Allied Life Financial Corp.: Form 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 Form 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 1996 Commission File Number 0-22404 ALLIED Life Financial Corporation (Exact name of registrant as specified in its charter) Iowa (State or other jurisdiction of incorporation or organization) 42-1406716 (I.R.S. Employer Identification No.) 701 Fifth Avenue, Des Moines, Iowa (Address of principal executive offices) 50391-2003 (Zip Code) 515-280-4211 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None (Title of Class) Securities registered pursuant to Section 12(g) of the Act: Common Stock, no par value (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes [ x ] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] As of March 5, 1997 the number of Registrant's Common Stock, no par value, outstanding was 4,503,599. The aggregate market value of the Common Stock of the Registrant (based on the average bid and asked prices at closing) held by nonaffiliates at March 5, 1997 was $57,414,915. Documents Incorporated By Reference TheRegistrant's definitive proxy statement (1997 Proxy Statement), which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1996, is incorporated by reference under Part III. The index to the exhibits is located on page 76. This document contains 107 pages. TABLE OF CONTENTS Part I Item 1. Business........................................................1 Item 2. Properties.....................................................19 Item 3. Legal Proceedings..............................................19 Item 4. Submission of Matters to a Vote of Security Holders............19 Part II Item 5. Market for Registrant's Common Equity and Related Stockholders Matters........................................................20 Item 6. Selected Financial Data........................................21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations..........................................22 Item 8. Financial Statements and Supplementary Data....................33 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...........................................61 Part III Item 10. Directors and Executive Officers of the Registrant.............61 Item 11. Executive Compensation.........................................61 Item 12. Security Ownership of Certain Beneficial Owners and Management.61 Item 13. Certain Relationships and Related Transactions.................61 Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.......................................................62 Index to Financial Statement Schedules.........................62 Signatures.................................................... 75 Index to Exhibits..............................................76 PART I Item 1. Business ALLIED Life Financial Corporation (the Company) is a holding company that through its principal subsidiary ALLIED Life Insurance Company (ALLIED Life) underwrites, markets, and distributes a select portfolio of life insurance and annuity products to individuals who live primarily in rural and suburban areas of the midwestern and western United States. The Company was organized in 1993 by ALLIED Mutual Insurance Company (ALLIED Mutual). ALLIED Mutual has been engaged in the property-casualty business since 1929. Prior to that, ALLIED Life, organized in 1966, was a wholly-owned subsidiary of ALLIED Mutual. The financial information included herein consists of the accounts of the Company and its wholly-owned subsidiaries: ALLIED Life, ALLIED Life Brokerage Agency (ALBA), and ALLIED Group Merchant Banking Corporation (AGMB). At December 31, 1996, ALLIED Mutual owned 54% of the outstanding voting stock of the Company and the ALLIED Life Employee Stock Ownership Trust owned 1%. The remainder was owned by public stockholders. The Company's long-term growth strategy is to: (1) provide its independent agents with well-designed products that are easy to understand, meet the needs of their customers and reward persistency over time, and (2) strengthen its distribution systems, which include marketing life insurance and annuity products through the independent property-casualty agencies (the ALLIED Agencies) representing ALLIED Mutual and the property-casualty insurance subsidiaries of ALLIED Group, Inc., and through the traditional distribution system, which includes independent marketing organizations, financial institutions, and independent life agencies. ALLIED Group, Inc. is an 18.3% owned subsidiary of ALLIED Mutual. There are 2,257 independent ALLIED Agencies which provide the Company with access to numerous agency customers in addition to approximately 600,000 households having one or more ALLIED property-casualty policy. Management believes that demand by these agencies for the Company's life insurance and annuity products is a result of several factors: (1) the Company's well-designed life products, coupled with a demonstrated commitment to service and support from a known insurance company, provide each agency with a competitive advantage in its local market; (2) sales of life insurance products enhance the agencies' relationships with their policyholders creating the potential for increased persistency of both life and property-casualty insurance policies; (3) life insurance sales, particularly given their high first-year commissions relative to property-casualty business, can provide substantial additional income to an agency; and (4) an annual ALLIED property-casualty/life sales incentive trip is available to qualifying agencies that achieve minimum property-casualty production targets as well as specified minimum life insurance and annuity production targets. The Company's products are designed to meet traditional needs, such as family income protection, supplemental retirement savings, mortgage protection, and college savings. The products are also designed to appeal to a wide array of consumers in the middle income and small business owner markets. The Company provides the independent ALLIED Agencies with many opportunities to cross-sell life insurance and deferred annuities to their existing property-casualty customers. Life insurance protection is sold as important elements of a total personal lines insurance package which may include auto insurance, homeowners insurance, personal liability, and inland marine coverage. The Company's annuities are marketed primarily as tax-deferred accumulation vehicles to individuals in anticipation of their retirement. See "Forward-looking Information" on page 22 for an outline of factors that may affect actual results. 1 Marketing and Distribution General ALLIED Life's products are sold through two distribution systems: the independent ALLIED Agencies and a traditional life insurance distribution system. In 1996, the Company sold 75% of its new life insurance face amount and 43% of its collected annuity premium through the ALLIED Agencies and the remainder of its products were sold through traditional distribution channels. Effective July 26, 1996, the Company split its property-casualty and traditional distribution systems into two separate areas of responsibility in an effort to improve traditional distribution sales. The Company hired Joseph P. Ross as Vice President, Marketing for the traditional distribution system for life and annuity products. Mr. Ross has twelve years experience in the insurance industry and his duties will be to recruit life marketing organizations and develop their sales, specifically in universal life and annuity products. Thomas F. Van Fossen, Vice President, Marketing, will be responsible for the marketing and sales of life and annuity products in the property-casualty marketplace. Property-Casualty Distribution System The property-casualty distribution system encompasses 2,257 independent ALLIED Agencies. The Company's relationship with the ALLIED Agencies is supported through a joint marketing arrangement between ALLIED Life and the ALLIED property-casualty affiliates (p-c affiliates) which provides for: (1) the promotion of ALLIED Life products through the p-c affiliates, in return for financial incentives related to successful new sales efforts; (2) shared data processing and client database resources, including the provision of on-line price quotes for universal life and term products; and (3) combined billing for all insurance products involving personal lines coverages, including life insurance, annuities, auto, homeowners, excess liability, and other types of insurance. The Company's marketing staff works with the following personnel to generate p-c business. Regional Directors. The 16 ALLIED Life Regional and 4 Life Marketing Directors are the Company's primary field marketing representatives to the ALLIED Agencies and are primarily responsible for the annual growth in life insurance and annuity sales in their respective geographic territories. Regional Directors, who are independent contractors and are not employees of the Company, implement the Company's sales strategies in the ALLIED Agencies, including packaging life insurance effectively with other personal lines coverages, promoting combined billing convenience, and expanding annuity sales and business continuation planning for small commercial property-casualty accounts. Each Regional Director is responsible for approximately 100 ALLIED Agencies. Regional Directors also recruit and train life insurance specialists (see Independent Property-Casualty Agencies on page 3) for certain ALLIED Agencies, as appropriate. Although substantially all of their life and annuity production is derived from sales by the ALLIED Agencies, Regional Directors also generate life and annuity production from non-property-casualty agencies. Regional Directors are compensated solely on an override and incentive basis. Regional Directors' incentive compensation is based upon the achievement of an annual production goal, determined by formula based on past production, the Company's annual sales increase goal, and the persistency of the book of business. Regional Directors who achieve certain levels of production may qualify for the annual ALLIED property-casualty/life incentive trip. (See ALLIED Property-Casualty/Life Incentive Trip on page 3). 2 Life Marketing Directors have responsibilities similar to those of the Regional Directors, but represent the Company in the newer property- casualty territories where there is not yet an established ALLIED Agency system. The Life Marketing Director is an employee of the Company and is compensated on a salary and production incentive basis. Property-Casualty Marketing Representatives. ALLIED property-casualty marketing representatives are employees of ALLIED Group, Inc. Their primary responsibility is to promote the sale of property-casualty products by the independent ALLIED Agencies. The field marketing representatives, however, are also responsible for promoting the relationship between the ALLIED Agencies and ALLIED Life in order to enhance the sale of life insurance products. The compensation of the marketing representatives includes bonuses based on the sale of ALLIED Life products by the ALLIED Agencies. In addition, their eligibility for the annual incentive trip partially depends on the level of life insurance sales achieved by the ALLIED Agencies under their supervision. Independent Property-Casualty Agencies. The ALLIED Agencies either sell life insurance and annuity products themselves, with the support of their Regional Director and the systems capabilities of ALLIED Life, or they work in conjunction with life insurance specialists. Life insurance specialists are independent life insurance agents either employed by an ALLIED Agency or working with an ALLIED Agency on a joint basis. Their primary activity is to market life insurance and annuities to existing ALLIED Agency clients. Life specialists may be recruited and introduced to an ALLIED Agency by its Regional Director when the agency becomes large enough to justify a full-time life insurance agent or when an agency would prefer one specialist to handle all of its life insurance sales. The compensation of the life specialist is usually directly related to life and annuity production, in the form of split commissions, draws against agency commissions or salary, and incentives from the agency. Life specialists are independent agents and may sell the products of other life insurance companies. ALLIED Property-Casualty/Life Incentive Trip. The ALLIED p-c affiliates and ALLIED Life annually sponsor a joint incentive trip for both life and property-casualty agents who have met incentive sales objectives. The incentive trip is an important motivating factor in encouraging the ALLIED Agencies to sell ALLIED Life's products. ALLIED Agencies qualify for the trip based upon achieving their property-casualty objectives as well as certain life and annuity new business objectives. Failure to achieve the life qualification may preclude an agency from participation, even if it meets its property-casualty production goals. Those agencies with insufficient property-casualty growth or agencies selling through the traditional distribution system may still qualify for the incentive trip by producing a substantial volume of new life and annuity premium. The following table shows the history of the ALLIED Agencies qualifying for the annual ALLIED property-casualty/life incentive trip. Year Ended December 31, 1996 1995 1994 Incentive trip production credit premiums from qualifying ALLIED Agencies (1) 3,787,256 3,694,750 3,257,000 Total incentive trip production credit premiums for all ALLIED Agencies (1) 6,098,912 5,541,484 5,336,000 Percentage of incentive trip production credit premiums earned by qualifying ALLIED Agencies 62% 67% 61% Number of qualifying ALLIED Agencies 197 174 191 (1) Production credit premiums represent annualized first-year target premium for universal life and term life and 2% of annuity premium collected. The minimum qualification level for 1997 is 9,200 production credit premiums. 