Gary Coleman and Larry Hutchinson, co-CEOs of Torchmark. Gary and Larry have held the CEO office for the past three years. Prior to their current roles, Gary served as CFO and Larry as general counsel. Each has over 25 years of experience with the company. Torchmark has been probably the most consistent grower of book value among the U.S. life insurers, spurred by a business model that drives stable margins and also stable cash flow. Maybe if we could just start broadly with an overview of the business and maybe for those here who are a little bit less oriented in the Torchmark story. There's several different distribution arms that Torchmark uses to sell its life and health products. If we could just start real broadly in terms of those different businesses and the core markets they're aiming to target.
Seth, I'll start this. Primarily, Torchmark companies sell basic protection life and health insurance products to the middle-income market, and we use controlled distribution. Our largest seller of life insurance is American Income Life Insurance Company. It operates through exclusive agencies and sells basic protection life insurance policies. It has a niche through its long-term, unique relationship with all of the local and international unions throughout the U.S. and Canada. Our second largest life insurance seller is Globe Life and Accident. It's a direct response company. It sells primarily through three channels. We have the direct mail, insert media, and of course, today we have the internet. Our third distribution is Liberty National Life Insurance Company. Liberty National sells through an exclusive agency that sells life and health products, basic products, and its niche is the worksite market and individual life insurance.
Its niche or its protected market is that it sells in the small employer worksite market and has many referrals from its long experience with the individual policyholders. We also sell basic protection health insurance through Family Heritage. Family Heritage sells a critical illness policy. It sells through an exclusive agency. It operates primarily in rural areas and smaller communities. Finally, we sell Medicare Supplement insurance through our United American Insurance Company. It sells both group and individual policies through brokers and general agents.
That's great. I think Torchmark's unique. We were speaking right before we came up in terms of really being a distributor of core life products. If we look at industry data over a very broad period, multi-decades, you saw just tremendous growth in the life insurance market from the 1970s through the 2000s. Over the last 15 years, you've really seen premiums flatten out. There's a variety of reasons for that, of course. In your estimation, what's changed for the industry over the last decade?
Well, Seth, I think I'll limit our comments to the middle-income market. That's our focus. In the last 15 years, we've seen a real decline in the number of agents selling individual life insurance policies, and consequently, we've had a flattening of premiums in that market. I contrast Torchmark to the general market, though, because we have added channels to our direct response distribution. We've also grown each of our agencies. If you look over the last 15 years, Torchmark's grown its premium on an average of about 5% each of the last 15 years.
If we look at industry data and some of the struggles that the industry has faced in terms of growth, a big part of it is the rate of uninsurance or underinsurance, which LIMRA puts at 75% of households being either uninsured or underinsured. Not a new story, but there's always attempts to try to increase the penetration of insurance and bring insurance coverage up to the proper level. What at Torchmark are you doing in order to improve education, ultimately improve coverage?
Over the last 15 years, we've really expanded our use of big data and technology to reach more of those middle-income customers. In addition, we've really changed our presentation to customers. We have a needs-based presentation, so we're helping people better understand their need for life insurance.
Are you finding that that's resonating?
Well, it is resonating. If you look across the market, we read articles that said it would be difficult to sell millennials to other segments of the market. That's just not true. We're seeing an increase across the market in the middle-income market. Our distribution has grown greatly. Our agency, as I said, has more than doubled in the last five to six years. We know that the key to growing in this market is growing our distribution. It's to expand the direct response channel, also to expand our agencies. At the same time, we know in middle market, we've got to control cost. Torchmark does a great job of controlling cost. It makes us efficient in that market. You have to control cost because these are smaller face policies. Lower premium amounts are sold to each policyholder.
You commented on millennials. Last fall, we did a survey of both millennials and non-millennials to see how coverage fell out. Not surprising, millennials are far less covered than the older generations. Part of that is age, part of that may be generation. One of the things that we found is that millennials prefer very much a direct-to-the-consumer approach, a disintermediation of the agent. You guys are positioned well with Globe Life with that. Millennials probably not quite the target consumer yet, but they will be shortly within the next decade. I'm curious about marketing changes to reach that demographic.
