Torchmark Corporation (NYSE:TMK)
Bank of America Merrill Lynch Insurance Conference Call
February 13, 2013 02:55 PM ET
Gary Coleman – Co-CEO
Larry Hutchison – Co-CEO
Hi, good afternoon, everybody. For those who you have not met me, I am (inaudible) I took over the life coverage in December. But you are not here to see me so I am going to introduce Gary Coleman and Larry Hutchison, Co-CEOs of Torchmark. Torchmark focuses on providing protection oriented life and supplemental health insurance to the low to middle class. It yielded very strong pre-cash flows and is consistently at or near the top of the White group in terms of cash payout ratios. Gary and Larry took over the CEO role last June and prior to their current roles, Gary served as a CFO and Larry as General Counsel, each with over 25 years of experience with the companies. And with that I will turn over the microphone.
Before we get started please be aware our presentation includes forward-looking statements, please take a note of this first slide. Torchmark had leadership transition last year and Larry and I became Co-CEOs. While at the (inaudible) Torchmark shows the CO-CEO structure and while we admit it, it’s a little unusual, we think is the best arrangement for the company because of the unique relationship that Larry and I have. We worked together for over 26 years at Torchmark, and we worked in all our insurance operating subsidiaries and due to that experience, our complimentary skill sets in primarily our trust in each other, we think this range of provides a depth to the position that wouldn't exist with a single CEO.
The Co-CEO arrangement facilitates a sound collective decision making process. It also allows us the flexibility to more easily oversee daily operations of plan for the future. We both believe in the Torchmark business model, we sell simple protection oriented products to middle income families through Cathy distribution with products that generate strong margins and high cash flow. We maintain a conservative investment approach and we manage our capital to maximize shareholder value. Our target market is vastly underserved and provides significant opportunity for growth as has been evidenced by the company's performance in recent years.
Due to our focus on stable protection oriented products and conservative management investments, Torchmark has delivered consistent growth. On this slide, we show operating earnings per share and I might mention that in 2012 life insurance companies adopted Accounting Standard A issue 2010-26, this is a new accounting standard regarding the deferral of acquisition cost. And as part of that adoption, life insurance companies restated earnings for the previous five years for comparability.
So on this slide, the EPS numbers for 2007 through 2012 reflect a new standard, while the years denoted by the answers 2003 through 2006 reflect the previous standards. But as you can see, the reader standard net operating earnings per share has increased a compound annual growth rate of 8.3% over the past 10 years despite the financial crisis. For the last five years, earnings per share on the new accounting basis has grown at 8.7% rate.
For 2012, we grew net operating earnings per share by 15%, our best year in the past 14 years. Torchmark has also shown consistent growth in book value per share, excluding net unrealized gains and losses; our fixed maturities are book day per share grew at compound annual rate of 9.7% over the last five years. While our reported GAAP book day which includes the unrealized gains and losses grew at a compound annual rate of 16% over the past five years.
As I mentioned, 2012 was a very good year for Torchmark, our highlights include, first of all operating earnings grew 15%. At American Income, life sales grew 12% while the agent accounting increased 18%. Our direct response life sales grew 3% despite a difficult economy. We also began a turnaround of Liberty National. Agent count and sales have grown steady since February of last year and life underwriting margins increased from 22% of premium to 26%.
We completed the acquisition of Family Heritage Life and did so without restricting the future buybacks or M&A activity. We have financed quite a bit of our debt on favorable terms, and we repurchased 7.5 million shares or 7.4% of the outstanding Torchmark shares. All in all it was a very good year for Torchmark.
Now I will ask Larry to give his comments on insurance operations.
As you can see the largest component of net operating income is underwriting income. Underwriting income is about 70% of our pretax operating income. Now let`s look at the breakdown of underwriting income. as you can see life underwriting income is the largest component of underwriting income. it produces about 72% of our underwriting income. health excluding Part D produces 16%. We focus on life insurances as it has higher margins, generates significant investment income, is less competitive, even less regulated than health insurance.
