-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, B0rIGFOWXDysqaPIUs7cU2ih11VbBStGs/fY9V/yjMHzjJGMWgqgEvwHfwMWcJ2c rZJ7qcoKk3o2x3x81A7z/g== 0000950137-97-001377.txt : 19970401 0000950137-97-001377.hdr.sgml : 19970401 ACCESSION NUMBER: 0000950137-97-001377 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 11 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: STANDARD MANAGEMENT CORP CENTRAL INDEX KEY: 0000853971 STANDARD INDUSTRIAL CLASSIFICATION: LIFE INSURANCE [6311] IRS NUMBER: 351773567 STATE OF INCORPORATION: IN FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-20882 FILM NUMBER: 97571552 BUSINESS ADDRESS: STREET 1: 9100 KEYSTONE CROSSING STE 600 CITY: INDIANAPOLIS STATE: IN ZIP: 46240 BUSINESS PHONE: 3175746200 MAIL ADDRESS: STREET 1: 9100 KEYSTONE CROSSING STREET 2: SUITE 600 CITY: INDIANAPOLIS STATE: IN ZIP: 46207 10-K 1 FORM 10-K DATED DECEMBER 31, 1997 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-K X - ------ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED) FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 OR - ------ TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) Commission file number 0-20882
STANDARD MANAGEMENT CORPORATION (Exact name of registrant as specified in its charter) Indiana 35-1773567 (State or other jurisdiction of incorporation or (I.R.S. employer identification no.) organization) 9100 Keystone Crossing, Indianapolis, Indiana 46240 (317) 574-6200 (Address of principal executive offices) (Telephone)
Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, No Par Value Class S Cumulative Convertible Redeemable Preferred Stock, $10 Par Value Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _____ 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. [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on February 28, 1997 as reported on The Nasdaq Stock Market, was approximately $21.9 million. Shares of Common Stock held by each executive officer and director and by each person who owns 5% or more the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. As of February 28, 1997, Registrant had outstanding 5,025,143 shares of Common Stock. Documents Incorporated by Reference: Portions of the Registrant's definitive Proxy Statement for the Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K. ================================================================================ 2 PART I As used herein, unless the context otherwise clearly requires, "SMC" refers to Standard Management Corporation and its consolidated subsidiaries and "Standard Management" refers to Standard Management Corporation on an unconsolidated basis. All financial information contained herein is presented in accordance with generally accepted accounting principles ("GAAP") unless otherwise specified. All information contained herein with respect to SMC Common Stock, including information presented on a per share basis, has been adjusted to reflect a 5% stock dividend effected on June 21, 1996 for holders of record on May 17, 1996. ITEM 1. BUSINESS OF SMC INTRODUCTION SMC is an insurance holding company which directly and through subsidiaries acquires and manages in force life insurance and annuity business and distributes life insurance and annuity products issued by SMC's insurance subsidiaries and a select group of unaffiliated insurers. SMC's active subsidiaries at December 31, 1996 include: (i) Standard Life Insurance Company of Indiana ("Standard Life") and its subsidiary, Dixie National Life Insurance Company ("Dixie National Life"), (ii) Standard Management International S.A. ("Standard Management International") and its subsidiaries, Premier Life (Luxembourg) S.A. ("Premier Life (Luxembourg)") and Premier Life (Bermuda) Ltd. ("Premier Life (Bermuda)"), and (iii) Standard Marketing Corporation ("Standard Marketing"). Standard Life, SMC's principal insurance subsidiary, was organized in 1934 as an Indiana-domiciled life insurer. It is licensed to write new business or service existing business in the District of Columbia and all states except New York and New Jersey. Standard Life offers flexible premium deferred annuities ("FPDAs") and whole and universal life insurance. Standard Life also generates cash flow and income from closed blocks of in force life insurance and annuities. At December 31, 1996, Standard Life's statutory assets were $347,329,660 and the aggregate of its statutory capital and surplus, asset valuation reserve ("AVR") and interest maintenance reserve ("IMR") (its "adjusted statutory capital") was $34,940,556. The ratio of Standard Life's adjusted statutory capital to its total statutory assets was 10.1% at December 31, 1996. Standard Life has a rating of "B" ("adequate") by A.M. Best Company, Inc. ("A.M. Best"), a rating agency. Standard Management International is a holding company organized under Luxembourg law with its registered office in Luxembourg. At December 31, 1996, Standard Management International and its subsidiaries had $141,837,000 in assets with policies in force in over 113 countries. The majority of its business is "unit-linked" products with a range of policyholder directed investment choices coupled with a small death benefit, sold through its subsidiaries: Premier Life (Luxembourg) and Premier Life (Bermuda). At December 31, 1996, Premier Life (Luxembourg) had statutory capital and surplus of $8,243,000 and its minimum capital and surplus was $3,295,000 and Premier Life (Bermuda) had statutory capital and surplus of $1,307,000 and its minimum capital and surplus was $250,000. Standard Life owns 99.3% of Dixie National Life. At December 31, 1996, Dixie National Life's statutory assets were $34,473,049, the adjusted statutory capital was $4,229,059 and the ratio of its adjusted statutory capital to its statutory assets was 12.3%. Dixie National Life has a rating of B- (Adequate) by A.M. Best. Dixie National Life markets a variety of life insurance products throughout the Mid-South offering primarily "burial expense" policies. Standard Marketing is a wholesale distributor of life insurance and annuity products. Through its network of master general agents and independent agents, Standard Marketing distributes life insurance and annuity products for Standard Life and Dixie National Life and for a select group of unaffiliated insurance companies. Standard Marketing earns override commission income from the sale of these products. On November 8, 1996, Standard Life acquired through merger Shelby Life Insurance Company ("Shelby Life") from Delta Life and Annuity Corporation ("DLAC"), a life insurance company located in Memphis, Tennessee (the "Shelby Merger"). The purchase price was approximately $14,650,000, including $13,000,000 in cash, 250,000 shares of restricted Common Stock (valued at $1,250,000) and acquisition costs of $400,000 associated with the purchase of Shelby Life. Financing for the Shelby Merger was provided by 1 3 senior debt of $10,000,000 and $4,000,000 in subordinated convertible debt. Shelby Life ceased writing new business effective November 1, 1996, thus reducing the statutory surplus strain associated with the issuance of policies. The acquisition of Shelby Life was accounted for using the purchase method of accounting and SMC's consolidated financial statements include the results of Shelby Life from November 1, 1996, the effective date of acquisition. Under purchase accounting, Standard Life allocated the total purchase price of Shelby Life to the assets and liabilities acquired, based on a preliminary determination of their fair values and recorded the excess of acquisition cost over net assets acquired as goodwill. Standard Life recorded goodwill of $9,000 which will be amortized on a straight-line basis over 20 years. Standard Life may adjust this allocation when a final determination of such values is made. On March 18, 1996, Standard Life completed the sale of a duplicate charter associated with First International Life Insurance Company ("First International") to The Guardian Insurance and Annuity Company, Inc. ("GIAC"), a subsidiary of The Guardian Group, New York, NY. Standard Life received proceeds of approximately $11,493,000, including $1,500,000 for the charter and licenses associated with First International and $1,800,000 of reinsurance ceding commissions. Standard Life realized a net pretax gain of $1,041,692 and a tax benefit of $1,420,000 on this sale or $2,461,692 ($.47 per share). In addition, First International, Standard Life and GIAC have entered into a series of reinsurance and other agreements that include provisions for Standard Life to administer First International policies in force at the date of sale, and for Standard Life to continue to receive the profit stream from the majority of First International's in force business at the date of sale. See Business of SMC - -- Reinsurance. In an unrelated matter, SMC decided in February 1996 to terminate the reinsurance agreement between Standard Reinsurance of North America Ltd. ("Standard Reinsurance") and Salamandra Joint-Stock Insurance Company in Ukraine ("Salamandra"), and to not renew the Barbados license of Standard Reinsurance. This resulted in the termination of Standard Reinsurance operations and the write-off of SMC's investment in Standard Reinsurance and certain intangible assets of Standard Reinsurance amounting to $155,856 ($.03 per share). The combined effect of the gain on sale of First International and related contracts, and the Standard Reinsurance write-offs, was a gain on disposal of subsidiaries of $885,836 and a tax benefit of $1,420,000, for net income effect of $2,305,836 or $.44 per share for the year ended December 31, 1996. In June 1988, Standard Life ceded a block of business to National Mutual Life Insurance Company ("National Mutual"). Effective May 31, 1996, Standard Life terminated by recapture the reinsurance agreement with National Mutual. As a result of this recapture, Standard Life received assets of $5,200,554 and liabilities of $4,953,055, primarily ordinary life policies. In connection with this transaction, Standard Life collected administration fees of $375,000 related to services provided in prior years that had not been recorded previously due to the uncertainty as to its collection. This administration fee income and premium income recorded with recapture, will not recur in the future. SMC has entered into an Agreement and Plan of Merger dated as of December 19, 1996, as amended February 17, 1997, with Savers Life Insurance Company ("Savers Life"). Savers Life offers retirement products, major medical insurance and Medicare supplement insurance through 5,000 independent brokers, primarily in North Carolina, South Carolina and Virginia. SMC will pay approximately $14,200,000 plus acquisition costs for the approximately $80,000,000 asset company, with shareholders of Savers Life initially receiving $8.00 for each share of Savers Life Common Stock, consisting of Standard Management Common Stock and an election of up to $1.50 per share in cash. The proposed acquisition is subject to certain conditions including SMC and Savers Life shareholder approval and approval by applicable regulatory authorities. The acquisition is expected to close during the second quarter of 1997. ACQUISITION STRATEGY A principal component of SMC's strategy is to grow through the acquisition of life insurance companies and blocks of in force life insurance and annuities. SMC regularly investigates acquisition opportunities in the life insurance industry that complement or are otherwise strategically consistent with its existing business. Any 2 4 decision to acquire a block of business or an insurance company will depend on a favorable evaluation of various factors. SMC believes that availability of blocks of business in the marketplace will continue in response to ongoing industry consolidation and risk-based capital requirements as well as other regulatory and rating agency concerns. In addition, SMC plans to market annuity and life insurance products directly as it has done in the past. SMC currently has no plans or commitments to acquire any specific insurance business or other material assets besides Savers Life. No assurance can be given that SMC will be successful in consummating any future acquisition. SMC has the information systems and administrative capabilities necessary to add additional blocks of business without a proportional increase in operating expenses. In addition, SMC has developed management techniques for reducing or eliminating the expenses of the companies it acquires through the consolidation of their operations with those of SMC, and for increasing investment yields. Such techniques include reduction or elimination of overhead, including the acquired company's management, staff and home office, elimination of marketing expenses and, where appropriate, the substitution of Standard Marketing's network for the acquired company's current distribution system, and the conversion of the acquired company's data processing operations to SMC's system. SMC may effect its acquisitions through the purchase or exchange of shares, if the acquisition candidate is an insurance company, or an assumption reinsurance transaction, if the proposed acquisition concerns a block of business. SMC's acquisitions may be subject to certain regulatory approvals, policyholder consents and stockholder approval, when applicable. MARKETING Domestic Marketing. Standard Marketing was organized as a wholesale distribution system to provide a lower cost alternative to the traditional captive agency force. Standard Marketing has established a network of approximately 4,000 independent general agents. These agents distribute a full line of life insurance and annuity products issued by Standard Life and Dixie National Life and a select group of unaffiliated insurance carriers that Standard Marketing represents. As part of its normal recruiting, Standard Marketing selectively recruits new agents from those formerly associated with companies acquired by SMC. SMC does not market its annuity products through stockbrokers. Crediting rates, commissions, the perceived quality of the issuer, product features and services are generally the principal factors influencing an agent's willingness and ability to sell particular life and annuity products. SMC believes that both agents and policy owners value the service provided by SMC. Standard Marketing assists its agents in submitting and processing policy applications and helps ensure that issuing insurers pay commissions on a timely basis. Standard Life issues an annuity and pays the Standard Marketing agent's commission within 24 hours after the submission of the policy application. Standard Marketing also assists its agents with licensing applications and provides other administrative support. Standard Marketing provides marketing support for its agents, including sales seminars and other continuing education programs, point of sale materials, illustrated proposal services, toll-free access for sales inquiries and access to senior executives. In addition, Standard Marketing can introduce agents to lead services who will provide such services at discounted rates that Standard Marketing has negotiated. Standard Marketing agents offer a full portfolio of life insurance and annuity products that Standard Marketing has selected on the basis of their competitive position and likely consumer acceptance. Such portfolio includes FPDAs and whole and universal life insurance issued by Standard Life and Dixie National Life, for which Standard Marketing is the exclusive distributor, and deferred annuities, whole life, term and universal life insurance, and pension and payroll deduction products issued primarily by the following unaffiliated insurers: American National Life Insurance Company, Indianapolis Life Insurance Company, Jefferson-Pilot Life Insurance Company, The Midland Life Insurance Company, The Old Line Life Insurance Company of America, United Presidential Life Insurance Company, U.S. Financial Life Insurance Company and others. Each of these unaffiliated insurers is rated "A-" to "A++" by a nationally recognized insurance company rating agency. Standard Marketing's relationships with these companies are non-exclusive and are terminable by either party upon 30 days notice. Standard Marketing regularly evaluates the products 3 5 its agents offer to determine whether products or insurers should be added to, or deleted from, the Standard Marketing portfolio. SMC does not insure any of the policies and contracts Standard Marketing's agents sell for unaffiliated insurers. Each general agent operates his own agency and is responsible for all expenses of the agency. The general agents are compensated directly by the issuing insurance companies, which perform all policy issuance, underwriting and accounting functions. SMC is not dependent on any one agent or agency for any substantial amount of its business. No single agent accounted for more than 4% of Standard Life's annual sales in 1996, and the top twenty individual agents accounted for approximately 36.6% of Standard Life's volume in 1996. At December 31, 1996, approximately 40% of Standard Marketing's independent agents were located in Indiana, Florida, Ohio, Georgia and Illinois, with the balance distributed across the country. SMC is attempting to increase the number and geographic diversity of its agents. SMC does not have exclusive agency agreements with its agents and management believes most of these agents sell products similar to those sold by the companies for other insurance companies. This could result in sales decline if the companies' products were to become relatively less competitive. Standard Life's 1996 FPDA sales increased partially due to an aggressive marketing campaign implemented by Standard Life with increased crediting rates. Also contributing to the increase in premiums was the continued development of Standard Life's distribution system. Standard Marketing receives, directly from the insurance companies it serves, override commissions on sales by its agents, which are in addition to the commissions paid to Standard Marketing's independent agents. The availability of override commissions provides an economic incentive to Standard Marketing to recruit agents who produce business. The following table shows for the periods indicated the aggregate override commissions and service fees received by Standard Marketing:
YEARS ENDED DECEMBER 31, ------------------------------ 1996 1995 1994 ---- ---- ---- (DOLLARS IN THOUSANDS) Standard Life and Dixie National Life(1).......... $ 988 $ 829 $867 Unaffiliated insurance companies.................. 397 252 55 ------ ------ ---- Total........................................ $1,385 $1,081 $922 ====== ====== ====
- ------------------------- (1) These amounts are eliminated in SMC's consolidated financial statements. International Marketing. The subsidiaries of Standard Management International, Premier Life (Luxembourg) and Premier Life (Bermuda), produced aggregate new premium deposits of approximately $17,000,000, $32,000,000 and $1,700,000 during 1996, 1995 and 1994, respectively. The decrease in 1996 is primarily due to a decrease in marketing costs and to changes in tax planning laws in certain countries in Western Europe, which made Standard Management International products less attractive. The countries within the European Union have been the main contributor to these sales. Although SMC expects this to be the case in the future, it plans to increase marketing efforts in other parts of the world as well. Although Standard Management International anticipates as part of its long term plan to grow significantly through internal sales, acquisitions of other European insurance companies may be considered. It has designed and launched new single and regular premium products in recent years. It is also in discussions with a number of companies to form alliances to produce tailored products for their markets. It is expected that these alliances will be consummated in 1997. It is currently the intention that Premier Life (Luxembourg) will write business within the European Union and Premier Life (Bermuda) will write international business elsewhere in the world. The market for Standard Management International's products is considered to be medium to high net worth individuals who typically have in excess of $75,000 to invest in a single premium policy and medium to high earners who have in excess of $3,000 per annum to invest in a regular premium savings product. The above individuals would come from a combination of expatriates, residents of European Union countries and from other targeted areas. The expatriate and European insurance markets are well 4 6 established and highly competitive with a large number of domestic and international groups operating in, or going into, the same markets as Standard Management International. Standard Management International's products are distributed via independent agents who have established connections with these targeted individuals. Standard Management International is striving to develop into an entrepreneurial intermediary oriented organization committed to building long term relationships with high quality distributors, thereby creating a niche position. Standard Management International places the same emphasis as SMC's U.S. insurance companies on a high level of service to intermediaries and policyholders while striving to achieve low overhead costs. PRODUCTS SMC primarily markets FPDAs, whole life and universal and interest-sensitive life insurance policies and unit-linked policies. SMC also generates cash flow and income from its closed blocks of in force life insurance and annuities. The following table sets forth the amounts and percentages of net premiums received by SMC from currently marketed products and closed block products for the years ended December 31, 1996, 1995 and 1994, respectively. Because GAAP generally excludes annuity and unit-linked products deposits and premiums from universal and interest-sensitive life insurance from premium income, and thus does not fully reflect SMC's cash flow from new business, the premium information contained in the following table is reported using statutory accounting principles which includes deposits on annuities and unit-linked policies and premiums from universal and interest-sensitive life insurance.
YEAR ENDED DECEMBER 31, -------------------------------------------------------- 1996 1995 1994 ---------------- ---------------- ---------------- AMOUNT % AMOUNT % AMOUNT % ------ - ------ - ------ - (DOLLARS IN THOUSANDS) Currently marketed products: FPDAs..................................... $37,322 47.7 $12,417 23.0 $50,421 85.7 Universal and interest-sensitive life..... 5,384 6.9 2,044 3.8 279 0.4 SPIAs..................................... 1,423 1.8 1,257 2.3 -- -- Whole life................................ 2,546 3.3 668 1.2 86 0.2 Unit-linked products...................... 16,902 21.6 31,793 58.8 1,715 2.9 ------- ----- ------- ----- ------- ----- 63,577 81.3 48,179 89.1 52,501 89.4 Closed blocks: Annuities and life........................ 9,230 6.5 5,906 10.9 6,364 10.8 Net effect of financial reinsurance....... 5,182 6.6 -- -- -- -- Recapture of National Mutual.............. 4,373 5.6 -- -- -- -- ------- ----- ------- ----- ------- ----- 18,942 18.7 5,906 10.9 6,364 10.8 ------- ----- ------- ----- ------- ----- $82,362 100.0 $54,085 100.0 $58,865 100.0 ======= ===== ======= ===== ======= =====
FPDA sales declined in 1995 reflecting competitive pressures due to Standard Life not matching other insurer's higher interest crediting and commission rates. Additionally, in order to reduce surplus strain Standard Life began ceding a portion of its new annuity business to an unaffiliated reinsurer effective January 1, 1995, which further reduced FPDA sales revenues by $20,089,762 in 1995. Deposits from unit-linked products increased in 1995 as a result of the resumption by Standard Management International of the sale of new policies in 1994. FPDA sales increased in 1996 partially due to an aggressive marketing campaign implemented by Standard Life with increased interest crediting rates. Standard Life also decreased the quota-share portion of business ceded pursuant to a reinsurance agreement, under which 70% of a portion of Standard Life's annuity business pursuant to the terms of the agreement produced after December 31, 1994 was ceded, to 50% at September 1, 1995, which was further decreased to 25% effective April 1, 1996. This reduction was possible since the surplus strain experienced by Standard Life was not as great as originally anticipated as a result of 5 7 lower than expected sales in 1995 and the additional surplus resulting from the sale of First International. Premium deposits ceded pursuant to this reinsurance agreement reduced net premium by $8,907,460 in the year ended December 31, 1996. The increase in closed blocks annuities and life products is primarily due to reinsurance premium assumed from GIAC and the acquisition of Shelby Life effective November 1, 1996. The following table shows, on a GAAP basis, certain information for SMC as of the dates set forth below.
AT DECEMBER 31, ------------------------------------------ 1996 1995 1994 ---- ---- ---- (DOLLARS IN THOUSANDS) Number of annuity contracts in force.................... 13,221(1) 8,637 7,480 Interest-sensitive annuity and other financial product reserves, net of reinsurance ceded.................... $ 333,633(1) $212,500 $173,334 ---------- -------- -------- Number of life policies in force........................ 76,219(2) 63,038(3) 40,317 Life insurance in force, net of reinsurance ceded....... $1,367,675(2) $826,296(3) $787,414 ---------- -------- -------- Number of separate contracts (primarily unit-linked products)............................................. 2,484 2,951 3,131 Total liabilities related to separate accounts (primarily unit-linked products)...................... $ 128,546 $122,705 $ 94,301
- ------------------------- (1) The number of annuity contracts in force and interest-sensitive annuity and other financial product reserves increased in 1996 primarily due to the increase in FPDA sales in 1996 and the Shelby Merger. (2) The number of life policies and insurance in force has increased in 1996, as a result of the Shelby Merger. Shelby Life had 16,603 life policies and $617,688,000 insurance in force as of November 1, 1996. (3) The number of life policies and insurance in force increased 26,522 and $219,663,000 in 1995, respectively, as a result of Standard Life's acquisition of Dixie National Life. CURRENTLY MARKETED PRODUCTS The individual annuity business is a growing segment of the savings and retirement industry, which increased in sales from $1 billion in 1970 to more than $54 billion in 1990. The individual annuity market, which is SMC's primary target, comprises 42% of those sales. As the 76 million baby boomers born from 1946 through 1964 grow older, demand for insurance products is expected to grow. SMC believes that those seeking adequate retirement incomes will depend less and less on Social Security and their employers' retirement programs and more and more upon their own financial resources. Annuities currently enjoy an advantage over certain other saving mechanisms because the annuity buyer receives a tax-deferred accrual of interest on his investment during the accumulation period. Standard Life, Dixie National Life and Standard Management International all currently issue new policies. Standard Life emphasizes the issuance of FPDAs. Dixie National Life primarily sells "burial expense" life insurance policies. Standard Management International markets unit-linked products. Over 27% of all net premiums and deposits collected in 1996 by SMC from its currently marketed products arise from the sale of unit-linked products by Standard Management International. The balance is represented by the sales of whole life and universal and interest-sensitive life insurance products by Standard Life and Dixie National Life and Standard Life's FPDAs. The portfolio of products is continuously reviewed by management, and product features and terms are adjusted in response to market conditions in an effort to remain competitive. 6 8 SMC's gross sales percentages by U.S. geographical region are summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------- STATE 1996 1995 1994 ----- ---- ---- ---- Indiana................................................ 18% 24% 30% Ohio................................................... 16 22 18 Florida................................................ 14 11 19 California............................................. 11 3 2 Michigan............................................... 6 4 5 All other states....................................... 35(1) 36 26 --- --- --- Total.................................................. 100% 100% 100% === === ===
- ------------------------- (1) No other state had gross sales greater than 4% for 1996. Standard Management International's products are sold primarily in Western Europe. STANDARD LIFE PRODUCTS Flexible Premium Deferred Annuities. FPDAs provide for an initial deposit by an annuitant and optional additional deposits, the time and amount of which are at the discretion of the annuitant. Standard Life credits the account of the annuitant with earnings at interest rates which are revised periodically by Standard Life until the maturity date. These interest earnings are tax deferred. Revisions to interest rates on FPDAs are restricted by an initial crediting rate guaranteed for a specific period of time and a minimum crediting rate guaranteed for the term of the FPDA. At maturity, the annuitant can elect a lump sum cash payment of the accumulated value or one of the various payout options available. Standard Life's FPDAs also provide for penalty-free partial withdrawals of up to 10% annually of the accumulation value after the annuitant has held the FPDA for more than 12 months. In addition, the annuitant may surrender the FPDA at any time before the maturity date and receive the accumulated value, less any surrender charge then in effect for that contract. To protect holders of FPDAs from a sharp reduction in the credited interest rate after a FPDA is issued, Standard Life permits the FPDA holder of certain annuities to surrender the annuity during a specified period without incurring a surrender charge if the renewal crediting rate is below a stated level. This stated level of interest is referred to as the "bail-out rate" and is typically below the original crediting rate, but above the minimum guaranteed crediting rate. As of December 31, 1996, the crediting rates available on Standard Life's currently marketed FPDAs ranged from 6.8% to 8.1% (5.1% + 3% first year bonus), with new issues having an interest rate with a one year guarantee period. After the initial period, the crediting rate may be changed periodically, subject to minimum guaranteed rates from 3% to 4%. As of December 31, 1996, interest crediting rates after the initial guarantee period ranged from 5% to 6.75%. The surrender charge is initially 13% or 15% of the contract value depending on the product and decreases over the applicable penalty period of nine, ten or thirteen years. As of December 31, 1996, the bail out rate for Standard Life's FPDAs was 4.5%; most currently marketed products carry a bail out rate for only the first two years after issue. Whole Life Insurance. Standard Life offers two types of non-participating whole life policies: one in face amounts up to $10,000 (which is only issued upon conversion of other policies) and the other in face amounts up to $50,000. Whole life insurance products involve fixed premium payments made over time, with the stated death benefit paid in full upon the death of the insured. The whole life policy combines the death benefit with a forced savings plan. Premiums remain level over the life of the policy, with the policyholder prefunding during the early years of coverage when risk of death is low. Over time, whole life policies begin to accrue a cash value which can be made available to the policyholder net of taxes and withdrawal penalties. Single Premium Immediate Annuities. Standard Life offers a single premium immediate annuity ("SPIA"), whereby an annuitant purchases an immediate annuity with a one-time premium deposit at the time of issuance. Standard Life begins a payout stream shortly after the time of issuance consisting of principal value plus accumulated interest credited to such annuity. This product credits interest based on an investment portfolio earned rate assumption. 7 9 Single Premium Universal Life. SPULs provide for an initial deposit, credit interest to account values and charge the account values for mortality and administrative costs. As of December 31, 1996, the current interest rate on new sales of SPULs is 7% with a guaranteed interest rate of 3%. DIXIE NATIONAL LIFE PRODUCTS. Life insurance policies sold by Dixie National Life in the final expense, or burial, market include fixed premium interest sensitive policies that provide for increasing death benefits, as well as traditional whole life policies. These policies are designed to cover expenses such as funeral, last illness, monument and cemetery lot. The policies provide for a death benefit, generally not in excess of $10,000, and a level premium payment. The products include a cash value which may be borrowed by the policyholder. Dixie National Life's policies sold in other markets include interest sensitive and traditional whole life policies and forms of term policies. The interest sensitive whole life policies have a guaranteed interest rate of 5.5% on currently marketed products at December 31, 1996. The interest sensitive and whole life policies include cash values which may be borrowed by the policyholder. Dixie National Life issues polices on both a participating and non-participating basis. STANDARD MANAGEMENT INTERNATIONAL PRODUCTS. Unit-linked Policies. Standard Management International currently writes unit-linked life products, which are similar to U.S. produced variable life products. Separate account assets and liabilities are maintained primarily for the exclusive benefits of universal life contracts and investment contracts of which the majority represents unit-linked business where benefit on surrender and maturity are not guaranteed. They generally represent funds held in accounts to meet specific investment objectives of policyholders who bear the investment risk. Investment income and investment gains and losses within the separate accounts accrue directly to such policyholders. The fees received by Standard Management International for administrative and contract holder maintenance services performed for these separate accounts are included in SMC's statement of operations. In the past, Standard Management International also wrote investment contracts and universal life policies and to a lesser extent, traditional life. The investment contracts are mainly short term single premium endowments or temporary annuities under which fixed benefits are paid to the policyholder. The terms of these contracts are such that SMC has relatively small morbidity or mortality risk. The universal life contracts are mainly regular premium and single premium endowment. The benefits payable to the policyholders are directly linked to the investment performance of the underlying assets. CLOSED BLOCKS The premiums received on the closed blocks were primarily from the ordinary and universal life business. This decline in premium income is expected as a result of policy lapses, surrenders and expiries from closed blocks of business. Ordinary Life. The ordinary life policies included in SMC's closed blocks are composed primarily of fixed premium, cash value whole life products. In addition, they include annually renewable term policies as well as five, ten and fifteen year level premium term policies. Universal Life. Certain closed blocks include universal life business. For this business, SMC credits deposits and interest to account values and charges the account values for mortality and administrative costs. Annuities. SMC's closed blocks of deferred annuities consist primarily of FPDAs and a small amount of single premium deferred annuities ("SPDAs") which, unlike FPDAs, do not provide for additional deposits. At December 31, 1996, these deferred annuities had crediting rates ranging from 5% to 5.5% and guaranteed minimum crediting rates ranging from 3% to 5.5%. The crediting rate may be changed periodically. The contract owner is permitted to withdraw all or part of the accumulation value. SMC's closed blocks of annuities include payout annuities. Payout annuities consist of those annuities whose benefits are being paid 8 10 out over a specified time period. Payout annuities cannot be terminated by surrender or withdrawal. SMC's crediting rates on payout annuities range from 5.5% to 6.5% and cannot be changed. Reinsurance. In connection with financial reinsurance, Dixie National Life terminated a reinsurance agreement with Crown Life Insurance Company and received redeemed premium income of $18,186,377 and entered into a financial reinsurance agreement with Cologne Life Reinsurance Company and added $13,091,290 of premium income in 1996. The policies subject to the recapture of the reinsurance agreement with National Mutual were primarily ordinary life policies. (See Business of SMC -- Reinsurance). PRODUCT PROFITABILITY The profitability of the life insurance and annuity products depend to a significant degree on the maintenance of profit margins between investment results from invested assets and interest credited on insurance and annuity products. During 1996, such margins continued to be positive as a result of reductions in crediting rates in spite of a fluctuating interest rate environment. The long-term profitability of insurance products depends on the accuracy of the actuarial assumptions that underlie the pricing of such products. Actuarial calculations for such insurance products, and the ultimate profitability of such products, are based on four major factors: (i) persistency, (ii) mortality (iii) return on cash invested by the insurer during the life of the policy and (iv) expenses of acquiring and administering the policies. The average expected remaining life of Standard Life and Dixie National Life's ordinary life business in force at December 31, 1996 is 9 and 10.75 years, respectively. These calculations were determined based upon SMC's actuarial models and assumptions as to expected persistency and mortality. Persistency is the extent to which insurance policies sold are maintained by the insured. The persistency of life insurance and annuity products is a critical element of their profitability. However, a surrender charge often applies in the early contract years and declines to zero over time. Policyholders sometimes do not pay premiums, thus causing their policies to lapse. For the years 1996, 1995 and 1994 Standard Life experienced total policy lapses of 6.3%, 5.1% and 6.3% of total policies in force at December 31 of each year, respectively. The American Council of Life Insurance 1996 Fact Book reported industry life insurance voluntary termination rates in 1996 of 17.1% for policies in force less than two years, 5.4% for policies in force for two years or more and 7.2% for all policies in force. OPERATIONS SMC emphasizes a high level of service to agents and policyholders and strives to achieve low overhead costs. SMC's principal administrative departments are its financial, policyholder services and management information services ("MIS") departments. The financial department provides accounting, budgeting, tax, investment, financial reporting and actuarial services and establishes cost control systems for SMC. The policyholder services department reviews policy applications, issues and administers policies and authorizes disbursements related to claims and surrenders. MIS department oversees and administers SMC's information processing systems. SMC's administrative departments in the United States use a common integrated system that permits SMC to function more efficiently, control costs and maintain low overhead. SMC's management information services system is now servicing approximately 150,000 active and inactive policies. SMC is continually improving its MIS systems to provide for continued growth from acquisitions and sales. SMC's 1997 capital budget for systems improvements is $250,000. Also, SMC anticipates minimal expenditure to be required in the update of the MIS system for the year 2000. Standard Management International's administrative and management information services departments in Luxembourg are an autonomous unit from the systems in the United States. SMC is in the process of 9 11 improving the MIS systems of Standard Management International and integrating them with the U.S. systems. INVESTMENTS Investment activities are an integral part of SMC's business; investment income of SMC's insurance subsidiaries is an important part of its total revenues. Profitability is significantly affected by spreads between rates credited on insurance liabilities and interest yield on invested assets. Substantially all credited rates on FPDAs may be changed at least annually. As of December 31, 1996, the weighted average interest rate credited on SMC's interest-sensitive liability portfolio, excluding liabilities related to separate accounts, was approximately 5.35% per annum, and the average net yield of SMC's investment portfolio for the year ended December 31, 1996 was 7.36% for a spread of 2.01% at December 31, 1996, compared to 2.05% at December 31, 1995. The decrease in the net spread in 1996 is primarily attributable to sales of FPDAs in 1996 with higher and more competitive crediting interest rates. Increases or decreases in interest rates could increase or decrease the interest rate spread between investment yields and interest rates credited on insurance liabilities, which in turn could have a beneficial or adverse effect on the future profitability of SMC. Sales of fixed maturity securities that result in investment gains may also tend to decrease future interest rate spreads. State insurance laws and regulations prescribe the types of permitted investments and limit their concentration in certain classes of investments. The following table shows SMC's pre-tax investment performance for the periods indicated.
YEAR ENDED DECEMBER 31, -------------------------------------- 1996 1995 1994 ---- ---- ---- (DOLLARS IN THOUSANDS) Average invested assets(1)............................... $285,186 $253,055 $221,138 Net investment income.................................... 20,871 18,517 16,057 Weighted average annual yield(2)......................... 7.32% 7.32% 7.26% Net realized investment gains............................ $ 1,302 $ 688 $ 558
- ------------------------- (1) Average invested assets are computed by dividing the total of the amortized cost of investments at the beginning of the period plus the individual quarter-end balances by the number of quarterly periods plus one. (2) The weighted average annual yield on SMC's investment portfolio for each period is computed by dividing net investment income (exclusive of realized and unrealized gains and losses) by average invested assets for such period. 10 12 The following table shows the amortized cost, gross unrealized gain (loss) and estimated fair value of SMC's securities available for sale:
DECEMBER 31, 1996 ------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ----- (DOLLARS IN THOUSANDS) Fixed maturity securities: United States Treasury securities and obligations of United States government agencies........... $ 20,753 $ 51 $ 420 $ 20,384 Obligations of states and political subdivisions................................... 3,588 106 -- 3,694 Foreign government securities..................... 10,042 51 166 9,927 Mortgage-backed securities........................ 72,264 247 919 71,592 Utilities......................................... 31,000 295 675 30,620 Corporate bonds................................... 210,977 3,086 3,539 210,524 Redeemable preferred stock........................ 527 42 -- 569 -------- ------ ------ -------- Total fixed maturity securities................ 349,151 3,878 $5,719 347,310 Equity securities................................... 58 4 -- 62 -------- ------ ------ -------- Total.......................................... $349,209 $3,882 $5,719 $347,372 ======== ====== ====== ========
DECEMBER 31, 1995 ------------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE --------- ---------- ---------- ----- (DOLLARS IN THOUSANDS) Fixed maturity securities: United States Treasury securities and obligations of United States government agencies........... $ 19,331 $ 452 $ 19 $ 19,764 Obligations of states and political subdivisions................................... 60 -- -- 60 Foreign government securities..................... 5,056 118 3 5,171 Mortgaged-backed securities....................... 45,161 417 416 45,162 Utilities......................................... 23,916 462 186 24,192 Corporate bonds................................... 132,119 7,281 1,657 137,743 -------- ------ ------ -------- Total fixed maturity securities................ 225,643 8,730 2,281 232,092 Equity securities................................... 52 -- -- 52 -------- ------ ------ -------- Total.......................................... $225,695 $8,730 $2,281 $232,144 ======== ====== ====== ========
The fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services, or by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit, and maturity of the investments. SMC balances the duration of its invested assets with the expected duration of benefit payments arising from insurance liabilities. The "duration" of a security is the time-weighted present value of the security's cash flows and is used to measure a security's price sensitivity to changes in market interest rates. At December 31, 1996, the adjusted modified duration of fixed maturities and short-term investments for its U.S. insurance subsidiaries was 5.5 years compared to 5.4 years at December 31, 1995. The amortized cost and estimated fair value of fixed maturity securities at December 31, 1996 by contractual maturity are shown below. Actual maturities will differ from contractual maturities because 11 13 borrowers may have the right to call or prepay obligations with or without call or prepayment penalties and because most mortgage-backed securities provide for periodic payments throughout their lives.
