Item 14. 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) ILCO Form 10-K as of December 31, 1996, 1997 and 1998 and the Financial Statements contained therein are hereby incorporated by reference. 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, September 31, 1998 and 1997. .. . . . . . . . F-3 Consolidated Statements of Income, for years ended December 31, 1998, 1997 and 1996. . . . . . . . . . . . . . . F-5 Consolidated Statements of Changes in Shareholders' Equity, for the years ended December 31, 1998, 1997 and 1996. . . . . . . . . . . .. . . . . . . . . . F-7 Consolidated Statement of Cash Flows, for the years ended December 31, 1998, 1997 and 1996. . . . . . . . . . . . . . . F-10 Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . . F-12 -57- 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-43 Schedule II - Condensed Financial Statements of Registrant. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .F-44 Schedule IV - Reinsurance . . . . . . . . . . .. . . . . . . . . . . . . . F-48 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. 2. Exhibits filed with this report or incorporated herein by reference are as listed in the Index to Exhibits on Page Ex-1. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the fiscal year ended December 31, 1998. -58- 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/ Roy F. Mitte By:/s/ James M. Grace Roy F. Mitte, Chairman of James M. Grace, Treasurer, the Board, President and Principal Accounting and Chief Executive Officer and Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 29, 1999. /s/ Roy F. Mitte /s/ James M. Grace Roy F. Mitte, Director James M. Grace, Director /s/ Eugene E. Payne /s/ Jeffrey H. Demgen Eugene E. Payne, Director Jeffrey H. Demgen, Director /s/ Joseph F. Crowe /s/ Thomas C. Richmond Joseph F. Crowe, Director Thomas C. Richmond, Director /s/ Theodore A. Fleron Theodore A. Fleron, Director /s/ Dale E. Mitte Dale E. Mitte, Director /s/ John D. Barnett John D. Barnett, Director /s/ Jerome H. Supple Jerome H. Supple, Director /s/ Frank Parker Frank Parker, Director -59- FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES FORM 10-K--ITEM 14 (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, 1998 and 1997..................................................F-3 Consolidated Statements of Income, for the years ended December 31, 1998, 1997 and 1996................................F-5 Consolidated Statements of Changes in Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996............................................F-7 Consolidated Statements of Cash Flows, for the years ended December 1998, 1997 and 1996................................F-10 Notes to Consolidated Financial Statements..................................F-12 (2) The following consolidated financial statements of Financial Industries Corporation and Subsidiaries are included: Schedule I - Summary of Investments Other Than Investments in Related Parties.........................................F-43 Schedule II - Condensed Financial Statements of Registrant..................................................................F-44 Schedule IV - Reinsurance...................................................F-47 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 consolidated financial statements listed in the index appearing under Item 14(a) (1) and (2) on page F-1 present fairly, in all material respects, the financial position of Financial Industries Corporation and its subsidiaries (the "Company") at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards 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 the opinion expressed above. PricewaterhouseCoopers LLP Dallas, Texas March 26, 1999 F-2 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1998 1997 (in thousands) ASSETS Investments other than investments in affiliate: Fixed maturities available for sale at market value (amortized cost of $76,727 and $79,054 at December 31, 1998 and 1997) $ 79,402 $ 81,854 Equity securities at market (cost approximates $11 at December 31, 1998 and 1997) 4 4 Policy loans 3,155 2,748 Short-term investments 27,589 34,475 Total investments 110,150 119,081 Cash 2,601 508 Investment in affiliate 70,950 66,752 Accrued investment income 1,209 1,184 Agency advances and other receivables 7,759 6,474 Reinsurance receivables 12,426 11,134 Due and deferred premiums 12,181 11,086 Property and equipment, net 1,758 1,724 Deferred policy acquisition costs 48,510 45,122 Present value of future profits of acquired businesses 28,294 34,437 Other assets 5,392 6,346 Separate account assets 508 476 Total Assets $ 301,738 $ 304,324 The accompanying notes are an integral part of these consolidated financial statements F-3 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1998 1997 (in thousands) LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Policy liabilities and contract holder deposit funds: Future policy benefits $ 60,069 $ 59,987 Contract holder deposit funds 45,128 44,304 Unearned premiums 28 90 Other policy claims and benefits payable 4,582 5,315 109,807 109,696 Subordinated notes payable to affiliate 47,645 53,792 Deferred federal income taxes 23,984 21,631 Other liabilities 4,474 4,880 Separate account liabilities 508 476 Total Liabilities 186,418 190,475 (See Notes 4, 8, 12, 14) Shareholders' equity: Common stock, $.20 par value, 10,000,000 shares authorized; 5,845,300 shares issued, 5,054,661 and 5,427,965 outstanding in 1998 and 1997, respectively 1,169 1,169 Additional paid-in capital 7,225 7,225 Accumulated other comprehensive income 5,898 6,692 Retained earnings 108,403 99,185 122,695 114,271 Common treasury stock, at cost, 790,639 and 417,335 shares in 1998 and 1997, respectively (7,375) (422) Total Shareholders' Equity 115,320 113,849 Total Liabilities and Shareholders' Equity $ 301,738 $ 304,324 The accompanying notes are an integral part of these consolidated financial statements. F-4 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Year Ended December 31, 1998 1997 1996 (in thousands) Revenues: Premiums $ 38,358 $ 40,249 $ 43,336 Net investment income 7,808 8,106 7,363 Net realized gain on sale of real estate -0- 4,548 -0- Earned insurance charges 5,971 6,989 5,569 Other 1,470 3,451 3,660 53,607 63,343 59,928 Benefits and expenses: Policyholder benefits and expenses 16,258 19,905 22,096 Interest expense on contract holders deposit funds 2,374 2,596 2,239 Amortization of present value of future profits of acquired businesses 6,143 6,167 4,811 Amortization of deferred policy acquisition costs 5,174 4,826 4,185 Operating expenses 11,822 12,755 12,975 Interest expense 2,863 3,683 3,831 44,634 49,932 50,137 Income before federal income tax and equity in net earnings of affiliates 8,973 13,411 9,791 Provision for federal income taxes: Current 119 1,348 (1,165) Deferred 2,249 2,193 3,811 Income before equity in net earnings of affiliates 6,605 9,870 7,145 Equity in net earnings of affiliate, net of tax 2,613 6,458 9,012 Net Income $ 9,218 $ 16,328 $ 16,157
The accompanying notes are an integral part of these consolidated statements. F-5 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Years Ended December 31, 1998 1997 1996 (in thousands) Net Income Per Share (Note 15) Basic: Average weighted shares outstanding 5,383 5,428 5,428 Basic earnings per share $ 1.71 $ 3.01 $ 2.98 Diluted: Common stock and common stock equivalents 5,557 5,589 5,568 Diluted earnings per share $ 1.66 $ 2.92 $ 2.90 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, 1995 5,845 $ 1,169 $ 7,225 Comprehensive Income: Net income Other Comprehensive Income: Change in net unrealized loss on investments in fixed maturities available for sale, net of tax Change in net unrealized appreciation (depreciation) of equity securities, net of tax Total Comprehensive Income Balance at December 31, 1996 5,845 1,169 7,225 Comprehensive Income: Net Income Other Comprehensive Income: Change in net unrealized loss on investments in fixed maturities available for sale, net of tax Change in net unrealized appreciation (depreciation) of equity securities, net of tax Total Comprehensive Income Balance at December 31, 1997 5,845 1,169 7,225 Comprehensive Income Net Income Other Comprehensive Income: Change in net unrealized loss on investments in fixed maturities available for sale, net of tax Change in net unrealized appreciation (depreciation) of equity securities, net of tax Total Comprehensive Income Balance at December 31, 1998 $ 5,845 $ 1,169 $ 7,225
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 (in thousands) Accumulated Other Comprehensive Income Net Unrealized Gain Net Unrealized on Invest- ments in Total Appreciation Fixed Maturities Accumulated Depreciation) of Available for Sale Other Comprehensive Equity Securities Income Balance at December 31, 1995 $ 11 $ 8,052 $ 8,063 Comprehensive Income: Net Income Other Comprehensive Income: Change in net unrealized gain on investments in fixed maturities available for sale, net of tax (6,832) (6,832) Change in net unrealized appreciation (depreciation) of equity securities, net of tax 14 14 Total Comprehensive Income 14 (6,832) (6,818) Balance at December 31, 1996 25 1,220 1,245 Comprehensive Income: Net Income Other Comprehensive Income: Change in net unrealized gain on investments in fixed maturities available for sale, net of tax 5,440 5,440 Change in net unrealized appreciation (depreciation) of equity securities, net of tax 7 7 Total Comprehensive Income 7 5,440 5,447 Balance at December 31, 1997 32 6,660 6,692 Comprehensive Income: Net Income Other Comprehensive Income: Change in net unrealized gain on investments in fixed maturities available for sale, net of tax (760) (760) Change in net unrealized appreciation (depreciation) of equity securities, net of tax (34) (34) Total Comprehensive Income (34) (760) (794) Purchase of treasury stock Balance at December 31, 1998 $ (2) $ 5,900 $ 5,898
