Business Segments

Torchmark is comprised of life insurance companies which primarily market individual life and supplemental health insurance products through niche distribution channels to middle income Americans. Torchmark’s core operations are insurance marketing and underwriting, and management of its investments. The insurance marketing and underwriting operation is segmented by the types of insurance products offered: life, health, Medicare Part D, and annuity. Premium income for Medicare Part D health insurance is included with the premium for other health products in the Condensed Consolidated Statements of Operations. Annuity revenue is classified as “Other premium.” Management’s measure of profitability for each insurance segment is insurance underwriting margin, which is underwriting income before other income and insurance administrative expenses. It represents the profit margin on insurance products before administrative expenses, and is calculated by deducting net policy obligations (claims incurred and change in reserves), commissions and other acquisition expenses from premium revenue. Torchmark further views the profitability of each insurance product segment by the marketing groups that distribute the products of that segment: direct response, independent agencies, or captive agencies.

Torchmark’s management prefers to evaluate the performance of its underwriting and investment activities separately, rather than allocating investment income to the underwriting results. As such, the investment function is presented as a stand-alone segment.

The investment segment includes the management of the investment portfolio, debt, and cash flow. Management’s measure of profitability for this segment is excess investment income, which is the income earned on the investment portfolio less the required interest on net policy liabilities and financing costs. Financing costs include the interest on Torchmark’s debt. Other income and insurance administrative expense are classified in a separate “Other” segment.

The majority of the Company’s required interest on net policy liabilities (benefit reserves less the deferred acquisition cost asset) is not credited to policyholder accounts. Instead, it is an actuarial assumption for discounting cash flows in the computation of benefit reserves and the amortization of the deferred acquisition cost asset. Investment income required to fund the required interest on net policy liabilities is removed from the investment segment and applied to the insurance segments to eliminate the effect of the required interest from the insurance segments. As a result, the investment segment measures net investment income against the required interest on net policy liabilities and financing costs, while the insurance segments simply measure premiums against benefits and expenses. We believe this presentation facilitates a more meaningful analysis of the Company’s underwriting and investment performance as the underwriting results are based on premiums, claims, and expenses and are not affected by unanticipated fluctuations in investment yields.

As noted, Torchmark’s “core operations” are insurance and investment management. The insurance segments issue policies for which premiums are collected for the eventual payment of policy benefits. In addition to policy benefits, operating expenses are incurred including acquisition costs, administrative expenses, and taxes. Because life and health contracts can be long term, premium receipts in excess of current expenses are invested. Investment activities, conducted by the investment segment, focus on seeking quality investments with a yield and term appropriate to support the insurance product obligations. These investments generally consist of fixed maturities, and, over the long term, the expected yields are taken into account when setting insurance premium rates and product profitability expectations. As a result, fixed maturities are generally held for long periods to support the liabilities, and Torchmark generally expects to hold investments until maturity. Dispositions of investments occur from time to time, generally as a result of credit concerns, calls by issuers, or other factors usually beyond the control of management.

Dispositions are sometimes required in order to maintain the Company’s investment policies and objectives. Investments are also occasionally written down as a result of other-than-temporary impairment. Torchmark does not actively trade investments. As a result, realized gains and losses from the disposition and write down of investments are generally incidental to operations and are not considered a material factor in insurance pricing or product profitability. While from time to time these realized gains and losses could be significant to net income in the period in which they occur, they generally have a limited effect on the yield of the total investment portfolio. Further, because the proceeds of the disposals are reinvested in the portfolio, the disposals have little effect on the size of the portfolio and the income from the reinvestments is included in net investment income. Therefore, management removes realized investment gains and losses from results of core operations when evaluating the performance of the Company. For this reason, these gains and losses are excluded from Torchmark’s operating segments.

Torchmark accounts for its stock options and restricted stock under current accounting guidance requiring stock options and stock grants to be expensed based on fair value at the time of grant. Management considers stock compensation expense to be an expense of the Parent Company. Therefore, stock compensation expense is treated as a corporate expense in Torchmark’s segment analysis.