AMORTIZED FAIR COST VALUE --------- ----- (DOLLARS IN THOUSANDS) Due in one year or less.................................. $ 7,418 $ 7,435 Due after one year through five years.................... 24,818 24,970 Due after five years through ten years................... 123,503 123,075 Due after ten years...................................... 120,621 119,669 -------- -------- Subtotal............................................ 276,360 275,149 Redeemable preferred stock............................... 527 569 Mortgage-backed securities............................... 72,264 71,592 -------- -------- Total fixed maturity securities..................... $349,151 $347,310 ======== ========
SMC's investment strategy is guided by strategic objectives established by the Investment Committee of the Board of Directors of Standard Life. SMC's major investment objectives are: (i) to ensure adequate safety of investments and to protect and enhance capital; (ii) to maximize after-tax return on investments; (iii) to match the anticipated duration of investments with the anticipated duration of policy liabilities; and (iv) to provide sufficient liquidity to meet cash requirements with minimum sacrifice of investment yield. Consistent with its strategy, SMC invests primarily in securities of the U.S. government and its agencies, investment grade utility and corporate debt securities and collateralized mortgage obligations ("CMOs"). From time to time when opportunities arise, however, below investment grade securities may be purchased. Protection against default risk is a primary consideration. SMC has determined it will not invest more than 7% of its bond portfolio in below investment grade securities. The following table sets forth the quality of SMC's fixed maturity securities as of December 31, 1996, classified in accordance with the ratings assigned by the National Association of Insurance Commissioners ("NAIC"):
PERCENT OF FIXED NAIC RATING (1) MATURITY SECURITIES --------------- ------------------- 1........................................................... 49% 2........................................................... 47 --- Investment Grade.......................................... 96 3-4......................................................... 4 5-6......................................................... -- --- Below Investment Grade.................................... 4 --- Total fixed maturity securities........................ 100% ===
- ------------------------- (1) The NAIC assigns securities quality ratings and uniform book values called "NAIC Designations," which are used by insurers when preparing their annual statements. The NAIC assigns ratings to publicly traded as well as privately-placed securities. The ratings assigned by the NAIC range from Class 1 to Class 6, with a rating in Class 1 being of the highest quality. SMC engages Conseco Capital Management Inc. ("CCM"), a wholly owned subsidiary of Conseco, Inc., to manage SMC's invested assets (other than mortgage loans, policy loans, real estate and other invested assets), subject to the direction of SMC's investment committee. A quarterly fee equal to .035% of the total market value of the assets under management as of the end of each quarter is paid to CCM for its investment advisory services. Approximately 21% of SMC's fixed maturity securities at December 31, 1996 is comprised of mortgage-backed securities. Investments in mortgage-backed securities include CMOs and mortgage-backed pass-through securities. Approximately 79% of the book value of the mortgage-backed securities in SMC's portfolio 12 14 are backed by an agency of the U.S. government (although generally not by the full faith and credit of the U.S. government) as to the full amount of both principal and interest. SMC closely monitors the market value of all investments within its mortgage-backed portfolio. The following table summarizes SMC's mortgage-backed securities at December 31, 1996:
ESTIMATED % OF % OF AVG. LIFE AVG. TERM BOOK FIXED FAIR FIXED OF TO FINAL VALUE MATURITIES VALUE MATURITIES INVESTMENT MATURITY ----- ---------- ----- ---------- ---------- --------- (DOLLARS IN THOUSANDS) (IN YEARS) (IN YEARS) Agency CMOs: Planned and target amortization classes....................... $23,371 6.7 $22,827 6.6 6.7 25.2 Sequential and support classes... 1,417 .4 1,456 .4 7.3 22.1 ------- ---- ------- ---- ---- ---- Total......................... 24,788 7.1 24,282 7.0 6.7 25.0 Non-agency CMOs: Planned amortization classes..... 1,492 .4 1,448 .4 10.8 27.0 Sequential classes............... 13,673 3.9 13,550 3.9 8.2 22.2 ------- ---- ------- ---- ---- ---- Total......................... 15,165 4.3 14,998 4.3 8.5 22.7 ------- ---- ------- ---- ---- ---- Total CMOs......................... 39,953 11.4 39,280 11.3 7.4 24.1 Agency mortgage-backed pass-through securities....................... 32,311 9.3 32,312 9.3 7.2 17.4 ------- ---- ------- ---- ---- ---- Total mortgage-backed securities.................. $72,264 20.7 $71,592 20.6 7.3 21.0 ======= ==== ======= ==== ==== ====
The market values for SMC's mortgage-backed securities were determined from broker-dealer market makers, internally developed methods and nationally recognized statistical rating organizations. Certain mortgage-backed securities are subject to significant prepayment risk, since, in periods of declining interest rates, mortgages may be repaid more rapidly than scheduled as individuals refinance higher rate mortgages to take advantage of the lower current rates. As a result, holders of mortgage-backed securities may receive large prepayments on their investment which cannot be reinvested at an interest rate comparable to the rate on the prepaying mortgages. SMC has addressed this risk of prepayment risk by investing 34% of its mortgage-backed investment portfolio in planned and target amortization classes. These investments are designed to amortize in a more predictable manner by shifting the primary risk of prepayment of the underlying collateral to investors in other tranches ("support classes"). Mortgage-backed pass-through securities, "sequential" and support class CMOs, comprising approximately 66% of the book value of SMC's mortgage-backed securities at December 31, 1996, are more sensitive to this prepayment risk. SEPARATE ACCOUNTS Separate account assets and liabilities are maintained primarily for universal life contracts of which the majority represents unit-linked business where benefits on surrender and maturity are not guaranteed; also there are investment contracts under which fixed benefits are paid to the policyholder and the terms of which are such that there is little or no mortality risk. They generally represent funds held in accounts to meet specific investment objectives of policyholders who bear the investment risk. Investment income and investment gains and losses accrue directly to such policyholders. UNDERWRITING Premiums charged on insurance products are based in part on assumptions about the incidence and timing of insurance claims. SMC has adopted and follows underwriting procedures for both its whole life and universal life insurance policies. To implement these procedures, SMC employs a professional underwriting staff. All underwriting decisions are made in SMC's home office. To the extent that an applicant does not 13 15 meet SMC's underwriting standards for issuance of a policy at the standard risk classifications, SMC may rate or decline the application. Underwriting with respect to FPDAs is minimal. No underwriting procedures are applied to Standard Life's $10,000 conversion policy or Standard Management International's unit-linked business. Traditional underwriting procedures are not applied to policies acquired in blocks. In these cases, SMC reviews the mortality experience for recent years and compares actual experience to that assumed in the actuarial projections for the acquired policies. RESERVES In accordance with applicable insurance laws, SMC's insurance subsidiaries have established and carry as liabilities in their statutory financial statements actuarially determined reserves to satisfy their respective annuity contract and life insurance policy obligations. Reserves, together with premiums to be received on outstanding policies and interest thereon at certain assumed rates, are calculated to be sufficient to satisfy policy and contract obligations. The actuarial factors used in determining such reserves are based on statutorily prescribed mortality tables and interest rates. The reserves recorded in the consolidated financial statements included elsewhere herein are calculated based on GAAP and differ from those specified by the laws of the various states and recorded in the statutory financial statements of SMC's insurance subsidiaries. These differences arise from the use of different mortality tables and interest rate assumptions, the introduction of lapse assumptions into the reserve calculation and the use of the net level premium reserve method on all insurance business. See Note 1 of the Notes to the Consolidated Financial Statements for certain additional information regarding reserve assumptions under GAAP. To determine policy benefit reserves for its life insurance and annuity products, SMC performs periodic studies to compare current experience for mortality, interest and lapse rates with projected experience used in calculating the reserves. Differences are reflected currently in earnings for each period. SMC historically has not experienced significant adverse deviations from its assumptions. REINSURANCE Consistent with the general practice of the life insurance industry, SMC has reinsured portions of the coverage provided by its insurance products with other insurance companies under agreements of indemnity reinsurance. Prior to January 1, 1995, reinsurance was not maintained with respect to SMC's currently marketed annuity products. The policy risk retention limit on the life of any one individual does not exceed $150,000. Indemnity reinsurance agreements are intended to limit a life insurer's maximum loss on a particular risk or to obtain a greater diversification of risk. Indemnity reinsurance does not discharge the primary liability of the original insurer to the insured, but it is the practice of insurers (subject to certain limitations of state insurance statutes) to account for risks which have been reinsured with other approved companies, to the extent of the reinsurance, as though they are not risks for which the original insurer is liable. Reinsurance ceded on life insurance policies to unaffiliated companies by SMC in 1996, 1995 and 1994 represented 57.6%, 68.8% and 75.4%, respectively, of gross combined individual life insurance in force at the end of such years. Reinsurance assumed in the normal course from unaffiliated companies by SMC (other than GIAC) in 1996, 1995 and 1994 represented .02%, .04% and .05% of net combined individual life insurance in force, respectively. SMC cedes reinsurance to numerous reinsurers. At December 31, 1996, approximately $477,980,000 of the face value of life policies had been ceded to The Lincoln National Life Insurance Company ("Lincoln National"), with $203,097,000 ceded to Security Life of Denver Insurance Company ("Security Life") and $191,813,000 ceded to The Mercantile and General Reinsurance Company ("Mercantile"). Lincoln National is the lead reinsurer with a total of 29.3% of total reinsurance ceded with Security Life and Mercantile each accounting for 12.4% and 11.7%, respectively of total reinsurance ceded by SMC's life insurance subsidiaries at December 31, 1996. The amount of life insurance business ceded to any 14 16 other reinsurer is not material. Of SMC's total life insurance in force at December 31, 1996 that is reinsured, 100.0% is ceded to insurers rated "A" or better by A.M. Best. SMC historically has not experienced any material losses in collection of reinsurance receivables. Commencing January 1, 1995, SMC began to reinsure a portion of its annuity business. The primary purposes of the reinsurance agreement were to limit the net loss arising from large risks, maintain SMC's exposure to loss within capital resources, and provide additional capacity for future growth. Furthermore, these reinsurance agreements have allowed SMC to write volumes of business that it would not otherwise have been able to write due to regulatory restrictions based on the amount of its statutory capital and surplus. SMC's largest annuity reinsurer at December 31, 1996, Winterthur Life Re Insurance Company ("Winterthur"), is rated "A" (Excellent) by A.M. Best. From January 1, 1995 to August 31, 1995 approximately 70% of certain of Standard Life's annuity business produced was ceded. SMC decreased the quota-share portion of business ceded to 50% at September 1, 1995 and further reduced it to 25% effective April 1, 1996. This reduction was possible since the surplus strain experienced by Standard Life was not as great as originally anticipated as a result of lower than expected sales in 1995 and the increase in surplus resulting from the sale of First International. Winterthur limits dividends and other transfers by Standard Life to SMC or affiliated companies in certain circumstances. At December 31, 1996, total annuity resources ceded to Winterthur amounted to $26,138,000. On March 18, 1996, Standard Life completed the sale of First International to GIAC. Standard Life received sale proceeds of approximately $11,493,000 including $1,500,000 for the charter and licenses associated with First International and $1,800,000 of reinsurance ceding commissions. Standard Life realized a net pretax gain of $1,041,692 and a tax benefit of $1,420,000 on the sale. First International, Standard Life and GIAC have entered into a series of reinsurance and other agreements that include provisions for Standard Life to administer First International policies in force at the date of sale, and for Standard Life to continue to receive the profit stream from the majority of First International's inforce business effective January 1, 1996. All the inforce business of First International effective January 1, 1996 was ceded to GIAC through a coinsurance indemnity reinsurance agreement. Under the terms of the agreement, approximately $18,841,000 of First International's reserves and the related assets were ceded to GIAC as of January 1,1996. The inforce business related to this automatic coinsurance indemnity reinsurance agreement is comprised of the following two blocks; ("Block I") -- ordinary life policies (issued in New York and New Jersey), universal life, immediate and deferred annuities (issued in New York, New Jersey and Vermont), supplemental contracts and group waivers, and ("Block II") -- ordinary life policies (not issued in New York and New Jersey) issued prior to 1989, and term life policies (issued in New York, New Jersey and Vermont) issued after 1988. Effective at January 1, 1996, GIAC entered into a modified coinsurance indemnity reinsurance agreement with Standard Life with respect to Blocks I and II. Under the terms of the agreement, approximately $18,841,000 of Standard Life's reserves were assumed from GIAC as of January 1, 1996. Standard Life incurs experience rating refunds to GIAC on Block I. There is no experience rating refund on Block II. As part of the acquisition of First International by SMC in 1992, Standard Life entered into an indemnity reinsurance agreement with First International effective July 1, 1992. This business was subsequently assumed by Standard Life effective January 1, 1993. At the date of the sale of First International to GIAC, Standard Life ceded this block of business with policy reserves of $12,514,000 and related assets to GIAC, pursuant to an automatic coinsurance indemnity reinsurance agreement. This block of business ("Block III") consisted of term life policies (not issued in New York, New Jersey or Vermont) issued after 1988 and immediate and deferred annuities (not issued in New York, New Jersey and Vermont) and lottery annuities. Standard Life will continue to receive profits from Block III through experience rating refunds from GIAC on Block III. Standard Life received an administration fee of $316,000 for the year ended December 31, 1996 from First International for the administration of the Block I and Block II policies that were in force at the time of the sale of First International. 15 17 SMC decided in February 1996 to terminate the reinsurance agreement between Standard Reinsurance and Salamandra, and to not renew the Barbados license of Standard Reinsurance. This resulted in the termination of Standard Reinsurance's operations and the write-off of SMC's investment in Standard Reinsurance and certain intangible assets of Standard Reinsurance amounting to $155,856. Standard Life terminated by recapture in May 1996 the reinsurance agreement with National Mutual. Standard Life received assets of $5,200,554 and liabilities of $4,953,055, primarily ordinary life policies. In connection with this transaction, Standard Life collected administration fees of $375,000 related to services provided in prior years that had not been recorded previously due to the uncertainty as to its collection. This administration fee income and premium income recorded in connection with the recapture will not recur in the future. In order to write an increasing amount of new business while continuing to meet the statutory requirements of the states in which it conducts its insurance operations, it has been necessary for Dixie National Life to utilize various forms of surplus relief. The principal source of surplus relief since 1989 has been financial reinsurance agreements, which for GAAP purposes are treated as financing arrangements, but for statutory accounting purposes provide reserve credits that, in equal amount, increase statutory surplus. Dixie National Life has a financial reinsurance agreement that entitles it to a credit to its statutory reserves of $1,500,000 at December 31, 1996, with the amount of the credit decreasing each quarter by the amount of profit generated to Dixie National Life by the underlying block of business. COMPETITION The life insurance industry is highly competitive and consists of a large number of both stock and mutual insurance companies, many of which have substantially greater financial resources, broader and more diversified product lines and larger staffs than those possessed by SMC. There are approximately 2,000 life insurance companies in the United States which may offer insurance products similar to those marketed by SMC. Competition within the life insurance industry occurs on the basis of, among other things, product features such as price and interest rates, perceived financial stability of the insurer, policyholder service, name recognition and ratings assigned by insurance rating organizations. Additionally, when SMC bids on companies it wishes to acquire, it typically is in competition with other entities. SMC must also compete with other insurers to attract and retain the allegiance of agents. SMC believes it has been successful in attracting and retaining agents because it has been able to offer a competitive package of innovative products, competitive commission structures, prompt policy issuance and responsive policyholder service. Because most annuity business written by life companies is through agents, management believes that competition centers more on the strength of the agent relationship rather than on the identity of the insurer. Competition also is encountered from the expanding number of banks, securities brokerage firms and other financial intermediaries that are marketing insurance products and that offer competing products such as savings accounts and securities. A change in legislation may increase interest on the part of banks to begin selling annuities or to expand their existing efforts to sell annuities. The decision could result in a partial shift in the distribution of annuities from insurance agents to national banks, which, in turn, could result in a decrease in sales for SMC, or it could result in an increase in the number of annuities sold because of distribution through national banks (or securities firms), which could result in new distribution opportunities for SMC. Financial institutions, school districts, marketing companies, agents who market insurance products and policyholders use the ratings of an insurer as one factor in determining which insurer's annuity to market or purchase. Standard Life and Dixie National Life have a rating of "B" and "B-", respectively by A.M. Best, an insurance rating organization. A rating of "B" or "B-" is assigned by A.M. Best to companies which, in their opinion, have achieved adequate overall performance when compared to the standards established by A.M. Best. According to A.M. Best, these companies generally have an adequate ability to meet their obligations to policyholders, but their financial strength is vulnerable to unfavorable changes in underwriting or economic conditions. In evaluating a company's financial and operating performance, A.M. Best reviews the company's profitability, leverage and liquidity as well as the company's book of business, the adequacy and 16 18 soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its reserves and the experience and competence of its management. A.M. Best's ratings are based upon factors relevant to policyholders, agents, insurance brokers and intermediaries and are not directed to the protection of investors. Generally, rating agencies base their ratings on information furnished to them by the issuer and on investigations, studies and assumptions by the rating agencies. There is no assurance that any particular rating will continue for any given period of time or that it will not be changed or withdrawn entirely if, in the judgement of the rating agency, circumstances so warrant. Although a higher rating by A.M. Best or another insurance rating organization could have a favorable effect on Standard Life and Dixie National Life's business, management believes that Standard Life and Dixie National Life are able to compete on the basis of their competitive crediting rates, asset quality, strong relations with their independent agents and the quality of service to their policyholders. FEDERAL INCOME TAXATION The life insurance and annuity products marketed and issued by Standard Life and Dixie National Life generally provide the policyholder with an income tax advantage, as compared to other saving investments such as certificates of deposit and bonds, in that income taxation on the increase in value of the product is deferred until receipt by the policyholder. With other savings investments, the increase in value is taxed as earned. Life insurance benefits which accrue prior to the death of the policyholder and annuity benefits are generally not taxable until paid and life insurance death benefits are generally exempt from income tax. The tax advantage for life insurance and annuity products is provided in the Internal Revenue Code ("IRC"), and is generally followed in all states and other United States taxing jurisdictions. Accordingly, it is subject to change by Congress and the legislatures of the respective taxing jurisdictions. SMC, Standard Marketing and other U.S. non-insurance subsidiaries file a consolidated return for federal income tax purposes. Standard Life and Dixie National Life, as life insurance companies, file separate federal income tax returns. As of December 31, 1996, SMC, Standard Marketing and other U.S. non- insurance subsidiaries had consolidated net operating loss carryforwards of approximately $8,600,000 for tax return purposes which expire from 2005 to 2011. At December 31, 1996, Standard Life had tax return net operating loss carry forwards of approximately $1,400,000, which expire in 2004 and 2005. As a result of changes in ownership of SMC and Standard Life, use of the loss carry forwards of Standard Life are subject to annual limitations. The maximum tax return operating loss carryforwards available for use by Standard Life in any one year are approximately $300,000. At December 31, 1996, Dixie National Life had tax return net operating loss carryforwards of approximately $5,800,000, which expire in 2010 and 2011. Standard Management International is a Luxembourg holding company which is currently exempt from Luxembourg income tax. Premier Life (Bermuda) is exempt from income tax until March 2016 pursuant to a decree from the Minister of Finance. Premier Life (Luxembourg) is subject to Luxembourg income taxation (statutory corporate rate of 39.39%) and a capital tax of approximately 1% of its net equity. At December 31, 1996, Premier Life (Luxembourg) had accumulated corporate income tax loss carryforwards of approximately $5,900,000, all of which may be carried forward indefinitely. To the extent that such income is taxable under U.S. law, such income will be included in SMC's consolidated return. INFLATION The primary direct effect on SMC of inflation is the increase in operating expenses. A large portion of SMC's operating expenses consists of salaries which are subject to wage increases at least partly affected by the rate of inflation. SMC attempts to minimize the impact of inflation on operating expenses through programs to improve productivity. The rate of inflation also has an indirect effect on SMC. To the extent that the government's economic policy to control the level of inflation results in changes in interest rates, SMC's new sales of insurance products and investment income are affected. Changes in the level of interest rates also have an effect on interest spreads, as investment earnings are reinvested. 17 19 FOREIGN OPERATIONS AND CURRENCY RISK SMC's foreign operations represent the Standard Management International group which consists of a Luxembourg holding company and two life insurance subsidiaries: Premier Life (Luxembourg) and Premier Life (Bermuda). Standard Management International policyholders invest in assets denominated in a wide range of currencies. Policyholders effectively bear the currency risk, if any, as these investments are matched by policyholder separate account liabilities. Therefore, their investment and currency risk is limited to premiums they have paid. Policyholders are not permitted to invest directly into options, futures and derivatives. Standard Management International could be exposed to currency fluctuations if currencies within the conventional investment portfolio or certain actuarial reserves are mismatched. The assets and liabilities of this portfolio and the reserves are continually matched by the company and at regular intervals by the independent actuary. In addition, Premier Life (Luxembourg)'s stockholder's equity is denominated in Luxembourg francs. Premier Life (Luxembourg) does not hedge it's translation risk because its stockholder's equity will remain in Luxembourg francs for the foreseeable future and no significant realized foreign exchange gains or losses are anticipated. At December 31, 1996, there is an unrealized gain from foreign currency translation adjustment of $691,000. Due to the nature of unit-linked products issued by Standard Management International, which represent over 91% of the Standard Management International portfolio, the investment risk rests with the policyholder. Investment risk for Standard Management International exists where Standard Management International makes investment decisions with respect to the remaining traditional business and for the assets backing certain actuarial and regulatory reserves. The investments underlying these liabilities mostly represent short term investments and fixed maturity securities. These short term investments and fixed maturity securities are normally only bought and/or disposed of on the advice of independent consulting actuaries who perform an annual exercise comparing anticipated cash flows on the insurance portfolio with the cash flows from the fixed maturity securities. Any resulting material foreign currency mismatches are then covered by buying and/or selling the securities as appropriate. REGULATORY FACTORS SMC's insurance subsidiaries are subject to regulation by the insurance regulatory authorities in the jurisdictions in which they are domiciled and the insurance regulatory bodies in the other jurisdictions in which they are licensed to sell insurance. The purpose of such regulation is primarily to ensure the financial stability of insurance companies and to provide safeguards for policyholders rather than to protect the interest of stockholders. The insurance laws of various jurisdictions establish regulatory agencies with broad administrative powers relating to the licensing of insurers and their agents, the regulation of trade practices, management agreements, the types of permitted investments and maximum concentration, deposits of securities, the form and content of financial statements, rates charged by insurance companies, sales literature and insurance policies, accounting practices and the maintenance of specified reserves, capital and surplus. Each of SMC's insurance subsidiaries is required to file detailed periodic financial reports with supervisory agencies in certain of the jurisdictions in which they do business. Most states have enacted legislation regulating insurance holding companies. The insurance holding company laws and regulations vary by state, but generally require an insurance holding company and its insurance company subsidiaries licensed to do business in the state to register and file certain reports with the regulatory authorities, including information concerning capital structure, ownership, financial condition, certain intercompany transactions and general business operations. State holding company laws also require prior notice or regulatory agency approval of certain material intercompany transfers of assets within the holding company structure. As a holding company, Standard Management's ability to pay operating expenses and meet debt service obligations if any, depends on the receipt of sufficient funds, primarily through management fees, rental income, dividends and interest payments on its Surplus Debentures from its subsidiaries. Subject to the restrictions described below, Standard Management may receive dividends from its direct subsidiaries, 18 20 Standard Life, Standard Management International and Standard Marketing. Dixie National Life is a subsidiary of Standard Life. Accordingly, any dividends paid by Dixie National Life to Standard Life may be paid to Standard Management only if Standard Life is entitled to pay dividends to Standard Management. Under Indiana insurance law, Standard Life may not enter into certain transactions, including management agreements and service contracts, with members of its insurance holding company system, including Standard Management, unless Standard Life has notified the Indiana Department of Insurance of its intention to enter into such transactions and the Indiana Department of Insurance has not disapproved of them within the period specified by Indiana law. Among other things, such transactions are subject to the requirement that their terms be fair and reasonable and that the charges or fees for services performed be reasonable. Pursuant to the management services agreement with Standard Management, Standard Life paid Standard Management a monthly fee of $150,000 during 1996 and 1995 for certain management services related to the production of business, investment of assets and evaluation of acquisitions. Management service agreements between Standard Life and Dixie National Life, which currently require a monthly payment of $100,000 have been approved by the Mississippi Department of Insurance. Both of these agreements provide that they may be modified or terminated by the Indiana and Mississippi departments of insurance in the event of financial hardship of Standard Life or Dixie National Life. The management service agreement between Standard Management and Standard Life has been renegotiated to increase the monthly fee to $166,667 (annual fee of $2,000,000) in 1997. This amended management service agreement has been approved by the Commissioner of the Indiana Department of Insurance. Dividends by Standard Life to Standard Management are limited by laws applicable to insurance companies. As an Indiana domiciled insurance company, Standard Life may pay a dividend or distribution from its surplus profits, without the prior approval of the Commissioner of the Indiana Department of Insurance, if the dividend or distribution, together with all other dividends and distributions paid within the preceding twelve months, does not exceed the greater of (i) net gain from operations or (ii) 10% of surplus, in each case as shown in its preceding annual statutory financial statements. Also, regulatory approval is required when dividends to be paid exceed unassigned surplus. For the year ended December 31, 1996, Standard Life reported statutory net gain from operations of $1,427,300, statutory surplus of $22,969,666 and unassigned surplus of, $1,139,659. Standard Life anticipates paying dividends of approximately $1,600,000 in 1997 and the approval of the Commissioner of the Indiana Department of Insurance may be required. Standard Life has declared a dividend of $1,000,000 to be paid in April 1997. The Indiana insurance laws and regulations require that the statutory surplus of Standard Life following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate to its financial needs. The Indiana Department of Insurance may bring an action to enjoin or rescind the payment of a dividend or distribution by Standard Life that would cause its statutory surplus to be unreasonable or inadequate under this standard. Under Luxembourg law, Standard Management International dividends are limited to its accumulated earnings without regulatory approval. Standard Management International and Premier Life (Luxembourg) were not permitted to pay dividends in 1996 and 1995 due to accumulated losses, and none are anticipated in 1997. Premier Life (Bermuda) did not pay dividends in 1996 and 1995. Pursuant to the management services agreement with Standard Management, Premier Life (Luxembourg) paid Standard Management a management fee of $100,000 per year during 1996 and 1995 for certain management and administrative services. The agreement provides that it may be modified or terminated by either Standard Management or Premier Life (Luxembourg). Most states, including Indiana, require administrative approval of the acquisition of 10% or more of the outstanding shares of an insurance company incorporated in the state or the acquisition of 10% or more of the outstanding shares of an insurance holding company whose insurance subsidiary is incorporated in the state. The request for approval must be accompanied by detailed information concerning the acquiring parties and the plan of acquisition. The acquisition of 10% of such shares is generally deemed to be the acquisition of "control" for the purpose of the holding company statutes. However, in many states the insurance authorities 19 21 may find that "control" in fact does or does not exist in circumstances in which a person owns or controls either a lesser or a greater amount of securities. In some instances many state regulatory authorities require deposits of assets for the protection of policyholders either in those states or for all policyholders. At December 31, 1996, securities representing approximately 4% of the book value of SMC's U.S. insurance subsidiaries' invested assets were on deposit with various state treasurers or custodians. Such deposits must consist of securities that comply with the standards that the particular state has established. Assets of Standard Management International of $7,750,000 at December 31, 1996 were held by a custodian bank approved by the Luxembourg regulatory authorities to comply with local insurance laws. In recent years, the NAIC and state insurance regulators have reexamined existing laws and regulations and their application to insurance companies. This reexamination has focused on insurance company investment and solvency issues, risk-based capital guidelines, assumption reinsurance, interpretations of existing laws, the development of new laws, the interpretation of nonstatutory guidelines, the standardization of statutory accounting rules and the circumstances under which dividends may be paid. The NAIC has encouraged states to adopt model NAIC laws on specific topics such as holding company regulations and the definition of extraordinary dividends. It is not possible to predict the future impact of changing state regulation on the operations of SMC. The NAIC, as well as Indiana and Mississippi, has adopted RBC requirements for U.S. life/health insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. The RBC formula is used by state insurance regulators as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. The RBC guidelines are intended to be a regulatory tool only, and are not intended as a means to rank insurers generally. In addition, the formula defines minimum capital standards that supplement the previously existing system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Enterprises below specific trigger points or ratios are classified within certain levels, each of which requires specific corrective action. If a company's RBC ratio is in the Company Action Level range defined as an RBC ratio of 1.5-2, the company must submit a plan to improve its RBC ratio. The Regulatory Action Level range defined as an RBC ratio of 1-1.5 provides that regulators will order corrective actions. At the Authorized Control Level range defined as an RBC ratio of 0.7-1, regulators are authorized to take control of the company. Finally, at the Mandatory Control Level defined as ratios below 0.7, regulators must take over the company. The RBC ratios of SMC's U.S. insurance subsidiaries are all in excess of 4 at December 31, 1996. However, should the insurance subsidiaries' RBC position decline in the future, the insurance subsidiaries' continued ability to pay dividends and the degree of regulatory supervision or control to which they are subjected could be affected. SMC attempts to manage its assets and liabilities so that income and principal payments received from investments are adequate to meet the cash flow requirements of its policyholder liabilities. The cash flows of SMC's liabilities are affected by actual maturities, surrender experience and credited interest rates. SMC periodically performs cash flow studies under various interest rate scenarios to evaluate the adequacy of expected cash flows from its assets to meet the expected cash requirements of its liabilities. SMC utilizes these studies to determine if it is necessary to lengthen or shorten the average life and duration of its investment portfolio. Because of the significant uncertainties involved in the estimation of asset and liability cash flows, there can be no assurance that SMC will be able to effectively manage the relationship between its asset and liability cash flows. In December 1995, the NAIC passed a model law for disclosure in life insurance policy illustrations which became effective on January 1, 1997. This law is not anticipated to have a significant effect on SMC. New rules adopted by the NAIC are effective only to the extent adopted by the states in which SMC operates, 20 22 and it is not possible to predict the future impact of changing state and federal regulation on the operations of SMC. The statutory filings of SMC's insurance subsidiaries require classifications of investments and the establishment of an AVR, an account designed to stabilize a company's statutory surplus against fluctuations in the market value of stocks and bonds, according to regulations prescribed by the NAIC. The AVR account consists of two main components: a "default component" to provide for future credit-related losses on fixed income investments and an "equity component" to provide for losses on all types of equity investments, including real estate. The NAIC requires an additional reserve, called the IMR, which consists of the portion of realized capital gains and losses from the sale of fixed income securities attributable to changes in interest rates. The IMR, is required to be amortized against earnings on a basis reflecting the remaining period to maturity of the fixed income securities sold. These regulations affect the ability of SMC's insurance subsidiaries to reflect future investment gains and losses in current period statutory earnings and surplus. The amounts related to AVR and IMR for the insurance subsidiaries at December 31, 1996 are summarized as follows:
MAXIMUM AVR AVR IMR --- ------- --- (DOLLARS IN THOUSANDS) Standard Life....................................... $3,553 $6,193 $8,418 Dixie National Life................................. 213 404 81
The annual addition to the AVR for 1996 is 20% of the maximum reserve over the accumulated balance. If the calculated reserve with current year additions exceeds the maximum reserve amount, the reserve is reduced to the maximum amount. For the year ended December 31, 1996, SMC's U.S. subsidiaries each made the required contribution to the AVR . Most jurisdictions require insurance companies to participate in guaranty funds designed to cover claims against insolvent insurers. Insurers authorized to transact business in these jurisdictions are generally subject to assessments based on annual direct premiums written in that jurisdiction to pay such claims, if any. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future state premium taxes. The incurrence and amount of such assessments have increased in recent years and may increase further in future years. Standard Life and Dixie National Life were assessed, and paid, $144,000 and $63,000 for the year ended December 31, 1996, respectively. The likelihood and amount of all future assessments cannot be reasonably estimated and are beyond the control of SMC. As part of their routine regulatory oversight process, approximately once every three to five years state insurance departments conduct periodic detailed examinations ("Examinations") of the books, records and accounts of insurance companies domiciled in their states. Standard Life underwent an Examination during 1996 for the five-year period ended December 31, 1995. The final report on such examination has been issued by the Indiana Department of Insurance and did not raise any significant issues. The Mississippi Department of Insurance concluded the Report of Examination of Dixie National Life for the period of January 1, 1991 through December 31, 1994 on October 18, 1995 and did not raise any significant issues. Although the federal government generally does not directly regulate the insurance industry, federal initiatives often have an impact on the business. Congress and certain federal agencies are investigating the current condition of the insurance industry (encompassing both life and health and property and casualty insurance) in the United States in order to decide whether some form of federal role in the regulation of insurance companies would be appropriate. Congress is currently conducting a variety of hearings relating in general to insurers. It is not possible to predict the outcome of any such congressional activity nor the potential effects thereof on SMC. Congressional initiatives have been introduced which are directed at repeal of the McCarran-Ferguson Act (which exempts the "business of insurance" from most federal laws to the extent it is subject to state regulation), and judicial decisions have been issued which narrow the definition of "business of insurance" for 21 23 McCarran-Ferguson Act purposes. Current and proposed federal measures which may also significantly affect the insurance industry including removal of barriers preventing banks from engaging in the insurance business. EMPLOYEES As of December 31, 1996, SMC had 87 employees: Standard Life had 55 employees, Standard Management International had 11 employees (3 of whom are covered by a collective bargaining agreement), Standard Marketing had 11 employees, and Standard Management had 10 employees. Dixie National Life has no current direct employees, which is consistent with SMC's management technique of eliminating an acquired company's staff and replacing them with its own employees. SMC believes that its future success will depend, in part, on its ability to continue to attract and retain highly-skilled technical, marketing, support and management personnel. Management believes that it has excellent relations with its employees. ITEM 2. PROPERTIES SMC leases approximately 31,000 square feet in an office building located at 9100 Keystone Crossing, Indianapolis, Indiana, under the terms of a lease which expires on June 1, 2001. SMC entered into a lease on March 31, 1997, for approximately 16,000 square feet in a warehouse located at 2525 North Shadeland, Indianapolis, Indiana, under the terms of a lease which expires on September 30, 1999. Standard Management International entered into a lease on March 15, 1996 for approximately 3,000 square feet in an office building located at 1, rue Emile Bian, L-1235 Luxembourg, Luxembourg, under the terms of a lease which expires on December 15, 1997. Dixie National Life leases approximately 1,000 square feet in an office complex located at 855 South Pear Orchard Road, Suite 305, Ridgeland, Mississippi, under the terms of a lease which expires on December 31, 1997. ITEM 3. LEGAL PROCEEDINGS SMC is involved in various legal proceedings in the normal course of business. In most cases, such proceedings involve claims under insurance policies or other contracts of SMC. The outcomes of these legal proceedings are not expected to have a material adverse effect on the consolidated financial position, liquidity, or future results of operations of SMC based on SMC's current understanding of the relevant facts and law. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS No matter was submitted to a vote of shareholders, through the solicitation of proxies or otherwise, during the fourth quarter of 1996. EXECUTIVE OFFICERS The following table sets forth information concerning each of SMC's executive officers:
NAME AGE POSITION ---- --- -------- Ronald D. Hunter..................... 45 Chairman of the Board, Chief Executive Officer and President Stephen M. Coons..................... 55 Executive Vice President, General Counsel and Secretary Raymond J. Ohlson.................... 46 Executive Vice President and Chief Marketing Officer John J. Quinn........................ 49 Executive Vice President, Chief Financial Officer and Treasurer Edward T. Stahl...................... 50 Executive Vice President and Director of Corporate Development
RONALD D. HUNTER: Mr. Hunter has been the Chairman of the Board, Chief Executive Officer and President of SMC since its formation in June 1989 and the Chairman of the Board and Chief Executive Officer of Standard Life since December 1987. Previously, Mr. Hunter held several management and sales positions in the life insurance industry with a number of companies including Conseco, Inc. (1981-1986), 22 24 Aetna Life & Casualty Company (1978-1981), United Home Life Insurance Company (1975-1977) and Prudential Life Insurance Company (1972-1975). STEPHEN M. COONS: Mr. Coons has been General Counsel and Executive Vice President of SMC since March 1993 and has been Secretary of SMC since March 1994. Mr. Coons also has been a director of SMC since August 1989. He was of counsel to the law firm of Coons, Maddox & Koeller from March 1993 to December 31, 1995. Prior to March 1993, Mr. Coons was a partner with the law firm of Coons & Saint. He has been practicing law for 25 years. Mr. Coons served as Indiana Securities Commissioner from 1978 to 1983. RAYMOND J. OHLSON: Mr. Ohlson has served as Executive Vice President and director of SMC since December 1993. He has served as President and director of Standard Marketing since August 1991. Since June 1993, Mr. Ohlson has served as President of Standard Life. Mr. Ohlson entered the life insurance business in 1971. While still in college, Mr. Ohlson qualified for the Million Dollar Round Table and is now a life member. He earned his CLU designation in 1980. Mr. Ohlson owned and operated Ohlson & Associates, an independent insurance marketing organization, from 1984 to April 1, 1994, when the assets of Ohlson & Associates were acquired by Standard Marketing. JOHN J. QUINN: Mr. Quinn has served as Executive Vice President, Chief Financial Officer and Treasurer of SMC since June 1993, and as a Director since August 1993. For 24 years prior to June 1993, Mr. Quinn was employed by Ernst & Young as an auditor specializing in the insurance industry. He was named Partner in 1981 and was Chairman of Ernst & Young's Insurance Industry Practice in Indiana from 1989 to 1993. Mr. Quinn is a CPA, a CLU and a Fellow of the Life Management Institute ("FLMI"). Mr. Quinn has been appointed as the Commissioner of the Indiana Department of Insurance. In connection with that appointment, he gave notice in the first quarter of 1997 he will be terminating his employment at SMC. EDWARD T. STAHL: Mr. Stahl, has been an Executive Vice President of SMC since its formation, has been a director of SMC since July 1989 (except for the period from January 12, 1990 to May 21, 1990) and has served as Director of Corporate Development since June 1993. Mr. Stahl was Secretary of SMC from June 1989 to March 1994. Mr. Stahl was President and Chief Operations Officer of Standard Life from May 1988 to June 1993. He has been a director of Standard Life since December 1987, and Executive Vice President and Secretary since June 1993. Mr. Stahl has served in various capacities in the insurance industry since 1966. He earned his FLMI designation in 1981, and is a member of several insurance associations. 23 25 PART II ITEM 5. MARKET FOR SMC COMMON STOCK AND RELATED STOCKHOLDER MATTERS SMC Common Stock trades on Nasdaq under the symbol "SMAN." The following table sets forth, for the periods indicated, the range of the high and low sales prices of SMC Common Stock as reported by Nasdaq (after adjustment for the May 17, 1996 5% stock dividend). SMC has never paid dividends on its Common Stock. At the close of business on March 28, 1997 there were approximately 3,200 holders of record of the outstanding shares of SMC Common Stock. Although SMC Common Stock is traded on Nasdaq, no assurance can be given as to the trading volume or the market price on SMC Common Stock.
SMC COMMON STOCK ------------------- HIGH LOW ---- --- 1995 Quarter ended March 31, 1995............................. $4.881 $2.857 Quarter ended June 30, 1995.............................. 4.881 3.571 Quarter ended September 30, 1995......................... 6.071 4.286 Quarter ended December 31, 1995.......................... 4.881 4.167 1996 Quarter ended March 31, 1996............................. 4.524 3.571 Quarter ended June 30, 1996.............................. 4.881 3.750 Quarter ended September 30, 1996......................... 5.500 4.000 Quarter ended December 31, 1996.......................... 5.375 4.000
24 26 ITEM 6. SMC SELECTED HISTORICAL FINANCIAL DATA (A) (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) The selected historical financial data of SMC set forth below at and for the years ended December 31, 1996, 1995, 1994, 1993 and 1992 were derived from audited consolidated financial statements of SMC. The selected historical financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the SMC Consolidated Financial Statements and related notes thereto, each included elsewhere herein.