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 (in thousands) Total Retained Treasury Shareholders' Earnings Stock Equity Balance at December 31, 1995 $ 66,700 $ (422) $ 82,735 Comprehensive Income: Net Income 16,157 16,157 Other Comprehensive Income: Change in net unrealized loss on investments in fixed maturities available for sale, net of tax (6,832) Change in net unrealized appreciation depreciation) of equity securities, net of tax 14 Total Comprehensive Income 16,157 -0- 9,339 Balance at December 31, 1996 82,857 (422) 92,074 Comprehensive Income: Net Income 16,328 16,328 Other Comprehensive Income: Change in net unrealized gain on investments in fixed maturities available for sale, net of tax 5,440 Change in net unrealized appreciation (depreciation) of equity securities, net of tax 7 Total Comprehensive Income 16,328 -0- 21,775 Balance at December 31, 1997 99,185 (422) 113,849 Comprehensive Income: Net Income 9,218 9,218 Other Comprehensive Income: Change in net unrealized gain on investments in fixed maturities available for sale, net of tax (760) Change in net unrealized appreciation (depreciation) of equity securities, net of tax (34) Total Comprehensive Income 9,218 8,424 Purchase of treasury stock (6,953) (6,953) Balance at December 31, 1998 $ 108,403 $ (7,375) $ 115,320
The accompanying notes are an integral part of these consolidated financial statements. F-9 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Year Ended December 31, 1998 1997 1996 (in thousands) CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 9,218 $ 16,328 $ 16,157 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of present value of future profits of acquired business 6,143 6,167 4,811 Amortization of deferred policy acquisition costs 5,174 4,826 4,185 Financing costs amortized -0- -0- 168 Equity in undistributed earnings of affiliate (4,965) (9,323) (12,558) Changes in assets and liabilities: (Increase) decrease in accrued investment income (25) 49 (131) Increase in agent advances and other receivables (2,577) (3,624) (1,233) Increase in due premiums (1,095) (435) (925) Increase in deferred policy acquisition costs (8,562) (8,615) (8,981) Decrease (increase) in other assets 954 (640) 558 Increase in policy liabilities and accruals 111 3,629 3,734 Decrease in other liabilities (406) (6,368) (67) Increase in policy loans (407) (462) (512) Increase in deferred federal income taxes 2,353 3,679 3,169 Other, net 34 (1,020) 1,330 Net cash provided by operating activities $ 5,950 $ 4,191 $ 9,705 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, 1998 1997 1996 (in thousands) CASH FLOWS FROM INVESTING ACTIVITIES Fixed maturities purchased $ (14,082) $ (4,056) $ (4,245) Proceeds from sales and maturities of fixed maturities 16,473 7,998 1,265 Net decrease in short-term investments 6,886 (8,860) 1,565 Purchase & retirement of property and equipment (34) 7,075 (1,347) Net Cash provided by (used in) investing activities 9,243 2,157 (2,762) CASH FLOW FROM FINANCING ACTIVITIES Issuance of subordinated notes payable -0- -0- 253 Repayment of senior loan and subordinated notes -0- -0- (6,765) Repayment of subordinated notes payable (6,147) (6,148) (1,537) Purchase of treasury stock. (6,953) Net cash used in financing activities (13,100) (6,148) (8,049) Net increase (decrease) in cash 2,093 200 (1,106) Cash, beginning of year 508 308 1,414 Cash, end of year $ 2,601 $ 508 $ 308 Supplemental Cash Flow Disclosures: Income taxes paid $ 1,184 $ 150 $ 125 Interest paid $ 2,935 $ 3,677 $4,300 The accompanying notes are an integral part of these consolidated financial statements.
F-11 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 and annuity products. The Company's insurance subsidiary is also engaged in the business of marketing and underwriting individual life insurance, disability insurance and annuity products in 49 states and the District of Columbia. Such products are marketed through an exclusive career agency system. Principles of Consolidation The consolidated financial statements include the accounts of FIC and its wholly-owned subsidiaries at December 31, 1998. 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) . The Company's approximate 45% investment in InterContinental Life Corporation (ILCO) is presented using the equity method of accounting. Basis of Presentation The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles which differ from statutory accounting principles required by regulatory authorities for the Company's insurance subsidiary. All material intercompany balances and transactions have been eliminated. 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 generally accepted accounting principles 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. F-12 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 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, 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 other accumulated comprehensive income, net of related income taxes. Premiums and discounts on collateralized mortgage obligations (CMOs) are amortized over the estimated redemption period as opposed to the stated maturity. An adjustment to the investment and investment income is recorded on a retrospective basis to reflect the amounts that would have existed had the new effective yield been applied since the acquisition of the CMO's. The Company endeavors to minimize the portfolio's exposure to interest rate changes inherent in interest-sensitive products by selecting and selling investments so that diversity, maturity and liquidity factors approximate the duration of related policyholder liabilities. Equity securities are carried at market value. Unrealized gains and losses on equity securities, net of deferred income taxes, if applicable, are reflected directly in shareholders' equity. Policy loans represent unpaid balances and do not exceed the cash surrender value of the related policies. Short-term investments are carried at cost, which approximates market value, and generally consist of those fixed maturities and other investments with maturities 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. 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. When an 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. 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. F-13 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Sale of Real Estate Net income for 1997 includes $4.5 million (before federal income tax) resulting from the sale during the fourth quarter of 1997 of the Bridgepoint Square office complex. The aggregate selling price was $78 million which was allocated approximately 21.5% to Family Life and 78.5% to Investors Life Insurance Company of North America (Investors-NA), a subsidiary of ILCO, in accordance with their respective ownership interests in the Bridgepoint Square office complex. The sale closed on December 5, 1997. 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 5 to 33 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 mortgage term life insurance business are deferred and amortized over the premium paying period of the related policies. Acquisition costs related to universal life 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. Present Value of Future Profits on Acquired Businesses The present value of future profits of acquired businesses (See Note 5) 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 present value of future profits is accreted at approximately 8.5% per annum. The fair value of the net assets acquired exceeded the purchase price and negative goodwill associated with the purchase has been netted against the calculated amount of present value of future profits. The negative goodwill is being amortized over seven years using the straight line method of amortization. Separate Accounts Separate account assets, carried at market value, and liabilities represent policyholder funds maintained in accounts having specific investment objectives. The net investment income, gains and losses of these accounts, less applicable contract charges, accrue directly to the policyholders. The separate account F-14 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued business was fully reinsured to Merrill Lynch at the date of sale through an assumption reinsurance agreement which is pending regulatory approval. Solvency Laws Assessments The solvency or guaranty laws of most states in which the Company's insurance subsidiary do business may require the Company's insurance subsidiary 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 subsidiary 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 for mortgage life and annuity insurance products are computed using the net level premium method or an actuarially equivalent method. The assumption for future investment yield is 8.5 %. Assumptions for mortality and withdrawal are based on company experience with provision for possible adverse deviation. Contract holder deposit funds are liabilities for universal life and annuity products. These liabilities consist of deposits received from customers and accumulated at actual credited interest rates on their fund balances less charges for expenses and mortality. 