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, 1997 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, 1998 the number of Registrant's Common Stock, no par value, outstanding was 4,411,310. 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, 1998 was $63,044,756. Documents Incorporated By Reference TheRegistrant's definitive proxy statement (1998 Proxy Statement), which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1997, is incorporated by reference under Part III. The index to the exhibits is located on page 77. This document contains 97 pages. TABLE OF CONTENTS Part I Item 1. Business...........................................................1 Item 2. Properties........................................................17 Item 3. Legal Proceedings.................................................18 Item 4. Submission of Matters to a Vote of Security Holders...............18 Part II Item 5. Market for Registrant's Common Equity and Related Stockholders Matters..................................19 Item 6. Selected Financial Data.................... ......................20 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.................21 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 ..................................................................76 Index to Exhibits............................................................77 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 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. 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, 1997, ALLIED Mutual owned 56% of the outstanding voting stock of the Company and the ALLIED Life Employee Stock Ownership Trust owned 2%. 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 18.2% owned subsidiary of ALLIED Mutual. There are approximately 2,300 independent ALLIED Agencies which provide the Company with access to numerous agency customers in addition to over 600,000 households having one or more ALLIED Property-casualty policies. 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 21 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 which includes financial institutions and a number of independent life insurance marketing organizations. In 1997, the Company sold 68% of its new life insurance face amount and 41% of its collected annuity premium through the ALLIED Agencies and the remainder of its products were sold through traditional distribution channels. Each distribution system is headed by a marketing vice president. Property-Casualty Distribution System The property-casualty distribution system encompasses approximately 2,300 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; 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 distribution system is led by a marketing vice president, who works with the following personnel. Regional Directors/Life Marketing Directors. The 12 ALLIED Life Regional Directors and 7 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 life insurance planning for small commercial property-casualty accounts. Most of the Regional Directors are responsible for approximately 150 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 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). Life Marketing Directors have responsibilities similar to those of the Regional Directors. The Life Marketing Directors are employees of the Company and are 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 could depend on the level of life insurance sales achieved by the ALLIED Agencies under their supervision. 2 Independent Property-Casualty Agencies. The ALLIED Agencies either sell life insurance and annuity products themselves, with the support of their Regional Director/Life Marketing 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 insurance specialists may be recruited and introduced to an ALLIED Agency by its Regional Director/Life Marketing 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 insurance specialists 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 and 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. 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 1997 produced approximately 32% of the total face amount of life insurance sold and 59% of the total annuity premium collected. A marketing vice president 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 sell the Company's life insurance and annuity products. Contracted agents associated with marketing organizations generated over 48% of the Company's total annuity premium and over 17% of the total life insurance face amount sold in 1997. The Company hopes to form alliances with more marketing organizations. These alliances give the Company access to the organizations' licensed agents in a manner that is more efficient than if the Company tried to recruit these agents one at a time. Admission into 5 states during the year helped align the Company's territories more closely to these marketing organizations. This brings to 41 the number of states where the Company is admitted and pursuing business. In 1998, the Company will apply for admission in 4 more states. 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 to a lesser degree, 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. 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. 1997 1996 1995 (dollars in thousands) Life insurance face amount in force Directly produced by agents Property-casualty agencies Universal Life $ 2,867,625 $ 2,809,270 $ 2,627,447 Term life 3,530,113 3,200,793 2,506,890 Whole Life 35,501 34,521 34,402 6,433,239 6,044,584 5,168,739 Traditional agencies Universal life 1,708,199 1,531,331 1,588,116 Term life 1,081,686 997,711 908,647 Whole life 15,617 14,558 15,778 2,805,502 2,543,600 2,512,541 9,238,741 8,588,184 7,681,280 Other 390,899 371,130 433,236 Total $ 9,629,640 $ 8,959,314 $ 8,114,516 Life insurance face amount sold Directly produced by agents Property-casualty agencies Universal life $ 311,600 $ 282,388 $ 384,763 Term life 946,842 1,127,060 889,624 Whole life 4,888 3,115 2,775 1,263,330 1,412,563 1,277,162 Traditional agencies Universal life 263,320 128,247 224,937 Term life 338,528 348,917 333,920 Whole life 2,310 1,124 1,736 604,158 478,288 560,593 Other 1,867,488 1,890,851 1,837,755 Total 8,266 9,431 21,549 $ 1,875,754 $ 