YEAR ENDED DECEMBER 31, --------------------------------------------------------------------- 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- STATEMENT OF OPERATIONS DATA: Premium income............................ $10,468(d) $ 5,504 $ 4,565 $ 5,511 $ 4,140 Investment Activity: Net investment income................... 20,871 18,517 16,057 12,171 9,406 Net realized investment gains........... 1,302 688 558 6,980 1,726 Total revenues............................ 40,682 30,238 26,518 26,542 15,873 Class action litigation and settlement costs (credit).......................... -- (314) 4,018 47 -- Interest expense and financing costs...... 805 118 47 519 1,628 Total benefits and expenses............... 36,772(d) 28,682 30,032 22,099 17,228 Income (loss) before income taxes, extraordinary gain (charge) and cumulative effect of change in accounting principle.................... 3,910 1,556 (3,514) 4,443(h) (1,354)(i) Income (loss) before extraordinary gain (charge) and cumulative effect of change in accounting principle................. 4,512(e) 1,313 (3,436) 2,984(h) (1,289)(i)(j) Net income (loss)......................... 5,014(f) 1,313 (3,436) 2,132 (1,400)(i) PER SHARE DATA: (b) Income (loss) per share before extraordinary gain (charge) and cumulative effect of change in accounting principle.................... $0.88(e) $0.25 $(0.62) $0.74(h) $(0.74)(i) Net income (loss)......................... $0.98(f) $0.25 $(0.62) $0.53(h) $(0.80)(i) Weighted average number of common and common equivalent shares outstanding.... 5,250,094 5,345,937 5,504,039 4,013,893 1,756,894 Book value per common share outstanding at period end.............................. $7.99 $7.73 $4.27 $7.82 $3.22 Book value per common share outstanding, excluding unrealized gain (loss) on securities available for sale........... $8.14(g) $7.23(g) $6.81(g) $7.82 $3.22 Common shares outstanding at period end... 5,024,270 5,205,425 5,291,455 4,954,676 1,565,801 BALANCE SHEET DATA (AT PERIOD END): Invested assets........................... $370,138 $280,597 $224,926 $199,413 $153,106 Assets held in separate accounts.......... 128,546 122,705 94,301 107,173 -- Total assets.............................. 628,788 479,598 373,524 354,431 197,860 Long-term debt, notes payable and capital lease obligations....................... 20,697 4,191 695 -- 20,750 Class S Cumulative Convertible Redeemable Preferred Stock......................... 1,757 -- -- -- -- Shareholders' equity...................... 40,166 40,242 22,610 36,914 4,807 Ratio of debt to total capitalization(c)....................... 36% 9% 3% -- 81%
25 27 NOTES TO SMC SELECTED HISTORICAL FINANCIAL DATA (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (a) Comparison of consolidated financial information is significantly affected by the acquisitions of First International at June 30, 1992, Standard Management International effective December 31, 1993, Dixie National Life on October 2, 1995 and Shelby Life effective November 1, 1996. Refer to the notes to the consolidated financial statements included in SMC's Audited Consolidated Financial Statements, included elsewhere herein, for a description of business combinations. (b) All applicable shares and per share amounts have been restated to reflect the May 17, 1996 5% stock dividend. (c) Total capitalization is the sum of SMC's debt (long term debt, notes payable, capital lease obligations and redeemable preferred stock) and shareholders' equity. (d) Includes recapture of premiums ceded and an increase in benefits due to an increase in reserves of $4,234 due to the termination and recapture of a reinsurance agreement with National Mutual Life Insurance Company. See "Business of SMC -- Reinsurance." (e) Does not reflect extraordinary gain of $502 ($.10 per share) on early redemption of Class S Preferred Stock. (f) Does not reflect preferred stock dividends of $208 ($.03 per share) on Class S Preferred Stock. (g) Excludes the effect of reporting securities available for sale at fair value and recording the unrealized gain or loss on such securities as a component of shareholders' equity, net of tax and other adjustments, which SMC began to do in 1994. Such adjustments are in accordance with Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" as described in the notes to the consolidated financial statements included in SMC's Consolidated Financial Statements, included elsewhere herein. (h) Before deduction of extraordinary charge of $1,301 ($.32 per share) on early extinguishment on long-term debt and cumulative effect of change in accounting principle of $449 ($.11 per share) from applying the new method of accounting for income taxes. (i) Includes a $1,325 allowance for losses ($1,221 after taxes) to reflect the fair value of property collateralizing a $3,200 mortgage loan which was subsequently foreclosed. (j) Before deduction of extraordinary charge of $110 ($.06 per share) to write-off unamortized deferred debt issuance costs in connection with retirement of previously outstanding debt. 26 28 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion highlights the principal factors affecting the results of operations and the significant changes in balance sheet items of SMC on a consolidated basis for the periods listed as well as SMC's liquidity and capital resources. This discussion should be read in conjunction with the SMC Consolidated Financial Statements and the Notes thereto appearing elsewhere herein. INTRODUCTION SMC acquired First International on July 10, 1992, Standard Management International on December 15, 1993, Dixie National Life on October 2, 1995 and Shelby Life on November 8, 1996. These acquisitions are accounted for using the purchase method of accounting (effective June 30, 1992 for the First International acquisition, December 31, 1993 for the Standard Management International acquisition, October 2, 1995 for the Dixie National Life acquisition and November 1, 1996 for the Shelby Life acquisition. Therefore, these subsidiaries are included in the SMC Consolidated Financial Statements commencing with their respective acquisition effective dates. SMC acquired a block of insurance liabilities and assets from The Midwest Life Insurance Company in Liquidation (the "Midwest Block") effective June 30, 1992, and it is included in the SMC Consolidated Financial Statements commencing with that date. SMC disposed of First International on March 18, 1996 (effective March 1, 1996) and terminated the operations of Standard Reinsurance on March 1, 1996. Product Profitability. Margins on life insurance and annuity products are affected by interest rate fluctuations. Rising interest rates would result in a decline in the market value of assets. However, as there are positive cash flows from renewal premiums, investment income and maturities of existing assets, the need for early disposition of investment assets to meet operating cash flow requirements would be unlikely. Rising interest rates would also result in available cash flows from maturities being invested at higher interest rates, which would help support a gradual increase in new business and renewal interest rates on interest-sensitive products. A sharp, sudden rise in the interest rate environment without a concurrent increase in crediting rates could result in higher surrenders, particularly for annuities. The effect of surrenders would be to reduce earnings over the long term but to increase or decrease earnings in the period of the surrender to the extent surrender charges were applicable and differed from the write-off of related deferred acquisition costs or present value of future profits. When interest rates fall, SMC generally attempts to adjust the credited interest rates subject to competitive pressures. Although SMC believes that such strategies will continue to permit it to achieve a positive spread, a significant decline in the yield on SMC's investments could adversely affect the results of operations and financial condition of SMC. Purchased Insurance Business. In accordance with industry practice, when SMC purchased First International, the Midwest Block, Dixie National Life and Shelby Life, and recaptured a block of insurance from National Mutual on July 31, 1996, effective as of May 1, 1996 (the "National Mutual Block"), it assigned a portion of the purchase price, called the present value of future profits, to the right to receive future cash flows arising from existing insurance policies. This asset was recorded when the business was purchased at the value of projected future cash flows on existing policies, less a discount to present value. As future cash flows emerge, they are treated as a recovery of this asset. Therefore, if cash flows emerging from the purchased or recaptured business during a period exactly equal the projections, they are offset by that period's amortization of the cost of the policies purchased. In that event, the only income statement effect from the purchased business is the realization of the discount that was initially deducted from the asset to reflect its present value. Changes in the future annual amortization of this asset are not expected to have a significant effect on the results of operations, because the amount of amortization is expected to be equal to the profits emerging from the purchased policies, net of interest on the unrecovered present value of future profits balance. This asset is amortized over the expected life of the related policies purchased. Present value of future profits is increased for the estimated effect of realizing unrealized investment losses and decreased for the estimated effect of realizing unrealized investment gains. 27 29 In selecting the interest rate to calculate the discounted present value of the projected future profits, SMC used the risk rate of return it needs to earn in order to invest in the business being acquired or recaptured. In determining this required rate of return, we consider the following factors: - The magnitude of the risks associated with each of the actuarial assumptions used in determining expected future cash flows (as described above). - Our cost of the capital required to fund the acquisition or recapture. - The likelihood of changes in projected future cash flows that might occur if there are changes in insurance regulations and tax laws. - The acquired company's compatibility with other SMC activities that may favorably affect future cash flows. - The complexity of the acquired company or recaptured business. - Recent prices (i.e., discount rates used in determining valuations) paid by others to acquire or recapture similar blocks of business. The discount rate used to determine the present value of the projected future profits is used to determine the subsequent amortization of the cost of the purchased policies for acquisitions prior to November 19, 1992. For acquisitions subsequent to November 19, 1992, the discount rate used to amortize the unamortized balance of the present value of future profits is the crediting rate of the underlying policies. The discount rate selected may affect subsequent earnings in those instances where the purchase price of the policies exceeds the value of net assets acquired (including the value of future profits discounted at the selected interest rate). Selection of a lower (or higher) discount rate will increase (or decrease) the portion of the purchase price assigned to the present value of future cash flows and will result in an offsetting decrease (or increase) in the amount of the purchase price assigned to goodwill. The effect on subsequent earnings caused by this variation in purchase price allocation will depend on the characteristics of the policies purchased. For products where the profits emerge at relatively constant levels over an extended period of time (for example, most of SMC's immediate and deferred annuities), use of a lower rate may result in an increase in reported earnings in the early years after an acquisition followed by a decrease in earnings in later years. For products where profits emerge over a shorter period of time or in amounts that decrease over the life of the product (for example, ordinary and term life products), selection of a lower rate will generally result in a decrease in reported earnings in the early years after an acquisition followed by an increase in reported earnings in later years. For SMC, the majority of the cost of policies purchased relates to ordinary life products and the balance to deferred annuity products. The activity related to the present value of future profits of the business acquired for SMC is summarized as follows:
YEAR ENDED DECEMBER 31, ----------------------------------- 1996 1995 1994 ---- ---- ---- (DOLLARS IN THOUSANDS) Balance at beginning of year................................ $15,246 $ 8,299 $9,144 Additions during the year from acquisitions and recaptures............................................. 10,723 7,901 -- Deletions during the year from disposal of subsidiaries... (733) -- -- Net amortization during the year.......................... (1,249) (780) (845) Adjustments relating to net unrealized (gains) loss on fixed maturities available for sale.................... 194 (174) -- ------- ------- ------ Balance at end of year...................................... $24,181 $15,246 $8,299 ======= ======= ======
The percentage of future expected net amortization of the present value of future profits before the effect of net unrealized gains and losses, based on the present value of future profits at December 31, 1996 and 28 30 current assumptions as to future events on all policies in force, will be between 6% and 8% in each of the years 1997 through 2001. The discount rate used to calculate the present value of future profits for business acquired prior to November 19, 1992, reflected in SMC's December 31, 1996 consolidated balance sheet ranged from 7.5% to 18%. SMC used a 15% discount rate to calculate the present value of future profits on the business of the Dixie National Life, Shelby Life and National Mutual acquisitions and recaptures. Acquisition of Blocks of Business. SMC's growth strategy includes the acquisition of in force blocks of business through assumption reinsurance agreements. The accounting recognition given these acquisitions is dependent upon the type of business acquired. FPDAs and payout annuities are recorded at full account value. Funds received are recorded as invested assets. The excess of the liabilities assumed over assets received is recorded as the present value of future profits and amortized in relation to expected gross profits. Produced Insurance Business. Insurance products generate two types of profit streams: (i) from the excess of investment income earned over that credited to the policyholder and (ii) from the excess of premiums received over costs incurred for policy issuance, administration and mortality. Costs incurred in issuing new policies are deferred and recorded as deferred acquisition costs ("DAC"), which are amortized using present value techniques so that profits are realized in proportion to premium revenue for certain products and estimated gross profits for certain other products. Profits from all of these elements are recognized over the lives of the policies; no profits are recorded at the time the policies are issued. Amortization of DAC was $1,221,000, $1,142,000 and $262,000 for the years ended December 31, 1996, 1995 and 1994, respectively. The increase in current year amortization expense resulted primarily from increased amortization of DAC as gross profits from business sold in recent years began to emerge. DAC of $18,078,000 at December 31, 1996 and additions to policy acquisition costs of $6,169,000 for business produced during the year ended December 31, 1996 are generally being amortized over the expected lives of the policies, a period of approximately 20 years, in a constant relationship to the present value of estimated future gross profits. Interest is being accreted at 7% during year 1 and 5% thereafter, the projected crediting rate on the policies. DAC is increased for the estimated effect of realizing unrealized investment losses and decreased for the estimated effect of realizing unrealized investment gains. The offset to these amounts is recorded directly to shareholders' equity, net of taxes. Future expected amortization of DAC for the next five years before the effect of net realized and unrealized gains and losses, based on DAC at December 31, 1996 and current assumptions, is as follows:
1997 1998 1999 2000 2001 ---- ---- ---- ---- ---- (DOLLARS IN THOUSANDS) Gross amortization................. $1,897 $1,938 $1,976 $1,932 $1,840 Interest accreted.................. (860) (750) (644) (551) (473) ------ ------ ------ ------ ------ Net amortization................... $1,037 $1,188 $1,332 $1,381 $1,367 ====== ====== ====== ====== ======
The amounts included in the foregoing table do not include any amortization of DAC resulting from the sale of new products after December 31, 1996. Any changes in future annual amortization of this asset are not expected to have a significant effect on results of operations because the amount of amortization is expected to be proportionate to the profits from the produced policies, net of interest on DAC. Variances Between Actual and Expected Profits. Actual experience on purchased and produced insurance may vary from projections due to differences in renewal premiums collected, investment spreads, mortality costs, surrender benefits, persistency, administrative costs and other factors. Variances from original projections, whether positive or negative, are included in net income as they occur. To the extent that these variances indicate that future experience will differ from the estimated profits reflected in the capitalization and amortization of the cost of policies purchased or the cost of policies produced, current and future amortization rates may be adjusted. Accounting for Annuities and Universal and Interest-Sensitive Life Products. The Company primarily accounts for its annuity and universal and interest-sensitive life policy deposits in accordance with Statement 29 31 of Financial Accounting Standards No. 97 ("SFAS No. 97"). "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses on the Sale of Investments". Under SFAS No. 97, a benefit reserve is established at the time of policy issuance in an amount equal to the deposits received. Thereafter, the benefit reserve is adjusted for any additional deposits, interest credited and partial or complete withdrawals. Revenues for annuities and universal and interest-sensitive life policies, other than certain non-interest sensitive annuities, consist of policy charges for surrenders and partial withdrawals, mortality and administration, and investment income earned. Such revenues do not include the annuity and universal and interest-sensitive life policy deposits. Expenses related to these products include interest credited to policyowner account balances, operating costs for policy administration, amortization of DAC and mortality costs in excess of account balances. Costs relating to the acquisition of new business, primarily commissions paid to agents, which vary with and are directly related to the production of new business, are deferred to the extent that such costs are recoverable from future profit margins. At the time of issuance, the acquisition expenses, approximately 10.25% of initial annuity premium deposits and (50%) of premiums from universal and interest-sensitive life products for SMC, are capitalized as DAC. In accordance with SFAS No. 97, DAC with interest is amortized over the lives of the policies in a constant relationship to the present value of estimated future gross profits. Unit-linked Product Accounting. Separate account assets and liabilities are maintained primarily for contracts of which the majority represents unit-linked products where benefits on surrender and maturity are not guaranteed. They generally represent funds held in accounts to meet specific investment objectives of policyholders who bear the investment risk. Investment income and investment gains and losses accrue directly to such policyholders. SMC earns income from the investment management fee it charges on such unit-linked contracts, which range from .8% to 1.2% of the value of the underlying separate accounts. DISCUSSION OF CHANGES IN THE CONSOLIDATED STATEMENT OF OPERATIONS FROM YEAR ENDED DECEMBER 31, 1996 TO YEAR ENDED DECEMBER 31, 1995 Operating Income. The income from operations (before net realized investment gains, gain on disposal of subsidiaries and reduction in accruals of certain legal expenses) was $1,421,000 in 1996, or $.29 per share, compared to $461,000 for 1995, or $.09 per share. The change resulted primarily from international operations producing income from operations of $1,218,000 compared to a loss of $(22,000) for 1996 and 1995, respectively. The international operating gains resulted primarily from increased management fees on an increasing separate account base due to portfolio sales in 1996 and 1995, and increased value of assets under management, coupled with a decrease in marketing costs in 1996 when compared to 1995. The income from operations in the United States decreased to $203,000 in 1996 compared to $483,000 in 1995. The decline was attributable to an increase in interest expense from borrowings to repurchase Common Stock, Class S Preferred Stock and the purchase of Shelby Life and additional costs to convert the operations and expand the marketing effort in Dixie National Life. Premium Income. Premium income is composed of premiums, including renewal premiums, received on ordinary life insurance policies. As noted above, SMC's new product sales are composed primarily of annuity products. Under GAAP, deposits from interest-sensitive annuities and other financial products are not recorded as revenues. GAAP premium income for the 1996 was $10,468,000, an increase of $4,964,000 or 90% from $5,504,000 for 1995. This increase is mainly attributable to recapture of premiums ceded of $4,234,000 due to the termination and recapture of a reinsurance agreement with National Mutual and the inclusion of Dixie National Life and Shelby Life in the results of operations for periods after October 2, 1995 and November 1, 1996, respectively. These amounts offset the decline in premiums from the cession of a portion of First International's life insurance business and the regular policy lapses, surrenders and expiries in SMC's closed blocks of business. Net premiums received from the sales of interest-sensitive annuities and other financial products (which are not recorded as revenues) were $42,347,000 compared to $17,524,000 for the years ended December 31, 1996 and 1995, respectively. The increase in premium deposits is partially due to an increase in gross domestic premium deposits. Gross domestic premium deposits received from interest-sensitive annuities and financial 30 32 products were $51,254,000 for the year ended December 31, 1996 compared to $37,614,000 for the year ended December 31, 1995. The increase is the result of an aggressive marketing campaign implemented by Standard Life with increased crediting interest rates. Also contributing to the increase in premiums is the continued development of SMC's distribution system. Since SMC's operating income is primarily a function of its investment spreads, mortality experience and operating expenses, a change in premium deposits in a single period does not directly cause operating income to change, although continued increases or decreases in premiums may affect the growth rate of total assets on which investment spreads are earned. SMC also decreased the quota-share portion of business ceded pursuant to a reinsurance agreement from 70% to 50% at September 1, 1995, which was further decreased to 25% effective April 1, 1996. Premium deposits ceded pursuant to this reinsurance agreement reduced net premium deposits by $8,907,000 in the year ended December 31, 1996 compared to $20,090,000 in 1995. Net Investment Income. Net investment income increased $2,354,000 or 13% to $20,871,000 for the year ended December 31, 1996 from $18,517,000 for 1995. The increase primarily resulted from an increase in total invested assets (amortized cost) of approximately 32% from 1995 to 1996, most of which occurred in the fourth quarter due to the acquisition of Shelby Life. The average net yield on SMC's invested assets was 7.32% for both years ended December 31, 1996 and 1995. The continued growth in SMC's total invested assets reflects increased sales of FPDAs and the inclusion of Dixie National Life and Shelby Life in the results of operations effective October 2, 1995 and November 1, 1996, respectively, which was offset by the invested assets ceded in the GIAC reinsurance transaction. Net Realized Investment Gains. Net realized investment gains increased $614,000 or 89% to $1,302,000 from $688,000 for the years ended December 31, 1996 and 1995, respectively. The increase primarily resulted from active portfolio management by SMC. Net realized investment gains fluctuate from period to period and arise when securities are sold in response to changes in the investment environment which provide opportunities to maximize return on the investment portfolio without adversely affecting the quality and overall yield of the investment portfolio. Gain on Disposal of Subsidiaries. On March 18, 1996, SMC completed the sale of a duplicate charter associated with First International to GIAC. SMC received sale proceeds of $11,493,000, including $1,500,000 for the charter and licenses associated with First International and $1,800,000 of reinsurance ceding commissions. Standard Life realized a net pre-tax gain of $1,042,000 on this sale. In addition, First International, Standard Life and GIAC have entered into a series of reinsurance and other agreements that include provisions for Standard Life to administer First International policies in force at the date of sale. In an unrelated matter, SMC decided in February 1996 to terminate the reinsurance agreement between Standard Reinsurance and Salamandra, and to not renew the Barbados license of Standard Reinsurance. This resulted in the write-off of SMC's investment in Standard Reinsurance and certain intangible assets of Standard Reinsurance amounting to $156,000. The combined effect of the pre-tax gain on the sale of First International and related contracts, and the Standard Reinsurance write-offs, was $886,000 pre-tax and $2,306,000 after tax ($.44 per share) in the first quarter of 1996. Policy Charges. Policy charges, which represent the amounts assessed against policyholder account balances for the cost of insurance, policy administration and surrenders, increased $84,000 or 3% to $2,551,000 for the year ended December 31, 1996 compared to $2,467,000 for the year ended December 31, 1995. The increase in policy charges resulted from an increase in policy surrender charges on FPDAs and the inclusion of Dixie National Life and Shelby Life in operating results for periods after October 2, 1995 and November 1, 1996, respectively, which offset the absence of policy charges from SMC's closed blocks of universal life business which were sold to GIAC through a reinsurance contract effective January 1, 1996. Amortization of Excess of Net Assets Acquired Over Acquisition Cost. Amortization of excess of net assets acquired over acquisition cost ("negative goodwill") is recorded to amortize into earnings the negative goodwill recorded in connection with the acquisition of Standard Management International in 1993. The 31 33 negative goodwill is being amortized on a straight-line basis over five years. Amortization of negative goodwill was $1,388,000 for each of the years ended December 31, 1996 and 1995. Management Fees and Similar Income from Separate Accounts. Management fees and similar income from separate accounts consists of the investment management fees earned by Standard Management International on its separate account assets and investment contracts. Management fees and similar income from separate accounts increased $270,000 or 21% to $1,564,000 for the year ended December 31, 1996 from $1,294,000 for the year ended December 31, 1995. This increase is due primarily to an increase in the value of assets held in separate accounts from $94,301,000 at December 31, 1994 to $128,546,000 at December 31, 1996 and to fluctuations in service fees being levied on certain transactions. Net deposits from sales of unit-linked products by Standard Management International were $16,902,000 and $31,793,000 for the years ended December 31, 1996 and 1995, respectively. Administration Fee Income. Administration fee income includes administration fees of $316,000 and other income related to reinsurance and administration agreements with GIAC and administration fees of $375,000 collected in connection with the terminated and recaptured reinsurance agreement with National Mutual. The administration fee income from National Mutual primarily related to services provided in prior years; the income was not previously recorded due to uncertainty as to its collection. The National Mutual fee income will not recur in the future. Administration fee income was $691,000 for the year ended December 31, 1996; there was no such income for 1995. Other Income. Other income increased $581,000 or 153% to $961,000 for the year ended December 31, 1996 compared to $380,000 for 1995. The increase resulted primarily from the reserve and experience refund adjustments in connection with the reinsurance agreements with GIAC and increased commissions received by Standard Marketing from the sale of unaffiliated products. Benefits and Claims. Benefits and claims include life insurance and payout annuity benefits paid and changes in policy reserves. Benefits and claims increased $4,128,000 or 71% to $9,919,000 for the year ended December 31, 1996 from $5,791,000 for the year ended December 31, 1995. The increase resulted primarily from an increase in reserves of $4,234,000 related to the termination and recapture of a reinsurance agreement with National Mutual. Throughout SMC's history, it has experienced both periods of higher and lower benefit claims. Such volatility is not uncommon in the life insurance industry and, over extended periods of time, periods of higher claims experience tend to be offset by periods of lower claims experience. Interest Credited on Interest Sensitive Annuities and Other Financial Products. Interest credited on interest sensitive annuities and other financial products was $11,281,000 for the year ended December 31, 1996, an increase of $1,272,000 or 13% from $10,009,000 for the comparable prior year period. The increase resulted primarily from SMC's increase of credited interest rates on new annuity sales and the increases in the growth in policy reserves for FPDAs from sales and the acquisition of Shelby Life. At December 31, 1996, the weighted average interest credited rate for Standard Life's annuities and other financial product liabilities was 5.35% compared to 5.27% at December 31, 1995. Salaries and Wages. Salaries and wages were $5,053,000 for the year ended December 31, 1996, an increase of $352,000 or 7% from $4,701,000 for the comparable prior year period. This increase was caused primarily by an increase in the number and average wages of employees in the United States due to the acquisitions of Dixie National Life and Shelby Life and the increase in incentive compensation for the increase in income for the year ended December 31, 1996. In the first quarter of 1997, the chief financial officer gave notice he will be terminating his employment at SMC as he has been named Commissioner of the Indiana Department of Insurance. The Company is currently discussing benefits that may or may not be due to the officer. The amount of such benefits cannot be determined at this time. Amortization. Amortization expense includes charges to operations for the amortization of deferred policy acquisition costs, the present value of future profits, the excess of cost over net assets acquired and subsidiary organization costs. Amortization expense increased $548,000 or 27% to $2,592,000 for the year ended December 31, 1996 from $2,044,000 for the year ended December 31, 1995. The increase in current 32 34 year amortization expense resulted primarily from increased amortization of deferred acquisition costs as gross profits from business sold in recent years began to emerge and increased surrenders and their corresponding increase in the amortization of deferred acquisition costs, and from the amortization of present value of future profits for the acquisitions of Dixie National Life, Shelby Life and National Mutual. These items more than offset reduced amortization of excess of cost over net assets acquired and present value of future profits due to the sale of First International. Other Operating Expenses. Other operating expenses increased $789,000 or 12% to $7,122,000 for the year ended December 31, 1996 from $6,333,000 for the year ended December 31, 1995. The increase in other operating expenses resulted primarily from the expenses of Dixie National Life and Shelby Life included in the results for the periods after October 2, 1995 and November 1, 1996, respectively and the increased expenses related to potential acquisitions and advisory fees. Interest Expense and Financing Costs. Interest expense and financing costs increased $687,000 or 582% to $805,000 for the year ended December 31, 1996 from $118,000 for the year ended December 31, 1995. The increase in interest expense and financing costs during 1996 resulted primarily from the borrowing on an Amended Revolving Line of Credit Agreement with a bank ("the Amended Credit Agreement"). The borrowing under the Amended Credit Agreement and the original credit agreement primarily occurred after December 31, 1995 in connection with the acquisition of Shelby Life and repurchase of Common Stock and Class S Preferred Stock. Class Action Litigation and Settlement Costs. Class action litigation and settlement costs were recorded to reflect the estimated costs of litigation and settlement of the shareholder class action lawsuit, based on the terms of the settlement agreement and assumptions as to the future estimated legal and other costs to settle the lawsuit, which was settled in March 1995, and to register the Class S Preferred Stock which was distributed to the class participants in February 1996. There were no class action litigation and settlement expenses in the years ended December 31, 1996 and 1995. However, with the signing of the Settlement Agreement with the 22 persons who previously excluded themselves from the class and the reevaluation of the future estimated legal and other costs to settle the lawsuit, SMC recorded a reduction of $314,000 in the second quarter of 1995 in the estimated future costs to settle the lawsuit and register the Class S Preferred Stock. Federal Income Taxes. Federal income tax expense (credit) was $(602,000) for the year ended December 31, 1996, compared to $243,000 for the year ended December 31, 1995. The large credit in 1996 is primarily due to tax benefits of $1,420,000 related to the sale of First International. Also, the effective rates are less than the statutory rates primarily because the amortization of excess of net assets acquired over acquisition cost resulting from the acquisition of Standard Management International is not subject to United States income tax. Extraordinary Gain on Early Redemption of Redeemable Preferred Stock. Extraordinary gains are recorded on the early redemption of the Class S Preferred Stock for the amount by which SMC is able to repurchase the Class S Preferred Stock below its book value. SMC will continue to repurchase these shares as long as holders of the Class S Preferred Stock are willing to sell at a substantial discount to book value. The extraordinary gain was $502,000 for the year ended December 31, 1996 compared to no gain for the prior comparable period. DISCUSSION OF CHANGES IN THE CONSOLIDATED STATEMENT OF OPERATIONS FROM YEAR ENDED DECEMBER 31, 1995 TO YEAR ENDED DECEMBER 31, 1994 Operating Income. The income from operations (before net realized investment gains and class action litigation and settlement costs) increased to $461,000 or $.09 per share from $293,000 or $.06 per share for 1995 and 1994, respectively. The increase resulted from U.S. operations producing income from operations of $483,000 compared to a U.S. loss from operations of $(720,000) for 1995 and 1994, respectively. The U.S. operating gains resulted primarily from increased interest spreads on an increasing asset base due to annuity sales in 1995 and 1994. The improvement in U.S. operations was offset by a decline in international income 33 35 from operations from $1,013,000 in 1994 to a loss of $(22,000) in 1995 as the costs of resuming marketing were absorbed. Premium Income. GAAP premium income for 1995 was $5,504,000, an increase of 21% from $4,565,000 for 1994. Increase in premium income resulted primarily from the inclusion of Dixie National Life in the results of operations effective October 2, 1995. Net premiums received from the sales of interest-sensitive annuities and other financial products (which are not recorded as revenues) were $17,524,000 for the year ended December 31, 1995 compared to $53,490,000 for the year ended December 31, 1994. The decline is partially due to increased competitive pressures. To protect its profit margins, SMC was not willing to match other insurers' high interest crediting and commission rates which caused a decrease in gross domestic premium deposits of $15,876,000 in 1995 when compared to 1994. Additionally, Standard Life began ceding a portion of its new annuity business to an unaffiliated reinsurer effective January 1, 1995. Premium deposits ceded pursuant to the reinsurance agreement with the reinsurer reduced net premiums by $20,090,000 for 1995. There was no such reinsurance in 1994. Net Investment Income. Net investment income increased 15% to $18,517,000 in 1995 from $16,057,000 in 1994. This increase primarily resulted from growth in SMC's total invested assets attributable to the increased sales of FPDAs in 1994 and the inclusion of Dixie National Life in the results of operations effective October 2, 1995. The amortized cost of total invested assets increased 12% to $274,148,000 in 1995 from $245,619,000 in 1994. These increased assets also benefited from a higher concentration of investments in fixed maturity securities. The average annualized yield of SMC's investment portfolio for the year ended December 31, 1995 increased to 7.32% from 7.26% for 1994. Net Realized Investment Gains. Net realized investment gains increased 23% to $688,000 in 1995 from $558,000 in 1994. 1995 results reflect increased gains on sales of investments due to rising values of fixed maturity securities as interest rate levels decreased, combined with active portfolio management. Net realized gains fluctuate from period to period and arise when securities are sold in response to changes in the investment environment which provide opportunities to maximize return on the investment portfolio without adversely affecting the quality of the investment portfolio. Policy Charges. Policy charges increased 21% to $2,467,000 for 1995 compared to $2,031,000 for 1994. The increase in universal life policy charges resulted from increased surrender charges on interest-sensitive annuity products and the inclusion of Dixie National Life in operating results for periods after October 2, 1995. Amortization of Excess of Net Assets Acquired Over Acquisition Cost. Amortization of negative goodwill increased 31% to $1,388,000 for 1995 compared to $1,063,000 for 1994 due to a reallocation of the purchase price in the fourth quarter of 1994 which increased negative goodwill. Management Fees and Similar Income from Separate Accounts. Management fees and similar income from separate accounts decreased 32% to $1,294,000 in 1995 from $1,888,000 in 1994. This decrease is due to a change in the mix of the types of separate accounts whereby those earning higher investment management fees represent a significantly smaller portion of the total in 1995 than in 1994. Most of the new policies sold in 1995 carried significantly smaller investment management fees than the policies lapsed or surrendered in 1995. Net deposits from sales of unit-linked products by Standard Management International were $31,793,000 in 1995 and $1,715,000 in 1994. Other Income. Other income includes primarily override commissions received by Standard Marketing from unaffiliated companies and other income recorded by Standard Management International. Other income increased 7% to $380,000 for 1995 from $356,000 in 1994. The increase primarily resulted from commissions from the sale of unaffiliated products and to a lesser extent the inclusion of Dixie National Life in the results of operations after October 2, 1995. These increases more than offset any loss of fee income generated by Standard Advertising which was sold in early 1995. 34 36 Benefits and Claims. Benefits and claims increased 3% to $5,791,000 for 1995 from $5,603,000 for 1994. The increase in benefits and claims resulted primarily from an increase in death benefits in 1995 when compared to the favorable mortality experience in 1994. Mortality experience is volatile and these trends are not predictable from period to period. Interest Credited on Interest-Sensitive Annuities and Other Financial Products. Interest credited on interest-sensitive annuities and other financial products was $10,009,000 for 1995, an increase of $1,333,000 or 15% from $8,676,000 for the prior year. The increase resulted primarily from increases in interest credited from the growth in policy reserves for FPDAs. This more than offsets any decreases from the decline in credited interest rates on interest-sensitive annuities and other financial products. At December 31, 1995, the weighted average interest credited rate for Standard Life's interest-sensitive annuities and other financial product liabilities was 5.27% compared to 5.82% at December 31, 1994. Salaries and Wages. Salaries and wages were $4,701,000 for 1995, an increase of 20% from $3,910,000 for the prior year. This increase was caused by $185,000 of unusual charges due to the termination of certain international marketing programs and the subsequent reduction of SMC's staff in Luxembourg in 1995, the capitalization of certain salaries of $203,000 associated with the internal development of computer software in 1994, increased salaries for new marketing efforts for Standard Management International in 1995 and the inclusion of Dixie National Life in the results of operations for periods after October 2, 1995. Additionally, the average wages per employee increased in 1995. Amortization. Amortization expense for 1995 was $2,044,000, an increase of $829,000, or 68%, from $1,215,000 for the prior year. The increase in current year amortization expense resulted primarily from increased amortization of deferred acquisition costs as gross profits from business sold in recent years began to emerge and from the amortization of present value of future profits for the acquisition of Dixie National Life, which more than offset reduced amortization of present value of future profits on previous acquisitions as persistency of the purchased business begins to improve. Other Operating Expenses. Other operating expenses for the year ended December 31, 1995 were $6,333,000, reflecting a decrease of 4%, compared to $6,563,000 for the year ended December 31, 1994. The decrease in other operating expenses resulted primarily from decreases in consulting, legal and other expenses related to potential acquisitions and the sale of Standard Advertising in early 1995, which more than offset the increased expenses of operating Dixie National Life from October 2, 1995 to December 31, 1995. Interest Expense and Financing Costs. Interest expense and financing costs increased 151% to $118,000 in 1995 from $47,000 in 1994. The increase in interest expense during 1995 resulted primarily from the payments on the capital lease obligations. Class Action Litigation and Settlement Costs. SMC recorded a reduction of $314,000 in 1995 in the estimated future costs to settle the lawsuit and list the Class S Preferred Stock. Federal Income Taxes. Federal income tax expense was $243,000 for 1995, compared to a credit of $(78,000) for 1994. The effective rate of 16% is less than the statutory rate of 34% primarily because the amortization of excess of net assets acquired over acquisition cost resulting from the acquisition of Standard Management International is not subject to United States income tax. SMC receives the benefits of a special deduction available to small life insurance companies and the utilization of capital and operating loss carry forwards in the life insurance subsidiaries. However, the losses incurred by Standard Management and the foreign subsidiaries, primarily due to class action litigation and settlement costs, and operating costs in excess of management fees, provide no current tax benefit as Standard Management and the foreign subsidiaries are in a net operating loss carryforward position. The benefits of the special deduction available to small life insurance companies will no longer be available when consolidated assets exceed $500,000,000. LIQUIDITY AND CAPITAL RESOURCES Standard Management is an insurance holding company. The liquidity requirements of Standard Management are met primarily from management fees, equipment rental fees and payments for other charges and dividends and interest on Surplus Debentures received from Standard Management's subsidiaries as well 35 37 as Standard Management working capital. These are Standard Management's primary source of funds to pay operating expenses and meet debt service obligations. The payment of dividends and interest on Surplus Debentures and management and other fees by Standard Life to Standard Management is subject to restrictions under the insurance laws of Indiana, Standard Life's jurisdiction of domicile. These internal sources of liquidity have been supplemented in the past by external sources such as lines of credit and revolving credit agreements and long-term debt and equity financing in the capital markets. SMC reported on a consolidated GAAP basis net cash provided by operations of $1,726,000 and $6,331,000 for the years ended December 31, 1996 and 1995, respectively. Although deposits received on SMC's interest-sensitive annuities and other financial products are not included in cash flow from operations under GAAP, such funds are available for use by SMC. Cash provided by operations plus net deposits received, less net account balances returned to policyholders on interest sensitive annuities and other financial products, resulted in positive cash flow of $26,717,000 and $6,003,000 for the years ended December 31, 1996 and 1995, respectively. Cash generated on a consolidated basis is available to the parent company only to the extent that it is generated at the parent company level or is available to the parent company through dividends, management fees or other payments from subsidiaries. In April 1993, Standard Management instituted a program to repurchase SMC Common Stock from time to time. The purpose of the stock repurchase program is to enhance shareholder value. Standard Management had repurchased 979,453 shares of SMC Common Stock for $4,747,000 as of December 31, 1996. The repurchases in 1996 have been paid for through additional borrowing under the Amended Credit Agreement. At December 31, 1996, Standard Management was authorized to purchase an additional 771,771 shares under this program. Standard Management implemented a policy to issue shares for the exercise of stock options from treasury stock. Standard Management has reissued 1,224 shares in 1996 under this program at a cost of $6,000. In February 1996, Standard Management instituted a program to repurchase from time to time up to 300,000 shares of its Class S Preferred Stock in the open market or privately negotiated transactions. As of December 31, 1996, Standard Management had repurchased and retired 140,111 shares of its Class S Preferred Stock for $949,000. At December 31, 1996, Standard Management had "parent company only" cash and short-term investments of $1,024,000. These funds are available to Standard Management for general corporate purposes. Standard Management's "parent company only" operating expenses (not including class action litigation and settlement costs and interest expense) were $3,470,000 and $2,793,000 for the years ended December 31, 1996 and 1995, respectively. Pursuant to the management services agreement with Standard Management, Standard Life paid Standard Management a monthly fee of $150,000 during 1996 and 1995 for certain management services related to the production of business, investment of assets and evaluation of acquisitions. Management service agreements between Standard Life and Dixie National Life have been approved by the Mississippi Department of Insurance which currently requires a monthly payment of $100,000 from Dixie National Life to Standard Life. Both of these agreements provide that they may be modified or terminated by the department of insurance in the event of financial hardship of Standard Life or Dixie National Life. The management service agreement between Standard Management and Standard Life for 1997 has been renegotiated to increase the monthly fee to $166,667 (annual fee of $2,000,000) in 1997. This amended management service agreement has been approved by the Commissioner of the Indiana Department of Insurance. Pursuant to the management services agreement with Standard Management, Premier Life (Luxembourg) paid Standard Management a management fee of $25,000 per quarter during 1996 and 1995 for certain management and administrative services. The agreement provides that it may be modified or terminated by either Standard Management or Premier Life (Luxembourg). Standard Management does not plan to modify this agreement in 1997. 36 38 At April 1, 1995, Standard Management sold its property and equipment to an unaffiliated leasing/ financing company for $1,396,000 and subsequently entered into a capital lease obligation whereby Standard Management pays a monthly rental amount of $45,000. Standard Management charges a monthly equipment rental fee to its subsidiaries of $77,000 for this equipment and additional equipment purchased after April 1, 1995. On November 8, 1996, Standard Life acquired through merger Shelby Life from DLAC for approximately $14,650,000, including $13,000,000 in cash, 250,000 shares of restricted SMC Common Stock (valued at $1,250,000) and $400,000 of acquisition costs. Financing for the Shelby Life transaction was provided by senior debt of $10,000,000 under the Amended Credit Agreement and $4,000,000 in subordinated convertible debt described below. The Amended Credit Agreement permits Standard Management to borrow up to $16,000,000 in the form of a seven-year reducing revolving loan arrangement. Standard Management has agreed to pay a non-use fee of .50% per annum on the unused portion of the commitment. In connection with the original and Amended Credit Agreement, Standard Management issued warrants to the bank to purchase 60,000 shares of SMC Common Stock. Borrowing under the Amended Credit Agreement may be used for contributions to surplus of insurance subsidiaries, acquisition financing, and repurchases of Class S Preferred and SMC Common Stock. The debt is secured by a Pledge Agreement of all of the issued and outstanding shares of common stock of Standard Life and Standard Marketing. Interest on the borrowing under the Amended Credit Agreement is determined, at the option of Standard Management, to be: (i) a fluctuating rate of interest to the corporate base rate announced by the bank from time to time plus 1% per annum, or (ii) a rate at LIBOR plus 3.25%. Annual principal repayments of $2,667,000 begin in November 1998 and conclude in November 2003. Indebtedness incurred under the Amended Credit Agreement is subject to certain restrictions and covenants including, among other things, certain minimum financial ratios, minimum statutory surplus requirements for the insurance subsidiaries, minimum consolidated equity requirements for Standard Management and certain investment and indebtedness limitations. At December 31, 1996, Standard Management had borrowed $16,000,000 under the Amended Credit Agreement at a weighted average interest rate of 8.849%. SMC anticipates increasing the Amended Credit Agreement to $20,000,000 to finance the acquisition of Savers Life. In connection with the acquisition of Shelby Life, Standard Management borrowed $4,000,000 from an insurance company pursuant to a subordinated convertible debt agreement which is due in December, 2003 and requires interest payments in cash at 12% per annum, or, if Standard Management chooses, in non-cash additional subordinated convertible debt notes at 14% per annum until December 31, 2000. The subordinated convertible notes are convertible into SMC Common Stock at the rate of $6.00 per share through November 1997, and $5.75 per share thereafter. Standard Management may prepay the subordinated convertible debt with not less than thirty days notice at any time. The subordinated convertible debt agreement contains terms and financial covenants substantially similar to those in the Amended Credit Agreement. Assuming the continuation of current level of debt under the Amended Credit Agreement ($16,000,000) and current interest rates at December 31, 1996 (weighted average rate of 8.849%) and assuming Standard Management elects the non-cash interest payment option under the subordinated convertible debt, annual debt service in 1997 would be approximately $1,416,000 in interest paid on the Amended Credit Agreement. In addition, Standard Management has 1997 obligations under a capital lease of $539,000. From the funds borrowed by Standard Management pursuant to the Amended Credit Agreement and the subordinated convertible debt agreement, $13,000,000 was loaned to Standard Life pursuant to an Unsecured Surplus Debenture Agreement ("Surplus Debenture") which requires Standard Life to make quarterly interest payments to Standard Management at a variable corporate base rate plus 2% per annum, and annual principal payments of $1,000,000 per year beginning in 2007 and concluding in 2019. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life's capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance. Standard Management currently anticipates these quarterly approvals will be granted. Assuming the approvals are granted and the 37 39 December 31, 1996 interest rate of 10.25% continues in 1997, Standard Management will receive interest income of $1,332,500 from the Surplus Debenture for 1997. Dividends from Standard Life to Standard Management are limited by laws applicable to insurance companies. As an Indiana domiciled insurance company, Standard Life may pay a dividend or distribution from its surplus profits, without the prior approval of the Indiana Commissioner of Insurance, if the dividend or distribution, together with all other dividends and distributions paid within the preceding twelve months, does not exceed the greater of (i) net gain from operations or (ii) 10% of surplus, in each case as shown in its preceding annual statutory financial statements. Also, regulatory approval is required when dividends to be paid exceed unassigned surplus. For the year ended December 31, 1996, Standard Life reported statutory net gain from operations of $1,427,000, statutory surplus of $22,969,666 and unassigned surplus of $1,139,659. Standard Life anticipates paying dividends of approximately $1,600,000 in 1997 and the approval of the Indiana Commissioner of Insurance may be required. Standard Life has declared a dividend of $1,000,000 to be paid in April 1997. Standard Management anticipates the available cash from its existing working capital, plus anticipated 1997 dividends, management fees, rental income and interest payments on its Surplus Debentures receivable will be more than adequate to meet its anticipated "parent company only" cash requirements for 1997. Standard Management has a note receivable of $2,858,000 from an affiliate and a note payable of $2,858,000 to a different affiliate. This note receivable and note payable are eliminated in the consolidated financial statements. U.S. Insurance Operations. The principal liquidity requirements of Standard Life are its contractual obligations to policyholders, dividend, rent and management fee payments to Standard Management and other operating expenses. The primary source of funding for these obligations has been cash flow from premium income, net investment income, investment sales and maturities and sales of FPDAs. These sources of liquidity for Standard Life significantly exceed scheduled uses. Liquidity is also affected by unscheduled benefit payments including death benefits and policy withdrawals and surrenders. The amount of withdrawals and surrenders is affected by a variety of factors such as renewal interest crediting rates, interest rates for competing products, general economic conditions, Standard Life's A.M. Best ratings (currently rated "B") and events in the industry that affect policyholders' confidence. The policies and annuities issued by Standard Life contain provisions that allow policyholders to withdraw or surrender their policies under defined circumstances. These policies and annuities generally contain provisions which apply penalties or otherwise restrict the ability of policyholders to make such withdrawals or surrenders. Standard Life closely monitors the surrender and policy loan activity of its insurance products and manages the composition of its investment portfolios, including liquidity, in light of such activity. Changes in interest rates may affect the incidence of policy surrenders and other withdrawals. In addition to the potential effect on liquidity, unanticipated withdrawals in a changing interest rate environment could adversely affect earnings if SMC were required to sell investments at reduced values to meet liquidity demands. SMC manages the asset and liability portfolios in order to minimize the adverse earnings effect of changing market interest rates. SMC seeks assets that have duration characteristics similar to the liabilities that they support. SMC also prepares cash flow projections and performs cash flow tests under various market interest rate scenarios to assist in evaluating liquidity needs and adequacy. SMC's U.S. insurance subsidiaries currently expect available liquidity sources and future cash flows to be adequate to meet the demand for funds. Statutory surplus is computed according to rules prescribed by the NAIC, as modified by the Indiana Department of Insurance, or the state in which the insurance subsidiaries do business. Statutory accounting rules are different from GAAP and are intended to reflect a more conservative perspective. With respect to new business, statutory accounting practices require that: (i) acquisition costs and (ii) reserves for future guaranteed principal payments and interest in excess of statutory rates, be expensed in the year the new business is written. These items cause a statutory loss ("surplus strain") from many insurance products in the year they are issued. SMC designs its products to minimize such first-year losses, but certain products 38 40 continue to cause a statutory loss in the year written. For each product, SMC controls the amount of net new premiums written to manage the effect of such statutory surplus strain. SMC's long-term growth goals contemplate continued growth in its insurance businesses. To achieve these growth goals, SMC's U.S. insurance subsidiaries will need to increase statutory surplus. Additional statutory surplus may be secured through various sources such as internally generated statutory earnings, equity sales, infusions by Standard Management with funds generated through debt or equity offerings or mergers with other life insurance companies. If additional capital is not available from one or more of these sources, SMC believes that it could reduce surplus strain through the use of reinsurance or through reduced issuance of new policies. During 1996, Standard Life produced a statutory net income of $3,291,000. As a result, Standard Management has not made cash capital contributions to Standard Life during 1996 to maintain adequate levels of statutory capital and surplus. In March 1996, Standard Life sold its subsidiary, First International, and realized an increase in statutory capital and surplus of approximately $4,951,000 from the statutory gain on the sale and related reinsurance transactions. In order to be able to write volumes of business that it would not otherwise have been able to write due to regulatory restrictions based on the amount of its statutory capital and surplus commencing January 1, 1995, Standard Life began to reinsure a portion of its annuity business. Standard Life's largest annuity reinsurer at December 31, 1996, Winterthur, is rated "A" (Excellent) by A.M. Best. From January 1, 1995 to August 31, 1995 approximately 70% of certain of Standard Life's annuity business produced was ceded. Standard Life decreased the quota-share portion of business ceded to 50% at September 1, 1995 and further reduced it to 25% effective April 1, 1996 to reflect the reduced need for additional capital and increase current earnings potential. This reduction was possible since the surplus strain experienced by Standard Life was not as great as originally anticipated as a result of lower than expected sales in 1995 and the increase in surplus resulting from the sale of First International. Winterthur limits dividends and other transfers by Standard Life to Standard Management or affiliated companies in certain circumstances. Management believes that operational cash flow of Standard Life will be sufficient to meet its anticipated needs for 1997. As of December 31, 1996, Standard Life had statutory capital and surplus for regulatory purposes of $22,969,666 compared to $12,876,960 at December 31, 1995. As the life insurance and annuity business produced by Standard Life and Dixie National Life increases, Standard Life expects to continue to satisfy statutory capital and surplus requirements through statutory profits, through the continued reinsurance of a portion of its new business, and through additional capital contributions by Standard Management. During 1996, Standard Management did not make any capital contributions to Standard Life, other than the Common Stock associated with the Shelby Merger. Net cash flow from operations on a statutory basis of Standard Life, after payment of benefits and operating expenses, was $17,921,422 and $4,263,011 for the years ended December 31, 1996 and December 31, 1995, respectively. If the need arises for cash which is not readily available, additional liquidity could be obtained from the sale of invested assets. State insurance regulatory authorities impose minimum risk-based capital requirements on insurance enterprises that were developed by the NAIC. The formulas for determining the amount of RBC specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Enterprises below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. Each of SMC's insurance subsidiaries has a Ratio that is at least 400% of the minimum RBC requirements; accordingly, the subsidiaries meet the RBC requirements. Standard Life's acquisition of Shelby Life, and merger of Shelby Life into Standard Life, effective November 1, 1996 is anticipated to have a positive effect on Standard Life's liquidity and cash flows. Shelby Life ceased writing new business effective November 1, 1996, thus reducing the statutory surplus strain normally associated with the issuance of new policies. The anticipated profits from Shelby Life's book of business are expected to exceed the related interest expense connected with the $13,000,000 of Surplus Debentures issued by Standard Life in connection with the acquisition of Shelby Life. The statutory net 39 41 income of Shelby Life was $1,660,855 for the year ended December 31, 1995 and $851,472 for the ten months ended October 31, 1996. International Operations. The consolidated balance sheet of SMC at December 31, 1996, includes a $2,775,000 credit representing the excess of net assets acquired over acquisition cost on the purchase of Standard Management International which will be amortized into future earnings. This amortization is a non-cash credit to SMC statement of operations. Standard Management International dividends are limited to its accumulated earnings without regulatory approval. Standard Management International and Premier Life (Luxembourg) were not permitted to pay dividends in 1996 and 1995 due to accumulated losses. Premier Life (Bermuda) did not pay dividends in 1996 and 1995. SMC does not anticipate any dividends from these companies in 1997. Due to the nature of unit-linked products issued by Standard Management International, which represent over 90% of the Standard Management International portfolio, the investment risk rests with the policyholder. Investment risk for Standard Management International exists where Standard Management International makes investment decisions with respect to the remaining traditional business and for the assets backing certain actuarial and regulatory reserves. The investments underlying these liabilities mostly represent short-term investments and fixed maturity securities. These short-term investments and fixed maturity securities are normally only bought and/or disposed of on the advice of independent consulting actuaries who perform an annual analysis comparing anticipated cash flows on the insurance portfolio with the cash flows from the fixed maturity securities. Any resulting material mis-matches are then covered by adjusting the securities in the investment portfolio as appropriate. Pending Acquisition. SMC's pending purchase of Savers Life will cost approximately $14,200,000, of which approximately $4,000,000 is to be borrowed in cash under the Amended Credit Agreement. The balance of the purchase price will be paid in shares of Common Stock. FACTORS THAT MAY AFFECT FUTURE RESULTS Mergers, Acquisitions and Consolidations. The U.S. insurance industry has experienced an increasing number of mergers, acquisitions, consolidations and sales of certain business lines. These consolidations have been driven by a need to reduce costs of distribution and overhead and maintain business in force. Additionally, increased competition, regulatory capital requirements and technology costs have also contributed to the level of consolidation in the industry. These forces are expected to continue as is the level of industry consolidation. Foreign Currency Risk. Standard Management International policyholders invest in assets denominated in a wide range of currencies. Policyholders effectively bear the currency risk, if any, as these investments are matched by policyholder separate account liabilities. Therefore, their investment and currency risk is limited to premiums they have paid. Policyholders are not permitted to invest directly into options, futures and derivatives. Standard Management International could be exposed to currency fluctuations if currencies within the conventional investment portfolio or certain actuarial reserves are mismatched. The assets and liabilities of this portfolio and the reserves are continually matched by the company and at regular intervals by the independent actuary. In addition, Premier Life (Luxembourg)'s shareholder's equity is denominated in Luxembourg francs. Premier Life (Luxembourg) does not hedge it's translation risk because its stockholder's equity will remain in Luxembourg francs for the foreseeable future and no significant realized foreign exchange gains or losses are anticipated. At December 31, 1996, there was an unrealized gain from foreign currency translation adjustment of $691,000. Uncertainties Regarding Intangible Assets. Included in SMC's financial statements as of December 31, 1996 are certain assets that are valued for financial statement purposes primarily on the basis of assumptions established by SMC's management. These assets include deferred acquisition costs, present value of future profits, costs in excess of net assets acquired and organization and deferred debt issuance costs. The total value of these assets reflected in the December 31, 1996 consolidated balance sheet aggregated $42,198,000 or 7% of SMC's assets. SMC has established procedures to periodically review the assumptions utilized to value these 40 42 assets and determine the need to make any adjustments in such values in SMC's consolidated financial statements. SMC has determined that the assumptions utilized in the initial valuation of these assets are consistent with the current operations of SMC as of December 31, 1996. Regulatory Environment. Currently, prescribed or permitted statutory accounting principles ("SAP") may vary between states and between companies. The NAIC is in the process of codifying SAP to promote standardization of methods utilized throughout the industry. Completion of this project might result in changes in statutory accounting practices for SMC's insurance subsidiaries; however, it is not expected that such changes would materially affect SMC's insurance subsidiaries' statutory capital requirements. Accounting Pronouncements. Effective January 1, 1996, SMC adopted SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 requires expanded disclosures of stock-based compensation arrangements with employees and encourages, but does not require, compensation cost to be measured based on the fair value of the equity instruments awarded. Companies are permitted, however, to continue to apply Accounting Principles Board (APB) Opinion No. 25, which recognizes compensation cost based on the intrinsic value of the equity instrument awarded. SMC will continue to apply APB Opinion No. 25 to its stock-based compensation awards to employees and directors and will disclose the required pro forma effect on net income and earnings per share in its consolidated financial statements for the year ended December 31, 1996. Safe Harbor Provisions. Forward-looking statements in this Annual Report on Form 10-K are made pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. There are certain important factors that could cause results to differ materially from those anticipated by some of the statements made above. Investors are cautioned that all forward-looking statements involve risks and uncertainty. In addition to the factors discussed above, among the other factors that could cause actual results to differ materially are the following: economic environment, interest rate changes, product development, regulatory changes, the results of financing efforts, SMC's accounting policies, competition, the reinsurance agreement with GIAC and the acquisitions of Shelby Life and Savers Life. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required with respect to this Item 8 are listed in Item 14(a)(1) and included in a separate section of this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III The Registrant will file a definitive proxy statement pursuant to Regulation 14A of the Securities Exchange Act of 1934 in connection with the Company's 1997 Annual Meeting of Shareholders (the "Proxy Statement") not later than 120 days after the end of the fiscal year covered by this Report, and certain information included therein is incorporated herein by reference. Only those sections of the Proxy Statement which specifically address the items set forth herein are incorporated by reference. Such incorporation does not include the Compensation Committee Report or the Performance graph included in the Proxy Statement. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning SMC's directors required by this item is incorporated by reference to SMC's Proxy Statement. The information concerning SMC's executive officers required by this Item is incorporated by reference herein to the section in Part I, entitled "Executive Officers of the Registrant." The information regarding compliance with Section 16 of the Securities and Exchange Act of 1934 is to be set forth in the Proxy Statement and is hereby incorporated by reference. 41 43 ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to SMC's Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is incorporated by reference to SMC's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to SMC's Proxy Statement. 42 44 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 31, 1997 STANDARD MANAGEMENT CORPORATION /s/ RONALD D. HUNTER -------------------------------------- Ronald D. Hunter Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 31, 1997 by the following persons on behalf of the Registrant and in the capacities indicated. /s/ RONALD D. HUNTER Chairman, President and Chief Executive Officer - ------------------------------------------ (Principal executive officer) Ronald D. Hunter /s/ JOHN J. QUINN Director, Executive Vice President, - ------------------------------------------ Treasurer and Chief Financial Officer John J. Quinn (Principal financial officer) /s/ RAYMOND J. OHLSON Director - ------------------------------------------ Raymond J. Ohlson /s/ EDWARD T. STAHL Director - ------------------------------------------ Edward T. Stahl /s/ STEPHEN M. COONS Director - ------------------------------------------ Stephen M. Coons /s/ MARTIAL R. KNIESER Director - ------------------------------------------ Martial R. Knieser /s/ RAMESH H. BHAT Director - ------------------------------------------ Ramesh H. Bhat /s/ JAMES C. LANSHE Director - ------------------------------------------ James C. Lanshe Director - ------------------------------------------ Robert A. Borns
43 45 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) and (2) The response to this portion of Item 14 is submitted as a separate section of this report. (a)(3) List of Exhibits: The exhibits set forth in the accompanying Exhibit Index are filed as a part of this report. The following is a list of each management contract or compensatory plan or arrangement required to be filed as an exhibit to this report.