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, including estimates of additional development of initial claims estimates, 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 In February, 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). The Company adopted FAS 109 on a prospective basis effective January 1, 1993. F-15 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued FAS 109 mandates the asset and liability method for computing deferred income taxes. 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 basis of assets and liabilities using the tax rates which are expected be in effect when these differences are anticipated to reverse. Revenue Recognition Premiums on mortgage life and health products are recognized as revenue over the premium paying period. Benefits and expenses are associated with earned premiums, so as to result in recognition of profits over the life of the contracts. Revenues for universal life and annuity products consist of contract charges (earned insurance charges) assessed against the fund values and net investment income. Related benefit expenses primarily consist of net investment income credited to the fund values after deductions for investment and risk charges. Revenues for universal life and annuity products consist of net investment income and mortality, administration and surrender charges assessed against the fund values. Related benefit expenses include universal life benefit claims in excess of fund values and net investment income credited to universal life and annuity fund values. 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. Both methods are presented on the face of the income statement. New Accounting Pronouncements In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," which revises the standards for computing earnings per share previously prescribed by APB Opinion No. 15, "Earnings Per Share." The Statement establishes two measures of 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 Statement requires dual presentation of basic and diluted earnings per share on the face of the income statement for all entities with potential dilutive securities outstanding. The Statement also requires a reconciliation of the numerator and denominator of F-16 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued the basic earnings per share computation to the numerator and denominator of the diluted earnings per share computation. The Statement is effective for interim and annual periods ending after December 15, 1997. The Company adopted SFAS No. 128 for the year ended December 31, 1997 and has restated the earnings per share computations for 1996 to conform to this pronouncement. In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for the reporting and display of comprehensive income and its components. Comprehensive income is defined as net income adjusted for changes in stockholders' equity resulting from events other than net income or transactions related to an entity's capital instruments. The Company has adopted SFAS 130 for the year ended December 31, 1998 and has restated financial statement presentation for 1997 and 1996 as required by this pronouncement. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for reporting information about operating segments. Generally, SFAS 131 requires that financial information be reported on the basis that is used internally for evaluating performance. The Company adopted SFAS 131 for the year ended December 31, 1998. As described in Note 1, the Company is principally engaged, through its subsidiaries, in 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 and annuity products in 49 states and the District of Columbia. Such products are marketed through an exclusive career agency system. Management considers the Company's insurance operations to constitute one reportable segment. Premium revenues for traditional insurance products and earned insurance charges on universal life and annuity products are presented in the accompanying consolidated statements of income. No single customer accounts for 10 percent or more of the Company's revenue. The Company has no foreign operations. In February 1998, the FASB issued SFAS No. 132, "Employers Disclosures about Pensions and Other Postretirement Benefits," which revises current disclosure requirements for employers' pension and other retiree benefits. SFAS 132 does not change the measurement or recognition of pension or other postretirement benefit plans. The Company adopted SFAS 132 for the year ended December 31, 1998, and restated disclosures for 1997 and 1996 as required by this pronouncement. In December 1997, the Accounting Standards Executive Committee issued Statement of Position ("SOP") 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments," which provides guidance on accounting for insurance-related assessments. The Company is required to adopt SOP 97-3 effective January 1, 1999. Previously issued financial statements should not be restated unless the SOP is adopted prior to the effective date and during an interim period. The adoption of this SOP is not expected to have a material impact on the Company's financial statements. In June, 1998, the FASB issued FAS F-17 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133 is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 1999. As the Company does not have significant investments in derivative financial instruments, the adoption of FAS 133 does not have a material impact on the Company's results of operations, liquidity or financial position Reclassification Certain prior years' amounts have been reclassified to conform with the 1998 presentation. F-18 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 2. Investments Fixed Maturities Investments in fixed maturities by category at December 31, 1998 and 1997, respectively, were as follows (in thousands): Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury securities and oligations of U.S. government agencies and corporations $ 16,125 $ 1,014 $ 0 $ 17,139 States, municipalities and political subdivisions 2,990 107 0 3,097 Corporate securities 24,499 783 4 25,278 Mortgage-backed securities 33,113 778 2 33,888 Total fixed maturities available for sale $ 76,727 $ 2,682 $ 6 $ 79,402
Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury securities and obligations of U.S. government agencies and corporations $ 18,142 $ 975 $ 1 $ 19,116 States, municipalities and political subdivisions 2,989 103 3,092 Corporate securities 18,996 527 111 19,412 Mortgage-backed securities 38,927 1,331 24 40,234 Total fixed maturities available for sale $ 79,054 $ 2,936 $ 136 $ 81,854
F-19 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The amounts of unrealized gains and losses reflected in the balance sheet in accumulated other comprehensive income have been reduced by estimated deferred taxes in the amount of $937,000 and $980,000 in 1998 and 1997, respectively. Additional deferred taxes of $313,000 and $367,000 in 1998 and 1997, respectively, have been provided with respect to the Company's protion of ILCO's unrealized appreciation in marketable securities The amortized value and market value of fixed maturities at December 31, 1998 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. Amortized Market Value Value (in thousands) Due in one year $ 10,142 $ 10,256 Due after on year through five years 16,717 16,880 Due after five years through ten years 3,276 3,522 Due after ten years 13,479 14,856 Mortgage-backed securities 33,113 33,888 Total fixed maturities available for sale $ 76,727 $ 79,402 To reduce the exposure to market rate changes, portfolio investments are selected so that diversity, maturity, and liquidity factors approximate the duration of associated policyholder liabilities. Proceeds from maturities of investments in fixed maturities during 1998, 1997 and 1996 were $16,473,000, $7,998,000 and $1,265,000, respectively. There were gains of $5,916 and losses of $16,437 in 1998 and gains of $23,000 and losses of $0 in 1997 and no gains or losses in 1996. F-20 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The net change in unrealized investment gains (losses) represents the only component of other comprehensive income for the years ended December 31, 1998, 1997 and 1996. The following is a summary of the change in unrealized investment gains (losses) net of related deferred income taxes which are reflected in accumulated other comprehensive income for the periods presented: Change in Unrealized Gains (Losses ) on Investments 1998 1997 1996 (in thousands) Fixed maturities $ (1,170) $ 8,369 $ (10,511) Equity securities (52) 11 22 (1,222) 8,380 (10,489) Deferred federal income taxes (428) 2,933 (3,671) Net change in unrealized gains (losses) on investments $ (794) $ 5,447 $ (6,818) The following table sets forth the reclassification adjustments required for the years ended December 31, 1998, 1997 and 1996: Reclassification Adjustments 1998 1997 1996 (in thousands) Unrealized holding gains (losses) on investments arising during the period $ (790) $ 5,432 $ (6,818) Reclassification adjustments for gains included in net income (4) 15 0 Unrealized gains (losses) on investments, net of reclass- ification adjustment $ (794) $ 5,447 $ (6,818) F-21 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Net Investment Income The components of net investment income are summarized as follows: Year ended December 31, 1998 1997 1996 (in thousands) Fixed maturities $ 5,792 $ 5,853 $ 5,891 Other, including short-term investments and policy loans 2,080 2,336 1,553 7,872 8,189 7,444 Investment expenses (64) (83) (81) Net investment income $ 7,808 $ 8,106 $ 7,363 There were no impairments in the value of investments in 1998, 1997 or 1996, which were considered other than temporary. 