3 Traditional Life Insurance and Annuity Distribution System The Company has traditional agency relationships with a number of independent life agencies, independent marketing organizations and financial institutions. These agency relationships represent an important source of business for the Company and in 1996 produced approximately 25% of the total new face amount of life insurance sold and 57% of the total annuity premium collected. A separate vice president, marketing, supervises the operation and performance of the Company's traditional distribution system and is responsible for its life insurance and annuity production. The Company has agency relationships with independent marketing organizations, most of which have more licensed agents covering a larger geographic area than a traditional independent life insurance agency. These organizations have their own insurance marketing systems and generally sell the Company's life insurance products. Additionally, the Company has agency relationships with traditional independent life agents which generally cover a smaller geographic area than the independent marketing organizations. The Company markets its annuity products through financial institutions (commercial and savings banks), and through annuity marketing agencies. Institutional annuity marketing is developed through agency relationships with third-party marketing agencies specializing in financial institutions as well as directly through several midwestern-based financial institutions. In 1996, annuity premiums collected by the Company from financial institutions were $26.8 million, representing 67% of the Company's total annuity premiums collected within the traditional distribution channel. Annuity marketing agencies represent a small but growing volume of annuity business. The Company is developing sales of its universal life and term life insurance products through both types of annuity marketing systems. 4 Production by Distribution System The following tables show production information by distribution system for ALLIED Life for the years indicated. 1996 1995 1994 (dollars in thousands) Life insurance face amount in force Directly produced by agents Property-casualty agencies Universal Life $2,809,270 $2,627,447 $2,426,012 Term life 3,200,793 2,506,890 1,981,560 Whole Life 34,521 34,402 34,757 ---------- ---------- ---------- 6,044,584 5,168,739 4,442,329 ---------- ---------- ---------- Traditional agencies Universal life 1,531,331 1,588,116 1,501,476 Term life 997,711 908,647 763,627 Whole life 14,558 15,778 13,613 ---------- --------- --------- 2,543,600 2,512,541 2,278,716 ---------- --------- --------- Other 371,130 433,236 521,692 ---------- --------- --------- Total $8,959,314 $8,114,516 $7,242,737 ========== ========== ========== Life insurance face amount sold Directly produced by agents Property-casualty agencies Universal life $ 282,388 $ 384,763 $ 503,665 Term life 1,127,060 889,624 759,740 Whole life 3,115 2,775 1,779 ---------- ---------- --------- 1,412,563 1,277,162 1,265,184 ---------- ---------- --------- Traditional agencies Universal life 128,247 224,937 375,679 Term life 348,917 333,920 364,873 Whole life 1,124 1,736 541 ---------- ---------- --------- 478,288 560,593 741,093 ---------- ---------- --------- Other 1,890,851 1,837,755 2,006,277 Total 9,431 21,549 59,778 ---------- ---------- --------- $1,900,282 $1,859,304 $2,066,055 ========== ========== ========== Annuity Premiums Deferred annuities Property-casualty agencies $ 30,816 $ 30,321 $ 37,611 Traditional agencies 40,188 45,956 48,646 ---------- ----------- ---------- 71,004 76,277 86,257 ---------- ----------- ---------- Immediate annuities 1,227 2,362 1,595 ---------- ----------- ---------- Total $ 72,231 $ 78,639 $ 87,852 ========== =========== ========== The Company has experienced double-digit growth in its face amount of life insurance in force and annuity account balance since 1994. The total face amount of life insurance in force grew at an average annual rate of 11.9% beginning at year end 1994 through year end 1996 and is up 10.4% at December 31, 1996 as compared to the prior year end. Annuity account balance grew at an average annual rate of 18.1% beginning at year end 1994 through year end 1996 and is up 13.4% at December 31, 1996 compared to the prior year end. 5 The face amount of new term life insurance sold totaled $1.5 billion accounting for 78% of 1996 new insurance production. Term life insurance provides protection during a specified number of years that expires without policy cash value if an insured survives the stated period. The face amount of new term life insurance sold increased 20.6% in 1996 due to the popularity of the Company's 10- and 20-year term life insurance products. For further information on this product line see Term Life Insurance on page 9. The face amount of new universal life insurance sold totaled $410.6 million representing 22% of 1996 new insurance production. Universal life insurance is flexible premium life insurance that allows policyholders to change the death benefit from time to time (with satisfactory evidence of insurability for increases) and vary the amount or timing of premium payments. Premiums minus policyholder assessments are credited to cash value or accumulative accounts to which interest is credited at rates that may change from time to time. The savings element of universal life products have become less attractive over the last several years due to generally lower interest rates and an increasing equity market. For further information on this product line see Universal Life Insurance on page 8. During 1996, first-year fixed deferred annuity premiums decreased 10.4% to $68.1 million. Fixed deferred annuities are tax-deferred cash accumulation contracts that pay a fixed interest rate established by the insurance company. The Company issues single and flexible premium annuities that permit additional deposits by policyholders after initial premiums are paid. Lower first and second quarter sales were caused by a flat interest yield curve, which allowed banks and other financial institutions to offer short-term certificates of deposit at more competitive interest rates. Interest rates rose during the middle of the year, and sales reached expected levels in the third and fourth quarters. For further information on this product line, see Annuities on page 10. 6 Market Area The following table shows direct life insurance premiums and annuity considerations for ALLIED Life by state for the years indicated. 1996 1995 1994 Life Insurance Annuity Percentage Percentage Percentage Premiums Considerations Total (1) of Total of Total of Total (Dollars in thousands) Iowa $ 9,869 $15,078 $ 25,451 21.5% 26.1% 29.6% Wisconsin 1,859 11,549 13,415 11.3 7.0 6.0 California 9,770 2,953 12,802 10.8 10.0 10.2 Illinois 1,233 10,794 12,487 10.6 5.5 4.7 Utah 1,244 8,554 9,801 8.3 5.8 5.7 Nebraska 4,413 2,534 7,276 6.2 6.2 4.8 Kansas 3,399 2,287 5,916 5.0 5.6 6.0 Idaho 1,266 4,078 5,375 4.5 1.3 1.6 Missouri 2,059 1,877 4,059 3.4 6.6 5.6 Oregon 378 3,328 3,706 3.2 0.5 0.2 Minnesota 2,064 950 3,036 2.6 4.8 3.7 South Dakota 522 1,924 2,475 2.1 5.9 9.5 Other (2) 5,671 6,325 12,406 10.5 14.7 12.4 ------- ------- -------- ------ ----- ----- $43,747 $72,231 $118,205 100.0% 100.0% 100.0% ======= ======= ======== ====== ===== ===== (1) Total includes accident and health and other miscellaneous premiums not separately shown in the table. (2) Includes all other jurisdictions, none of which accounted for more than 2% in 1996. For more information regarding premium by state and the states where ALLIED Life is admitted for insurance business, see the 1996 Annual Report, page 3. Subsidiaries ALBA is a general agency which uses the ALLIED Life agency force to sell complementary insurance products not developed nor written by ALLIED Life, such as health insurance, major medical, and disability insurance. ALBA's revenues amounted to $681,000 in 1996, $496,000 in 1995, and $476,000 in 1994. AGMB is a registered broker-dealer which facilitates securities transactions for the insurance agents of the Company and its affiliates who are licensed to sell securities. AGMB's revenues for 1996, 1995, and 1994 were $389,000, $203,000, and $189,000. 7 Products Universal Life Insurance The Company's universal life policies provide permanent life insurance protection with a flexible premium structure that allows the customer to pre-fund future insurance costs and to accumulate savings on a tax-deferred basis. The policyholder may surrender the policy at any time and receive the accumulated account balance less a specified surrender charge based on the duration of the contract and the amount of the coverage. The following table reflects the account value, average face amount and average policyholder age at date of issue for the Company's universal life products (excludes riders): Average Average Number Average Account Face of Issue Value Amount Policies Age Policies sold in 1996: Policies with a minimum face amount in excess of $150,000 $ 7,833 $358,414 390 44 All other policies 2,023 50,987 3,009 39 Total policies in force as of December 31, 1996: Policies with a minimum face amount in excess of $150,000 $10,826 $326,748 5,000 40 All other policies 3,827 57,698 33,033 36 When the Company issues a universal life policy it receives an initial premium based on the face amount of insurance purchased and the premium is reflected as a deposit to the policyholder's account. Additional premiums may be deposited by the policyholder up to a specified maximum. The Company deducts an expense allowance from each premium within a contractually specified range and credits the remainder to the policyholder's account. Thereafter, the account balance is charged monthly for the cost of insurance, which reflects mortality and benefit charges and an administrative fee, and is credited interest monthly at current crediting rates. Certain of the Company's universal life policies are designed to encourage policyowner persistency and larger account balances by providing higher crediting rates for larger account balances as well as those maintained for longer periods. Policy liabilities for universal life contracts are comprised of policyholder account balances. The following table shows changes in account balances for each year in the five-year period ended December 31, 1996: Benefit Account Payments Account Deferred Average Balance, Plus Balance, Policy Interest Beginning of Premiums Interest Cost of Expense Surrender End of Acquisition Credited Year Year Received Credited Insurance Allowances Charges Year Costs Rate (dollars in thousands) 1992 $110,714 $26,120 $8,626 $ (9,487) $(3,020) $ (7,303) $125,650 $36,794 7.3% 1993 125,650 32,468 9,293 (11,498) (3,931) (10,541) 141,441 40,890 7.0 1994 141,441 29,640 9,229 (13,810) (3,591) (7,064) 155,845 46,653 6.2 1995 155,845 30,382 9,530 (15,563) (4,448) (7,092) 168,654 51,774 5.9 1996 168,654 32,644 9,490 (16,178) (4,549) (7,334) 182,727 56,333 5.4 8 The Company's universal life products are designed to provide long-term returns to its policyowners. Most of the Company's products currently being sold are structured so that the Company's policy acquisition costs will be recovered on an in force basis upon the receipt of 5 to 10 years of annual premiums, depending on the product. In the event of an early surrender, the Company imposes surrender charges in order to fully recover its acquisition costs at the point of surrender by the policyowner. Additionally, variable periodic mortality and benefit charges, percent-of-premium loads, and monthly policy fees cover the costs of insurance and other benefits, policy administration and taxes, and provide the Company with a profit margin. The products are structured so policyowners are rewarded for higher cash values and life insurance face amounts. Term Life Insurance Over 80% of the Company's current term life insurance sales are 10- and 20-year level premium policies. Under these policies, the customer purchases basic term insurance protection without the tax-deferred accumulation feature available under the Company's universal life insurance policies. Term life insurance provides only a death benefit for a specified period of time to the policyowner for a lower premium than would be required for a comparable face amount of universal life insurance. Cash value does not accumulate, rather, the premium charged is a function of mortality risk and policy expenses. The following table reflects the average face amount and average policyholder age at date of issue for the Company's term life products (excludes riders): Number Average Average of Face Issue Policies Amount Age Policies sold in 1996: Policies with a minimum face amount in excess of $150,000 2,058 $403,296 41 All other policies 5,746 96,303 41 Total policies in force as of December 31, 1996: Policies with a minimum face amount in excess of $150,000 6,922 $373,875 41 All other policies 16,083 92,134 39 The Company encourages the conversion of term life insurance to universal life insurance, and as an incentive it credits a portion of the term life premium as an additional deposit into the universal life insurance account of a policyholder upon conversion. The credit is substantially offset by a reduction in the commission payable to the agent. The agent has incentive to encourage term conversion because the reduced commission payable upon conversion still exceeds the commission payable on the renewal of a term life insurance policy. This incentive to convert is promoted directly to the term policyowner at each of the first five policy renewals. Term conversions represented 8.5% of 1996 universal life face amount sold. Universal life insurance face amount sold resulting from conversions from ALLIED Life term products were $38.9 million in 1996, $30.5 million in 1995, and $65.3 million in 1994. Group Life and Other In Force Life Policies As of December 31, 1996, the Company had $267.5 million face amount of group term life insurance in force on 2 employee groups, one of which is the ALLIED Group, Inc. employee group. 9 As of December 31, 1996, the Company had $49.1 million face amount of other life insurance products in force consisting of smaller, non-participating whole life policies. These are guaranteed premium and cash value contracts. Annuities The Company offers a variety of fixed deferred annuity products, including single premium and flexible premium designs, to customers who wish to accumulate savings on a tax-deferred basis. Annuities currently enjoy an advantage over certain other savings vehicles because the annuity buyer receives a tax-deferred accrual of interest on his or her investment during the accumulation period. Annuities generally are marketed to individuals in anticipation of retirement. The following table reflects the average account value and average policyholder age at date of issue for the Company's deferred annuity products : Number Average Average of Account Issue Policies Value Age Annuities sold in 1996: 3,451 $20,906 69 Total policies in force as of December 31, 1996: 23,305 19,914 65 Policy liabilities for annuity contracts without mortality risk are comprised of policyholder account balances. The following table shows changes in account balances for each year in the five-year period ended December 31, 1996: Benefit Account Payments Account Deferred Average Balance, Plus Balance, Policy Interest Beginning of Considerations Interest Surrender End of Acquisition Credited Year Year Received Credited Charges Year Costs Rate (dollars in thousands) 1992 $165,179 $50,000 $13,683 $(7,294) $221,568 $ 10,545 7.2% 1993 221,568 56,427 16,682 (23,292) 271,385 15,114 6.7 1994 271,385 86,899 17,723 (32,617) 343,390 21,393 5.8 1995 343,390 77,199 22,613 (30,986) 412,216 25,613 5.9 1996 412,216 71,770 24,566 (41,047) 467,505 25,623 5.6 Annuity account balances have increased from $221.6 million at December 31, 1992 to $467.5 million at December 31, 1996, an average yearly increase of 27.7%. Considerations received decreased 7% in 1996 compared to 1995 due to a flat interest yield curve which allowed financial institutions to offer short-term investments at more competitive interest rates. Benefit payments plus surrender charges in the table above have increased in recent years due primarily to the fact that the Company wrote very few annuities prior to 1989. Thus the increasing age of the Company's annuity portfolio results in more surrenders because the older products have lower surrender charges. The Company's deferred annuities are sold as an alternative to bank certificates of deposit and other taxable savings vehicles. Annuity premiums are typically invested in intermediate term, investment grade securities with the investment terms generally matching the underlying product surrender charge periods of three to nine years. For most plans, the initial interest is guaranteed for one to three years with renewal crediting rates based on port- 10 folio earnings and market conditions. As a competitive enhancement, some of the Company's annuity products include interest rate bonuses which are added to the policies account value at various points during the contract period. Liquidity benefits are provided in the form of no-penalty partial withdrawal allowances, interest income payments, a nursing home waiver, and bonus annuitization options. Several of the Company's annuity products provide 1% to 2% first-year interest bonuses and additional annual interest bonuses for long-term persistency. The present value of the interest rate bonuses are generally deducted from agents compensation, allowing the Company to maintain its targeted profit margin. Surrender charges, which the Company imposes in the early years of a policy, reduce the amount payable to a policyholder upon surrender of a policy and generally permits the Company to recover its acquisition costs. These charges also reduce the statutory reserve applicable to the policy. During the second quarter of 1996, the Company introduced an equity indexed-annuity product. While guaranteeing the return of principal to the customer, interest credited is based on a percentage of the gain of the S&P 500 Index(R). A portion of the premium from each customer is invested in investment grade fixed income securities to cover the minimum guaranteed value due the customer at the end of the term. A portion of the premium is used to purchase S&P 500 call options to hedge the growth in interest credited to the customer as a direct result of increases in the S&P 500 Index(R). The call options provide the Company the opportunity to participate in the increases of the S&P 500 Index(R) if the market advances. See notes 1 and 3 of the 1996 Notes to Consolidated Financial Statements for additional information regarding call options. Insurance Operations The Company's insurance and annuity operations achieve significant cost efficiencies through automation of policy issue and administration. Budgetary, quality service, and time service standards are established and closely monitored. Internal financial analysis and reporting are used to focus on the most profitable elements of the Company's operations and to identify cost saving and marketing opportunities. The Company is headquartered in Des Moines, Iowa, and physically located in the ALLIED property-casualty companies' home office. This close proximity facilitates marketing plan implementation between ALLIED Life and the ALLIED property-casualty affiliates. It also allows the Company to lease automation systems and support from ALLIED Group, Inc. on a more cost effective basis. See "Certain Transactions and Relationships" in the 1997 Proxy Statement for additional information. Life Insurance Underwriting The Company had adopted and follows detailed, uniform underwriting standards and procedures designed to properly assess and quantify life insurance risks before issuing policies to individuals. Underwriting administration is automated and management emphasizes the achievement of quality and time service objectives. The Company's underwriters review each applicant's written application, which is prepared under the supervision of the Company's agents or representative, and any required medical records. The Company employs blood and urine testing to provide additional information on nicotine and cocaine use and alcohol abuse. Based on the results of these tests, the Company adjusts the mortality charge or declines coverage completely. Any nicotine use by a life applicant within the preceding one year results in a substantially higher mortality charge. In accordance with industry practice, material misrepresentations on a policy application can result in the cancellation by the Company of the policy generally within the first 2 years upon the return of any premiums paid. 11 The increasing incidence of Acquired Immune Deficiency Syndrome (AIDS) has not thus far adversely affected the Company's mortality experience. The Company considers AIDS information and testing results in its underwriting and pricing decisions. The Company's blood test includes a screening for AIDS antibodies. Reinsurance In keeping with industry practices, the Company reinsures portions of its life insurance and disability income exposure with unaffiliated insurance companies under traditional indemnity reinsurance agreements. New insurance sales are reinsured above prescribed limits and do not require the reinsurer's prior approval within certain guidelines. These treaties are automatically renewed and nonterminable for the first 10 years with regard to cessions already made and are terminable after 90 days with regard to future cessions. After 10 years, the Company has the right to terminate and can generally discontinue the reinsurance on a block of business. This is normally done to increase the Company's retention on older business to the same level as current cessions. Generally, the Company enters into indemnity reinsurance arrangements to assist in diversifying its risk and to limit its maximum loss on risks that exceed the Company's policy retention limits, which are currently $150,000 or less per life ($250,000 or less per life for ages 59 and under). Indemnity reinsurance does not fully discharge the Company's obligation to pay policy claims on the reinsured business. The Company, as the ceding insurer, remains responsible for policy claims to the extent the reinsurer fails to pay such claims. No reinsurer of business ceded by the Company has failed to pay any material policy claims (either individually or in the aggregate) with respect to such ceded business. At December 31, 1996, the Company had ceded to reinsurers $2.6 billion of insurance in force, substantially all of which was reinsured with insurance companies rated A (excellent) or better by A.M. Best. There is currently no reinsurance with affiliated insurance companies and all reinsurance entered into is in the ordinary course of business. The Company continually monitors the financial strength of its reinsurers and the availability of replacement coverages in the reinsurance market. If for any reason such