10-Q 1 fic10q1q02.txt FIC 10Q 1ST QUARTER 2002 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934 For the Quarterly Period Ended March 31, 2002 Commission File Number 0-4690 FINANCIAL INDUSTRIES CORPORATION (Exact Name of Registrant as specified in its charter) Texas 74-2126975 (State of Incorporation) (I.R.S. Employer Identification Number) 6500 River Place Blvd., Building One, Austin, Texas 78730 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (512) 404-5000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO Number of common shares outstanding ($.20 par value) at end of period: 9,499,629. - 1 - Forward-Looking Statements Except for historical factual information set forth in this Form 10-Q, the statements, analyses, and other information contained in this report relating to trends in the Company's operations and financial results, the markets for the Company's products, the future development of the Company's business, and the contingencies and uncertainties to which the Company may be subject, as well as other statements including words such as "anticipate," "believe," "path," "estimate," "expect," "intend" and other similar expressions constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Such statements are made based upon management's current expectations and beliefs concerning the financial results, economic conditions and are subject to known and unknown risks, uncertainties and other factors contemplated by the forward-looking statements. Such factors include, among other things: (1) general economic conditions and other factors, including prevailing interest rate levels and stock market performance, which may affect the ability of FIC to sell its products, the market value of FIC's investments and the lapse rate and profitability of policies; (2) FIC's ability to achieve anticipated levels of operational efficiencies and cost-saving initiatives; (3) customer response to new products, distribution channels and marketing initiatives; (4) mortality, morbidity and other factors which may affect the profitability of FIC's insurance products; (5) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of FIC's products; (6) increasing competition in the sale of insurance and annuities; (7) regulatory changes or actions, including those relating to regulation of insurance products and insurance companies; (8) ratings assigned to FIC's insurance subsidiaries by independent rating organizations such as A.M. Best Company, which FIC believes are particularly important to the sale of annuity and other accumulation products; and (9) unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect FIC. - 2 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES INDEX Page No. Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets March 31, 2002 and December 31, 2001................................ 4 Consolidated Statements of Income For the three month periods ended March 31, 2002 and March 31, 2001................................... 6 Consolidated Statements of Cash Flows For the three month periods ended March 31, 2002 and March 31, 2001................................... 8 Notes to Consolidated Financial Statements.................................. 10 Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations...................... 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk .................................................. 22 Part II Other Information........................................................... 23 Signature Page.............................................................. 25 - 3 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) March 31, December 31, 2002 2001 (unaudited) ASSETS Investments other than investments in affiliate: Fixed maturities held to maturity, at amortized cost (market value approximates $1,042 and $1,028 at March 31, 2002 and December 31, 2001, respectively) $ 1,035 $ 1,029 Fixed maturities available for sale, at market value (amortized cost of $492,814 and $496,704 at March 31, 2002 and December 31, 2001, respectively) 492,471 501,395 Equity securities, at market (cost approximates $59 at March 31, 2002 and December 31, 2001) 48 56 Policy loans 48,926 49,794 Mortgage loans 4,674 4,715 Invested real estate 64,029 61,049 Short-term investments 128,271 138,291 Total investments 739,454 756,329 Cash and cash equivalents 9,819 7,094 Accrued investment income 10,735 8,483 Agency advances and other receivables 30,072 30,324 Reinsurance receivables 14,976 14,709 Due and deferred premiums 12,861 13,411 Real estate occupied by Company 19,950 20,054 Property and equipment, net 3,576 3,546 Deferred policy acquisition costs 81,191 80,290 Present value of future profits of acquired businesses 30,590 31,251 Other assets 17,553 14,074 Separate account assets 388,480 399,264 Total Assets $ 1,359,257 $ 1,378,829 The accompanying notes are an integral part of these consolidated financial statements - 4 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands) March 31, December 31, 2002 2001 (unaudited) LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Policy liabilities and contract holder deposit funds: Contract holder deposit funds $ 552,851 $ 556,117 Future policy benefits 180,144 180,953 Other policy claims and benefits payable 13,789 13,985 746,784 751,055 Deferred federal income taxes 29,090 31,920 Excess of net assets acquired over cost 0 15,847 Other liabilities 9,283 8,938 Separate account liabilities 380,716 391,593 Total Liabilities 1,165,873 1,199,353 Commitments and Contingencies: Shareholders' equity: Common stock, $.20 par value, 25,000 shares authorized, 11,762 and 11,736 shares issued at March 31, 2002 and December 31, 2001, 9,499 and 9,499 shares outstanding at March 31, 2002 and December 31, 2001. 