10-Q 1 a2001aq.txt ILCO 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended March 31, 2001 Commission File Number 2-39310 INTERCONTINENTAL LIFE CORPORATION (Exact Name of Registrant as specified in its charter) Texas 22-1890938 (State of Incorporation) (I.R.S. Employer Identification Number) 6500 River Place Blvd., Building I Austin, Texas 78730 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (512) 404-5000 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 Number of common shares outstanding ($.22 Par Value) at end of period: 8,180,407 - 1 - Forward-Looking Statements Except for historical factual information set forth in this Form 10-Q, the statements, analyses, and other information contained in this report relating to trends in the Company's operations and financial results, the markets for the Company's products, the future development of the Company's business, and the contingencies and uncertainties to which the Company may be subject, as well as other statements including words such as "anticipate," "believe," "path," "estimate," "expect," "intend" and other similar expressions constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. Such statements are made based upon management's current expectations and beliefs concerning the financial results, economic conditions and are subject to known and unknown risks, uncertainties and other factors contemplated by the forward-looking statements. Such factors include, among other things: (1) general economic conditions and other factors, including prevailing interest rate levels and stock market performance, which may affect the ability of ILCO to sell its products, the market value of ILCO's investments and the lapse rate and profitability of policies; (2) ILCO's ability to achieve anticipated levels of operational efficiencies and cost-saving initiatives; (3) customer response to new products, distribution channels and marketing initiatives; (4) mortality, morbidity and other factors which may affect the profitability of ILCO's insurance products; (5) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of ILCO's products; (6) increasing competition in the sale of insurance and annuities; (7) regulatory changes or actions, including those relating to regulation of insurance products and insurance companies; (8) ratings assigned to ILCO's insurance subsidiaries by independent rating organizations such as A.M. Best Company, which ILCO believes are particularly important to the sale of annuity and other accumulation products; and (9) unanticipated litigation. There can be no assurance that other factors not currently anticipated by management will not also materially and adversely affect ILCO. - 2 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES INDEX Page No. Part I - Financial Information Item 1. Financial Statements Consolidated Balance Sheets March 31, 2001 and December 31, 2000.................................. 4 Consolidated Statements of Income For the three month periods ended March 31, 2001 and March 31, 2000......................................6 Consolidated Statements of Cash Flows For the three month periods ended March 31, 2001 and March 31, 2000......................................7 Notes to Consolidated Financial Statements..................................9 Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations........................10 Item 3. Quantitative and Qualitative Disclosures About Market Risk.....................................................19 Part II Other Information..........................................................20 Signature Page.............................................................23 - 3 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands of dollars) March 31, December 31, 2001 2000 ASSETS (Unaudited) Investments: Fixed maturities, at amortized cost (market value approximates $1,014 and $1,386 at March 31, 2001 and December 31, 2000) $ 1,002 $ 1,386 Fixed maturities available for sale, at market value (amortized cost of $418,020 and $436,997 at March 31, 2001 and December 31, 2000) 427,360 440,749 Equity securities, at market value (cost approximates $338 at March 31, 2001 and December 31, 2000) 2,510 1,764 Policy loans 48,139 48,449 Mortgage loans 4,824 4,858 Invested real estate and other invested assets 40,401 32,969 Short-term investments 143,530 129,807 Total investments 667,766 659,982 Cash and cash equivalents 10,203 9,066 Notes receivable from affiliates 33,812 35,349 Accrued investment income 8,552 8,304 Accounts receivable and other receivables 26,130 24,340 Reinsurance receivables 16,606 17,448 Real estate occupied by the Company 20,086 19,938 Property and equipment, net 5,032 5,005 Deferred policy acquisition costs 40,323 39,395 Present value of future profits of acquired businesses 35,446 36,024 Other assets 7,731 7,866 Separate account assets 427,659 444,898 Total Assets $ 1,299,346 $ 1,307,615 The accompanying notes are an integral part of the consolidated financial statements. - 4 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS, Continued (in thousands of dollars) March 31, December 31, LIABILITIES AND SHAREHOLDERS' EQUITY 2001 2000 (Unaudited) Liabilities: Policy liabilities and contractholder deposit funds: Future policy benefits $ 128,371 $ 130,325 Contractholder deposit funds 520,797 520,349 Unearned premiums 1,589 1,589 Other policy claims and benefits payable 10,581 10,801 661,338 663,064 Other policyholders' funds 2,584 3,015 Deferred federal income taxes 29,384 27,188 Other liabilities 15,741 10,045 Separate account liabilities 422,618 440,127 Total Liabilities 1,131,665 1,143,439 Commitments and Contingencies Redeemable preferred stock: Class A Preferred, $1 par value, 5,000,000 shares authorized, issued 5,000 5,000 Class B Preferred, $1 par value, 15,000,000 shares authorized, issued 15,000 15,000 20,000 20,000 Redeemable preferred stock held in treasury (20,000) (20,000) -0- -0- Shareholders' Equity: Common Stock, $.22 par value, 15,000,000 shares authorized; 10,883,478 and 10,859,478 shares issued, 8,180,407 and 