Summary of CITIZENS INC - Yahoo! Finance

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operation
Overview
We conduct operations as an insurance holding company emphasizing ordinary life insurance products in niche markets where we believe we can achieve competitive advantages. Our core operations include issuing:
• U.S. Dollar-denominated ordinary whole life insurance policies predominantly to high net worth, high income foreign residents, located principally in Latin America and the Pacific Rim, through approximately 2,200 independent marketing consultants;

• ordinary whole life insurance policies to middle income households in the midwest and the southern United States through approximately 300 independent marketing consultants; and

• final expense and limited liability property policies to middle to lower income households in Louisiana and Arkansas through approximately 540 employee and independent agents in our home service distribution segment.

We operate through two segments as follows:
Life Insurance. For over the past 30 years, CICA and its predecessors have accepted policy applications from foreign nationals for U.S. Dollar-denominated ordinary whole life insurance. Traditionally, this market has been concentrated in the top 3-5% of the population of a country in terms of income and net worth. In recent years, however, there has been a shift to encompass a broader spectrum of the population, as upper middle classes develop in Latin America and the Pacific Rim. We make our insurance products available using third-party marketing organizations and independent marketing consultants. The number of our producing independent consultants has expanded over the years in this segment to approximately 2,200, and we received applications from residents of 34 countries outside of the U.S. in 2008. Historically, the majority of our international business has come from Latin America. However, in 2004 the Pacific Rim began to represent a meaningful and growing source of new business, and in 2008 was one of the leading sources of new premium income.
In 2008, our Life Insurance segment generated revenue of $105.5 million, which accounted for 71.9% of our total revenue. For the year ended December 31, 2007, this segment produced revenue of $114.8 million or 67.7% of our total revenue, compared to 2006 when it produced approximately $101.9 million or 66.1% of total revenue. The decrease in 2008 revenues was due to the write-down of $13.6 million of equity mutual funds in this segment. Our strategy in operating our Life Insurance segment is to increase new business written through our existing marketers as well as expand the number of countries from which we receive policy applications. The development of new markets in the Pacific Rim and the expansion of existing markets in Latin America were the primary contributors to the insurance revenue growth in this segment.
From time to time we will issue new products to stay abreast of changes in the market and in our clients. In 2008, CICA introduced a new set of international products, which caused new production of insurance from non-U.S. residents to slow in the first nine months of 2008 compared to the same period in 2007. This was due to our less than optimum introduction process and slower than anticipated acceptance of these new policies. However, the products were well accepted in the international market during the latter half of 2008, as fourth quarter new business production exceeded the prior year's fourth quarter. Through the domestic market of our Life Insurance segment, we provide ordinary whole life, credit life insurance, and final expense policies to middle income families or individuals in certain markets in the midwest and southern U.S. The majority of our revenues in this regard are the result of acquisitions of domestic life insurance companies since 1987.
We also realize revenues from our investment portfolio. Life insurance companies earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid out under policies. Changes in interest rates, changes in economic conditions and volatility in the capital markets, such as the ones caused by our impairment of our equity mutual funds in 2008, can all impact the amount of earnings that we realize from our investment portfolio. Home Service Insurance. Through our subsidiaries, SPLIC and ONLIC, we provide final expense ordinary life insurance to middle to lower income individuals in Louisiana and Arkansas. Our policies in this segment are sold and serviced through home service marketing distribution system utilizing employee-agents who work on a route system to collect premiums and service policyholders or through networks of funeral homes who collect premium and provide personal service to policyholders.