1,900,282 $ 1,859,304 Annuity Premiums Deferred annuities Property-casualty agencies $ 30,212 $ 30,816 $ 30,321 Traditional agencies 42,872 40,188 45,956 73,084 71,004 76,277 Immediate annuities 1,782 1,227 2,362 Total $ 74,866 $ 72,231 $ 78,639 5 The total face amount of life insurance in force grew at an average annual rate of 9.3% beginning at year end 1995 through year end 1997 and is up 7.5% at December 31, 1997 as compared to the prior year end. Annuity account balance grew at an average annual rate of 12.5% beginning at year end 1995 through year end 1997 and is up 10.1% at December 31, 1997 compared to the prior year end. The face amount of new term life insurance sold totaled $1.3 billion accounting for 69% of 1997 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 decreased 12.9% in 1997. The Company continues to sell mainly 10- and 20-year guaranteed rate term life insurance policies within this product line. For further information on this product line see Term Life Insurance on page 9. The face amount of new universal life insurance sold totaled $574.9 million representing 31% of 1997 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 face amount of universal life insurance sold increased 40% in 1997. For further information on this product line see Universal Life Insurance on page 8. During 1997, first-year deferred annuity premiums increased 5.1% to $71.5 million. The Company offers two types of deferred annuities, fixed interest and equity indexed. Fixed interest annuities are tax-deferred cash accumulation contracts that pay a fixed interest rate established by the Company. Equity indexed annuities credit interest, which is also tax deferred, to the policyholders' account based on a percentage of the gain of the S&P 500 Index(R). The Company issues single and flexible premium annuities. Flexible premium annuities permit additional deposits by policyholders after initial premiums are paid. Sales of fixed interest annuities were slowed in the fourth quarter 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. Sales of equity indexed annuities reached expected levels during the latter part of the year fueled by more product offerings and expectations of gains in the equity markets. 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. 1997 1996 1995 Life Insurance Annuity Percentage Percentage Percentage Premiums Considerations Total (1) of Total of Total of Total (Dollars in thousands) Iowa $ 9,727 $ 14,025 $ 24,517 19.5 % 21.5% 26.1% California 11,534 5,408 17,040 13.5 10.8 10.0 Illinois 1,265 13,496 15,466 12.3 10.6 5.5 Wisconsin 2,162 12,126 14,334 11.4 11.3 7.0 Utah 1,469 8,591 10,062 8.0 8.3 5.8 Kansas 3,967 3,119 7,437 5.9 5.0 5.6 Nebraska 4,474 1,975 6,911 5.5 6.2 6.2 Missouri 2,107 1,918 4,214 3.3 3.4 6.6 Colorado 1,232 2,395 3,668 2.9 1.9 1.7 Minnesota 2,335 729 3,112 2.5 2.6 4.8 Idaho 1,264 1,622 2,927 2.3 4.5 1.3 Other (2) 6,037 9,462 16,285 12.9 13.9 19.4 $ 47,573 $ 74,866 $ 125,973 100.0% 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 1997. For more information regarding the states where ALLIED Life is admitted for insurance business by distribution system, see the 1997 Annual Report, pages 6 and 8. 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 $1,000,000 in 1997, $681,000 in 1996, and $496,000 in 1995. 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 1997, 1996, and 1995 were $579,000, $389,000, and $203,000. 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 insured 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 1997: Policies with a minimum face amount in excess of $150,000 $ 6,758 $ 376,442 499 43 All other policies 1,559 69,564 3,290 39 Total policies in force as of December 31, 1997: Policies with a minimum face amount in excess of $150,000 $ 11,799 $ 328,320 5,247 40 All other policies 3,923 59,107 33,905 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, 1997: 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) 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 1997 182,727 34,271 10,127 (17,322) (4,604) (8,490) 196,709 60,427 5.3 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 upon the receipt of 5 to 10 years of annual premiums, depending on the product. The Company imposes surrender charges in order to recover its upfront acquisition costs upon an early lapse or 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 A significant amount of the Company's current term life insurance sales are 10- and 20-year guaranteed rate 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 insured 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 1997: Policies with a minimum face amount in excess of $150,000 2,188 $ 377,782 41 All other policies 4,026 91,648 40 Total policies in force as of December 31, 1997: Policies with a minimum face amount in excess of $150,000 7,988 $ 368,168 40 All other policies 16,823 89,925 39 The Company encourages the conversion of term life insurance to universal life insurance, and as an incentive it credits an amount equal to 50% of the current 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 5.4% of 1997 universal life face amount sold. Universal life insurance face amount sold resulting from conversions from ALLIED Life term products were $30.9 million in 1997, $35 million in 1996, and $30.5 million in 1995. Group Life and Other In Force Life Policies As of December 31, 1997, the Company had $297.9 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, 1997, the Company had $51.1 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 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 age of annuitant at date of issue for the Company's deferred annuity products : Number Average Average of Account Issue Policies Value Age Annuities sold in 1997: 3,384 $ 23,722 66 Total policies in force as of December 31, 1997: 24,027 21,330 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, 1997: 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) 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 1997 467,505 74,328 25,692 (52,617) 514,908 27,669 5.3 The Company's deferred annuities are sold as an alternative to bank certificates of deposit and other taxable savings vehicles. Annuity premiums are generally invested in intermediate term investment grade securities, the investment terms typically matching the underlying product surrender charge periods of three to nine years. For most fixed interest plans, the initial interest rate is guaranteed for one to three years with renewal crediting rates based on portfolio earnings and market conditions. Several of the Company's annuity plans 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. Liquidity benefits are provided in the form of no-penalty partial withdrawal allowances, interest income payments, a nursing home waiver, a terminal illness waiver, and bonus annuitization options. 