8,129,385 shares outstanding in 2001 and 2000, respectively 2,398 2,389 Additional paid-in capital 4,745 4,561 Accumulated other comprehensive income 7,482 3,365 Retained earnings 163,169 163,998 177,794 174,313 Common treasury stock, at cost, 2,703,071 and 2,730,093 in 2001 and 2000, respectively (10,113) (10,137) Total Shareholders' Equity 167,681 164,176 Total Liabilities and Shareholders' Equity $ 1,299,346 $ 1,307,615 The accompanying notes are an integral part of the consolidated financial statements. - 5 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (in thousands of dollars, except for per share data) (unaudited) Three Months Ended March 31, 2001 2000 Revenues: Premium $ 2,063 $ 2,278 Net investment income 12,337 12,204 Earned insurance charges 9,894 10,149 Other 643 768 24,937 25,399 Benefits and expenses: Policyholder benefits and expenses 6,911 7,353 Interest expense on contract holders deposit funds 7,391 7,159 Amortization of present value of future profits of acquired businesses 577 966 Amortization of deferred policy acquisition costs 747 694 Operating expenses 4,825 4,129 20,451 20,301 Income from operations 4,486 5,098 Provision for federal income taxes 1,654 1,867 Net income $ 2,832 $ 3,231 Net income per share Basic: Weighted average common stock outstanding 8,160 8,817 Basic earnings per share $ 0.35 $ 0.37 Diluted: Common stock and common stock equivalents 8,241 8,824 Diluted earnings per share $ 0.34 $ 0.37 The accompanying notes are an integral part of these consolidated financial statements. - 6 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands of dollars) (unaudited) Three Months Ended March 31, CASH FLOWS FROM OPERATING 2001 2000 ACTIVITIES Net Income $ 2,832 $ 3,231 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Amortization of present value of future profits of acquired businesses 577 966 Amortization of deferred policy acquisition costs 747 694 Depreciation 426 59 Changes in assets and liabilities: Increase in accrued investment income (248) (803) Decrease (increase) in agent advances and other receivables (948) 2,878 Policy acquisition costs deferred (1,675) (1,513) Decrease in policy liabilities and contractholder deposit funds (1,726) (7,676) (Increase) decrease in other policyholders' funds (431) 13 Increase in other liabilities 5,696 2,679 Increase in deferred federal income taxes 2,196 1,068 Decrease (increase) in other assets 135 (800) Deferred tax on change in comprehensive income (2,217) 0 Accrual for shareholder dividends (3,937) 0 Other, net (120) (808) Net cash provided by (used in) operating activities $ 1,307 $ (12) The accompanying notes are an integral part of these consolidated financial statements. - 7 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands of dollars) (unaudited) Three Months Ended March 31, CASH FLOWS FROM INVESTING 2001 2000 ACTIVITIES Investments purchased $ (26,524) $(32,773) Proceeds from calls and maturities of investments 38,776 12,384 Net change in short-term investments (13,723) 27,267 Purchases and sales of equipment (453) (72) Decrease in notes receivable from affiliates 1,537 1,537 Net cash(used in) provided by investing activities (387) 8,343 CASH FLOWS FROM FINANCING ACTIVITIES Purchase of treasury stock -0- (5,159) Issuance of common stock 217 -0- Net cash provided by (used in) financing activities 217 (5,159) Net increase in cash and cash equivalents 1,137 3,172 Cash and cash equivalents, beginning of period 9,066 3,358 Cash and cash equivalents, end of period $ 10,203 $ 6,530 The accompanying notes are an integral part of these consolidated financial statements. - 8 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) The financial statements included herein have been presented to conform to the requirements of Form 10-Q. This presentation includes year end balance sheet data which was derived from audited financial statements. The notes to the financial statements do not necessarily include all disclosures required by generally accepted accounting principles (GAAP). The reader should refer to Form 10-K for the year ended December 31, 2000 previously filed with the Securities and Exchange Commission for financial statements prepared in accordance with GAAP. Management believes the financial statements reflect all adjustments necessary to present a fair statement of interim results. Certain prior year amounts have been reclassified to conform with current year presentation. Other Comprehensive Income The following is a reconciliation of total accumulated other comprehensive income from December 31, 2000 to March 31, 2001 (in thousands): Net unrealized gain on investments Total in fixed Net accumulated maturities appreciation other available for of equity comprehensive sale securities income Balance at December 31, 2000 $ 2,438 $ 927 $ 3,365 Current period change 3,633 484 4,117 Balance at March 31, 2001 $ 6,071 $ 1,411 $ 7,482 Dividends Declared In March, 2001, ILCO announced that its board of directors approved the payment of an annual cash dividend in the amount of $.41 per share. The dividend was paid on April 12, 2001 to shareholders of record on March 19, 2001. The dividend has been accrued in other liabilities on the consolidated balance sheet. New Accounting Pronouncements In June, 1998, the FASB issued FAS No. 133, 'Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133, as amended by FAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - An Amendment of FASB Statement No. 133", is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000, as amended by FAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No. 133". As the Company does not have significant investments in derivative financial instruments, the adoption of FAS 133 did not have a material impact on the Company's results of operations, liquidity or financial position. - 9 - Item 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations Results of Operations - Three Months Ended March 31, 2001 and 2000 For the three-month period ended March 31, 2001, InterContinental Life Corporation's ("ILCO" or the "Company") net income was $2,832,000 (basic earnings of $0.35 and diluted earnings of $0.34 per common share) as compared to $3,231,000 (basic earnings and diluted earnings of $0.37 per common share) in the first three months of 2000. Earnings per share are stated in accordance with the requirements of FAS No. 128, which establishes two measures of earnings per share: basic earnings per share and diluted earnings per share. Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect the potential dilution that would occur if securities or other contracts to issue common stock were converted or exercised. For the three-month period ended March 31, 2001, ILCO's income from operations, before provision for federal income taxes was $4,486,000 on revenues of $24,937,000 as compared to income of $5,098,000 on revenues of $25,399,000 for the first three months of 2000. The operating strategy of the Company's management emphasizes several key objectives: expense management; marketing of competitively priced insurance products which are designed to generate an acceptable level of profitability; maintenance of a high quality portfolio of investment grade securities; and the provision of quality customer service. Revenues. Premium income, net of reinsurance, for the first three months of 2001 was $2.06 million, as compared to $2.28 million for the first three months of 2000. This source of revenues is related to the traditional life insurance and accident & health insurance book of business of ILCO's insurance subsidiaries. The decrease from March 31, 2000 to March 31, 2001 is attributable to the decrease of the in-force face amounts of the traditional life insurance book of business from $131.7 million at March 31, 2000 to $128.4 million at March 31, 2001. Reinsurance premiums ceded were $0.15 million for the first three months of 2001, as compared to $0.3 million in the first three months of 2000. The decrease in the amount of reinsurance premiums ceded is consistent with the decrease in premium from the traditional business. Net investment income for the quarter ended March 31, 2001 was $12.3 million as compared to $12.2 million for the same quarter in 2000. The increase in investment income is primarily attributable to the rental income derived from the River Place Pointe properties being developed by a subsidiary of ILCO. Since the properties were in developmental stage during the first quarter of 2000, the project did not contribute to investment income for that period. The increase in rental income was partially offset by a lower level of interest income received on fixed income and short-term investments. - 10 - Earned insurance charges for the three month period ended March 31, 2001 were $9.89 million, as compared to $10.15 million for the same period in 2000. This source of revenues is related to the universal life insurance and annuity book of business of the insurance subsidiaries of the Company. The decrease in income from earned insurance charges is attributable to a decrease in the face amount of in- force universal life insurance policies. The face amount of in force universal life policies was $4.86 billion at March 31, 2000 as compared to $4.60 billion at March 31, 2001. The decline in earned insurance charges was also affected by a slight decrease in the amount of surrender charges received in connection with policy surrenders and partial withdrawals from in-force policies. Benefits and Expenses. Policyholder benefits and expenses for the quarter ended March 31, 2001 were $6.91 million, as compared to $7.35 million for the quarter ended March 31, 2000. The decline is primarily attributable to a decrease in benefits paid to policyholders in connection with the surrender of policies. Interest expense on contract holders deposit funds was $7.39 million for the quarter ended March 31, 2001, as compared to $7.16 million for the quarter ended March 31, 2000. This expense reflects increases or decreases in cash value or interest rates of the universal life and annuity books of business. The increase from the first quarter of 2000 to the first quarter of 2001 reflects higher cash values of in- force life insurance and annuity policies as of March 31, 2001. The expense related to the amortization of present value of future profits of acquired businesses was $0.58 million for the three-month period ended March 31, 2001, as compared to $0.97 million for the same period ended March 31, 2000. The decrease for the first quarter of 2001 is in line with the expected amortization of the remaining book of business. The expense related to the amortization of deferred policy acquisition costs was $0.75 million for the three-month period ended March 31, 2001, as compared to $0.69 million for the same three month period in 2000. The slight increase in amortization of deferred policy acquisition costs is attributable to the continued capitalization of expenses incurred in connection with the writing of new business. The operating expenses of the Company were $4.83 million for the quarter ended March 31, 2001, as compared to $4.13 million for the quarter ended March 31, 2000. The provision for federal income taxes was $1.65 million in the quarter ended March 31, 2001 as compared to $1.87 million in the quarter ended March 31, 2000. The decrease is primarily attributable to the lower level of income from operations. For the three-month period ended March 31, 2001, the lapse rate with respect to universal life insurance policies decreased from the lapse rate experienced in the similar period in 2000. The rate for the 2001 period was 4.86 %, as compared to 6.96 % in the 2000 period. The lapse rate with respect to traditional (non-universal) life insurance policies slightly increased from the levels experienced in the first quarter of 2000. The rate for the three-month period ended March 31, 2001 was 7.89 %, as compared to 7.88 % in the similar period in 2000. The lapse rates experienced during these periods were within the ranges anticipated by management. - 11 - Liquidity and Capital Resources Liquidity describes