I'm Seth Weiss, the life insurance analyst at B. of A. Merrill Lynch. I'm pleased to kick off the life insurance portion of our insurance conference with Torchmark, and to introduce Gary Coleman and Larry Hutchison, Co-CEOs of Torchmark. Gary and Larry took on the CEO role in mid-2012. Prior to their current roles, Gary served as CFO and Larry served as general counsel, each with over 25 years of experience with the company. I'm going to turn it over to Larry quickly for some forward-looking statements. We'll get into Q&A.
Seth, before we get started, please be aware that some of our comments or answers to questions may contain forward-looking statements and provided for general guidance purposes only. Accordingly, please refer to Torchmark's cautionary statement regarding forward-looking statements in the business environment in which the company operates, contained in our 2013 10-K, subsequent forms 10-Q on file with the SEC.
Great. Thank you. For those of you who may not be familiar with Torchmark, it's a little bit of a different kind of a company than traditional life companies. First, there's a focus on middle market and distribution through captive sales forces. First, Gary and Larry, could you discuss the focus on middle market and your view of the growth potential of this business in today's environment?
Seth, Torchmark has always focused on the middle-income market. On the agency side, our companies have 25 to 100 years experience in the middle market. Our direct response operation, we have over 50 years of experience. It's a market we're very comfortable with. We know the products that are needed. We also know how to recruit and train agents to serve that market. In direct response, we have a great deal of experience and data that's very helpful in the market. We know the market, and also it's an underserved market. There's not as much competition there, so that's good also. As far as sales growth, we think that there's great potential for sales growth. As we talked about, it is a very large market and it is underserved. It's also a challenging market from the standpoint that protection life insurance has to be sold.
Consumers don't come to our offices to buy insurance. We have to get out and reach them. To achieve future sales growth, the challenge for us is to continue to grow the number of agents that we have and expand our direct response operations and do it in an efficient manner.
Seth, I think I'll add is that it's really a large market, but it's also a market in which we operate in different niches. Those niches are really defined by distribution, either towards our direct response operation or our captive agencies. As Gary said, we have simple life products. We have simple supplemental health products in this market.
Within that context, simpler products, underserved population, we think about improving U.S. economy, and I believe you're almost solely focused in the U.S. How do your products benefit from the current U.S. economic backdrop? Are they more defensive in nature, or should we see a tick-up in sales given what's been a strong economic recovery or improving economic recovery recently?
We really don't find that our sales are directly related to general economic conditions. We really sell those basic protection products, and we found that our customers' need for those products are independent of general economic conditions. In fact, if you look at the last economic downturn, we increased our sales by expanding our direct response operation and our exclusive agencies.
What about on the agent front in terms of agent recruiting and a growing employment market?
Most of our agents come from other positions. The unemployment really doesn't affect agent recruiting. Obviously, in higher unemployment, may be a little easier to recruit neophytes, people who don't have experience. Largely, our sales and recruiting aren't related to economic conditions. Certainly it's a help with lower gas prices. People have more disposable income. I would like to see real wages grow in the U.S. That'll be helpful to our markets. Again, it's the demand for the product that drives the sales, not economic conditions.
If we look at the middle market, there appears to be growing competition. For example, we heard MetLife at their recent Investor Day speak about trying to increase their presence in that market. Have you seen any of the effects of this increased competition, particularly from some of the behemoths?
Not really. We're aware there is increasing interest in the middle-income market, but to date, none of our business has been affected by competition. We think we retain a competitive advantage with our low cost structure. Again, our growth is dependent on growing our agencies, growing our direct response operation. As Gary stated earlier, it's a very large market, and we currently reach a very small percentage of our potential customers. There is room for competition within that market.
We are seeing some increased competition, I think one thing that you have to keep in mind, the companies coming into the middle-income market, it's the base amounts are fairly low, which means low premiums. To be profitable in that market, you've got to maintain your cost structures, and you have to keep the costs low. A lot of the companies we hear talking about the middle-income market used to be in the middle-income market years ago, and most of them got out of it, and one of the main reasons was they weren't able to control the cost of captive agencies. It's interesting to see some of them come back. It looks like it'll be more on the direct response side, but we'll see that competition.