reinsurance coverages would need to be replaced, the Company believes that replacement coverages from financially responsible reinsurers would be available. Policy Liabilities The policy liabilities reflected in the consolidated financial statements are calculated in accordance with generally accepted accounting principles (GAAP). Liabilities for universal life and annuity policies consist of the premiums and considerations received plus accumulated credited interest, less accumulated policyholder assessments and benefits. For traditional products, liabilities for future policy benefits have been provided based on the net level premium method. These liabilities are based upon actuarial tables adjusted for ALLIED Life's actual mortality and persistency experience and investment income. GAAP policy liabilities differ from those established for statutory reporting purposes due to the use of different assumptions regarding mortality and interest rates and the introduction of lapse assumptions into the GAAP policy liability calculation. Actual mortality experience in a particular period may be greater than expected mortality experience and, consequently, may materially affect the Company's operating results for such period. See note 1 of the 1996 Notes to Consolidated Financial Statements for additional information regarding policy liability assumptions under GAAP. Interest Crediting Policy On a monthly basis, or more frequently if required, the Company reviews and establishes current period interest rates based upon existing and anticipated investment opportunities. This applies to both new sales 12 as well as in force universal life insurance and annuity products after any initial guaranteed period. The Company attempts to match the duration of the asset-liability characteristics of various universal life insurance and annuity products with the underlying investment opportunities available. Interest rates are then established based on each product's required interest spread and market conditions at the time. Interest rates are reviewed and, if appropriate, adjusted for money received in the Company's home office on or after the effective date of the interest rate change. Investments Without prior approval from the Company's Investment Committee, the investment policy for ALLIED Life requires purchases of securities for the fixed maturity portfolio to be invested in debt obligations rated "BBB" or higher at the time of acquisition. Any security which is rated below "BBB" or is non-rated requires approval from the Company's Investment Committee prior to its purchase. At December 31, 1996, 89% of the Company's fixed maturity investments were rated "A" or higher, and less than 1% were rated lower than investment grade. At December 31, 1996, the fair value of ALLIED Life's fixed maturity portfolio was approximately $6.1 million more than the financial statement carrying value. The carrying values and the investment ratings of all of the Company's investments in fixed maturities are reviewed on an ongoing basis for credit deterioration, and if this review indicates a decline in fair value below cost that is other than temporary, the Company's carrying value in the investment is reduced to its estimated realizable value and a specific write-down is taken. Such reductions in carrying value are recognized as realized losses and charged to income. No such reductions in carrying value were recognized for the years ended December 31, 1996 and 1995. In November of 1995, the Financial Accounting Standards Board (FASB) issued a Special Report entitled "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities." The Special Report allowed companies to reassess the appropriateness of the classification of all securities and make any resulting transfers concurrent with the initial adoption of the implementation guide but no later than December 31, 1995. Effective November 30, 1995, the Company made such reassessment and reclassified $215.2 million of held-to-maturity securities to available for sale. The net effect of such reclassification increased stockholders' equity by $4.4 million. 13 The table below shows the composition of the Company's investments at December 31, 1996: Estimated 1996 1995 Fair Carrying Percent Percent Investment Category Value Value Of Total Of Total (dollars in thousands) Fixed maturities: U.S. Treasury obligations (1) $ 34,904 $ 34,941 4.8% 1.4% Foreign governments 11,119 10,888 1.5 2.0 Public utilities 91,300 90,351 12.5 10.3 Asset-backed securities (other than first lien mortgages) 22,856 22,509 3.1 3.9 Mortgage-backed securities: Pools 122,611 121,657 16.8 21.4 Collateralized mortgage obligations 92,417 92,142 12.8 14.5 --------- --------- ---- ---- Total mortgage-backed securities 215,028 213,799 29.6 35.9 --------- --------- ---- ---- Corporate debt securities: Investment grade (BBB or greater) (2) 330,430 327,010 45.3 43.3 Non-investment grade (BB + or below) (2) --- --- --- 0.7 --------- --------- ----- ---- Total corporate debt securities 330,430 327,010 45.3 44.0 --------- --------- ----- ---- Total fixed maturities 705,637 699,498 96.8 97.5 --------- --------- ----- ---- Equity securities 6,407 6,406 0.9 0.6 Mortgage loans on real estate (3) 1,457 1,457 0.2 0.3 Policy loans 10,307 10,307 1.4 1.4 Other invested assets (4) 4,276 3,751 0.5 --- Short-term investments 920 920 0.2 0.2 --------- --------- ----- ----- Total investments $729,004 $722,339 100.0% 100.0% ========= ======== ===== ===== (1) All such securities are backed by the full faith and credit of the United States government. (2) Ratings are assigned primarily by Standard & Poor's or a recognized equivalent. (3) Consists of single family residential and farm mortgages. (4) Consists of instruments purchased for hedging purposes. 14 The following table sets forth the composition of the Company's portfolio of fixed maturity investments by rating at December 31, 1996: Estimated 1996 1995 Fair Carrying Percent Percent Rating (1) Value Value Of Total Of Total (dollars in thousands) AAA $269,839 $267,985 38.3% 42.9% AA 83,731 82,150 11.7 10.8 A 275,734 273,046 39.0 39.9 BBB 74,769 74,753 10.7 4.5 -------- -------- ---- ---- Total investment grade fixed maturities 704,073 697,934 99.7 98.1 -------- -------- ---- ---- Non investment grade 1,564 1,564 0.3 1.9 -------- -------- ---- ---- Total fixed maturities $705,637 $699,498 100.0% 100.0% ======== ======== ===== ===== (1) Ratings are assigned primarily by Standard & Poor's or a recognized equivalent. The following table sets forth expected maturities in the Company's fixed maturity portfolio at December 31, 1996. Expected maturities at December 31, 1996 are shorter than contractual maturities because of mortgage backed and call-option securities in the portfolio. Borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Expected maturities are based on the same prepayment assumptions used in amortizing premiums and discounts on these securities. For additional information on contractual maturities, see note 2 of the 1996 Notes to Consolidated Financial Statements. 1996 1995 Amortized Percent Percent Cost Of Total Of Total (dollars in thousands) One year or less $ 38,827 5.6% 7.6% Over 1 year through 5 years 171,830 24.8 24.8 Over 5 years through 10 years 343,707 49.7 44.8 Over 10 years through 20 years 103,031 14.9 17.2 Over 20 years 34,500 5.0 5.6 ------- ------ ----- Total $691,895 100.0% 100.0% ======= ====== ===== 15 Investment results of the Company for each year in the three years ended December 31, 1996 are shown on the following table. 1996 1995 1994 (dollars in thousands) Average invested assets, net (1) $653,908 $584,223 $489,612 Investment income (2) 48,182 45,411 38,137 Average annual yield on total investments 7.4% 7.8% 7.8% Realized investment gains (losses) $ 122 $ (722) $ (724) (1) Total invested assets, at cost, less balance outstanding on Federal Home Loan Bank note payable (see (2) below), on an average quarterly basis. (2) Investment income is net of interest and investment expenses and does not include realized investment gains or losses or provision for income taxes. Mortgage-backed securities (including collateralized mortgage obligations [CMOs]) comprise 30.6% of the Company's total fixed maturity portfolio at December 31, 1996. The mortgage-backed securities are backed primarily by first lien single family residential mortgages. All of the mortgage-backed securities are investment grade. The Company's investments in CMOs consist of pools of mortgages divided into sections or "tranches" which provide sequential retirement of bonds. As of December 31, 1996, ALLIED Life held CMO investments with a carrying value of $92.1 million (fair value of $92.4 million). As of December 31, 1996, 86.8% (84% in 1995) of the Company's CMO investments were in planned amortization classes (PACs) and sequential pay bonds. The Company invests primarily in PACs to provide call protection and more stable average lives. This provides more predictable cash flows within a range of prepayment speeds by shifting the prepayment risks to support tranches. All of the Company's CMO investments have an active secondary market and accordingly are not expected to affect the Company's liquidity differently than other fixed maturity investments. The following table shows the December 31, 1996 estimated fair value and carrying value of the CMO portfolio by investment rating: Estimated 1996 1995 Fair Carrying Percent Percent Rating(1) Value Value Of Total Of Total (dollars in thousands) AAA $83,036 $82,923 90.0% 97.0% AA 9,381 9,219 10.0 3.0 ------- ------ ----- ----- Total investments in CMOs $92,417 $92,142 100.0% 100.0% ======= ======= ===== ===== (1) Ratings are assigned primarily by Standard & Poor's or a recognized equivalent. 16 The following table shows the December 31, 1996 estimated fair value and carrying value of the CMO portfolio by type: Estimated 1996 1995 Fair Carrying Percent Percent Type of CMO Value Value Of Total Of Total (dollars in thousands) Planned amortization class $55,435 $55,427 60.2% 57.5% Sequential pay 24,814 24,508 26.6 26.5 Other 12,168 12,207 13.2 16.0 ------- ------ ----- ----- Total investments in CMOs $92,417 $92,142 100.0% 100.0% ======= ======= ===== ===== Hedging Activities In June 1996, the Company began interest rate hedging programs whereby certain derivative financial instruments including cash settle put swaptions (swaptions) and interest rate floors (floors) were purchased. Swaptions are being purchased to reduce the negative effect of increased withdrawal activity related to the Company's annuity liabilities that may result from extreme increases in interest rates. As of December 31, 1996, the Company was party to 44 agreements for these instruments. The agreements expire quarterly from June 1999 through March 2006. They entitle the Company to receive payments from the instrument's counter parties on future reset dates if the interest rate (which is directly tied to the 5-year constant maturity swap curve) on any expiration date is above a specified fixed rate (8.8% to 10.5% for instruments entered into as of December 31, 1996). The notional amounts range from $3 million to $9 million (total of $244 million). Floors are being purchased to reduce the negative effect that may result from extreme decreases in interest rates to a level below the guaranteed interest rates provided for in the universal life insurance contracts. The 28 agreements for the floors outstanding as of December 31, 1996 expire quarterly from June 1999 through March 2006. They entitle the Company to receive payments from the instrument's counter parties on future reset dates if the interest rate (which is tied directly to the 10-year constant maturity treasury curve) on the expiration date is below a specified fixed rate (5.0% for instruments entered into as of December 31, 1996). The notional amounts for each quarter range from $140 million to $270 million. The costs of the interest rate hedging programs are not expected to have a material impact on the interest rate margin. For both swaptions and floors, the Company pays only the original premium and is not at risk of further payments regardless of market conditions. The Company does not anticipate making any further purchases of interest rate hedges in the near future. Premiums paid to purchase these instruments are capitalized and included in other invested assets. Through December 31, 1996, the Company had paid approximately $4.1 million in premiums. Premiums are amortized into income over the term of the instruments on a straight-line basis. Gains and losses on these instruments and related assets are not recorded in income until realized. The Company is exposed to the risk of losses in the event of nonperformance of the counter parties of the above swaptions and floors. Losses recorded in the Company's financial statements in the event of non-performance will be limited to the unamortized premium paid to enter into the instruments. Economic losses will be measured by the net replacement cost of such instruments or by their fair value if the net fair value is in the Company's favor. The Company limits its exposure to such losses by diversification among reputable counter parties with appropriate credit ratings. 