Good day, welcome to the Torchmark Corporation second quarter 2018 earnings release conference call. Today's conference is being recorded. For opening remarks and introductions, I would like to turn the conference over to Mike Majors, VP Investor Relations. Please go ahead, sir.
Thank you. Good morning, everyone. Joining the call today are Gary Coleman and Larry Hutchison, our Co-Chief Executive Officers, Frank Svoboda, our Chief Financial Officer, and Brian Mitchell, our General Counsel. Some of our comments or answers to your questions may contain forward-looking statements that are provided for general guidance purposes only. Accordingly, please refer to our 2017 10-K and any subsequent forms, 10-Q on file with the SEC. Some of our comments may also contain non-GAAP measures. Please see our earnings release and website for discussion of these terms and reconciliations to GAAP measures. I will now turn the call over to Gary Coleman.
Thank you, Mike, good morning, everyone. In the second quarter, net income was $184 million or $1.59 per share, compared to $140 million or $1.18 per share a year ago. Net operating income for the quarter was $175 million, or $1.51 per share, a per share increase of 27% from a year ago. Excluding the impact of a tax reform, we estimate that this growth would've been approximately 8%. On a GAAP reported basis, return on equity was 12.2% and book value per share was $48.44. Excluding unrealized gains and losses on fixed maturities, return on equity was 14.6% and book value per share grew 26% from a year ago to $42.08. In our life insurance operations, premium revenue increased 5% to $603 million and life underwriting margin was $161 million, up 9% from a year ago.
Growth in underwriting margin exceeded premium growth due to higher margins at American Income and Direct Response. For the year, we expect life underwriting income to grow around 5%-7%. On the health side, premium revenue grew 4% to $251 million, health underwriting margin was up 8% to $60 million. Growth in underwriting margin exceeded premium growth due to higher margins at Family Heritage. For the year, we expect health underwriting income to grow around 6%-8%. Administrative expenses were $55 million for the quarter, up 8% from a year ago and in line with our expectations. As a percentage of premium, administrative expenses were 6.5% compared to 6.3% a year ago. For the full year, we expect administrative expenses to be up 5%-6% and around 6.5% of premium, compared to 6.4% in 2017.
I will now turn the call over to Larry for his comments on the marketing operations.
Thank you, Gary. At American Income, life premiums were up 9% to $270 million, and life underwriting margin was up 11% to $89 million. Net life sales were $60 million, up 5%. The producing agent count for the second quarter was 7,064, up 1% from a year ago and up 4% from the first quarter. The producing agent count at the end of the second quarter was 7,143. At Liberty National, life premiums were up 2% to $69 million, while life underwriting margin was down 7% to $17 million. Net life sales increased 9% to $13 million, and net health sales were $5 million, up 9% from a year ago quarter. The sales increase was driven primarily by growth in agent count. The average producing agent count for the second quarter was 2,185, up 9% from a year ago and up 5% compared to the first quarter.
The producing agent count at Liberty National ended the quarter at 2,198. In our Direct Response operation at Globe Life, life premiums were up 3% to $209 million, and life underwriting margin increased 21% to $36 million. Net life sales were down 5% to $35 million. As we've discussed on previous calls, the sales decline is by design. We continue to refine and adjust our marketing programs in an effort to maximize the profitability of new sales. At Family Heritage, health premiums increased 8% to $68 million, and health underwriting margin increased 14% to $16 million. Health net sales grew 10% to $16 million. The average producing agent count for the second quarter was 1,052, up 2% from a year ago and up 6% from the first quarter. The producing agent count at the end of the quarter was 1,090.