3. Disclosure about Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments at December 31, 1998 are as follows: Carrying Fair Amount Value (in thousands) Financial assets: Fixed maturities $ 79,402 $ 79,402 Policy loans 3,155 3,155 Short-term investments 27,589 27,589 Cash and cash equivalents 2,601 2,601 Financial liabilities: Subordinated notes payable to affiliate $ 47,645 $ 47,645 F-22 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: 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. Cash and Short-term Investments The carrying amount of these instruments approximates market value. Subordinated Notes Payable to Affiliate The fair value is based on the Company's estimate of current market conditions. F-23 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 4. Investment in InterContinental Life Corporation The Company carries its investment in ILCO on the equity method of accounting. At December 31, 1998, excess of cost over net assets acquired of $1,686,000, net of accumulated amortization of $1,544,000, is included in investment in affiliate. At December 31, 1997, these amounts were $1,686,000 and $1,444,000, respectively. Amortization of this excess is reflected in equity in net earnings of affiliate. ILCO is primarily engaged in the sale and administration of life insurance products. Summarized financial information for ILCO is set forth below: Balance sheet information: 1998 1997 (in thousands) Investments $ 702,086 $ 693,059 Deferred policy acquisition costs and present value of future profits 75,619 75,907 Other assets 572,543 552,687 Total Assets $ 1,350,248 $ 1,321,653 Policy liabilities and contract holder deposit funds $ 694,351 $ 671,634 Other liabilities 501,662 504,257 Total liabilities 1,196,013 1,175,891 Common stock, additional paid-in capital and retained earnings 142,664 131,359 Accumulated other comprehensive income 11,571 14,403 Shareholders' equity 154,235 145,762 Total liabilities and shareholders' equity $ 1,350,248 $ 1,321,653 F-24 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Results of Operations: 1998 1997 1996 (in thousands) Premium income $ 10,890 $ 11,031 $ 9,980 Net investment income 54,619 57,740 59,836 Gain on sale of real estate -0- 14,630 23,520 Earned insurance charges 41,067 40,853 42,238 Benefits and expenses 91,876 96,081 96,801 Net income 11,119 20,540 26,938 Basic earnings per share $ 2.54 $ 4.75 $ 6.36 Diluted earnings per share $ 2.49 $ 4.70 $ 6.07 Total market value basis of the Company's investment in ILCO approximated $39,326,920 at both December 31, 1998 and 1997. FIC directly or indirectly owns 1,966,346 shares (approximately 45%, 45%, and 46%) of ILCO's outstanding common stock at December 31, 1998, 1997 and 1996, respectively. In January 1985, FIC acquired 26.53% of ILCO's common stock. FIC and Family Life subsequently acquired additional shares of ILCO's common stock and as of March 16, 1998, FIC owned, directly and indirectly through Family Life, approximately 45% of the outstanding shares of ILCO's common stock. Prior to October 1, 1998, FIC held options to acquire up to 1,702,155 additional shares of ILCO Common Stock. As a result of the final repayment on ILCO's Senior Loan (see discussion under the caption "Senior Loan") on September 30, 1998, FIC's options to acquire shares of ILCO's Common Stock expired. The amount of net realized gains included in net earnings of ILCO is $642,000, $9,623,000, and $15,262,000, for the years ended December 31, 1998, 1997 and 1996, respectively. 5. Acquisition of Business In 1991, the Company acquired Family Life, a Washington domiciled life insurance company, from Merrill Lynch Insurance Group, Inc. Present value of future profits of $87,726,000 was recorded as a result of the purchase. F-25 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued An analysis of the present value of future profits follows: 1998 1997 (in thousands) Balance at beginning of year $ 34,437 $ 40,604 Accretion of interest 2,667 3,212 Amortization during the period (8,810) (9,379) Present value of future profits at December 31 $ 28,294 $ 34,437 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): 1999 $ 5,713 2000 $ 4,613 2001 $ 3,725 2002 $ 3,008 2003 $ 2,430 At purchase, the present value of future profits was calculated using a discount rate of approximately 15%. Interest is accredited on the unamortized portion at approximately 8.5%. F-26 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 6. Subordinated Notes Payable Following is a summary of outstanding debt at December 31: 1998 1997 (in thousands) Subordinated senior notes payable to Investors-NA beginning with a $1,125,000 payment on December 12, 1996 and each subsequent quarter through September 12, 2001. Interest is payable on a quarterly basis at 11% $ 16,654 $ 16,875 Subordinated notes payable to Investors- NA beginning with a $223,856 payment on December 12, 1996 and each subsequent quarter through September 12, 2001. Interest is payable on a quarterly basis at 12% 2,463 3,358 Subordinated notes payable to Investors- NA beginning with a $188,071 payment on December 12, 1996 and each subsequent quarter through September 12, 2001, a payment of $1,536,927 on December 12, 2001 and each subsequent quarter through June 12, 2006 with a final payment of $1,536,967 on September 12, 2006. Interest is payable on a quarterly basis at 9% 28,528 33,559 Total subordinated notes payable $47,645 $53,792 The obligors are allowed to prepay the Investors-NA Subordinated Loans, in whole or in part, without premium or penalty. The Investors-NA Subordinated Loans were subordinated to the Senior Loan and now constitute a lien on the Pledged Collateral. Repayment of the Investors-NA Subordinated Loans is also guaranteed by the Company. Aggregate maturities of the Subordinated Notes Payable are as follows: (in thousands) 1999 $6,148 2000 6,148 2001 6,148 2002 6,148 2003 6,148 Thereafter 16,905 $47,645 F-27 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 7. Income Taxes The Company files a consolidated federal income tax return with its non-life subsidiaries. The Company's life insurance subsidiary files a separate federal income tax return. The U.S. federal income tax provision (benefit) charged to continuing operations was as follows: 1998 1997 1996 (in thousands) Current $ 119 $ 1,348 $ (1,165) Deferred 2,249 2,193 3,811 Total provision for income tax $2,368 $ 3,541 $ 2,646 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: 1998 1997 1996 (in thousands) Income taxes at the statutory rate $ 3,141 $ 4,694 $ 3,427 Increase (decrease) in taxes resulting from: Small life insurance company deduction (238) (499) -0- Dividends received deduction (586) (649) (771) Tax rate differential (90) (135) (98) Non-deductible compensation 38 -0- -0- Other items, net 103 130 88 Total provision for income taxes $ 2,368 $ 3,541 $ 2,646 Provision has not been made for state and foreign income tax expense since this expense is minimal. Premium taxed are paid to various states where premium revenue is earned. Premium taxes are included in the statement of income as operating expenses. F-28 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: Deferred tax liability: 1998 1997 (in thousands) Equity in net earnings of affiliate $ 4,414 $ 4,062 Excess pension benefit 436 436 Deferred policy acquisition costs 13,072 11,742 Present value of future profits 8,221 7,067 Guaranty fund assessments 388 536 Deferred and uncollected premium 4,141 3,769 Unrealized appreciation on marketable securities 1,250 1,347 Other taxable temporary differences 5,314 4,442 Total deferred tax liability 37,236 33,401 Deferred tax asset: Policy reserves 12,123 11,146 Net operating loss carry forward 957 159 Alternative minimum tax credit 114 407 Accrued liabilities 58 58 Total deferred tax assets, net 13,252 11,770 Net deferred tax liability $ 23,984 $21,631 Deferred federal income tax (benefit) expense of $(97,000) and $992,000 for 1998 and 1997, respectively, have been provided on the unrealized appreciation (depreciation) of marketable securities and included in the balance of the deferred tax liability. This increase or decrease in deferred tax liability has been recorded as 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-29 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 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. Provision for U.S. income taxes has not been made on a portion of the undistributed earnings of ILCO from the date of the Company's investment since the Company expects such earnings to be remitted in the form of dividends. The Company has provided for the tax on the undistributed earnings of ILCO net of the dividends received deduction expected to be allowed when such dividends are paid. The Company expects that additional deferred taxes would be payable on the undistributed earnings of ILCO if the Company should sell its investment. At December 31, 1998, FIC's 1995 federal income tax return was under review by the IRS. The statute of limitations for examinations remains open for all tax years subsequent to 1992. 