Larry Hutchison, Co-CEOs of Torchmark. Torchmark has had this unique CEO structure that's worked well for the last four years as they've held this shared office of CEO. Prior to their current role, Gary served as CFO and Larry served as general counsel. Each has over 25 years of experience with the company. Torchmark has been one of the most consistent earnings, capital distributions, and book value growth stories in the life sector, and a lot of that is due to Gary and Larry's leadership. Thank you both for joining us today.
Thank you for having us.
Thank you.
I wanted to start just broadly in terms of the market trends in the market that Torchmark serves, that of the middle income. This remains a market that, according to industry publications, it's chronically under-insured. What do you think the industry has to do to improve insurance penetration, and what's Torchmark doing to sort of further this cause?
Gary will start that. Seth, I think to increase the penetration of the market is a fairly simple answer. It's a market that's not product driven, it's distribution driven. I think the industry needs to increase distribution. It can do that in two ways. You need to increase the number of agents that are selling life insurance. We need to broaden the direct response channels. At Torchmark, we've had a great history in this market and in our agencies, we're both expanding our agencies. We're creating new agencies using technology. We're improving our training systems, our recruiting systems, our selling systems to support that agent growth. In direct response, currently, we're focused on stabilizing our profit margins. For 2017 and 2018, I think you'll see Torchmark actually reducing sales somewhat to stabilize those profit margins.
As the profit margins stabilize and go forward, we know that we can increase the distribution by using analytics, new marketing programs, finer segmentation, and you'll see the growth in direct response begin again. When I say direct response channels, I'm talking about direct mail, I'm talking about insert media, electronic channels. The greatest growth at Torchmark in the last 10 years has really been the electronic channel, the internet channel, and then of course, the insert media channel has been another good growth factor for our direct response operation. What's imperative with the middle income market too is cost control. Torchmark has to always control cost. We're in a market where you have lower premiums because of the smaller face policies. To grow distribution, you must control cost.
Are you able to better maybe target your core market with these advances in technologies and leveraging analytics and the marketing programs that you said?
What you can really do is the finer segmentation is even within zip codes now, you can break down a zip code to determine when the direct mail operation, who you mail and you don't mail. We have a lot more consumer information today. What we're targeting is the more profitable consumer, and what it brings is the expected mortality and the expected persistency with the product.
If we think back to, I guess, the industry before getting into maybe Torchmark specifically, premium growth has really flattened out since the turn of the millennium after having phenomenal premium growth beforehand. If you think about top-line trends, what do you think the industry could attain? What do you think you could attain, and what's really necessary to have an inflection point to have growth again?
Well, let's talk about Torchmark first. I can't speak for the entire industry. For the last 15 years, Torchmark has really focused exclusively on the middle-income market. We sell basic protection life insurance products. We don't sell investment-type products. We don't sell group life insurance. I think as the industry expands distribution, again, as we add agents, as we expand the direct market channels, I think you'll see a correlation that the premium will grow as that expansion takes place.
Talk about the industry, the growth rate being flat. In the last 15 years in that middle-income market, American Income's premiums have grown at an average rate of 9% a year. And at Globe, we've grown premiums at an average rate of 7% a year. So we have had growth, and it's been dependent on, as Larry said, growing the distribution, growing the number of agents, and also the outreach we have in the direct response unit.
Maybe we could dig into direct response. And Larry, you had mentioned some of the underwriting changes over the last couple of years. And there has been some underwriting pressure over the last two, three years specifically. Curious if you could just review what that underwriting pressure was, why it happened-
Sure
what you've done to rectify it.
Well, the underwriting pressure came from the fact that we had higher than expected mortality. The great example of that is when we began to use prescription drug underwriting in 2011 in our direct response operation. We had better results with prescription drug underwriting. It just wasn't as great as we thought. We had higher mortality and as a result, lower profits. To address that, in 2016, we repriced our direct response business. In addition, we've changed our marketing in direct response. We've either reduced our marketing numbers to certain segments, or if those segments don't meet our profit objectives, we've eliminated those segments altogether. Again, as we go forward, we know we can grow direct response. We have the analytics. We have finer segmentation. We have different marketing programs.