At United American General Agency, health premiums increased 3% to $94 million. Net health sales were $13 million, up 3% compared to the year-ago quarter. To complete my discussion of the marketing operations, I will now provide some projections. We expect the producing agent count for each agency at the end of 2018 to be in the following ranges: American Income, 7,000-7,300. Liberty National, 2,200-2,400. Family Heritage, 1,160-1,210. Approximate life net sales trends for the full year 2018 are expected to be as follows. American Income, 4%-8% growth. Liberty National, 8%-12% growth. Direct response, 7%-10% decline. Health net sales trends for the full year 2018 are expected to be as follows. Liberty National, 4%-8% growth. Family Heritage, 5%-9% growth. United American individual Medicare supplement, 10%-20% growth.
I will now turn the call back to Gary.
I want to spend a few minutes discussing our investment operations. First, excess investment income. Excess investment income, which we define as net investment income, less required interest on net policy liabilities and debt, was $60 million, a 3% decrease over the year ago quarter. On a per share basis, reflecting the impact of our share repurchase program, excess investment income was flat. Year-to-date, excess investment income is up 1% in dollars and 4% per share. For the full year 2018, we expect excess investment income to grow by around 2%, which result in a per share increase of 4% to 5%. Now, regarding the portfolio, invested assets are $16.1 billion, including $15.4 billion of fixed maturities at amortized cost. Of the fixed maturities, $14.7 billion are investment-grade with an average rating of A-, and below investment-grade bonds are $688 million compared to $672 million a year ago.
The percentage of the low investment-grade bonds to fixed maturities is 4.5% compared to 4.6% a year ago. With a low portfolio leverage of 3.2 times, the percentage of below investment-grade bonds to equity, excluding net unrealized gains on fixed maturities, is 14%. Overall, the total portfolio is rated BBB+, same as year ago quarter. In addition, we have net unrealized gains in the fixed maturity portfolio of $935 million, approximately $732 million lower than a year ago, due primarily to changes in market interest rates. In the second quarter, we invested $182 million in investment-grade fixed maturities, primarily in industrial and financial sectors. We invested at an average yield of 5.16%, an average rating of BBB+, and an average life of 18 years. For the entire portfolio, the second quarter yield was 5.57%, down 11 basis points from the 5.68% yield in the second quarter of 2017.
As of June 30, the portfolio yield was 5.56%. At the midpoint of our guidance, we are assuming an average new money rate of around 5% for the remainder of the year. We would like to see higher interest rates going forward. Higher new money rates have a positive impact on operating income by driving up excess investment income. We are not concerned about potential unrealized losses that are interest rate driven since we would not expect to realize them. We have the intent, and more importantly, the ability to hold our investments to maturity. However, if rates don't rise, a continued low interest rate environment will impact our income statement, but not the GAAP or statutory balance sheets, since we primarily sell non-interest sensitive protection products accounted for under FAS 60.
While we would benefit from higher interest rates, Torchmark would continue to earn substantial excess investment income in an extended low interest rate environment. I will turn the call over to Frank.
Thanks, Gary. I want to spend a few minutes discussing our share repurchases and capital position. The parent company's excess cash flow, as we define it, results primarily from the dividends received by the parent from its subsidiaries, less the interest paid on debt and the dividends paid to Torchmark shareholders. We expect excess cash flow in 2018 to be around $325 million. Including the assets on hand at the beginning of the year of $48 million, we currently expect to have around $375 million of cash and liquid assets available to the parent during the year. In the second quarter, we spent $88 million to buy 1 million Torchmark shares at an average price of $84.54. Far in July, we have spent $20 million to purchase 243,000 shares at an average price of $83.
For the full year through today, we have spent $195 million of parent company cash to acquire approximately 2.3 million shares at an average price of $85.16. These purchases are being made from the parent company's excess cash flow. As noted on previous calls, we will use our cash as efficiently as possible. If market conditions are favorable, we expect that share repurchases will continue to be a primary use of those funds. We also expect to retain approximately $50 million of parent assets at the end of 2018, absent the need to utilize any of these funds to support our insurance company operations. Regarding capital levels at our insurance subsidiaries. Our goal is to maintain capital at levels necessary to support our current ratings. For the past several years, that level has been around an NAIC RBC ratio of 325% on a consolidated basis.