the ability of a company to generate sufficient cash flows to meet the cash requirements of business operations. ILCO is a holding company whose principal assets consist of the common stock of Investors Life Insurance Company of North America ("Investors-NA") and its subsidiary - Investors Life Insurance Company of Indiana ("Investors-IN"). Historically, our principal cash flow sources have been from periodic payment of principal and interest by Investors-NA, pursuant to the terms of the Surplus Debentures. In addition to the need for cash flow to meet operating expenses, our liquidity requirements relate principally to the liabilities associated with our various life insurance and annuity products. Our product liabilities include the payment of benefits under life insurance and annuity products, as well as the payment of policy surrenders, withdrawals and policy loans. Prior to June 30, 2000, ILCO's principal source of liquidity consisted of the periodic payment of principal and interest by Investors-NA, pursuant to the terms of the Surplus Debentures. The Surplus Debentures were originally issued by Standard Life Insurance Company and their terms were previously approved by the Mississippi Insurance Commissioner. In connection with the 1993 merger of Standard Life into Investors-NA, the obligations of the Surplus Debentures were assumed by Investors-NA. As of June 30, 2000, the outstanding principal balance of the Surplus Debentures was completely paid off. For periods subsequent to June 30, 2000, ILCO's available source of liquidity is dividends paid to it from its subsidiaries. Applicable state insurance laws generally restrict the ability of insurance companies to pay cash dividends in excess of prescribed limitations without prior approval. The ability of Investors-NA to pay shareholder dividends is and will continue to be subject to restrictions set forth in the insurance laws and regulations of Washington, its domiciliary state. The Washington insurance law limits how and when Investors-NA can pay shareholder dividends by including the "greater of" standard for payment of dividends to shareholders, and requiring that prior notification of a proposed dividend be given to the Washington Insurance Commissioner and that cash dividends may be paid only from earned surplus. Under the "greater of" standard, an insurer may pay a dividend in an amount equal to the greater of (i) 10% of the policyholder surplus or (ii) the insurer's net gain from operations for the previous year. As of March 31, 2001, Investors-NA had earned surplus of $60.7 million. Investors-IN is domiciled in the State of Indiana. Under the Indiana insurance code, a domestic insurer may make dividend distributions upon proper notice to the Department of Insurance, as long as the distribution is reasonable in relation to adequate levels of policyholder surplus and quality of earnings. Under Indiana law the dividend must be paid from earned surplus. Extraordinary dividend approval would be required where a dividend exceeds the greater of 10% of surplus or the net gain from operations for the prior fiscal year. Investors-IN had earned surplus of $23.4 million at March 31, 2001. - 12 - ILCO's cash and cash equivalents at March 31, 2001 was $10.2 million as compared to $9.07 million at December 31, 2000. The $1.13 million increase in cash and cash equivalents at March 31, 2001 as compared to the year end 2000 was due primarily to $1.8 million of funds received from a tenant in River Place Pointe for tenant improvement reimbursement related to the construction of their office space. ILCO's net cash flow provided by (used in) operating activities was $1.31 million for the three-month period ended March 31, 2001, as compared to $(12,000) for the first three months of 2000. The change is related to an increase in policy liabilities and contractholder deposit funds due to a lower amount of surrendered policies. The net cash provided by (used in) financing activities was $0.22 million for the quarter ended March 31, 2001, as compared to $(5.16) million for the quarter ended March 31, 2000. The cash used in financing activities for the year 2000 was attributable to ILCO's stock repurchase plan. Net cash flow (used in) provided by investing activities was $(0.39)million for the three months ended March 31, 2001, as compared to $8.34 million for the same period in 2000. The decrease in cash flow provided by investing activities was due to reinvestments in other invested assets during the first quarter of 2001, whereas in the first quarter of 2000 the cash provided by investing activities was used to finance the stock repurchases described above. Management believes that its cash, cash equivalents and short term investments are sufficient to meet the needs of its business. Investments. As of March 31, 2001, the book value of the Company's investment assets totaled $667.77 million, as compared to $659.98 as of December 31, 2000. Total assets as of March 31, 2001 ($1.30 billion) decreased slightly from the level as of December 31, 2000 ($1.31 billion). The increase in investment assets was primarily attributable to an increase in short-term investments as well as an increase in invested real estate and other invested assets. The level of short-term investments at March 31, 2001 was $143.53 million, as compared to $129.81 million at the end of 2000. This increase was primarily attributable to new investments in short-term assets. Since interest rates were lower in the first quarter of 2001, long-term investments that matured or were called early were primarily reinvested in short- term investments, avoiding long term investments at low interest rates. - 13 - As of March 31, 2001, the market value of the fixed maturities available for sale segment was $427.36 million as compared to an amortized cost of $418.02 million, or an unrealized gain of $9.34 million. The increase reflects unrealized gains on such investments related to changes in interest rates subsequent to the purchase of such investments. To reduce the exposure to interest