Now let's looks look at our major operating units. American Income is our largest and most profitable distribution channel. As you can see on this chart, life premiums at American Income has steadily increased at a 10 year compound annual growth rate of 9.1%. underwriting margins as a percentage of premium has consistently ranged from 30% to 33% before administrative expenses.
2012 was a great year for American Income, life sales were up 12% over 2011 and agent count was up 18% over a year ago. We continue to focus on developing middle management to ensure sustainable agency growth. we also continue to define our agent training programs and financial incentives. Our laptop sales presentation provides us with a wealth of valuable data we can use to manage the agency force. The data allows us to monitor and breakdown agent activity at all levels of the organization by individual agent, by individual managers and by region.
American Income's labor union affinity and underserved target market allow to operate in a niche that provides plentiful opportunity for future growth. We expect to see strong, net life sales growth throughout the year beginning in the low to mid-single digit growth to the first quarter and rise in the 10% to 14% for the entire year.
Our second largest issue is the channel Direct Response. As you can see on the chart here Direct Response life premium has grown at a 10 year compound annual growth rate of 7.1%. Our basic strategy is to continually search for new ways to reach our market. We take innovative approach is constantly involving. over the past few years, internet marketing and our inbound call center have been our fastest growing sources of new production. Five years ago, internet marketing and inbound calls produced about 5% of a Direct Response new business. Today, internet marketing and inbound calls produce approximately 40% for Direct Response new business. Despite a difficult economy, Direct Response life sales grew 3% in 2012. We expect sales to be relatively flat in the first quarter. But as I said on the conference call last week, we are optimistic that the initiatives we're putting in place throughout 2013 will increase response rates resulting in mid-single digit sales growth for the full year.
However, I'd like to add here that the post office or the postal services recently announced planned to discontinue Saturday mail delivery is not expected to have any impact on our direct mail business. As you can see on this chart, Liberty National has a history of stagnant premium growth. several years ago we began to convert Liberty National from a fixed cost model to a variable cost model. We accelerated this process and began a turnaround program late in 2011. We made a management change at Liberty and several other significant changes including office operating expenses and other responsibility to branch managers rather than the home office.
All new agents are hired as independent contractors rather than employees. We added a new layer of middle management and we cut a significant portion of our non-deferred acquisition cost. While this is a significant change in the culture of this agency, we knew the changes were necessary to produce acceptable profit margins on the business we write and we put Liberty in a position to grow going forward. The changes we made are paying off as we have steady sequential growth in both sales and agent count in 2012 beginning in the mid February, and our life underwriting margin as a percent of premium has increased from 22% to 26%.
We are excited about the acquisition of Family Heritage. This is the kind of company we have looking to acquire. A company selling protection, insurance to middle income families through a captive agency. They are offering a return on premium health products in non-urban areas, gives them a unique operating niche. The integration of Family Heritage's operation has gone very smoothly so far. We believe there is a potential for strong, long-term sales growth through geographic expansion and integration of Torchmark's agent recruiting technique. As we said earlier, this acquisition will not restrict our future share repurchases or M&A activity.
I will now ask Gary to discuss our investment operation.
The second major component of operating income is excess investment income. In 2012, its $237 million or about 30% of pretax operating income. Excess investment income is our net investment income, that's the required interest on the debt policy liabilities and the interest on our debt. The primary component is the investment income earned on our $12 billion investment portfolio. And regarding the interest on the policy liabilities, since we sell basic whole life and term insurance that is not interest sensitive, the interest on the policy liabilities is primarily the interest resulting from the discounting of the liabilities at the GAAP discount rates.
Over the years we have followed a conservative long-term investment strategy with a higher underwriting margins in our insurance products, we don't have to stretch for investment yield. As shown in this slide, 96% of our investment portfolio consists of fixed maturities. These assets are primarily long-term investment grade corporate bonds with no commercial mortgage backed securities or securities backed by subprime or Alt-A mortgages. We invest in long-term fixed grade assets because they provide the best match for our Alt -A liabilities that have long duration and a fixed rate nature they are.