In light of the current tax reform legislation and proposed adjustments to the NAIC RBC factors, we are having discussions with the rating agencies to determine the appropriate target consolidated RBC ratio for our insurance subsidiaries going forward. We will continue our dialogue with them over the next several months before making any final decisions. In June, the NAIC issued adjustments to certain RBC factors to reflect the reduction in the corporate income tax rate from 35%-21%. These new factors will be effective for 2018. Taking into account these new factors, we have roughly estimated that our Company Action Level RBC ratio for year-end 2018 could be in the range of 275%-285%. As previously noted, we have not yet finalized our target RBC ratio.
However, if we were to set a target ratio of 300%-325%, it would require approximately $100 million-$225 million of additional capital. We understand that we may not be required to meet the appropriate target RBC ratio immediately, and that we could be allowed to reach the target over a period of time. Given the fact that tax reform increased our GAAP equity substantially and thus lowered our debt-to-capital ratio, we have additional borrowing capacity. Thus, we are confident that we can fund any amount to be contributed without a significant impact on our excess cash flow. Furthermore, any additional borrowings should not adversely impact earnings, as the additional capital will be invested by the insurance companies in long-duration assets. Next, a few comments on our operations.
With respect to our Direct Response operations, the underwriting margin as a % of premium in the quarter was 17%, compared to 15% in the year-ago quarter. This was primarily attributable to favorable claims in the second quarter of this year, compared to higher-than-normal winter claims in the second quarter of 2017. On our last call, we estimated that the underwriting margin % for the full year 2018 would be in the range of 15%-17%. Now, for the full year 2018, we are estimating the underwriting margin % for Direct Response to be in the range of 16%-18%. We are encouraged by the improved claims experience and the fact that the underwriting margin % for the last four quarters has averaged 17%. We are obviously pleased to see underwriting income from Direct Response increase again.
With respect to our stock compensation expense, we saw an increase during the quarter, primarily attributable to the decrease in the tax rate and excess tax benefits in 2018 as a result of the tax reform legislation. We are anticipating the expense for the full year 2018 to be in the range of $21 million-$23 million. Finally, with respect to our earnings guidance for 2018, we are projecting the net operating income per share will be in the range of $6.02-$6.12 for the year ending December 31st, 2018. The $6.07 midpoint of this guidance reflects a $0.07 increase over the prior quarter midpoint of $6, primarily attributable to the continued positive outlook for underwriting income, especially for our Direct Response channel. Those are my comments. I will now turn the call back to Larry.
Thank you, Frank. Those are our comments. We will now open the call up for questions.
Thank you. If you would like to ask a question, please signal by pressing *1 on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press *1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. Our first question comes from Ryan Krueger with KBW.
Hi. Thanks. Good morning. First, on direct response. On the updated margin expectations, as we look beyond 2018, at this point, would you expect the margins to continue to gradually move back upward?
Good morning, Ryan. At this point in time, with the information that we do have today, we do anticipate the margins really continuing in that 16%-18% range. As always, we only give guidance one year out, but looking forward, we know that the new business that we're putting on the books has a little bit of an underwriting margin higher than that, but it'll take some time for that to really, I think, bleed into the results.
Okay, thanks. Then last quarter, you indicated interest in Gerber Life. As the sale process has continued to move forward, is that still a property that you're interested in acquiring and looking at?
Brian, why don't you take that question?
Certainly. In accordance, Ryan, with our corporate policy, we are not addressing or taking any questions regarding any possible transactions prior to a formal announcement, if and when such an announcement is made.
Okay. Understood. Thank you.
Thank you.
Our next question comes from Jimmy Bhullar with J.P. Morgan.
Hi, good morning. Just on a potential acquisition, how do you think about your capacity to do a deal and how large of a deal you could do without really issuing equity? Just using debt and actually maybe using some of the capital capacity within your subsidiaries.