17 Competition The Company operates in a highly competitive industry. In connection with the development and sale of its products, the Company encounters significant competition from other insurance companies, many of whom have financial resources substantially greater than those of the Company, as well as from other investment alternatives available to its customers. The operating results of companies in the insurance industry have historically been subject to significant fluctuations due to competition, economic conditions, interest rates, investment performance, maintenance of insurance ratings, and other factors. Management believes that the Company's ability to compete with other insurance companies is dependent upon, among other things, its ability to attract and retain agents to market its insurance products, its ability to develop competitive and profitable products, and its maintenance of high ratings from A.M. Best (currently "A" [excellent]) and Duff and Phelps Credit Rating Company (currently "A"). The Company competes on the basis of its distribution system, its innovative product development, its strong financial condition, and its high-quality agent services and marketing support. Growth in the Company's distribution channels is based on providing a competitive product portfolio combined with the value of its marketing, underwriting, and administrative support services to agents. Regulation The Company's insurance subsidiary is subject to varying degrees of regulation and supervision by the states in which it is admitted to transact business. State insurance laws establish regulatory agencies with broad administrative and supervisory powers related to granting and revoking licenses to transact business, establishing guaranty fund associations, licensing agents, approving policy forms, regulating premium rates for some lines of business, establishing reserve requirements, prescribing the form and content of required financial statements and reports, determining the reasonableness and adequacy of statutory capital and surplus, and regulating the type and amount of investments permitted. ALLIED Life must file guaranteed rates for the policies it underwrites with the insurance departments of certain states in which it operates; reinsurance generally is not subject to rate regulation. Insurance departments also examine the affairs of insurance companies, which includes periodic market conduct examinations by the regulatory authorities and review of annual and other reports prepared on a statutory accounting basis required to be filed on the financial condition of insurers or for other purposes. Further, state insurance statutes typically place limitations on the amount of dividends or other distributions payable by insurance companies in order to protect their solvency. The Iowa statute requires that insurance companies pay dividends only out of earned profits (unassigned surplus) and requires prior regulatory approval for the payment of any dividend which exceeds the greater of either (I) 10% of statutory policyholders surplus (total capital stock and surplus) as of December 31 of the preceding year or (ii) the statutory net gain from operations of the insurer for the 12-month period ending the December 31 of the preceding year. The Company is also subject to statutes governing insurance holding company systems. Typically, such statutes require the Company to periodically file information with the state insurance regulatory authority, including information concerning its capital structure, ownership, financial condition, and general business operations. Under the terms of applicable state statutes, any person or entity desiring to acquire more than a specified percentage (commonly 10%) of the Company's outstanding voting securities is required first to obtain approval of the applicable state insurance regulators. Chapter 521A of the Iowa Code relating to holding companies, to which the Company is subject, requires disclosure of transactions between the Company and its insurance subsidiary or between an insurer and another subsidiary, that such transactions satisfy certain standards, including that they be fair, equitable and reasonable, and that the Insurance Commissioner be given an opportunity to disapprove certain material transactions. Further, prior approval by the Iowa Insurance Division is required for affiliated sales, purchases, exchanges, loans or extensions of credit, guarantees or investments which involve 5% or more of the insurer's admitted assets as of the preceding December 31st. 18 Under insolvency or guaranty fund laws in states in which ALLIED Life operates, insurers can be assessed, up to prescribed limits, for losses incurred by policyholders as a result of the insolvency of other insurance companies. The amounts and timing of such assessments are beyond the control of the Company and generally have an adverse impact on the Company's earnings. A number of insurance companies are under supervision resulting in assessments to cover losses to policyholders of such companies. The Company cannot predict the amount of any future assessments. Recently, the insurance regulatory framework has been placed under increased scrutiny by various states, the federal government, and the National Association of Insurance Commissioners (NAIC). The NAIC has recommended to the states for adoption and implementation several regulatory initiatives. Iowa as well as three other states have adopted the NAIC regulation for life insurance policy sales illustrations. Additional states are expected to adopt the new regulation in 1997. The effect of any adoption by individual states is not expected to have a significant effect on the Company's insurance production. Employees At December 31, 1996, ALLIED Life employed 113 persons. ALLIED Life employs all persons serving the Company and its subsidiaries. None of the employees are members of a collective bargaining unit. Management believes that relations with its employees are good. Item 2. Properties The Company does not own any real estate. The Company's principal operations are conducted from leased office space pursuant to a leasing arrangement with ALLIED Mutual. See "Certain Transactions and Relationships" in the 1997 Proxy Statement for additional information. Management considers the leased space to be adequate for its needs. Item 3. Legal Proceedings The Company is a party to lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or results of operations. Item 4. Submission of Matters to a Vote of Securities Holders No matters were submitted during the fourth quarter of 1996 to a vote of holders of ALLIED Life Financial Corporation stock. 19 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's common stock trades on The Nasdaq Stock Market under the symbol ALFC. As of December 31, 1996, there were 136 stockholders of record. The following table shows the high and low market prices and dividends paid per share for each calendar quarter for the two most recent years. High Low Last Dividends 1996 First qtr. $18 1/4 $16 1/2 $17 $.05 Second qtr. 21 1/2 15 20 .05 Third qtr. 20 15 1/4 15 3/4 .05 Fourth qtr. 18 3/4 15 3/4 17 1/2 .06 1995 First qtr. $16 3/4 $13 3/4 $15 $.04 Second qtr. 17 3/4 15 17 1/4 .04 Third qtr. 20 17 1/4 17 1/2 .04 Fourth qtr. 18 16 1/4 18 .05 There are certain regulatory restrictions relating to the payment of dividends (see note 10 of the 1996 Notes to Consolidated Financial Statements). It is the present intention of the Board of Directors to declare quarterly cash dividends. 20 Item 6. Selected Financial Data At or for the year ended December 31, 1996 1995 1994 1993 1992 Income Statement Data (Dollars in thousands, except per share data) Revenues Total insurance revenues $31,350 $29,934 $25,393 $20,822 $17,732 Investment income 48,182 45,411 38,136 33,243 28,979 Realized investment gains (losses) 122 (722) (724) 2,154 2,511 Other income 1,056 688 648 277 236 ------- ------- ------- ------ ------- Total revenues 80,710 75,311 63,453 56,496 49,458 ------- ------- ------- ------ ------- Benefits and expenses Policyholder benefits 47,988 46,063 37,359 32,870 27,660 Amortization of deferred policy acquisition costs (2) 10,595 5,941 5,136 5,347 5,068 Commissions 3,316 2,725 2,627 2,390 1,904 Insurance operating expenses 6,801 6,313 5,715 4,966 4,316 ------- ------ ------- ------ ------ Total benefits and expenses 68,700 61,042 50,837 45,573 38,948 ------- ------ ------- ------ ------ Income before income taxes 12,010 14,269 12,616 10,923 10,510 Income taxes 3,937 4,557 4,059 3,739 3,709 ------- ------ ------- ------ ------ Net income (1)(2) $ 8,073 $ 9,712 $ 8,557 $ 7,184 $ 6,801 ======= ======= ======= ======= ======= Net income applicable to common stock (1)(2) $ 6,471 $ 8,219 $ 7,226 $ 5,930 $ 5,551 Earnings per common share (1)(2) 1.41 1.78 1.58 1.67 1.63 Dividends paid per common share $ 0.21 $ 0.17 $ 0.13 $ 0.03 $ --- Weighted average number of common shares outstanding (in thousands) 4,580 4,613 4,577 3,545 3,413 Balance Sheet Data Investments at cost $714,483 $637,245 $554,889 $451,982 $372,080 Assets 835,600 759,947 643,340 532,588 439,060 Preferred stock 24,586 22,871 21,341 19,028 18,517 Stockholders' equity $99,942 $101,682 $ 76,027 $ 74,368 $54,123 Preferred shares outstanding (in thousands) 2,238 2,087 1,948 1,754 1,707 Common shares outstanding (in thousands) 4,497 4,633 4,586 4,572 3,413 Other Data Death benefits per share $ 1.02 $ 1.03 $ 0.85 $ 0.86 $ 0.71 Book value per share 16.16 15.01 13.42 11.98 10.42 Statutory capital and surplus 46,544 45,504 47,413 42,403 28,726 Life insurance in force 8,959,314 8,114,516 7,242,737 5,915,558 4,875,840 Annuity account balances $467,505 $ 412,216 $ 343,390 $271,385 $221,568 (1) The 1988 amounts are before the cumulative effect of a change in accounting for income taxes (SFAS 96). (2) The 1996 amounts include an additional $2.8 million ($1.9 million or $0.42 per share net of income taxes) charge relating to unlocking adjustments to deferred policy acquisitions costs. 