10 The Company's equity indexed annuity products guarantee the return of principal to the customer if held for the whole term and credit interest 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 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 by the Company to purchase S&P 500 call options to hedge the interest credited to the customer if there are increases in the S&P 500 Index(R). See Note 3 of Notes to Consolidated Financial Statements for additional information regarding call options. 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 generally reduce the statutory reserve applicable to the policy. 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 1998 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. On larger cases the Company employs blood and urine testing to provide additional information on nicotine and drug usage. 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. 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 human immunodeficiency virus (HIV). 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. 11 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, 1997, the Company had ceded to reinsurers $2.4 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 1997 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 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 the 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 The investment policy for ALLIED Life requires at least 95% of the portfolio consist of investment grade securities. At December 31, 1997, 84% of the Company's fixed maturity investments were rated "A" or higher, and less than 1% were rated less than investment grade. Effective May 13, 1997, the Company transferred its remaining securities classified as held to maturity ($196 million) to available for sale and recorded an increase to stockholders' equity of $1.2 million in accordance with Statement of Financial Accounting Standards (SFAS) 115. The Company now carries all of its securities at fair value and has more flexibility in managing its investment portfolio. The Company has no intent to classify future purchases of securities as held to maturity. 12 The table below shows the composition of the Company's investments: Estimated 1997 1996 Fair Carrying Percent Percent Investment Category Value Value Of Total Of Total (dollars in thousands) Fixed maturities: U.S. Treasury obligations (1) $ 26,462 $ 26,462 3.4 4.8% Foreign governments 5,408 5,408 0.7 1.5 Public utilities 106,924 106,924 13.6 12.5 Asset-backed securities (other than first lien mortgages) 49,990 49,990 6.3 3.1 Mortgage-backed securities: Pools 112,135 112,135 14.2 16.8 Collateralized mortgage obligations 55,426 55,426 7.0 12.8 Total mortgage-backed securities 167,561 167,561 21.2 29.6 Corporate debt securities: Investment grade (BBB - or greater) (2) 409,433 409,433 52.0 45.3 Non-investment grade (BB + or below) (2) 250 250 ----- ----- Total corporate debt securities 409,683 409,683 52.0 45.3 Total fixed maturities 766,028 766,028 97.2 96.8 Equity securities 3,201 3,201 0.4 0.9 Mortgage loans on real estate (3) 984 984 0.1 0.2 Policy loans 11,164 11,164 1.4 1.4 Other invested assets (4) 3,014 3,014 0.4 0.5 Short-term investments 3,594 3,594 0.5 0.2 Total investments $ 787,985 $ 787,985 100.0% 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 mortgages and farm mortgages. (4) Consists of instruments purchased for hedging purposes. 13 The following table sets forth the composition of the Company's portfolio of fixed maturity investments by rating at December 31, 1997: Estimated 1997 1996 Fair Carrying Percent Percent Rating (1) Value Value Of Total Of Total (dollars in thousands) AAA .......................................... $238,937 $238,937 31.2% 38.3% AA ........................................... 103,664 103,664 13.5 11.7 A ............................................ 302,368 302,368 39.5 39.0 BBB .......................................... 119,546 119,546 15.6 10.7 Total investment grade fixed maturities 764,515 764,515 99.8 99.7 Non investment grade 1,513 1,513 0.2 0.3 Total fixed maturities ................ $766,028 $766,028 100.0% 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, 1997. Expected maturities at December 31, 1997 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 1997 Notes to Consolidated Financial Statements. 1997 1996 Amortized Percent Percent Cost Of Total Of Total (dollars in thousands) One year or less $ 36,460 5.0% 5.6% Over 1 year through 5 years 192,151 26.2 24.8 Over 5 years through 10 years 334,636 45.6 49.7 Over 10 years through 20 years 111,493 15.2 14.9 Over 20 years 59,023 8.0 5.0 Total $ 733,763 100.0% 100.0% 14 Investment results of the Company for each year in the three years ended December 31, 1997 are shown on the following table. 1997 1996 1995 (dollars in thousands) Average invested assets, net (1) $ 719,053 $ 653,908 $ 584,223 Investment income (2) 52,197 48,182 45,411 Average annual yield on total investments 7.3% 7.4% 7.8% Realized investment gains (losses) $ 2,354 $ 122 $ (722) (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 21.9% of the Company's total fixed maturity portfolio at December 31, 1997. The mortgage-backed securities are backed primarily by first lien single family residential mortgages. The majority 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, 1997, ALLIED Life held CMO investments with a fair value of $55.4 million. As of December 31, 1997, 88.3% (86.8% in 1996) 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 are rated "AAA", 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, 1997 estimated fair value and carrying value of the CMO portfolio by type: Estimated 1997 1996 Fair Carrying Percent Percent Type of CMO Value Value Of Total Of Total (dollars in thousands) Planned amortization class $ 37,147 $ 37,147 67.0% 60.2% Sequential pay 11,810 11,810 21.3 26.6 Other 6,469 6,469 11.7 13.2 Total investments in CMOs $ 55,426 $ 55,426 100.0% 100.0% 15 Hedging Activities In 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. 