2,353 2,348 Additional paid-in capital 65,747 65,558 Accumulated other comprehensive income (441) 2,297 Deferred compensation (263) (292) Retained earnings 148,345 131,462 215,741 201,373 Common treasury stock, at cost, 2,263 and 2,237 shares at March 31, 2002 and December 31, 2001, respectively. (22,357) (21,897) Total Shareholders' Equity 193,384 179,476 Total Liabilities and Shareholders' Equity $ 1,359,257 $ 1,378,829 The accompanying notes are an integral part of these consolidated financial statements. - 5 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended March 31, 2002 2001 (unaudited) Revenues: Premiums, net $ 9,914 $ 8,038 Earned insurance charges 10,825 934 Net investment income 11,048 1,631 Other 452 0 32,239 10,603 Benefits and expenses: Policyholder benefits and expenses 10,284 2,591 Interest expense on contract holders deposit funds 7,985 570 Amortization of present value of future profits of acquired businesses 1,070 838 Amortization of deferred policy acquisition costs 1,923 1,439 Operating expenses 8,887 3,140 Interest expense 0 427 30,149 9,005 Income before federal income tax, equity in net earnings of affiliates and cumulative effect of change in accounting principle 2,090 1,598 Provision for federal income taxes 933 360 Income before equity in net earnings of affiliates and cumulative effect of change in accounting principle 1,157 1,238 Equity in net earnings of affiliate, net of tax 0 845 Net income before cumulative effect of change in accounting principle 1,157 2,083 Cumulative effect of change in accounting principle 15,727 0 Net Income $ 16,884 $ 2,083 The accompanying notes are an integral part of these consolidated statements. - 6 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands except per share data) Three Months Ended March 31, 2002 2001 (unaudited) Net Income Per Share Basic: Average weighted shares outstanding $ 9,500 $ 5,055 Basic earnings per share: Income per share before cumulative effect of change in accounting principle $ 0.12 $ 0.41 Cumulative effect of change in accounting principle 1.66 0 Basic earnings per share $ 1.78 $ 0.41 Diluted: Common stock and common stock equivalents 9,575 5,183 Diluted earnings per share: Income per share before cumulative effect of change in accounting principle $ 0.12 $ 0.40 Cumulative effect of change in accounting principle 1.64 0 Diluted earnings per share $ 1.76 $ 0.40 The accompanying notes are an integral part of these consolidated financial statements. - 7 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Three Months Ended March 31, 2002 2001 (unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Net Income $ 16,884 $ 2,083 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Amortization of present value of future profits of acquired business 1,070 838 Amortization of deferred policy acquisition costs 1,923 1,439 Cumulative change in accounting principle (15,727) 0 Equity in undistributed earnings of affiliate 0 (1,361) Changes in assets and liabilities: Increase in accrued investment income (2,252) (176) Increase in agent advances and other receivables (15) (2,920) Decrease (increase) in due premiums 550 (326) Increase in deferred policy acquisition costs (2,335) (1,973) Increase in other assets (3,478) (336) (Decrease) increase in policy liabilities and accruals (4,243) 296 Increase in other liabilities 345 1,757 (Decrease) increase in deferred federal income taxes (1,424) 36 Other, net (36) (661) Net cash used in operating activities $ (8,738) $ (1,304) The accompanying notes are an integral part of these consolidated financial statements. - 8 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, Continued (in thousands) Three Months Ended March 31, 2002 2001 (unaudited) CASH FLOWS FROM INVESTING ACTIVITIES Fixed maturities purchased $ (27,395) $ (5,200) Real estate capitalized (2,980) 0 Change in policy loans 868 (47) Proceeds from calls and maturities of fixed maturities 31,276 8,496 Net change in short-term investments 10,020 762 Purchase and retirement of property and equipment (30) 0 Net cash provided by investing activities 11,759 4,011 CASH FLOW FROM FINANCING ACTIVITIES Repayment of subordinated notes payable 0 (1,537) Contract holder fund deposits 12,518 1,063 Contract holder fund withdrawals (12,548) (1,111) Issuance of capital stock 194 0 Purchase of treasury stock (460) 0 Net cash used in financing activities (296) (1,585) Net increase in cash 2,725 1,122 Cash and cash equivalents, beginning of year 7,094 2,733 Cash and cash equivalents, end of period $ 9,819 $ 3,855 The accompanying notes are an integral part of these consolidated financial statements. - 9 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The financial statements included herein have been presented to conform to the requirements of Form 10-Q. This presentation includes year end balance sheet data which was derived from audited financial statements. The notes to the financial statements do not necessarily include all disclosures required by generally accepted accounting principles (GAAP). The reader should refer to Form 10-K for the year ended December 31, 2001 previously filed with the Securities and Exchange Commission for financial statements prepared in accordance with GAAP. Management believes the financial statements reflect all adjustments necessary to present a fair statement of interim results. Certain prior year amounts have been reclassified to conform with current year presentation. The consolidated financial statements include the accounts of Financial Industries Corporation ("FIC") and its wholly-owned subsidiaries. All significant intercompany items and transactions have been eliminated. Other Comprehensive Income The following is a reconciliation of accumulated other comprehensive income from December 31, 2001 to March 31, 2002 (in thousands): Net unrealized Total gain (loss) on Net accumulated investments appreciation other in fixed maturities of equity comprehensive available for sale securities Other income Balance at December 31, 2001 $ 2,527 $ (2) $ (228) $ 2,297 Current Period Change (2,733) (5) 0 (2,738) Balance at March 31, 2002 $ (206) $ (7) $ (228) $ (441)
- 10 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Dividends Declared In March, 2001 FIC announced that its board approved the payment of an annual cash dividend in the amount of $0.41 per share. The dividend was paid on April 12, 2001, to shareholders of record as of the close of business on March 19, 2001. Related Party Transactions On January 8, 2001, the Company donated $375,000 to the Roy F. and Joann Cole Mitte Foundation (the "Foundation"). The Foundation is a charitable entity exempt from federal income tax under section 501(a) of the Code as an organization described in section 501(c)(3) of the Code, and owns 16.31% of the outstanding shares of FIC's common stock. The sole members of the Foundation are Roy F. Mitte, Chairman, President and Chief Executive Officer of FIC, ILCO and their insurance subsidiaries, and his wife, Joann Cole Mitte. On January 2, 2002, FIC made a donation of $1,000,000 to the Foundation. New Accounting Pronouncements During 2001, the FASB issued Statement