We can grow our direct response with three channels, but I don't think that takes place until 2018 or early 2019 once you've seen the stabilizations result of the three actions we talked about.
Maybe moving over to Liberty and American Income. You had spoken in your introductory comments about distribution being key. Can you talk about the trends you've seen in terms of producing agent count growth over the last few years, and what you expect this to be maybe in the near term for those two agencies?
Sure, Seth. I think as a base, let's start with 2012 and talk about the last five years. At American Income since 2012, we've had greater than a 50% increase in our producing agent count. At Liberty National, in that same period, we've had greater than a 30% increase in our producing agent count. As we think about that trajectory going forward, I think we can keep those growth rates. There's a little different challenge for the two companies. At American Income, we currently operate throughout the U.S. and Canada. I think the challenge there is to continue to develop middle management, improve these systems, and really create new agencies. We did that last year. We created six new agencies at American Income last year, and we grew our middle management by 8%. At Liberty National, it's really a different story.
As you know, we restructured the company in 2011, and we're seeing the benefits of that restructuring. As we go forward at Liberty National, we need to continue to improve the systems that we've adopted, develop middle management, and then we'll open new agencies outside our traditional four states in the Southeast. I think with both companies, they're poised to have that kind of growth. At American Income, I stated what we had last year. At Liberty National, my recollection is we had a 40% increase in middle management last year. That's indicative of the new offices that we can now open at Liberty National.
How do you think of the lag time between setting up that infrastructure, when the producing agent count starts to ramp up, and then when sales and premium ramp?
Well, it's different with the two companies. At American Income, it's almost instantaneous. They've traditionally had four levels of management. As we move people to a beginning agent through the middle management levels, they're prepared to take over and run an office. We've seen a real difference at Liberty National. As we introduced our new systems, when we first opened offices in 2012 and 2013, it was a struggle. Last year, as we opened our five new offices at Liberty National, we saw that there was a 100% increase in production in that office in the first year because the new systems have been adopted. The managers that are taking over new offices or starting new offices at Liberty National are people that grew up in that system. They came in, and they trained as an agent, as a middle manager, with the systems that were adopted in 2012.
You had spoken about the turnaround effort at Liberty National. If we go back, what were some of the issues there? How were they rectified? If you think about a trajectory for both sales and, I suppose, margins. Are we at a steady state of margins at Liberty National, or is there still any room for improvement there?
Let's talk about that. Gary and I worked on that project during 2000-2010. It was a frustrating project. What we saw from 2000-2010 was a fixed cost structure. We just could not grow Liberty National, and we couldn't produce the margins that we needed. In 2011, we restructured that company. We took the company and made a variable cost model. Now that the agency owners are paid strictly on a commission basis, there are no employee costs or fixed costs absorbed by the company. The other changes that occurred in 2011 is that we had a successful agency at American Income. We took those successful recruiting, training, sales, leadership development systems, and incorporated those into Liberty National. We think about Liberty National, as we go forward, it has a bright future.
It's much smaller, I talked about the agent growth we've seen. We know we can continue to have agent growth. We know that with this current structure, that the profit margins will continue to improve as we expand the agency and improve sales.
Yes, Seth, you talk about the profit margins. The problem that we had with Liberty, it was an old home service company, we had so many employee costs and partial salaries, also benefits. The costs were rising at such a level that the profit margins were declining. We've made this change, as Larry's mentioned, going to more of where it's a commission-based system, where it's a variable cost, we've seen an improvement in our margins, and we should be able to maintain those margins going forward. As far as growth, now as we're currently structured, we are creating management, mid-management people that can go out and grow offices. We didn't have that at Liberty in the past. It's much improved.
Seth, the last change really is the most difficult of the changes. That's a cultural change. As Gary said, that was a home service company. Really had an employee thinking. Starting in 2011, as we hired agents, we talked about an opportunity to perhaps run your own agency at some point. We're now recruiting people to a different thought process. Instead of being just a producer, a number of those producers are thinking about, I want to get into middle management and eventually open or take over another office. I want to be an entrepreneur rather than just an employee agent of the company. That's a real cultural change to instill in a company in a four or five-year period.