Of the $12 billion of fixed maturities $11.4 billion are investment grade and $585 million of bonds are below investment grade bonds. The percentage of below investment grade bonds, of total fixed maturities is 4.9% compared to 6.4% a year ago, and as you can see, higher levels in prior years. At the current level, it was the portfolio leverage of 3.5 times, the percentage of below investment grade bonds to equity excluding net unrealized gains and losses is 17% which is less than most of our peers. Overall, the portfolio was rated A minus.
Now, I would like to discuss the current interest rate environment, the topic that seems to be the most concern to investors in the life insurance industry. While lower interest rates pressure investing income of all life companies, we believe that we face less exposure to our lower for longer environment than most of our peers. As long as we are in this low interest rate environment, the portfolio yield will continue to decline and thus pressure excess investment income. However, the impact on the Torchmark will be diminished by the fact that on average only 2% to 3% of fixed maturities will run off each year over the next five years.
To quantify the potential impact of an extended low rate environment, we performed a stress test assuming a new money rate of 400 quarter percent for all investments made in the next five years. This scenario results in a portfolio yield of about 5.55% at the end of 2017. If you run this test again assuming the amount of yield of 4%, it only make about five basis point difference or in other words the portfolio yield at the end of 2017 would be 5.50%.
At these rates, we will still earn a small spread of a net policy liabilities ordering the pool of 550 to 555 basis points on our equity. In either scenario, we will still generate substantial excess investment income. In addition, unlike many of our peers, we don't have concerns regarding the potential impact of low interest rates on our benefit reserves or DAC. Companies that sell interest sensitive variable life and variable annuity policies follow the accounting standard that's previously referred to as FAS-97. That standard requires annual and locking of assumptions used to calculate reserves in DAC. In a lower for longer environment, companies may have to lower assumptions regarding future interest rates resulting in immediate increases in reserves and or write-downs to DAC.
As mentioned, we sell simple whole lot interim products; these products are accounted for under the accounting standard previously referred to as FAS-60. As such DAC is amortized based on premiums earned not gross profits. In addition, interest rates are locked in at policy issuance and are only changed if it is apparent that the policy is in an involved situation.
Because of our high underwriting margins, it is unlikely that we would ever experience a loss recognition situation. For loss recognition to occur because of lower interest rates, our average portfolio yield would have to decline to 4% and remain there permanently. Our portfolio yield at the end of 2012 was 6.04%. Even if new money raised remained at 4% for the next 20 years, our portfolio yield will still be in excess of 4% 20 years from now, thus no loss recognition.
With respect to our statutory balance sheet, we performed cash flow testing each year for regulatory purposes, and our statutory reserves are more than adequate. In fact, in the New York seven cash flow testing performance 2012, the margin of adequacy in each of the company statutory reserves was substantial.
In summary, with hunt with high underwriting margins, we generate significant underwriting income and don't have to rely on excess investment income to generate positive earnings. However for March stress testing we are confident that we can maintain or grow the current level of excess investment income per share in extended low rate environment. That said, we strongly prefer higher interest rates because of our product profile and our strong and consistent cash flow, we would greatly benefit from the sparkling rates. We would not be concerned about the resulting unrealized losses in investment portfolio because we have the intent and more importantly the ability to hold our investments to maturity.
Now, I would like to move on to capital management. This slide shows the free cash flow generated at the parent company in each of the last 10 years. We define free cash flow as a cash that is available to the parent company from the annual dividends received from the subsidiaries less the interest expense on our debt, and less the dividends paid to Torchmark shareholders. The net amount leftover is free cash that can be used for any corporate purpose. Because of products we offer in our high underwriting margins, we have a large stable enforce block that consistently generates substantial free cash flow year after year.
This graph shows our free cash flow over the past 10 years. As you can see we generate a strong free cash even at the height of the financial crisis. In 2013, we expect to general free cash of around $355 to $365 million.