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, 1997). 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. 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, 1997). The costs of the interest rate hedging programs have not had 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 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. For further information on swaptions and floors see Note 3 of Notes to Consolidated Financial Statements. 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 (upgraded to "A+" during 1997). 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. 16 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. 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, none of which are expected to have a material impact on ALLIED Life. Employees At December 31, 1997, ALLIED Life employed 126 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 1998 Proxy Statement for additional information. Management considers the leased space to be adequate for its needs. 17 Item 3. Legal Proceedings For a description of certain lawsuits pending against the Company, see Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this report which is incorporated herein by reference. Item 4. Submission of Matters to a Vote of Securities Holders No matters were submitted during the fourth quarter of 1997 to a vote of holders of ALLIED Life Financial Corporation stock. 18 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, 1997, there were 122 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 1997 First qtr. $ 19 $ 17 $ 17 $ .06 Second qtr. 20 15 3/4 19 3/4 .06 Third qtr. 23 3/4 18 3/4 23 3/4 .06 Fourth qtr. 24 19 3/4 21 .07 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 There are certain regulatory restrictions relating to the payment of dividends (see Note 10 of the 1997 Notes to Consolidated Financial Statements). It is the present intention of the Board of Directors to declare quarterly cash dividends. 19 Item 6. Selected Financial Data At or for the year ended December 31, 1997 1996 1995 1994 1993 Income Statement Data (Dollars in thousands, except per share data) Revenues Total insurance revenues $ 34,142 $ 31,350 $ 29,934 $ 25,393 $ 20,822 Investment income 52,197 48,182 45,411 38,136 33,243 Realized investment gains (losses) 2,354 122 (722) (724) 2,154 Other income 1,559 1,056 688 648 277 Total revenues 90,252 80,710 75,311 63,453 56,496 Benefits and expenses Policyholder benefits 51,392 47,988 46,063 37,359 32,870 Amortization of deferred policy acquisition costs (1) 11,097 10,595 5,941 5,136 5,347 Commissions 4,232 3,316 2,725 2,627 2,390 Operating expenses 7,832 6,801 6,313 5,715 4,966 Total benefits and expenses 74,553 68,700 61,042 50,837 45,573 Income before income taxes 15,699 12,010 14,269 12,616 10,923 Income taxes 5,226 3,937 4,557 4,059 3,739 Net income (1) $ 10,473 $ 8,073 $ 9,712 $ 8,557 $ 7,184 Net income applicable to common stock (1) $ 8,862 $ 6,567 $ 8,304 $ 7,239 $ 5,930 Diluted earnings per share (1) 1.94 1.39 1.75 1.57 1.67 Dividends paid per common share $ 0.25 $ 0.21 $ 0.17 $ 0.13 $ 0.03 Weighted average number of shares outstanding (in thousands) 4,572 4,712 4,732 4,612 3,546 Balance Sheet Data Investments at cost $ 755,615 $ 714,483 $ 637,245 $ 554,889 $ 451,982 Assets 904,457 835,600 759,947 643,340 532,588 Preferred stock 26,336 24,586 22,871 21,341 19,028 Stockholders' equity $ 114,157 $ 99,942 $ 101,682 $ 76,027 $ 74,368 Preferred shares outstanding (in thousands) 2,393 2,238 2,087 1,948 1,754 Common shares outstanding (in thousands) 4,398 4,497 4,633 4,586 4,572 Other Data Death benefits per share $ 0.91 $ 0.81 $ 0.81 $ 0.68 $ 0.72 Book value per share 17.84 16.16 15.01 13.42 11.98 Statutory capital and surplus 51,275 46,544 45,504 47,413 42,403 Life insurance in force 9,629,640 8,959,314 8,114,516 7,242,737 5,915,558 Annuity account balances $ 514,908 $ 467,505 $ 412,216 $ 343,390 $ 271,385 (1) The 1996 amounts include an additional $2.8 million ($1.9 million or $0.40 per share net of income taxes) charge relating to unlocking adjustments to deferred policy acquisitions costs. 20 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 cautionary statements identifying important factors that could cause actual results to differ materially from those discussed. Forward-looking statements relate to the plans and objectives of management for future operations, future economic performance, or projections of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items. In the following discussion and elsewhere in this report, statements containing words such as expect, anticipate, believe, goal, objective, or similar words are intended to identify forward-looking statements. ALLIED Life Financial Corporation (ALFC or the Company) undertakes no obligation to update such forward-looking statements, and it wishes to identify important factors that could cause actual results to differ materially from those projected in the forward-looking statements contained in the following discussion and elsewhere in this report. The risks and uncertainties that may affect the operations, performance, development, and results of the Company's business include, but are not limited to, 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 the 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; (6) inaccuracies in assumptions regarding future morbidity, persistency, mortality, and interest rates; and (7) other risks detailed herein and from time to time in the Company's other reports. Overview The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with Selected Financial Data and Financial Statements and related footnotes included elsewhere herein. ALLIED Life Financial Corporation is an insurance holding company with 56% of its outstanding voting stock owned by ALLIED Mutual Insurance Company (ALLIED Mutual). 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. Annuity contracts are products that 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. 