EXHIBIT NUMBER - ------- 10.2 10.3 10.4 10.5 10.8 10.9 10.19
(b) Reports on Form 8-K filed during the fourth quarter of 1996. The Company did not file a Current Report on Form 8-K during the fourth quarter of 1996. 44 46 STANDARD MANAGEMENT CORPORATION INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
PAGE ---- AUDITED CONSOLIDATED FINANCIAL STATEMENTS: Report of Management........................................ F-2 Report of Independent Auditors.............................. F-3 Consolidated Balance Sheets as of December 31, 1996 and 1995...................................................... F-5 Consolidated Statements of Operations for the years ended December 31, 1996, 1995 and 1994.......................... F-6 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1996, 1995 and 1994.............. F-7 Consolidated Statements of Cash Flows for the years ended December 31, 1996, 1995 and 1994.......................... F-8 Notes to Consolidated Financial Statements.................. F-9 FINANCIAL STATEMENT SCHEDULES: The following consolidated financial statement schedules are included as part of this Report and should be used in conjunction with the Audited Consolidated Financial Statements. Schedule II -- Condensed Financial Information of Registrant (Parent Company) for the years ended December 31, 1996, 1995 and 1994............................................. F-34 Schedule IV -- Reinsurance for the years ended December 31, 1996, 1995 and 1994....................................... F-39 Schedules not listed above have been omitted because they are not applicable or are not required, or because the required information is included in the Audited Consolidated Financial Statements or Notes thereto.
F-1 47 REPORT OF MANAGEMENT To Our Shareholders The management of Standard Management Corporation is responsible for the reliability of the financial information appearing in this Annual Report. The consolidated financial statements are prepared by management in accordance with generally accepted accounting principles and the other financial information in this Annual Report is consistent with that in the consolidated financial statements. The integrity of the financial information relies in large part on maintaining a system of internal control that is established by management to provide reasonable assurance that assets are safeguarded and transactions are properly authorized, recorded and reported. Reasonable assurance is based upon the premise that the cost of controls should not exceed the benefits derived from them. Certain financial information presented depends upon management's estimates and judgments regarding the ultimate outcome of transactions which are not yet complete. Management believes these estimates and judgments are fair and reasonable in view of present conditions and available information. The Company engages independent auditors to audit its consolidated financial statements and express their opinion thereon. They have full access to each member of management in conducting their audits. Such audits are conducted in accordance with generally accepted auditing standards and include a review of internal controls, tests of the accounting records, and such other auditing procedures as they consider necessary to express an opinion on the Company's consolidated financial statements. The Audit Committee of the Board of Directors, composed solely of outside directors, meets periodically with management and the independent auditors to review the system of internal control, audit activities and financial reporting matters. The independent auditors have full and free access to the Audit Committee to discuss the results of their audit work and their views on accounting policies, the adequacy of internal accounting controls and the quality of financial reporting. Ronald D. Hunter Chairman of the Board, President and Chief Executive Officer John J. Quinn Executive Vice President, Chief Financial Officer and Treasurer F-2 48 REPORT OF INDEPENDENT AUDITORS Shareholders and Board of Directors Standard Management Corporation We have audited the accompanying consolidated balance sheets of Standard Management Corporation as of December 31, 1996 and 1995, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the consolidated balance sheets at September 30, 1996 and 1995 or the consolidated statements of operations, shareholder's equity and cash flows for the three years ended September 30, 1996 of Standard Management International S.A. and subsidiaries, a wholly owned subsidiary group, which financial statements reflect assets totaling approximately 23% and 28% of the Company's consolidated assets at December 31, 1996 and 1995 and revenues totaling approximately 9%, 12% and 14% of consolidated revenues for each of the three years in the period ended December 31, 1996. Those financial statements, which as explained in Note 1 are included in the Company's consolidated balance sheets at December 31, 1996 and 1995, and the Company's consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996, were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the data included for Standard Management International S.A., is based solely on the report of other auditors. 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 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 and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Standard Management Corporation at December 31, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Ernst & Young LLP Indianapolis, Indiana March 18, 1997 F-3 49 REPORT OF INDEPENDENT AUDITORS Shareholders and Board of Directors Standard Management International S.A. We have audited the accompanying consolidated balance sheets of Standard Management International S.A. and subsidiaries as at September 30, 1996 and 1995 and the related consolidated statements of operations, shareholder's equity and cash flows for each of the three years in the period ended September 30, 1996. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards in the United States of America. 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 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 financial statements referred to above present fairly, in all material aspects, the consolidated financial position of Standard Management International S.A. and subsidiaries as at September 30, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended September 30, 1996 in conformity with generally accepted accounting principles in the United States of America. Luxembourg City, Luxembourg March 12, 1997 KPMG Audit F-4 50 STANDARD MANAGEMENT CORPORATION CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
DECEMBER 31, -------------------- 1996 1995 ---- ---- ASSETS Investments: Securities available for sale: Fixed maturity securities, at fair value (amortized cost: $349,151 in 1996 and $225,643 in 1995).................................................. $347,310 $232,092 Equity securities, at fair value (cost: $58 in 1996 and $52 in 1995)........................................... 62 52 Mortgage loans on real estate, at unpaid principal balances................................................ 3,035 2,963 Policy loans, at unpaid principal balances................ 9,903 8,509 Real estate, at cost less accumulated depreciation of $91 in 1996 and $81 in 1995................................. 546 556 Other invested assets..................................... 865 1,367 Short-term investments, at cost, which approximates fair value................................................... 8,417 35,058 -------- -------- Total investments..................................... 370,138 280,597 Cash........................................................ 5,113 5,762 Accrued investment income................................... 6,198 4,637 Amounts due and recoverable from reinsurers................. 68,811 33,419 Deferred policy acquisition costs........................... 18,078 10,054 Present value of future profits, less accumulated amortization of $3,520 in 1996 and $2,803 in 1995............................................ 24,181 15,246 Excess of acquisition cost over net assets acquired, less accumulated amortization of $314 in 1996 and $393 in 1995............................. 2,260 3,175 Other assets................................................ 5,463 4,003 Assets held in separate accounts............................ 128,546 122,705 -------- -------- Total assets.......................................... $628,788 $479,598 ======== ======== LIABILITIES, REDEEMABLE SECURITIES AND SHAREHOLDERS' EQUITY Liabilities: Future policy benefits: Interest-sensitive annuities and other financial products............................................... $333,633 $212,500 Traditional life insurance.............................. 87,106 82,762 -------- -------- Total future policy benefits.......................... 420,739 295,262 Policy claims and other policyholders' benefits and funds................................................... 4,585 2,572 -------- -------- 425,324 297,834 Accounts payable and accrued expenses..................... 6,189 4,880 Class action litigation and settlement liability.......... -- 3,000 Obligations under capital lease........................... 637 1,084 Notes payable............................................. 20,060 3,107 Deferred federal income taxes............................. 3,334 2,583 Excess of net assets acquired over acquisition cost, less accumulated amortization of $3,839 in 1996 and $2,451 in 1995....................... 2,775 4,163 Liabilities related to separate accounts.................. 128,546 122,705 -------- -------- Total liabilities..................................... 586,865 439,356 Class S Cumulative Convertible Redeemable Preferred Stock, par value $10 per share: Authorized 300,000 shares; issued and outstanding 159,889 shares......................................... 1,757 -- Shareholders' Equity: Preferred Stock, no par value: Authorized 700,000 shares; none issued and outstanding............................................. -- -- Common Stock, no par value: Authorized 20,000,000 shares Issued 5,752,499 shares in 1996 and 5,459,573 in 1995... 40,481 39,808 Treasury stock, at cost, 728,229 shares in 1996 and 502,025 shares in 1995 (deduction)...................... (3,528) (2,621) Unrealized gain (loss) on securities available for sale... (746) 2,582 Foreign currency translation adjustment................... 691 1,159 Retained earnings (deficit)............................... 3,268 (686) -------- -------- Total shareholders' equity............................ 40,166 40,242 -------- -------- Total liabilities, redeemable securities and shareholders' equity................................. $628,788 $479,598 ======== ========
See accompanying notes to consolidated financial statements. F-5 51 STANDARD MANAGEMENT CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31, ----------------------------------- 1996 1995 1994 ---- ---- ---- Revenues: Premium income............................................ $10,468 $ 5,504 $ 4,565 Net investment income..................................... 20,871 18,517 16,057 Net realized investment gains............................. 1,302 688 558 Gain on disposal of subsidiaries.......................... 886 -- -- Policy charges............................................ 2,551 2,467 2,031 Amortization of excess of net assets acquired over acquisition cost....................................... 1,388 1,388 1,063 Management fees and similar income from separate accounts............................................... 1,564 1,294 1,888 Administration fee income................................. 691 -- -- Other income.............................................. 961 380 356 --------- --------- --------- Total revenues....................................... 40,682 30,238 26,518 Benefits and expenses: Benefits and claims....................................... 9,919 5,791 5,603 Interest credited on interest-sensitive annuities and other financial products..................................... 11,281 10,009 8,676 Salaries and wages........................................ 5,053 4,701 3,910 Amortization.............................................. 2,592 2,044 1,215 Other operating expenses.................................. 7,122 6,333 6,563 Interest expense and financing costs...................... 805 118 47 Class action litigation and settlement costs (credit)..... -- (314) 4,018 --------- --------- --------- Total benefits and expenses.......................... 36,772 28,682 30,032 --------- --------- --------- Income (loss) before federal income taxes, extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends................................. 3,910 1,556 (3,514) Federal income tax expense (credit)......................... (602) 243 (78) --------- --------- --------- Income (loss) before extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends................................................. 4,512 1,313 (3,436) Extraordinary gain on early redemption of redeemable preferred stock, net of $-- federal income tax............ 502 -- -- --------- --------- --------- NET INCOME (LOSS)........................................... 5,014 1,313 (3,436) Preferred stock dividends................................... 208 -- -- --------- --------- --------- Earnings available to common shareholders................... $ 4,806 $ 1,313 $(3,436) ========= ========= ========= Earnings per share: Income (loss) before extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends........................................ $.88 $.25 $(.62) Extraordinary gain........................................ .10 -- -- --------- --------- --------- NET INCOME (LOSS)......................................... .98 .25 (.62) Preferred stock dividends................................. .03 -- -- --------- --------- --------- Earnings available to common shareholders................. $.95 $.25 $(.62) ========= ========= ========= Weighted average number of common and common equivalent shares outstanding........................................ 5,250,094 5,345,937 5,504,039 ========= ========= =========
See accompanying notes to consolidated financial statements. F-6 52 STANDARD MANAGEMENT CORPORATION CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31, ---------------------------------------------------------------- AMOUNTS NUMBER OF SHARES ---------------------------- --------------------------------- 1996 1995 1994 1996 1995 1994 ---- ---- ---- ---- ---- ---- Common Stock: Balance, beginning of year.............. $39,808 $39,695 $ 36,348 5,459,573 5,457,906 4,820,739 Issuance of common stock.............. 100 -- -- 20,000 -- -- 5% common stock dividend.............. 850 -- -- 272,926 -- -- Issuance of common stock warrants..... 285 107 -- -- -- -- Repurchase of common stock warrants... (600) -- -- -- -- -- Gain on reissuance of treasury stock in connection with purchase of Shelby Life........................ 38 -- -- -- -- -- Issuance of common stock in connection with exercise of stock options..... -- 6 -- -- 1,667 -- Issued in connection with the offshore offering at an average per share price of $5.85 in 1994 less $382 in 1994 in related issuance costs..... -- -- 3,347 -- -- 637,167 ------- ------- -------- --------- --------- --------- Balance, end of year.................... 40,481 39,808 39,695 5,752,499 5,459,573 5,457,906 ------- ------- -------- --------- --------- --------- Treasury stock (at cost): Balance, beginning of year.............. (2,621) (2,221) (867) (502,025) (418,425) (102,000) Treasury stock acquired............... (2,126) (400) (1,354) (431,026) (83,600) (316,425) 5% common stock dividend.............. -- -- -- (46,402) -- -- Reissuance of treasury stock in connection with exercise of stock options............................ 6 -- -- 1,224 -- -- Reissuance of treasury stock in connection with purchase of Shelby Life............................... 1,213 -- -- 250,000 -- -- ------- ------- -------- --------- --------- --------- Balance, end of year.................... (3,528) (2,621) (2,221) (728,229) (502,025) (418,425) ------- ------- -------- --------- --------- --------- Unrealized gain (loss) on securities: Balance, beginning of year.............. 2,582 (13,411) (4) Change in unrealized gain (loss) on securities available for sale, net................................ (3,328) 15,993 (14,538) Cumulative effect of adoption of SFAS No. 115 as of January 1, 1994 (net of deferred federal income taxes of $583).............................. -- -- 1,131 ------- ------- -------- Balance, end of year.................... (746) 2,582 (13,411) ------- ------- -------- Foreign currency translation adjustments: Balance, beginning of year.............. 1,159 546 -- Translation adjustments for the year............................... (468) 613 546 ------- ------- -------- Balance, end of year.................... 691 1,159 546 ------- ------- -------- Retained earnings (deficit): Balance, beginning of year.............. (686) (1,999) 1,437 Net income (loss)..................... 5,014 1,313 (3,436) 5% common stock dividend, plus cash in lieu of fractional shares.......... (850) -- -- Loss on reissuance of treasury stock.............................. (2) -- -- Preferred stock dividend.............. (208) -- -- ------- ------- -------- Balance, end of year.................... 3,268 (686) (1,999) ------- ------- -------- Total shareholders' equity and common shares outstanding...................... $40,166 $40,242 $ 22,610 5,024,270 4,957,548 5,039,481 ======= ======= ======== ========= ========= =========
See accompanying notes to consolidated financial statements. F-7 53 STANDARD MANAGEMENT CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
YEAR ENDED DECEMBER 31, --------------------------------- 1996 1995 1994 ---- ---- ---- OPERATING ACTIVITIES Net income (loss)........................................... $ 5,014 $ 1,313 $ (3,436) Adjustments to reconcile net income (loss) to net cash provided (used) by operating activities: Amortization of deferred policy acquisition costs......... 1,221 1,142 262 Policy acquisition costs deferred......................... (6,169) (1,863) (5,462) Class action litigation and settlement liability.......... -- (655) 3,655 Deferred federal income taxes............................. 286 353 (80) Depreciation and amortization............................. 544 78 513 Future policy benefits and reinsurance recoverable........ 4,143 6,533 2,490 Policy claims and other policyholders' benefits and funds................................................... 642 (260) (33) Net realized investment gains............................. (1,302) (688) (558) Accrued investment income................................. (770) 347 (1,226) Extraordinary gain on early redemption of redeemable preferred stock......................................... (502) -- -- Other..................................................... (1,381) 31 1,097 --------- --------- --------- NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES...... 1,726 6,331 (2,778) FINANCING ACTIVITIES Issuance of Common Stock, net............................... -- 6 3,347 Borrowings, net of debt issuance costs of $208 in 1996 and $81 and 1995.............................................. 16,792 2,923 -- Repayments on long-term debt and capital lease obligation... (491) (353) -- Short-term borrowings, net.................................. -- (550) 550 Premiums received on interest-sensitive annuities and other financial products credited to policyholder account balances, net of premiums ceded........................... 42,347 17,524 53,490 Return of policyholder account balances on interest-sensitive annuities and other financial products, net of premiums ceded..................................... (17,356) (17,852) (10,922) Redemption of redeemable preferred stock.................... (949) -- -- Repurchase of Common Stock warrants......................... (600) -- -- Proceeds from common and treasury stock sales............... 100 -- -- Purchase of Common Stock for treasury....................... (2,126) (400) (1,353) --------- --------- --------- NET CASH PROVIDED BY FINANCING ACTIVITIES............. 37,717 1,298 45,112 INVESTING ACTIVITIES Fixed maturity securities available for sale: Purchases................................................. (249,638) (183,183) (307,358) Sales..................................................... 194,244 191,477 253,773 Maturities................................................ 10,254 7,812 3,768 Purchase of Shelby Life Insurance Company, less cash acquired of $32........................................... (14,618) -- -- Dividends paid by Shelby Life Insurance Company to former parent.................................................... (3,000) -- -- Purchase of Dixie National Life Insurance Company, less cash acquired of $4,626........................................ -- (3,393) -- Purchase of Standard Management International, less cash acquired of $314.......................................... -- -- (67) Short-term investments, net................................. 11,890 (21,662) 2,104 Other investments, net...................................... (551) 4,082 763 Proceeds from sale of property and equipment under capital lease..................................................... -- 1,396 -- Proceeds from sale of First International Life Insurance Company, less cash transferred to seller of $265.......... 11,327 -- -- --------- --------- --------- NET CASH USED BY INVESTING ACTIVITIES................. (40,092) (3,471) (47,017) --------- --------- --------- Net increase (decrease) in cash............................. (649) 4,158 (4,683) Cash at beginning of year................................... 5,762 1,604 6,287 --------- --------- --------- CASH AT END OF YEAR......................................... $ 5,113 $ 5,762 $ 1,604 ========= ========= =========
See accompanying notes to consolidated financial statements. F-8 54 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 31, 1996 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization Standard Management Corporation ("SMC") is an international insurance holding company, which directly and through its subsidiaries acquires and manages in force life insurance and annuity business and distributes life insurance and annuity products issued by its subsidiaries and a select group of unaffiliated insurers. SMC's active subsidiaries at December 31, 1996 include: (i) Standard Life Insurance Company of Indiana ("Standard Life") and its subsidiary, Dixie National Life Insurance Company ("Dixie National Life"), (ii) Standard Management International S.A. ("Standard Management International") and its subsidiaries, Premier Life (Luxembourg) S.A. ("Premier Life (Luxembourg)") and Premier Life (Bermuda) Ltd. ("Premier Life (Bermuda)"), and (iii) Standard Marketing Corporation ("Standard Marketing"). Basis of Presentation The accompanying consolidated financial statements of SMC and its subsidiaries (the "Company") have been prepared in conformity with generally accepted accounting principles ("GAAP") and include the accounts of SMC and its majority-owned subsidiaries since acquisition or organization. Subsidiaries that are not majority-owned are reported on the equity method. All significant intercompany balances and transactions have been eliminated. The fiscal year end for Standard Management International is September 30. To facilitate reporting on the consolidated level, the fiscal year end for Standard Management International was not changed and the consolidated balance sheets and statements of operations for Standard Management International at September 30, 1996 and 1995 and for each of the three years in the period ended December 31, 1996, are included in the Company's consolidated balance sheets at December 31, 1996 and 1995 and for each of the three years in the period ended December 31, 1996. Use of Estimates The nature of the Company's insurance businesses requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein. Investments The Company classifies its fixed maturity and equity securities as available-for-sale and, accordingly such securities are carried at fair value. Fixed maturity securities include bonds and redeemable preferred stocks. Changes in fair values of securities available for sale, after adjustment for deferred policy acquisition costs, present value of future profits and deferred income taxes, are reported as unrealized gains or losses directly in shareholders' equity and, accordingly, have no effect on net income. The deferred policy acquisition costs and present value of future profits adjustments to the unrealized gains or losses represent valuation adjustments or reinstatements of these assets that would have been required as a charge or credit to operations had such unrealized amounts been realized. F-9 55 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The cost of fixed maturity securities is adjusted for amortization of premiums and discounts. The amortization is provided on a constant effective yield method over the life of the securities and is included in net investment income. Mortgage-backed and other collateralized securities, classified as fixed maturity securities in the balance sheet, are comprised principally of obligations backed by an agency of the United States government (although generally not by the full faith and credit of the United States government). The Company has reduced the risk normally associated with these investments by primarily investing in highly rated securities and in those that provide more predictable prepayment patterns. The income from these securities is recognized using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the income recognized is adjusted currently to match that which would have been recorded had the effective yield been applied since the acquisition of the security. This adjustment is included in net investment income. Mortgage loans on real estate and policy loans are carried at unpaid principal balances and are generally collateralized. Real estate investments, which the Company has the intent to hold for the production of income, are carried at cost, less accumulated depreciation. Short-term investments are carried at amortized cost. Net Realized Investment Gains or Losses Net realized investment gains and losses are calculated using the specific identification method and included in the consolidated statements of operations. If the values of investments decline below their amortized cost and this decline is considered to be other than temporary, the amortized cost of these investments is reduced to net realizable value and the reduction is recorded as a realized loss. Future Policy Benefits Liabilities for future policy benefits for deferred annuities and universal life policies are equal to full account value that accrues to the policyholder (cumulative premiums less certain charges, plus interest credited with rates ranging from 4.5% to 9% in 1996 and 4% to 9.75% in 1995). The average credited rate for deferred annuities and universal life policies is 5.35% at December 31, 1996. Liabilities for future policy benefits for immediate annuities are based on the 1983 Basic Annuity Mortality Table with interest rates ranging from 6.5% to 7.5%. Group annuities in payout status are recorded at discounted future cash flows with interest rates ranging from 5.5% to 6.15% in 1996 and 5.5% to 6.5% in 1995. Future policy benefits for traditional life insurance contracts are computed using the net level premium method on the basis of assumed investment yields, mortality and withdrawals which were appropriate at the time the policies were issued. Assumed investment yields are based on interest rates ranging from 6.5% to 7.5%. Mortality is based upon various actuarial tables, principally the 1965-1970 Select and Ultimate Table. Withdrawals are based upon Company experience and range from 5% to 20% per year. Recognition of Insurance Policy Revenue and Related Benefits and Expenses Revenue for interest-sensitive annuity contracts consists of policy charges for surrenders and investment income earned. Premiums received for these annuity contracts are reflected as premium deposits and are not recorded as revenues. Expenses related to these annuities include interest credited to policyholder account balances. Revenue for universal life insurance policies consists of policy charges for the cost of insurance, policy administration charges, surrender charges and investment income earned during the period. Expenses related to universal life policies include interest credited to policyholder account balances and death benefits incurred during the period in excess of policyholder account balances. F-10 56 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Traditional life insurance and immediate annuity premiums are recognized as premium revenue when due over the premium paying period of the policies. Benefits are charged to expense in the period when claims are incurred and are associated with related premiums through changes in reserves for future policy benefits which results in the recognition of profit over the premium paying period of the policies. Reinsurance Premiums, annuity policy charges, benefits and claims, interest credited and amortization expense are reported net of reinsurance ceded. Reinsurance premiums, annuity policy charges, benefits and claims, interest credited and amortization expense are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Assets Held in Separate Accounts/Liabilities Related to Separate Accounts Separate account assets and liabilities are maintained primarily for universal-life contracts written by Standard Management International of which the majority represent unit-linked business where benefits on surrender and maturity are not guaranteed; also there are investment contracts under which fixed benefits are paid to the policyholder and the terms of which are such that there is little or no mortality risk. Separate account assets and liabilities also generally represent funds maintained in accounts to meet specific investment objectives of policyholders who bear the investment risk. Investment income and investment gains and losses accrue directly to such policyholders. The assets of each account are segregated and are not subject to claims that arise out of any other business of the Company. Deposits, net investment income and realized gains and losses on separate accounts assets are not reflected in the consolidated statements of operations. Management fees received by Standard Management International for administrative and policyholder maintenance services performed for these separate accounts are included in management fees and similar income from separate accounts in the consolidated statements of operations. Foreign Currency Translation The Company's foreign subsidiaries' balance sheets and statements of operations are translated at the year end exchange rates and average exchange rates for the year, respectively. The resulting unrealized gain or loss adjustment from the translation to U.S. dollars is recorded in the foreign currency translation adjustment as a separate component of shareholders' equity. Other translation adjustments for foreign exchange gains or losses have been reflected in the consolidated statements of operations. Foreign exchange gains or losses relating to policyholders' funds in separate accounts are allocated to the relevant separate account. Income Taxes Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which the change is enacted. Standard Life and Dixie National Life file separate federal income tax returns and are taxed as separate life insurance companies. SMC, Standard Marketing and other U.S. non-insurance subsidiaries are taxed as regular corporations and file a consolidated return. SMC and its U.S. non-insurance subsidiaries were able to consolidate with Standard Life for income tax purposes beginning in 1996, but do not currently plan to do so. F-11 57 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Standard Management International is incorporated as a holding company in the Grand Duchy of Luxembourg and, accordingly, is not currently subject to taxation on income or capital gains. Standard Management International is subject to an annual capital tax which is calculated on the nominal value of the statutory shareholder's equity at an annual rate of .20%. Premier Life (Luxembourg) is a normal commercial taxable company and is subject to income tax at regular corporate rates (statutory corporate rate of 39.39%), and annual capital taxes amounting to approximately 1% of its net equity. Premier Life (Bermuda) is exempt from taxation on income until March 2016 pursuant to a decree from the Minister of Finance in Bermuda. To the extent that such income is taxable under U.S. law, such income will be included in SMC's consolidated return. Present Value of Future Profits Present value of future profits is recorded in connection with acquisitions of insurance companies or a block of policies. The initial value is based on the actuarially determined present value of the projected future gross profits from the in-force business acquired. In selecting the interest rate to calculate the discounted present value of the projected future gross profits, the Company uses the risk rate of return believed to best reflect the characteristics of the purchased policies, taking into account the relative risks of such policies, the cost of funds to acquire the business and other factors. The value of insurance in force purchased is amortized on a constant yield basis over the estimated life of the insurance in force at the date of acquisition in proportion to the emergence of profits over a period of approximately 20 years. For acquisitions the Company made on or before November 19, 1992, the Company amortizes the asset with interest at the same discount rate used to determine the present value of future profits at date of purchase. For acquisitions after November 19, 1992, including the acquisitions of Dixie National Life and Shelby Life, the Company amortizes the asset using the interest rate credited to the underlying policies. Deferred Policy Acquisition Costs Costs relating to the acquisition of universal life insurance, interest-sensitive annuities, and traditional life insurance (primarily commissions and certain costs of marketing, policy issuance and underwriting) which vary with and are directly related to the production of new business are deferred and included in the deferred policy acquisition cost asset to the extent that such costs are recoverable from future related policy revenues. For interest-sensitive annuities and other financial products, deferred policy acquisition costs, with interest, are amortized over the lives of the policies and products in a constant relationship to the present value of estimated future gross profits, discounted using the interest rate credited to the policy. Traditional life insurance deferred policy acquisition costs are being amortized over the premium-paying period of the related policies using assumptions consistent with those used in computing policy benefit reserves. The Company periodically reviews the carrying value of the deferred policy acquisition costs. For interest-sensitive annuities and other financial products, the Company considers estimated future gross profits in determining whether the carrying value is appropriate; for other insurance products, the Company considers estimated future premiums. In all cases, the Company considers expected mortality, interest earned and crediting rates, persistency and expenses. Amortization is adjusted retrospectively for interest-sensitive annuities and other financial products when estimates of future gross profits to be realized are revised. Excess of Acquisition Cost Over Net Assets Acquired The excess of the cost to acquire purchased companies over the fair value of net assets acquired is being amortized on a straight-line basis over periods that generally correspond with the benefits expected to be derived from the acquisitions, usually 20 to 40 years. The Company continually monitors the value of excess of F-12 58 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) acquisition cost over net assets acquired ("goodwill") based on estimates of future earnings. If it determines that goodwill has been impaired, the carrying value is reduced with a corresponding charge to expense. Excess of Net Assets Acquired Over Acquisition Cost The excess of the net assets acquired over the cost to acquire purchased companies ("negative goodwill"), after reducing the basis in property and equipment and other noncurrent assets to zero, is being amortized into earnings on a straight-line basis over a five year period. Stock Options The Company recognizes compensation expense for its stock option plan using the intrinsic value method of accounting. Under the terms of the intrinsic value method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date, or other measurement date, over the amount an employee must pay to acquire the stock. Under the Company's stock option plans, no expense is recognized since the exercise price equals or exceeds the market price at the measurement date. Earnings Per Share Earnings per share is computed by dividing earnings available to common shareholders by the weighted average number of common and common equivalent shares outstanding for the applicable period. The weighted average number of common equivalent shares outstanding is determined by calculating the number of shares issuable on exercise of common stock options and warrants, reduced by the number of shares assumed to have been repurchased (at the average market price per share of Common Stock) with the proceeds from their exercise; these shares are then added to the number of average common shares outstanding during the period. Reclassifications Certain amounts in the 1995 and 1994 consolidated financial statements and notes have been reclassified to conform with the 1996 presentation. These reclassifications had no effect on previously reported shareholders' equity or net income during the periods involved. 2. CHANGES IN ACCOUNTING PRINCIPLES In May 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 115 ("SFAS No. 115"), "Accounting for Certain Investments in Debt and Equity Securities." The Company adopted the provisions of SFAS No. 115 as of January 1, 1994. Under SFAS No. 115, securities are classified as available for sale, held-to-maturity, or trading. The Company recognizes that there may be circumstances where it may be appropriate to sell a security prior to maturity in response to unforeseen changes in circumstances. The Company classified all of its fixed maturity portfolio as of January 1, 1994 as available for sale. Securities classified as available for sale are carried at fair value and unrealized gains and losses on such securities are reported as a separate component of shareholders' equity. With the adoption of SFAS No. 115, the January 1, 1994 balance of shareholders' equity was increased by $1,131 (net of deferred taxes of $583 that would have been recorded if such securities had been sold at their fair value on January 1, 1994) to reflect the net unrealized gains on securities classified as available for sale that were previously carried at lower of amortized cost or market. F-13 59 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. ACQUISITIONS AND DISPOSALS On November 8, 1996, Standard Life acquired through merger Shelby Life Insurance Company ("Shelby Life") from Delta Life and Annuity Corporation ("DLAC"), a life insurance company located in Memphis, Tennessee (the "Shelby Merger"). The purchase price was approximately $14,650, including $13,000 in cash, 250,000 shares of restricted Common Stock (valued at $1,250) and acquisition costs of $400 associated with the purchase of Shelby Life. Financing for the Shelby Merger was provided by senior debt of $10,000 and $4,000 in subordinated convertible debt. The acquisition of Shelby Life was accounted for using the purchase method of accounting and the consolidated financial statements will include the results of Shelby Life from November 1, 1996, the effective date of acquisition. Under purchase accounting, Standard Life allocated the total purchase price of Shelby Life to the assets and liabilities acquired, based on a preliminary determination of their fair values and recorded the excess of acquisition cost over net assets acquired as goodwill. Standard Life recorded goodwill of $9 which will be amortized on a straight-line basis over 20 years. Standard Life may adjust this allocation when a final determination of such values is made. On October 2, 1995, Standard Life completed its acquisition of 99.3% of Dixie National Life from Dixie National Corporation ("DNC"), a life insurance holding company located in Jackson, Mississippi. Dixie National Life markets a variety of life insurance products throughout the Mid-South offering primarily "burial expense" policies. The purchase price was $8,019, including costs associated with acquiring Dixie National Life of $684, the forgiveness of a $3,689 DNC note payable to Standard Life and a $1,720 repayment of a DNC note payable. The remaining purchase price of $1,926 was paid in cash from internally generated funds. The acquisition was accounted for using the purchase method of accounting and the consolidated financial statements include the results of Dixie National Life from the date of acquisition. Under purchase accounting, Standard Life allocated the total purchase price of Dixie National Life to the assets and liabilities acquired, based on a determination of their fair values. Standard Life recorded goodwill of $1,589 which will be amortized on a straight-line basis over 40 years. F-14 60 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. ACQUISITIONS AND DISPOSALS (CONTINUED) The following schedule summarizes the assets acquired and the liabilities assumed with the Shelby Life and Dixie National Life acquisitions described above:
DIXIE SHELBY NATIONAL LIFE LIFE ------ -------- Assets acquired: Fixed maturity securities............................... $ 93,376 $17,804 Policy loans............................................ 2,430 3,042 Guaranteed government student loans..................... -- 5,158 Short term investments.................................. 4,725 567 Cash.................................................... 32 4,626 Present value of future profits......................... 9,372 7,901 Other assets............................................ 2,880 1,599 -------- ------- Total assets acquired..................................... 112,815 40,697 Liabilities assumed: Policy reserves......................................... 91,221 30,981 Policy claims and policyholder funds.................... 1,101 2,030 Deferred federal income taxes........................... 1,750 450 Other liabilities....................................... 1,102 761 Dividends payable to DLAC............................... 3,000 -- Minority interest....................................... -- 45 -------- ------- Total liabilities assumed................................. 98,174 34,267 -------- ------- Net assets acquired....................................... 14,641 6,430 Excess of acquisition cost over net assets acquired....... 9 1,589 -------- ------- Total purchase price...................................... $ 14,650 $ 8,019 ======== =======
The following are supplemental unaudited pro forma consolidated results of operations of the Company as if the acquisitions for Shelby Life and Dixie National Life had occurred at the beginning of the period presented at the same purchase price, based on estimates and assumptions considered appropriate.