I'm curious if we put it all together, there's a lot of moving pieces here in terms of changes in direct response, the turnaround effort at Liberty. American Income's been basically running at steady state for a while now. If you consolidated all together, what do you think is an appropriate growth rate for operating earnings? EPS I know is a different story with heavy capital deployment, but if you think about operating earnings, steady state growth for Torchmark, what's a fair number to think about?
Well, in the recent past, we were growing life premiums at around a 4% rate, and I think the health insurance a little bit less than that. Now we're in a mode where we're growing premiums in this year, probably life premiums close to 6%. We're seeing a pickup in the growth in premium there. In the health insurance, which is a smaller part of our business, may not grow quite at that rate, but if we grow the life insurance at the 5%-6% rate, stabilize the margins in direct response, our operating earnings, operating margins should grow in that 5%-6% range as well. Our excess investment income should be growing in the range of 4%-5%.
I think if you're talking about just true dollars, excluding the capital management side of it, I think you're talking about a 4%-5% growth rate. If you're talking about an earnings per share rate, I think you're talking about in the 7%-9% growth rate.
On the excess investment income, the model is very different in terms of protection versus savings account-oriented products. Can you speak about the interest rate sensitivity you have to your earnings? We've been in a prolonged low rate environment that's been a drag on earnings, maybe not as much of a drag as others. If you could help us quantify that and think about the sensitivity.
The good thing about the products that we sell, they're not interest sensitive. They're basic protection, whole life term insurance. Our interest rate risk is solely on the investment income side. It's not on the liability side. What we've had in the last 10 years, our portfolio rate has declined about 10 to 12 basis points a year because of the low new money rates. We have grown investment income each year. The disappointing thing about that, though, is the rate of growth of the income has been lower than the rate of growth of the underlying assets. For us, we want higher interest rates, and the sooner the better.
If interest rates stabilize at the current levels or maybe increase a little bit, we would get back to the point where we'd be growing investment income about the same rate as we're growing the assets, and that'd be probably 4%-5% a year.
Just want to pause to see if there are any questions from the field. I'll come back to my list. On the topic of the investment portfolio. It looks from just a glance at the portfolio that maybe you're a little bit more heavily concentrated in financials and energy if I just take a look at these categories. Could you speak about your approach on the investment portfolio and then if you see risk if we see a slowdown in these sectors?
Well, as far as our investment portfolio is primarily long-term fixed rate corporate bonds. The reason we do that, we're more heavily weighted into corporate bonds than our peer companies. That's because of our liabilities. Those assets are the best match for the long-term fixed rate liabilities that we have. Investing for the long term, we want to have a diversified portfolio, but because we're investing so long, we also have great concern about we're investing in companies that are going to be there for the long term. Now, when you're talking about financials and energy, let's talk about financials first. That makes up a little over 20% of our portfolio. Within those financials, 14% of our total portfolio is in insurance company bonds, 5% banks, and then the rest is some other financials.
We like the insurance companies and the banks that we're invested in because of their financial profiles, but also we also like the fact they're regulated industries. Again, we're looking for companies that are going to be there for the long term. We are overweight as compared to the other sectors, but we think we're well positioned there, and we think those are good credits. Now, on the energy side, we have $1.5 billion of bonds in the energy sector. That's about 11% of our portfolio. Again, we do our credit work when we bought those bonds, and we looked at companies, looking for companies that we think can withstand negative cycles. When we were here a year ago, we had the same bonds we have today.
When we were here a year ago, we had an unrealized loss of $270 million, and we had a lot of people here asking why we own those bonds, should we be selling those bonds. Again, we pointed out that we felt these were companies that could go through a negative cycle. Well, they proved us right. Those same bonds now have a $90 million unrealized gain. We felt comfortable at the time, we still do, and we like the credits that we have, and we spread our risk over a fairly large number of credits. These companies, we felt all along, and they proved it this past year, they can withstand negative cycles. The one advantage we have is because of the cash flow we have, we never have to sell bonds for cash purposes. We have a building.
We do hold our bonds until maturity. We never were at a point last year where we felt like we had to sell a bond, and we felt like those credits would be good, and they've proven to be so. Yeah, compared to peer companies, we have a little higher in energy, but we feel comfortable with the bonds that we have.