What would you categorize as the penetration into the middle market? Is there anything on the horizon in the next two to three years that you think will allow you to further penetrate that market? Because it seems that hasn't really moved in terms of penetration of the under-insured middle market.
I think in terms of penetration, our studies show we reach less than 1% of that market. Our studies also show that 50% of that market either has little insurance or no life insurance. The majority of our research also shows that people in the market recognize they need those basic protection products.
Anything on the education standpoint that could improve that 50% that are under-insured or not insured at all?
That's a good thing about competition in this market, is other people enter, it's going to raise the awareness of people's needs. As Gary said, the life insurance is not a product that's a retail product. It's a product that's sold, that really makes it a different market than, say, car and casualty markets.
One of the areas you mentioned, your direct response business or Globe Life, traditionally has been a mail order driven business. You're getting into the internet world there as well. How important are internet sales? How's the penetration and growth of that distribution channel?
It's really a three-part history. If you go back to 1985, we were really a direct mail business. Start of the 1990s, we entered the insert media segment of our business. By 2005, insert media was about 50% of our business. The internet began to pick up in 2006. In 2006, less than 5% of our business came from the internet. Last year, we would say approximately one-third of our business came from the internet. Seth, it's hard to measure that exactly because our direct mail and our insert media operations are intertwined with the internet sales.
As an example of how they're intertwined, we have people that go out on the internet. They may get almost all the way through the process but not actually buy the policy. We gather the data such that we can mail them later through our mail operation, that leads to additional sales. Sometimes it's hard to tell exactly where the sale came from. All three areas are interconnected, it's not solely dependent on just the internet. There's other ways to reach them.
On the topic of Globe Life, last year you entered into a partnership with the Texas Rangers. I believe that's called Globe Life Stadium now. Have you seen any meaningful pickup in response rates in Texas?
Yes, we have. In fact, our partnership with the Rangers has really been better than we anticipated. We've had an increase in our response rates in Texas. When we say Texas, there's a five-state region in which we operate with the Texas Rangers. We also seen a dramatic increase in our electronic inquiries. That's from our internet traffic in that five-state region. If we look at our net sales in the five-state region as compared to the rest of the country, we've had a higher growth rate in net sales in the five-state region.
Are you able to size that at all to give us a sense of the success of that program?
I know that it's a little difficult to measure in terms of size because we increased sales last year at Globe direct response greater than 10%. Part of that lift was in the entire country. The brand is not just in the five-state region as other major metropolitan areas are impacted by that. Their baseball teams come to Texas, and with every pitch, they're seeing Globe Life behind home plate. No, it's had a positive lift, so it's almost impossible to measure which of the 10% in increase of sales came from the branding. We also saw a dramatic increase in electronic inquiries last year. We had a 20% increase in inquiries, some of it related to the branding effort because there's a lot of internet traffic that's related to the naming rights agreement. It's really the composite of all these efforts related to increase in sales.
Are there any other regional type of marketing programs similar to what you did in Texas in the five-state region that you're considering?
We've been approached with a number of national and regional branding opportunities. Right now, we're focused on trying to maximize the benefit of our naming rights agreement. As we go forward, I think it's more apt that we look at a regional opportunity. Given the cost of a national program, I don't think we have the branding and awareness yet to enter that kind of an arrangement. We'll look at that and build on that over our naming rights agreement.
Seth, we've always recognized that of all our operations, direct response would benefit the most from branding. Our agencies all have their individual niches, but the direct response, we felt if we could brand it, we could improve the sales. The problem is that in the past, we looked at national branding, and again, as I mentioned earlier, we're talking about small face amount policies. Premium revenue per policy is not high. We never could make it work economically to do national branding. The thing that we like about the Rangers partnership is we've been able to see the impact of branding in that five-state region, and we're able to do it on a cost-effective basis. I agree with Larry. We want to explore other opportunities, but to us, it's more likely to be on a regional basis as opposed to national basis.