of Financial Accounting Standards No. 141 (FAS 141), "Business Combinations," which supersedes Accounting Principles Board Opinion No. 16 (APB 16), "Business Combinations," and establishes guidelines to account for all acquisitions of a controlling interest, regardless of the form of consideration. The most significant changes made by FAS 141 are that it: (1) requires the purchase method of accounting, rather than the pooling method, be used for all business combinations initiated after June 30, 2001; (2) establishes specific criteria for the recognition of intangible assets separately from goodwill; and (3) requires unallocated negative goodwill (which is an excess of net assets acquired over cost) to be recognized immediately as an extraordinary gain (instead of being deferred and amortized). As of the first quarter of 2002, the amount of any unamortized deferred credit related to negative goodwill arising from (a) a business combination for which the acquisition date was before July 1, 2001, or (b) an investment accounted for by the equity method acquired before July 1, 2001, is recognized and reported as the effect of a change in accounting principle. The effect of the accounting change and related income tax effects is presented in the income statement between the captions "extraordinary items" and "net income". The per-share information presented in the income statement includes the per-share effect of the accounting change. During the first quarter of 2002, FIC recognized the unamortized balance of $15,727,000 of negative goodwill. There was no amortization of negative goodwill recorded during the first quarter of 2002 and during the first quarter of 2001. - 11 - During 2001, the FASB issued Financial Accounting Standards No. 142 (FAS 142), "Goodwill and Other Intangible Assets," which supersedes Accounting Principles Board Opinion No. 17 (APB 17), "Intangible Assets," and which addresses financial accounting and reporting for acquired goodwill and other intangible assets upon and subsequent to their acquisition. The provisions of FAS 142 are effective for FIC's fiscal year beginning January 1, 2002. The most significant changes made by FAS 142 are: (1) goodwill and indefinite lived intangible assets will no longer be amortized, but instead will be tested for impairment at least annually at the reporting unit level, and (2) the amortization period of intangible assets with finite lives will no longer be limited to forty years. The adoption of FAS 142 did not materially affect FIC's results of operations, liquidity or financial position. During 2001, the FASB issued Statement of Financial Accounting Standards No. 143 (FAS 143), "Accounting for Asset Retirement Obligations", which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. FAS 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002, the adoption of which is not expected to materially affect FIC's results of operations, liquidity or financial position. During 2001, the FASB issued Statement of Financial Accounting Standard No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets" (FAS 144). FAS 144 supersedes Statement of Financial Accounting Standard No. 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" (FAS 121) and amends Accounting Principles Bulletin Opinion No. 30, "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" (APB 30) and Accounting Research Bulletin No. 51 (ARB 51) "Consolidated Financial Statements". FAS 144 is effective for fiscal years beginning after December 15, 2001. The adoption of FAS 144 did not materially affect FIC's results of operations, liquidity or financial position. In May 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 145 (FAS 145), "Rescission of FAS Nos. 4, 44, and 64, Amendment of FAS 13, and Technical Corrections as of April 2002." This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. FAS 145 is effective for financial statements issued for fiscal years beginning after May 15, 2002, and is not expected to affect FIC's results of operations, liquidity or financial position. The AICPA also recently issued Statement of Position No. 01-06 ("SOP 01-06") "Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others." The guidance in SOP 01-06 relating to financing and lending activities is explicitly applicable to insurance companies. SOP 01-06 reconciles and conforms the accounting and financial reporting guidance presently contained in other accounting guidance. SOP 01-06 is effective for financial statements issued for fiscal years beginning after December 15, 2001. The Company's accounting practices for its lending activities are already consistent with the guidance contained in SOP 01-06. The adoption of SOP 01-06 did not have a significant effect on the Company's financial statements. - 12 - Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operation The following discussion addresses the financial condition of FIC as of March 31, 2002, compared with December 31, 2001, and its results of operations for the three months ended March 31, 2002, compared with the same period last year. This discussion should be read in conjunction with Management's Discussion and Analysis included in FIC's 10-K dated April 1, 2002, to which the reader is directed for additional information. Transactions Affecting Comparability of Results of Operations On May 18, 2001, pursuant to an Agreement and Plan of Merger, as amended (the "Merger Agreement"), dated as of January 17, 2001, among FIC, InterContinental Life Corporation ("ILCO"), and ILCO Acquisition Company, a Texas corporation and wholly-owned subsidiary of FIC ("Merger Sub"), Merger Sub was merged with and into ILCO (the "Merger"). ILCO was the surviving corporation of the Merger and became a wholly-owned subsidiary of FIC. In accordance with the Merger Agreement, FIC issued 1.1 shares of common stock, par value $0.20 per share ("FIC Common Stock"), for each share of common stock, par value $0.22 per share, of ILCO outstanding at the time of the Merger ("ILCO Common Stock"). In addition, each share of ILCO Common Stock issuable pursuant to outstanding options was assumed by FIC and became an option to acquire FIC Common Stock with the number of shares and exercise price adjusted for the exchange ratio in the Merger. Prior to the merger, FIC owned approximately 48.1% of ILCO's common stock. Since ILCO was a wholly-owned subsidiary of FIC for the quarter ending March 31, 2002, the operations of ILCO