YEAR ENDED DECEMBER 31, ------------------ 1996 1995 ---- ---- Revenues................................................... $49,719 $45,097 Income (loss) before extraordinary gain.................... 4,942 (90) Net income (loss).......................................... 5,444 (61) Income (loss) per common share and common equivalent share before extraordinary gain................................ .90 (.01) Net income (loss) per common share......................... $ .99 $ (.01)
The above amounts are based upon certain assumptions and estimates which the Company believes are reasonable and do not reflect any benefit from savings which might be achieved from combined operations. The unaudited pro forma results do not necessarily represent results which would have occurred if the acquisitions had taken place on the basis assumed above, nor are they indicative of the results of future combined operations. On March 18, 1996, Standard Life completed the sale of a duplicate charter associated with First International Life Insurance Company ("First International") to The Guardian Insurance and Annuity F-15 61 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. ACQUISITIONS AND DISPOSALS (CONTINUED) Company, Inc. ("GIAC"), a subsidiary of The Guardian Group, New York, NY. Standard Life received proceeds of approximately $11,493, including $1,500 for the charter and licenses associated with First International and $1,800 of reinsurance ceding commissions. Standard Life realized a net pretax gain of $1,042 and a tax benefit of $1,420 on this sale, or $2,462 ($.47 per share). In addition, First International, Standard Life and GIAC have entered into a series of reinsurance and other agreements that include provisions for Standard Life to administer First International policies in force at the date of sale, and for Standard Life to continue to receive the profit stream from the majority of First International's in force business at the date of sale (See Note 10). SMC decided in February 1996 to terminate the reinsurance agreement between Standard Reinsurance of North America Ltd. ("Standard Reinsurance") and Salamandra Joint-Stock Insurance Company in Ukraine ("Salamandra"), and to not renew the Barbados license of Standard Reinsurance. This resulted in the termination of Standard Reinsurance operations and the write-off of SMC's investment in Standard Reinsurance and certain intangible assets of Standard Reinsurance amounting to $156 ($.03 per share). 4. INVESTMENTS The amortized cost, gross unrealized gain (loss) and estimated fair value of securities available for sale are as follows:
DECEMBER 31, 1996 ---------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAIN LOSS VALUE --------- ---------- ---------- ----- Securities available for sale: Fixed maturity securities: United States Treasury securities and obligations of United States government agencies..................................... $ 20,753 $ 51 $ 420 $ 20,384 Obligations of states and political subdivisions................................. 3,588 106 -- 3,694 Foreign government securities.................. 10,042 51 166 9,927 Utilities...................................... 31,000 295 675 30,620 Corporate bonds................................ 210,977 3,086 3,539 210,524 Mortgaged-backed securities.................... 72,264 247 919 71,592 Redeemable preferred stock..................... 527 42 -- 569 -------- ------ ------ -------- Total fixed maturity securities........... 349,151 3,878 5,719 347,310 Equity securities................................. 58 4 -- 62 -------- ------ ------ -------- Total securities available for sale............ $349,209 $3,882 $5,719 $347,372 ======== ====== ====== ========
F-16 62 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. INVESTMENTS (CONTINUED)
DECEMBER 31, 1995 ---------------------------------------------- GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAIN LOSS VALUE --------- ---------- ---------- ----- Securities available for sale: Fixed maturity securities: United States Treasury securities and obligations of United States government agencies..................................... $ 19,331 $ 452 $ 19 $ 19,764 Obligations of states and political subdivisions................................. 60 -- -- 60 Foreign government securities.................. 5,056 118 3 5,171 Utilities...................................... 23,916 462 186 24,192 Corporate bonds................................ 132,119 7,281 1,657 137,743 Mortgaged-backed securities.................... 45,161 417 416 45,162 -------- ------ ------ -------- Total fixed maturity securities........... 225,643 8,730 2,281 232,092 Equity securities................................. 52 -- -- 52 -------- ------ ------ -------- Total securities available for sale............ $225,695 $8,730 $2,281 $232,144 ======== ====== ====== ========
The estimated fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services, or by discounting expected future cash flows using a current market rate applicable to the coupon rate, credit, and maturity of the investments. The change in net unrealized gains (losses) of securities available for sale before effects of deferred acquisition costs, present value of future profits and deferred federal income taxes are as follows:
YEAR ENDED DECEMBER 31, ---------------------------- 1996 1995 1994 ---- ---- ---- Fixed maturity securities......................... $(8,290) $27,142 $(22,407) Equity securities................................. 4 --..... -- ------- ------- -------- $(8,286) $27,142 $(22,407) ======= ======= ========
The amortized cost and estimated fair value of fixed maturity securities at December 31, 1996 by contractual maturity are shown below. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties and because most mortgage-backed securities provide for periodic payments throughout their lives.
AMORTIZED FAIR COST VALUE --------- ----- Due in one year or less.................................. $ 7,418 $ 7,435 Due after one year through five years.................... 24,818 24,970 Due after five years through ten years................... 123,503 123,075 Due after ten years...................................... 120,621 119,669 -------- -------- Subtotal............................................ 276,360 275,149 Redeemable preferred stock............................... 527 569 Mortgage-backed securities............................... 72,264 71,592 -------- -------- Total fixed maturity securities..................... $349,151 $347,310 ======== ========
F-17 63 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 4. INVESTMENTS (CONTINUED) The Company maintains a highly-diversified investment portfolio with limited concentration of financial instruments in any given region, industry or economic characteristic. Investments in any entity in excess of 10% of shareholders' equity at December 31, 1996, other than asset-backed securities and investments issued or guaranteed by the U.S. government or a U.S. government agency, all of which were classified as fixed maturity securities available for sale and are investment-grade securities, were as follows:
AMORTIZED FAIR INVESTMENT COST VALUE ---------- --------- ----- Republic of Indonesia....................................... $5,676 $5,566 AMERCO...................................................... 5,080 5,161 Eastern Energy Limited...................................... 4,974 4,932 Delta Airlines.............................................. 4,590 4,767 Torchmark Corporation....................................... 4,362 4,259
Net investment income was attributable to the following:
YEAR ENDED DECEMBER 31, --------------------------- 1996 1995 1994 ---- ---- ---- Fixed maturity securities.......................... $19,865 $17,457 $15,350 Mortgage loans on real estate...................... 309 152 121 Policy loans....................................... 447 305 331 Real estate........................................ 65 120 290 Short-term investments and other................... 602 990 801 ------- ------- ------- Gross investment income....................... 21,288 19,024 16,893 Investment expenses................................ 417 507 836 ------- ------- ------- Net investment income......................... $20,871 $18,517 $16,057 ======= ======= =======
The Company had no investments in fixed maturity securities available for sale, mortgage loans or real estate that were non-income producing for the year ended December 31, 1996. Net realized investment gains arose from the following:
YEAR ENDED DECEMBER 31, ------------------------ 1996 1995 1994 ---- ---- ---- Fixed maturity securities available for sale: Gross realized gains................................ $2,012 $2,115 $1,933 Gross realized losses............................... 911 1,662 1,240 ------ ------ ------ Net.............................................. 1,101 453 693 Real estate........................................... -- 124 (504) Other................................................. 201 111 204 Change in allowance for losses........................ -- -- 165 ------ ------ ------ Net realized investment gains.................... $1,302 $ 688 $ 558 ====== ====== ======
Life insurance companies are required to maintain certain amounts of assets with state or other regulatory authorities. At December 31, 1996 fixed maturity securities carried at $15,326 and short-term investments carried at $691 were held on deposit by various state regulatory authorities in compliance with statutory regulations. Additionally, fixed maturity securities carried at $2,539 and short-term investments carried at $5,211 of Standard Management International were held by a custodian bank approved by the Luxembourg regulatory authorities to comply with local insurance laws. F-18 64 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. DEFERRED POLICY ACQUISITION COSTS AND PRESENT VALUE OF FUTURE PROFITS The activity related to the deferred policy acquisition costs of business produced is summarized as follows:
YEAR ENDED DECEMBER 31, --------------------------- 1996 1995 1994 ---- ---- ---- Balance at beginning of year....................... $10,054 $12,206 $ 6,513 Deferrals during the year........................ 6,169 1,863 5,462 Amortization during the year..................... (1,221) (1,142) (262) Adjustment relating to net unrealized (gain) loss on fixed maturity securities available for sale.......................................... 3,076 (2,873) 493 ------- ------- ------- Balance at end of year............................. $18,078 $10,054 $12,206 ======= ======= =======
The activity related to the present value of future profits of the business acquired for the Company is summarized as follows:
YEAR ENDED DECEMBER 31, ----------------------------- 1996 1995 1994 ---- ---- ---- Balance at beginning of year....................... $15,246 $ 8,299 $ 9,144 Additions during the year from acquisitions...... 10,723 7,901 -- Deletions during the year from disposal of subsidiaries.................................. (733) -- -- Interest accreted on unamortized balance......... 2,563 1,566 1,461 Amortization during the year..................... (3,812) (2,346) (2,306) Adjustments relating to net unrealized (gain) loss on fixed maturities available for sale... 194 (174) -- ------- ------- ------- Balance at end of year............................. $24,181 $15,246 $ 8,299 ======= ======= =======
The percentages of future expected net amortization of the beginning balance of the present value of future profits before the effect of net unrealized gains and losses, based on the present value of future profits at December 31, 1996 and current assumptions as to future events on all policies in force, will be between 6% and 8% in each of the years 1997 through 2001. The discount rate used to calculate the present value of future profits reflected in the Company's consolidated balance sheet at December 31, 1996, ranged from 7.5% to 18%. The Company used a 15% discount rate to calculate the present value of future profits on the Shelby Life and Dixie National Life acquisitions and block of business from the recapture of the National Mutual Life Insurance Company ("National Mutual") reinsurance agreement (See Note 10). 6. NOTES PAYABLE SMC has outstanding borrowings at December 31, 1996 pursuant to an Amended Revolving Line of Credit Agreement with a bank (the "Amended Credit Agreement") that provides for it to borrow up to $16,000 in the form of a seven-year reducing revolving loan arrangement. SMC has agreed to pay a non-use fee of .50% per annum on the unused portion of the commitment. In connection with the original and Amended Credit Agreement, SMC issued warrants to the bank to purchase 61,500 shares of Common Stock. Borrowings under the Amended Credit Agreement may be used for contributions to surplus of insurance subsidiaries, acquisition financing, and repurchases of Class S Cumulative Convertible Redeemable Preferred Stock ("Class S Preferred Stock") and Common Stock. The debt is secured by a Pledge Agreement of all of the issued and outstanding shares of common stock of Standard Life and Standard Marketing. Interest on the F-19 65 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. NOTES PAYABLE (CONTINUED) borrowings under the Amended Credit Agreement is determined, at the option of SMC, to be: (i) a fluctuating rate of interest to the corporate base rate announced by the bank from time to time plus 1% per annum, or (ii) a rate at LIBOR plus 3.25%. Annual principal repayments of $2,667 begin in November 1998 and conclude in November 2003. Indebtedness incurred under the Amended Credit Agreement is subject to certain restrictions and covenants including, among other things, certain minimum financial ratios, minimum consolidated equity requirements for SMC, positive net income, minimum statutory surplus requirements for the Company's insurance subsidiaries and certain limitations on acquisitions, additional indebtedness, investments, mergers, consolidations and sales of assets. At December 31, 1996, SMC had borrowed $16,000 under this Amended Credit Agreement at a weighted average interest rate of 8.849%. In connection with the acquisition of Shelby Life, SMC borrowed $4,000 from an insurance company pursuant to a subordinated convertible debt agreement which is due in December 2003 and requires interest payments in cash at 12% per annum, or, if SMC chooses, in non-cash additional subordinated convertible debt notes at 14% per annum until December 31, 2000. The subordinated convertible notes are convertible into Common Stock at the rate of $6.00 per share through November 1997, and $5.75 per share thereafter. SMC may prepay the subordinated convertible debt with not less than thirty days notice at any time. The subordinated convertible debt agreement contains terms and financial covenants substantially similar to those in the Amended Credit Agreement. Standard Management International has an unused line of credit of $1,583 which was renewed in February 1997. There were no borrowings in connection with this line of credit in 1996. Interest expense during 1996, 1995 and 1994 was $773, $116 and $47, respectively. Cash paid for interest was $356, $100 and $105 in 1996, 1995 and 1994, respectively. 7. INCOME TAXES The components of the federal income tax expense (credit), applicable to earnings before extraordinary gains, was as follows:
YEAR ENDED DECEMBER 31, ---------------------------- 1996 1995 1994 ---- ---- ---- Current tax provision (benefit).................... $(888) $(110) $ 2 Deferred tax provision (benefit)................... 286 353 (80) ----- ----- ---- $(602) $ 243 $(78) ===== ===== ====
F-20 66 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED) The effective tax rate on pre-tax income before extraordinary gain is lower than the statutory corporate federal income tax rate as follows:
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 ---- ---- ---- Federal income tax statutory rate.................. 34% 34% 34% ======= ===== ======= Federal income tax expense (credit) at statutory rates............................................ $ 1,329 $ 529 $(1,195) Amortization of excess of acquisition cost over net assets acquired.................................. 41 37 33 Small insurance company deduction.................. -- (128) (290) Non recognition of losses in SMC consolidated return and in foreign subsidiaries............... 543 372 290 Class action litigation and settlement costs....... -- (107) 1,366 Amortization of excess of net assets acquired over acquisition cost................................. (472) (472) (361) Tax benefit from disposal of subsidiary............ (1,420) -- -- Release of reserve for tax adjustments............. (325) -- -- Other items, net................................... (298) 12 79 ------- ----- ------- Federal income tax expense (credit).............. $ (602) $ 243 $ (78) ======= ===== ======= Effective tax rate............................... (15)% 16% 2% ======= ===== =======
The Company recovered $130, $280 and $684 in federal income taxes in 1996, 1995 and 1994, respectively and paid federal income taxes of $900 in 1996. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax return purposes. Significant temporary differences included in the Company's deferred tax assets (liabilities) are as follows:
DECEMBER 31, -------------------- 1996 1995 ---- ---- Deferred income tax assets: Unrealized loss on securities available for sale........ $ 355 $ -- Future policy benefits.................................. 8,267 6,902 Capital and net operating loss carryforwards............ 7,719 7,230 Other-net............................................... 1,385 864 ------- ------- Gross deferred tax assets............................ 17,726 14,996 Valuation allowance for deferred tax assets............. (8,750) (8,680) ------- ------- Deferred income tax assets, net of valuation allowance.......................................... 8,976 6,316 Deferred income tax liabilities: Unrealized gain on securities available for sale........ -- (1,961) Present value of future profits......................... (8,221) (5,184) Deferred policy acquisition costs....................... (4,089) (1,754) ------- ------- Total deferred income tax liabilities................ (12,310) (8,899) ------- ------- Net deferred income tax assets (liabilities)............ $(3,334) $(2,583) ======= =======
The Company is required to establish a "valuation allowance" for any portion of its deferred tax assets which are unlikely to be realized. The valuation allowance for deferred tax assets includes $2,308 at F-21 67 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED) December 31, 1996 with respect to corporate income tax loss carryforwards of Standard Management International which, if recognized in the future, will result in an addition to negative goodwill and be amortized into income over its remaining life. The valuation allowance for deferred tax assets includes $2,745 at December 31, 1996 with respect to deferred tax assets at the date of acquisition and net tax operating loss carryforwards of Dixie National Life and Shelby Life which, if recognized in the future, will result in a reduction in goodwill and be amortized into income over its remaining life by reducing goodwill amortization expense. As of December 31, 1996, SMC and its noninsurance subsidiaries had consolidated net operating loss carryforwards of approximately $8,600 for tax return purposes which expire from 2005 through 2011. At December 31, 1996, Standard Life had tax return net operating loss carryforwards of approximately $1,400 which expire in 2004 and 2005. As a result of changes in ownership of SMC and Standard Life, use of the loss carryforwards of Standard Life are subject to annual limitations. The maximum tax return operating loss carryforwards available for use by Standard Life in any one year are approximately $300. At December 31, 1996, Dixie National Life had tax return net operating loss carryforwards of approximately $5,800 which expire in 2010 and 2011. These carryforwards will only be available to reduce the respective taxable income of SMC, Standard Life and Dixie National Life. At December 31, 1996, Premier Life (Luxembourg) had accumulated corporate income tax loss carryforwards of approximately $5,900, all of which may be carried forward indefinitely. The Internal Revenue Service has completed its examination of the Company for years through 1993 in 1996. All adjustments to taxable income determined by completed examinations, which were not material, have reduced the net operating loss carryforwards. Upon completion of the examination, a tax reserve for adjustments of $325 was released and recorded in income in 1996. 8. SHAREHOLDERS' EQUITY Redeemable Preferred Stock Shareholders have authorized 1,000,000 shares of Preferred Stock. Other terms, including preferences, voting and conversion rights, may be established by the Board of Directors. In connection with the class action lawsuit settlement in March 1995, 300,000 of these shares designated as Class S Preferred Stock, $10.00 per share par value, were issued February 8, 1996. The Class S Preferred Stock is redeemable in February 2003, has an 11% annual cumulative dividend payable in February 2003, and is convertible into SMC Common Stock at $7.62 per share until February 1998 and $10.00 per share thereafter, subject to adjustment under a formula intended to protect against dilution. SMC may voluntarily redeem the Class S Preferred Stock prior to February 2003 at par value plus accumulated and unpaid dividends. In February 1996, SMC instituted a program to repurchase from time to time up to 300,000 shares of its Class S Preferred Stock in the open market or privately negotiated transactions. As of December 31, 1996, SMC had repurchased and retired 140,111 shares of its Class S Preferred Stock for $949, primarily paid through additional borrowings under the Amended Credit Agreement. This repurchase resulted in an extraordinary gain on early redemption of redeemable preferred stock of $502 for the year ended December 31, 1996. Common Stock SMC declared a 5% stock dividend on shares of its Common Stock for shareholders of record on May 17, 1996 which was distributed on June 21, 1996. All applicable number of shares and per share amounts included in the accompanying consolidated financial statements and notes have been retroactively adjusted to reflect this stock dividend for all periods presented. F-22 68 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. SHAREHOLDERS' EQUITY (CONTINUED) The Company commenced an offshore offering of newly issued Common Stock exclusively to foreign investors in December 1993. During December 1993 and January 1994 the Company sold 1,666,667 shares of common stock at an average offering price of $5.87 per share. Certain costs amounting to $852 and related to the offering, including legal and underwriting fees, have been charged to common stock and deducted from the proceeds of the offering. The Company received total consideration of $9,783 from the offering, of which 637,167 shares with net proceeds of $3,347 were received during January 1994. A portion of the proceeds was used to complete the acquisition of Standard Management International, with the additional proceeds used to infuse capital into Standard Life and provide working capital to SMC. The Company has a stock repurchase program and repurchases its Common Stock from time to time for the purpose of enhancing shareholder value. The Company repurchased 431,026, 83,600 and 316,425, shares of Common Stock for $2,126, $400 and $1,354 in 1996, 1995 and 1994, respectively. At December 31, 1996, the Company is authorized to purchase an additional 771,771 shares under this program. The Company implemented a policy to issue shares for the exercise of stock options from treasury stock. The Company reissued 1,224 shares at a cost of $6 in 1996 under this program. The following table represents the Company's warrants outstanding to purchase Common Stock as of December 31, 1996:
ISSUE DATE EXPIRATION DATE EXERCISE PRICE WARRANTS OUTSTANDING ---------- --------------- -------------- -------------------- June 1989..................................... December 1999 $3.5216 236,858 July 1992..................................... June 1998 3.5296 175,800 January 1994.................................. January 1998 7.8571 42,000 September 1995................................ September 1998 5.2381 4,200 November 1995................................. November 2002 4.5238 31,500 July 1996..................................... July 2003 4.375 30,000 August 1996................................... August 1998 4.3125 100,000 September 1996................................ September 1998 5.00 25,000 September 1996................................ September 1999 5.50 17,000 ------- 662,358 =======
Unrealized Gain (Loss) on Securities The components of the balance sheet caption "Unrealized gain (loss) on securities available for sale" in shareholders' equity are summarized as follows:
DECEMBER 31, -------------------- 1996 1995 ---- ---- Fair value of securities available for sale.............. $347,372 $232,144 Amortized cost of securities available for sale.......... 349,209 225,695 -------- -------- Gross unrealized gain (loss) on securities available for sale.......................................... (1,837) 6,449 Adjustments for: Deferred policy acquisition costs...................... 696 (2,380) Present value of future profits........................ 20 (174) Deferred federal income tax recoverable (liability).... 375 (1,311) Minority interest...................................... -- (2) -------- -------- Net unrealized gain (loss) on securities available for sale.......................................... $ (746) $ 2,582 ======== ========
F-23 69 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTION PLAN SMC has a Non-qualified Stock Option Plan (the "Plan") under which 1,500,000 shares of Common Stock are reserved for grants of stock options to employees and directors. The purchase price per share specified in any Plan option must be at least equal to the fair market value of common stock at the grant date. Options generally become exercisable over a three-year period and have a term of 10 years. The Plan is administered by the Board of Directors and officers of SMC. The terms of the options, including the number of shares and the exercise price, are subject to the sole discretion of the Board of Directors. Statement of Financial Accounting Standard No. 123 entitled "Accounting for Stock-Based Compensation" ("SFAS 123") issued in October 1995, was adopted by the Company as of December 31, 1996. The provisions of SFAS 123 allow companies to either expense the estimated fair value of stock options or to continue their current practice but disclose the pro forma effects on net income and earnings per share had the fair value of the options been expensed. The Company has elected to continue its practice of recognizing compensation expense for its Plan using the intrinsic value based method of accounting and to provide the required pro forma information for stock options granted after December 31, 1994. Had compensation cost for the Plan been determined based on the fair value at the grant date for awards in 1995 and 1996 consistent with the provisions of SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below:
YEAR ENDED DECEMBER 31, ---------------- 1996 1995 ---- ---- Net income -- as reported................................... $5,014 $1,313 Net income -- pro forma..................................... 4,094 685 Earnings per share -- as reported........................... .98 .25 Earnings per share -- pro forma............................. $ .78 $ .13
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1995 and 1996, respectively: expected volatility of .3882% and .4980%; risk-free interest rate of 6.62% and 5.88%; and expected lives of 7 years. Information regarding the Plan for 1996, 1995 and 1994 is as follows:
1996 1995 1994 ---------------------------- --------------- --------------- WEIGHTED- AVERAGE EXERCISE SHARES PRICE SHARES SHARES ------ --------- ------ ------ Options outstanding, beginning of year............................... 1,164,720 $6.464 520,294 523,194 Exercised............................ (1,224) $3.571 (1,667) -- Granted.............................. 769,122 $6.140 655,008 2,600 Expired or forfeited................. (486,449) $7.564 (8,915) (5,500) --------------- ------ --------------- --------------- Options outstanding, end of year..... 1,446,169 $5.984 1,164,720 520,294 =============== =============== =============== Option price range at end of year.... $3.571 - $9.405 $3.571 - $9.405 $4.286 - $9.405 Option price range for exercised shares............................. $ 3.571 $ 3.571 -- Options available for grant at end of year............................... 50,939 333,613 979,706 =============== =============== =============== Weighted-average fair value of options granted during the year.... $ 3.623 $ 2.906 =============== ===============
F-24 70 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTION PLAN (CONTINUED) Shares under options that were exercisable at year-end are as follows:
DECEMBER 31, 1996 1995 1994 ------------ ---- ---- ---- Options exercisable......................................... 1,097,028 762,374 363,179
Information with respect to stock options outstanding at December 31, 1996 is as follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE - -------------------------------------------------------------------------------- ---------------------------------- WEIGHTED-AVERAGE RANGE OF NUMBER REMAINING WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE EXERCISE OUTSTANDING AT CONTRACTUAL EXERCISE EXERCISABLE AT EXERCISE PRICES DEC. 31, 1996 LIFE (YEARS) PRICE DEC. 31, 1996 PRICE -------- -------------- ---------------- ---------------- -------------- ---------------- $3 - $5............... 337,224 8 Years $4.25 145,775 $4.20 $5 - $7............... 517,975 8 Years $5.27 360,283 $5.29 $7 - $9............... 571,282 9 Years $7.38 571,282 $7.38 $9 - $11.............. 19,688 6 Years $9.41 19,688 $9.41 --------- --------- 1,446,169 1,097,028 ========= =========
Effective May 1, 1996, the Board of Directors cancelled 480,480 options that had previously been granted to certain executive officers with exercise prices ranging from $8.00 to $13.00 per share (representing the market price of the Common Stock on the date such options were initially granted), and granted an identical number of new options with identical terms and vesting periods (the "Replacement Options") to these persons with an exercise price of $7.60, the book value per share of Common Stock on September 30, 1995. On May 1, 1996, the last reported sale price per share of the Common Stock was $4.375. The per share exercise price relating to each Replacement Option was reduced to $7.238 in connection with the 5% stock dividend effected on June 21, 1996 for holders of record of Common Stock on May 17, 1996. 10. REINSURANCE The Company's insurance subsidiaries have entered into reinsurance agreements with non-affiliated companies to limit the net loss arising from large risks, maintain their exposure to loss within capital resources, provide additional capacity for future growth, and effect sharing arrangements. The maximum amount of life insurance retained on any one life ranges from $30 to $150. Amounts of standard risk in excess of that limit are reinsured. Reinsurance premiums ceded to other insurers were $2,152, $4,312 and $5,534 in 1996, 1995 and 1994, respectively. Reinsurance ceded has reduced benefits and claims incurred by $6,201, $1,369 and $4,664 in 1996, 1995 and 1994, respectively. A contingent liability exists to the extent any of the reinsuring companies are unable to meet their obligations under reinsurance agreements. To minimize its exposure to significant losses from reinsurance insolvencies, the Company evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers. The Company believes the assuming companies are able to honor all contractual commitments under the reinsurance agreements, based on its periodic reviews of these companies. The Company's largest annuity reinsurer at December 31, 1996 represented $26,138, or 38% of total reinsurance recoverable, $8,907 of premium deposits ceded in 1996 and is rated "A" (Excellent) by A.M. Best. From January 1, 1995 to August 31, 1995, approximately 70% of Standard Life's annuity business pursuant to the terms of the agreement produced after December 31, 1994 was ceded. Standard Life decreased the quota-share portion of business ceded pursuant to this agreement to 50% at September 1, 1995, F-25 71 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. REINSURANCE (CONTINUED) and further reduced it to 25% effective April 1, 1996. This agreement limits dividends and other transfers by Standard Life to SMC or affiliated companies in certain circumstances. All the inforce business of First International effective January 1, 1996 was ceded to GIAC through a coinsurance indemnity reinsurance agreement. Under the terms of the agreement, approximately $18,841 of First International's reserves and the related assets were ceded to GIAC as of January 1, 1996. The inforce business related to this automatic coinsurance indemnity reinsurance agreement is comprised of the following two blocks; ("Block I") - ordinary life policies (issued in New York and New Jersey), universal life, immediate and deferred annuities (issued in New York, New Jersey and Vermont), supplemental contracts and group waivers, and ("Block II") - ordinary life policies (not issued in New York and New Jersey) issued prior to 1989, and term life policies (issued in New York, New Jersey and Vermont) issued after 1988. Effective at January 1, 1996, GIAC entered into a modified coinsurance indemnity reinsurance agreement with Standard Life with respect to Blocks I and II. Under the terms of the agreement, approximately $18,841 of Standard Life's reserves were assumed from GIAC as of January 1, 1996. Standard Life incurs experience rating refunds to GIAC on Block I. There is no experience rating refund on Block II. As part of the acquisition of First International by SMC in 1992, Standard Life entered into an indemnity reinsurance agreement with First International effective July 1, 1992. This business was subsequently assumed by Standard Life effective January 1, 1993. At the date of the sale of First International to GIAC, Standard Life ceded this block of business with policy reserves of $12,514 and related assets to GIAC, pursuant to an automatic coinsurance indemnity reinsurance agreement. This block of business ("Block III") consisted of term life policies (not issued in New York, New Jersey or Vermont) issued after 1988 and immediate and deferred annuities (not issued in New York, New Jersey and Vermont) and lottery annuities. Standard Life will continue to receive profits from Block III through experience rating refunds from GIAC on Block III. Standard Life received an administration fee of $316 for the year ended December 31, 1996 from First International for the administration of the Block I and Block II policies that were in force at the time of the sale of First International. In June 1988, Standard Life ceded a block of business to National Mutual. Effective May 31, 1996, Standard Life terminated by recapture the reinsurance agreement with National Mutual. As a result of this recapture, Standard Life received assets of $5,201 and liabilities of $4,953, primarily ordinary life policies. In connection with this transaction, Standard Life collected administration fees of $375 related to services provided in prior years that had not been recorded previously due to uncertainty as to collection. This administration fee income and premium income recorded with recapture will not recur in the future. 11. RELATED PARTY TRANSACTIONS The Company paid legal fees of $23 and $114 in 1995 and 1994, respectively, to a law firm of which a partner is a director and officer of SMC. This director and officer resigned from the law firm effective January 1, 1996. In April 1994, the Company made a loan to this director and officer in the amount of $70, due May 1, 1995, at an annual interest rate of 7%. This loan was renewed in May 1995 and was due in two installments of $40 on May 1, 1996 and $30 on August 1, 1997. This loan was collateralized by 10,000 shares of Common Stock owned by the director and officer. The outstanding principal balance at December 31, 1995 was $70. This note was repaid in 1996, with SMC becoming a guarantor supporting a $70 loan to this director and officer on June 25, 1996. The guaranty will be effective until the earlier of repayment of the loan or June 25, 1999. A director and officer of SMC was the sole owner of an independent insurance marketing organization. On April 1, 1994, the assets of this marketing organization were sold to Standard Marketing for $174 payable F-26 72 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. RELATED PARTY TRANSACTIONS (CONTINUED) on an installment basis over a four year period. The outstanding principal balance due on this installment note was $60 and $104 on December 31, 1996 and 1995, respectively. Until the consummation of this transaction, this marketing organization was a master general agent for Standard Marketing and received commissions from Standard Life for sales made on its behalf. These commissions, which amounted to approximately $128 in 1994, were paid at rates comparable to commissions received by non-affiliated master general agents. As a result of the purchase of the marketing organization assets, Standard Marketing receives those commissions previously received by the marketing organization. In December 1994, SMC consolidated two loans to an officer and director of SMC, in the amount of $325 with an annual interest rate of 6.5%, repayable at $2 per month (principal and interest) with a final payment due on December 31, 1996. This loan was refinanced December 29, 1995, and again at December 31, 1996, at an annual interest rate of 5%, payable at $1 per month, with additional annual payments ranging from $50 to $84 through December 31, 2001. The outstanding principal balance was $338 and $333 at December 31, 1996 and 1995, respectively. A director of SMC received $197 in fees for services rendered in connection with the offshore offering of common stock in December 1993 and January 1994. In December 1993, the Company entered into a consulting agreement with a director. The consulting agreement was effective December 1, 1993 and expired on November 30, 1996. Under the terms of the agreement the Company agreed to pay the director $30, $35 and $40 during the first, second and third year of the agreement, respectively. In July 1994, SMC made two loans to this director of SMC in the amounts of $100 and $80. Both notes were at an annual interest rate of prime plus 1%, require quarterly principal repayments and were due in 1996. The outstanding principal balances on these notes were $127 at December 31, 1995. Both notes were repaid in 1996. SMC entered into a covenant not to compete agreement with a former officer and director in February 1997, effective July 1, 1996, the date his employment agreement terminated. In accordance with the covenant not to compete agreement, the officer and director received a lump sum payment of $150 in February 1997, and will receive $125 in each of July 1997 and 1998, and $100 in July 1999. 12. COMMITMENTS AND CONTINGENCIES Lease Commitments The Company rents office and storage space under noncancellable operating leases. The Company incurred rent expense for operating leases of $1,037, $1,092 and $916 in 1996, 1995 and 1994, respectively. Pursuant to the terms of a lease agreement effective June 1, 1991, Standard Life has agreed to lease office space for a ten year period. After the initial ten year lease period, Standard Life may continue to lease the premises on a month to month basis at a rental of 125% of the prevailing market rate for the leased premises in effect at that time. In April 1995, SMC sold its equipment and leased it back under a capital lease. SMC has the option to renew or purchase the equipment at the end of the lease term in April 1998. The cost and accumulated depreciation of the equipment was $1,396 and $814, respectively at December 31, 1996. F-27 73 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 12. COMMITMENTS AND CONTINGENCIES (CONTINUED) Future required minimum rental payments, by year and in the aggregate, under noncancellable capital leases and operating leases as of December 31, 1996, are as follows:
CAPITAL OPERATING LEASES LEASES ------- --------- 1997........................................................ $539 $ 958 1998........................................................ 144 717 1999........................................................ -- 558 2000........................................................ -- 558 2001........................................................ -- 232 Thereafter.................................................. -- -- ---- ------ Total minimum lease payments................................ 683 $3,023 ====== Less amounts representing interest.......................... 46 ---- Present value of net minimum lease payments under capital lease..................................................... $637 ====
Employment Agreements Certain officers are employed pursuant to executive employment agreements that create certain liabilities in the event of the termination of the covered executives following a change of control of the Company. The commitment under these agreements is approximately three times their current annual salaries. Additionally, following termination from the Company following a change in control, each executive is entitled to receive a lump sum payment equal to all unexercised stock options granted multiplied by the highest per share fair market value during the six month period ending on the date of termination. There were unexercised options outstanding to these executives to buy 1,081,080 shares at December 31, 1996. In the first quarter of 1997, the chief financial officer gave notice that he will be terminating his employment at the Company as he has been named Commissioner of the Indiana Department of Insurance. The Company is currently discussing benefits that may or may not be due to the officer. The amount of such benefits can not be determined at this time. 13. EMPLOYEE BENEFIT PLAN The Company has an employee savings plan, available to substantially all salaried employees, containing a matched savings provision that permits both pretax and after-tax employee contributions pursuant to Section 401(k) of the Internal Revenue Code. Participants can contribute from 1% to 15% of their annual compensation and receive a matching employer contribution not to exceed 4% of their annual compensation. The matching contribution is at the discretion of the Company pursuant to the savings plan contract. The contributions may be invested in several investment funds including Common Stock. The Company's total expense for the plan was $104, $43 and $38 in 1996, 1995 and 1994, respectively. 14. LITIGATION SMC and certain of its officers, directors and underwriters were named as defendants in a class action lawsuit originally filed in March 1993 related to allegations surrounding SMC's initial public offering ("IPO") of 2.3 million shares of Common Stock in February 1993. On November 9, 1994, SMC signed a Stipulation of Settlement in the class action suit. The settlement was approved by the United States District Court on March 2, 1995 after notice and hearing. On April 28, 1995, SMC signed a Settlement Agreement with the 22 persons who previously excluded themselves from the F-28 74 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. LITIGATION (CONTINUED) class of plaintiffs in the November 9, 1994 settlement. The settlement was approved by the United States District Court on April 28, 1995. Although SMC firmly believes the lawsuit was without merit, management decided it was in the best interest of shareholders and policyholders to settle the suit, thereby decreasing legal costs and enhancing the Company's ability to make acquisitions and obtain related financing. SMC charged the estimated future costs of the settlement of $3,700 to earnings in 1994. The $3,700 charge includes $3,000 of Class S Preferred Stock (see Note 8), $263 in cash which was distributed to the class participants, and $437 of estimated future legal and other costs to settle the lawsuit and register the Class S Preferred Stock. The $263 cash settlement was part of a $650 cash settlement fund, the remainder of which was paid by the underwriters of the IPO. When aggregated with the class action lawsuit litigation costs already incurred prior to the settlement, the total class action lawsuit litigation and settlement costs were $4,018 ($.73 per share) for 1994. With the signing of the Settlement Agreement with the 22 persons who previously excluded themselves from the class and a reevaluation of the estimated future legal and other costs to settle the lawsuit, SMC recorded a reduction in the estimated future costs to settle the lawsuit and list the Class S Preferred Stock of $314 in 1995. The Class S Preferred Stock was issued on February 8, 1996. In addition, the Company is involved in various legal proceedings in the normal course of business. In most cases, such proceedings involve claims under insurance policies or other contracts of the Company. The outcomes of these legal proceedings are not expected to have a material adverse effect on the consolidated financial position, liquidity, or future results of operations of the Company based on the Company's current understanding of the relevant facts and law. 15. STATUTORY ACCOUNTING INFORMATION OF SUBSIDIARIES The Company's domestic insurance subsidiaries maintain their records in conformity with statutory accounting practices prescribed or permitted by state insurance regulatory authorities. Statutory accounting practices differ in certain respects from GAAP. In consolidation, adjustments have been made to conform the Company's domestic subsidiaries' accounts with GAAP. The Company's U.S. life insurance subsidiaries had consolidated statutory capital and surplus of $22,970 and $12,877 at December 31, 1996 and 1995, respectively, after appropriate eliminations of intercompany accounts among such subsidiaries. Consolidated net income (loss) of the Company's life insurance subsidiaries on a statutory basis, after appropriate eliminations of intercompany accounts among such subsidiaries, was $3,291, $(1,339) and $68 for the years ended December 31, 1996, 1995 and 1994, respectively. Minimum capital and surplus required by the Indiana Insurance Code as of December 31, 1996 was $450 on a statutory basis. "Prescribed" statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners ("NAIC"), as well as state laws, regulations, and general administrative rules. "Permitted" statutory accounting practices encompass all accounting practices that are not prescribed; such practices may differ from state to state, may differ from company to company within a state, and may change in the future. The NAIC currently is in the process of codifying statutory accounting practices, the result of which is expected to constitute the only source of "prescribed" statutory accounting practices. Accordingly, that project, which is expected to be completed in 1998, will likely change, to some extent, prescribed statutory accounting practices, and may result in changes to the accounting practices that insurance enterprises use to prepare their statutory financial statements. Policy reserves for Dixie National Life's fixed premium universal life policies were calculated according to the Commissioners' Reserve Valuation Method ("CRVM") for traditional whole life policies. This differs F-29 75 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 15. STATUTORY ACCOUNTING INFORMATION OF SUBSIDIARIES (CONTINUED) from prescribed statutory accounting practices. Effective October 2, 1995, Dixie National Life received permission from the Mississippi Insurance Department to strengthen the reserves for these policies by using the CRVM methodology as modified by the Universal Life Model Regulation. This reserve strengthening will be recorded quarterly through September 30, 1998. This permitted accounting practice increased statutory surplus as of December 31, 1996 by $1,053. From the funds borrowed by SMC pursuant to the Amended Credit Agreement and the subordinated convertible debt agreement, $13,000 was loaned to Standard Life pursuant to an Unsecured Surplus Debenture Agreement ("Surplus Debenture") which requires Standard Life to make quarterly interest payments to SMC at a variable corporate base rate plus 2% per annum, and annual principal payments of $1,000 per year beginning in 2007 and concluding in 2019. As required by state regulatory authorities, the balance of the surplus debenture at December 31, 1996 of $13,000 is classified as a part of capital and surplus of Standard Life. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life's capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance. SMC's ability to pay operating expenses and meet debt service obligations is partially dependent upon the amount of dividends received from Standard Life. Standard Life's ability to pay cash dividends to SMC is, in turn, restricted by law or subject to approval by the insurance regulatory authorities of Indiana. Dividends are permitted based on, among other things, the level of preceding year statutory surplus and net income. In 1994 and 1995, Standard Life paid no dividends to SMC. In 1996, Standard Life paid a dividend of $1,000 to SMC. During 1997, Standard Life can pay dividends of $2,297 without regulatory approval; Standard Life must notify the Indiana regulatory authorities of the intent to pay dividends at least thirty days prior to payment. State insurance regulatory authorities impose minimum risk-based capital requirements on insurance enterprises that were developed by the NAIC. The formulas for determining the amount of risk-based capital ("RBC") specify various weighting factors that are applied to financial balances or various levels of activity based on the perceived degree of investment and insurance risks. Regulatory compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Enterprises below specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. Each of the Company's insurance subsidiaries has a Ratio that is at least 400% of the minimum RBC requirements; accordingly, the subsidiaries meet the RBC requirements. The statutory capital and surplus for Premier Life (Luxembourg) was $8,243 and $6,857 at fiscal years ended 1996 and 1995, respectively, and minimum capital and surplus under local insurance regulations was $3,295 and $2,736 at fiscal years ended 1996 and 1995, respectively. The statutory capital and surplus for Premier Life (Bermuda) was $1,307 and $1,245 at fiscal years ended 1996 and 1995, respectively, and minimum capital and surplus under local insurance regulations was $250 at fiscal years ended 1996 and 1995. Standard Management International dividends are limited to its accumulated earnings without regulatory approval. Standard Management International and Premier Life (Luxembourg) were not permitted to pay dividends under Luxembourg law in 1996 and 1995 due to accumulated losses. 16. OPERATIONS BY GEOGRAPHIC AREA The Company operates exclusively in one business segment -- the sale and administration of life insurance business (principally annuities and other financial products). F-30 76 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 16. OPERATIONS BY GEOGRAPHIC AREA (CONTINUED) The revenues, pre-tax income and assets by geographic area for 1994 through 1996 are as follows:
YEAR ENDED DECEMBER 31, ------------------------------- 1996 1995 1994 ---- ---- ---- Revenues: United States................................. $36,899 $26,851 $22,514 Europe........................................ 3,783 3,379 3,911 Caribbean..................................... -- 8 93 ------- ------- ------- Total.................................... $40,682 $30,238 $26,518 ======= ======= ======= Income (loss) before federal income taxes, extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends: YEAR ENDED DECEMBER 31, ------------------------------- United States................................. $ 2,688 $ 1,224 $(4,710) Europe........................................ 1,243 411 1,259 Caribbean..................................... (21) (79) (63) ------- ------- ------- Total.................................... $ 3,910 $ 1,556 $(3,514) ======= ======= =======
AT DECEMBER 31, ------------------------------ 1996 1995 1994 ---- ---- ---- Assets: United States................................. $486,951 $343,040 $264,906 Europe........................................ 141,837 136,318 108,237 Caribbean..................................... -- 240 381 -------- -------- -------- Total.................................... $628,788 $479,598 $373,524 ======== ======== ========
The states in the U.S. with the largest share of U.S. premiums collected in 1996 were Indiana (18%), Ohio (16%), Florida (14%), California (11%) and Michigan (6%). No other state accounted for more than 4% of total collected premiums. 17. FAIR VALUE OF FINANCIAL INSTRUMENTS The following discussion outlines the methods and assumptions used by the Company in estimating its fair value disclosures for its financial instrument assets and liabilities as of December 31, 1996 and 1995. Because fair values for all balance sheet items are not required to be disclosed pursuant to SFAS No. 107, "Disclosures about Fair Values of Financial Instruments", the aggregate fair value amounts presented herein do not necessarily represent the underlying value of the Company; likewise, care should be exercised in deriving conclusions about the Company's business or financial condition based on the fair value information presented herein. Fixed maturity securities: Fair values for fixed maturity securities are based on quoted market prices from broker-dealers, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services, or, in the case of private placements, are estimated by discounting the expected future cash flows using current market rates applicable to the coupon rate, credit, and maturity of the investments. Equity securities: The fair values for equity securities are based on the quoted market prices. Mortgage loans and policy loans: The estimated fair values for mortgage loans and policy loans are estimated using discounted cash flow analyses and interest rates currently being offered for similar loans to borrowers with similar credit ratings. F-31 77 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 17. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) Assets and liabilities held in separate accounts: Fair values for the assets held in separate accounts are determined from broker-dealer market makers, or valuations supplied by internationally recognized statistical rating organizations. The separate account liability represents the Company's obligations to policyholders and approximates fair value. Insurance liabilities for investment contracts: Fair values for the Company's liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining contracts being valued. The estimated fair value of the liabilities for investment contracts was approximately equal to its carrying value at December 31, 1996 and 1995, as credited rates on the vast majority of account balances approximate current rates paid on similar investments and because these rates are generally not guaranteed beyond one year. Insurance liabilities for non-investment contracts: Fair value disclosures for the Company's reserves for insurance contracts other than investment-type contracts are not required and have not been determined by the Company. However, the Company closely monitors the level of its insurance liabilities and the fair value of reserves under all insurance contracts are taken into consideration in the Company's overall management of interest rate risk. Notes payable: The Company believes the fair value of its variable rate long-term debt was equal to its carrying value at December 31, 1996 and 1995. The Company negotiated the terms of its Amended Credit Agreement with its lenders in November 1996. Those negotiations were based on the financial condition of the Company and market conditions at that time. The financial condition of the Company has not changed significantly since the negotiations and although market conditions have changed, the Company pays a variable rate of interest on the debt which reflects the changed market conditions. The carrying amount for all other financial instruments approximates their fair values. The fair value of the Company's financial instruments is shown below using a summarized version of the Company's assets and liabilities at December 31, 1996 and 1995. Refer to Note 4 for additional information relating to the fair value for investments.