The thing that made the Rangers arrangement particularly interesting, we looked at the demographics of their fans, and it fit our customer base.
Right.
It was also a great fit there. As we look at other branding opportunities, we want to see what those customers look like against our demographics for our customers.
If we could switch gears. Interest rates are the hot topic when it comes to life insurers. I think a little bit less of an issue for Torchmark, given the products that you're in and the duration of the business that you're in. How do you think about the earnings headwinds of interest rates considering where they are today?
First of all, you're right. I think it's less pressure on us than other companies. We're selling whole life term insurance. The policy liabilities are fixed. With those type products, there's no policy guarantees. They're not interest sensitive. From an accounting basis, they're accounted for under FAS 60, we don't see any situation where we'd have to write off the AC or add to reserves. In addition, on the statutory side, we don't see a situation where we would have to add to the statutory reserve. For us, the lower interest rates is not a balance sheet issue. It is an income statement issue. As far as headwinds, we've seen it, some pretty extensive headwinds over the last 5 years.
Since 2009, we've invested new money at rates lower than the portfolio yield, and during that time, we've seen our portfolio yield decline by almost 100 basis points. I think where we are today, even with the low rates where we are today, that in the next 5 years, we see a decline, because we're still investing below that portfolio yield. The gap has narrowed and also we don't have that much in terms of maturities coming out of the portfolio. I think it's less than 2% per year is going to be coming off the portfolio. We've seen the major headwinds, I think, and what happened in the past 5 years is we grew investment income, but we didn't grow it at near the rate we grew the assets.
I think we had a compound growth rate of 4% on the income, and it was 7% on the assets. I think what you'll see now in the next few years is we're going to be growing the investment income at much closer to the rate that we're growing the assets. Still a little bit of a headwind, but not to the extent that we've had in the past few years.
I think I'll add is, if all it's a headwind, it doesn't affect either operation. We've not lowered our underwriting standards to increase sales. We increased our underwriting income by growing our agencies, growing our direct response. We'd like to see a spike in interest rates, but it really is isolated to the investment income. As Gary said, as we grow our assets, we can grow our investment income.
The other thing that interest rates affect is the heavy impact on its pricing. The good thing about the markets we're in, it's not that price competitive, not the price sensitive. In 2012, because of the low rates at that time, we increased our premium rates, and we actually increased them more than we needed to. So even if rates stay where they are for a few years, I don't see us having to raise prices again. If we do, we can do it in our market without dramatically impacting the operations.
Maybe shifting to capital uses. Historically, you've used free cash flow to buy back stock. Dividend yield seems to be something investors are willing to pay a premium for. Has there been any consideration of changing the mix of buyback versus dividend?
Yeah. Actually, we do work with our board, meet with them every quarter, and we discuss our dividend policy. Before we go into the mix of dividends versus share repurchases, I think it's important to understand that an advantage that Torchmark has is the high profit margins we have in our products, and those generate a great deal of cash. Our first priority always is to use whatever cash is needed to grow the operation. We generate enough cash each year to more than fund what is needed by our operations to grow. We move all the excess cash we can to the holding company, because we're going to have strong cash flow again the next year and the next year and so on.
We started a share repurchase program back in the mid-'80s, we've continued, I think, every year but one year when we had an acquisition. Share repurchase is built into our business model. Our dividend yield was around 1%. I think last year we paid $65 million in dividends. That left $375 million of free cash that we needed to invest, and we needed to invest it in the best interest of the shareholders. We've long felt that the share repurchase program has provided the best benefit and also gives us flexibility. We haven't done that without talking to our shareholders. We talk to our larger shareholders quite often, and some express indifference as to dividends versus share repurchases, but most of them prefer the share repurchases. That's really guided us in our decision-making over the past years.