Good morning, Jimmy. Just in general terms with respect to any large transaction, potential acquisition or whatever, of course, any analysis that we would do would have to stand on its own as far as any merits were concerned. We do look and we say as of the end of the year, we anticipate that we'd have around $700 million of debt capacity just to stay within some of the guidelines that our rating agencies have established to keep our current ratings.
I think as we noted on the last call, if it's in connection with an acquisition, at least in the past, and as we've said in the past, that we would be able to probably go over some of the guidelines that they've established, as long as we would have a plan to be able to get back underneath those using some of the cash flows from any acquired entity to get ourselves back within an appropriate debt-to-capital ratio. That's probably the extent of what we can do without having to issue some type of equity or without at least having to partner with somebody on some type of a transaction.
Okay. On your margins overall in the life business are pretty good this quarter, but Liberty, the margins the last couple of quarters have been weaker than they used to be. I think in the 24%-25% range recently, versus 27%+ in the past. Is there anything specific going on in terms of claims trends, or is it just normal volatility in the benefits ratio?
Jimmy, the underwriting margin in the 2Q was 24.5%. We were lower than that in the 1Q because we had a high claims quarter. We expect the claims to even out. Even at that, I think that our margin will be in the 24%-25% range for the year. Last year it was at 26%, and the reason for the lower margin is the amortization is a little bit higher. That's because of the volume of new business we put on the books in recent years has a little bit higher amortization rate than the older blocks that are running off. It's not a huge difference. It's a gradual trend. Amortization was at 31% last year. It'll be just a little over 32% for this year.
That, along with the fact that the non-deferred acquisition expenses are a little higher, it's a little over 6% now versus 5% last year. That's due to additional technology costs in improving our agency operations. That shouldn't go any higher. Again, getting back to it, we're not in the 26% range where we were last year. I think we're more in the 24%-25% range going forward.
Okay. Just lastly on expectations for direct response sales, I think you mentioned that for this year, you expect an 8% to 10%, 12% drop. You were down 11% year-to-date, but were down only 5% in 2Q. Are you expecting results to get worse than 2Q in the second half, or is your guidance just somewhat conservative?
The guidance is we'll be down 7%-10% for the entire year 2018. We don't expect the sales to get weaker, but get lower volumes in the second half of the year in terms of the Direct Response. Jimmy, I think it'll be the early 2019 we start to see positive sales growth in the Direct Response channel.
Okay, thank you.
Our next question comes from Erik Bass with Autonomous Research.
Hi, thank you. You moved up the growth guidance for health underwriting margin pretty materially for the year. I was just hoping you could talk about the drivers of the better outlook for that business.
Erik, the approved guidance there is we're experiencing a little better claims experience than we expected. Two quarters now. We expect that to continue for the year. That's not just in one particular distribution, it's across the board in terms of the Family Heritage, the Other Health, American Income, and Liberty National. Due to that, we've increased our underwriting income estimate.
Thanks. Your sales guidance for health was also pretty promising. Should we expect premium growth to start to pick up there as well?
Yes, Erik. In time here with some of that'll definitely flow through the additional premium growth here. Probably not so much impacting this particular year. You may see just a little bit of it here over the remainder of the year, but more in 2019.
Yeah, Erik, last year health premium was growing 3%. I think if I'm right, at the midpoint of our guidance, we're expecting more of a 4% or a little bit higher increase in 2018.
Thank you. Just lastly, you mentioned in your discussion or your script that you are having ongoing discussions with the rating agencies. I know AM Best recently put Torchmark on a negative outlook, and I realize your business is less rating sensitive than many others, but how important is it for you to maintain the A+ rating, and what actions would you contemplate to do this if needed?