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During 2008, revenue from this segment was $42.2 million, which accounted for 28.8% of our total revenue. For the year ended December 31, 2007, revenue from this segment was $52.9 million or 31.2% of our total revenue compared to $51.2 million or 33.2% of our total revenue in 2006. The decrease in revenue in 2008 was primarily due to the write-down of $9.9 million of equity mutual funds during 2008. Our business strategy in this segment is to continue to serve existing customers in Louisiana as well as expand the business through new marketing management that we put in place in early 2005.
In 2008, SPLIC's property insurance subsidiary, SPFIC, was negatively impacted by Hurricanes Gustav and Ike. Losses incurred by SPFIC were $500,000 for Hurricane Gustav and $285,000 for Hurricane Ike. The Company also incurred $478,000 in reinstatement premiums. During 2005, Hurricane Katrina devastated the Gulf Coast. Commencing in 2005 and through December 31, 2007, total incurred losses related to Hurricane Katrina not covered by reinsurance amounted to $4.0 million, resulting in SPLIC's need to provide $4 million of additional capital to SPFIC. Legislative and judicial decrees further extended for an additional year the period for filing claims beyond that provided under SPFIC's insurance contracts. Due to this extended claims filing period, an incurred but not reported claim and loss adjustment expense (LAE) liability of $500,000 was recorded at December 31, 2006 to cover any claims filed in 2007. When the extended deadline for filing of claims expired in the third quarter of 2007, SPFIC released approximately $425,000 of liabilities, which SPFIC determined were not payable under the contracts.
As discussed earlier, the Company completed the acquisition of ONLIC in the fourth quarter of 2008. ONLIC writes both final expense and home service ordinary life insurance in Arkansas and is included in the Home Service segment. As the income statement contains only two months of ONLIC operations, there is an insignificant impact upon revenue, expenses or net income. ONLIC increased the Home Service operation assets by $26.0 million and liabilities by $17.2 million.
Marketplace Conditions and Trends
Described below are some of the significant recent events and trends affecting the life insurance industry and the possible effects they may have on our future operations.
• As an increasing percentage of the world population reaches retirement age, we believe we will benefit from increased demand for living products rather than death products, as aging consumers will require cash accumulation to provide expenses to meet their lifetime needs. Our ordinary life products are designed for our policyowners to accumulate cash values to provide for living expenses in a policy owner's later years, while continuously providing a death benefit.

• We are exposed to a variety of risks, including the current financial recession as well as the credit crisis and corresponding potential changes in the fair value of our investments. Financial markets in the United States and elsewhere have experienced extreme volatility and disruption, due largely to stresses affecting the global banking system, which accelerated significantly in the second half of 2008. The global economies have entered a severe recession that is likely to persist well into and perhaps through and even beyond 2009, despite past and expected governmental intervention in the world's major economies. These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes and have resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. The current economic environment could also reduce the persistency of our existing insurance policies.

• As a financial institution and life insurer with significant investment exposure, we have been adversely affected by the volatility and disruption in the global capital markets and face significant financial and capital markets risk in our operations. Corporate bond defaults and credit downgrades, which have resulted in other-than-temporary impairments in the value of some securities, have had a material impact on life insurers in the past few years. The majority of our investment portfolio is held in debt instruments carrying the full faith and credit of the U.S. Government, or in U.S. Government-sponsored enterprises. Most of the municipal bonds we own are privately insured. We have not experienced any material impairments in the value of our debt securities due to the current credit crisis in world financial markets. We intend to manage our investment portfolio conservatively in the future by continuing to utilize these types of debt instruments. During the course of 2008, the significant declines in equity markets have negatively impacted our assets under management. We incurred realized losses relative to limited equity positions we took during 2007 and the first half of 2008 under the current accounting guidance for OTTI analysis. Due to current economic forecasts, we expect continued pressure on our equity positions in 2009.

• Because of the trends described above coupled with increasing costs of regulatory compliance such as the Sarbanes-Oxley Act of 2002, we believe there is a trend towards consolidation of domestic life insurance companies. We believe this should be a benefit to our acquisition strategy because there should be more complementary acquisition candidates available for us to consider.

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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES • Many of the events and trends affecting the life insurance industry have had an impact on the life reinsurance industry. These events led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, we may find it difficult to obtain reinsurance in the future, forcing us to seek reinsurers who are more expensive to us. If we cannot obtain affordable reinsurance coverage, either our net exposures will increase or we would have to reduce our underwriting commitments.