21 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. A significant source of revenue 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. 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 adjustments related to prior amortization as well as changes to ongoing amortizations rates. 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 following table 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. Life insurance operations included in the following analysis should be read with reference to the table on page 23. 22 Results of Operations 1997 Compared with 1996 Consolidated revenues for the year ended December 31, 1997 were $90.3 million, an 11.8% increase over the $80.7 million reported for 1996. Life insurance premiums and other insurance income net of reinsurance premiums ceded rose 12.6% to $9.5 million from $8.4 million. Investment income grew 8.3% to $52.2 million from $48.2 million. In 1997 the Company had realized gains on investments of $2.4 million as compared with realized gains of $122,000 in 1996. Life Insurance Operations Year Ended December 31, 1997 1996 1995 (Dollars in thousands) Production information Life insurance Life insurance face amount in force directly produced by agents Universal Life $ 4,575,824 $ 4,340,601 $ 4,215,564 Term life 4,611,799 4,198,504 3,415,536 Whole life 51,118 49,079 50,180 9,238,741 8,588,184 7,681,280 Other 390,899 371,130 433,236 $ 9,629,640 $ 8,959,314 $ 8,114,516 Face amount of new life insurance sold directly produced by agents Universal Life $ 574,920 $ 410,635 $ 609,700 Term life 1,285,370 1,475,977 1,223,544 Whole life 7,198 4,239 4,511 1,867,488 1,890,851 1,837,755 Other 8,266 9,431 21,549 $ 1,875,754 $ 1,900,282 $1,859,304 Life insurance termination rate Universal Life 7.1% 6.1% 6.7% Term life 19.7% 18.2% 18.9% Annuities Account balance $ 514,908 $ 467,505 $ 412,216 First-year annuity premiums $ 71,509 $ 68,063 $ 75,944 23 Life Insurance Operations (continued) Year Ended December 31, 1997 1996 1995 (Dollars in thousands) Profitability Investment income $ 52,131 $ 48,145 $ 45,215 Interest credited on Annuities 26,452 24,732 22,613 Universal life 10,126 9,490 9,530 Other 479 464 324 Total interest expense 37,057 34,686 32,467 Investment spread 15,074 13,459 12,748 Fee income Universal life charges 23,898 22,410 21,586 Annuity surrender charges 739 495 662 Total fee income 24,637 22,905 22,248 Other insurance income 9,505 8,445 7,686 Adjusted insurance revenues 49,216 44,809 42,682 Other expenses Amortization of deferred policy acquisition costs (1) 9,578 10,730 6,036 Renewal commissions 3,258 2,675 2,437 Other insurance operating expenses 4,875 4,505 3,973 Premium and other taxes 1,830 1,343 1,528 Administrative fees 520 508 309 Total acquisition and operating expenses 20,061 19,761 14,283 Death benefits, net 8,192 6,945 6,894 Other policyholder benefits, net 6,141 6,357 6,702 Total other expenses 34,394 33,063 27,879 Insurance operating income before income taxes and realized investment gains (losses) $ 14,822 $ 11,746 $ 14,803 (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 of deferred policy acquisition costs. Operating income before taxes (which excludes realized investment gains and losses net of related amortization of deferred policy acquisition costs) was $14.9 million for 1997 compared with $11.8 million in 1996. Operating earnings per share were $1.82 compared with $1.35. Net income totaled $10.5 million ($1.94 per share) compared with $8.1 million ($1.39 per share). Operating income before taxes for 1996 included an adjustment 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. The effect of the adjustment was to decrease operating earnings per share by $0.40. 24 Life Insurance Operations Total life insurance in force grew 7.5% to $9.6 billion at December 31, 1997 from $9 billion at December 31, 1996. Growth was slowed by lower term life insurance sales. The face amount of new life insurance sold directly by agents in 1997 remained even at $1.9 billion. The face amount of new universal life insurance sold increased 40% to $574.9 million from $410.6 million. Universal life account balances increased 7.7% at year-end 1997 from year-end 1996. Fee income increased 7.6% in 1997 to $24.6 million from $22.9 million in 1996. The face amount of new term life insurance sold directly by agents decreased 12.9% to $1.3 billion from $1.5 billion. ALLIED Life continues to sell mainly 10- and 20-year guaranteed rate term life policies within this product line. First-year annuity premiums increased 5.1% to $71.5 million from $68.1 million in 1996. Sales of fixed interest annuities were slowed in the fourth quarter 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. The total annuity account balance increased 10.1% to $514.9 million at year-end 1997 from $467.5 million at year-end 1996. Adjusted insurance revenues increased 9.5% to $49.2 million in 1997 from $44.9 million in 1996. The increase was primarily attributable to increased investment spread, which grew 11% to $15.1 million from $13.6 million. Invested assets at cost increased 5.8% to $755.6 million at December 31, 1997 from $714.1 million at December 31, 1996; in 1997, investment income increased 8.3%. ALLIED Life's return on invested assets decreased to 7.3% in 1997 from 7.4% in 1996. Annual average interest-credited rates on universal life contracts decreased to 5.3% from 5.4% and on annuities decreased to 5.4% from 5.6%. The ratio of investment spread to investment income increased to 28.9% from 28.2% despite the volatile interest rate environment during 1997. This ratio 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 increased 18% to $8.2 million from $6.9 million. Other policyholder benefits decreased 3.4% to $6.1 million from $6.4 million. Other insurance operating expenses increased 9% to $4.4 million from $4 million. Amortization of deferred policy acquisition costs (DPAC) decreased 10.7% in 1997 to $9.6 million from $10.7 million in 1996. Included in the 1996 amount was an adjustment of $2.8 million taken by the Company as the result of its annual DPAC study that suggested refinements in assumptions concerning future annuity policy persistency and interest rate spreads were necessary. While the Company continues 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. Primarily due to the DPAC adjustment taken in 1996, ALLIED Life's operating income in 1997 grew 26.2% to $14.8 million from $11.7 million. 