are reported on a consolidated basis with FIC. For the first quarter of 2001, FIC's net income includes its equity interest in the net income of ILCO, with such equity interest being based on FIC's percentage ownership of ILCO. Results of Operations - Three Months Ended March 31, 2002 and 2001 For the three-month period ended March 31, 2002, Financial Industries Corporation's ("FIC") net income was $16,884,000 (basic earnings of $1.78 per common share, or diluted earnings of $1.76 per common share) on revenues of $32,239,000 as compared to net income of $2,083,000 (basic earnings of $0.41 per common share, or diluted earnings of $0.40 per common share) on revenues of $10,603,000 in the first three months of 2001. Net income before the cumulative effect of change in accounting principle was $1,157,000 (basic earnings of $0.12 per common share, or diluted earnings of $0.12 per common share). Earnings per share for the three months ended March 31, 2002 were affected by the increase in the number of FIC's common shares outstanding due to the Merger. As of March 31, 2002, the number of FIC's common shares outstanding was 9,499,629, as compared to 5,054,661 as of March 31, 2001. Additionally, net income and earnings per share were affected by a cumulative effect of a change in accounting principle of $15.7 million. This amount represents the excess of net assets acquired over cost as of the beginning of 2002 related to the Merger. The Company recorded this cumulative effect in conjunction with adopting Statement of Financial Accounting Standards No. 141 (FAS 141), "Business Combinations," this quarter, as required. - 13 - Revenues. Premium revenues reported for traditional life insurance products are recognized when due. Premium income for the first three months of 2002, net of reinsurance ceded, was $9.9 million, as compared to $8.0 million in the first three months of 2001. This source of revenues is related to the traditional life insurance book of business of FIC's insurance subsidiaries. The consolidation of ILCO's operations contributed approximately $2.5 million to premium income for the three month period ended March 31, 2002. At Family Life Insurance Company ("Family Life", which has been a subsidiary of FIC for the periods ending March 31, 2002 and 2001), first year net collected premiums for traditional life insurance products for the three month period ending March 31, 2002 were $0.8 million as compared to $1.0 million for the same period in 2001. The level of renewal premiums for traditional life insurance products at Family Life for the three month period ending March 31, 2002 was $6.3 million, as compared to $6.8 million for the same period in 2001. The decrease in renewal premium is attributable to the decrease in the traditional life insurance book of business. Income from universal life and annuity charges for the first three months of 2002 was $10.8 million, as compared to $0.9 million in the same period of 2001. The consolidation of ILCO's operations contributed approximately $10.0 million to earned insurance charges for the three month period ended March 31, 2002. At Family Life, earned insurance charges declined from $0.9 million in the 2001 period ending March 31st to $0.8 million in the 2002 period ending March 31st. This change is attributable to a decrease in Family Life's universal life and annuity business. The face amount of in force universal life policies was $741 million at March 31, 2001 as compared to $602 million at March 31, 2002. Net investment income for the first three months of 2002 was $11.0 million as compared to $1.6 million in the same period of 2001. The consolidation of ILCO's operations contributed approximately $9.6 million to net investment income for the three month period ended March 31, 2002. FIC and its subsidiaries investment portfolio were adversely affected by the decline in the level of interest income received from fixed income and short-term investments. This decline is attributable to lower interest rates during the period. Net real estate income, included in net investment income, was $1.0 million for the three month period ended March 31, 2002, as compared to $0 for the same period in 2001. Real estate income is attributable to the inclusion of ILCO's investment income with FIC's for the three month period. ILCO's real estate income was not included in FIC's income statements for the first quarter of 2001. Real estate income is earned from the leases on the buildings at River Place Pointe, an office complex in Austin, Texas which is owned and being developed by Investors Life Insurance Company of North America ("Investors Life"). - 14 - Benefits and Expenses. Policyholder benefits and expenses were $10.3 million in the first three months of 2002, as compared to $2.6 million in the first three months of 2001. The consolidation of ILCO's operations for the three month period ending March 31, 2002 contributed approximately $7.6 million to policyholder benefits and expenses. At Family Life, the level of policyholder benefits and expenses was $2.6 million for the first three months of 2001 compared to $2.7 million for the same period in 2002. Interest expense on contract holders deposit funds was $8.0 million in the first three months of 2002, as compared to $0.6 million in the same period of the year 2001. This increase is primarily attributable to $7.3 million of interest expense on contract holders deposit funds resulting from the consolidation of ILCO's operations. The expense related to the amortization of deferred policy acquisition costs increased $0.5 million to $1.9 million in the first three months of 2002, from $1.4 million in the first three months of 2001. A portion of the increase in amortization is attributable to the Merger. In the first quarter of 2002, expenses related to acquiring new business were $3.0 million, of which $2.2 million has been capitalized as a deferred policy acquisition cost. The amount not capitalized was recorded as an expense in the first quarter. In the first three months of 2002, the amortization of PVFP was $1.1 million as compared to $0.8 million in the first three months of 2001. The consolidation of ILCO's amortization expense with FIC's contributed approximately $0.4 million. The operating expenses for the first three months of 2002 were $8.9 million, as compared to $3.1 million in the first three months of 2001. The consolidation of ILCO's operations contributed