Torchmark provides coverage under the Medicare Part D prescription drug plan for Medicare beneficiaries. In accordance with GAAP, Part D premiums are recognized evenly throughout the year when they become due, but benefit costs are recognized when the costs are incurred. Due to the design of the Part D product, premiums are evenly distributed throughout the year, but benefit costs are higher earlier in the year. As a result, under GAAP, benefit costs can exceed premiums in the first part of the year, but be less than premiums during the remainder of the year. In order to more closely match the benefit cost with the associated revenue for interim periods, Torchmark defers these excess benefits for segment reporting purposes. In addition, GAAP recognizes in each quarter a government risk-sharing premium adjustment consistent with the contract as if the quarter represented an entire contract period. These quarterly risk-sharing adjustments are removed in the segment analysis because the actual contract payments are based upon the experience of the full contract year, not the experience of interim periods. Total premiums less total benefits will be the same for segment reporting purposes as they will be under GAAP for the full calendar year. The Company’s presentation results in the underwriting margin percentage in interim periods reflecting the expected margin percentage for the full year. These interim adjustments do not impact the full year results.

An analysis of the adjustments for the difference in the interim results as presented for segment purposes and GAAP for Medicare Part D is as follows:



	Nine Months Ended September 30,
	2015		2014
Benefit costs deferred	$	11,649	$	45,382
Government risk-sharing premium adjustment	9,322		(28,532		)
Pre-tax addition to segment interim period income	$	20,971	$	16,850
After tax amount	$	13,631	$	10,952

Additionally, management does not view the risk-sharing premium for Medicare Part D as a component of premium income, and accordingly adjusts health premium income in its segment analysis. A reconciliation of health premium included in the segment analysis with health premium as reported in the Condensed Consolidated Statements of Operations is presented in the following table.



	Nine Months Ended September 30,
	2015			2014		% Change
Premium per segment analysis:
Medicare Part D premium	$	232,102		$	258,243	(10	)
Other health premium	690,221			644,758		7
Part D risk-sharing adjustment	(9,322		)	28,532		(133	)
Health premium per Condensed Consolidated Statements of Operations	$	913,001		$	931,533	(2	)

During the first nine months of 2014, Torchmark accrued for certain litigation cases in the net amount of $3.7 million ($2.4 million after tax) that were not directly related to its insurance operations. Additionally, Torchmark received $1.3 million ($853 thousand after tax) in settlement of litigation regarding investments. Also in the second quarter of 2014, the Company recorded $8.2 million in administrative settlements ($5.3 million after tax) related to benefits paid for deaths occurring in prior years where claims had not been filed. These administrative settlements were the result of the Company matching policyholder information against the Social Security death master file and obtaining due proof of loss. These administrative settlements were included in "Policyholder benefits" in the Consolidated Statements of Operations in 2014. Torchmark removes amounts that do not relate to its core insurance operations from its segment analysis.

The following tables set forth a reconciliation of Torchmark’s revenues and operations by segment to its pretax income and each significant line item in its Condensed Consolidated Statements of Operations.

Reconciliation of Segment Operating Information to the Consolidated Statement of Operations



	For the Nine Months Ended September 30, 2015
	Life			Health			Medicare Part D		Annuity			Investment			Other & Corporate			Adjustments				Consolidated
Revenue:
Premium	$	1,552,309		$	690,221		$	232,102	$	119								$	(9,322	)	(1)	$	2,465,429
Net investment income												$	579,632									579,632
Other income															$	2,201		(149		)	(3)	2,052
Total revenue	1,552,309			690,221			232,102		119			579,632			2,201			(9,471		)		3,047,113
Expenses:
Policy benefits	1,029,261			448,539			192,634		29,447									11,649			(1)	1,711,530
Required interest on reserves	(412,264		)	(51,450		)			(40,084		)	503,798										—
Required interest on DAC	129,339			17,058			673		885			(147,955		)								—
Amortization of acquisition costs	265,641			61,858			2,649		6,542													336,690
Commissions and premium tax	115,452			60,820			16,258		32									(149		)	(3)	192,413
Insurance administrative expense ⁽²⁾															142,829							142,829
Parent expense															6,662							6,662
Stock compensation expense															21,877							21,877
Interest expense												57,420										57,420
Total expenses	1,127,429			536,825			212,214		(3,178		)	413,263			171,368			11,500				2,469,421
Subtotal	424,880			153,396			19,888		3,297			166,369			(169,167		)	(20,971		)		577,692
Nonoperating items																		20,971			(1)	20,971
Measure of segment profitability (pretax)	$	424,880		$	153,396		$	19,888	$	3,297		$	166,369		$	(169,167	)	$	—			598,663
Deduct applicable income taxes																						(196,005		)
Segment profits after tax																						402,658
Add back income taxes applicable to segment profitability																						196,005
Add (deduct) realized investment gains (losses)																						7,872
Deduct Part D adjustment ⁽¹⁾																						(20,971		)
Pretax income per Consolidated Statements of Operations																						$	585,564

(1) Medicare Part D items adjusted to GAAP from the segment analysis, which matches expected benefits with policy premium.