rate changes, portfolio investments are selected so that diversity, maturity and liquidity factors approximate the duration of associated policyholder liabilities. The net of tax effect of this increase ($6.07 million at March 31, 2001) is included in "Accumulated other comprehensive loss" on the Consolidated Balance Sheets and has been recorded as a decrease in shareholders' equity. As required under the provisions of FAS No. 130, the determination of "Accumulated other comprehensive income" includes separate identification of the change in values which occurred during the current period. Invested real estate and other invested assets increased from $33.0 million at December 31, 2000 to $40.4 million as of March 31, 2001. This increase is related to the development of the River Place Pointe project ("River Place Pointe") by Investors-NA. In October, 1998, Investors-NA purchased River Place Pointe, two adjoining tracts of land located in Austin, Texas totaling 47.995 acres. The aggregate purchase price for these tracts was $8.1 million. Prior to the closing of the transaction, Investors-NA obtained a Site Development Permit for the tracts from the City of Austin. The Site Development Permit allows for the construction of seven office buildings totaling 600,000 square feet, with associated parking, drives and related improvements. Construction on the first phase of the Project, which consists of two office buildings, an associated parking garage, and related infrastructure was completed during 2000. The second phase of construction, which includes two more office buildings, is in progress. Investors-NA began receiving rental income on the entire third building during March, 2001 and expects completion of the remaining office building in this phase by the end of May, 2001. The liquidity of our insurance operations is also related to the overall quality of our investments. The assets held by ILCO's life insurance subsidiaries must comply with applicable state insurance laws and regulations. In selecting investments for the portfolios of its life insurance subsidiaries, the Company's emphasis is to obtain targeted profit margins, while minimizing the exposure to changing interest rates. This objective is implemented by selecting primarily short- to medium-term, investment grade fixed income securities. In making such portfolio selections, the Company generally does not select new investments which are commonly referred to as "high yield" or "non-investment grade." The Company's fixed maturities portfolio (including short-term investments), as of March 31, 2001, included a non-material amount (0.7% of total fixed maturities and short-term investments) of debt securities which, in the annual statements of the companies as filed with state insurance departments, were designated under the National Association of Insurance Commissioners ("NAIC") rating system as "3" (medium quality) or below. For the year ended December 31, 2000, the comparable percentage was also 0.7%. This number is attributable to mortgage bonds which the Company's insurance subsidiaries own in California utilities, which were downgraded to a "5" (lower quality) rating by the NAIC as of December, 2000. Investors-NA owns mortgage bonds in Pacific Gas & Electric which were purchased for $1.031 million and had a market value as of March 31, 2001 of $830,000 and as of December 31, 2000 of $720,000, and owns bonds in Southern California Edison which were purchased for $1.96 million and had a market value as of March 31, 2001 of $1.64 million and as of December 31, 2000 of $1.48 million. Investors-IN also owns bonds in Southern California Edison which were purchased for $488,085 and had a market value as of March 31, 2001 of $410,000 and as of December 31, 2000 of $370,000. - 14 - The investment objective of the Company's insurance subsidiaries emphasizes the selection of short to medium term high quality fixed income securities, rated Baa-3 (investment grade) or better by Moody's Investors Service, Inc. As of March 31, 2001, only 5.02% of the Company's total assets were invested in mortgage loans or real estate. Non-affiliated corporate debt securities that were non-investment grade represented only 0.2 % of the Company's total assets at March 31, 2001. The Company had investments in debt securities of affiliated corporations aggregating $ 33.8 million as of March 31, 2001, as compared to $35.3 million as of December 31, 2000. Investments in mortgage-backed securities included collateralized mortgage obligations ("CMOs") of $173 million and mortgage-backed pass-through securities of $39.4 million at March 31, 2001. Mortgage-backed pass-through securities, sequential CMOs and support bonds, which comprised approximately 56.2% of the book value of the Company's mortgage-backed securities at March 31, 2001, are sensitive to prepayment and extension risks. The Company has reduced the risk of prepayment associated with mortgage-backed securities by investing in planned amortization class ("PAC") instruments, target amortization class ("TAC") instruments, accretion directed bonds and scheduled bonds. These investments are designed to amortize in a predictable manner by shifting the risk of prepayment of the underlying collateral to other investors in other tranches ("support classes") of the CMO. PAC and TAC instruments and accretion directed and scheduled bonds represented approximately 43.8% and sequential and support classes represented approximately 37.7% of the book value of the Company's mortgage-backed securities at March 31, 2001. In addition, the Company limits the risk of prepayment of CMOs by not paying a premium for any CMOs. The Company does not invest in mortgage-backed securities with increased prepayment risk, such as interest-only stripped pass-through securities and inverse floater bonds. ILCO did not have any z- accrual bonds as of March 31, 2001. The prepayment risk that certain mortgage-backed securities are subject to is prevalent in periods of declining interest rates, when 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 