Before we pay dividends to the shareholders, we generated this past year $440 million of free cash. We could make that 1% yield of what was about $440 million in dividends instead of $65 million. I think the issue there is for us to increase the dividend rate to where we would attract investors that are looking for dividend yield, it would be a dramatic impact on the share repurchase program. We might pick up some shareholders, we may lose some longtime shareholders. Those are the kind of things we have to balance when, as a board, we're looking at what is the best mix of dividends versus share repurchases. We do increase the dividend rate each year, and we generally increase it by about the rate that we grew the earnings. We have weighted heavily towards share repurchases.
The one thing I'll say, whether it's dividends or share repurchases, we are committed to returning excess cash to our shareholders. Over the past 10 years, we've contributed over 80% of our net income back to the shareholders, primarily through the share repurchase, but also through the dividends.
I just want to reemphasize Gary's earlier point, it truly is excess cash. Our first use of cash is to grow our operations.
Maybe to talk about another use of cash, which is more sporadic M&A. How do you view the market now? Anything that you think may be compelling?
Gary and I are continually looking at opportunities in M&A. We're really looking for something in the middle-income market, like captive distribution. Unfortunately, it's a fairly small profile that we're looking at, and there aren't many companies that fit that profile. The best example of that is our last acquisition, which is Family Heritage Life. We purchased that two years ago, met that profile, and we're starting to grow that agency force. We're very pleased with that position. Because acquisitions are somewhat opportunistic, we're really focused on organic growth.
Yeah, I think, the type of companies we're looking at, as Larry said, there are just not that many out there. We're always looking. Our focus is on internal growth and using that excess cash to return to shareholders. However, having that cash coming in every year, it helps us to be more flexible, and if an opportunity comes up, an M&A opportunity, we can shift into that if needed. You never know when a company's going to come forward that's available. In the meantime, we'll continue to try to grow our distribution.
Just want to pause for a second to see if we have any questions. One over here. Sorry, can't see with the light, but I see a hand.
You talked earlier about your competitive advantage being cost structure. Can you just talk about what the sources of that better cost structure is relative to your competition? With the free cash flow that you generate, and the longstanding share repurchase, what benefits does Torchmark have being a public company? Thank you.
If I'll talk about low cost structure first is we have a completely variable cost model. Each of our agencies, they're compensated only through commission. We have very low overhead costs in terms of running those agencies.
Yeah, Larry's point is good on the variable cost system. To run captive agencies, in the past, it's generally been where companies are paying the operating costs of the individual offices that they have or the overhead, paying salaries for clerical help, those kind of things. I go back to the fact that the premium sizes on the policies they're selling, a $400 annual premium is a high annual premium for us. You can't let the cost escalate, control it, have those fixed costs. We have an advantage in that even though our agents are exclusive, they're selling just for us, they're independent contractors. They're taking care of all the overhead expenses. Our expense is we pay commissions, and that commission arises from the fact that they sold policies. That's on the acquisition side. We have an advantage there.
On the administrative side, our administrative expenses are very low versus the industry. That's been the culture at Torchmark for a long time, and it's something we continue to work on because there's only so many pennies in the dollar. When we receive those premiums, after we pay the clients, the lower we can keep those acquisition costs and administrative costs, the stronger the profit margins are. The second question is?
What advantage?
If I heard your question right, what advantage do we see we're the company?
Public company, yeah.
Being a public company.
Oh, being a public.
Yeah.
Great. Well, we wouldn't mind being a private company. I don't think we can buy all the shares, though, as we get there. Yeah, being a public company gives us advantages of more scale and more availability of capital. I think being a public company really helps us in recruiting. For years, we didn't have a brand awareness in Globe Life, or Globe Life was really our brand awareness. In the exclusive agencies, they recruit to the Torchmark name. When you're calling on a prospective agent, they may not have heard of American Income, they may not have heard of Family Heritage Life, but certainly they've heard of Torchmark, or they've heard of Torchmark's name or our public image. I think it's helpful in the recruiting process.