8. Reinsurance Family Life reinsures portions of certain policies it writes, thereby providing greater diversification of risk and minimizing exposure on larger policies. The Company's retention on any one individual ranges from $-0- to $200,000 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 subsidiary remains liable to the extent the reinsurance companies are unable to meet their obligation under the reinsurance agreements. Under the provisions of the purchase agreement between the Company and Merrill Lynch, certain life insurance companies affiliated with Merrill Lynch agreed to assume (on an assumption reinsurance basis) certain single premium whole life and annuity products written by Merrill Lynch's insurance division on Family Life's paper. The transfer of these reserves, in accordance with the reinsurance agreement, is subject to certain regulatory approvals. The amount remaining under this agreement that had not yet been approved for transfer to Merrill Lynch was $115,524 and $106,221 at December 31, 1998 and 1997, respectively. F-30 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The amounts in the consolidated financial statements for reinsurance ceded are as follows: December 31, 1998 1997 1996 (in thousands) Future policy benefits $ 11,950 $ 9,765 $5,729 Unearned premiums 28 90 4 Other policy claims and benefits payable 448 1,279 426 $ 12,426 $ 11,134 $6,159 For the years ended 1998 1997 1996 (in thousands) Premiums $ 5,600 $6,169 $6,259 Policyholder benefits and expenses $ 2,479 $1,697 $ 670 Estimated amounts recoverable from reinsurers on paid claims were $4,603 and $64,142 in 1998 and 1997, respectively. These amounts were included in other receivables in the consolidated financial statements at December 31, 1998 and 1997. 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 ILCO. Family Life is 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. F-31 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued Family Life does not presently have earned surplus as defined by the regulations adopted by the Washington Insurance Commissioner and, therefore, is not presently permitted to pay cash dividends. However, the Company does not directly own its life insurance subsidiary's stock, but instead indirectly owns that stock through a downstream holding company, FLC, whose ability to pay dividends to the Company is significantly limited by some of the subordinated notes referred to in Note 6 during the terms of those loans. Consolidated net assets FLC aggregated approximately $54,514,000 and $53,158,000 at December 31, 1998 and 1997, respectively. The ability of ILCO to pay dividends to the Company and the other shareholders of ILCO is affected by receipt of dividends from its insurance subsidiaries, which are generally limited by law to the greater of their net income for the prior year or 10% of capital and surplus. 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 $30,294,446 and $30,386,953 at December 31, 1998 and 1997, respectively. Statutory net income aggregated approximately $10,473,492, $13,302,000 and $9,153,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The Company employed no permitted statutory accounting practices that individually or in the aggregate materially affected statutory surplus or risk-based capital at December 31, 1998 or 1997. In 1998, the NAIC adopted the Codification of Statutory Accounting Principles guidance, which will replace the current Accounting Practices and Procedures manual as the NAIC's primary guidance on statutory accounting. The NAIC is now considering amendments to the Codification guidance that would also be effective upon implementation. 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. It is not known whether Family Life's state of domicile's Insurance Department will adopt the Codification, and whether the Department will make any changes to that guidance. The Company has not estimated the potential effect of the Codification guidance on statutory net income and statutory capital and surplus if adopted by the Department. However, the actual effect of adoption could differ as changes are made to the Codification guidance, prior to its recommended effective date of January 1, 2001. The Company's Articles of Incorporation were amended during 1996 to: (i) increase the number of authorized shares of common stock from 3,304,200 shares to 10,000,000 shares and (ii) to reduce the par value of the common stock from $1.00 to $.20. These amendments to the Articles of Incorporation were related to the implementation of the five-for-one stock split in 1996, authorized by the Board of Directors. F-32 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 10. Options In connection with the subordinated senior notes and subordinated notes payable to Investors-NA, Investors-NA was granted non-transferrable options to purchase, in amounts proportionate to their respective loans, up to a total of 9.9 percent of the common shares of FIC. The option price is $2.10 per share (adjusted to reflect the five-for-one stock split in 1996), equivalent to the then current market price, subject to adjustment to prevent the effect of dilution. The options expire at the time of final repayment of each of the respective loans. 11. Retirement Plans and Employee Stock Plans Retirement Plan Family Life has a non-contributory defined benefit pension plan which covers employees who have completed one year or more of service. Under the 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): (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 .65% of Final Average Earnings up to Covered Compensation. With respect to service prior to April 1, 1997, the accrual rate described in paragraph (b), above, is applicable, with Average Final Earnings taking into account a participant's earnings subsequent to April 1, 1997. F-33 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 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 plan includes the following components: 1998 1997 1996 (in thousands) Service cost for benefits earned during the year $ 59 $ 88 $ 81 Interest cost on projected benefit obligation 452 509 497 Expected return on plan assets (633) (719) (690) Pension benefit $ (122) $ (122) $ (112) F-34 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued The following summarizes the status of the plan at December 31: 1998 1997 (in thousands) Change in benefit obligation: Benefit obligation at beginning of year $ 6,683 $ 6,563 Service cost 59 88 Interest cost 452 509 Benefits paid (897) (907) (Gain)/Loss due to change in assumptions 525 -0- (Gain)/Loss due to experience 868 430 Benefit obligation at end of year $ 7,690 $ 6,683 Change in plan assets: Fair value of plan assets at beginning of year $ 8,361 $ 8,990 Actual return on plan assets 495 278 Benefits paid (898) (907) Fair value of plan assets at end of year $ 7,958 $ 8,361 Funded Status: Funded status at end of year $ 268 $ 1,678 Unrecognized actuarial net (gain) loss 1,564 33 Prepaid pension expense at end of year $ 1,832 $ 1,710 The significant assumptions for the plans are as follows: The discount rate for projected benefit obligations was 7.25%, 7.75% and 7.75% for the years ended December 31, 1998, 1997 and 1996, respectively. The assumed long-term rate of compensation increases was 5.0 %, 6.0% and 6.0% for the years ended December 31, 1998, 1997 and 1996, respectively. The assumed long-term rate of return on plan assets was 8.0% for the years ended December 31, 1998, 1997 and 1996. F-35 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued During 1995, the ILCO Employee Stock Ownership Plan and the ILCO Savings and Investment Plan were amended to allow for the addition of Family Life as a participating employer, thus allowing Family Life employees to participate in the plans. In 1997, the ILCO Savings and Investment Plan was amended to provide for a matching contribution by participating companies. The match, which is in the form of shares of ILCO common stock, is equal to 100% of an eligible participant's elective deferral contributions, as defined in the Plan, not to exceed 1% of the participant's plan compensation. Allocations are made on a quarterly basis to the account of participants who have at least 250 hours of service in that quarter. Stock Option Plans 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, 1998, no options had been granted under this plan. 12. Leases Family Life occupies office facilities under lease agreements with unrelated third parties which expire over the next year. Certain office space leases may be renewed at the option of the Company. Rent expense in 1998, 1997 and 1996 was $628,979, $781,104, and $886,189 respectively. Minimum annual