On an ongoing basis, we evaluate alternative usage of free cash but share buybacks have generally been the most efficient use. We began our share repurchase program in 1986 and have purchased Torchmark shares in all years since then except 1995, the year we acquired American Income Life. In the last 27 years, we have repurchased 74% of the company's outstanding shares. As mentioned, we expect to generate $355 to $365 million of free cash in 2013. And if markets conditions are favorable, we plan to use most, if not all that cash for share repurchases.
Now, I'd like to conclude my remarks on capital management by discussing our thoughts on returning cash to shareholders. For over 25 years, Torchmark management and Board of Directors have agreed on distributing the free cash to shareholders. We have accomplished this through share repurchases and dividends with an obvious emphasis on share repurchases. As a result, Torchmark has consistently distributed a large percentage of earnings to our shareholders. In fact, in the last 10 years Torchmark distributed 81% of net income to the shareholders. As for the future, maintaining our cash flow in high levels and returning a substantial percentage of earnings to shareholders, will continue to be an important part of our business model.
Now, I will ask Larry to make some final comments.
All right, let`s summarize what Torchmark has offered shareholders and potential investors. First, Torchmark's growth potential. How many people see life insurance as a mature industry? Torchmark actually operates in a vastly underserved market with little competition, with majority of individuals have no life insurance or don't have enough life insurance. Our vast experience along with our ability to control cost allows us to operate effectively in the middle income market, and with the acquisition of Family Heritage life, we expect to reverse the recent trend of decline in health sales.
Our high underwriting margins, our operating margins are among the highest in the industry. We don't have to rely on investment income to generate profits. Our conservative investment philosophy because of our high underwriting margins, we can generate strong profits without having to take significant investment risks. A sustainable, mid-double digit ROE, our return on equity excluding net unrealized gains on our fixed maturities was 15.5% in 2012. And we expect to maintain ROE at around the 15% level.
A safe haven and a low interest rate environment, we are much less exposed to low interest rate environment than most of our peers. We are very confident that it poses no threat to our balance sheet, and we expect to get with net operating earnings per share close to 10% per year even in a low interest driven environment. Our insurance operations are relatively immune to the economy, while our interest rates compared to our net invest income, our insurance operations have always proven relatively immune to the economy. Even though sales can be more challenging in a difficult economy, our persistency has never been impacted, and our earnings are driven by our enforce block. We have strong, reliable free cash flow. our statutory earnings are driven by our large stable enforced block. even if we had not sales in a given year, we will still generate over $300 million in free cash flow. Our return of cash to shareholders as Gary stated, Torchmark has a long history of using free cash flow to repurchase stock. Since 1986, we have repurchased 74% of our stock. We expect that the majority if not all, of our free cash flow in 2013, were used to repurchase shares as long as market conditions are favorable.
This concludes our comments. We'll be happy to answer any questions now.
Okay, I will start with one. You talked a lot about free cash flow and even share buyback. At this year also you were able to put significant capital to work by Family Heritage. Maybe if you could talk about a little bit your view of the M&A environment and what you view as funding sources when opportunities become available.
Well as far as the M&A environment, the companies that we're interested in met all the criteria. Companies that sell to middle income market like other operations there have a captive or a controlled distribution and have high underwriting margins. they are hard to find, we have been looking pretty hard for the last four, five years and there is companies that fit that criteria that we are interested in but they are owned by other companies and are not for sale at the moment. We'll continue to look if our acquisitions, we like the Family Heritage acquisition, one we think even though small it has much opportunity to grow.
The second, we were able to finance that acquisition using in large part insurance company funds which didn't start the free cash but we can also use for share repurchase. When I say that share repurchase has been most sufficient use, if we found like we do with Family Heritage, if we found an acquisition that is going to give us a good yield, then we'll do as opposed to share repurchase but we are not going to sit on money, the great thing about Torchmark is that free cash comes in every year, we talked about funding, our leverage in the low to middle range than the peers, and we have that cash coming in every year, we've got multiple ways to finance the transaction.