Well, one thing about millennials, we really have two types of customers. The first is our prospective agents. As we've looked over the last five years, Gary and I have seen a greater and greater percentage of our new agents are, in fact, millennials. Last year, greater than 50% of our new agents were, in fact, millennials. As we do our research with millennial agents, we know that we need to approach them differently. We also train millennials differently than we have in the past. In terms of the customers, I'd agree with your survey that millennials want to do more research about their insurance products online. We also find that millennials like to talk to an agent, either in person or over the telephone, at the time they make that purchase decision.
At Globe Life in the last five years, we have an inbound phone call unit where we have licensed representatives that take phone calls. Many of those calls are where people became aware of the life insurance products on the internet. At the time of the final decision, they want to talk to an agent to help them make that needs decision. We've expanded that unit, Gary, I think fivefold-
Right
over the last five years. Likewise, as I talked about earlier, for millennials, we have a needs-based analysis that better explains that. With over 50% of new agents being millennials, that really is a significant part of our agent produced business. I don't think it's a trend that is going to come in the future. It's a trend now. We're seeing tremendous sales to millennials from both direct response and the agency business.
I think Larry's right. I think a lot of people millennials do want to follow through the whole process. There is a large portion that do want to call in. About half the people that go through the internet either they go all the way through the process and buy there. The other half, we get a large portion of those, not only through phone calls, but we'll send the follow-up mailings to them. We're finding that there's not one hard and fast rule for millennials or anybody else, and that we need to provide every possible way we can for people to buy insurance.
One of the topics that's come up on every earnings call is not surprising, credit and energy. I was hoping to spend just a little bit of time here to outline your exposure to energy and maybe some sensitivities around that. Maybe first just to orient those who are newer to the story. What is your energy exposure? Both broadly speaking, and then if we think about investment grade versus below investment grade.
Okay. Yeah. December 31st, we had $1.6 billion of fixed maturities in the energy sector. $1.5 billion of those were investment grade. The ratio of market to book at that time was 89%. Of the different sectors within the energy industry, only $143 million of our bonds are in the service and drilling sectors, which we think are the most exposed. Of that $143 million, $100 million of those bonds are investment grade. We think that in looking at our portfolio, we don't foresee realizing any credit losses through the portfolio because of the low amount of below investment grade bonds, because of low exposure to the service and drilling sectors. Also because the underwriting that we do, we feel that the companies that we've invested in have the financial strength to withstand periods of low oil prices. Finally, and this is an advantage for Torchmark.
A lot of people say the intent to hold securities to maturity. We don't have the intent. We have the complete ability to do so with the strong cash flow that we have. I can't foresee time that we would have to sell an energy holding when it's at a depressed value. The combination of all those, we feel good about our portfolio. Now, having said we don't think we'll have credit losses, we do expect to have some further ratings migration downward.
Could you help us think about a sensitivity on ratings migration? I think I probably get questions more on ratings migration than I do on actual credit losses. I think your point is pretty well understood. If we had a one-notch downgrade across the energy portfolio, for example, is there a rule of thumb that we could think about of what that would mean for the capital?
Well, we've actually looked at that scenario, across the board, a one-notch downgrade would result in our risk-based capital declining from our target of 325% to roughly 300%. If you put that in terms of dollars, our capital would be about $125 million less than needed to be at the 325% level which we target. Got to look at that as the extreme case. We think if we do have downgrades, any capital deficit we would subdue to be less than $125 million.
This is across the energy portfolio.
Across the energy portfolio.
That's right. Okay. If we think about that scenario, you size 25 RBC points, about $125 million. Would that come out of share repurchase if we think about our expectations of share repurchase for 2016?
No. I don't think it would have much impact at all. Again, we talked about $125 million. We think that's an extreme case. Anything between that and up to the $125 million, if we decided to put capital down in the companies to ease that deficit, we could do that through liquid assets that are on hand at the parent company and if necessary, through low-cost commercial paper borrowings. By doing that, the impact on free cash flow, if any, might be a slight increase of financing costs to the extent we use commercial paper. I will add this, if that situation happens, I think we have to decide whether we want to contribute to capital down in the insurance companies because this may be a temporary situation. We expect oil prices to go up in the next 12 to 24 months.
Bonds have been downgraded could be upgraded. I think we have to make a decision, do we want to contribute the money down to the companies or do we want to wait it out? If we did make a contribution, again, we can do so without limiting the free cash flow that we distribute to the shareholders.
How comfortable are you at RBC levels of 300 without impacting your financial strength rating?