rentals are as follows: (in thousands) 1999 $ 476 2000 476 2001 469 2002 320 2003 19 Thereafter - 0- Total $ 1,760 F-36 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 13. Related Party Transactions The obligations of ILCO under the ILCO Senior Loan were guaranteed by FIC. FIC presently owns 1,966,346 shares of ILCO Common Stock, constituting 44.93% of such shares outstanding. As described under the heading "ILCO Senior Loan", the current Senior Loan of ILCO was fully repaid on September 30, 1998. Accordingly FIC's rights under the 1986 option agreement expired on September 30, 1998. FIC Property, a subsidiary of FIC, conducted the leasing activities for the Bridgepoint Square properties previously owned by Investors-NA. In connection with the December, 1997 sale of Bridgepoint Square Offices by Investors-NA and Family Life Insurance Company, FIC Realty received a commission in the amount of $156,000, of which $122,538 was paid by Investors-NA and $33,462 by Family Life. In connection with the 1996 sale of Austin Centre by Investors-NA, FIC Realty received a commission in the amount of $123,350 from Investors-NA. As part of the financing arrangement for the acquisition of Family Life, a $22.5 million loan was made by Investors-NA to FLC, a subsidiary of FIC, and a $2.5 million loan was made by Investors Life Insurance Company of California (Investors-CA), which was merged into Investors-NA in 1992, to FIC. In addition to the interest provided under those loans, Investors-NA 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 percent of shares of FIC's common stock at a price of $10.50 per share, equivalent to the then current market price, subject to adjustment to prevent dilution. As a result of the FIC's five-for-one stock split, which was effective November 12, 1996, the option price is currently $2.10 per share. The options originally were to expire on June 12, 1998 if not previously exercised. 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. On July 30, 1993, the subordinated indebtedness owed to Merrill Lynch and its affiliate was prepaid. The Company paid $38 million plus accrued interest to retire the indebtedness, which had a principal balance of approximately $50 million on July 30, 1993. The primary source of the funds used to prepay the subordinated debt was new subordinated loans totaling $34.5 million that FLC and Family Life Insurance Investment Company ("FLIIC"), another subsidiary of FIC, obtained from Investors-NA. The principal amount of the new subordinated debt is payable 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 new debt are substantially the same as those of the $22.5 million subordinated loans that Investors-NA had previously made to FLC and that continue to be outstanding. As of June 12, 1996, the provisions of the notes from Investors-NA to FIC, FLC and FLIIC were modified as follows: (a) the $22.5 million note was amended to provide for twenty quarterly principal payments, in the amount of $1,125,000 F-37 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued each, to commence on December 12, 1996; the final quarterly principal payment is due on September 12, 2001; the interest rate on the note remains at 11%, (b) 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%, (c) 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%, (d) the $2.5 million note was amended to provide that the principal balance of the note is to be repaid in twenty quarterly installments of $125,000 each, commencing December 12, 1996 with the final payment due on September 12, 2001; the rate of interest remains at 12%, (e) the Master PIK note, which was issued to provide for the payment in kind of interest due under the terms of the $2.5 million note prior to June 12, 1996, was amended to provide that the principal balance of the note $1,977,119 is to be paid in twenty quarterly principal payments, in the amount of $98,855.95 each, to commence December 12, 1996 with the final payment due on September 12, 2001; the interest rate on the note remains at 12%. 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. FIC was reimbursed by ILCO for rental expense and certain other operating expenses incurred during 1998, 1997 and 1996 on behalf of ILCO. The amount of such reimbursement was approximately $ -0- , $822,000 and $305,000, respectively. Data processing services are provided to ILCO's and FIC's Austin, Texas and Seattle, Washington facilities by FIC Computer Services, Inc. ("FIC Computer"), a subsidiary of FIC. Each of FIC's and ILCO's insurance subsidiaries has entered into a data processing agreement with FIC Computer whereby FIC Computer provides data processing services to each subsidiary for fees equal to such subsidiary's proportionate share of FIC Computer's actual costs of providing those services to all of the subsidiaries. Family Life paid $ 1,610,397, $824,425 and $1,055,639 and ILCO's insurance subsidiaries paid $2,818,095, $3,010,110 and $2,243,234 to FIC Computer for data processing services provided during 1998, 1997 and 1996, respectively. In 1995, Family Life entered into a reinsurance agreement with Investors-NA 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 F-38 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 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-NA, pertaining to annuity contracts written by Family Life. The agreement applies to contracts written on or after January 1, 1996. Pursuant to a Service Agreement between Family Life and Investors NA, the Company reimbursed Investors NA for certain operating expenses incurred on behalf of FLIC totaling approximately $11 million, $14 million, and $14million in 1998, 1997 and 1996, respectively. In November, 1998, FIC purchased 101,304 shares of FIC's common stock from the Roy F. and Joann Cole Mitte Foundation (the "Foundation"), a Texas non-profit corporation which is controlled by Mr. Mitte and his wife, at a price of $18.625 per share (or a total purchase price of $1,886,787). At the same time, Family Life purchased 272,000 shares of FIC's common stock from the Foundation at a price of $18.625 per share (or a total purchase price of $5,066,000). Mr. Mitte and his wife had previously donated the shares to the Foundation. The shares are included in common treasury stock in the Company's financial statements at cost. 14. 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-39 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 15. Net Income Per Share (in thousands except per share data) The following table reflects the calculation of basic and diluted earnings per share: December 31, 1998 1997 1996 (Amounts in thousands, except per share amounts) Basic: Net income available to common shareholders $ 9,218 $ 16,328 $ 16,157 Average weighted common stock outstanding 5,383 5,428 5,428 Basic earnings per share $ 1.71 $ 3.01 $ 2.98 Diluted: Net income available to common shareholders $ 9,218 $16,328 $ 16,157 Average weighted common stock outstanding 5,383 5,428 5,428 Common stock options 293 293 288 Effect of shares of ILCO owns of FIC (85) (86) (88) Repurchase of treasury stock (34) (46) (60) Common stock and common stock equivalents 5,557 5,589 5,568 Diluted earnings per share $ 1.66 $ 2.92 $ 2.90
16. Business Concentration The Company's insurance subsidiary, 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 1998, premium income from these products was derived from forty-nine states with concentrations of approximately 24% and 25% in California and Texas, respectively. In 1997, these amounts were 23% and 25%, respectively. F-40 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued 17. Quarterly Financial Data (unaudited) (in thousands, except per share data) Three Months Three Months Ended Ended March 31, June 30, 1998 1997 1998 1997 Total revenues $ 13,476 $ 14,076 $ 14,028 $ 14,367 Net income $ 2,333 $ 2,228 $ 2,493 $ 2,221 Basic earnings per share $ 0.43 $ 0.41 $ 0.46 $ 0.41 Diluted earnings per share $ 0.42 $ 0.40 $ 0.44 $ 0.40
Three Months Three Months Ended Ended September 30, December 31, 1998 1997 1998 1997 Total revenues $ 13,461 $ 14,542 $ 12,642 $ 19,171 Net income $ 2,153 $ 2,603 $ 2,240 $ 9,276 Basic earnings per share $ 0.40 $ 0.48 $ 0.43 $ 1.71 Diluted earnings per share $ 0.38 $ 0.47 $ 0.41 $ 1.66
18. Subsequent Events On March 6, 1999, ILCO's Board of Directors approved a stock dividend in the amount of one share of ILCO common stock for each share issued and outstanding. The stock dividend was paid on March 17, 1999, to holders of record on March 8, 1999 F-41 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SCHEDULE I - SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 1998 (in thousands) Column A Column B Column C Column D Amount Shown on Type of Investment Amortized Cost Fair Value the Balance Sheet Fixed Maturities Available for Sale: Bonds: United States Government and government agencies and authorities $ 16,125 $ 17,139 $ 17,139 States, municipalities and political subdivisions 2,990 3,097 3,097 Corporate securities 24,499 25,278 25,278 Mortgage-backed securities 33,113 33,888 33,888 Total fixed maturities 76,727 79,402 79,402 Equity securities: Common Stocks Industrial and miscellaneous other 11 4 4 Total equity securities 11 4 4 Policy loans 3,155 3,155 3,155 Short -term investments 27,589 27,589 27,589 Total investments $ 107,482 $ 110,150 $ 110,150