Recent Acquisitions
In the fourth quarter of 2008, the Company completed its acquisition of ONLIC for $8.0 million and had additional acquisition related expenses of $900,000. The Company completed its acquisition of Integrity Capital Corporation in exchange for 1,292,000 shares of Citizens, Inc. Class A common stock in the first quarter of 2009. Integrity Capital Corporation is the parent of Integrity Capital Insurance Company, an Indiana life insurance company. The transaction was valued at $8.4 million when the transaction closed on February 27, 2009. Consolidated Results of Operations
The following table sets forth our net income for the periods indicated:

   Years ended     Net Income (loss)       Net Income (loss)       Increase (decrease)
   December 31,     (In thousands)         per Class A Share       from Previous Year
   2008           $           (15,707 )   $             (0.42 )                 (194.9) %
   2007                        16,557                    0.35                      90.8
   2006                         8,677                    0.16                      18.8

As further discussed below, the impairment of $23.5 million of equity securities plus the tax valuation allowance thereon, the property losses incurred by SPFIC from Hurricanes Gustav and Ike and the increase in fair value of the warrants associated with the Company's Preferred stock contributed to a 194.9% decrease in earnings for 2008.
Total revenues for 2008 were $146.7 million, a 13.5% decrease compared to 2007 revenues of $169.6 million. Total revenues for 2006 were $154.2 million. Total revenues from Home Service were $42.2 million in 2008 and $52.9 million in 2007, compared to $51.2 million in 2006. Total revenues from our Life Insurance segment amounted to $105.5 million during 2008, compared to $114.8 million for 2007 and $101.9 million for 2006.
Premium Income. Premium income during 2008 increased to $141.3 million from $136.7 million in 2007, or 3.3%, and $124.6 million in 2006. The 2008 increase was attributable to the new international business written in 2007 and 2008 in the Life Insurance segment, which had $102.0 million of premium income during 2008. Additionally, we continued to experience improved persistency in our international life business, which contributed largely to the increase. First year premium in the Life Insurance segment in 2008 was up slightly from its 2007 level.
Net Investment Income. Net investment income decreased slightly during 2008 to $30.5 million, compared to $30.7 million during 2007 and $27.0 million in 2006. The decrease was primarily from lower income earned on equity mutual funds. Mutual fund income was $2.2 million in 2007 but only $1.0 million in 2008. Although investments were flat, cash grew substantially during 2008, investment income was only marginally up. Aside from lower mutual fund income, the low interest rate environment coupled with larger amounts invested in lower yielding cash balances reduced income in 2008. We continue to invest primarily in bonds of U.S. Government-sponsored enterprises, such as Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Association (FHLMC), although the Company expects lower investment yields with these instruments due to historically low interest rates.
Realized Gains (Losses) on Investments. As previously mentioned, the Company recognized OTTI write-downs of $23.5 million on its holdings of mutual funds during the fourth quarter of 2008, as these securities experienced an unrealized loss position for more than twelve months. These mutual funds are well diversified and have a history of out-performing the overall market, although past performance is not a guarantee of future results. The Company believes these funds will recover as the overall market recovers. During 2008, the Company also permanently impaired two bonds due to credit quality, recognizing a realized loss of $288,000.

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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Increase in Fair Value of Warrants. As the market value of our Class A common stock increased during 2008, we incurred a loss on the increase in fair value of warrants of $2.7 million in 2008, compared to a gain of $828,000 in 2007 and a loss of $244,000 in 2006. The sizeable loss in 2008 was directly related to the increase in the price of our Class A common stock, as well as an increase in volatility. The warrant liability is calculated using the Black-Scholes option pricing model, which attempts to predict the value of the warrants when they expire in July 2011 and 2012. Current accounting standards require the change in the value of the warrant liability be recorded as a component of revenues. When the liability increases we incur a loss, and when the liability decreases we generate income. The warrant liability has no affect on the Company's cash flows, as the Company expects the warrants will be converted into our Class A common stock in July 2011, or sooner, at the election of the warrant holders, or expire.
Claims and Surrenders. As noted in the table below, claims and surrenders increased 11.2% from $50.6 million in 2007 to $56.3 million in 2008. The 2008 increase primarily related to an increase in property claims in SPFIC from Hurricanes Gustav and Ike, as well as an increase in death claims, surrender expense and endowments.