(2) Administrative expense is not allocated to insurance segments.

(3) Elimination of intersegment commission.

Reconciliation of Segment Operating Information to the Condensed Consolidated Statement of Operations *



	For the Nine Months Ended September 30, 2014
	Life			Health			Medicare Part D		Annuity			Investment			Other & Corporate			Adjustments				Consolidated
Revenue:
Premium	$	1,472,734		$	644,758		$	258,243	$	334								$	28,532		(1)	$	2,404,601
Net investment income												$	567,569									567,569
Other income															$	1,990		(178		)	(3)	1,812
Total revenue	1,472,734			644,758			258,243		334			567,569			1,990			28,354				2,973,982
Expenses:
Policy benefits	964,305			414,607			213,184		31,599									53,561			(1,5)	1,677,256
Required interest on reserves	(395,595		)	(48,018		)			(41,576		)	485,189										—
Required interest on DAC	125,758			16,823			534		1,120			(144,235		)								—
Amortization of acquisition costs	251,954			53,088			2,127		5,959													313,128
Commissions and premium tax	105,724			59,787			19,664		37									(178		)	(3)	185,034
Insurance administrative expense ⁽²⁾															134,918			2,337			(4)	137,255
Parent expense															6,284							6,284
Stock compensation expense															25,219							25,219
Interest expense												57,119										57,119
Total expenses	1,052,146			496,287			235,509		(2,861		)	398,073			166,421			55,720				2,401,295
Subtotal	420,588			148,471			22,734		3,195			169,496			(164,431		)	(27,366		)		572,687
Nonoperating items																		27,366			(1,4,5)	27,366
Measure of segment profitability (pretax)	$	420,588		$	148,471		$	22,734	$	3,195		$	169,496		$	(164,431	)	$	—			600,053
Deduct applicable income taxes																						(196,288		)
Segment profits after tax																						403,765
Add back income taxes applicable to segment profitability																						196,288
Add (deduct) realized investment gains (losses)																						15,713
Deduct Part D adjustment ⁽¹⁾																						(16,850		)
Deduct legal settlement expense ⁽⁴⁾																						(2,337		)
Deduct administrative settlements ⁽⁵⁾																						(8,179		)
Pretax income per Consolidated Statements of Operations																						$	588,400

(1) Medicare Part D items adjusted to GAAP from the segment analysis, which matches expected benefits with policy premium.

(2) Administrative expense is not allocated to insurance segments.

(3) Elimination of intersegment commission.

(4) Legal settlement expenses.

(5) Administrative settlements.

* Retrospectively adjusted to give effect to the adoption ASU 2014-01 as described in Note G- Adoption of New Accounting Standards.

The following table summarizes the measures of segment profitability for comparison. It also reconciles segment profits to net income.

Analysis of Profitability by Segment



	Nine Months Ended September 30,						Increase (Decrease)
	2015			2014*			Amount			%
Life	$	424,880		$	420,588		$	4,292		1
Health	153,396			148,471			4,925			3
Medicare Part D	19,888			22,734			(2,846		)	(13	)
Annuity	3,297			3,195			102			3
Investment	166,369			169,496			(3,127		)	(2	)
Other and corporate:
Other income	2,201			1,990			211			11
Administrative expense	(142,829		)	(134,918		)	(7,911		)	6
Corporate	(28,539		)	(31,503		)	2,964			(9	)
Pretax total	598,663			600,053			(1,390		)	—
Applicable taxes	(196,005		)	(196,288		)	283			—
Total	402,658			403,765			(1,107		)	—
Reconciling items, net of tax:
Realized gains (losses) - Investments	5,117			10,213			(5,096		)	(50	)
Part D adjustment	(13,631		)	(10,952		)	(2,679		)	24
Administrative settlements	—			(5,316		)	5,316			(100	)
Legal settlement expense	—			(1,519		)	1,519			(100	)
Net income	$	394,144		$	396,191		$	(2,047	)	(1	)

* Retrospectively adjusted to give effect to the adoption of ASU 2014-01 as described in Note G-Adoption of New Accounting Standards.