That is one of the factors that the rating agencies look at, but it's not the only factor. We would discuss it with them and determine the impact. I'm just saying we might not even have to fill a hole, but if we do, we can do it without disturbing the free cash flow.
I'm interested in moving to your sales outlook for 2016, which you just gave on the fourth quarter call. I believe it was mid-single digit increases by most channels, relatively flat in direct response. Can you just give a little context about your expectations for sales growth in 2016 across channels?
I think your question provided the answer. Last week in the earnings call, we said that I'll just go through each of the distributions. In American Income, we'd expect net life sales growth about 5%-7%. In direct response, we expect sales in 2016 to be flat or slightly lower than 2015. In our Liberty National operation, our net health sales would grow by 2%-4%, and we should see 5%-7% growth in our net life sales. At Family Heritage, we'd expect to see 5%-9% net health sales growth. Finally, at United American, we'd expect individual Medicare Supplement sales to grow between 8% and 10%.
If we look at LNL and direct response, which I guess are the two sectors that maybe would have lower than trend growth in 2016, what are the factors contributing to that?
Well, Liberty National, we just didn't have the middle management or the agent growth in 2015 than we had in 2014. While we're disappointed, we were pleased with 4% sales growth in 2015. Liberty National is a company that for 10 years really didn't have any sales growth at all. We had greater than 10% in 2014, and we had 4% in 2015. We realized in gross sales at Liberty National, we need to increase that agent count. That's dependent upon increasing our middle management and expanding offices outside our traditional area of the Southeast. Really a different story at Globe Life, the direct response operation. We just had disappointing results in some blocks of business, and we've eliminated our lower performing segments of our insert media or our direct mail. As a result, we're going to see a circulation decrease in 2016 of about 20%-25%.
That translates into lower inquiries, probably 10%. We started to decrease that circulation in the last half of 2015, that lowered actually our sales activity in 2015, and that's incorporated in our sales guidance of flat to slightly lower than 2015 for 2016.
I think that segues into the direct response business, and you commented on some of the margin pressure from older vintages of businesses. Shifting the mix and maybe cutting off sales of those poor return type products is an answer. How should we think about the trajectory of margins in direct response, and at what point does that flatten out?
Over time, those blocks of business will be a lower percentage of the in-force business at Globe Life, as we'd expect in 2017 to 2018 to see a stabilization of that profit margin. I think we want to remind everybody that we still have significant profit margins in this block of business. In 2016, I think we are predicting a 19%-20% profit margin for our Globe business. We can grow direct response. That growth will be dependent upon increasing circulation, increasing the inquiries in our internet channel. As we grow that, we'll return to our traditional margins.
Taking a step back and thinking about sales growth as it translates to earnings growth or revenue growth, very persistent business at Torchmark. If we think about your persistency levels, what type of sales growth or the mid-single digit sales growth that you target across channels in the long term, how does that translate to top line and bottom line growth?
Let's talk about persistency first. Over the last five years, we've really focused on conservation, both at the agency level and the home office.
We've gone from a 5% conservation to about 20% conservation of our new business. That's a tremendous increase, but we think we're going to slow. The real growth as we go forward in terms of top line will come from increasing our agency, increasing our direct response. Really have different growth rates in that two businesses. If you look over the last 10 years in our agency business, at American Income, our largest producer, we've increased sales by about 10% per year. That's dependent upon growing the agency 8%-10% per year. One thing Gary and I have found that quarter to quarter and year to year, agent sales growth can really vary. It's not a straight line growth, it's more of a stair step process. In direct response, we have a 10-year history of mid-single digit growth, probably 4%-5%. Again, that varies greatly.
It depends on the modeling, the new products, the new creative that we introduce. As we test that, in some years, 2014, we had greater than 10% growth. Last year, we had 4% growth. It really is dependent upon how we can grow that direct response distribution channel and direct mail, insert media, and the internet.
Seth, the products we're selling are the same products we've sold for 20-plus years. We really don't see that much variability in persistency. Whether we have low sales growth or high sales growth, the persistency stays pretty consistent. The one thing that we've done with our-- you've heard us talk about our conservation program. We've just done things that we didn't do in the past, and that's what Larry was saying, that last year, out of the 250 million lapses we had, we were able to save 20% of them. It helps in the persistency, but it doesn't dramatically impact it as if it was a new product or something like that. I think you can look at our pattern of sales growth, then the related premium growth from that in the past, that's pretty much going to follow through in the future.