investments which cannot be reinvested at an interest rate comparable to the rate on the prepaying mortgages. The Company does not invest in non-agency mortgage-backed securities, which have a greater credit risk than that of agency mortgage-backed securities. - 15 - ILCO does not make new mortgage loans on commercial properties. Substantially all of the Company's mortgage loans were made by its subsidiaries prior to their acquisition by the Company. At March 31, 2001, none of the mortgage loans held by the Company had defaulted as to principal or interest for more than 90 days, and none of the Company's mortgage loans were in foreclosure. Another key element of the Company's investment strategy is to avoid large exposure in other investment categories which the Company believes carry higher credit or liquidity risks, including private placements, partnerships and bank participations. These categories accounted for approximately 0.2% of the Company's invested assets at March 31, 2001. The consolidated balance sheets of the Company as of March 31, 2001 include $33.8 million of "Notes receivable from affiliates", represented by (i) a loan of $22.5 million from Investors-NA to Family Life Corporation and a $2.5 million loan from Investors-CA to Financial Industries Corporation (which is now owned by Investors-NA as a result of the merger of Investors-CA into Investors-NA) and $2.0 million of additions to the $2.5 million note made in accordance with the terms of such note; these loans were granted in connection with the 1991 acquisition of Family Life Insurance Company by a wholly-owned subsidiary of FIC (ii) a loan of $30 million by Investors-NA to Family Life Corporation made in July, 1993, in connection with the prepayment by the FIC subsidiaries of indebtedness which had been previously issued to Merrill Lynch as part of the 1991 acquisition and (iii) a loan of $4.5 million by Investors-NA to Family Life Insurance Investment Company made in July, 1993, in connection with the same transaction described above. As of June 12, 1996, the provisions of the notes from Investors-NA to FIC, FLC and FLIIC were modified as follows: (a) the $22.5 million note was amended to provide for twenty quarterly principal payments, in the amount of $1,125,000 each, to commence on December 12, 1996; the final quarterly principal payment is due on September 12, 2001; the interest rate on the note remains at 11%, (b) the $30 million note was amended to provide for forty quarterly principal payments, in the amount of $163,540 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $1,336,458; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%, (c) the $4.5 million note was amended to provide for forty quarterly principal payments, in the amount of $24,531 each for the period December 12, 1996 to September 12, 2001; beginning with the principal payment due on December 12, 2001, the amount of the principal payment increases to $200,469; the final quarterly principal payment is due on September 12, 2006; the interest rate on the note remains at 9%, (d) the $2.5 million note was amended to provide that the principal balance of the note is to be repaid in twenty quarterly installments of $125,000 each, commencing December 12, 1996 with the final payment due on September 12, 2001; the rate of interest remains at 12% and (e) the Master PIK note, which was issued to provide for the payment in kind of interest due under the terms of the $2.5 million note prior to June 12, 1996, was amended to provide that the principal balance of the note, in the amount of $1,977,119, is to be paid in twenty quarterly principal payments, in the amount of $98,855.95 each, to commence December 12, 1996 with the final payment due on September 12, 2001; the interest rate on the note remains at 12%. - 16 - In December, 1998, FLIIC was dissolved. In connection with the dissolution, all of the assets and liabilities of FLIIC became the obligations of FLIIC's sole shareholder (FIC). Accordingly, the obligations under the provisions of the $4.5 million note described above are now the obligations of FIC. The NAIC continued its rating of "3" to the "Notes receivable from affiliates", as amended. These loans have not been included in the preceding description of NAIC rating percentages. Management believes that the absence of any material amounts of "high-yield" or "non-investment grade" investments (as defined above) in the portfolios of its life insurance subsidiaries enhances the ability of the Company to service its debt, provide security to its policyholders and to credit relatively consistent rates of return to its policyholders. New Accounting Pronouncements In June, 1998, the FASB issued FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. FAS No. 133, as amended by FAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - An Amendment of FASB Statement No. 133", is applicable to financial statements for all fiscal quarters of fiscal years beginning after June 15, 2000, as amended by FAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FAS No. 133". As the Company does not have significant investments in derivative financial instruments, the adoption of FAS 133 did not have a material impact on the Company's results of operations, liquidity or financial position. Other Developments Agreement and Plan of Merger. On January 17, 2001, ILCO entered into an Agreement and Plan of Merger (the "Agreement") with FIC and ILCO Acquisition Company ("ILCO Acquisition"), a Texas corporation and wholly-owned subsidiary of FIC. In general, the Agreement provides that, following the approval of the Agreement by the shareholders of ILCO and the approval of the issuance of shares of FIC common stock and amendment to FIC's articles of incorporation by the shareholders of FIC and the satisfaction or waiver of the other conditions to the merger: (1) ILCO Acquisition will merge with and into ILCO; and (2) ILCO Acquisition will cease to exist and ILCO will continue as the surviving corporation and as a wholly-owned subsidiary of FIC following