                                                Years ended December 31,
                                             2008         2007         2006
                                                     (In thousands)

            Death claims                   $ 22,529       20,720       21,686
            Surrender expenses               15,222       13,832       13,335
            Endowments                       13,814       12,835       10,786
            Property claims                   2,657        1,090        5,194
            Other policy benefits             1,604        1,783          849
            Accident and health benefits        427          311          541

            Total claims and surrenders    $ 56,253       50,571       52,391

Death benefits increased in 2008 compared to 2007, primarily in the Home Service segment, where death claims were up $1.9 million. However, there was a $650,000 decrease in 2007 to correct an overstatement of prior years claim liability. Death benefits decreased slightly in 2007 compared to 2006.
Policy surrenders increased 10.0% in 2008 to $15.2 million from $13.8 million in 2007, up from $13.3 million in 2006. The increase in surrender expense is in line with management expectations, considering the inforce business has increased over the last three years. Surrenders as a percent of inforce business were 0.4% in 2008, 2007 and 2006.
Endowment benefits increased 7.6% from $12.8 million in 2007 to $13.8 million in 2008. Endowments totaled $10.8 million in 2006. We have a series of international policies that carry an immediate endowment benefit of an amount elected by the policy owner. These benefits have been particularly popular in the Pacific Rim, where the Company has experienced increased business in recent years. Like policy dividends, endowments are factored into the premium and, as such, the increase has no impact on profitability.
Property claims increased 143.8% in 2008, from $1.1 million in 2007 to $2.7 million in 2008, and were $5.2 million in 2006. In 2008, Hurricanes Gustav and Ike swept through Louisiana resulting in an increase in property claims of $1.6 million over 2007. In 2007, the Company began to experience a dramatic decline in property claims that adversely affected the business in 2006. Hurricane claims in 2007 were a negative $711,000, as the Company released claim liabilities that were no longer required due to the expiration of the statute of limitations. Of the 2006 property claims, $3.0 million were due to Hurricane Katrina.
Reserves. The change in future policy benefit reserves increased from $36.4 million in 2007 to $37.1 million in 2008, predominantly due to an improvement in persistency on our international life business, as well as the continued sale of international policies. During 2007 and 2006, a shift in products sold occurred with the addition of sales in the Pacific Rim, which resulted in a more rapid rise in reserves. The change in future policy benefit reserves increased from $30.7 million in 2006 to $36.4 million in 2007, due predominantly to increased persistency on our business and an increase and change in product mix in new business. Additionally, sales of certain endowment products, which build reserves at a much higher rate, contributed to the increase.
Policyholder Dividends. Policyholder dividends increased 7.2% during 2008 to $6.9 million from $6.4 million in 2007 and $5.4 million in 2006, due to improved persistency and the continued sale of participating ordinary whole life products in the international market. All of our international policies are participating, and the improvement in persistency and increase in new business on our international business have contributed to the growth in dividends. Policyholder dividends are factored into the premiums and have no impact on profitability.