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-looking Information The Private Securities Litigation Reform Act of 1995 provides a safe harbor to encourage companies to provide prospective information so long as it is identified as forward-looking and is accompanied by meaningful cautions identifying important factors that could cause actual results to differ materially from the prospective information. The management of ALLIED Life Financial Corporation (ALFC or the Company) is adhering to these provisions. This report contains cautionary statements identifying important factors that could cause actual results to differ materially from those projected in forward-looking statements in the following discussion and elsewhere in this report. Forward-looking statements relate to future operations, strategies, financial results, or other developments and are not based on historical information. In particular, statements containing words such as "expect," "anticipate," "believe," "goal," "objective," or similar words generally qualify as forward-looking statements. The Company undertakes no obligation to update such forward-looking statements. The risks and uncertainties that may affect the operations, performance, development, and results of the Company's business include the following: (1) heightened competition, particularly intensified price competition, the entry of new competitors from the financial services sector, and the creation of new products by competitors; (2) adverse state and federal legislation and regulations, including federal tax laws affecting individuals, changes in the taxation of insurance companies, federal legislation allowing the entry of new competitors from the financial services sector, and the regulation of product design and marketing of those products; (3) changes in interest rates causing a reduction of investment income; (4) general economic and business conditions that are less favorable than expected; (5) unanticipated changes in industry trends; and (6) inaccuracies in assumptions regarding future morbidity, persistency, mortality, and interest rates. Overview The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data and Financial Statements and related footnotes included elsewhere herein. ALLIED Life Financial Corporation is an insurance holding company formed by ALLIED Mutual Insurance Company (ALLIED Mutual) in July of 1993. The financial statements include the accounts of ALLIED Life Insurance Company (ALLIED Life), ALLIED Life Brokerage Agency, Inc. (ALBA), and ALLIED Group Merchant Banking Corporation (AGMB). ALLIED Life accounts for substantially all of the Company's operations and sells primarily life insurance and annuity products. ALLIED Life's universal life insurance products provide life insurance coverages with flexible premium payments determined by policyholders and accumulate cash value over the policy term. Premiums received less policy assessments for administration expenses and mortality costs are credited to policyholder account balances, to which tax-deferred interest is credited at rates adjusted periodically by ALLIED Life. Surrender charges may be deducted from the account balances if policies are surrendered within a specified period after their effective dates. Term life insurance policies provide life insurance protection over a specified number of years. Policyholders remit premiums for the insurance protection but accumulate no cash value. 22 Annuity contracts are products which provide for fixed or variable periodic benefit payments that commence according to contract terms and permit interest income to accumulate on a tax-deferred basis. Considerations paid by policyholders are credited to their accounts and earn interest at rates determined by ALLIED Life. To encourage policy persistency, surrender charges are imposed against account balances for early termination of annuity contracts. In accordance with Generally Accepted Accounting Principles (GAAP), universal life insurance premiums received are shown as increases in liabilities for policyholder account balances and not as revenues. Revenues reported for universal life products consist of fee income from mortality charges, administration expenses, and surrender charges assessed against the account balances. Surrender benefits paid are reflected as decreases in liabilities for these account balances and not as expenses. Interest credited to account balances is reported as benefit expenses in the financial statements. Premium revenues reported for term life insurance products are recognized as revenues when due. Benefits relating to these products are associated with earned premiums. They are reported as benefit expenses by means of the change in the liabilities for future policy benefits so as to recognize profits over the premium-paying periods of the policies. Annuity considerations received and surrender benefits paid are shown as increases and decreases to liabilities for policyholder account balances and are not shown as revenues or expenses. Revenues reported for annuity products consist of surrender charges deducted from policyholder accounts. Expenses consist of interest credited to account balances. Another source of revenues for ALLIED Life is investment income earned from the funds deposited to accounts by universal life and annuity policyholders, a portion of which is passed through to these policyholders in the form of interest credited. The costs related to acquiring new business (principally commissions), certain costs of issuing policies, and certain other variable selling expenses (defined as deferred policy acquisition costs) are capitalized and amortized into expense primarily in proportion to the present value of expected gross profits. This amortization is adjusted when ALLIED Life revises its current or estimated future gross profits. For example, deferred policy acquisition costs are amortized earlier than originally estimated when policy terminations are higher than expected and when investments are sold at a gain prior to their anticipated maturity. Death and other policyholder benefits reflect ALLIED Life's exposure to mortality risk. They fluctuate from period to period according to the level of claims incurred under ALLIED Life's insurance retention limit. Profitability is primarily affected by investment spread (the excess of investment income earned over the amounts credited as interest to policyholder accounts), mortality experience (difference between actual and expected death and other policyholder benefits), and the ability to control policy acquisition costs and other operating expenses. Because of ALLIED Life's relatively small size, its operating results may be affected significantly by the level of death and other policyholder benefits incurred in any one reporting period. The tables on pages 24 and 25 reflects ALLIED Life's production information and pretax operating results excluding realized investment gains (losses) and related amortization of deferred policy acquisition costs for the years indicated. The following analysis of life insurance operations should be read with reference to the table. 23 Results of Operations 1996 Compared with 1995 Consolidated revenues for the year ended December 31, 1996 were $80.7 million, a 7.2% increase over the $75.3 million reported for 1995. The increase was attributable to life insurance premiums and other insurance income net of reinsurance premiums ceded that rose 9.9% due to increased sales of term life insurance. In 1996 the Company had realized gains on investments of $122,000 as compared with realized losses of $722,000 in 1995. Consolidated revenues have grown at a slower rate over the last several quarters due to lower sales of universal life and annuity products. Investment income and policyholder assessments on universal life have shown decreases in growth primarily because of lower increases in invested assets and universal life account balances. Life Insurance Operations Year Ended December 31, 1996 1995 1994 (Dollars in thousands) Production information Life insurance Life insurance face amount in force directly produced by agents Universal Life $4,340,601 $4,215,564 $3,927,488 Term life 4,198,504 3,415,536 2,745,187 Whole life 49,079 50,180 48,370 ---------- ---------- ---------- 8,588,184 7,681,280 6,721,045 ---------- ---------- ---------- Other 371,130 433,236 521,692 ---------- ---------- ---------- $8,959,314 $8,114,516 $7,242,737 ========== ========== ========== Face amount of new life insurance sold directly produced by agents Universal Life $ 410,635 $ 609,700 $ 879,344 Term life 1,475,977 1,223,544 1,124,613 Whole life 4,239 4,511 2,320 --------- --------- --------- 1,890,851 1,837,755 2,006,277 --------- --------- --------- Other 9,431 21,549 59,778 --------- --------- --------- $1,900,282 $1,859,304 $2,066,055 ========== ========== ========== Life insurance termination rate Universal Life 6.1% 6.7% 6.7% Term life 18.2% 18.9% 17.6% Annuities Account balance $ 467,505 $ 412,216 $ 343,390 First-year annuity premiums $ 68,063 $ 75,944 $ 85,787 24 Life Insurance Operations (continued) Year Ended December 31, 1996 1995 1994 (Dollars in thousands) Profitability Investment income $48,145 $45,215 $38,015 ------- ------- ------- Interest credited on Annuities 24,732 22,613 17,723 Universal life 9,490 9,530 9,229 Other 464 324 263 ------- ------- ------- Total interest expense 34,686 32,467 27,215 ------- ------- ------- Investment spread 13,459 12,748 10,800 ------- ------- ------- Fee income Universal life charges 22,410 21,586 18,780 Annuity surrender charges 495 662 393 ------- ------- ------- Total fee income 22,905 22,248 19,173 ------- ------- ------- Other insurance income 8,445 7,686 6,220 ------- ------- ------- Adjusted insurance revenues 44,809 42,682 36,193 ------- ------- ------- Other expenses Amortization of deferred policy acquisition costs (1) 10,730 6,036 5,345 Renewal commissions 2,675 2,437 2,217 Other insurance operating expenses 5,848 5,501 5,330 Administrative fees 508 309 163 ------- ------ ------ Total acquisition and operating expenses 19,761 14,283 13,055 ------- ------ ------ Death benefits, net 6,945 6,894 5,733 Other policyholder benefits, net 6,357 6,702 4,412 ------- ------ ------- Total other expenses 33,063 27,879 23,200 ------- ------ ------- Insurance operating income before income taxes and realized investment gains (losses) $11,746 $14,803 $12,993 ======= ======= ======= (1) Amounts exclude amortization of deferred policy acquisition costs resulting from net realized investment gains (losses). In 1996, amortization includes an additional charge of $2.8 million relating to unlocking adjustments to deferred policy costs acquisition . See "Additional Charge to DPAC"on page 26. Operating income before taxes (which exclude realized investment gains and losses net of related amortization of deferred policy acquisition costs) for the year includes an additional charge to deferred policy acquisition costs of $2.8 million reflecting changes in assumptions used to estimate future gross profits on certain blocks of annuity business (see Additional Charge to DPAC on page 26). Including the additional charge of $2.8 million, operating income before taxes was $11.8 million for 1996 compared with $14.9 million reported in 1995. Operating earnings per share including the additional charge of $0.42 per share were $1.37 in 1996 compared with $1.88 in 1995. Net income totaled $8.1 million ($1.41 per share) in 1996 and was $9.7 million ($1.78 per share) in 1995. Life Insurance Operations Total life insurance in force grew 10.4% to $9 billion at December 31, 1996 from $8.1 billion at December 31, 1995. The increase was due to policy retention and new term life insurance sales. 25 The face amount of new life insurance sold directly by agents in 1996 increased 2.9% to $1.9 billion from $1.8 billion in 1995. The face amount of new universal life insurance sold decreased 32.6% to $410.6 million from $609.7 million. Universal life account balances increased 8.3% at year-end 1996 from year-end 1995. Fee income increased 3% to $22.9 million from $22.2 million. The savings element of universal life products has become less attractive over the last several years due to generally lower interest rates and an increasing equity market. The face amount of new term life insurance sold directly by agents increased 20.6% to $1.5 billion for 1996 from $1.2 billion for 1995. Sales of term insurance with 10- and 20-year guaranteed rates were strong. First-year annuity premiums decreased 10.4% to $68.1 million from $75.9 million for 1995. The decrease was due to lower sales in the first and second quarter. The lower sales were caused by a flat interest yield curve, which allowed banks and other financial institutions to offer short-term certificates of deposit at more competitive interest rates. Interest rates rose during the middle of the year, and sales reached expected levels in the third and fourth quarters. The total annuity account balance increased 13.4% to $467.5 million at year-end 1996 from $412.2 million at year-end 1995. Adjusted insurance revenues increased 5.3% to $44.9 million for 1996 from $42.7 million for 1995. The increase was primarily attributable to increased investment spread and other insurance income (due to term life insurance sales). The growth in life insurance in force and policyholder account balances permitted invested assets at cost to increase 12.2% to $714.1 million at December 31, 1996 from $636.7 million at December 31, 1995. Investment income increased by 6.5%. ALLIED Life's return on invested assets decreased to 7.4% in 1996 from 7.8% in 1995. Investment spread grew to $13.6 million from $12.7 million. Annual average interest-credited rates on universal life contracts decreased to 5.4% from 5.9% and on annuities decreased to 5.6% from 5.9%. The ratio of investment spread to investment