And when you think about leverage is there, opportunity there, if you see something attractive in order to ramp that up a little bit?
Right now our debt cash ratio is around 28% and once we retire our maturity August of 2013 maturity here in August, we drop down around 26% rating agency. While we try to really maintain it somewhere in the 25 to 30% range, so we have a little bit of capacity to increase the debt if an opportunity came about.
And then I will ask just one more on Liberty National. You mentioned a very strong result for this year and the margin expansion. In the presentation you also mentioned migrating from South Eastern town to more urban areas. Can you talk about what you view is may be the long-term trajectory there and where margins could eventually head?
I think our turn growth strategy inside of the Southeast but to first grow we have to develop our middle management, so we have people we can promote to send another states. We started that process in 2012 we opened an office in Southwest, in the Midwest and the Northeast. What's happening right now is the lack of Canada to fill those positions. It will be an expansion in urban areas, it's easier to recruit agents in more urban area than a more rural area. But you will see that steady progress throughout 2013 and '14 and forward. I think the growth of Liberty National also standard, we'd like to see low double digit growth in our agency force, in our sales, that's a standard we'll try and hold ourselves as we go forward. We can change the culture of the company and so yet to change the culture, and we saw a steady progress last year sequentially, I think '13 will see some year-over-year growth and '14 , '15 as we go forward. We will see that growth expand.
As far as the margin expansion, you shouldn't expect that to pick-up another three, four points the coming year. We issued the around 26 level, maybe a little bit higher net but what we did this past year by making the change and may be more to independent, although they are still captive more than independent operations where the branch managers are paying, responsible for the expenses, there are more expenses that the company was expensing before. So that's why we picked up that extra margin.
When you are talking about the interest rate assumptions used to set your reserves and sensitivity to continued low interest rates, how did you arrive at that? Is that a mean reversion assumption or is that based on a role forward of your portfolio yield?
As far as we roll forward the portfolio yield assuming earning at four and four in a quarter. It is same talking no doubt we lowered the discount rate on our reserves, and again (inaudible) inside that but we don't sell instances there, so we are not crediting interest to funds or simply we have to discount the reserves in there. And so we've also lowered the discount rate on the reserves, so as a portfolio yield comes down, also the weighted average discount on the reserves come down as well.
The 4.25% was a just a little bit lower than what the actual new money rate that we incurred for 2012. So that's when we just went ahead and used that assuming going forward that should the rate stays stable at the 4.25 that looking with effect on the portfolio would be even, as Gary indicated we tested that down at 4% as well.
If rates stay low for a longer period, could you see foresee any scenario where you could, you may have to lower the discount rate more and there could be reserve.
No, I don't think there will be reserves, when you lower the discount rate, we continue to have to that, that can impair, that can reduce our underwriting margins. Now one thing we did American Income which is our largest operation, we increased the premium rates on new business going forward by 5% in 2012. We estimated by having to change the discount rate and reserves we needed 1% to 2% increase in premium rates in order to keep underwriting margins the same. We went ahead and raised them 5%, we got a little bit of margin there.
The great thing about that is we had the ability to raise the premiums. Where there is not a lot of competitors, American Income really has no great competitors, we were able to make that change, we explained it to the agents, they had no problem with it. And there is already 5% on a $400 annual premium is not a big change, so we were able to do that and that helps keep our underwriting margins where they were, will have less investment income while still protecting underwriting margins. And we have the ability to raise, you don't want to do it hard, we still have ability to raise premiums in the future.
To follow up on the low rates, I know you said it would take for statutory reserves to be adjusted it will take more than 20 years. But do you have any sense if you ever did after to add to those reserves, how large that increase in reserves would be?
Well, actually we're talking about the 20 years, we are talking about GAAP reserves. from a statutory standpoint interest rates were very low to begin with, saying those reserves, I can't imagine us having to add anything significant to reserve. You got to remember we are talking about 26% profit margin so even we had that reserves it would be still be a profitable business.
Thank you very much.
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