the merger. - 17 - Upon the consummation of the merger: (1) each share of ILCO common stock issued and outstanding immediately prior to the merger, other than shares of ILCO common stock held as treasury shares by ILCO (but excluding shares of ILCO common stock held by any of ILCO's subsidiaries, whether or not treated as treasury shares of ILCO on a consolidated basis under generally accepted accounting principles) or shares of ILCO common stock held by FIC, will be converted into the right to receive 1.1 shares of FIC common stock. However, in the event of any change in FIC common stock and/or ILCO common stock prior to the merger, such as a stock split, stock dividend, subdivision, reclassification, recapitalization, combination, exchange of shares or the like, the number and class of shares of FIC common stock to be issued and delivered in the merger in exchange for each outstanding share of ILCO common stock will be adjusted so as to maintain the relative proportionate interests of the holders of ILCO common stock and FIC common stock; (2) each share of ILCO common stock, series A preferred stock and series B preferred stock of ILCO, in each case which is held as treasury shares by ILCO prior to the merger (excluding shares of ILCO common stock held by any of ILCO's subsidiaries, whether or not treated as treasury shares of ILCO on a consolidated basis under generally accepted accounting principles), and each share of ILCO common stock which is held by FIC (excluding any shares of ILCO common stock owned by any of FIC's subsidiaries) prior to the merger, will be cancelled and retired; (3) each share of common stock of ILCO Acquisition issued and outstanding immediately prior to the merger will be converted into one share of common stock of ILCO and such shares will represent all of the issued and outstanding capital stock of ILCO following the merger; and (4) shares of FIC common stock outstanding immediately prior to the merger (including shares of FIC common stock held by any subsidiary of FIC or ILCO) will remain outstanding and will be unaffected by the merger. No fractional shares of FIC common stock will be issued in the merger. A holder of ILCO common stock who would otherwise be entitled to receive fractional shares of FIC common stock as a result of the merger will receive, in lieu of fractional shares, cash in an amount equal to the average closing price per share of FIC common stock for the 30 trading days immediately prior to the merger multiplied by the fraction to which the holder would otherwise be entitled. FIC will make available to First Union National Bank, as exchange agent, from time to time sufficient cash amounts to satisfy payment for fractional shares and First Union will distribute such proceeds, without interest, to the holders of the fractional interests. The consummation of the merger remains subject to various conditions precedent set forth in the Agreement, including the approval of certain matters by the shareholders of FIC and ILCO. The shareholder meetings for approval of the merger and related matters are set for May 18, 2001. For a more detailed description of the Agreement, see the complete copy of the Agreement, attached as an annex to the S-4 filed by FIC with the Securities and Exchange Commission on February 1, 2001, as amended by the S-4/A filed on March 13, 2001 and the S-4/A filed on April 3, 2001. Unsolicited Verbal Inquiries Concerning Possible Purchase of Post-Merger Company. On March 8, 2001, FIC announced that it has received unsolicited verbal indications of interest from a few companies that may be interested in acquiring FIC after completion of the merger with ILCO. The press release did not state any price ranges or other material terms. In conjunction with such indications of interest, FIC has retained Philo Smith Capital Corporation as its financial advisor to explore the possibility of a post-merger sale of FIC with these companies and to further solicit indications of interest from other companies that may have similar interests. As indicated on the Form 424B3 filed with the Securities and Exchange Commission on May 9, 2001, FIC has received one indication of interest that it intends to pursue through further discussions with the third party submitting such indication of interest. However, FIC has still not determined whether it will sell the company, and no price or material terms on which it would agree to sell the company have been determined by the board of directors of FIC or agreed upon with any third party. - 18 - Dividend. In March, 2001, ILCO announced that its board of directors approved the payment of an annual cash dividend in the amount of $0.41 per share. The dividend was paid on April 12, 2001, to record holders as of the close of business on March 19, 2001. Item 3. Quantitative and Qualitative Disclosures About Market Risk General ILCO's principal assets are financial instruments, which are subject to market risks. Market risk is the risk of loss arising from adverse changes in market rates and prices, principally interest rates on fixed rate investments. For a discussion of the Company's investment portfolio and the management of that portfolio to reflect the nature of the underlying insurance obligations of the Company's insurance subsidiaries, please refer to the information set forth in Item 2, "Management's Discussion and Analysis of Financial Conditions and Results of Operations - Investments" of this report. The following is a discussion of the Company's primary market risk sensitive instruments. It should be noted that this discussion has been developed using estimates and assumptions. Actual results may differ materially from those described below. Further, the following discussion does not take into account actions which could be taken by management in response to the assumed changes in market rates. In addition, the discussion does not take into account other types of risks which may be involved in the business operations of the Company, such as the reinsurance recoveries on reinsurance treaties