25 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 in 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. Investment income increased 6.1% to $48.2 million from $45.4 million. In 1996 the Company had realized investment gains of $122,000 compared with realized losses of $722,000 in 1995. Operating income before taxes (which excludes realized investment gains and losses net of related amortization of deferred policy acquisition costs) for the year included an adjustment 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. Including the adjustment of $2.8 million, operating income before taxes was $11.8 million compared with $14.9 million reported in 1995. Operating earnings per share including the adjustment of $0.40 per share were $1.35 compared with $1.85. Net income totaled $8.1 million ($1.39 per share) in 1996 and was $9.7 million ($1.75 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. 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 in 1995. The face amount of new term life insurance sold directly by agents increased 20.6% to $1.5 billion in 1996 from $1.2 billion in 1995. Sales of term insurance with 10- and 20-year guaranteed rates were strong during 1996. First-year annuity premiums decreased 10.4% to $68.1 million from $75.9 million in 1995. 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. 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 in 1996 from $42.7 million in 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 remained even at 28.2%. 26 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 9.1% to $4 million from $3.7 million. Amortization of DPAC was $10.7 million in 1996. Included in that amount was an adjustment taken by the Company of $2.8 million as the result of its annual DPAC study. DPAC amortization was $6 million in 1995. Primarily due to the increase in DPAC amortization, operating income before taxes decreased to $11.7 million in 1996 from $14.8 million in 1995. 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. Retained earnings of ALLIED Life available for distribution as dividends to ALLIED Life Financial Corporation are limited by law. Under the Iowa Insurance Code, dividends may be paid by ALLIED Life only from statutory earned surplus, which as of December 31, 1997 was $21.3 million. In addition, ALLIED Life may not pay an extraordinary dividend with-out 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 as of December 31 of the preceding year (ii)the statutory net gain from operations of the insurer for the twelve-month period ending December 31 of the preceding year. During 1998, the maximum amount available for distribution to the Company from ALLIED Life is approximately $9 million. During 1997, the Company paid cash dividends of $1.2 million to common and preferred stockholders. ALLIED Life paid to the Company dividends of $1.8 million primarily to fund the Company's dividend requirement and its note payments on indebtedness to affiliates. Annual dividends payable on the currently outstanding 6.75% Series preferred stock are approximately $1.6 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 1997, the Company paid dividends in the form of 148,402 shares of 6.75% Series preferred stock. Effective May 13, 1997, the Board of Directors approved a stock repurchase program to acquire shares of Company common stock on the open market. The Company completed the program during the second quarter of 1997, repurchasing and cancelling 150,000 shares at an average cost of $16.52 per share. 27 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 1997, 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 $9.4 million in 1997, $16.6 million in 1996, and $11.7 million in 1995. Cash inflows from financing activities amounted to $32.5 million, $62.4 million, and $73.3 million during 1997, 1996, and 1995, 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, 1997, 97.2% of the Company's investments were in fixed maturities. The investment policy for the Company 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 1997, 84.2% were rated "A" or better; less than 1% were rated below investment grade (below "BBB"). 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. At year-end 1997, all of the Company's CMOs were investment-grade securities. They were carried at a fair value of $55.4 million; 88.3% 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. Effective May 13, 1997, the Company transferred its remaining securities classified as held to maturity ($196 million) to available for sale. In accordance with Statement of Financial Accounting Standards (SFAS) 115, the Company now carries all of its securities at fair value; as a result, a $1.2 million increase to stockholders' equity was recognized. The Company now has more flexibility in selling securities from its investment portfolio. The Company has no intent to classify future purchases of securities as held to maturity. 28 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, 1998. At December 31, 1997, the Company had an outstanding borrowing of $6.4 million under the line of credit agreement. Interest is payable at the current rate upon issuance. From time to time, the Company has borrowed funds from its affiliates on an arm's-length basis. The Company has entered various note-payable agreements with ALLIED Mutual, an affiliate. The outstanding borrowing at December 31, 1997 was $3.6 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, 1997, 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 frequently. 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. They entitle the Company to receive payments from the instruments' counterparties 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, 1997). 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. They entitle the Company to receive payments from the instruments' counterparties 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, 1997). 