Maybe if I could just ask a question on Part D. There seems to be a whole lot of focus on Part D. Premiums and margins have shifted around by large amounts in the last couple of years. I guess if we look at earnings impact, it's really only been $0.02.
Yeah.
Maybe there's misconceptions out there, but is there anything to be worried about in terms of fluctuations of premiums and margins? If premiums go way up, does this have any strain on capital? Does this change the risk profile of the business?
I'll start with this. I'm smiling at you, Seth, because we're a little surprised at the interest in Medicare Part D. It is a very small part of our earnings. You think about Torchmark, 70% of our underwriting income comes from our life operation. This falls within the 30% of our underwriting income that comes from health sales, but that is still a small percentage. As we talk about margin, the margins have decreased over time, but it's still a profitable segment. I know in our last earnings calls, we had a number of questions, but again, the midpoint of our earnings guidance this year for Medicare Part D is a range of $21 million-$23 million.
I think over time, it's become a little more volatile, and I think that's part of what's generating the interest because Torchmark has such predictability in its earnings in each of its segments. I don't think it's the size of the segment. It's still just a few pennies impact on earnings. It's really that volatility that creates the interest in Medicare Part D.
As far as the issue of capital, there's very little capital involved in Medicare Part D, and that's one reason we got into it, is that there's very little capital outlay, and we have companies that sell Medicare Part D are protected from catastrophic losses by the federal government. It hasn't been very big, but it's been very consistent up until this past year. It's a type of thing that, as far as growing premiums, it doesn't take up more capital, but I think what we want to be careful of is we want to maintain. We're also concerned about the margin dollars. We want to maintain that margin percentage of premium because there is risk associated with that business.
If you ask would we rather have more premium and lower profit margin percentage, I'd say no, I really want to keep that profit margin percentage up around the 10% range because that gives us more protection on risk.
Seth, I think what makes us different from our other segments too is it's a year-by-year pricing mechanism. Every June, we have to reprice our business. It's a one-year business. Part D uncertainty is the fact that it's a government program, and we found out last year that after our pricing, the government could add a major drug to the formulary. Likewise, anytime the government can shift the cost sharing, so they shift more cost onto the insurer rather than with the government. We'll continue to look at this program, but we look at it on a year-by-year basis.
It has been just an opportunistic type business. It's less than 2% of our earnings. Our focus is, and will remain on our life insurance operations.
Are there any other questions from crowd? One more question, perhaps we could just end on retention, conservation. We spoke about this here last year at the conference. Can you give an update on the effectiveness of home office retention efforts?
Yeah. We started a policy conservation program back in 2011. We've enhanced it each year since then. I'm not sure why we didn't do this in the past. In 2011, we started working with policyholders who either just recently lapsed their coverage or about to lapse their coverage. We made contact with them and determined that many times the policyholders had a short-term cash need. That's why they didn't pay their policy. We started out by waiving a monthly premium for some of the policyholders that there are instances where we would even lower the coverage a little bit to make the premiums more affordable. We've continued to find different ways to do that, to keep policies in force.
Now we do a significant amount of outbound phone calls, emails to policies that are about to lapse and help the policyholder save the policy. We started out, I think the first year, we were able to save about 5% of the policy that were lapsing. This past year, we saved 18% of the policy lapses. We kept the business in force. That translates into about $45 million of additional premium that would've gone away forever. The business that we do save doesn't quite have as good a persistency as the regular business as you go forward, but it's better than we expected. It's for sure better than losing them at once. We get more premium revenue going along. We've seen a dramatic impact on our first year and our renewal year persistency. We're pleased with the program.
The benefits from it greatly outweigh the cost of the program. We're looking not only to continue it but to try to enhance and serve even more business.
Down home office, each of the agencies has appointed a conservation officer. Each of the agencies is more focused on conservation. We've seen some fairly dramatic results that the agencies also help in the conservation of our business.
Okay. Well, I think we're going to have to end it there. Please join me in thanking Gary and Larry for coming up today.
Thank you.
Thank you.