income decreased only slightly to 28% from 28.2% despite the volatile interest rate environment during 1996. This is evidence of ALLIED Life's ability to adjust interest credited to policyholder accounts to reflect trends in investment earnings. Death benefits net of reinsurance remained at $6.9 million. Other policyholder benefits decreased 5.1% to $6.4 million from $6.7 million as decreases in reserves for supplemental contracts and single premium immediate annuities with life contingencies more than offset the increase in reserves on new term life sales and policyholder bonus reserves on universal life products. Other insurance operating expenses increased 6.3% to $5.8 million from $5.5 million. Additional Charge to DPAC Amortization of deferred policy acquisition costs (DPAC) was $10.7 million in 1996. Included in that amount was an additional charge taken by the Company of $2.8 million as the result of its annual DPAC study that suggested refinements in assumptions concerning future annuity policy persistency and interest rate spreads were necessary. Annuity DPAC reflects the deferred costs (primarily commissions) associated with sales. These expenses are amortized in proportion to the actual profits and estimated future profits of a given block of annuity policies. Estimated future profits and amortization of costs are reviewed annually for universal life insurance and annuity products and may be reviewed more frequently if circumstances dictate. GAAP requires that the estimated future profits and future amortization be recomputed based on actual experience and updated expectations of future experience (unlocking). This unlocking may result in both adjustments related to prior amortization as well as changes to ongoing amortization rates. While the Company will continue to re-evaluate the DPAC assumptions, it does not anticipate making additional material adjustments to DPAC amortization schedules in the foreseeable future. Further adjustments would be necessary only if actual experience should differ significantly from the assumptions used in the DPAC study models. DPAC amortization was $6 million in 1995. 26 Primarily due to the additional charge of $2.8 million, operating income before taxes decreased to $11.7 million in 1996 from $14.8 million in 1995. Results of Operations 1995 Compared with 1994 Consolidated revenues for the year ended December 31, 1995 were $75.3 million, an 18.7% increase over the $63.5 million reported for 1994. The increase was primarily attributable to higher investment income, which rose 19.1% to $45.4 million from $38.1 million, and policyholder assessments on universal life contracts, which increased 15% to $20 million from $17.4 million. These increases resulted from the growth in invested assets and policyholder account balances during the year. Policyholder account balances increased 16.4% primarily as a result of policy retention and premiums and considerations received from universal life and annuity products. Income before income taxes and realized investment (losses) gains net of related amortization of deferred policy acquisition costs (operating income before taxes) for 1995 increased 13.4% to $14.9 million from $13.1 million reported for 1994. Net income totaled $9.7 million, up 13.5% from $8.6 million in 1994. Operating earnings per common share rose to $1.88 for 1995 from $1.66 for 1994; net income per common share was $1.78 for 1995 compared with $1.58 for 1994. Life Insurance Operations Total life insurance in force grew 12% to $8.1 billion at December 31, 1995 from $7.2 billion at December 31, 1994. The increase was due to policy retention and insurance sales. The face amount of new life insurance sold directly by agents in 1995 decreased 8.4% to $1.8 billion from $2 billion in 1994. The primary factor was a 30.7% decrease in the face amount of new universal life insurance sold to $609.7 million from $879.3 million. This decrease was partially due to the discontinuance of the Champion product on January 1, 1995. Lower market interest rate levels also affected sales. Policyholder account balances, however, were up 8.2%, and fee income increased 16% to $22.2 million from $19.2 million. The face amount of new term life insurance sold directly by agents increased 8.8% to $1.2 billion for 1995 from $1.1 billion for 1994. ALLIED Life introduced a 10-year term life insurance product at the beginning of 1994, and sales remained strong in 1995. First-year annuity premiums decreased 11.5% to $75.9 million for 1995 from $85.8 million for 1994. The decrease was due to a flat interest yield curve, which made short-term certificates of deposit available at more competitive interest rates. The total annuity account balance increased 20% to $412.2 million at year-end 1995 from $343.4 million at year-end 1994. Adjusted insurance revenues increased 17.9% to $42.7 million for 1995 from $36.2 million for 1994. The increase was primarily attributable to increased investment spread, greater fee income, and other insurance income. The growth in life insurance in force and policyholder account balances permitted invested assets at cost to increase 15.4% to $636.7 million at December 31, 1995, from $551.6 million at December 31, 1994, allowing investment income to increase by 18.9%. ALLIED Life's return on invested assets in 1995 remained unchanged from 1994 at 7.8%. 27 Investment spread grew to $12.7 million from $10.8 million. Annual average interest-credited rates on universal life contracts decreased to 5.9% from 6.2% and on annuities increased to 5.9% from 5.8%. The ratio of investment spread to investment income decreased only slightly to 28.2% from 28.4% despite the volatile interest rate environment during 1995. Amortization of deferred policy acquisition costs increased 12.9% to $6 million from $5.3 million because of ALLIED Life's increase in profitability. Other insurance operating expenses increased 5.8% to $5.8 million from $5.5 million, a result of overall growth. Death benefits net of reinsurance increased 20.3% to $6.9 million from $5.7 million. Other policyholder benefits increased 51.9% to $6.7 million from $4.4 million as a result of increased reserves on new term life sales and supplemental contracts and an increase in policyholder bonus reserves on universal life products. ALLIED Life's operating income before taxes was up 13.9% to $14.8 million from$13 million in 1994. The increase occurred because the improved investment spread and increased fee income more than offset the higher expenses and policyholder benefits. Liquidity and Capital Resources ALLIED Life Financial Corporation As an insurance holding company, ALFC relies on dividends from ALLIED Life to make dividend payments to its preferred and common stockholders. The ability of ALLIED Life to pay dividends to the Company is limited by law to earned profits (unassigned surplus) as of the dates dividends are paid. Such ability is determined in accordance with accounting practices prescribed or permitted by insurance regulatory authorities of the State of Iowa. The Iowa Insurance Holding Company Act precludes ALLIED Life's payment of an extraordinary dividend without prior notice to and approval of the Iowa Insurance Commissioner. An extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value together with that of other dividends or distributions made within the preceding twelve months exceeds the greater of (i) 10% of statutory policyholders' surplus (total capital stock and surplus) as of December 31 of the preceding year or (ii) the net gain from operations on a statutory basis for the twelve-month period ending December 31 of the preceding year. During 1997, the maximum amount available for distribution to the Company from ALLIED Life without special regulatory approval of or notification to the Iowa Insurance Commissioner is approximately $5.2 million. A source of cash flows for ALFC is dividend payments from ALLIED Life. During 1996, the Company paid cash dividends of $1.1 million to common and preferred stockholders. ALLIED Life paid to the Company dividends of $1.4 million primarily to fund the Company's dividend requirement. Annual dividends payable on the currently outstanding 6.75% Series preferred stock are approximately $1.5 million. In accordance with the terms of the 6.75% Series preferred stock, the Company may pay dividends thereon by issuing additional shares of such stock for any quarter ending on or prior to September 30, 1998. In 1996, the Company paid dividends in the form of 138,793 shares of 6.75% Series preferred stock. 28 Effective August 6, 1996, the Board of Directors approved a stock repurchase program to acquire shares of the Company common stock on the open market. The Company completed the program during the third quarter of 1996, repurchasing and cancelling 150,000 shares at an average cost of $16.94 per share. Consolidated Life insurance companies generally produce a positive cash flow from operations. Its adequacy is measured by liquidity. There should be sufficient cash to meet benefit obligations to policyholders and normal operating expenses as they are incurred and sufficient excess to help meet future policy benefit payments and to write new business. ALLIED Life's liquidity position continued to be favorable in 1996, with cash inflows at levels sufficient to provide the funds necessary to meet obligations. The Company's cash inflows consist primarily of deposits to policyholder account balances, proceeds from sales, maturities and calls of investments, and repayments of investment principal. The Company's cash outflows primarily are related to policyholder account withdrawals, investment purchases, policy acquisition costs, policyholder benefits, and current operating expenses. These outflows are typically met from normal annual premium and net investment cash inflows. Company operations provided cash inflows of $15.5 million in 1996, $11.5 million in 1995, and $8.2 million in 1994. Cash inflows from financing activities amounted to $62.5 million, $73.3 million, and $94.2 million during 1996, 1995, and 1994, respectively. These funds and the excess operating inflows were used primarily to increase the Company's fixed maturity investment portfolio. Matching the investment portfolio maturities to the cash flow demands of the insurance coverages being provided is an important consideration. The Company continually monitors benefit and claims statistics to project future cash requirements. As part of this monitoring process, the Company performs cash-flow testing of its assets and liabilities under various scenarios to evaluate the adequacy of reserves. In developing its investment strategy, the Company establishes a level of cash and securities that when combined with expected net cash inflows from operations, maturities of fixed maturity investments, principal payments on amortizing securities, and its insurance products is believed to be adequate to meet anticipated short-term and long-term benefit and expense payment obligations. As of December 31, 1996, 96.8% of the Company's investments were in fixed maturities. The investment policy for ALLIED Life requires that the fixed maturity portfolio be invested primarily in debt obligations rated "BBB" or higher when they are acquired. Of the Company's fixed maturity investments held at year-end 1996, 89% were rated "A" or better; 1% were rated below investment grade (below "BBB"). The carrying values of all the Company's investments in fixed maturities are reviewed on an ongoing basis for credit deterioration. If review indicates a decline in fair value below cost that is other than temporary, the Company's carrying value in the investment is reduced to its estimated realizable value and a corresponding write-down is taken. Such reductions in carrying value are recognized as realized losses and charged to income. No reductions in carrying value were recognized for the year ended December 31, 1996. The Company's fixed maturity portfolio includes collateralized mortgage obligations (CMOs). CMOs consist of pools of mortgages divided into tranches that provide sequential retirement of bonds. To provide call protection and more stable average lives, the Company invests primarily in planned amortization classes (PACs) and sequential-pay bonds that generally provide more predictable cash flows within a range of prepayment speeds by shifting some of the prepayment risks to support tranches. 