approximately $4.6 million to operating expenses for the three month period ended March 31, 2002. The level of operating expenses for the three month period ending March 31, 2002 included: (i) expenses related to acquiring new business; (ii) a donation of $1 million to the Roy F. and Joann Cole Mitte Foundation which was made in the first quarter of 2002, as compared to a $375,000 donation in the first quarter of 2001; and (iii) $159,078 related to the repurchase of James M. Grace's employment contract. For a further discussion of the donation or repurchase see FIC's 10-K for the year ended December 31, 2001, dated April 1, 2002. Interest expense for the first three months of 2002 was $0, as compared to $0.4 million in the first three months of 2001. This interest expense is related to indebtedness owed to Investors Life by Family Life Corporation (a wholly owned subsidiary of FIC) and FIC. The consolidation of ILCO's operations with those of FIC for the three month period ending March 31, 2002 results in the elimination of this interest expense in the income statements of FIC. The provision for federal income taxes was $0.9 million in the first three months of 2002 as compared to $0.4 million in the first three months of 2001. The inclusion of ILCO's results contributed approximately $1.2 million to the level of federal income taxes. Because of the Merger and subsequent consolidation of FIC and ILCO's provision for federal income taxes, FIC was not able to utilize the small company tax deduction, which provided lower tax rates. The increase in federal income taxes due to the loss of this deduction was $69,000. Additionally, due to the Merger, the Company will incur approximately $200,000 in federal income taxes in the first quarter of 2002 related to excess compensation. - 15 - Equity in Net Income of InterContinental Life Corporation For the three-month period ended March 31, 2001, the Company's equity in the net earnings of InterContinental Life Corporation ("ILCO"), net of federal income tax, was $845,000. Following the merger of ILCO with FIC on May 18, 2001, the results of ILCO were consolidated with those of FIC. Accordingly, there is no equity in net earnings of affiliate results for the period ended March 31, 2002. Prior to the merger with ILCO, FIC owned 3,591,534 shares of ILCO's common stock. In addition, Family Life owned 342,400 shares of ILCO common stock. As a result, FIC owned, directly and indirectly through Family Life, 3,933,934 shares (approximately 48.1%) of ILCO's common stock. Upon completion of the merger, ILCO became a wholly-owned subsidiary of FIC. Liquidity and Capital Resources Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. FIC is an insurance holding company whose principal assets consist of the outstanding capital stock of its insurance subsidiaries - Family Life Insurance Company ("Family Life"), Investors Life Insurance Company of North America ("Investors Life"), and prior to February 19, 2002, Investors Life Insurance Company of Indiana ("Investors-IN"). Prior to the merger of FIC and ILCO on May 18, 2001, the principal assets of FIC consisted of the common stock of its insurance subsidiary, Family Life - and its equity ownership in ILCO. As a holding company, FIC's ability to meet its cash requirements, pay interest on any debt, pay expenses related to its affairs and pay dividends on its common stock substantially depends upon dividends from its subsidiaries. Prior to June 2001, the principal source of liquidity for FIC and its wholly-owned subsidiary, Family Life Corporation, consisted of the periodic payment of principal and interest by Family Life pursuant to the terms of the surplus debenture issued in connection with the Family Life acquisition from Merrill Lynch. For periods subsequent to June 30, 2001, FIC's available source of liquidity will be dividends paid to it from its subsidiaries. Applicable state insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of prescribed limitations without prior approval. The ability of Family Life and Investors Life to pay shareholder dividends is and will continue to be subject to restrictions set forth in the insurance laws and regulations of Washington, their domiciliary state. Washington limits how and when Family Life and Investors Life can pay shareholder dividends by (a) including the "greater of" standard for payment of dividends to shareholders, (b) requiring that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and (c) requiring that cash dividends be paid only from earned surplus. Under the "greater of" standard, an insurer may pay a dividend in an amount equal to the greater of: (i) 10% of the policyholder surplus or (ii) the insurer's net gain from operations for the previous year. Neither Investors Life nor Family Life paid any dividends during the first quarter of 2002. For the three month period ended March 31, 2002, Investors Life had earned surplus of $50.7 million and a net gain from operations of $1.8 million, and Family Life had earned surplus of $0.7 million and a net gain from operations of $0.7 million. - 16 - Prior to the merger of Investors Life and Investors-IN in February 2002, Investors-IN was domiciled in the State of Indiana. Under the Indiana insurance code, a domestic insurer may make dividend distributions upon proper notice to the Department of Insurance, as long as the distribution is reasonable in relation to adequate levels of policyholder surplus and quality of earnings. Investors-IN did not make any dividend payments during the first quarter of 2002. Sources of cash for FIC's insurance subsidiaries consist of premium payments from policyholders and annuity holders, charges on policies and contracts, investment income, and proceeds from the sale of investment assets. These funds are applied primarily to provide for the payment of claims under insurance and annuity policies, payment of policy withdrawals, surrenders and loans, operating expenses, taxes, investments in portfolio securities, and shareholder dividends. FIC's cash and cash equivalents at March 31, 2002 was $9.8 million as compared to $7.1 million at December 31, 2001. The $2.7 million increase in cash and cash equivalents at March 31, 2002 from December 31, 2001 was due primarily to the sale of short-term investments. Cash and cash equivalents at March 31, 2001 was $3.9 million. The increase in cash from March 31, 2001 to March 31, 2002 was primarily attributable to