DECEMBER 31, -------------------------------------------- 1996 1995 -------------------- -------------------- FAIR CARRYING FAIR CARRYING VALUE AMOUNT VALUE AMOUNT ----- -------- ----- -------- Assets: Investments: Securities available for sale: Fixed maturity securities.................... $347,310 $347,310 $232,092 $232,092 Equity securities............................ 62 62 52 52 Mortgage loans on real estate.................. 3,041 3,035 2,990 2,963 Policy loans................................... 7,767 9,903 6,674 8,509 Other invested assets.......................... 888 865 1,401 1,367 Short-term investments......................... 8,417 8,417 35,058 35,058 Assets held in separate accounts............... 128,546 128,546 122,705 122,705 Liabilities: Insurance liabilities for investment contracts.................................... 333,633 333,633 212,500 212,500 Class action litigation and settlement liability.................................... -- -- 3,000 3,000 Capital lease obligation....................... 637 637 1,084 1,084 Notes payable.................................. 20,060 20,060 3,107 3,107 Liabilities related to separate accounts....... 128,546 128,546 122,705 122,705
F-32 78 STANDARD MANAGEMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 18. PENDING ACQUISITION SMC has entered into an Agreement and Plan of Merger dated as of December 19, 1996, as amended February 17, 1997, with Savers Life Insurance Company ("Savers Life"). Savers Life offers retirement products, major medical insurance and Medicare supplement insurance through 5,000 independent brokers, primarily in North Carolina, South Carolina and Virginia. SMC will pay approximately $14,200 plus acquisition costs for the approximately $80,000 asset company, with shareholders of Savers Life initially receiving $8.00 for each share of Savers Life Common Stock, consisting of Common Stock and an election of up to $1.50 per share in cash. The proposed acquisition is subject to certain conditions including SMC and Savers Life shareholder approval and approval by applicable regulatory authorities. The acquisition is expected to close during the second quarter of 1997. 19. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Earnings per common and common equivalent share for each quarter are computed independently of earnings per share for the year. Due to the transactions affecting the weighted average number of shares outstanding in each quarter and due to the uneven distribution of earnings during the year, the sum of the quarterly earnings per share may not equal the earnings per share for the year. All applicable per share amounts have been retroactively adjusted to reflect the 5% stock dividend.
1996 QUARTERS -------------------------------------- FIRST SECOND THIRD FOURTH ----- ------ ----- ------ Total revenues............................................ $8,856 $13,040 $7,969 $10,817 ====== ======= ====== ======= Components of net income: Operating income........................................ $ 214 $ 60 $ 342 $ 804 Net realized investment gains........................... 145 125 129 387 Gain on disposal of subsidiaries........................ 2,306 -- -- -- Extraordinary gain on early redemption of redeemable preferred stock...................................... 101 166 233 2 ------ ------- ------ ------- Net income.............................................. $2,766 $ 351 $ 704 $ 1,193 ====== ======= ====== ======= Net income per common and common equivalent share......... $ .48 $ .07 $ .14 $ .24 ====== ======= ====== =======
1995 QUARTERS ------------------------------------ FIRST SECOND THIRD FOURTH ----- ------ ----- ------ Total revenues.............................................. $7,379 $6,910 $7,104 $8,846 ====== ====== ====== ====== Components of net income: Operating income (loss)................................... $ 250 $ (279) $ 323 $ 167 Net realized investment gains............................. 36 213 122 167 Class action litigation and settlement credit............. -- 314 -- -- ------ ------ ------ ------ Net income................................................ $ 286 $ 248 $ 445 $ 334 ====== ====== ====== ====== Net income per common and common equivalent share........... $ .05 $ .05 $ .08 $ .06 ====== ====== ====== ======
Reporting the results of insurance operations on a quarterly basis requires the use of numerous estimates throughout the year, primarily in the computation of reserves and the effective rate for federal income taxes. It is the Company's practice to review estimates at the end of each quarter and, if necessary, make appropriate adjustments, with the effect of such adjustments being reported in current operations. Only at year-end is the Company able to assess the accuracy of its previous quarterly estimates. The Company's fourth quarter results include the effect of the difference between previous estimates and actual year-end results. Therefore, the results of an interim period may not be indicative of the results of the entire year. F-33 79 SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT STANDARD MANAGEMENT CORPORATION (PARENT COMPANY) CONDENSED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
DECEMBER 31, ----------------------- 1996 1995 ---- ---- ASSETS Investments: Investment in subsidiaries................................ $46,669 $44,452 Surplus debenture due from Standard Life.................. 13,000 -- Equity securities available for sale, at fair value (amortized cost: $8)................................... 12 -- Real estate, at cost less accumulated depreciation of $23 in 1996 and $15 in 1995................................ 139 147 Investment in joint venture............................... 320 -- Notes receivable from officers and directors.............. 338 534 Short-term investments, at cost, which approximates fair value.................................................. 124 714 ------- ------- 60,602 45,847 Cash........................................................ 900 254 Property and equipment, less accumulated depreciation of $989 in 1996 and $399 in 1995............................. 1,087 1,431 Note receivable from affiliate.............................. 2,858 2,858 Amounts receivable from subsidiaries........................ 638 505 Other assets................................................ 829 484 ------- ------- Total assets......................................... $66,914 $51,379 ======= ======= LIABILITIES Obligations under capital lease............................. 637 1,084 Class action litigation and settlement liability............ -- 3,000 Notes payable............................................... 20,000 3,000 Note payable to affiliate................................... 2,858 2,858 Amounts due to subsidiaries................................. 473 677 Other liabilities........................................... 1,023 518 ------- ------- Total liabilities.................................... 24,991 11,137 Class S Cumulative Convertible Redeemable Preferred Stock, par value $10 per share: Authorized 300,000 shares; issued and outstanding 159,889 shares................................................. 1,757 -- SHAREHOLDERS' EQUITY Preferred Stock, no par value: Authorized 700,000 shares; none issued and outstanding.... -- -- Common Stock, no par value: Authorized 20,000,000 shares Issued 5,752,499 shares in 1996 and 5,459,573 in 1995..... 40,481 39,808 Treasury stock, at cost, 728,229 shares in 1996 and 502,025 shares in 1995 (deduction)................................ (3,528) (2,621) Unrealized gain (loss) on securities available for sale of subsidiaries.............................................. (746) 2,582 Foreign currency translation adjustment of subsidiaries..... 691 1,159 Retained earnings (deficit)................................. 3,268 (686) ------- ------- Total shareholders' equity........................... 40,166 40,242 ------- ------- Total liabilities, redeemable securities and shareholders' equity................................ $66,914 $51,379 ======= =======
See accompanying notes to condensed financial statements. F-34 80 SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STANDARD MANAGEMENT CORPORATION (PARENT COMPANY) CONDENSED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
YEAR ENDED DECEMBER 31, ---------------------------- 1996 1995 1994 ---- ---- ---- Revenues: Net investment income..................................... $ 32 $ 112 $ 130 Interest income from subsidiaries......................... 357 172 90 Net realized investment gains (losses).................... -- 23 (276) Loss on disposal of subsidiary............................ (156) -- -- Other income.............................................. 135 28 -- Rental income from subsidiaries........................... 853 715 525 Management fees from subsidiaries......................... 1,905 1,930 1,630 ------- ------ ------- Total revenues......................................... 3,126 2,980 2,099 Expenses: Other operating expenses.................................. 3,470 2,793 2,772 Interest expense and financing costs...................... 799 110 38 Interest expense on note payable to affiliate............. 161 172 90 Class action litigation and settlement costs (credit)..... -- (314) 4,018 ------- ------ ------- Total expenses......................................... 4,430 2,761 6,918 ------- ------ ------- Income (loss) before federal income taxes, equity in earnings of consolidated subsidiaries, extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends................................. (1,304) 219 (4,819) Federal income tax expense (credit)......................... -- (57) (67) ------- ------ ------- Income (loss) before equity in earnings of consolidated subsidiaries, extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends................................................. (1,304) 276 (4,752) Equity in earnings of consolidated subsidiaries............. 5,816 1,037 1,316 ------- ------ ------- Income (loss) before extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends................................................. 4,512 1,313 (3,436) Extraordinary gain on early redemption of redeemable preferred stock, net of $-- federal income tax............ 502 -- -- ------- ------ ------- NET INCOME (LOSS)........................................... 5,014 1,313 (3,436) Preferred stock dividends................................... 208 -- -- ------- ------ ------- Earnings available to common shareholders................... $ 4,806 $1,313 $(3,436) ======= ====== =======
See accompanying notes to condensed financial statements. F-35 81 SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STANDARD MANAGEMENT CORPORATION (PARENT COMPANY) CONDENSED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
YEAR ENDED DECEMBER 31, ------------------------------ 1996 1995 1994 ---- ---- ---- OPERATING ACTIVITIES Net income (loss)........................................... $ 5,014 $ 1,313 $(3,436) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Extraordinary gain on early redemption of redeemable preferred stock........................................ (502) -- -- Amortization of deferred debt issuance costs.............. 32 2 -- Class action litigation and settlement liability.......... -- (655) 3,655 Depreciation and amortization............................. 564 562 470 Equity in earnings of subsidiaries........................ (5,816) (1,037) (1,316) Accrued interest payable.................................. 320 -- -- Other liabilities......................................... 192 480 495 Net realized investment gain (loss)....................... -- (23) 276 Dividend from Standard Life............................... 1,000 -- -- Other..................................................... 165 (250) 179 -------- ------- ------- NET CASH PROVIDED BY OPERATING ACTIVITIES.............. 969 392 323 FINANCING ACTIVITIES Issuance of Common Stock, net............................... -- 6 3,347 Borrowings, net of debt issuance costs of $208 in 1996 and $81 in 1995............................................... 16,792 2,923 -- Repayments on long-term debt and capital lease obligation... (491) (312) -- Short-term borrowings, net.................................. -- (550) 550 Redemption of redeemable preferred stock.................... (949) -- -- Repurchase of stock warrants................................ (600) -- -- Proceeds from common and treasury stock sales............... 100 -- -- Purchase of Common Stock for treasury....................... (2,126) (822) (931) -------- ------- ------- NET CASH PROVIDED BY FINANCING ACTIVITIES.............. 12,726 1,245 2,966 INVESTING ACTIVITIES Investments, net............................................ 197 653 (1,309) Surplus debenture contributed to Standard Life.............. (13,000) -- -- Capital contribution to Standard Life....................... -- (3,000) (1,225) Capital contribution to Standard Management International... -- (170) (90) Capital contribution to Standard Advertising, Inc........... -- (173) -- Capital contribution to Standard Reinsurance................ -- (6) -- Purchase of Standard Management International............... -- -- (67) Proceeds from sale of property and equipment under sales leaseback................................................. -- 1,396 -- Purchase of property and equipment, net..................... (246) (475) (1,448) -------- ------- ------- NET CASH USED BY INVESTING ACTIVITIES.................. (13,049) (1,775) (4,139) -------- ------- ------- Net increase (decrease) in cash............................. 646 (138) (850) Cash at beginning of year................................... 254 392 1,242 -------- ------- ------- Cash at end of year......................................... $ 900 $ 254 $ 392 ======== ======= =======
See accompanying notes to condensed financial statements. F-36 82 SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STANDARD MANAGEMENT CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 31, 1996 1. BASIS OF PRESENTATION For purposes of these condensed financial statements Standard Management Corporation ("SMC") carries its investments in subsidiaries at cost plus equity in undistributed earnings of subsidiaries since date of acquisition. Net income of its subsidiaries is included in income using the equity method. These condensed financial statements should be read in conjunction with SMC's consolidated financial statements included elsewhere in this document. 2. DIVIDENDS FROM SUBSIDIARIES SMC received a cash dividend from subsidiaries of $1,000 in 1996. There were no cash dividends paid to SMC from its subsidiaries in 1995 and 1994. 3. NOTES PAYABLE SMC has outstanding borrowings at December 31, 1996 pursuant to an Amended Revolving Line of Credit Agreement with a bank (the "Amended Credit Agreement") that provides for it to borrow up to $16,000 in the form of a seven-year reducing revolving loan arrangement. SMC has agreed to pay a non-use fee of .50% per annum on the unused portion of the commitment. In connection with the original and Amended Credit Agreement, SMC issued warrants to the bank to purchase 60,000 shares of Common Stock. Borrowings under the Amended Credit Agreement may be used for contributions to surplus of insurance subsidiaries, acquisition financing, and repurchases of Class S Cumulative Convertible Redeemable Preferred Stock ("Class S Preferred Stock") and Common Stock. The debt is secured by a Pledge Agreement of all of the issued and outstanding shares of common stock of Standard Life and Standard Marketing. Interest on the borrowings under the Amended Credit Agreement is determined, at the option of SMC, to be: (i) a fluctuating rate of interest to the corporate base rate announced by the bank from time to time plus 1% per annum, or (ii) a rate at LIBOR plus 3.25%. Annual principal repayments of $2,667 begin in November 1998 and conclude in November 2003. Indebtedness incurred under the Amended Credit Agreement is subject to certain restrictions and covenants including, among other things, certain minimum financial ratios, minimum consolidated equity requirements for SMC, positive net income, minimum statutory surplus requirements for the Company's insurance subsidiaries and certain limitations on acquisitions, additional indebtedness, investments, mergers, consolidations and sales of assets. At December 31, 1996, SMC had borrowed $16,000 under this Amended Credit Agreement at a weighted average interest rate of 8.849%. In connection with the acquisition of Shelby Life, SMC borrowed $4,000 from an insurance company pursuant to a subordinated convertible debt agreement which is due in December 2003 and requires interest payments in cash at 12% per annum, or, if SMC chooses, in non-cash additional subordinated convertible debt notes at 14% per annum until December 31, 2000. The subordinated convertible notes are convertible into Common Stock at the rate of $6.00 per share through November 1997, and $5.75 per share thereafter. SMC may prepay the subordinated convertible debt with not less than thirty days notice at any time. The subordinated convertible debt agreement contains terms and financial covenants substantially similar to those in the Amended Credit Agreement. 4. SURPLUS DEBENTURE From the funds borrowed by SMC pursuant to the Amended Credit Agreement and the subordinated convertible debt agreement, $13,000 was loaned to Standard Life pursuant to an Unsecured Surplus Debenture Agreement ("Surplus Debenture") which requires Standard Life to make quarterly interest F-37 83 SCHEDULE II -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) STANDARD MANAGEMENT CORPORATION (PARENT COMPANY) NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED) 4. SURPLUS DEBENTURE (CONTINUED) payments to SMC at a variable corporate base rate plus 2% per annum, and annual principal payments of $1,000 per year beginning in 2007 and concluding in 2019. As required by state regulatory authorities, the balance of the surplus debenture at December 31, 1996 of $13,000 is classified as a part of capital and surplus of Standard Life. The interest and principal payments are subject to quarterly approval by the Indiana Department of Insurance, depending upon satisfaction of certain financial tests relating to levels of Standard Life's capital and surplus and general approval of the Commissioner of the Indiana Department of Insurance. 5. REDEEMABLE PREFERRED STOCK In connection with the class action lawsuit settlement in March 1995, 300,000 of these shares designated as Class S Preferred Stock, $10.00 per share par value, were issued February 8, 1996. The Class S Preferred Stock is redeemable in February 2003, has an 11% annual cumulative dividend payable in February 2003, and is convertible into Common Stock at $7.62 per share until February 1998 and $10.00 per share thereafter, subject to adjustment under a formula intended to protect against dilution. SMC may voluntarily redeem the Class S Preferred Stock prior to February 2003 at par value plus accumulated and unpaid dividends. In February 1996, SMC instituted a program to repurchase from time to time up to 300,000 shares of its Class S Preferred Stock in the open market or privately negotiated transactions. As of December 31, 1996, SMC had repurchased and retired 140,111 shares of its Class S Preferred Stock for $949, primarily paid through additional borrowings under the Amended Credit Agreement. This repurchase resulted in an extraordinary gain on early redemption of redeemable preferred stock of $502 for the year ended December 31, 1996. 6. STOCK DIVIDEND SMC declared a 5% stock dividend on shares of its common stock for shareholders of record on May 17, 1996 which was distributed on June 21, 1996. All applicable number of shares and per share amounts included in the accompanying condensed financial statements and notes have been retroactively adjusted to reflect this stock dividend for all periods presented. F-38 84 SCHEDULE IV -- REINSURANCE STANDARD MANAGEMENT CORPORATION YEARS ENDED DECEMBER 31, 1996, 1994 AND 1993 (DOLLARS IN THOUSANDS)
PERCENTAGE CEDED TO ASSUMED OF AMOUNT GROSS OTHER FROM OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES AMOUNT TO NET ------ --------- ---------- ------ ---------- YEAR ENDED DECEMBER 31, 1996: Life insurance in force............... $3,000,763 $1,633,340 $252 $1,367,675 .02% ========== ========== ==== ========== === Premiums Life insurance and annuities........ $ 11,862 $ 2,152 $ -- $ 9,710 Accident and health insurance....... 21 -- -- 21 Supplementary contract and other funds on deposit................. 737 -- -- 737 ---------- ---------- ---- ---------- Total premiums................... $ 12,620 $ 2,152 $ -- $ 10,468 ========== ========== ==== ========== YEAR ENDED DECEMBER 31, 1995: Life insurance in force............... $2,316,826 $1,490,812 $282 $ 826,296 .03% ========== ========== ==== ========== === Premiums Life insurance and annuities........ $ 9,574 $ 4,312 $ -- $ 5,262 Accident and health insurance....... 22 -- -- 22 Supplementary contract and other funds on deposit................. 220 -- -- 220 ---------- ---------- ---- ---------- Total premiums................... $ 9,816 $ 4,312 $ -- $ 5,504 ========== ========== ==== ========== YEAR ENDED DECEMBER 31, 1994: Life insurance in force............... $2,561,412 $1,774,308 $310 $ 787,414 .04% ========== ========== ==== ========== === Premiums Life insurance and annuities........ $ 9,670 $ 5,534 $ -- $ 4,136 Accident and health insurance....... 27 -- -- 27 Supplementary contracts and other funds on deposit................. 402 -- -- 402 ---------- ---------- ---- ---------- Total premiums................... $ 10,099 $ 5,534 $ -- $ 4,565 ========== ========== ==== ==========
F-39 85 EXHIBIT INDEX
SEQUENTIAL EXHIBIT PAGE NUMBER DESCRIPTION OF DOCUMENT NUMBER - ------- ----------------------- ---------- 2.1 Agreement and Plan of Merger dated as of December 19, 1996 by and among SMC and Savers Life. (incorporated by reference to SMC's Form 8-K (File No. 0-20882) as filed with the Commission on January 24, 1997. 2.2 Amendment to Agreement and Plan of Merger dated as of February 17, 1997 by and among SMC and Savers Life (incorporated by reference to SMC's Form 8-K (File No. 0-20882) as filed with the Commission on February 19, 1997). 3(i) Amended and Restated Articles of Incorporation, as amended (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 3(ii) Amended and Restated Bylaws of SMC as amended (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993 and to Exhibit 3 of SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1994). 4.1 Form of Senior Note Agreement Warrant (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 4.2 Form of Oppbridge Partners Warrant (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 4.3 Registration Rights Agreement, dated as of May 3, 1990 among SMC, Howard T. Cohn and Joseph J. Piazza and the first amendment thereto, dated June 4, 1990 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 4.4 Amended and Restated Registration Rights Agreement dated as of November 8, 1996 by and between SMC and Fleet National Bank (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 4.5 Form of Fleet National Bank Warrant (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 4.6 Form of President's Club Warrant (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 4.7 Registration Rights Agreement dated as of November 8, 1996 by and between SMC and Great American Reserve Insurance Company ("Great American Reserve") (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 4.8 Form of Sand Brothers & Company, Ltd. Warrant 10.1 Amended Advisory Agreement, dated as of August 1, 1991, between SMC and Conseco Capital Management, Inc., as amended, April 17, 1995 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.2 Second Amended and Restated Employment Contract by and between SMC and Ronald D. Hunter, dated and effective, as amended, April 3, 1995 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended June 30, 1995).
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SEQUENTIAL EXHIBIT PAGE NUMBER DESCRIPTION OF DOCUMENT NUMBER - ------- ----------------------- ---------- 10.3 Second Amended and Restated Employment Contract by and between SMC and Edward T. Stahl, dated and effective, as amended, April 3, 1995 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended June 30, 1995). 10.4 Second Amended and Restated Employment contract by and between SMC and Raymond J. Ohlson, dated and effective, as amended, April 3, 1995 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended June 30, 1995). 10.5 First Amended and Restated Employment Contract by and between SMC and Stephen M. Coons dated and effective, April 3, 1995 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended June 30, 1995). 10.8 Indemnification Agreement between SMC and Stephen M. Coons and Coons & Saint, dated August 1, 1991 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 10.9 Second Amended and Restated 1992 Stock Option Plan, as amended (incorporated by reference to SMC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 and as amended by SMC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1994). 10.10 Lease by and between Standard Life and WRC Properties, Inc., dated February 27, 1991 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 10.11 Management Service Agreement between Standard Life and SMC dated August 1, 1992, as amended on January 1, 1997. 10.12 Agreement for Assumption Reinsurance between the National Organization Of Life and Health Insurance Guaranty Associations and Standard Life, concerning, The Midwest Life Insurance Company In Liquidation effective June 1, 1992 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 10.13 Reinsurance Agreement between Standard Life and The Mercantile and General Reinsurance Company Limited effective May 1, 1975 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 10.14 Reinsurance Agreement between Firstmark Standard Life Insurance Company and The Mercantile and General Reinsurance Company of America effective February 1, 1984 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 10.15 Reinsurance Contract between First International and Standard Life dated July 10, 1992 (incorporated by reference to SMC's Registration Statement on Form S-1 (Registration No. 33-53370) as filed with the Commission on January 27, 1993). 10.19 Renewal Promissory Note from Ronald D. Hunter to SMC in the amount of $337,854 executed December 31, 1996 and due December 31, 2001. 10.20 Amended Reinsurance Agreement between Standard Life and Winterthur Life Re Insurance Company effective January 1, 1995 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995).
87
SEQUENTIAL EXHIBIT PAGE NUMBER DESCRIPTION OF DOCUMENT NUMBER - ------- ----------------------- ---------- 10.21 Management Service Agreement between Premier Life (Luxembourg) and SMC dated September 30, 1994 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 0-20882) for the year ended December 31, 1994). 10.22 Assignment of Management Contract dated October 2, 1995 of Management Contract dated January 1, 1987 between DNC and Dixie National Life to Standard Life (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.23 Indemnity Reinsurance Agreement between Dixie National Life and Crown Life Insurance Company dated and effective September 30, 1992, and Amendment No. 1 as amended October 29, 1992; Amendment No. 2 as amended December 9, 1992; Amendment No. 3 as amended February 11, 1993; Amendment No. 4 as amended June 29, 1993; Amendment No. 5 as amended November 17, 1994; Amendment No. 6 as amended December 31, 1996. 10.24 Automatic Indemnity Reinsurance Agreement between the First International and The Guardian Insurance & Annuity Company, Inc. dated and effective January 1, 1996 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.25 Indemnity Retrocession Agreement between The Guardian Insurance & Annuity Company, Inc. and the Standard Life dated and effective January 1, 1996 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.26 Automatic Indemnity Reinsurance Agreement between The Guardian Insurance & Annuity Company, Inc. and the Standard Life dated and effective January 1, 1996 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.27 Administrative Services Agreement between First International and Standard Life dated and effective March 18, 1996 (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.28 Amended and Restated Revolving Line of Credit Agreement dated as of November 8, 1996 between SMC and Fleet National Bank (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 10.29 Note Agreement dated as of November 8, 1996 between SMC and Fleet National Bank in the amount of $16,000,000 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 10.30 Amended and Restated Pledge Agreement dated as of November 8, 1996 between SMC and Fleet National Bank (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 10.31 Revised Service Contract Agreement dated as of October 16, 1995 and effective January 1, 1995 between Standard Life and Standard Marketing (incorporated by reference to SMC's Annual Report on Form 10-K (File No. 2-20882) for the year ended December 31, 1995). 10.32 Note Agreement dated as of November 8, 1996 by and between SMC and Great American Reserve in the amount of $4,000,000 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996).
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SEQUENTIAL EXHIBIT PAGE NUMBER DESCRIPTION OF DOCUMENT NUMBER - ------- ----------------------- ---------- 10.33 Senior Subordinated Convertible Note dated as of November 8, 1996 by and between SMC and Great American Reserve in the amount of $4,000,000 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 10.34 Surplus Debenture dated as of November 8, 1996 by and between SMC and Standard Life in the amount of $13,000,000 (incorporated by reference to SMC's Quarterly Report on Form 10-Q (File No. 0-20882) for the quarter ended September 30, 1996). 10.35 Portfolio Indemnify Reinsurance Agreement between Dixie National Life and Cologne Life Reinsurance Company dated and effective December 31, 1996. 11 Statement regarding computation of per share earnings 21.1 List of Subsidiaries of SMC 23.1 Consent of Ernst & Young LLP 23.2 Consent of KPMG Audit 27 Financial Data Schedule, which is submitted electronically pursuant to Regulation S-K to the Securities and Exchange Commission for information only and not filed.
EX-4.8 2 FORM OF SAND BROTHERS & COMPANY WARRANT 1 EXHIBIT 4.8 WARRANT AGREEMENT dated as of August 19, 1996 between Standard Management Corporation, an Indiana corporation (the "Company") and Sands Brothers & Co., Ltd., a Delaware corporation (hereinafter referred to variously as the "Holder" or "Sands Brothers"). W I T N E S S E T H: WHEREAS, the Company and Sands Brothers have entered into a certain financial advisory agreement of even date herewith (hereinafter the "Advisory Agreement"), pursuant to which Sands Brothers is entitled to receive certain compensation, including, among other things, warrants ("Warrants") to purchase 100,000 shares of the Company's common stock, no par value per share ("Common Stock"), upon and subject to the terms and conditions of the Advisory Agreement. NOW, THEREFORE, in consideration of the premises, the payment by the Holder to the Company of TWENTY FIVE ($25.00) DOLLARS, the agreements herein set forth and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agrees as follows: 1. Grant. The Holder is hereby granted the right to purchase, at any time from August 19, 1996, until 5:30 p.m., New York time, on August 19, 1998, up to an aggregate of 100,000 shares of Common Stock at the initial exercise price per share (subject to adjustment as provided in Section 8 hereof) as provided in Section 6 hereof. 2 2. Warrant Certificates. The warrant certificates (the "Warrant Certificates") delivered and to be delivered pursuant to this Agreement shall be in the form set forth in Exhibit A attached hereto and made a part hereof, with such appropriate insertions, omissions, substitutions, and other variations as required or permitted by this Agreement. 3. Exercise of Warrant. Section 3.1 Method of Exercise. The Warrants initially are exercisable at an initial exercise price (subject to adjustment as provided in Section 8 hereof) per share of Common Stock set forth in Section 6 hereof payable by certified or official bank check in New York Clearing House funds, subject to adjustment as provided in Section 8 hereof. Upon surrender of a Warrant Certificate with the annexed Form of Election to Purchase duly executed, together with payment of the Exercise Price (as hereinafter defined) for the shares of Common Stock purchased at the Company's principal offices in Indiana (presently located at 9100 Keystone Crossing, Suite 600, Indianapolis, IN 46240) the registered holder of a Warrant Certificate ("Holder" or "Holders") shall be entitled to receive a certificate or certificates for the shares of Common Stock so purchased. The purchase rights represented by each Warrant Certificate are exercisable at the option of the Holder thereof, in whole or in part (but not as to fractional shares of the Common Stock underlying the Warrants). Warrants may be exercised to purchase all or part of the shares of Common Stock represented thereby. In the case of the purchase of less than all the shares of Common Stock purchasable under any Warrant Certificate, the Company shall cancel said Warrant Certificate upon the surrender thereof and shall execute and deliver a new Warrant Certificate of like tenor for the balance of the shares of Common Stock. 2 3 Section 3.2 Exercise by Surrender of Warrant. (a) In addition to the method of payment set forth in Section 3.1 and in lieu of any cash payment required thereunder, the Holder(s) of the Warrants shall have the right at any time and from time to time exercise the Warrants in full or in part by surrendering the Warrant Certificate in the manner specified in Section 3.1 in exchange for the number of shares of Common Stock equal to the product of (x) the number of shares to which the Warrants are being exercised multiplied by (y) a fraction, the numerator of which is the Market Price (as defined in Section 8.1 (vi) hereof) of the Common Stock less the Exercise Price and the denominator of which is such Market Price. (b) Solely for the purposes of this Section 3.2, Market Price shall be calculated either (i) on the date on which the form of election attached hereto is deemed to have been sent to the Company pursuant to Section 13 hereof ("Notice Date") or (ii) as the average of the Market Price for each of the ten trading days preceding the Notice Date, whichever of (i) or (ii) is greater. 4. Issuance of Certificates. Upon the exercise of the Warrants, the issuance of certificates for shares of Common Stock or other securities, properties or rights underlying such Warrants, shall be made forthwith (and in any event such issuance shall be made within five (5) business days thereafter) without charge to the Holder thereof including, without limitation, any tax which may be payable in respect of the issuance thereof, and such certificates shall (subject to the provisions of Sections 5 and 7 hereof) be issued in the name of, or in such names as may be directed by, the Holder thereof; provided, however, that the Company shall not be required to pay any tax which may be payable in respect of any transfer involved in the issuance and delivery of any such certificates in a name other than that of the Holder and the Company shall not be required to issue or deliver such certificates unless or until the person or persons requesting the issuance thereof shall 3 4 have paid to the Company the amount of such tax or shall have established to the satisfaction of the Company that such tax has been paid. The Warrant Certificates and the certificates representing the shares of Common Stock (and/or other securities, property or rights issuable upon exercise of the Warrants) shall be executed on behalf of the Company by the manual or facsimile signature of the then present Chairman or Vice Chairman of the Board of Directors or President or Vice President of the Company under its corporate seal reproduced thereon, attested to by the manual or facsimile signature of the then present Secretary or Assistant Secretary of the Company. Warrant Certificates shall be dated the date of execution by the Company upon initial issuance, division, exchange, substitution or transfer. 5. Restriction On Transfer of Warrants. The Holder of a Warrant Certificate, by its acceptance thereof, covenants and agrees that the Warrants are being acquired as an investment and not with a view to the distribution thereof. 6. Exercise Price. Section 6.1 Initial and Adjusted Exercise Price. Except as otherwise provided in Section 8 hereof, the initial exercise price of each Warrant shall be $4.3125 per share of Common Stock. The adjusted exercise price shall be the price which shall result from time to time from any and all adjustments of the initial exercise price in accordance with the provisions of Section 8 hereof. 4 5 Section 6.2 Exercise Price. The term "Exercise Price" herein shall mean the initial exercise price or the adjusted exercise price, depending upon the context. 7. Registration Rights. Section 7.1 Registration Under the Securities Act of 1933. The Warrants and the shares of Common Stock issuable upon exercise of the Warrants and any of the other securities issuable upon exercise of the Warrants have not been registered under the Securities Act of 1933, as amended (the "Act") for public resale. Upon exercise, in part or in whole, of the Warrants, certificates representing the shares of Common Stock and any other securities issuable upon exercise of the Warrants (collectively, the "Warrant Securities") shall bear the following legend: The securities represented by this certificate have not been registered under the Securities Act of 1933, as amended ("Act") for public resale, and may not be offered or sold except pursuant to (i) an effective registration statement under the Act, (ii) to the extent applicable, Rule 144 under the Act (or any similar rule under such Act relating to the disposition of securities), or (iii) an opinion of counsel, if such opinion shall be reasonably satisfactory to counsel to the issuer, that an exemption from registration under such Act is available. Section 7.2 Piggyback Registration. If, at any time during the five year period commencing after the date hereof, the Company proposes to register any of its securities under the Act (other than in connection with a merger or pursuant to Form S-8, S-4 or comparable registration statement) it will give written notice by registered mail, at least thirty (30) days prior to the filing of each registration statement, to Sands Brothers and to all other Holders of the Warrants and/or the Warrant Securities of its intention to do so. If Sands Brothers or other Holders of the Warrants and/or Warrant Securities notify the Company within twenty (20) days after receipt of any such notice of its or their desire to include any such securities in such proposed registration statement, the Company shall afford Sands Brothers and such Holders of the Warrants and/or Warrant Securities the opportunity to have any such Warrant Securities registered under such registration statement. The Company shall thereupon include in such filing the number of shares of Common Stock for 5 6 which registration is so requested, subject to the next sentence, and shall use its best efforts to effect registration under the Act of such shares. If the managing underwriter of a proposed underwritten public offering of Common Stock shall advise the Company in writing that, in its reasonable opinion, the distribution of the Common Stock requested to be included in the registration concurrently with the securities being registered by the Company or any demanding security holder would materially and adversely affect the distribution of such securities by the Company or such demanding security holder, then the number of shares of Common Stock determined by such underwriter to be the maximum number capable of being included by the holders of Warrants and/or Warrant Shares, pro rata based upon the numbers of Warrants and/or Warrant Shares held by each such holder. Alternatively, in the event of such reasonable advice by the managing underwriter, any holder of the Common Stock may at its option delay its offering and sale for a period not to exceed ninety (90) days after the effective date of such registration as such managing underwriter shall reasonably request. In the event of such delay, the Company shall use its best efforts to effect any registration or qualification under the Act and the securities or blue sky laws of any jurisdiction as may be necessary to permit such holder to make its proposed offering and sale following the end of such period of delay. 6 7 Section 7.3 Demand Registration. (a) At any time after the date hereof, the Holders of the Warrants and/or Warrant Securities representing a "Majority" (as hereinafter defined) of such securities (assuming the exercise of all of the Warrants) shall have the right (which right is in addition to the registration rights under Section 7.2 hereof), exercisable by written notice to the Company, to have the Company prepare and file with the Commission, on one occasion, a registration statement and such other documents, including a prospectus, as may be necessary in the opinion of both counsel for the Company and counsel for Sands Brothers and Holders, in order to comply with the provisions of the Act, so as to permit a public offering and sale of their respective Warrant Securities for six (6) consecutive months by such Holders and any other Holders of the Warrants and/or Warrant Securities who notify the Company within ten (10) days after receiving notice from the Company of such request. (b) The Company covenants and agrees to give written notice of any registration request under this Section 7.3 by any Holder or Holders to all other registered Holders of the Warrants and the Warrant Securities within (10) days from the date of the receipt of any such registration request. (c) Notwithstanding anything to the contrary contained herein, if the Company shall not have filed a registration statement for the Warrant Securities within the time period specified in Section 7.4(a) hereof pursuant to the written notice specified in Section 7.3(a) of a Majority of the Holders of the Warrants and/or Warrant Securities, the Company agrees that upon the written notice of election of a Majority of the Holders of the Warrants and/or Warrant Securities it shall repurchase (i) any and all Warrant Securities at higher of the Market Price (as defined in Section 8.1(vi)) per share of Common Stock on (x) the date of the notice sent pursuant to Section 7.3(a) or (y) the expiration of the period in Section 7.4(a) and (ii) any and all Warrants at such Market Price less the exercise price of such Warrant. Such repurchase shall be in immediately available funds and shall close within two (2) days after the later of (i) the expiration of the period specified in Section 7.4(a) or (ii) the delivery of the written notice of election specified in this Section 7.3(d). 7 8 Section 7.4 Covenants of the Company With Respect to Registration. In connection with any registration under Section 7.2 or 7.3 hereof, the Company covenants and agrees as follows: (a) The Company shall use its best efforts to file a registration statement within ninety (90) days of receipt of any demand therefor, shall use its best efforts to have any registration statements declared effective at the earliest possible time, and shall furnish the Holder desiring to sell Warrant Securities such number of prospectuses as shall reasonably be requested. (b) The Company shall pay all costs (excluding any underwriting or selling commissions or other charges of any broker-dealer acting on behalf of Holders), fees and expenses in connection with all registration statements filed pursuant to Sections 7.2 and 7.3(a) hereof including, without limitation, the Company's legal and accounting fees, printing expenses, blue sky fees and expenses. (c) The Company will take all necessary action which may be required in qualifying or registering the Warrant Securities included in a registration statement for offering and sale under the securities or blue sky laws of the state requested by the Holder. 8 9 (d) The Company shall indemnify the Holder(s) of the Warrant Securities to be sold pursuant to any registration statement and each person, if any, who controls such Holder within the meaning of Section 15 of the Act or Section 20(a) of the Securities Exchange Act of 1934, as amended ("Exchange Act"), against all loss, claim, damage, expense or liability (including all expenses reasonably incurred in investigating, preparing or defending against any claim whatsoever) to which any of them may become subject under the Act, the Exchange Act or otherwise, arising from such registration statement, except insofar as such losses, claims, damages, liabilities or expenses are caused by any untrue statement or alleged untrue statement or omission or alleged omission based upon information furnished to the Company expressly for use therein in a writing signed by the Holder(s) of the Warrant Securities or arising from an underwriter's or holder's actual failure to deliver a prospectus to a purchaser when the delivery was required by law. (e) Nothing contained in this Agreement shall be construed as requiring the Holder(s) to exercise their Warrants prior to the initial filing of any registration statement or the effectiveness thereof. (f) Excluding existing outstanding warrants issued by the Company as of the date of this Agreement and not otherwise covered by a Registration on Form S-8, and the Convertible Subordinated Debenture to be issued to Conseco, Inc. or a subsidiary thereof, the Company shall not permit the inclusion of any securities other than the Warrant Securities to be included in any registration statement filed pursuant to Section 7.3 hereof, or permit any other registration statement to be or remain effective during the effectiveness of a registration statement filed pursuant to Section 7.3 hereof, without the prior written consent of the Holders of the Warrants and Warrant Securities representing a Majority of such securities (assuming an exercise of all of the Warrants). 9 10 (g) The Company shall furnish to each Holder participating in the offering and to each underwriter, if any, a signed counterpart, addressed to such Holder or underwriter, of (i) an opinion of counsel to the Company, dated the effective date of such registration statement (and, if such registration includes an underwritten public offering, an opinion dated the date of the closing under the underwriting agreement), and (ii) a "cold comfort" letter dated the effective date of such registration statement (and, if such registration includes an underwritten public offering; a letter dated the date of the closing under the underwriting agreement) signed by the independent public accountants who have issued a report on the Company's financial statements included in such registration statement, in each case covering substantially the same matters with respect to such registration statement (and the prospectus included therein) and, in the case of such accountants' letter, with respect to agents subsequent to the date of such financial statements, are as customarily covered in opinions of issuer's counsel and in accountants' letters delivered to underwriters in underwritten public offering of securities. (h) The Company shall as soon as practicable after the effective date of the registration statement, and in any event within 15 months thereafter, make "generally available to its security holders" (within the meaning of Rule 158 under the Act) an earnings statement (which need not be audited) complying with Section 11(a) of the Act and covering a period of at least 12 consecutive months beginning after the effective date of the registration agreement. 