29 At year-end 1996, all of the Company's CMOs were investment-grade securities. They had a carrying value of $92.1 million and a fair value of $92.4 million; 86.8% of these investments were in PAC and sequential-pay bonds. All of the Company's CMO investments have an active secondary market; therefore, their effect on liquidity is not expected to differ from the effect of other fixed maturity investments. The Company has a line of credit agreement with the Federal Home Loan Bank that provides additional liquidity. The agreement makes $25 million available through March 13, 1997. Interest is payable at the current rate upon issuance. From time to time, the Company has borrowed funds from its affiliates on an arms-length basis. At December 31, 1996, the Company had an outstanding borrowing of $20.5 million under the line of credit agreement. During 1996, the Company entered into a note-payable agreement with ALLIED Mutual, an affiliate. The outstanding borrowing at December 31, 1996 was approximately $1.6 million. Management anticipates that funds to meet the Company's short-term and long-term capital expenditures, cash dividends, and operating cash needs will come from existing capital and internally generated funds. As of December 31, 1996, the Company had no material commitments for capital expenditures. As additional capital needs arise, the Company will consider taking on additional debt or issuing equity. Specific methods for meeting such needs will depend upon financial market conditions at the time. Effects of Inflation and Interest Rate Changes Management does not believe inflation has had a material effect on consolidated results of operations. To reduce exposure to interest rate fluctuations, management attempts to invest new funds in securities with expected durations that match related policyholder obligations. As a rule, the fair value of the Company's fixed maturity portfolio increases or decreases in inverse relationship with fluctuations in interest rates while investment income moves in direct relationship with interest rate changes. For example, if interest rates decrease, the Company's fixed maturity investments generally will increase in value. Investment income, on the other hand, will decrease as fixed maturity investments mature or are sold and the proceeds are reinvested at the lower interest rates. Interest rate changes and the slope of the yield curve may have temporary effects on the sale and profitability of the universal life and annuity products offered by ALLIED Life. For example, if interest rates rise, competing investments may become more attractive to potential purchasers until the interest rates credited to policyholder account balances are increased. If interest rates fall, profitability will be affected negatively until credited rates are adjusted to compensate for the decline in investment income. ALLIED Life sells universal life and annuity contracts that generally permit flexible responses to interest rates, which are monitored constantly. Hedging Activities In June 1996, the Company began interest rate hedging programs whereby certain derivative financial instruments including cash settle put swaptions (swaptions) and interest rate floors (floors) were purchased. Swaptions are being purchased to reduce the negative effect of increased withdrawal activity related to the Company's annuity liabilities that may result from extreme increases in interest rates. As of December 31, 1996, the Company was party to 44 agreements for these instruments. The agreements expire quarterly from June 1999 through March 2006. They entitle the Company to receive payments from the instrument's counter parties on future reset dates if the interest rate (which is directly tied to the 5-year constant maturity swap curve) on any expiration date is above a specified fixed rate (8.8% to 10.5% for instruments entered into as of December 31, 1996). The notional amounts range from $3 million to $9 million (total of $244 million). 30 Floors are being purchased to reduce the negative effect that may result from extreme decreases in interest rates to a level below the guaranteed interest rates provided for in the universal life insurance contracts. The 28 agreements for the floors outstanding as of December 31, 1996 expire quarterly from June 1999 through March 2006. They entitle the Company to receive payments from the instrument's counter parties on future reset dates if the interest rate (which is tied directly to the 10-year constant maturity treasury curve) on the expiration date is below a specified fixed rate (5.0% for instruments entered into as of December 31, 1996). The notional amounts for each quarter range from $140 million to $270 million. The costs of the interest rate hedging programs are not expected to have a material impact on the interest rate margin. For both swaptions and floors, the Company pays only the original premium and is not at risk of further payments regardless of market conditions. The Company does not anticipate making any further purchases of interest rate hedges in the near future. Premiums paid to purchase these instruments are capitalized and included in other invested assets. Through December 31, 1996, the Company had paid approximately $4.1 million in premiums. Premiums are amortized into income over the term of the instruments on a straight-line basis. Gains and losses on these instruments and related assets are not recorded in income until realized. At the beginning of the second quarter of 1996, the Company introduced an equity-indexed annuity product that guarantees customers the return of principal. Interest credited is based on a percentage of the gain of the S&P 500 Index(R). A portion of the premium from each customer is invested in investment grade fixed income securities to cover the minimum guaranteed value due the customer at the end of the term. A portion of the premium is used to purchase S&P 500 call options (call options) to hedge the growth in interest credited to the customer as a direct result of increases in the S&P 500 Index(R). The call options provide the Company the opportunity to participate in the increases of the S&P 500 Index(R) if the market advances. At December 31, 1996, the Company had purchased 40 call options with notional amounts between $65,000 and $900,000 (total of $11.2 million). Premiums paid to purchase call options are capitalized and included in other assets. Through December 31, 1996, the Company had paid approximately $2.3 million in premiums. Premiums are amortized as an expense over the term of the instruments on a straight-line basis. Gains and losses on these instruments and related liabilities are not recorded in income until realized. The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) are evaluating the accounting and disclosure requirements for hedging activities and derivative financial instruments. As a result of these deliberations, the Company's accounting treatment may change in the future. The Company is actively monitoring the proposals that are in various stages of discussion; the impact of the final standards cannot be clearly projected at this time. The Company is exposed to the risk of losses in the event of nonperformance of the counter parties of the above swaptions, floors, and call options. Losses recorded in the Company's financial statements in the event of non-performance will be limited to the unamortized premium paid to enter into the instruments. Economic losses will be measured by the net replacement cost of such instruments or by their fair value if the net fair value is in the Company's favor. The Company limits its exposure to such losses by diversification among reputable counter parties with appropriate credit ratings. 31 Emerging Regulatory Issues The Company's insurance subsidiary is subject to regulation and supervision by the states in which it is admitted to transact business. State insurance laws generally establish supervisory agencies with broad administrative and supervisory powers related to granting and revoking licenses to transact business, establishing guaranty fund associations, licensing agents, approving policy forms, regulating premium rates for some lines of business, establishing reserve requirements, prescribing the form and content of required financial statements and reports, determining the reasonableness and adequacy of statutory capital and surplus, and regulating the type and amount of investments permitted. Recently, the insurance regulatory framework has received increased scrutiny from various states, the federal government, and the National Association of Insurance Commissioners (NAIC). The NAIC has recommended to the states for adoption and implementation several regulatory initiatives. Iowa as well as three other states have adopted the NAIC regulation for life insurance policy sales illustrations. Additional states are expected to adopt the new regulation in 1997. The effect of any adoption by individual states is not expected to have a significant effect on the Company's insurance production. New Accounting Standards In 1996 the Company adopted SFAS 121, "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of such assets may not be recoverable. Management determined the adoption had no impact on the Company's financial condition, results of operations, or liquidity. In 1996, the Company adopted SFAS 123, "Accounting for Stock-Based Compensation." This statement establishes a fair value-based method of accounting for stock-based compensation plans, but permits continued application of the provisions of Accounting Principles Board Opinion 25, "Accounting for Stock Issued to Employees," in determining compensation expense related to stock-based compensation. Companies that continue to apply Opinion 25 must nonetheless comply with the new disclosure requirements of SFAS 123. The Company elected to continue to account for stock-based compensation under the provisions of Opinion 25 and its related interpretations. This adoption had no impact on the Company's financial condition, results of operations, or liquidity. In June of 1996, the FASB issued SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. SFAS 125 is effective for fiscal years beginning after December 31, 1996. Earlier or retroactive application of this statement is not permitted. The Company will adopt SFAS 125 on January 1, 1997. Management has determined that the implementation will not have a material effect on its financial condition, results of operations, or liquidity. 32 Item 8. Financial Statements and Supplementary Data Report of Management The management of ALLIED Life Financial Corporation and its subsidiaries is responsible for the accompanying financial information appearing in this annual report. The consolidated financial statements have been prepared in conformity with generally accepted accounting principles and include amounts based on the best estimates and judgments of management. The Company maintains a system of internal accounting controls designed to provide reasonable assurance that assets are safeguarded and transactions are properly authorized and recorded. Management continually monitors these internal accounting controls, modifying and improving them as business conditions and operations change. An internal audit department also evaluates the adequacy and effectiveness of internal accounting controls and measures adherence to established policies and procedures. The management of ALLIED Life Financial Corporation believes that as of December 31, 1996, the Company's system of internal accounting controls was adequate to accomplish the objectives discussed herein. The Company's financial statements for the years ended December 31, 1996, 1995, and 1994 have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The audits were made in accordance with generally accepted auditing standards and included a consideration of the system of internal accounting controls to the extent necessary to express an independent opinion on the financial statements. The audit committee of the Board of Directors, comprised solely of outside directors, meets regularly with the independent auditors, management, and internal auditors to review the scope and results of the audit work performed. The internal auditors and independent auditors have access to the audit committee