the cash obtained by FIC in the Merger. FIC's net cash flow used in operating activities was ($8.7) million for the three month period ending March 31, 2002, as compared to ($1.3) million for the same period in the year 2001. The increase in cash used in operating activities of $7.4 million from 2001 to 2002 was primarily attributable to an increase in accrued investment income of $2.1 million, a decrease in policy liabilities of $4.5 million and a decrease in income from operations of $0.9 million. Net cash flow provided by investing activities was $11.8 million in the three month period ending March 31, 2002, as compared to $4.0 million in the same period of 2001. The increase in cash provided by investing activities from 2001 to 2002 was due to the purchase of ILCO. Further, the cash provided by investing activity was positively affected by fixed maturity proceeds in excess of purchases of $3.9 million and a $10.0 million increase in cash from the sale of short-term investments. These amounts were offset by a ($3.0) million capitalization of real estate. - 17 - Net cash flow used in financing activities was ($0.3) million in the first three months of 2002, as compared to ($1.6) million in the first three months of 2001. The decrease in cash used in financing activities is primarily due to the elimination on FIC's cash flow statements of principle payments on the subordinated debt, described in the paragraphs below, due to the Merger. The cash requirements of FIC, and its holding company subsidiary, Family Life Corporation, consist primarily of its service of the indebtedness created in connection with FIC's ownership of Family Life. As of March 31, 2002, the investment portfolio of Investors Life included $27.7 million of notes receivable from affiliates, represented by (i) a loan of $30 million by Investors Life to Family Life Corporation made in July 1993, in connection with the prepayment of indebtedness which had been previously issued to Merrill Lynch as part of the 1991 acquisition of Family Life Insurance Company by a wholly-owned subsidiary of FIC, and (ii) a loan of $4.5 million by Investors Life to Family Life Insurance Investment Company made in July 1993, in connection with the same transaction described above. The provisions of the notes owned by Investors Life include the following provisions: (a) the $30 million note provides for quarterly principal payments, in the amount of $163,540 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $1,336,458; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%, and (b) the $4.5 million note provides for quarterly principal payments, in the amount of $24,531 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $200,469; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%. Due to the Merger, this indebtedness is not included as a liability on the consolidated financial statements of FIC. FIC's other liquidity requirements relate principally to the need for cash flow to meet operating expenses, as well as the liabilities associated with its insurance subsidiaries' various life insurance and annuity products. Given the historical cash flow of our subsidiaries and the current financial results, management believes that the cash, cash equivalents and short term investments of FIC and its subsidiaries are sufficient to meet the needs of its business and to satisfy debt service. There are no trends, commitments or capital asset requirements that are expected to have an adverse effect on the liquidity of FIC. - 18 - Investments As of March 31, 2002, FIC's invested assets, excluding separate accounts, totaled $739.5 million, a decrease of $16.8 million from $756.3 million at December 31, 2001. The decrease is primarily attributable to a decrease of $8.9 million in fixed maturities, $4.9 million of which resulted from a drop in the market value of the portfolio, and a decrease of $10 million in short-term investments, with $3 million of that change reinvested in real estate and $7 million used in operations. There are no significant differences between the portfolio composition as of March 31, 2002 as compared to December 31, 2001. The assets held by Family Life and Investors Life must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the Company's emphasis is to obtain targeted profit margins, while minimizing the exposure to changing interest rates. This objective is implemented by selecting primarily short- to medium-term, investment grade fixed income securities. In making such portfolio selections, the Company generally does not select new investments which are commonly referred to as "high yield" or "non-investment grade". FIC determines the allocation of our assets primarily on the basis of cash flow and return requirements of our products and secondarily by the level of investment risk. A key element of the Company's investment strategy is to avoid large exposure in other investment categories which the Company believes carry higher credit or liquidity risks, including private placements, partnerships and bank participations. These categories accounted for only $40,746 of invested assets as of March 31, 2002 and $45,479 of invested assets at December 31, 2001. Our fixed maturity securities portfolio is predominately comprised of low risk, investment grade, available for sale publicly traded corporate securities, mortgage-backed securities and United States Government bonds. As of March 31, 2002, the market value of the fixed maturities available for sale segment was $492.5 million as compared to an amortized cost of $492.8 million or an unrealized loss of $0.3 million. The decrease reflects unrealized losses on such investments related to changes in interest rates subsequent to the purchase of such investments. - 19 - The investments of FIC's insurance subsidiaries in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $177.6 million as of March 31, 2002 as compared to $201.8 million at December 31, 2001, and mortgage-backed pass-through securities of $26.9 million as of March 31, 2002 and $31.2 million at December 31, 2001. Mortgage-backed pass-through securities, sequential CMO's and support bonds, which comprised approximately 46.7% of the book value of FIC's mortgage- backed securities at March 31, 2002, are sensitive to prepayment and extension risks. FIC's insurance subsidiaries have reduced the risk of prepayment associated with mortgage-backed securities by investing in planned amortization