One of the topics we were talking about before, the health business, a smaller part of your business. A repealing of ACA, which is of course speculative, that could impact that business. Just curious how you would expect that to impact sales profitability, the whole mix.
For health business, I don't think that repeal of the ACA would have any effect on the profitability of the demand for those products. Let's remember that for our products, they're not subject to the terms of the ACA. Secondly, none of the Torchmark companies have participated in the exchanges since 2008. I think there's an opportunity if ACA is repealed, Gary and I will look at that and see what new gaps in coverage exist, and we think about introducing some new products that could possibly fill those gaps in coverage. Otherwise, the demand for our health products are really separate apart from the ACA, and any repeal should have no effect.
Okay. There's not a supplemental impact of high out-of-pocket that Torchmark's health products meet in the current ACA environment?
I think we'll come on under the current ACA. We had success with these products before 2008.
Right.
These are the same products we sold during that period. I think if anything, it's speculative to say what's the new health act going to look like and what are those gaps in coverage going to be. It could increase the demand. I think it's more likely that the impact on us would be to look at those gaps in coverage and introduce some new products to fill those gaps.
The tax reform is a subject that's come up already multiple times in the conference so far. You guys are pretty high taxpayer. Are you thinking of tax reform as an unambiguous positive, or are there any offsets that could impact you on the negative side?
Well, first of all, nobody knows really what tax reform measures are going to be adopted. I want to point out that we haven't included anything regarding tax reform in our guidance. As far as us, I think it is an unambiguous positive. We talk about maybe eliminating or reducing certain deductions. One that's mentioned is the dividends-received deduction. That would have an immaterial impact on us. It's the getting a lower tax rate benefits certainly after-tax earnings, but also there'll be an increase in equity as we adjust the deferred tax liability based on the new tax rate. We're looking at it as going to be a total positive.
Finally, one last one from me. Capital deployment has been a big part of the Torchmark story forever, basically. I believe your valuations now are at post-crisis highs, both on an absolute and relative basis. How are you thinking about your mix of capital deployment, given the current environment, given your stock valuation?
First of all, I want to point out on the Torchmark has had an ongoing share repurchase program since the mid-'80s. The great thing about the product mix that we have, we generate a great deal of cash flow, the cash flow that we use for share purchases is really excess cash flow. Our first priority is always to put cash back into operations to grow them. We do that until we get to the point where the returns aren't adequate. The cash that flips over is truly our excess cash. By the way, we'll spend over $1 billion in policy acquisition costs this year. Those are costs that reduce our statutory income that's dividended to the parent company. Those are absolutely necessary expenses to grow the operations.
Even after those expenses, all other expenses, including our interest on the debt and the regular shareholder dividends, we still will have excess cash this year between $325 million-$335 million. Our position at Torchmark has always been to return excess cash back to the shareholders, whether in the form of share repurchases or additional dividends. That's something that, we meet with our It's a daily issue for us as management. We meet with our board quarterly to discuss our policy, whether share repurchases or paying a higher dividend. The way we look at, as far as repurchasing the stock, we look at the share prices, first of all, what we think the intrinsic value is. We also look at what the return on the share repurchase is compared to our cost of capital, compared to the risk-adjusted return on other investments.
You're right, we're at historical highs in price to book, price to earnings. Over the years, we have bought shares at similar type price-to-book ratios and got a good return for the shareholders in excess of 10%. If we get to the point where we think the stock is overvalued, I'm sure we'll discuss with the board of stopping the share repurchases and considering paying additional dividends. We're not quite at that point yet, but I think the main point is we do want to return that excess cash to the shareholders, and it could be in the form of a special dividend as opposed to share repurchase.
Secondly, I'll add to that is that the other factor is, Gary and I meet with the majority of our institutional shareholders each year, we want their feedback.
Yeah.
To date, overwhelmingly, that feedback's been they want us to continue the share buyback program, and we report that to the board on a quarterly basis. That's really a factor. If that changes going forward, we'll listen to our shareholders, what their opinion is in terms of capital deployment.
Right.
That's great. I'm going to just scan the audience one more time. If not, we'll leave it there. Thanks so much for joining us.
All right.
Okay. Thank you.
Bye.
Good to see you all.