When we think about those conservation efforts, 5% moving to 20%, what does that translate to on a persistency ratio? Does that mean roughly a move from 95 to 96? Am I thinking about that properly?
Well, persistency varies by channel.
Sure.
If you look at Liberty or American Income or direct response, it is different persistency. It definitely has a positive impact. It moves up several points.
Right.
It is not going to be a continuing increase. I think we have reached a persistency level that Gary and I are comfortable with.
Yeah. I think, Seth, the biggest impact it has, most of what we conserve is policies that are toward the end of the first year. Once we conserve them, they kind of fall in with the rest of the block and have similar persistency, as if they had not lapsed in the first place. It is more we see a little bit of improvement in the first year lapse rate, which is good. Then, after that, it pretty much holds true.
Seth, there is a last aspect of persistency that is helpful is in direct response and also in the agency, we are trying to establish a customer relationship. As their incomes grow, their circumstances change. We go back, and we can sell more life insurance, more health insurance. Those persistency efforts help in that customer relationship. It is the continuing contract with the customer has been a positive in both the agencies and direct response.
If there's any questions from the audience, feel free to raise a hand and we'll pass the mic around. If not, moving on to Part D. Small part of the business, have been a volatile part of the business, from an earnings standpoint. Last week you announced the exit of this Medicare Part D business. Can you just discuss some of the reasons behind this and how this will or won't impact earnings?
Yeah, Seth, we got into Part D when it began back in 2006, I believe it was. We never looked at that as a core business. We really looked at it as an opportunistic business. We thought it would help us in our Med Supp business. Also the government was taking most of the risk on the underwriting side.
That point about the government taking the risk, can you explain that just technically.
Well, basically, we were protected against if our loss ratios were above a certain level, the government would step in and subsidize that. At the time when the program came out, nobody knew really what the experience was going to be. Had we not had that, the government backup, we probably wouldn't have gotten in the program. We got in and it was profitable. It's changed dramatically in the last couple of years. A couple of things have happened. Escalating drug costs and also the government now shifting some of the excess costs back to the insurance carriers has introduced more risk in the program. Also with consolidation and preferred networks, it's become much more competitive, which means profit margins are lower. It also makes it harder for smaller players like us to be profitable. Okay, we're giving up some earnings by exiting that business.
In 2015, Part D made up about $0.05 of our earnings per share. That's less than 1% of our earnings. What we were concerned about is we thought this decline in profits, we were looking at it that will continue, especially with more high cost, specialty drugs coming out, and we just didn't feel like the risk was worth what little return we were getting. Also by exiting that, we now not only are we getting out of that risk, but also it was a distraction. It took a lot of administrative effort the last couple of years to run this program. This way, we can get back, and we can put our full focus on our core life and health insurance business, which the earnings there are much more profitable and more predictable.
Seth, all I'll add is it truly is a standalone business, as Gary said. A fairly small percentage of our Medicare Supplement policyholders actually have Part D with us. It's not sold through our agency. It was sold on a direct contact basis. It's not going to impact our ability to continue to sell and grow our Medicare Supplement business.
Then maybe just one final question, and coming back to the discussion of sales and millennials. As we think about the internet as a growing portion of your business, particularly the direct response business, how has that contributed to sales if we think about the mix of sales coming from the internet?
Seth, I'd estimate that today about 35% of our direct response business comes through the internet. When I say comes through the internet, it's hard to measure that precisely because it's intertwined with those other channels. We certainly issue policies directly over the internet. The internet also generates inbound phone calls. People become aware of the insurance and want to talk to an agent. As I talked about earlier, we've seen a tremendous increase in inbound phone calls. Likewise, the internet affects our direct mail and our insert media business. With the direct mail business, we're able to take those electronic inquiries, use that in our direct mail operation. There's a lift in direct mail.
Likewise, we have better response rates on that insert media channel because with all the traffic and through our branding efforts, there's a greater awareness of Globe, there's a higher response to insert media, but also direct mail pieces.
Have you noticed any difference in profitability of internet sales versus the traditional insert media?
Not really, because as you're trying to expand that, it's the same analysis we use in the other channels. You're looking at the return on investment as you segment each part of the internet.
Okay, great. Well, thank you both for coming. Hope you have an easy trip back down South. Thanks for coming up to the cold in February to New York for our conference.
Thank you.
Thank you.