29 Premiums paid to purchase these instruments are capitalized and included in other invested assets. No swaptions or floors were purchased in 1997. For the year ended December 31, 1996, the Company paid $4.1 million in premiums. All such 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. For more information on swaptions and floors see Note 3 of Notes to Consolidated Financial Statements. The Company's equity indexed annuity products guarantee 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 is used to purchase S&P 500 call options (call options) to hedge the growth in interest credited to the customer if there are advances in the S&P 500 Index(R). Premiums paid to purchase call options are capitalized and included in other assets. For the years ended December 31, 1997 and 1996, the Company paid $6.4 million and $2.3 million, respectively, 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. For more information on call options see Note 3 of Notes to Consolidated Financial Statements. The Company is exposed to the risk of extreme declines in the market value of its call options if there is a sharp and prolonged decrease in the stock market. The Company currently is purchasing puts to reduce the negative effect of such a decline. The put agreements allow the Company to receive payments on future exercise dates if the S&P 500 Index(R) is below specified levels. The costs of the interest rate hedging programs are not expected to have a material impact on the interest rate margin. The Company does not anticipate making any further purchases of interest rate hedges in the near future. For swaptions, floors, call, and puts the Company pays only the original premium and is not at risk of further payments regardless of market conditions. The Financial Accounting Standards Board (FASB) is evaluating the accounting and disclosure requirements for hedging activities and derivative financial instruments. It is likely the resulting accounting standards will require that these instruments be carried at fair value. The impact of such standards on the Company is not expected to be material to its financial position or results of operations. The Company is exposed to the risk of losses in the event of nonperformance of the counter-parties of the previously described swaptions, floors, and options. Losses recorded in the Company's financial statements in the event of nonperformance are limited to the unamortized premium paid to purchase 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 counterparties with appropriate credit ratings. Contingencies On January 20, 1998, a complaint was filed by Sharlotte G. Harbott, a policyholder of ALLIED Life, in Superior Court of the State of California for the County of Los Angeles, against the Company, ALLIED Life, ALLIED Mutual, and unnamed persons. The complaint, an alleged class action suit, asserts that ALLIED Life fraudulently increased the cost of insurance rates charged to policyholders in breach of the terms of its universal life policies, its fiduciary obligations, and its obligations of good faith and fair dealing toward its policyholders and without adequate notice. The plaintiff, an insured under a universal life policy issued by ALLIED Life, seeks actual, consequential, and punitive damages in unspecified amounts as well as interest, attorney's fees, an accounting for moneys allegedly improperly charged to policyholders, and injunctive relief on behalf of herself and all policyholders of ALLIED Life with similar universal life policies. 30 The Company believes the allegations relate to a claim that ALLIED Life collected a federal tax, known as the deferred acquisition cost tax (DAC tax), as well as other increased costs of doing business from its policyholders. The Company believes the amount of DAC tax and other costs claimed to have been collected from each policyholder is minimal, but the plaintiff in the case has asked the California court to treat the case as a class action representing all ALLIED Life policyholders from whom the claimed costs were collected. Similar class actions have been filed against other life insurance companies since the federal DAC tax law was enacted in 1990. The Company believes the action will raise the issue of whether the DAC tax may be included in the cost of insurance charged to policyholders under the terms of the universal life contracts. Management believes the increased costs charged to policyholders never violated the contracts. The Company believes that the increased costs complained of relate to universal life policies issued during and prior to 1991 and that ALLIED Life charged the increased costs to universal life policyholders primarily during the 1992 through 1995 accounting periods. The Company, ALLIED Life, and ALLIED Mutual do not expect the lawsuit to materially affect their claims-paying ratings or daily business operations. The Company, ALLIED Life, and ALLIED Mutual disagree with the allegations, believe the claims presented in this case are without merit, and believe the resolution of this matter will not materially affect the Company's financial position. Year 2000 Issue The Company is aware of the problems associated with the programming code in existing computer systems as the millennium (year 2000) approaches. The year 2000 problem is pervasive and complex as virtually every computer operation will be affected in some way by the rollover of the two-digit year value to 00. Computer systems must properly recognize date-sensitive information when the year changes to 2000. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. The Company has assessed all computer systems as they relate to the year 2000 issue. The Company has formulated a plan to resolve the issue. Appropriate internal and external resources have been acquired and dedicated to implement the plan. The Company believes that testing of the systems will be finalized before the year 2000 and will not have a significant effect on the Company's ability to conduct business in a reasonable fashion. Anticipated expenditures for year 2000 compliance are not expected to be material to fiscal year 1998 and 1999 operations. 