class ("PAC"), target amortization class ("TAC") instruments and scheduled bonds. These investments are designed to amortize in a predictable manner by shifting the risk of prepayment of the underlying collateral to other investors in other tranches ("support classes") of the CMO. At March 31, 2002, PAC and TAC instruments and scheduled bonds represented approximately 53.3% of the book value of FIC's mortgage-backed securities. Sequential and support classes represented approximately 31.5% of the book value of FIC's mortgage-backed securities at March 31, 2002. In addition, FIC's insurance subsidiaries limit the risk of prepayment of CMOs by not paying a premium for any CMOs. FIC's insurance subsidiaries do not invest in mortgage-backed securities with increased prepayment risk, such as interest-only stripped pass-through securities and inverse floater bonds. FIC's insurance subsidiaries did not have any z-accrual bonds as of March 31, 2002. The prepayment risk that certain mortgage-backed securities are subject to is prevalent in periods of declining interest rates, when mortgages may be repaid more rapidly than scheduled as individuals refinance higher rate mortgages to take advantage of the lower current rates. As a result, holders of mortgage-backed securities may receive large prepayments on their investments which cannot be reinvested at an interest rate comparable to the rate on the prepaying mortgages. For the year 2002, the investment objectives of FIC's insurance subsidiaries include the making of selected investments in CMOs. The securities valuation office (SVO) of the National Association of Insurance Commissioners evaluates all public and private bonds purchased as investments by insurance companies. The SVO assigns one of six investment categories to each security it reviews. Category 1 is the highest quality rating, and Category 6 is the lowest. As of March 31, 2001, the majority of our bonds are investment grade (Category 1 and 2). The Company's fixed maturities portfolio (including short-term investments), included only a non-material amount of debt securities which, in the annual statements of the companies as filed with state insurance departments, were designated by the SVO as "3" (medium quality) or below. This number is attributable to mortgage bonds which Investors Life owns in a California utility, which has been downgraded to a "6" (lowest quality) rating by the NAIC. As of March 31, 2002, Investors Life owned bonds in Southern California Edison which were purchased for $0.98 million and had a market value as of March 31, 2002 of $0.94 million. FIC's short-term investments consist primarily of U.S. Government bonds. The level of short-term investments at March 31, 2002 was $128.3 million, as compared to $138.3 million as of December 31, 2001. Invested real estate at March 31, 2002 was $64.0 million as compared to $61.0 million at December 31, 2001. The real estate investment is primarily related to the development of the River Place Pointe project ("River Place Pointe") by Investors Life. In October 1998, Investors Life purchased River Place Pointe, two adjoining tracts of land located in Austin, Texas totaling 47.995 acres. The aggregate purchase price for these tracts was $8.1 million. Investors Life obtained a Site Development Permit for the tracts from the City of Austin allowing for the construction of seven office buildings totaling 600,000 square feet, with associated parking, drives and related improvements. Construction on the first section of the Project, which consists of four office buildings, an associated parking garage, and related infrastructure was completed during 2000 and 2001. Construction on the second section continued during the first quarter of 2002, including work on buildings six and seven. Completion of the entire project is expected by the end of 2002. - 20 - As of March 31, 2002, Investors Life had invested $84.5 million in the construction of River Place Pointe, of which $20.0 million is recorded on FIC's balance sheet as real estate occupied by the Company. Investors Life paid $3.0 million during the first quarter of 2002 on construction of the project and expects to pay an additional $10 million to complete the project. As of March 31, 2002, $4.7 million was invested in mortgage loans, as compared to $4.7 million at December 31, 2001. The Company does not make new mortgage loans on commercial properties. Substantially all of the Company's mortgage loans were made by its subsidiaries prior to their acquisition by the Company. At March 31, 2002, none of the mortgage loans held by the Company had defaulted as to principal or interest for more than 90 days, and none of the Company's mortgage loans were in foreclosure. Policy loans totaled $48.9 million at March 31, 2002, as compared to $49.8 million at December 31, 2001. Management believes that the absence of "high-yield" or "non-investment grade" investments (as defined above) in the portfolios of FIC's life insurance subsidiaries 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. Critical Accounting Policies Cumulative Effect of Accounting Changes. During the first quarter of 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations." SFAS No. 141 eliminates the practice of amortizing and deferring excess of net assets acquired over costs and requires unallocated negative goodwill to be recognized immediately. In accordance with the standard, FIC ceased negative goodwill amortization on January 1, 2002 and recognized the unamortized balance of $15.7 million of negative goodwill acquired in the Merger. Deferred Policy Acquisition Costs and Present Value of Future Profits of Acquired Business. The costs of acquiring new business, including certain costs of issuing policies and certain other variable selling expenses (principally commissions), are deferred policy acquisition costs ("DAC"). DAC is capitalized and then amortized to reflect an expense in relation to the projected stream of profits (for universal life and annuity products) or to the premium revenue (for traditional life products). Such projections require use of certain assumptions, including interest margins, product loads, mortality rates, persistency rates, and maintenance expense levels. Effective with respect to new business issued on and after January 1, 2002, the Company has capitalized DAC based on an updated analysis of its cost structure and assumptions as to product performance. For