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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES Commissions. Commissions increased slightly during 2008 to $36.0 million from $35.6 million in 2007 and $35.7 million in 2006, primarily due to the new business issued during the period. Commissions were essentially flat all three years, even though premiums were up due to the increased amount of renewal premiums, which pay a lower commission.
Underwriting, Acquisition and Insurance Expense. Underwriting, acquisition and insurance expenses increased to $28.6 million in 2008 from $27.6 million in 2007. The 2008 increase was largely due to an increase in employee compensation and increased fees for international shipping.
Deferred Policy Acquisition Costs. Capitalized deferred policy acquisition costs ("DAC") decreased 8.0% from $26.2 million in 2007 to $24.1 million in 2008. These costs were $27.0 million in 2006. The 2008 decrease from 2007 was primarily related to flat new life production discussed above, and tracked consistently with the slight increase in commissions. Amortization of these costs was $15.6 million, $12.5 million and $11.4 million in 2008, 2007 and 2006, respectively. Amortization is higher due to higher deaths and surrenders. In addition, the DAC asset has grown 8.4% since December 31, 2007, which resulted in higher amortization in 2008. Also, the write-off of DAC on internal replacements under the American Institute of Certified Public Accountants (AICPA) Statement of Position, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1), added $917,000 to amortization in 2007.
Cost of Customer Relationships Acquired and Other Intangibles. Amortization of cost of customer relationships acquired and other intangibles decreased from $4.7 million in 2006, to $3.2 million in 2007 and $2.9 million in 2008. Analysis of goodwill for CNLIC, a reporting unit within the Life Insurance segment, showed it to be impaired at December 31, 2006. Due to significant declines in new business issued by CNLIC, the fair value of this reporting unit was below its carrying value. As a result, an impairment loss of $1.0 million was recognized in the fourth quarter of 2006. The fair value of that reporting unit was estimated using the present value of estimated future cash flows. The remaining goodwill is associated with CICA and ONLIC. At December 31, 2007 and 2008, there was no impairment of goodwill.
Federal Income Tax. The federal income tax expense was $3.1 million, $6.9 million and $4.7 million in 2008, 2007 and 2006, respectively, resulting in effective tax rates of 24.7%, 29.5% and 35.0%, respectively. The Company established a tax valuation allowance related to OTTI losses on its mutual funds of $6.9 million in 2008. The establishment of the valuation allowance had the effect of decreasing the effective tax rate. In 2007, our valuation allowance was released, as the CNLIC sale agreement was terminated and the Company's plan is to now consolidate CNLIC in the Company's life-nonlife tax return for 2008. CICA had sufficient life income to absorb the CNLIC net operating losses in 2008. In 2006, this release of the valuation allowance reduced our effective tax rate by 4.7%. The 2006 tax rate was higher due to a write-off of $1.0 million of goodwill, which has no resulting tax benefit. The write-off of goodwill added 2.7% to the effective tax rate. (See Note 11 of the "Notes to Consolidated Financial Statements" for additional information on federal income tax.) Investments
State insurance statutes prescribe the quality and percentage of the various types of investments that may be made by insurance companies and generally permit investment in qualified state, municipal, federal and foreign government obligations, high quality corporate bonds, preferred and common stock, real estate, mortgage loans and real estate within certain specified percentages. The administration of our investment portfolios is handled by our management, pursuant to board-approved investment guidelines, with all trading activity approved by a committee of the respective boards of directors of our insurance company subsidiaries. The guidelines used require that bonds, both government and corporate, are of high quality and comprise a majority of the investment portfolio. The assets selected are intended to mature in accordance with the average maturity of the insurance products and to provide the cash flow for our insurance company subsidiaries to meet their respective policyholder obligations.
Valuation of Investments in Fixed Maturity and Equity Securities At December 31, 2008, investments in fixed maturity and equity securities were 92.8% of our total investments. All of our fixed maturities were classified as available-for-sale securities at December 31, 2008 and thus are reported on our consolidated financial statements at fair value; equity securities are also reported at fair value. We had no fixed maturity or equity securities that were classified as trading securities at December 31, 2008.

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CITIZENS, INC. AND CONSOLIDATED SUBSIDIARIES At December 31, 2008, 70.5% of our fixed maturity securities were invested in U.S. Government-sponsored enterprises or securities backed by the U.S. Government. We evaluate the carrying value of our fixed maturity and equity securities at least quarterly. The Company monitors all debt and equity securities on an on-going basis relative to changes in credit ratings, market prices, earnings trends and financial performance, in addition to specific region or industry reviews. The Company determines other-than-temporary impairment by reviewing all relevant evidence related to the specific security issuer as well as the Company's intent and ability to hold the investment for a period of time sufficient for a forecasted recovery. The Company's intent to hold investments for the long term can be evidenced by security maturities as opposed to sales within the portfolios and the long term nature of our insurance contracts and the strategy of matching assets and liabilities as key business drivers. A decline in the fair value of any fixed maturity or equity security below cost that is deemed other-than-temporary is charged to earnings resulting in the establishment of a new cost basis for the security. The new cost basis is not changed for subsequent recoveries in the fair value of the fixed maturity or equity security. With the exception of Security Plan, virtually all of our subsidiaries fixed maturity investments are in U.S. Government or U.S. Government-sponsored enterprises or U.S. Government instruments. Security Plan has significant investments in corporate and municipal bonds. Based upon our emphasis on investing in fixed maturity securities primarily composed of obligations of U.S. Government-sponsored corporations, our intent and ability to hold temporarily impaired fixed maturities until recovery, and our analysis of whether declines in fair value below cost are temporary or other-than-temporary, management believes that our investments in fixed maturity investments at December 31, 2008 were not impaired, and no other-than-temporary losses needed to be recorded. The Company did impair one Lehman Brothers bond and a Ford Motor Credit bond during 2008, because the Company does not expect these securities to recover in value in the near term. The Company will closely monitor its fixed . . .