Well, we would like to retain that rating, it really, even the AM Best rating is not used that much in our marketing operations. If we had a downgrade there to say an A, I don't know that that would be a big effort. We would like to retain that rating. I think as Frank has mentioned, we're going to work with AM Best, the other rating agencies. I think we feel like we have appropriate capital levels, and I think we need to work with them to make our case there and see where we go. Frank, do you have any comments?
No. I don't really have anything more to add to what you said. I mean, we'll continue. We would like to, as Gary said, maintain where we're at. We'll continue to work with them. We do think that there are reasonable arguments for why target levels can be a little bit less than 325%, and we'll make our case over the coming months.
Great. Thank you for the comments.
Our next question comes from Alex Scott with Goldman Sachs.
Hey, good morning. I had a question about there was a recent Supreme Court ruling related to, I guess it was public labor unions and just around collective bargaining fees. I guess there's been some speculation that it could lead to reductions in just like the members of public sector labor unions. The question I have for you guys was just when I think about Torchmark's earnings stream and sales, how much of it currently comes from unions? Is there any way for you to help us dimension what portion comes from the public sector versus the private sector unions?
I'm not sure I can address what percentage comes from the public sector versus the other unions. Currently, about 30% of the new business that we issue with American Income comes from union relationships or union leads. Over the last 10 years, that percentage has really dropped. We're dependent upon referrals, and certainly our union relationship's important as a number of those referrals to non-union members come from our union relationships. We're hopeful that this won't have a major impact on the public unions. We have relationships with all the internationals and all the local unions in the U.S., and so I don't see it having a material impact on Torchmark.
Got it. When I think about the in-force, if there were a greater than expected reduction in unions, do you think would it affect persistency? I guess specifically what I'm asking is, are the premiums paid by the union in some cases, or are they paid by the individual? In which case maybe it would stay with them even if they dropped out of the union.
The premiums are paid by the individuals, not the union. If there's a reduction in union members, it doesn't have anything to do with the payment process.
Got it. Okay. Thanks for taking the questions.
Our next question comes from John Nadel with UBS.
Hey, good morning, everybody. I've got just a couple of quick ones. One, Gary, I think you mentioned on excess investment income an expectation that in dollar terms, it would grow around 2% in 2018. I think in the first half of the year, it's running at just about 1%. What's the driver of the sort of acceleration? I know it's only modest. Is that just about new money yields being a bit better? Or is it about cash flows being maybe stronger?
John, the new money would have a little bit of an impact, but it'd be small. I think the biggest impact is that we had a little bit of a timing difference on some non-fixed maturity income, limited partnership income we had was a little bit lower in the second quarter, and that should pick up. We should regain that in the second half of the year. Also, the interest expense on the short-term debt is going to stabilize, we believe so. I think it's a combination of those two things that'll give us to the 2% growth.
Got you. Okay. That's helpful. I know in American Income and Liberty, there's been a pretty sizable correlation, of course, between agent count growth or producing agent count growth and sales growth. Family Heritage, though, we saw a pretty sizable pickup in sales growth and your agent count is growing, but not nearly as quickly. What's sort of happening there? It seems like productivity is certainly improving. Is there something on the product offering side that has changed, or is there something on the demand side that you think has changed?
It's not been the offering side. The products are basically the same. What we've seen is an increase in the percentage of agents submitting business. We've also seen an increase in the average premium submitted per agent. The emphasis of Family Heritage has been to have consistency in production. That emphasis has resulted in an increase in percentage of agents producing. Long term, there's a close correlation between agent growth and production, John. In the short run, really it's productivity as a bigger driver quarter to quarter.
Got you. Okay. That's helpful. The last one, I don't know, maybe for Gary or Frank. What dialogue have you had to date with the rating agencies? I was interested in your comment, Frank, that it sounds like you think there might be an opportunity to sort of raise your risk-based capital level or recover, if you will, the risk-based capital ratio over a longer period of time than necessarily having to get there by year-end 2018. Is that something that you're just speculating, or is that something that you've had some initial discussion with the rating agencies around?