with third party insurers. The primary market risk to the Company's investment portfolio is interest rate risk. The Company does not use derivative financial instruments. Interest Rate Risk Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in fair market value related to the financial instruments segment of the Company's balance sheet is estimated to be $19.4 million at March 31, 2001 and $21.1 million at December 31, 2000. For purposes of the foregoing estimate, the following categories of the Company's fixed income investments were taken into account: (i) fixed maturities, including fixed maturities available for sale, (ii) short-term investments and (iii) notes receivable from affiliates. The approximate market value of such assets was $605.7 million at March 31, 2001 and $607.3 million at December 31, 2000. - 19 - The fixed income investments of the Company include certain mortgage-backed securities. The market value of such securities was $220.8 million at March 31, 2001 and $ 223.6 million at December 31, 2000. Assuming an immediate increase of 100 basis points in interest rates, the net hypothetical loss in the fair market value related to such mortgage-backed securities is estimated to be $9.3 million at March 31, 2001 and $11.1 million at December 31, 2000. Fixed income investments held in separate accounts have not been included, since gains and losses on those assets generally accrue to the policyholders. The hypothetical effect of the interest rate risk on fair values was estimated by applying a commonly used model. The model projects the impact of interest rate changes on a range of factors, including duration and potential prepayment. Part II. Other Information Item 1. Legal Proceedings The Company and its subsidiaries are defendants in certain legal actions related to the normal business operations of the Company. Management believes that the resolution of such legal actions will not have a material impact upon the financial statements. Universal Life Litigation: ILCO and Investors-NA are defendants in a lawsuit which was filed in October, 1996, in Travis County, Texas. CIGNA Corporation, an unrelated Company, is also a named defendant in the lawsuit. The named plaintiffs in the suit (a husband and wife), allege that the universal life insurance policies sold to them by INA Life Insurance Company (a company which was merged into Investors-NA in 1992) utilized unfair sales practices. The named plaintiffs seek reformation of the life insurance contracts and an unspecified amount of damages. The named plaintiffs also seek a class action as to similarly situated individuals. In April, 2001, the named plaintiffs filed an amended complaint, so as to include various post-sale allegations, including allegations related to the manner in which increases in the cost of insurance were applied, the allocation of portfolio yields to the universal life policies and changes in the spread between the earned rate and the credited rate. The Company filed a motion to strike the amended Complaint, which motion was denied by the Court. No certification of a class has been granted as of the date hereof. The Company believes that the suit is without merit and intends to vigorously defend this matter. - 20 - Litigation Relating to the FIC/ ILCO Merger: On the day that FIC and ILCO each publicly announced the formation of a special committee to evaluate a potential merger, two class action lawsuits were filed against ILCO, FIC and the officers and directors of ILCO. The actions allege that a cash consideration in the proposed merger is unfair to the shareholders of ILCO, that it would prevent the ILCO shareholders from realizing the true value of ILCO, and that FIC and the named officers and directors had material conflicts of interest in approving the transaction. In their initial pleadings, the plaintiffs sought certification of the cases as class actions and the named plaintiffs as class representatives, and among other relief, requested that the merger be enjoined (or, if consummated, rescinded and set aside) and that the defendants account to the class members for their damages. Recently, the plaintiffs initiated discovery in this matter. The defendants believe that the lawsuits are without merit and intend to vigorously contest the lawsuits. Management is unable to determine the impact, if any, that the lawsuits may have on the results of operations of the Company. Other Litigation: Additionally, ILCO's insurance subsidiaries are regularly involved in litigation, both as a defendant and as plaintiff. The litigation naming the insurance subsidiaries as defendant ordinarily involves our activities as a provider of insurance protection products. We do not believe that such litigation, either individually or in the aggregate, will have a material adverse effect on the Company's business, financial condition or results of operations. Item 2. Changes in Securities None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None - 21 - Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Form 10-K Annual Report of Registrant for the year ended December 31, 2000 heretofore filed by Registrant with the Securities and Exchange Commission, which is hereby incorporated by reference. (b) Reports on Form 8-K On January 22, 2001, the Registrant filed a report on Form 8-K. The report pertained to the announcement by the Registrant that it had entered into a definitive agreement whereby Financial Industries Corporation ("FIC") would acquire the remaining common shares (approximately 52%) of ILCO which FIC does not currently own. The terms and provisions of the transaction are set forth in an Agreement and Plan of Merger dated as of January 17, 2001, among the Registrant, FIC and ILCO Acquisition Company. A copy of the Agreement and Plan of Merger is attached to the Report of Form 8-K. - 22 - INTERCONTINENTAL LIFE CORPORATION AND SUBSIDIARIES SIGNATURE Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. INTERCONTINENTAL LIFE CORPORATION /s/ James M. Grace James M. Grace, Treasurer Date: May 15, 2001 - 23 -