10 11 (i) The Company shall deliver promptly to each Holder participating in the offering requesting the correspondence and memoranda described below and the managing underwriter copies of all correspondence between the Commission and the Company, its counsel or auditors and all memoranda relating to discussions with the Commission or its staff with respect to the registration statement and permit the Holder and underwriter to do such investigation, upon reasonable advance notice, with respect to information contained in or omitted from the registration statement as it deems reasonably necessary to comply with applicable securities laws or rules of the National Association of Securities Dealers, Inc. ("NASD"). Such investigation shall include access to books, records and properties and opportunities to discuss the business of the Company with its officers and independent auditors, all to such reasonable extent and at such reasonable times and as often as any such Holder shall reasonably request as it deems necessary to comply with applicable securities laws or NASD rules. (j) In addition to the Warrant Securities, upon the written request therefor by any Holder(s), the Company shall include in the registration statement any other securities of the Company held by such Holder(s) as of the date of filing of such registration statement, including without limitation, restricted shares of Common Stock, options, warrants or any other securities convertible into shares of Common Stock. (k) For purposes of this Agreement, the term "Majority" in reference to the Holders of Warrants or Warrant Securities, shall mean in excess of fifty percent (50%) of the then outstanding Warrants or Warrant Securities that (i) are not held by the Company, an affiliate, officer, creditor, employee or agent thereof or any of their respective affiliates, members of their family, persons acting as nominees or in conjunction therewith or (ii) have not been resold to the public pursuant to a registration statement filed with the Commission under the Act. 11 12 8. Adjustments to Exercise and Number of Securities. Section 8.1 Computation of Adjusted Exercise Price. Except as hereinafter provided, in case the Company shall at any time after the date hereof issue or sell any shares of Common Stock (other than the issuances or sales referred to in Section 8.7 hereof), including shares held in the Company's treasury and shares of Common Stock issued upon the exercise of any options, rights or warrants, to subscribe for shares of Common Stock and shares of Common Stock issued upon the direct or indirect conversion or exchange of securities for shares of Common Stock, for a consideration per share less than the Exercise Price in effect immediately prior to the issuance or sale of such shares or the "Market Price" (as defined in Section 8.1(vi) hereof) per share of Common Stock on the date immediately prior to the issuance or sale of such shares, or without consideration, then forthwith upon such issuance or sale, the Exercise Price shall (until another such issuance or sale) be reduced to the price (calculated to the nearest full cent) equal to the quotient derived by dividing (A) an amount equal to the sum of (X) the product of (a) the lower of (i) the Exercise Price in effect immediately prior to such issuance or sale and (ii) the Market Price per share of Common Stock on the date immediately prior to the issuance or sale of such shares, multiplied by (b) the total number of shares of Common Stock outstanding immediately prior to such issuance or sale, plus (Y) the aggregate of the amount of all consideration, if any, received by the Company upon such issuance or sale, by (B) the total number of shares of Common Stock outstanding immediately after such issuance or sale; provided, however, that in no event shall the Exercise Price be adjusted pursuant to this computation to an amount in excess of the Exercise Price in effect immediately prior to such computation, except in the case of a combination of outstanding shares of Common Stock, as provided by Section 8.3 thereof. For the purposes of this Section 8 the term Exercise Price shall mean the Exercise Price per share of Common Stock set forth in Section 6 hereof, as adjusted from time to time pursuant to the provisions of this Section 8. For the purposes of any computation to be made in accordance with this Section 8.1, the following provisions shall be applicable: (i) In case of the issuance or sale or shares of Common Stock for a consideration part or all of which shall be cash, the amount of the cash consideration therefor shall be deemed to be the amount of cash received by the Company for such shares (or, if shares of Common Stock are offered by the Company for subscription, the subscription price, or, if either of such securities shall be sold to underwriters or dealers for public offering without a subscription offering, the initial public offering price) before deducting therefrom any compensation paid or discount allowed in the 12 13 sale, underwriting or purchase thereof by underwriters or dealers or others performing similar services, or any expenses incurred in connection therewith and less any amounts payable to security holders or any affiliate thereof, including without limitation, any employment agreement, royalty, consulting agreement, covenant not to compete, earned or contingent payment right or similar arrangement, agreement or understanding, whether oral or written, but excluding all such existing agreements as of the date of this Warrant Agreement; all such amounts shall be valued at the aggregate amount payable thereunder whether such payments are absolute or contingent and irrespective of the period or uncertainty of payment, the rate of interest, if any, or the contingent nature thereof. (ii) In case of the issuance or sale (otherwise then as a dividend or other distribution on any stock of the Company) of shares of Common Stock for a consideration part or all of which shall be other than cash, the amount of the consideration therefor other than cash shall be deemed to be the value of such consideration as determined in good faith by the Board of Directors of the Company. (iii) Shares of Common Stock issuable by way of dividend or other distribution on any stock of the Company shall be deemed to have been issued immediately after the opening of business on the day following the record date for the determination of stockholders entitled to receive such dividend or other distribution and shall be deemed to have been issued without consideration. (iv) The reclassification of securities of the Company other than shares of Common Stock shall be deemed to involve the issuance of such shares of Common Stock for a consideration other than cash immediately prior to the close of business on the date fixed for the 13 14 determination of security holders entitled to receive such shares, and the value of the consideration allocable to such shares of Common Stock shall be determined as provided in subsection (ii) of this Section 8.1. (v) The number of shares of Common Stock at any one time outstanding shall include the aggregate number of shares issued or issuable (subject to readjustment upon the actual issuance thereof) upon the exercise of options, rights, warrants and upon the conversion or exchange of convertible or exchangeable securities. (vi) As used herein, the phase "Market Price" at any date shall be deemed to be the last reported sale price, or, in case no such reported sale takes place on such day, the average of the last reported sale prices for the last three (3) trading days, in either case as officially reported by the principal securities exchange on which the Common Stock is listed or admitted to trading, or, if the Common Stock is not listed or admitted to trading on any national securities exchange, the average closing bid price as furnished by the NASD through NASDAQ or similar organization if NASDAQ is no longer reporting such information, or if the Common stock is not quoted on NASDAQ, as determined in good faith by resolution of the Board of Directors of the Company, based on the best information available to it. Section 8.2 Options, Rights, Warrants and Convertible and Exchangeable Securities. In case the Company shall at any time after the date hereof issue options, rights or warrants to subscribe for shares of Common Stock, or issue any securities convertible into or exchangeable for shares of Common Stock, for a consideration per share less than the Market Price immediately prior to the issuance of such options, rights or warrants, or such convertible or exchangeable securities, or without consideration, the exercise Price in effect immediately prior to the issuance of such options, 14 15 rights or warrants, or such convertible or exchangeable securities, as the case may be, shall be reduced to a price determined by making a computation in accordance with the provisions of Section 8.1 hereof, provided that: (l) The aggregate maximum number of shares of Common Stock, as the case may be, issuable under such options, rights or warrants shall be deemed to be issued and outstanding at the time such options, rights or warrants were issued, and for a consideration equal to the minimum purchase price per share provided for in such options, rights or warrants at the time of issuance, plus the consideration (determined in the same manner as consideration received on the issue or sale of shares in accordance with the terms of the Warrants), if any, received by the Company for such options, rights or warrants. (m) The aggregate maximum number of shares of Common Stock issuable upon conversion or exchange of any convertible or exchangeable securities shall be deemed to be issued and outstanding at the time of issuance of such securities, and for a consideration equal to the consideration (determined in the same manner as consideration received on the issue or sale of shares of Common Stock in accordance with the terms of the Warrants) received by the Company for such securities, plus the minimum consideration, if any, receivable by the Company upon the conversion or exchange thereof. (n) If any change shall occur in the price per share provided for in any of the options, rights or warrants referred to in subsection (a) of this Section 8.2, or in the price per share at which the securities referred to in subsection (b) of this Section 8.2 are convertible or exchangeable, such options, rights or warrants or conversion or exchange rights, as the case may be, shall be deemed to have expired or terminated on the date when such price change became effective 15 16 in respect of shares not theretofore issued pursuant to the exercise or conversion or exchange thereof, and the Company shall be deemed to have issued upon such date new options, rights or warrants or convertible or exchangeable securities at the new price in respect of the number shares issuable upon the exercise of such options, rights or warrants or the conversion or exchange of such convertible or exchangeable securities. Section 8.3 Subdivision and Combination. In case the Company shall at any time subdivide or combine the outstanding shares of Common Stock, the Exercise Price shall forthwith be proportionately decreased in the case of subdivision or increased in the case of combination. Section 8.4 Adjustment in Number of Securities. Upon each adjustment of the Exercise Price pursuant to the provisions of this Section 8, the number of Securities issuable upon the exercise of each Warrant shall be adjusted to the nearest full amount by multiplying a number equal to the Exercise Price in effect immediately prior to such adjustment by the number of Warrant Securities issuable upon exercise of the Warrants immediately prior to such adjustment and dividing the product so obtained by the adjusted Exercise Price. Section 8.5 Definition of Common Stock. For the purpose of this Agreement, the term "Common Stock" shall mean (i) the class of stock designated as Common Stock in the Articles of Incorporation of the Company as may be amended as of the date hereof, or (ii) any other class of stock resulting from successive changes or reclassifications of such Common Stock consisting solely of changes in par value, or from par value to no par value, or from no par value to par value. In the event that the Company shall after the date hereof issue securities with greater or superior voting rights than the shares of Common Stock outstanding as of the date hereof, the Holder, at its option, 16 17 may receive upon exercise of any Warrant either shares of Common Stock or a like number of such securities with greater or superior voting rights. Section 8.6 Merger or Consolidation. In case of any consolidation of the Company with, or merger of the Company with, or merger of the Company into, another corporation (other than a consolidation or merger which does not result in any reclassification or change of the outstanding Common Stock), the corporation formed by such consolidation or merger shall execute and deliver to the Holder a supplemental warrant agreement providing that the holder of each Warrant then outstanding or to be outstanding shall have the right thereafter (until the expiration of such Warrant) to receive, upon exercise of such warrant, the kind and amount of shares of stock and other securities and property receivable upon such consolidation or merger, by a holder of the number of shares of Common Stock of the Company for which such warrant might have been exercised immediately prior to such consolidation, merger, sale or transfer. Such supplemental warrant agreement shall provide for adjustments which shall be identical to the adjustments provided in Section 8. The above provision of this Subsection shall similarly apply to successive consolidations or mergers. Section 8.7 No Adjustment of Exercise Price in Certain Cases. No adjustment of the Exercise Price shall be made: (a) Upon the issuance or sale of the Warrants or the shares of Common Stock issuable upon the exercise of the Warrants; or (b) Upon the exercise of existing stock options or warrants as of the date of this Warrant Agreement or upon the conversion of the Convertible Subordinated Debentures to be issued to Conseco, Inc. or a subsidiary thereof; or 17 18 (c) If the amount of said adjustment shall be less than 2 cents ($.02) per Security, provided, however, that in such case any adjustment that would otherwise be required then to be made shall be carried forward and shall be made at the time of and together with the next subsequent adjustment which, together with any adjustment so carried forward, shall amount to at least 2 cents ($.02) per Security. Section 8.8 Intentionally Omitted. 9. Exchange and Replacement of Warrant Certificates. Each Warrant Certificate is exchangeable without expense, upon the surrender thereof by the registered Holder at the principal executive office of the Company, for a new Warrant Certificate of like tenor and date representing in the aggregate the right to purchase the same number of Securities in such denominations as shall be designated by the Holder thereof at the time of such surrender. Upon receipt by the Company of evidence reasonably satisfactory to it of the loss, theft, destruction or mutilation of any Warrant Certificate, and, in case of loss, theft or destruction, of indemnity or security reasonably satisfactory to it, and reimbursement to the Company of all reasonable expenses incidental thereto, and upon surrender and cancellation of the Warrants, if mutilated, the Company will make and deliver a new Warrant Certificate of like tenor, in lieu thereof. 10. Elimination of Fractional Interests. The Company shall not be required to issue certificates representing fractions of shares of Common Stock upon the exercise of the Warrants, nor shall it be required to issue scrip or pay cash in lieu of fractional interests, it being the intent of the parties that all fractional interests shall be eliminated by rounding any fraction up to the nearest whole number of shares of Common Stock or other securities, properties or rights. 18 19 11. Reservation and Listing of Securities. The Company shall at all times reserve and keep available out of its authorized shares of Common Stock, solely for the purpose of issuance upon the exercise of the Warrants, such number of shares of Common Stock or other securities, properties or rights as shall be issuable upon the exercise thereof. The Company covenants and agrees that, upon exercise of the Warrants and payment of the Exercise Price therefor, all shares of Common Stock and other securities issuable upon such exercise shall be duly and validly issued, fully paid, non-assessable and not subject to the preemptive rights of any stockholder. As long as the Warrants shall be outstanding, the Company shall use its best efforts to cause all shares of Common Stock issuable upon the exercise of the Warrants to be listed (subject to official notice of issuance) on all securities exchanges on which the Common Stock issued to the public in connection herewith may then be listed and/or quoted on NASDAQ. 12. Notice to Warrant Holders. Nothing contained in this Agreement shall be construed as conferring upon the Holders the right to vote or to consent or to receive notice as a stockholder in respect of any meetings of stockholders for the election of directors or any other manner, or as having any rights whatsoever as a stockholder of the Company. If, however, at any time prior to the expiration of the Warrants and their exercise, any of the following events shall occur: (a) the Company shall take a record of the holders of its shares of Common Stock for the purpose of entitling them to receive a dividend or distribution payable otherwise than in cash, or a cash dividend or distribution payable otherwise than out of current or retained earnings, as indicated by the accounting treatment of such dividend or distribution on the books of the Company; or 19 20 (b) the Company shall offer to all the holders of its Common Stock any additional shares of capital stock of the Company or securities convertible into or exchange for shares of capital stock of the Company, or any option, right or warrant to subscribe therefor; or (c) a dissolution, liquidation or winding up of the Company (other than in connection with a consolidation or merger) or a sale of all or substantially all of its property, assets and business as an entirety shall be proposed; then, in any one or more of said events, the Company shall give notice of such event at least fifteen (15) days prior to the date fixed as a record date or the date of the closing the transfer books for the determination of the stockholders entitled to such dividend, distribution, convertible or exchangeable securities or subscription rights, or entitled to vote on such proposed dissolution, liquidation, winding up or sale. Such notice shall specify such record date or the date of closing the transfer books, as the case may be. Failure to give such notice or any defect therein shall not affect the validity of any action taken in connection with the declaration or payment of any such dividend, or the issuance of any convertible or exchangeable securities, or subscription rights, options or warrants, or any proposed dissolution, liquidation, winding up or sale. 13. Notices. All notices, requests, consents and other communications hereunder shall be in writing and shall be deemed to have been duly made when delivered, or mailed by registered or certified mail, return receipt requested: (a) If to the Holders, Sands Brothers & Co., Ltd., 90 Park Avenue, 39th Floor, New York, New York 10016 as shown on the books of the Company; or (b) If to the Company, to the address set forth in Section 3 hereof or to such other address as the Company may designate by notice to the Holders. 20 21 14. Supplements and Amendments. Except as otherwise expressly provided herein, the provisions of this Agreement may be amended or waived at any time only by the written agreement of the parties hereto. Any waiver, permit, consent or approval of kind or character on the part of each Company or the Holder of any provisions or conditions of this Agreement must be made in writing and shall be effective only to the extent specifically set forth in such writing. 15. Successors. All the covenants and provisions of this Agreement shall be binding upon and inure to the benefit of the Company, the Holder and their respective successors and assigns hereunder. 16. Governing Law; Submission to Jurisdiction. This Agreement and each Warrant Certificate issued hereunder shall be deemed to be a contract made under the laws of the State of New York and for all the purposes shall be construed in accordance with the laws of said State without giving effect to the rules of said State governing the conflicts of laws. The Company and the Holder hereby agree that any action, proceeding or claim against it arising out of, or relating in any way to, this Agreement shall be brought and enforced in the courts of the State of New York or of the United States of America for the Southern District of New York, and irrevocably submits to such jurisdiction, which jurisdiction shall be exclusive. The Company, and the Holder hereby irrevocably waive any objection to such exclusive jurisdiction or inconvenient forum. Any such process or summons to be served upon any of the Company and the Holder (at the option of the party bringing such action, proceeding or claim) may be served by transmitting a copy thereof, by registered or certified mail, return receipt requested, postage prepaid, addressed to it at the address as set forth in Section 13 hereof. Such mailing shall be deemed personal service and shall be legal and binding upon the party so served in any action, proceeding 21 22 or claim. The Company and the Holder agree that the prevailing party(ies) in any such action or proceeding shall be entitled to recover from the other party(ies) all of its/their reasonable legal costs and expenses relating to such action or proceeding and/or incurred in connection with the preparation therefor. 17. Entire Agreement; Modification. This Agreement and the Purchase Agreement (to the extent portions thereof are referred to herein) contain the entire understanding between the parties hereto with respect to the subject matter hereof and may not be modified or amended except by a writing duly signed by the party against whom enforcement of the modification or amendment is sought. 18. Severability. If any provision of this Agreement shall be held to be invalid or unenforceable, such invalidity or unenforceability shall not affect any other provision of this Agreement. 19. Captions. The caption headings of the Sections of this Agreement are for convenience of reference only and are not intended, nor should they be construed as, a part of this Agreement and shall be given no substantive effect. 20. Benefits of this Agreement. Nothing in this Agreement shall be construed to give to any person or corporation other than the Company and the Holder any legal or equitable right, remedy or claim under this Agreement; and this Agreement shall be for the sole and exclusive benefit of the Company and the Holder. 21. Counterparts. This Agreement may be executed in any number of counterparts and each of such counterparts shall for all purposes be deemed to be an original, and such counterparts shall together constitute but one and the same instrument. 22 23 IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed, as of the day and year first above written. [SEAL] STANDARD MANAGEMENT CORPORATION By: Ronald D. Hunter --------------------------- Ronald D. Hunter, Chairman and Chief Executive Officer Attest: Stephen M. Coons - ---------------------------- Stephen M. Coons, Secretary SANDS BROTHERS & CO., LTD By: Steven B. Sands ------------------------- Authorized Officer 23 24 EXHIBIT A-1 FORM OF WARRANT CERTIFICATE THE WARRANTS REPRESENTED BY THIS CERTIFICATE AND THE OTHER SECURITIES ISSUABLE UPON EXERCISE THEREOF MAY NOT BE OFFERED OR SOLD EXCEPT PURSUANT TO (i) AN EFFECTIVE REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, (ii) TO THE EXTENT APPLICABLE, RULE 144 UNDER SUCH ACT (OR ANY SIMILAR RULE UNDER SUCH ACT RELATING TO THE DISPOSITION OF SECURITIES), OR (iii) AN OPINION OF COUNSEL, IF SUCH OPINION SHALL BE REASONABLY SATISFACTORY TO COUNSEL FOR THE ISSUER, THAT AN EXEMPTION FROM REGISTRATION UNDER SUCH ACT IS AVAILABLE. THE TRANSFER OR EXCHANGE OF THE WARRANTS REPRESENTED BY THIS CERTIFICATE IS RESTRICTED IN ACCORDANCE WITH THE WARRANT AGREEMENT REFERRED TO HEREIN. EXERCISABLE ON OR BEFORE 5:30 P.M., NEW YORK TIME, AUGUST 19, 1998 No. SB-1 100,000 Warrants WARRANTS CERTIFICATE This Warrant Certificate certifies that __________________________, or registered assigns, is the registered holder of 100,000 Warrants to purchase initially, at any time from August 19, 1996, until 5:30 p.m. New York time on August 19, 1998 ("Expiration Date"), up to 100,000 fully-paid and non-assessable shares of common stock, no par value per share ("Common Stock") of STANDARD MANAGEMENT CORPORATION, an Indiana corporation (the "Company"), at an initial exercise price, subject to adjustment in certain events (the "Exercise Price"), of $4.3125 per share of Common Stock, upon surrender of this Warrant Certificate and payment of the Exercise Price at an office or agency of the Company, or by surrender of this Warrant Certificate in lieu of cash payment, but subject to the conditions set forth herein and in the warrant agreement dated as of August 19, 1996 between the Company and Sands Brothers & Co., Ltd. (the "Warrant Agreement"). Payment of the Exercise Price shall be made by certified or official bank check in New York Clearing House funds payable to the order of the Company. No Warrant may be exercised after 5:30 p.m., New York time, on the Expiration Date, at which time all Warrants evidenced hereby, unless exercised prior thereto, hereby shall thereafter be void. - A-1 - 25 The Warrants evidenced by this Warrant Certificate are part of a duly authorized issue of Warrants issued pursuant to the Warrant Agreement, which Warrant Agreement is hereby incorporated by reference in and made a part of this instrument and is hereby referred to for a description of the rights, obligations, duties and immunities thereunder of the Company and the holders (the words "holders" or "holder" meaning the registered holders or registered holder) of the Warrants. The Warrant Agreement provides that upon the occurrence of certain events the Exercise Price and the type and/or number of the Company's securities issuable thereupon may, subject to certain conditions, be adjusted. In such event, the Company will, at the request of the holder, issue a new Warrant Certificate evidencing the adjustment in the Exercise Price and the number and/or type of securities issuable upon the exercise of the Warrants; provided, however, that the failure of the Company to issue such new Warrant Certificates shall not in any way change, alter, or otherwise impair, the rights of the holder as set forth in the Warrant Agreement. Upon due presentment for registration of transfer of this Warrant Certificate at an office or agency of the Company, a new Warrant Certificate or Warrant Certificates of like tenor and evidencing in the aggregate a like number of Warrants shall be issued to the transferee(s) in exchange for this Warrant Certificate, subject to the limitations provided herein and in the Warrant Agreement, without any charge except for any tax in other governmental charge imposed in connection with such transfer. Upon the exercise of less than all of the Warrants evidenced by this Certificate, the Company shall forthwith issue to the holder hereof a new Warrant Certificate representing such numbered unexercised Warrants. The Company may deem and treat the registered holder(s) hereof as the absolute owner(s) of this Warrant Certificate (notwithstanding any notation of ownership or other writing hereon made by anyone), for the purpose of any exercise hereof, and of any distribution to the holder(s) hereof, and for all other purposes, and the Company shall not be affected by any notice to the contrary. All terms used in this Warrant Certificate which are defined in the Warrant Agreement shall have the meanings to them in the Warrant Agreement. - A-2 - 26 IN WITNESS WHEREOF, the Company has caused this Warrant Certificate to be duly executed under its corporate seal. Dated as of August 19, 1996. STANDARD MANAGEMENT CORPORATION [SEAL] By: ______________________________________ Title: Attest: Secretary - A-3 - 27 [FORM OF ELECTION TO PURCHASE PURSUANT TO SECTION 3.1] The undersigned hereby irrevocably elects to exercise the right, represented by this Warrant Certificate, to purchase ______ shares of Common Stock at an exercise price of $_______ per share and herewith tenders in payment for such Securities a certified or official bank check payable in New York Clearing House Funds to the order of ______________ in the amount of $____, all in accordance with the terms hereof. The undersigned requests that a certificate for such Securities be registered in the name of _____________ whose address is _____________ and that such Certificate be delivered to _____________ whose address is _____________. Signature __________________________ (Signature must conform in all respects to name of holder as specified on the face of the Warrant Certificate.) ____________________________________ (Insert Social Security or Other Identifying Number of Holder) - A-4 - 28 [FORM OF ELECTION TO PURCHASE PURSUANT TO SECTION 3.2] The undersigned hereby irrevocably elects to exercise the right, represented by this Warrant Certificate, to purchase shares of Common Stock in accordance with the terms of Section 3.2 of that certain Warrant Agreement dated as of August 19, 1996 among STANDARD MANAGEMENT CORPORATION and SANDS BROTHERS & CO., LTD. The Undersigned requests that a certificate for such Securities be registered in the name of _____________ whose address is _____________ and that such Certificate be delivered to _____________ whose address is _____________. Signature __________________________ (Signature must conform in all respects to name of holder as specified on the face of the Warrant Certificate.) ________________________________ (Insert Social Security or Other Identifying Number of Holder) - A-5 - 29 [FORM OF ASSIGNMENT] (To be executed by the registered holder if such holder desires to transfer the Warrant Certificate.) FOR VALUE RECEIVED ________________ here sells, assigns and transfers unto (Please print name and address of transferee) this Warrant Certificate, together with all right, title and interest therein, and does hereby irrevocably constitute and appoint ________________ Attorney, to transfer the within Warrant Certificate on the books of the within-named Company, with full power of substitution. Dated: Signature: (Signature must conform in all respects to name of holder as specified on the face of the Warrant Certificate.) (Insert Social Security or other Identifying Number of Assignee) - A-6 - 30 ACTUAL WARRANT FOLLOWS: - A-7 - 31 THE WARRANTS REPRESENTED BY THIS CERTIFICATE AND THE OTHER SECURITIES ISSUABLE UPON EXERCISE THEREOF MAY NOT BE OFFERED OR SOLD EXCEPT PURSUANT TO (i) AN EFFECTIVE REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933, (ii) TO THE EXTENT APPLICABLE, RULE 144 UNDER SUCH ACT (OR ANY SIMILAR RULE UNDER SUCH ACT RELATING TO THE DISPOSITION OF SECURITIES), OR (iii) AN OPINION OF COUNSEL, IF SUCH OPINION SHALL BE REASONABLY SATISFACTORY TO COUNSEL FOR THE ISSUER, THAT AN EXEMPTION FROM REGISTRATION UNDER SUCH ACT IS AVAILABLE. THE TRANSFER OR EXCHANGE OF THE WARRANTS REPRESENTED BY THIS CERTIFICATE IS RESTRICTED IN ACCORDANCE WITH THE WARRANT AGREEMENT REFERRED TO HEREIN. EXERCISABLE ON OR BEFORE 5:30 P.M., NEW YORK TIME, AUGUST 19, 1998 No. SB-1 100,000 Warrants WARRANTS CERTIFICATE This Warrant Certificate certifies that Sands Brothers & Co., Ltd., or registered assigns, is the registered holder of 100,000 Warrants to purchase initially, at any time from August 19, 1996, until 5:30 p.m. New York time on August 19, 1998 ("Expiration Date"), up to 100,000 fully-paid and non-assessable shares of common stock, no par value ("Common Stock") of STANDARD MANAGEMENT CORPORATION, an Indianapolis corporation (the "Company"), at an initial exercise price, subject to adjustment in certain events (the "Exercise Price"), of $4.3125 per share upon surrender of this Warrant Certificate and payment of the Exercise Price at an office or agency of the Company, or by surrender of this Warrant Certificate in lieu of cash payment, but subject to the conditions set forth herein and in the warrant agreement dated as of August 19, 1996 between the Company and Sands Brothers & Co., Ltd. (the "Warrant Agreement"). Payment of the Exercise Price shall be made by certified or official bank check in New York Clearing House funds payable to the order of the Company. No Warrant may be exercised after 5:30 p.m., New York time, on the Expiration Date, at which time all Warrants evidenced hereby, unless exercised prior thereto, hereby shall thereafter be void. The Warrants evidenced by this Warrant Certificate are part of a duly authorized issue of Warrants issued pursuant to the Warrant Agreement, which Warrant Agreement is hereby incorporated by reference in and made a part of this instrument and is hereby referred to for a description of the rights, obligations, duties and immunities thereunder of the Company and the holders (the words "holders" or "holder" meaning the registered holders or registered holder) of the Warrants. 32 The Warrant Agreement provides that upon the occurrence of certain events the Exercise Price and the type and/or number of the Company's securities issuable thereupon may, subject to certain conditions, be adjusted. In such event, the Company will, at the request of the holder, issue a new Warrant Certificate evidencing the adjustment in the Exercise Price and the number and/or type of securities issuable upon the exercise of the Warrants; provided, however, that the failure of the Company to issue such new Warrant Certificates shall not in any way change, alter, or otherwise impair, the rights of the holder as set forth in the Warrant Agreement. Upon due presentment for registration of transfer of this Warrant Certificate at an office or agency of the Company, a new Warrant Certificate or Warrant Certificates of like tenor and evidencing in the aggregate a like number of Warrants shall be issued to the transferee(s) in exchange for this Warrant Certificate, subject to the limitations provided herein and in the Warrant Agreement, without any charge except for any tax in other governmental charge imposed in connection with such transfer. Upon the exercise of less than all of the Warrants evidenced by this Certificate, the Company shall forthwith issue to the holder hereof a new Warrant Certificate representing such numbered unexercised Warrants. The Company may deem and treat the registered holder(s) hereof as the absolute owner(s) of this Warrant Certificate (notwithstanding any notation of ownership or other writing hereon made by anyone), for the purpose of any exercise hereof, and of any distribution to the holder(s) hereof, and for all other purposes, and the Company shall not be affected by any notice to the contrary. All terms used in this Warrant Certificate which are defined in the Warrant Agreement shall have the meanings to them in the Warrant Agreement. 2 33 IN WITNESS WHEREOF, the Company has caused this Warrant Certificate to be duly executed under its corporate seal. Dated as of August 19, 1996. [SEAL] STANDARD MANAGEMENT CORPORATION By:____________________________ Ronald D. Hunter, Chairman and Chief Executive Officer Attest: ______________________________ Stephen M. Coons, Secretary 3 34 [FORM OF ELECTION TO PURCHASE PURSUANT TO SECTION 3.1] The undersigned hereby irrevocably elects to exercise the right, represented by this Warrant Certificate, to purchase ______ shares of Common Stock at an exercise price of $___ per share and herewith tenders in payment for such Securities a certified or official bank check payable in New York Clearing House Funds to the order of ______________ in the amount of $____, all in accordance with the terms hereof. The undersigned requests that a certificate for such Securities be registered in the name of _____________ whose address is _____________ and that such Certificate be delivered to _____________ whose address is _____________. Signature __________________________ (Signature must conform in all respects to name of holder as specified on the face of the Warrant Certificate.) ____________________________________ (Insert Social Security or Other Identifying Number of Holder) 4 35 [FORM OF ELECTION TO PURCHASE PURSUANT TO SECTION 3.2] The undersigned hereby irrevocably elects to exercise the right, represented by this Warrant Certificate, to purchase shares of Common Stock in accordance with the terms of Section 3.2 of that certain Warrant Agreement dated as of August 19, 1996 among STANDARD MANAGEMENT CORPORATION and SANDS BROTHERS & CO., LTD. The Undersigned requests that a certificate for such Securities be registered in the name of _____________ whose address is _____________ and that such Certificate be delivered to _____________ whose address is _____________. Signature __________________________ (Signature must conform in all respects to name of holder as specified on the face of the Warrant Certificate.) ________________________________ (Insert Social Security or Other Identifying Number of Holder) 5 36 [FORM OF ASSIGNMENT] (To be executed by the registered holder if such holder desires to transfer the Warrant Certificate.) FOR VALUE RECEIVED ________________ here sells, assigns and transfers unto (Please print name and address of transferee) this Warrant Certificate, together with all right, title and interest therein, and does hereby irrevocably constitute and appoint ________________ Attorney, to transfer the within Warrant Certificate on the books of the within-named Company, with full power of substitution. Dated: Signature: (Signature must conform in all respects to name of holder as specified on the face of the Warrant Certificate.) (Insert Social Security or other Identifying Number of Assignee) 6 EX-10.11 3 AMEND #2 TO MANAGEMENT SERVICE AGREEMENT 1 EXHIBIT 10.11 AMENDMENT #2 TO MANAGEMENT SERVICE AGREEMENT WHEREAS, Standard Management Corporation and Standard Life Insurance Company of Indiana have entered into a Management Service Agreement effective August 1, 1992. AND WHEREAS, Standard Management Corporation and Standard Life Insurance Company of Indiana have entered into Amendment #1 to this Management Service Agreement effective January 1, 1995. NOW THEREFORE, effective January 1, 1997, paragraph 4 of such agreement as amended by Amendment #1 shall be amended by deleting the former paragraph 4 in its entirety and replacing it with the following: 4. In consideration for the services provided in paragraphs 1, 2, and 3, Standard agrees to pay the Company a monthly fee of One Hundred Sixty-six Thousand Six Hundred Sixty Six Dollars and sixty-seven cents ($166,666.67) which is due and payable within ten (10) days from the receipt of the invoice. IN WITNESS WHEREOF, the parties hereto have executed effective January 1, 1997 this Amendment #2 to the Management Service Agreement. Standard Management Corporation Standard Life Insurance Company of Indiana By: /s/ EDWARD T. STAHL By: /s/ RAYMOND J. OHLSON ---------------------------- ---------------------------- Edward T. Stahl, Raymond J. Ohlson, Executive Vice President and President Director of Corporate Development EX-10.19 4 RENEWAL PROMISSORY NOTE 1 EXHIBIT 10.19 DUE: DECEMBER 31, 2001 FOR VALUE RECEIVED, I, Ronald D. Hunter of 3570 Sedgemoor Circle, Carmel, Indiana, 46032, promise to pay to the order of Standard Management Corporation the sum of Three Hundred Thirty-Seven Thousand Eight Hundred and Fifty-Three Dollars and Seventy Cents ($337,853.70) on or before December 31, 2001, with interest compounded monthly at five (5%) percent per annum, payable at $1,000 per month, and with the following additional payments: December 31: 1997 $50,000.00 1998 60,000.00 1999 65,000.00 2000 75,000.00 2001 84,189.95 On failure to pay when due, the entire unpaid balance,including interest to date, will become due and collectible with interest thereon at the rate of 9% per annum from the date of default until paid, with reasonable attorney fees and all without relief from valuation or appraisement laws. The undersigned waives presentment for payment, protest, notice of protest and non-payment of this note and no demand for payment in full shall be required to be served on the maker on the occasion of default hereunder. DATE: DECEMBER 31, 1996 /s/ RONALD D. HUNTER /s/ CARLA JAMES - ----------------------------- ----------------------------- Ronald D. Hunter Witness, Carla James 3570 Sedgemoor Circle Carmel, IN 46032 EX-10.23 5 REINSURANCE TREATY 1 EXHIBIT 10.23 AMENDMENT NO. 6 to the INDEMNITY REINSURANCE TREATY EFFECTIVE SEPTEMBER 30, 1992 Between CROWN LIFE INSURANCE COMPANY referred to as RECEIVER AND DIXIE NATIONAL LIFE INSURANCE COMPANY referred to as COMPANY 1. The effective date of this amendment is December 31, 1996. 2. This agreement has been cancelled for all business. IN WITNESS WHEREOF, the parties hereto have by a duly authorized and acting officer, executed this Amendment in duplicate on the dates shown below. DIXIE NATIONAL LIFE INSURANCE ATTEST COMPANY By MICHAEL L. KASTER By JANET K. TAYLOR ------------------------------------ ----------------------------------- Title Vice President and Chief Actuary Title Vice President and Controller ---------------------------------- --------------------------------- Date January 9, 1997 Date January 14, 1997 ----------------------------------- ---------------------------------- CROWN LIFE INSURANCE COMPANY ATTEST By REMI HOULE By CAROL DOYLE ------------------------------------ ----------------------------------- Title Vice President Title Reinsurance Operations ---------------------------------- --------------------------------- Date Jan 8/97 Date Jan 8/97 ----------------------------------- ---------------------------------- EX-10.35 6 PORTFOLIO INDEMNITY REINSURANCE AGREEMENT 1 EXHIBIT 10.35 PORTFOLIO INDEMNITY REINSURANCE AGREEMENT between the THE DIXIE NATIONAL LIFE INSURANCE COMPANY RIDGELAND, MISSISSIPPI and the THE COLOGNE LIFE REINSURANCE COMPANY STAMFORD, CONNECTICUT Treaty # D008-001-000 Combination Coinsurance Modified Coinsurance Account # 2642 2 CONTENTS ARTICLE I REINSURANCE COVERAGE ARTICLE II COMMENCEMENT AND TERMINATION OF LIABILITY ARTICLE III GENERAL PROVISIONS ARTICLE IV DEFINITION OF REINSURANCE PREMIUM ARTICLE V DEFINITION OF REINSURANCE BENEFITS ARTICLE VI ACCOUNTING, REPORTING, SETOFF AND RECOUPMENT ARTICLE VII SETTLEMENT OF CLAIMS ARTICLE VIII INSOLVENCY ARTICLE IX ARBITRATION ARTICLE X DURATION OF AGREEMENT ARTICLE XI PAYMENTS UPON TERMINATION OF AGREEMENT ARTICLE XII OTHER REINSURANCE AND ACQUISITION CLAUSE ARTICLE XIII EXECUTION SCHEDULE A CONTRACTS AND RISKS REINSURED SCHEDULE B POLICY ALLOWANCES AND EXPERIENCE REFUND SCHEDULE C REPORTS SCHEDULE D QUARTERLY ACCOUNTING PERIOD REINSURANCE REPORTS SCHEDULE E INTEREST RATES SCHEDULE F COINSURANCE CONVERSION ADJUSTMENT SCHEDULE G DIVIDEND REIMBURSEMENT ADDENDUM 1 FORMULAS AND ACCOUNTING WORKSHEET