So far, John, we have had discussions with Moody's, and we've had discussions with AM Best, obviously. At least through some of those discussions with Moody's, they have at least indicated the potential a little bit on a company-by-company basis and at least didn't indicate that we'd be outside of that realm. That at least if there was a willingness to, if companies were coming in below their target RBC for their ratings, that there'd at least be some limited period of time that they would be allowed to replenish that capital. Generally giving some credence to the fact that with the new tax law, generally is considered to be a capital favorable or at least a credit favorable event to rebuild that.
Again, the companies would need to be making a commitment and having some type of a plan in order to do so in order for them to give them that period of time. At least there have been those indications so.
At your current rating levels, assuming no downgrades, how much incremental borrowing capacity would you estimate Torchmark at?
Again, by the time we get to the end of the year, we would estimate that we'd have about $700 million.
Right. Okay. This $100 million-$225 million estimate really does not push you anywhere close to your sort of upper limits, if you will.
Yes. That's the way we were looking at it.
From a cash flow coverage, you feel very comfortable with that too, I would assume.
Absolutely. We currently have a cash flow coverage of about five times, and it's above what the rating agencies look for us to have, and so we feel really comfortable with that. We've also got some optimism knowing that our nine and a quarter debt that's coming due here in 2019. We're looking at that and evaluating that. As we refinance that, we'll obviously be able to refinance that at lower rates, and that would give us some additional cushion, if you will, on those coverage ratios.
Understood. Really helpful. Thank you.
Our next question comes from Bob Glasspiegel with Janney Montgomery Scott.
Good morning, Torchmark. The outlook for direct response that's improved a little bit. Could you give us a little bit more color on whether it's pricing working its way through the system or just experience bottoming out? How soon do you think you can put your foot on the gas pedal on this line?
With respect to what's really kind of driving some of that guidance, it really is the claims settling in again in the second quarter really did give us some additional confidence with respect to where those claims should emerge here for the remainder of 2018. In part is due to some of the changes that we did make overall to our marketing and underwriting processes. At this point in time, most of those changes didn't go in until 2017. We're not seeing a lot of experience from that yet.
It is really just a settling down of some of the claims in that 2011 to 2015 era of policies. Again, that gives us some added comfort.
With respect to sales, Bob, what we're seeing for 2018 is that our media inquiries are only down about 1% or 2%. Our mail volume will only be down another 2% or 3%. At the same time, electronic inquiries are up 6%-10%, and circulation is up about 6%-8%. When we look at our most recent analysis of the profitability impact of those rate increases in 2016 to 2017 in all states, in order to maximize total profits, we're going to return to the previous rates in certain of those states. Those reduced rates will be implemented at the end of the third quarter, and that should result in a pickup in sales in the first or second quarter of next year. Any additional adjustments to rates will be dependent on future results.
We're really focused on maximizing total profits, not trying to just maximize the margin.
Bob, to summarize, right now the improvement is really as Frank mentioned, the lower claims. As he mentioned, we haven't seen the full impact of the underwriting changes in pricing that we changed. What we have seen from those so far is positive. We don't give guidance past a year as far as sales, but we think sales, as Larry mentioned, will increase. We're really positive about direct response. One, we think the margin, we've reached the bottom level, and if anything, it will increase. That's a positive. We think with improved sales growth, we'll get higher premium growth. The combination of all that is very positive because we think we'll see greater growth in our underwriting income. After having two years where underwriting income is declining, we're going to see growth this year, and we think that growth will continue.
Got you. Just to follow up on Frank's color on potential borrowing. What I think you were saying was you can out-invest your cost of debt or roughly match it with whatever you borrow. The income impact for borrowing wouldn't be material?
I do think that's correct, Bob.
Thanks. Got it. Appreciate it.
Once again, if you would like to ask a question, please press star one. I'm showing no more questions in the queue at this time.
All right. Thank you for joining us this morning, and we'll talk to you again next quarter.