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, none of which are expected to have a material impact on ALLIED Life. 31 New Accounting Standards In 1997, the Company adopted SFAS 128, "Earnings Per Share." SFAS 128 supersedes Opinion 15, "Earnings Per Share," and specifies the computation, presentation, and disclosure requirements for earnings per share (EPS). It replaces the presentation of primary EPS and fully diluted EPS with basic EPS and diluted EPS, respectively. Basic EPS includes the weighted average number of common shares outstanding and excludes all dilutive securities. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stocks were exercised or converted to common stock. Prior year amounts have been restated to conform to the new standard. In 1997, the Company adopted 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. This adoption had no impact on the Company's financial position, results of operations, or liquidity. In June of 1997, the FASB issued SFAS 130, "Reporting Comprehensive Income." This statement establishes new rules for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. The new rules require that all items that are recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. SFAS 130 is effective for fiscal years beginning after December 15, 1997. Earlier application of this statement is permitted. The Company will adopt SFAS 130 on January 1, 1998. This statement will require revised and additional disclosures but will have no effect on the results of operations or the financial position of the Company. In June of 1997, the FASB issued SFAS 131, "Disclosure about Segments of an Enterprise and Related Information." Under this statement, public companies will report financial and descriptive information about their operating segments. SFAS 131 is effective for fiscal years beginning after December 15, 1997. Earlier application of this statement is permitted. The Company will adopt SFAS 131 on January 1, 1998. This statement will require revised and additional disclosures but will have no effect on the results of operations or the financial position of the Company. In December of 1997, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments." This statement provides guidance on when an insurance or other enterprise should recognize a liability for guaranty fund and other assessments and on how to measure such liability. SOP 97-3 is effective for fiscal years beginning after December 15, 1998. Earlier application of this statement is permitted. The Company will adopt SOP 97-3 on January 1, 1999. Management expects that such adoption will not have a material impact on the financial position or results of operations of the Company since the majority of guaranty fund assessments are expected to be recovered through future premium tax offsets. 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, 1997 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, 1997, 1996, and 1995 have been audited by KPMG Peat Marwick LLP, independent certified public accountants. The audits were conducted 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 to discuss the results of the audit, the adequacy of internal accounting controls, and the quality of financial reporting. /s/Samuel J. Wells Samuel J. Wells President /s/Wendell P.Crosser Wendell P. Crosser Treasurer /s/Donald J. Iverson Donald J. Iverson Chief Actuary 33 Independent Auditors' Report The Board of Directors and Stockholders ALLIED Life Financial Corporation We have audited the accompanying consolidated balance sheets of ALLIED Life Financial Corporation and subsidiaries as of December 31, 1997 and 1996 and the related consolidated statements of income, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1995. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based upon our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ALLIED Life Financial Corporation and subsidiaries as of December 31, 1997 and 1996 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. /s/KPMG Peat Marwick LLP KPMG Peat Marwick LLP Des Moines, Iowa February 12, 1998 34 Consolidated Statements of Income Year ended December 31, 1997 1996 1995 (In thousands, except per share data) Revenues Insurance revenues Policyholder assessments on universal life contracts $ 21,926 $ 20,727 $ 20,011 Surrender charges 2,711 2,177 2,237 Life insurance premiums 14,201 13,005 12,568 Other insurance income 5,946 3,948 2,878 Reinsurance premiums ceded (10,641) (8,507) (7,760) Total insurance revenues 34,143 31,350 29,934 Investment income (notes 2 and 4) 52,197 48,182 45,411 Realized investment gains (losses) (note 2) 2,354 122 (722) Other income 1,558 1,056 688 90,252 80,710 75,311 Benefits and Expenses Policyholder benefits Interest credited to policyholder account balances Annuity contracts 26,452 24,732 22,613 Universal life contracts 10,127 9,490 9,530 Other 479 463 324 Death benefits 12,041 10,046 13,035 Other policyholder benefits 5,856 7,388 6,702 Reinsurance recoveries (3,563) (4,131) (6,141) Total policyholder benefits 51,392 47,988 46,063 Amortization of deferred policy acquisition costs 11,097 10,595 5,941 Commissions 4,232 3,316 2,725 Affiliated operating expenses (note 4) 640 839 1,411 Other insurance operating expenses 7,192 5,962 4,902 74,553 68,700 61,042 Income before income taxes 15,699 12,010 14,269 Income Taxes (note 13) Current 6,206 5,797 4,673 Deferred (980) (1,860) (116) 5,226 3,937 4,557 Net Income $ 10,473 $ 8,073 $ 9,712 Net income applicable to common stock (diluted basis) $ 8,862 $ 6,567 $ 8,304 Earnings per Share Basic earnings per share $ 1.98 $ 1.41 $ 1.78 Diluted earnings per share $ 1.94 $ 1.39 $ 1.75 See accompanying Notes to Consolidated Financial Statements 35 Consolidated Balance Sheets December 31, 1997 1996 (In thousands) Assets Investments Fixed maturities (notes 2 and 5) Held to maturity, at amortized cost $ ----- $ 199,209 Available for sale, at fair value 766,028 500,289 Equity securities, at fair value (notes 2 and 5) 3,201 6,407 Mortgage loans on real estate 984 1,457 Policy loans 11,164 10,307 Other invested assets (notes 3 and 5) 3,014 3,751 Short-term investments, at cost (notes 2, 4, and 5) 3,594 919 Total investments 787,985 722,339 Accrued investment income 10,988 9,738 Accounts receivable 912 608 Reinsurance ceded receivables 7,168 5,786 Deferred policy acquisition costs 84,188 92,418 Other assets (notes 3 and 5) 13,216 4,711 Total assets $ 904,457 $ 835,600