3 PORTFOLIO INDEMNITY REINSURANCE AGREEMENT This Agreement is made and entered into between The Dixie National Life Insurance Company, of Ridgeland, Mississippi, a corporation, organized under the laws of the State of Mississippi, hereinafter referred to as the "Company," and The Cologne Life Reinsurance Company, of Stamford, Connecticut, a corporation, organized under the laws of the Connecticut, hereinafter referred to as the "Reinsurer". The Company and the Reinsurer mutually agree to reinsure on the terms and conditions stated herein. This Agreement is an indemnity reinsurance agreement solely between the Company and the Reinsurer and the performance of the obligations of each party under this Agreement shall be rendered solely to the other party. In no instance shall anyone other than the Company or the Reinsurer have any rights under this Agreement, and the Company shall be and remain solely liable to any insured, contract owner, or beneficiary under any contract reinsured hereunder. This Agreement shall constitute the entire agreement between the parties with respect to the business reinsured hereunder. There are no understandings between the parties other than as expressed in this Agreement and any change or modification of this Agreement shall be null and void unless made by amendment to the Agreement and signed by both parties. ARTICLE I REINSURANCE COVERAGE 1. Effective the 31st day of December, 1996, hereinafter referred to as the "Effective Date," the Company agrees to reinsure with the Reinsurer the risks under the policies issued by the Company, as described in Schedule A, and, with respect to such reinsurance the Reinsurer agrees to indemnify the Company against the risks assumed by the Company, except as herein provided. ARTICLE II COMMENCEMENT & TERMINATION OF LIABILITY 1. The liability of the Reinsurer on reinsurance ceded hereunder shall commence on the later of the Effective Date and the date the liability of the Company commences. 2. The liability of the Reinsurer on all reinsurance hereunder shall terminate simultaneously with that of the Company unless, prior to such date, the Agreement is terminated as otherwise provided herein. If the Agreement is so terminated, the liability of the Reinsurer shall cease on the date of termination, hereinafter referred to as the "Termination Date." 4 ARTICLE III GENERAL PROVISIONS 1. Contracts and Risks Reinsured. The Reinsurer agrees to indemnify and the Company agrees to reinsure with the Reinsurer, according to the terms and conditions hereof, the portion of the risks described in Schedule A hereto, which are in force on the Effective Date of this Agreement. 2. Coverages and Exclusions. (a)Only risks under the life or annuity contracts referred to in Schedule A, are reinsured under this Agreement. (b) Extended Term and Reduced Paid-Up policies shall be treated as surrendered policies. (c) Paid-Up dividend additions are covered in the same proportion as the original policy. (d) Waiver of Premium benefits, Accidental Death Benefits, Guaranteed Insurability Benefits, Supplementary Contracts, or other "miscellaneous benefits" are not reinsured under this Agreement. (e) Excess interest credited to any reinsured contract is excluded from coverage under this Agreement, unless prior written approval has been obtained from the Reinsurer. 3. Plan of Reinsurance. This indemnity reinsurance agreement shall be a combination of the coinsurance/modified coinsurance plan. The Company shall retain, maintain, and own all assets held in relation to the Mod Co Reserves. 4. Reserves. The term "Total Reserves", "Reserves", or "Reserve", whenever used, shall mean the gross statutory reserves held by the Company on its NAIC Convention Blank, with respect to the portions of contracts reinsured hereunder, and shall be net of due and deferred premiums. The term "Coinsurance Reserve" shall mean the portion of the Total Reserves covered under the Coinsurance Plan, and the term "Mod Co Reserves" shall mean the portion of the Total Reserve covered under the Modified Coinsurance Plan. 5. Extracontractual Damages. The Reinsurer does not indemnify and shall not be liable for any of the Company's extracontractual damages, including but not limited to actual punitive, exemplary or compensatory damages; excluded damages include but are not limited to damages or liability of any kind whatsoever resulting from, but not limited to: negligent, reckless or intentional wrongs, fraud, oppression, bad faith, or strict liability, arising from claims related to breach of contract or any form of tortuous conduct unless the Reinsurer is the cause of same. If the Company is ordered by a court to make refunds to policyholders on any contract, the contract shall be considered a recaptured contract, and subject to the provisions of the Addendum 1. 6. Contract Administration. The Company shall administer the contracts reinsured hereunder and shall perform all accounting for such contracts. 7. Inspection. At any reasonable time, each party or its designated representative may inspect, during normal business hours, at the offices where such records are located, the papers and any and all other books or documents of the other relating to reinsurance under this Agreement. The information obtained shall be used only for reinsurance purposes and shall be kept confidential except to the extent disclosure is required by law. The Reinsurer's rights under this paragraph shall survive termination of this Agreement. 5 7. Capital Gains and Losses. The Reinsurer will not participate in capital gains or losses of the Company attributable to the assets underlying the Mod Co Reserves, other than to the extent such capital gains or losses are reflected in the Mod Co Interest Rate. 8. Premium Taxes. The reinsurance allowances for any taxes paid in connection with the contracts reinsured hereunder are included as part of the Company's expense allowance granted by the Reinsurer in accordance with Schedule B of this Agreement. The Reinsurer will not reimburse the Company for any premium taxes, Federal, state or local taxes, or any licenses or other fees allocated directly or indirectly to the risks reinsured, with the exception of the DAC tax charge as addressed in Addendum 1, it being expressly understood that the Company shall be solely liable for all such amounts that may be owed by it. 9. Conditions. The reinsurance hereunder is subject to the same limitations and conditions as the contracts written or assumed by the Company which are reinsured hereunder, unless otherwise expressly provided in this Agreement. 10. Misunderstandings and Oversights. If any non-material delay, omission, error or failure to pay amounts due or to perform any other act required by this Agreement is unintentional and caused by misunderstanding or oversight, the Company and the Reinsurer will adjust the situation to what it would have been had the misunderstanding or oversight not occurred. The party that first discovers such non-material oversight or incorrect act as a result of the misunderstanding will notify the other party in writing promptly upon discovery of the misunderstanding or oversight. The parties shall act to correct the error, omission or oversight within twenty (20) days of notification of the problem. In the event that any delay, omission, error or failure is or becomes material (where "material" is defined in this article), or is not corrected within a reasonable time following receipt of notice as described hereinabove, the offended party shall be entitled to a remedy as outlined in Article XII. However, this section shall not be construed as a waiver by either party of their right to enforce strictly the terms of this Agreement. For the purposes of this paragraph a material delay shall be equal to a full accounting period beyond the due date of the information. With respect to materiality of the omission or error, the definition in paragraph 24 (c) shall apply. 11. Age or Sex Adjustment. If the Company's liability under any of the contracts reinsured under this Agreement is changed because of a misstatement of age or sex, the Reinsurer will share in the change proportionately to the amount reinsured hereunder. 12. Reinstatements. If a contract reinsured hereunder that was reduced, terminated, or lapsed, is reinstated, the reinsurance for such contract under this Agreement will be reinstated automatically to the amount that would be in force if the contract had not been reduced, terminated, or lapsed. The Company will pay to the Reinsurer the Reinsurer's proportionate share of all amounts collected from, or charged to, the insured. 13. Amendments. This Agreement shall be amended only by written agreement signed by a duly authorized officer of the Company and Reinsurer respectively. 14. Internal and External Replacements. An internal or external replacement of any contracts reinsured hereunder, pursuant to a program of internal or external replacement, shall be considered as a recaptured contract and not a surrender unless the reinsurance is continued for the new contract. It shall be subject to a Recapture Fee as defined in Addendum 1. An internal replacement shall include all policies which are reinsured under this Agreement which under a program initiated by the Company after the Effective date of this Agreement are surrendered, and within 6 months before or after termination are covered under a new policy written by the Company or an affiliate. 6 An external replacement program shall consist of a program entered into by the company with a non affiliated company to replace the contracts reinsured hereunder for a contract with another insurer. 15. Contract Changes or Reserve Changes. The Company must provide written notification to the Reinsurer of any change in the terms or conditions of any contract reinsured hereunder or in the calculation of the Reserves within fifteen (15) days after the change is initiated. If the Reinsurer accepts any such change, the Company and the Reinsurer shall share proportionately in any increase or decrease in the Company's liability which results from such change. If the change is voluntary on the part of the Company and if the Reinsurer does not accept such change, the Reinsurer's liability under this Agreement shall be determined as if no such change occurred. If the change is not voluntary on the part of the Company, the Reinsurer shall participate in such change. 16. Conditional Receipt. A Policy under this treaty is not considered in force until the policy is issued. Under no circumstances will claims under the conditional receipt coverage be recognized as a claim under the provisions of this treaty. 17. Territory. The Reinsurer's liability shall be limited to policies issued in the United States of America, its territories and possessions, Puerto Rico, and Canada. 18. Currency. All payments and accounts shall be made in United States Dollars, and all fractional amounts shall be rounded to the nearest whole dollar. For the purposes of this Agreement, where the Company receives premiums or pays benefits in currencies other than United States Dollars, such premiums and benefits shall be converted into United States Dollars at the actual rates of exchange at which such premiums and benefits are entered in the Company's books. 19. Delayed Payments. Should the payment due either the Reinsurer or the Company be delayed beyond the due date specified in Article VI, such delayed payment shall accrue interest as specified in Schedule E. 20. Successors and Assigns. This Agreement cannot be assigned by the Company or Reinsurer without the prior written approval of the other party. However, any successor of the Company by operation of law, including without limitation any liquidator, rehabilitator, receiver or conservator, shall have the unilateral right to assign this Agreement without the consent of the Reinsurer. The Reinsurer shall be given written notice of any such assignment. The provisions of this Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective permitted successors and assigns. 21. Notices. All notices hereunder shall be in writing and shall become effective when received. Any written notice shall be by either certified or registered mail, return receipt requested or overnight delivery service (providing for delivery receipt) or delivered by hand. All notices under this Agreement shall be addressed as follows: If to the Reinsurer: The Cologne Life Reinsurance Company 30 Oak Street, P. O. Box 300 Stamford, CT 06904-0300 ATTENTION: Art Garrison If to the Company: 7 The Dixie National Life Insurance Company 9100 Keystone Crossing, Suite 600 Indianapolis, IN 46240 ATTENTION: Michael Kaster 22. Assessments and Tax Changes. If the Reinsurer is assessed any additional Federal, state or local premium or sales taxes, or assessments for insolvencies or rehabilitations, or any other assessments as a result of assuming the business reinsured, and the Company received a deduction for such amounts, the Reinsurer shall be reimbursed for such assessment or tax. Such assessment will include any increase in the section 848 charges for "deferred acquisition costs" but shall not include any change in the corporate income tax rate. 23. Compliance with Applicable Laws and Regulations (a) Agreement to be Construed in Accordance with Existing Law It is the intention of the parties that this Agreement comply with all existing applicable laws and regulations, as from time to time are in effect, so that the Risks Reinsured remain reinsured on a combination coinsurance/modified coinsurance plan. (b) Amendment and/or Termination Upon Failure to Comply In the event that it is determined by an insurance regulatory authority or the Internal Revenue Service or by either party upon the advice of an insurance regulatory authority or the Internal Revenue Service that this Agreement fails to conform to the requirements of existing applicable laws and regulations and that the Agreement may be brought into conformity with said requirements only by means of a material change to the Agreement, or in the event that such laws or regulations are changed subsequent to the Effective Date and such change has a material adverse affect on either party or requires a material change to the Agreement in order for the Agreement to conform with applicable laws and regulations, the parties shall exercise reasonable efforts to reach an agreement to amend the Agreement so as to return the parties to the economic position that they would have been in had no such change occurred or so that both parties share the economic detriment of such change equally. If the parties are unable to reach an agreement to amend the Agreement, then the differences between the parties shall be resolved through arbitration in accordance with the provisions of Article IX. In the event that any change required to conform the Agreement to the requirements of applicable law or regulation is not material, the Agreement shall be amended accordingly. In no event, however, shall this provision prevent either party from exercising any right it otherwise has under this Agreement. (c) Notification of Disapproval or Change in Law The company shall promptly notify the Reinsurer of any disapprovals or required changes regarding the Agreement that are made by any insurance regulatory authorities. The Reinsurer shall be allowed to defend the Agreement on its own behalf with such authorities after consultation with the Company. 8 ARTICLE IV DEFINITION OF REINSURANCE PREMIUM 1. Initial Reinsurance Consideration. The Initial Reinsurance Consideration is due on the latter of the Effective Date or the Execution Date and shall be the net of (a)-(b)-(c), as defined below. The Initial Reinsurance Consideration may be positive (paid to the Reinsurer) or negative (paid to the Company). a. The Initial Reinsurance Premium shall be the Total Reserves on the quota share of the policies cited in Schedule A. b. The Initial Allowance, as defined in Schedule B. The Company shall include the initial allowance as taxable income. c. The Initial Mod Co Reserve Adjustment shall be the Mod Co Reserves with respect to the risks reinsured hereunder, where the initial Mod Co Reserve equals (a)-(b). 2. Terminal Payments. On full or partial recapture the Company and Reinsurer shall make Terminal Payments as defined in Article XI. 3. Quarterly Reinsurance Premium. The Quarterly Reinsurance Premium shall be the net of (a)-(b)+(c)-(d)-(e)-(f)-(g) as defined below, and may be positive (paid to the Reinsurer) or negative (absolute value paid to the Company). a. Reinsurer's Share of Policy Premium. Policy Premiums are the gross premiums, including contract fees, collected from the policyholder with respect to the Risks Reinsured hereunder and described on Schedule A hereto, reduced by an amount equal to the Reinsurer's share of reinsurance premiums paid by the Company for risks ceded under other reinsurance agreements. The Reinsurer's share of the Policy Premium is specified in Schedule A. b. Mod Co Reserve Adjustment. The Mod Co Reserve Adjustment is equal to the algebraic increase in the Total Reserves for the Accounting Period just ended less interest calculated at the Mod Co Interest Rate, as defined in Schedule E, on the Mod Co Reserve on the first day of such Accounting Period. The Mod Co Reserve Adjustment may be either positive (owed to the Company) or negative (absolute value owed to the Reinsurer). c. Recapture Fee. On a full or partial recapture there shall be a Recapture Fee as defined in Addendum 1. d. Reimbursement for Policyholder Dividends. The Reinsurer shall reimburse the Company for dividends paid to policyholders as specified in Schedule G. 9 e. Allowances. (a) Quarterly Allowances. The Allowances, which shall include an allowance for premium tax, are set forth in Schedule B of this Agreement. (b) Initial Allowance. On the Effective Date, the Reinsurer shall pay the Company an Initial Allowance as described in Schedule B. f. Surrender and Endowment Payments. Surrender and endowment payments shall equal the surrender and endowment payments paid by the Company on the Risks Reinsured, net of any reinsurance coverages due and payable from other reinsurers of the policies reinsured hereunder, regardless of whether such amounts due from other reinsurers are in fact or as a matter of law deemed to be collectible or uncollectible. In order to be reimbursed, the surrender or endowment payments must have occurred after the Effective Date and on or before the Termination Date. g. Experience Refunds. The experience refunds will be computed in accordance with Schedule B hereto and shall be based upon experience of the Risks Reinsured under this Agreement. h. Coinsurance Reserve Adjustment. In order to reduce the cash otherwise payable resulting from profits on the reinsured business, a Coinsurance Reserve Adjustment shall be calculated in accordance with Schedule F. 4. Indivisibility of Reinsurance Premium. It is expressly understood that the debits and credits under this Agreement, including but not limited to such debits and credits arising under this Article, shall at all times and under all circumstances relevant to the rights and liabilities of the parties to this Agreement be netted and that such debits and credits may never be treated as severable or divisible. 10 ARTICLE V DEFINITION of REINSURANCE BENEFITS The Reinsurance Benefits shall include the following: 1. Death Benefits. The Reinsurer shall reimburse the Company for the death benefits incurred by the Company on the portion of any contract reinsured hereunder. The reimbursement shall be net of other reinsurance benefits deemed payable from other reinsurers on the portions of the policies reinsured hereunder before the effective date of this Agreement, regardless if such amounts due from the other reinsurers are in fact or as a matter of law deemed to be collectible or uncollectible. The death benefit shall also be reduced by any amount above the Maximum Coverage per life. In order to be reimbursed, the death must have occurred after the Effective Date and before the Termination Date. The Reinsurance Benefits shall be net of any Reinsurance Premiums owed by the Company. 11 ARTICLE VI ACCOUNTING, REPORTING, INSURING CLAUSE, SETOFF and RECOUPMENT 1. Accounting and Reporting Periods. The "Accounting Period" for this treaty shall be the calendar year. The first Accounting Period is from the Effective Date until the end of the then current calendar year. The last Accounting Period shall be from the beginning of the last calendar year until the Termination Date. The "Reporting Period" shall be the Calendar Quarter. 2. Insuring Clause. The amount owed the Company for any accounting period shall be the excess, if any, of Reinsurance Benefits less Reinsurance Premiums, and the amount owed the Reinsurer for any accounting period shall be the excess, if any, of Reinsurance Premiums over Reinsurance Benefits. If such amounts cannot be determined at such date on an exact basis, such payments may be determined on an estimated basis and any final adjustments are to be made within six (6) weeks after the end of the Accounting Period. 3. Setoff. Any debts or credits, matured or unmatured, liquidated or unliquidated, regardless of when they arose or were incurred, in favor of or against either the Company or the Reinsurer with respect to this Agreement are deemed mutual debts or credits, as the case may be, and shall be set off, and only the balance shall be allowed or paid. 4. Recoupment. All net amounts due either party under this Agreement, for any accounting period, shall be netted regardless of when they arose, and regardless of the insolvency, rehabilitation or receivership of either party. In particular, amounts due under this Agreement to one party before or after the insolvency of the other party may be recouped and only the net balance due shall be paid. 5. Reports (a) An Initial Reinsurance Report, as prescribed in Schedule C shall be provided by the Company to the Reinsurer within thirty (30) days following the later of the Date of Execution or the Effective Date, but in no case later than January 31, 1997. (b) Quarterly Reinsurance Reports and any cash payment due there with, if any, as prescribed Schedule D shall be provided by the Company to the Reinsurer within thirty (30) days following the end of each calendar quarter. In turn the Reinsurer shall have thirty (30) days to provide the Company with any cash payment due, if any. (c) Annual Reinsurance Reports, as prescribed in Schedule D shall be provided by the Company to the Reinsurer within thirty (30) days following the end of each calendar year, or as indicated in Schedule D. 12 ARTICLE VII SETTLEMENT OF CLAIMS 1. In the case of a claim on a policy reinsured hereunder, whether the claim payment is made under the policy conditions or compromised for a lesser amount, the settlement made by the Company shall be unconditionally binding upon the Reinsurer. 2. The Company shall, on request, furnish the Reinsurer with copies of the proofs of claim, together with any information the Company may possess in connection with the claim. 3. The Reinsurer shall share in the expense of any contest or compromise of a claim in the same proportion that the net amount at risk reinsured with the Reinsurer bears to the total net amount at risk of the Company under all policies respecting that individual being contested by the Company and shall share in the total amount of any reduction in liability in the same proportion. Compensation of salaried officers and employees of the Company shall not be considered claim expense. Furthermore, the Reinsurer shall not share in that part of any expense which constitutes Noncontractual Damages or Amounts or Extracontractual Damages or Amounts. 4. It is expressly understood that all benefits reinsured under this Agreement shall be netted against the Reinsurance Premium and other amounts due the Reinsurer from the Company under this Agreement. 13 ARTICLE VIII INSOLVENCY 1. In the event of the insolvency of the Company, payments due the Company on all reinsurance made, ceded, renewed or otherwise becoming effective under this Agreement shall be payable by the Reinsurer directly to the Company or to its liquidator, receiver, or statutory successor on the basis of the liability of the Company under the policy or policies reinsured without diminution because of the insolvency of the Company. It is understood, however, that in the event of the insolvency of the Company, the Reinsurer shall be given written notice of the pendency of a claim against the insolvent Company on a policy reinsured within a reasonable time after such claim is filed in the insolvency proceeding and that during the pendency of such claim the Reinsurer may investigate such claim and interpose, at its own expense, in the proceeding where such claim is to be adjudicated any defense or defenses which it may deem available to the Company or its liquidator or receiver or statutory successor. 2. It is further understood that the expense thus incurred by the Reinsurer shall be chargeable, subject to court approval, against the insolvent Company as part of the expense of liquidation to the extent of a proportionate share of the benefit which may accrue to the Company solely as a result of the defense undertaken by the Reinsurer. Where two or more assuming reinsurers are involved in the same claim and a majority in interest elect to interpose defense to such claim, the expense shall be apportioned in accordance with the terms of this Agreement as though such expense had been incurred by the Company. 14 ARTICLE IX ARBITRATION 1. In the event of any disputes or difference arising hereafter between the contracting parties with reference to any transaction arising from or relating in any way to this Agreement on which agreement between the parties hereto cannot be reached, the same shall be decided by arbitration. Three arbitrators will decide any dispute or difference. The arbitrators must be disinterested officers or retired officers of life and health insurance or life and health reinsurance companies other than the two parties to this Agreement or their affiliates. Each of the contracting companies agrees to appoint one of the arbitrators with the third, the "Umpire," to be chosen by the other arbitrators. In the event that either party should fail to choose an arbitrator within 30 days following a written request by the other party to do so, the requesting party may choose an "umpire" before entering upon arbitration. In the event that the two arbitrators shall not be able to agree on the choice of the Umpire within 30 days following their appointment, each arbitrator shall nominate five candidates within 10 days thereafter, four of whom the other shall decline, and the Umpire shall be chosen by the President of the American Arbitration Association. 2. The arbitrators shall consider customary and standard practices in the life and health reinsurance business. They shall decide by a majority vote of the arbitrators. There shall be no appeal from their written decision. Judgment may be entered on the decision of the arbitrators by any court having jurisdiction. 3. Each party shall bear the expense of its own arbitrator and outside attorney fees, and shall jointly and equally bear with the other party the expense of the third arbitrator. 4. Any arbitration instituted pursuant to this Article shall be held in Stamford, Connecticut and the laws of the State of Connecticut and, to the extent applicable, the Federal Arbitration Act shall govern the interpretation and application of this Agreement. 5. This Article shall survive termination of this Agreement. 6. Submission of a matter to arbitration shall be a condition precedent to any right to seek injunctive or other provisional relief pending the arbitration of a matter subject to arbitration pursuant to this Agreement. In any legal proceeding, the laws of the State of Connecticut will govern. 15 ARTICLE X DURATION OF AGREEMENT 1. Canceled for New Business. This Agreement may be canceled at any time, insofar as it pertains to the handling of new business after the Effective Date, by either party giving ninety (90) days' notice of cancellation in writing. The Reinsurer shall continue to accept reinsurance in accordance with this Agreement during the ninety (90) day period aforesaid. Except as provided in paragraphs 2 and 3 of this Article, the reinsurance with the Reinsurer on all policies shall remain in force as long as Reinsurance Premiums are paid when due and the Reinsurer shall remain liable thereon until termination or expiry of the insurance reinsured. 2. Recapture. The Company shall have the right, after providing ninety (90) days written notice to the Reinsurer, to recapture in full or in part pursuant to the provisions of this Agreement. Such recapture shall be subject to the provisions of Addendum 1. Upon such recapture the Agreement shall automatically terminate. 3. Automatic Termination. If at the end of an accounting period, none of the policies reinsured hereunder are in force, this Agreement shall automatically terminate. 4. Termination Due to Nonpayment. The Reinsurer may elect to terminate this Agreement if the Company fails to pay Reinsurance Premiums or other amounts due the Reinsurer, when due, provided the Reinsurer has given at least thirty (30) days prior written notice of its intent to terminate. The Company may avoid termination by paying all Reinsurance Premiums that are either delinquent or then due on or before the effective date of such election to terminate the Agreement. 5. Termination of Liability. If recapture is elected by Company subject to the provisions of paragraph 2 or by the Reinsurer, subject to the provisions of paragraph 4 of this Article, both the Company and the Reinsurer shall be obligated to make and shall make the payments set forth in Article XI. 16 ARTICLE XI PAYMENTS UPON TERMINATION OF AGREEMENT 1. In the event that this Agreement is terminated pursuant to the provisions of Article X, a terminal accounting and settlement shall take place. 2. The terminal accounting and settlement will become due and payable as of the effective date of termination ("Terminal Accounting Date") and shall consist of: (i) the Net Amount Due from the Accounting Period Reinsurance Report for the final Accounting Period, and, (ii) a Terminal Mod Co Reserve Adjustment by the Company and a Terminal Surrender Benefit returned by the Reinsurer, as defined in paragraph 3 of this Article, and, (iii) if terminated pursuant to the provisions of paragraph 2 of Article X, a Recapture Fee, as defined in Addendum 1 payable by the Company to the Reinsurer. If, in the calculation of the terminal accounting and settlement, the amount due the Reinsurer exceeds the amount due the Company, the Company shall pay the difference to the Reinsurer. If, in the calculation of the terminal accounting and settlement, the amount due the Company exceeds the amount due the Reinsurer, the Reinsurer shall pay the difference to the Company. 3. The Company shall pay to the Reinsurer a Terminal Mod Co Reserve Adjustment in an amount equal to the reserves on the portion of the policies reinsured hereunder on a modified coinsurance basis on the day immediately prior to the Terminal Accounting Date. The Reinsurer shall return to the Company a Terminal Surrender Benefit of an amount equal to the Total Reserves (excluding any premium deficiency reserves and excess interest reserves) on the portion of the policies reinsured hereunder on the day immediately prior to the Terminal Accounting Date. 4. In the event that, subsequent to the terminal accounting and settlement as above provided, an adjustment is made with respect to any amount taken into account pursuant to Schedule D, a supplementary accounting shall take place pursuant to paragraph 2 of this Article. Any amount owed to the Reinsurer or the Company by reason of such supplementary accounting shall be paid promptly upon the completion thereof. 5. In the event of a partial recapture the recapture provisions will apply to the amount of business terminated. 17 ARTICLE XII OTHER REINSURANCE AND ACQUISITION CLAUSE 1. Other Reinsurance. The Company may not reinsure with any other reinsurer the complement of the quota share (i.e. 100% - quota share %) of the business reinsured under this Agreement without the prior written approval of the Reinsurer. This provision does not preclude the Company*s continued use of yearly renewable term type reinsurance to cover the excess over retention mortality risks. 2. Acquisition of Business Reinsured. In the event that the Company's claims paying ratings by two third party rating agencies, such as Standard and Poor's or Moody's, are lowered below BB/Ba, then the Reinsurer, at its option, shall be entitled to make a bid to purchase the blocks reinsured hereunder by means of an assumption reinsurance agreement. The specific terms of such transaction shall be negotiated in good faith by the Company, but the Company shall not be obligated to accept the Reinsurer's offer and continuance of this Agreement shall not be affected should the negotiations be unsuccessful. 18 ARTICLE XIII EXECUTION IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be executed by their duly authorized representatives. THE DIXIE NATIONAL LIFE INSURANCE COMPANY By: Mike Kaster -------------------------------------- Title: Vice President - Chief Actuary ----------------------------------- Attest By: Mark Mennen ------------------------------- Title: Vice President ----------------------------------- Date: 3/27/97 ------------------------------------ THE COLOGNE LIFE REINSURANCE COMPANY By: Art Garrison -------------------------------------- Title: Assistant Vice President ---------------------------------- Attest By: ------------------------------- Title: ----------------------------------- Date: 3/27/97 ------------------------------------ 19 SCHEDULE A CONTRACTS AND RISKS REINSURED 1. Under this Agreement, the Reinsurer reinsures a quota share of the risks on the blocks of insurance contracts issued or assumed by the Company and described below: 60% quota share of the December 31, 1996 in force ordinary (including interest sensitive and traditional) life insurance portfolio, where such portfolio includes any life insurance business previously reinsured with Crown Life Insurance Company and recaptured from Crown Life as of December 31, 1996. The Company warrants to the Reinsurer that all life insurance business previously reinsured with Crown Life Insurance Company has been completely recaptured from Crown Life as of December 31, 1996 and that such business is included in the December 31, 1996 in force reinsured under this Agreement. The Reinsurer's share of the Policy Premium, as defined in Article IV, shall equal 100% times the applicable quota share percentage shown above. 2. In no event, however, will the Reinsurer*s liability on any life exceed the Maximum Coverage Per Life, which is the quota share percentage times the lower of $1 million ($1,000,000) or the Company*s retention level on the Effective Date of this Agreement. 20 SCHEDULE B COMMISSION AND EXPENSE ALLOWANCE AND EXPERIENCE REFUND 1. The Initial Allowance is $1.5 million as of the Effective Date. 2. The renewal allowances for years 1997 and later shall be equal to the quota share percentage times (i) $7.50 per policy in force at the beginning of each quarter, plus (ii) actual renewal year commissions paid during each quarter. 3. There shall be no Experience Refunds. 21 SCHEDULE C INITIAL REINSURANCE REPORT 1. In force by policy form i. Policy count ___________ ii. Amount Ceded ___________ ii. Reserves ___________ 2. Accounting Transaction - Initial Reinsurance Consideration equals net of: i. Due Reinsurer Initial Reinsurance Premium ____________ ii. Due Company Initial Allowance ____________ Initial Mod Co Reserve Adjustment ____________ 22 SCHEDULE D - PART I QUARTERLY REPORTING PERIOD REINSURANCE REPORTS from DIXIE NATIONAL LIFE INSURANCE COMPANY to THE COLOGNE LIFE REINSURANCE COMPANY for the quarter ending / / A. NET CASH FLOW REINSURANCE PREMIUM 1. Reinsurer's Share of Policy Premium 2a. Mod Co Reserve beg of quarter _________ 2b. Mod Co Reserve end of quarter _________ 2c. Increase = (2b)-(2a) _________ 2d. Mod Co Interest Rate _________ 2e. Mod Co Interest = (2d)(2a) _________ 2. Mod Co Reserve Adjustment = (2c)-(2e) _________ 3. Recapture Fees _________ 4. Reimbursement for policyholder dividends _________ (Schedule G) 5. Allowances (Schedule B) _________ 6. Surrender and Endowment Payments _________ 7. Coinsurance Reserve Adjustment (schedule F) _________ 8. Experience Refunds (Schedule B) _________ REINSURANCE PREMIUM = (1)-(2)+(3)-(4)-(5)-(6)-(7)-(8) _________ REINSURANCE BENEFITS 1. Death Benefits _________ REINSURANCE BENEFITS = (1) _________ NET CASH FLOW = REINSURANCE PREMIUM - REINSURANCE BENEFITS _________ IF POSITIVE, THEN NCF OWED TO REINSURER IF NEGATIVE, THEN ABSOLUTE VALUE OF NCF OWED TO COMPANY 23 SCHEDULE D - PART I (continued) B. COINSURANCE and MOD CO RESERVES Beg. of quarter Reserves 1. Total Reserve 1a. Coinsurance Reserve __________ 1b. Mod Co Reserve __________ 1c. Coinsurance Percentage = (1a)/(1) __________ End of quarter Reserves before CRA 2. Total Reserve _________ 2a. Coinsurance Reserve = (1c)(2) _________ 2b. Mod Co Reserve = (2)-(2a) _________ Coinsurance Reserve Adjustment (CRA) 3. CRA (Schedule F) _________ End of quarter Reserves after CRA 4. Total Reserve = (2) _________ 4a. Coinsurance Reserve = (2a)-(3) _________ 4b. Mod Co Reserve = (4)-(4a) _________ 24 SCHEDULE D - PART II ANNUAL REPORTS A. POLICY EXHIBIT Policies Face ----------- -------- a. In force beg. of period ________________ ________________ b. Increases ________________ ________________ c. Deaths ________________ ________________ d. Maturities ________________ ________________ e. Surrenders ________________ ________________ f. Expires ________________ ________________ g. Lapses ________________ ________________ h . Other Decreases ________________ ________________ i. In force end of period ________________ ________________ B. ADDITIONAL POLICY EXHIBIT INFORMATION - Page 15A (as applicable) Number Amount ------ ------ 23. Additions by Dividends ________________ ________________ 24. Other paid-up Insurance ________________ ________________ 25. Debit Ordinary Insurance ________________ ________________ Issued During Year In Force End of Year Number Amount Number Amount 26. Term Policies - decreasing 27. Term Policies - other 28. Other term insurance - decreasing 29. Other term insurance 29B. Term Additions 29C. Extended Term Insurance - total 29D. Whole Life and Endowment - total Issued During Year In force End of Year Non-Participating Participating Non-Participating Participating 30. Industrial 31. Ordinary 31A.Credit Life 32. Group 25 SCHEDULE D - PART II (continued) C. ANALYSIS OF INCREASE IN RESERVES - Page 6 1. Reserve December 31 of prior year 2. Tabular Net Premiums 4. Tabular Interest 5. Tabular Less Actual Reserve Released 7. Other Increases (net) 9. Tabular Cost 10. Reserves Released by Death 11. Reserves Released by Other Termination (net) 15. Reserves December 31 of current year E. DAC CHARGE PREMIUMS BY PLAN (as defined in Addendum 1) F. TAX RESERVES On or before June 30 following the end of the calendar year the Company shall supply tax reserves split by tax basis (table, interest rate, and reserve method). G. AUDITED STATUTORY AND GAAP STATEMENTS H. POLICY BY POLICY IN FORCE LISTING I. LEVERAGE WORKSHEET (see SCHEDULE D, PART III) J. Any management letter from the Company's external auditors regarding reinsurance ceded. G:\SLIDIXIE\COMODCO.DOCPAGE 24 OF 323/30/97 26 SCHEDULE D - PART III Leverage Ratio Calculation as of 12/31/ Surplus Relief _______________ Surplus Notes _______________ Premium Load Securitization _______________ Commission Levelization _______________ Affiliated Investments _______________ (in Upstream Companies) TOTAL NUMERATOR _______________ Capital and Surplus _______________ IMR & AVR _______________ Premium Deficiency Reserves _______________ Excess Interest Reserves _______________ 1/2 Dividend Provision _______________ TOTAL DENOMINATOR _______________ LEVERAGE RATIO _______________ 27 SCHEDULE E INTEREST RATES 1. The annual Mod Co Interest Rate shall equal the Portfolio Rate for the Company assets for the current calendar year. The Portfolio Rate shall be determined from the Blue Blank or similar report submitted to the Mississippi Insurance Department for the Company based on the formula given below: rate = (I+CG)/.5x(A+B-I-CG) Where: A = cash and invested assets plus accrued investment income less borrowed money at the end of year (page 2, lines 1 through 10 plus line 16, less page 3, line 22); B = same quantity as "A" above except for the beginning of year; I = net investment income for the year (exhibit 2, line 16) CG = capital gain/loss for the prior year (exhibit 4, line 10) For quarterly reporting purposes, the Portfolio Rate shall be estimated as follows, with an adjustment to reflect the actual experience during the first quarter of the succeeding calendar year: First quarter: one-fourth of the prior year Portfolio Rate. Second quarter: two-fourths of a reasonable estimate of the current year Portfolio Rate. Third quarter: three-fourths of a reasonable estimate of the current year Portfolio Rate. Fourth quarter: a reasonable estimate of the current year Portfolio Rate. 2. Interest on delayed payments due the Company or the Reinsurer shall be computed using the rate specified in paragraph 1. 28 SCHEDULE F COINSURANCE RESERVE ADJUSTMENT. Coinsurance Reserve Adjustment. In order to reduce the cash payments between the Company and the Reinsurer resulting from profits on the reinsured business, the Agreement shall provide for a conversion of Coinsurance into Modified Coinsurance through a Coinsurance Reserve (CRA). The CRA shall equal the lesser of the following: (i) the end of period Coinsurance Reserve prior to the CRA; (ii) the Net Cash Flow as defined in Schedule D, before the CRA and Experience Refund, less the Risk Charge and DAC Charge, both as defined in the Addendum 1; If positive, the CRA shall be paid by the Reinsurer to the Company. If negative the CRA shall be set equal to zero except on the Effective Date when the CRA cannot be more negative than the Initial Allowance. The CRA shall be subtracted from the Coinsurance Reserve and added to the Mod Co Reserve. 29 SCHEDULE G DIVIDEND REIMBURSEMENT The Reinsurer will reimburse the Company for an amount equal to 0% of the dividends paid on or after the Effective Date on the portion of the policies reinsured hereunder. The Reinsurer shall be promptly notified of any changes in the dividend scale subsequent to the Effective Date. The Reinsurer shall participate in changes to the dividend scale if such changes are supported by the experience on the policies reinsured hereunder. The Reinsurer shall not participate in any "additional" or "extra" dividends paid as a result of the apportionment and distribution of the Company's accumulated surplus not related to the policies reinsured hereunder. 30 ADDENDUM 1 to ARTICLE X, PARAGRAPH 2 FORMULAS 1. Net Cash Flow (NCF). The Net Cash flow on the effective date shall equal the Initial Reinsurance Consideration. The Net Cash Flow for any subsequent quarter shall equal the Reinsurance Premiums less the Reinsurance Benefits. The Net Cash Flow shall also include the Terminal Mod Co Reserve Adjustment and the Terminal Surrender Benefit for any contracts recaptured during the quarter, prior to the Termination Date. 2. Experience Account Interest. The quarterly Experience Account interest rate shall equal one fourth of the quantity: Mod Co Interest Rate, as shown in Schedule E, less 20 basis points to cover investment expenses. 3. Experience Account Assets (EAA). On the effective date of this Agreement the Experience Account Assets shall equal zero. At the end of a calendar quarter, the EAA shall equal the EAA at the beginning of the quarter plus one quarter's interest on such amount plus the Net Cash Flow during the quarter, less the quarterly risk and DAC charges. 4. Experience Account Balance (EAB). On the effective date of this Agreement the Experience Account Balance shall be equal to the negative of the Initial Allowance, as shown in Schedule B. At the end of a calendar quarter, the EAB shall equal the EAA less the quantity: (a) minus (b), where (a) is the Coinsurance Reserve at the end of the Accounting Period, before taking into account the Coinsurance Reserve Adjustment, and (b) is the Coinsurance Reserve Adjustment for the Accounting Period. On the final Terminal Date the Coinsurance Reserve, after payment of any Terminal Surrender Benefit, shall be zero. 5. Taxable EAB. The Taxable EAB shall equal the EAB, except that the Coinsurance Reserves shall be computed on a tax basis. 6. Risk Charge. The expense and risk charge for 1996 will be 3.00% of the absolute value of the quantity EAB minus EAA as of December 31, 1996. Thereafter, the expense and risk charge percentage shall be .75% per quarter for calendar years 1997 and thereafter. The expense and risk charge shall equal the expense and risk charge percentage times the absolute value of the quantity EAB minus EAA as of the end of the period, but not less than $3,000 per quarter. 7. DAC Charge. The initial DAC charge percentage shall be .7%. Subsequent percentages shall be determined quarterly based on the average yield for Seven Year Treasuries on the last Friday of the quarter as published in the Wall Street Journal. The DAC charge calculation assumes a 35% tax rate, 7.7% capitalization rate and 10 year amortization period and will be modified if any of these factors change. The DAC charge percentage shall apply to the "reinsurance premium" as defined by IRS regulations. 31 The Company and the Reinsurer hereby agree to the following pursuant to Section 1.848-2(g)(8) of the Income Tax Regulations issued December 29, 1992, under Section 848 of the Internal Revenue code 1986, as amended. This election shall be effective for 1996 and all subsequent taxable years for which this Agreement remains in effect. a. The term "party" will refer to either the Company or the Reinsurer as appropriate. b. The terms used in this Article are defined by reference to Treasury Regulations Section 1.848-2 in effect as of December 29, 1992. c. The party with the net positive consideration for this Agreement for each taxable year will capitalize specified policy acquisition expenses with respect to this Agreement without regard to the general deductions limitation of IRC Section 848(c)(1). d. Both parties agree to exchange information pertaining to the amount of net consideration under this Agreement each year to ensure consistency. The parties also agree to exchange information which may be otherwise required by the IRS. e. The Company will submit a schedule to the Reinsurer by April 1 of each year of its calculation of the net consideration of the preceding calendar year. This schedule will be accompanied by a statement signed by an officer of the Company stating that the Company will report such net consideration in its tax return for the preceding calendar year. f. The Reinsurer may contest such calculation by providing an alternate calculation to the Company in writing within 30 days of the Reinsurer's receipt of the Company's calculation. If the Reinsurer does not so notify the Company, the Reinsurer will report the net consideration as determined by the Company in the Reinsurer's tax return for the previous calendar year. g. If the Reinsurer contests the Company's calculation of the net consideration, the parties will act in good faith to reach an agreement as to the correct amount within 30 days of the date the Reinsurer submits its alternate calculation. If the Reinsurer and the Company reach an agreement on an amount of net consideration, each party shall report such amount in their respective tax returns for the previous calendar year. Any future tax changes which benefit the Company with an adverse impact on the Reinsurer, or conversely, shall also be reflected in the DAC charge. 8. Recapture Fee. The Company can recapture on or after January 1, 1997 upon 90 days notice and payment of a Recapture Fee equal to the absolute value of the EAB, if such is negative. Prior to January 1, 1998 there is an Early Recapture Fee equal to the absolute value of the EAB, if such is negative, times the 104%. The Early Recapture Fee for 1997 shall be reduced to 100% if, concurrent with the recapture, the Company and the Reinsurer enter into an agreement which provides relief equal to the amount recaptured on a block of business acceptable to the Reinsurer. 32 ACCOUNTING WORKSHEET FOR EARLY RECAPTURE EXPERIENCE ACCOUNT BALANCE 1. Beg. Experience Account Assets (EAA) ________ 2a. Interest rate on EAA ________ 2b. Interest = (1)(2a) ________ 3. Net Cash Flow After CRA ________ 4. Risk Charge ________ 5. DAC charge ________ 6 Ending EAA = (1)+(2b)+(3)-(4)-(5) ________ 7. Ending Coinsurance Reserves ________ 8. Ending Experience Acct. Balance ________ EAB = (6)-(7) EX-11 7 STATEMENT RE COMPUTATION OF PER SHARE EARNINGS 1 EXHIBIT 11 STANDARD MANAGEMENT CORPORATION STATEMENT REGARDING COMPUTATION OF PER SHARE EARNINGS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31, -------------------------------------- 1996 1995(2) 1994(2)(3) ---- ------- ---------- PRIMARY Weighted average common shares outstanding............... 4,743,627 5,244,495 5,504,039 5 percent common stock dividend.......................... 112,689 -- -- Common equivalent shares related to: Stock warrants at average market price................. 108,062 96,202 -- Stock options at average market price.................. 24,311 5,240 -- Net issuable shares for modified treasury stock method (after assumed buyback of 20 percent of outstanding stock options and warrants)......................... 261,405 -- -- ---------- ---------- ---------- WEIGHTED AVERAGE PRIMARY SHARES OUTSTANDING.............. 5,250,094 5,345,937 5,504,039 ========== ========== ========== Income (loss) before extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends as reported $ 4,512 $ 1,313 $ (3,436) Reduction in interest expense and increase in short-term investment income for modified treasury stock method... 131 -- -- ---------- ---------- ---------- 4,643 1,313 (3,436) Extraordinary gain on early redemption of redeemable preferred stock........................................ 502 -- -- ---------- ---------- ---------- NET INCOME (LOSS) (AS ADJUSTED).......................... 5,145 1,313 (3,436) Preferred stock dividends as reported.................... (208) -- -- Preferred stock dividends reduction for modified treasury stock method........................................... 46 -- -- ---------- ---------- ---------- Earnings available to common shareholders (as adjusted).............................................. $ 4,983 $ 1,313 $ (3,436) ========== ========== ========== EARNINGS PER SHARE: Income (loss) before extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends........................... $ .88 $ .25 $ (.62) Extraordinary gain..................................... .10 -- -- ---------- ---------- ---------- Net income (loss)...................................... .98 .25 (.62) Preferred stock dividends.............................. (.03) -- -- ---------- ---------- ---------- Earnings available to common shareholders................ $ .95 $ .25 $ (.62) ========== ========== ==========
2 EXHIBIT 11 STANDARD MANAGEMENT CORPORATION STATEMENT REGARDING COMPUTATION OF PER SHARE EARNINGS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31, ------------------------------------ 1996 1995(2) 1994(2)(3) ---- ------- ---------- FULLY DILUTED(1) Weighted average primary shares outstanding................. 5,250,094 5,345,937 5,504,039 Incremental common equivalent shares: Related to options and warrants using the period-end market price, if higher than average market price...... 24,823 211 -- --------- --------- --------- WEIGHTED AVERAGE FULLY DILUTED SHARES OUTSTANDING........... 5,274,917 5,346,148 5,504,039 ========= ========= ========= Income (loss) before extraordinary gain on early redemption of preferred stock and preferred stock dividends as reported.................................................. $ 4,512 $ 1,313 $ (3,436) Reduction in interest expense and increase in short-term investment income for modified treasury stock method...... 125 -- -- --------- --------- --------- 4,637 1,313 (3,436) Extraordinary gain on early redemption of redeemable preferred stock........................................... 502 -- -- --------- --------- --------- NET INCOME (LOSS) (AS ADJUSTED)............................. 5,139 1,313 (3,436) Preferred stock dividends as reported....................... (208) -- -- Preferred stock dividends reduction for modified treasury stock method.............................................. 46 -- -- --------- --------- --------- Earnings available to common shareholders (as adjusted)..... $ 4,977 $ 1,313 $ (3,436) ========= ========= ========= EARNINGS PER SHARE: Income (loss) before extraordinary gain on early redemption of redeemable preferred stock and preferred stock dividends........................................ $ .88 $ .25 $ (.62) Extraordinary gain........................................ .09 -- -- --------- --------- --------- NET INCOME (LOSS)......................................... .97 .25 (.62) Preferred stock dividends................................. (.03) -- -- --------- --------- --------- Earnings available to common shareholders................... $ .94 $ .25 $ (.62) ========= ========= =========
- ------------------------- (1) This calculation is submitted in accordance with the Securities Exchange Act of 1934 Release No. 9083 although not required by footnote 2 to paragraph 14 of APB Opinion No. 15 because it results in dilution of less than 3 percent. (2) Share amounts have been retroactively adjusted for the effect of the 5 percent stock dividend distributed on June 21, 1996, to shareholders of record on May 17, 1996. (3) According to AICPA Accounting Interpretation of APB Opinion No. 15, net loss per share is based on outstanding shares. Assuming exercise of options and warrants would be anti-dilutive for 1994 because an increase in the number of shares assumed to be outstanding would reduce the amount of the loss per share. EX-21.1 8 LIST OF SUBSIDIARIES OF SMC 1 EXHIBIT 21.1 SUBSIDIARIES OF STANDARD MANAGEMENT CORPORATION
PERCENTAGE OF STATE OR COUNTRY IN NAME OF SUBSIDIARY OUTSTANDING WHICH ORGANIZED ------------------ ------------- ------------------- Standard Life Insurance Company of Indiana.................. 100% Indiana Dixie National Life Insurance Company....................... 99.3% Mississippi Standard Marketing Corporation.............................. 100% Indiana Standard Marketing International, Ltd. ..................... 100% Bermuda Standard Administrative Services, Inc. ..................... 100% Indiana Standard Management International S.A. ..................... 100% Luxembourg Premier Life (Luxembourg) S.A. ............................. 100% Luxembourg Premier Life (Bermuda) Limited.............................. 100% Bermuda Standard Development, LLC................................... 50% Indiana Standard Acquisition Corporation............................ 100% North Carolina Standard Investor Services Corporation...................... 100% Indiana
EX-23.1 9 CONSENT OF ERNST & YOUNG LLP 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-92906) pertaining to the Second Amended and Restated Stock Option Plan of our report dated March 18, 1997, with respect to the consolidated financial statements and schedules of Standard Management Corporation included in the Annual Report (Form 10-K) for the year ended December 31, 1996. Ernst & Young LLP Indianapolis, Indiana March 28, 1997 EX-23.2 10 CONSENT OF KPMG AUDIT 1 EXHIBIT 23.2 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the reference to our firm under the caption "Experts" in the Registration Statement (Form S-8 No. 33-92906) pertaining to the Second Amended and Restated 1992 Stock Option Plan and to the incorporation by reference therein of our report dated March 12, 1997 with respect to the consolidated financial statements of Standard Management International S.A. included in the Annual Report on Form 10-K for the year ended December 31, 1996 of Standard Management Corporation filed with the Securities and Exchange Commission. Luxembourg, March 18, 1997 KPMG Audit [COPY WHITE] EX-27 11 FINANCIAL DATA SCHEDULE
7 1,000 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 347,310 0 0 62 3,035 546 370,138 5,113 68,811 18,078 628,788 420,739 0 0 4,585 20,060 1,757 0 40,481 (315) 628,788 10,468 20,871 1,302 8,041 9,919 2,592 12,175 3,910 (602) 0 0 502 0 5,014 $.95 0 0 0 0 0 0 0 0
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