business written previously, DAC is amortized using previously established methods and practices. Management periodically reviews the assumptions associated with the amortization models prospectively. - 21 - Present value of future profits of acquired business ("PVFP") are the costs associated with acquiring blocks of insurance from other companies or through the acquisition of other companies. PVFP is capitalized and amortized in a manner that matches these costs against the associated revenues. For the quarter ending March 31, 2001, FIC's net income includes its equity interest in the net income of ILCO, with such equity interest being based on FIC's percentage ownership of ILCO. For a further discussion of accounting standards, see New Accounting Pronouncements on pages 11-12, herein. Item 3. Quantitative and Qualitative Disclosures About Market Risk General. FIC's principal assets are financial instruments, which are subject to market risks. Market risk is the risk of loss arising from adverse changes in market rates, principally interest rates on fixed rate investments. For a discussion of the Company's investment portfolio and the management of that portfolio to reflect the nature of the underlying insurance obligations of the Company's insurance subsidiaries, please refer to the information set forth in "Management's Discussion and Analysis of Financial Condition and Operations - Investments". The following is a discussion of the Company's primary market risk sensitive instruments. It should be noted that this discussion has been developed using estimates and assumptions. Actual results may differ materially from those described below. Further, the following discussion does not take into account actions that could be taken by management in response to the assumed changes in market rates. In addition, the discussion does not take into account other types of risks that may be involved in the business operations of the Company, such as the reinsurance recoveries on reinsurance treaties with third party insurers. The primary market risk to the Company's investment portfolio is interest rate risk. The Company does not use derivative financial instruments. Interest Rate Risk. The Company manages the interest rate risk inherent in our assets relative to the interest rate risk inherent in our liabilities. Generally, we manage interest rate risk based on the application of a commonly used model. The model projects the impact of interest rate changes on a range of factors, including duration and potential prepayment. For example, assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in fair market value related to the financial instruments segment of the Company's balance sheet is estimated to be $26.1 million at March 31, 2002 and $24.6 million at December 31, 2001. For purposes of the foregoing estimate, fixed maturities, including fixed maturities available for sale, and short-term investments were taken into account. The market value of such assets was $621.8 million at March 31, 2002 and $640.7 million at December 31, 2001. - 22 - The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $186.8 million at March 31, 2002 and $209.9 million at December 31, 2001. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in the fair market value related to such mortgage-backed securities is estimated to be $5.9 million at March 31, 2002 and $6.7 million at December 31, 2001. Separate account assets have not been included, since gains and losses on those assets generally accrue to the policyholders. The Company does not use derivative financial instruments to manager our exposure to fluctuations in interest rates. The hypothetical effect of the interest rate risk on fair values was estimated by applying a commonly used model. The model projects the impact of interest rate changes on a range of factors, including duration and potential prepayment. Part II. Other Information Item 1. Legal Proceedings The Company and its subsidiaries are defendants in certain legal actions related to the normal business operations of the Company. Management believes that the resolution of such legal actions will not have a material impact on the financial statements. Litigation Relating to the FIC/ ILCO Merger. On the day that FIC and ILCO each publicly announced the formation of a special committee to evaluate a potential merger, two class action lawsuits were filed against ILCO, FIC and the officers and directors of ILCO. The actions allege that a cash consideration in the proposed merger is unfair to the shareholders of ILCO, that it would prevent the ILCO shareholders from realizing the true value of ILCO, and that FIC and the named officers and directors had material conflicts of interest in approving the transaction. In their initial pleadings, the plaintiffs sought certification of the cases as class actions and the named plaintiffs as class representatives, and among other relief, requested that the merger be enjoined (or, if consummated, rescinded and set aside) and that the defendants account to the class members for their damages. The defendants believe that the lawsuits are without merit and intend to vigorously contest the lawsuits. Management is unable to determine the impact, if any, that the lawsuits may have on the results of operations of the Company. - 23 - Other Litigation. Additionally, FIC's insurance subsidiaries are regularly involved in litigation, both as a defendant and as plaintiff. The litigation naming the insurance subsidiaries as defendant ordinarily involves our activities as a provider of insurance protection products. Management does not believe that such litigation, either individually or in the aggregate, will have a material adverse effect on the Company's business, financial condition or results of operations. Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the first quarter of 2002. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K: (a) Exhibits Form 10-K Annual Report of Registrant for the year ended December 31, 2001 heretofore filed by Registrant with the Securities and Exchange Commission, which is hereby incorporated by reference. (b) Reports on Form 8-K: None. - 24 - FINANCIAL INDUSTRIES CORPORATION AND SUBSIDIARIES SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FINANCIAL INDUSTRIES CORPORATION /s/ Jeffrey Demgen Jeffrey Demgen Vice-President /s/ David Hopkins David Hopkins Chief Accounting Officer Date: May 15, 2002 - 25 -