F-42 FINANCIAL INDUSTRIES CORPORATION (PARENT COMPANY) SCHEDULE II - CONDENSED FINANCIAL STATEMENTS OF REGISTRANT BALANCE SHEETS December 31, 1998 1997 ASSETS (in thousands) Cash $ 55 $ 54 Short-term investments 57 1,103 Long-term bonds 16 16 Investments in subsidiaries* 131,333 117,286 Property, plant and equipment, net 509 474 Other assets 968 1,018 Accounts receivable 126 77 Total assets $ 133,064 $ 120,032 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Subordinated notes payable $ 6,742 $ 3,358 Other liabilities and intercompany payables 5,936 2,825 Total liabilities 12,678 6,183 Shareholders' equity Common stock, $.20 par value, 10,000,000 shares authorized; 5,845,300 shares issued, 5,326,661 and 5,427,965 shares outstanding in 1998 and 1997,respectively 1,169 1,169 Additional paid-in capital 7,225 7,225 Accumulated other compensation income 5,898 6,692 Retained earnings (including $106,037 and $95,703 of undistributed earnings of subsidiaries at December 31, 1998 and 1997) 108,403 99,185 122,695 114,271 Common treasury stock, at cost, 518,639 and 417,335 shares in 1998 and 1997, respectively (2,309) (422) Total shareholders' equity 120,386 113,849 Total liabilities and shareholders' equity $133,064 $120,032 * $60,383 and $50,534 are eliminated in consolidation in 1998 and 1997, respectively. F-43 FINANCIAL INDUSTRIES CORPORATION (PARENT COMPANY) SCHEDULE II - CONDENSED FINANCIAL STATEMENTS OF REGISTRANT, STATEMENTS OF INCOME FOR THE YEARS ENDED December 31, (in thousands) 1998 1997 1996 Income $ 89 $ 1,375 $ 811 Operating expenses 436 1,136 461 Interest expense* 769 869 977 1,205 2,005 1,438 Loss from operations (1,116) (630) (627) Equity in undistributed earnings from subsidiaries 10,334 16,958 16,784 Net income $ 9,218 $ 16,328 $ 16,157 *In consolidation, $179 is reported as a reduction in equity in earnings of unconsolidated subsidiary. F-44 FINANCIAL INDUSTRIES CORPORATION (PARENT COMPANY) SCHEDULE II - CONDENSED FINANCIAL STATEMENTS OF REGISTRANT STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED December 31, (in thousands) 1998 1997 1996 CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 9,218 $16,328 $16,157 Adjustments to reconcile net income to net cash used in operating activities: Increase in accounts receivables (49) (20) 3 Increase in investment in subsidiaries* (14,837) (21,024) (13,619) Decrease in other assets 50 68 2 Decrease in other liabilities and intercompany payables 3,111 (980) (694) Decrease in property and equipment (35) 5,702 26 Net cash (used in) provided by in operating activities (2,542) 74 1,875 CASH FLOWS FROM FINANCING ACTIVITIES Net change in short-term investments 1,046 823 (1,926) Subordinated notes payable issued to Investors-NA 3,384 (895) 32 Purchase of treasury stock (1,887) 0 0 Net cash provided by (used in) financing activities 2,543 (72) (1,894) Increase in cash 1 2 (19) Cash, beginning of year 54 52 71 Cash, end of year $ 55 $ 54 $ 52
*Eliminated in consolidation F-45 FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SCHEDULE IV-REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 and 1996 (in thousands) Ceded to Other Assumed From Percentage of Direct Amount Companies Other Companies Net Amount Amount Assumed 1998 Life Insurance in- force $7,755,545 $440,270 $ 6,159 $7,321,434 0.08% Life insurance $ 38,908 $ 769 $ 60 $ 38,199 0.16% Accident-health insurance 809 650 0 159 0.00% Total $ 39,717 $ 1,419 $ 60 $ 38,358 0.16% 1997 Life insurance in- force $7,809,531 $403,600 $ 6,663 $7,412,594 0.09% Premium: Life insurance $ 40,333 $ 704 $ 94 $ 39,723 0.24% Accident-health insurance 934 408 -0- 526 0.00% Total $ 41,267 $ 1,112 $ 94 $ 40,249 0.23% Life insurance in- force $8,324,406 $365,103 $ 5,772 $7,965,075 0.07% Life insurance $ 42,881 $ 851 $ 64 $ 42,094 0.15% Accident-health insurance 1,243 1 0 1,242 0.00% Total $ 44,124 $ 852 $ 64 $ 43,336 0.15%
F-46 EXHIBIT INDEX Exhibit Page Description No. Nos 3 The current Articles of Incorporation and Bylaws of Registrant. Exhibit 3 to Registrant's Report on Form 10-K filed for the year 1985 is hereby incorporated by reference. 3(a) Certificate of Amendment to the Articles of Incorporation of Registrant, dated November 12, 1996, filed as an exhibit with Registrant's 10-Q for the quarter ended September 30, 1996 and incorporated herein by reference. 10(ah) Guaranty Agreement dated as of December 28, 1988 from Registrant to a group of banks on Senior Loan to ILCO, filed as an exhibit with Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 10(ai) Guaranty Agreement, dated as of December 1, 1988, on loan to ILCO on the Note Purchase Agreement between ILCO and a Connecticut based insurance/financial services company; a guaranty agreement in substantially identical form was provided by FIC to each of the seven other entities participating in said loan, filed as an exhibit with Registrant's Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 10(aj) Guaranty Agreement, dated as of July 30, 1990, issued by the Registrant to a holder of ILCO's 1999 Series Subordinated Notes; a guaranty agreement in substantially identical form was provided by the Registrant to each of the holders of said notes. *10(ak) Stock Purchase Agreement by and among Merrill Lynch Insurance Group, Inc., Family Life Insurance Company, Family Life Corporation, Family Life Insurance Investment Company and Financial Industries Corporation dated as of March 19, 1991, as amended. Ex-1 *10(al) Note dated June 12, 1991 in the amount of $30 million made by a subsidiary of the Registrant in favor of Merrill Lynch Insurance Group, Inc. *10(am) Note dated June 12, 1991 in the amount of $12 million made by a subsidiary of the Registrant to Merrill Lynch & Co., Inc. *10(an) Note dated June 12, 1991 in the amount of $2 million made by a subsidiary of the Registrant in favor of the Seller under the Stock Purchase Agreement dated as of March 19, 1991. *10(ao) Performance and Payment Guaranty Agreement dated June 12, 1991 by Registrant in favor of the Seller under the Stock Purchase Agreement dated as of March 19, 1991. *10(ap) Payment Guaranty Agreement dated June 12, 1991 by Registrant in favor of the Seller under the Stock Purchase Agreement dated as of March 19, 1991. *10(aq) InterCreditor Agreement dated June 12, 1991 among Investors Life Insurance Company of North America, Investors Life Insurance Company of California, Merrill Lynch Insurance Group, Inc., and Merrill Lynch & Co., Inc. *10(ar) Credit Agreement dated as of June 12, 1991 among Family Life Corporation (a subsidiary of the Registrant), the Lenders named therein and the Agent. *10(as) Guaranty Agreement by Registrant of the $50 million loan to Family Life Corporation in favor of the bank lenders under the Credit Agreement dated as of June 12, 1991. *10(at) Guaranty Agreement by a subsidiary of the Registrant on the $50 million loan to Family Life Corporation in favor of the bank lenders under the Credit Agreement dated as of June 12, 1991. Ex-2 *10(au) Pledge Agreement by Family Life Corporation (a subsidiary of the Registrant) in favor of the bank lenders under the Credit Agreement dated as of June 12, 1991. *10(aw) Pledge Agreement by Family Life Insurance Investment Company (a subsidiary of the Registrant) in favor of the bank lenders under the Credit Agreement dated as of June 12, 1991. *10(ax) Note dated June 12, 1991 in the amount of $22.5 million made by a subsidiary of the Registrant in favor of Investors Life Insurance Company of North America. *10(ay) Note dated June 12, 1991 in the amount of $2.5 million made by the Registrant in favor of Investors Life Insurance Company of California. *10(az) InterCreditor Agreement among Investors Life Insurance Company of North America, Investors Life Insurance Company of California, and the Agent under the Credit Agreement dated as of June 12, 1991. *10(aaa) Option Agreement by the Registrant in favor of Investors life Insurance Company of North America and Investors Life Insurance Company of California. 10(aab) Hotel Lease Agreement dated as of August 22, 1991 between Investors Life Insurance Company of North America and FIC Realty Services, Inc. filed as exhibit 10(aab) by Registrant on Form 10-K for the year ended December 31, 1991 is hereby incorporated by reference. 10(aac) Management Agreement dated as of September 4, 1991 between Investors Life Insurance Company of North America and FIC Property Management, Inc. filed as exhibit 10(aac) by Registrant on Form 10-K for the year ended December 31, 1991 is hereby incorporated by reference. 10(aad) Stock Option Agreement dated March 8, 1986 between ILCO and Registrant filed as exhibit 10(aad) by Registrant on Form 10-K for the year ended December 31, 1992 is hereby incorporated by reference. Ex-3 10(aae) Amended and Restated Guaranty of Registrant dated January 29, 1993 filed as exhibit 10(aae) by Registrant on Form 10-K for the year ended December 31, 1992 is hereby incorporation by reference. 10(aaf) Surplus Debenture dated as of June 12, 1991 in the amount of $97.5 million made by Family Life Insurance Company in favor of Family Life Corporation filed as exhibit 10(aaf) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aag) Note dated July 30, 1993 in the amount of $30 million made by Family Life Corporation in favor of Investors Life Insurance Company of North America filed as exhibit 10(aag) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aah) Note dated July 30, 1993 in the amount of $4.5 million made by Family Life Insurance Investment Company in favor of Investors Life Insurance Company of North America filed as exhibit 10(aah) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aai) Amendment No. 1 dated July 30, 1993 between Family Life Corporation and Investors Life Insurance Company of North America amending $22.5 million note filed as exhibit 10(aai) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aaj) Amendment No. 1 dated July 30, 1993 between Family Life Insurance Company and Family Life Corporation amending $97.5 million Surplus Debenture filed as exhibit 10(aaj) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aak) Guaranty Agreement dated July 30, 1993 by Registrant of the $30 million loan to Family Life Corporation in favor of Investors Life Insurance Company of North America filed as exhibit 10(aak) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. Ex-4 10(aal) Guaranty Agreement dated July 30, 1993 by Registrant of the $4.5 million loan to Family Life Insurance Investment Company in favor of Investors Life Insurance Company of North America filed as exhibit 10(aal) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aam) Letter agreement dated May 26, 1993 among Family Life Corporation, Family Life Insurance Investment Company, Merrill Lynch & Co., Inc. and Merrill Lynch Group, Inc. filed as exhibit 10(aam) by Registrant on Form 10-K for the year ended December 31, 1993 is hereby incorporated by reference. 10(aan) Waiver and Amendment Agreement dated as of July 23, 1993 among Family Life Corporation, the Lenders named therein and the Agent filed as exhibit 10(aan) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporate by reference. 10(aao) Waiver and Amendment Agreement dated as of December 14, 1993 among Family Life Corporation, the Lenders named therein and the Agent filed as exhibit 10(aao) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporated by reference. 10(aap) Data Processing Agreement dated as of November 30, 1994 between InterContinental Life Insurance Company and FIC Computer Services, Inc filed as exhibit 10(aap) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporated by reference. 10(aaq) Data Processing Agreement dated as of November 30, 1994 between Investors Life Insurance Company of North America and FIC Computer Services, Inc filed as exhibit 10(aaq) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporated by Reference. 10(aar) Data Processing Agreement dated as of November 30, 1994 between Family Life Insurance Company and FIC Computer Services, Inc filed as exhibit 10(aar) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporated by reference. Ex-5 10(aas) Lease Agreement dated as of September 30, 1994 between FIC Realty Services, Inc. and Atrium Beverage Corporation filed as exhibit 10(aas) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporated by reference. 10(aat) Management Agreement dated as of September 30, 1994 between HCD Austin Corporation as agent for FIC Realty Services, Inc. and Atrium Beverage Corporation filed as exhibit 10(aat) by Registrant on Form 10-K for the year ended December 31, 1994 is hereby incorporated by reference. 10(aau) Amendment Agreement dated as of July 31, 1995 among Family Life Corporation, the Lenders named therein and the Agent filed as exhibit 10(aau) by Registrant on Form 10-K for the year ended December 31, 1995 is hereby incorporated by reference. 10(aav) Amendment No. 2 dated December 12, 1996, effective June 12, 1996 to the note dated June 12, 1991 in the amount of $22.5 million made by Family Life Corporation in favor of Investors Life Insurance Company of North America filed as exhibit 10(aav) by Registrant on Form 10-K for the year ended December 31, 1996 is hereby incorporated by reference. 10(aaw) (i) Amendment No. 1 dated December 12, 1996, effective June 12, 1996 to the note dated June 12, 1991 in the amount of $2.5 million made by Financial Industries Corporation in favor of Investors Life Insurance Company of California filed as exhibit 10(aaw)(i) by Registrant on Form 10-K for the year ended December 31, 1996 is hereby incorporated by reference. (ii) Amendment No. 1 dated December 12, 1996, effective June 12, 1996 to the "payment in kind" provisions of the note dated June 12, 1991 in the amount of $2.5 million made by Financial Industries Corporation in favor of Investors Life Insurance Company of North America filed as Ex-6 exhibit 10(aaw)(ii) by Registrant on Form 10-K for the year ended December 31, 1996 is hereby incorporated by reference. 10(aax) Amendment No. 1 dated December 12, 1996, effective June 12, 1996 to the note dated July 30, 1993 in the amount of $30 million made by Family Life Corporation in favor of Investors Life Insurance Company of North America filed as exhibit 10(aax) by Registrant on Form 10-K for the year ended December 31, 1996 is hereby incorporated by reference. 10(aay) Amendment No. 1 dated December 12, 1996, effective June 12, 1996 to the note dated July 30, 1993 in the amount of $4.5 million made by Family Life Insurance Investment Company in favor of Investors Life Insurance Company of North America filed as exhibit 10(aay) by Registrant on Form 10-K for the year ended December 31, 1996 is hereby incorporated by reference. 10(aaz) Amendment Agreement dated December 12, 1996 amending the Option Agreement by Financial Industries Corporation in favor of Investors Life Insurance Company of North America and Investors Life Insurance Company of California filed as exhibit 10(aaz) Registrant on Form 10-K for the year ended December 31, 1996 is hereby incorporated by reference. 10(aaaa) Ex-9 Assignment Agreement dated December 23, 1998, from Family Life Insurance Investment Company to Financial Industries Corporation, assigning the 9% Senior Subordinated Note dated July 30, 1993 in the amount of $4.5 million made by Family Life Insurance Investment Company in favor of Investors Life Insurance Company of North America. 21 Ex-11 Subsidiaries of Registrant. 28 Report on Form 10-K filed by ILCO for the year ended December 31, 1998 is hereby incorporated by reference in its entirety. Ex-7 * Filed as an Exhibit with Registrant's Current Report on Form 8-K dated June 25, 1991, and incorporated herein by reference. Ex-8 Exhibit 10(aaaa) Assignment of 9% Senior Subordinated Note Dated July 30, 1993 This Assignment Agreement ("Assignment") is entered into effective December 23, 1998 , 1998 by and between Family Life Insurance Investment Corporation ("Assignor"), Financial Industries Corporation ("Assignee") and Investors Life Insurance Company of North America ("Payee"). WHEREAS, Assignor is the obligor and Payor under that certain 9% Subordinated Senior Note dated July 30, 1993 in the principal amount of $4,500,000, as amended by Amendment No. 1 dated December 12, 1996, with a current principal balance of $4,279,221 (as amended, the "Note"), and WHEREAS, Investors Life Insurance Company of North America is the Payee under the Note, and WHEREAS, Assignor will dissolve pursuant to a Plan of Dissolution and Articles of Dissolution dated November 30, 1998 which were prepared by the Board of Directors of Assignor and approved by the shareholders of Assignor, and WHEREAS, Assignee has agreed to assume all of the rights, duties and obligations of Assignor under the Note, and WHEREAS, Payee has agreed to release Assignor from Assignor's duties and obligations under the Note once the Note is assumed by Assignee, NOW THEREFORE, for good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto agree as follows: 1. Capitalized terms used herein and not otherwise defined in this Assignment shall have the meanings attributed to such terms in the Note. 2. Assignor hereby assigns and sets over to Assignee all of Assignor's rights, duties and obligations under the Note. 3. Assignee hereby accepts all of Assignor's rights, duties and obligations under the Note and agrees to perform all of the duties and obligations contained in the Note. 4. By consenting to this Assignment, Payee agrees that Assignee shall assume all of Assignor's rights, duties and obligations under the Note. Ex-9 IN WITNESS WHEREOF, Family Life Insurance Investment Company, Financial Industries Corporation and Investors Life Insurance Company of North America have executed this Assignment as of December 23 , 1998 Assignor: FAMILY LIFE INSURANCE INVESTMENT CORPORATION By: /s/ James M. Grace Name: James M. Grace Title: Executive Vice President Assignee: FINANCIAL INDUSTRIES CORPORATION By: /s/ Roy F. Mitte Name: Roy F. Mitte Title: President Approved and Agreed to by Payee: INVESTORS LIFE INSURANCE COMPANY OF NORTH AMERICA By: /s/ Roy F. Mitte Name: Roy F. Mitte Title: President Ex-10 EXHIBIT 21 Subsidiaries of Registrant 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. Atrium Beverage Corporation Ex-11 EX-27 2
7 THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR DEC-31-1998 DEC-31-1998 79,402 0 0 4 0 0 110,150 2,601 12,426 48,510 301,738 60,069 28 45,128 4,582 47,645 0 0 1,169 114,151 301,738 38,358 7,808 0 1,470 16,258 5,174 11,822 11,586 2,368 9,218 0 0 0 9,218 1.71 1.66 0 0 0 0 0 0 0
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