ITEM 1. BUSINESS
Pioneer Financial Services, Inc. (the Company) underwrites and markets health insurance, life insurance and annuities throughout the United States. In the ten years since it became public, the Company's total revenue has grown from $52 million in 1986 to $888 million in 1996; total assets have increased from $165 million at December 31, 1986 to over $1.8 billion at December 31, 1996; and stockholders' equity has increased from $34 million at December 31, 1986 to $189 million at December 31, 1996. The Company sells its products and services through three marketing divisions: Senior Health Division, Group Medical Division and Life Insurance Division.
PENDING MERGER WITH CONSECO, INC.
On December 15, 1996, the Company and Conseco, Inc. ("Conseco"), a financial services holding company engaged primarily in the development, marketing and administration of annuity, individual health insurance and individual life insurance products, entered into a merger agreement whereby the Company will be acquired by Conseco. In the merger, each of the issued and outstanding shares of the Company's common stock would be converted into the right to receive a fraction of a share of Conseco common stock having a value between $25.00 and $28.00, depending on the average closing price of Conseco common stock in the ten trading days immediately preceding the second trading day prior to closing. The Company's outstanding convertible subordinated notes would become convertible into shares of Conseco common stock on an equivalent basis. The total value of the transaction would be approximately $477 million, including $417 million to purchase the Company's 16.9 million common shares and equivalents, and $60 million to retire bank debt and pay other costs. Based on a Conseco common stock share value which exceeds $28.00 per share (said price being exceeded on the date hereof), Conseco will issue 8.7 million shares of Conseco common stock with a value of approximately $352.4 million to acquire the Company's common stock. In addition, Conseco will assume Company notes payable of $27.8 million and the Company's 6 1/2% of Convertible Subordinated Notes due 2003, which will be convertible into an assumed 3.0 million shares of Conseco common stock with a value of approximately $120.7 million. The merger is subject to customary terms and conditions, including approval by the Company's stockholders and regulatory approvals.
OPERATIONS
Senior Health Division. The Senior Health Division markets a wide range of specialty health insurance and life insurance and annuities for individuals age 65 and older. Products which are underwritten by this division include Medicare supplement, long-term care, home health care and specialty health. In addition, this division markets cash burial life policies and annuities which are underwritten by the Company's Life Insurance Division. The Company's Medicare supplement policies provide coverage for many of the expenses which the federal Medicare program does not fully cover and its long-term care and home health care policies provide coverage, within various prescribed benefit limits, for nursing home and in-home care.
The Company is the fifth largest issuer of individual Medicare supplement insurance in the nation, excluding Blue Cross and Blue Shield-related entities, based on direct premiums earned. The Company sells products designed for senior citizens through a distribution network which has grown from approximately 15,000 agents at the end of 1994 to nearly 25,000 agents at the end of 1996. Future revenue growth in this division is expected to be generated in part from the increased number of agents and increased sales of Medicare supplement, long- term care and home health care policies.
Group Medical Division. The Group Medical Division underwrites and markets hospital and medical policies, primarily to self-employed individuals and small business owners. In 1996, approximately 73% of this division's business was sold through a sales force of approximately 1,200 career agents, 15% was sold through a brokerage system of 14,000 independent agents and the remaining 12% was sold through 40,000 independent brokers in a distribution system related to the block of business acquired in August 1996 from Washington National Insurance Company. This division uses the services provided by the preferred provider organizations ("PPOs") and other managed care operations to help control claims costs. The Company believes that the Group Medical Division's use of managed care services resulted in significant claims savings for the Company in 1996, with most of these savings being passed on to customers in the form of more competitive premium rates.
Life Insurance Division. The Life Insurance Division underwrites and markets traditional life (term and whole life), universal life, and interest sensitive life insurance and annuities targeted primarily to the middle income market. The Life Insurance Division sells its products through a nationwide network of brokerage general agents ("BGAs") and managing general agents ("MGAs") who in turn contract with multiple brokers and general agents. This division grew significantly when the Company acquired Connecticut National Life Insurance Company ("CNL") in January 1995. In addition, the Company acquired Secura Life Insurance Company ("SLIC") in December 1996. This division also underwrites, issues and administers the life insurance products marketed by the Senior Health Division.
Investment Portfolio. The Company has maintained and intends to continue to maintain a diversified portfolio of medium-term investment-grade fixed income securities. As of December 31, 1996, 86% of the Company's invested assets were fixed income securities and the weighted average quality of the fixed income portfolio was "AA."
PRODUCTS AND SERVICES
The Company markets and underwrites health insurance, life insurance and annuities throughout the United States. The Company sells products and provides its services through three marketing divisions: Senior Health Division, Group Medical Division and Life Insurance Division. The Company's distribution systems for its products have increased from approximately 12,000 agents in 1986 to nearly 90,000 agents at the end of 1996.
Senior Health Division
The products marketed by the Senior Health Division include Medicare supplement, long-term care, home health care, various specialty health coverages, life insurance and annuities. In addition, this division markets cash burial life policies and annuities which are underwritten by the Company's Life Insurance Division. This division markets these products to individuals age 65 and older and underwrites and issues all such products except the life insurance and annuity products which are underwritten and issued by the Life Insurance Division.
In the Senior Health Division, the Company may adjust health insurance premium rates generally by class, policy form and state in which the policy is issued, subject to applicable regulation, in order to maintain anticipated loss ratios. Since premium rate increases can increase policy lapses, conservation and customer service activities are emphasized. The Senior Health Division follows a proactive approach involving the examination of health premium rates on a monthly basis, including comparisons of pricing structure to actual claims experience by product line and state. This ongoing analysis provides lead time for the orderly adjustment of premiums.
Medicare Supplement. Since the inception of the federal Medicare program in 1966, the Company has offered policies designed to supplement Medicare benefits and is now the fifth largest issuer of individual Medicare supplement insurance in the nation, excluding Blue Cross and Blue Shield-related entities, based on direct premiums earned. Medicare supplement policies provide coverage for many of the medical expenses which the Medicare program does not cover, such as deductible and coinsurance costs and specified losses which exceed the Federal program's maximum benefits.
In 1991, the National Association of Insurance Commissioners (the "NAIC") defined ten model Medicare supplement policies. In states which have adopted the NAIC model, only those ten policies can be sold. In most states, the Company markets eight of the ten model policies those which the Company believes are most applicable to its target market. All states have adopted either the NAIC model or similar legislation which specifically defines policy models.
Medicare Select policies combine the cost advantages of a preferred provider organization with a Medicare supplement policy to provide a reduced premium cost for policyholders. Utilization of specified hospitals, which waive certain deductibles covered by the Medicare supplement policy, allows the Company to reduce the premium charged. The federal government recently expanded the Medicare Select program to all states. Although the market for this product is just developing, the Company sells Medicare Select policies in a number of states and has plans to expand sales nationally.
Long-Term Care and Home Health Care. The Senior Health Division also offers long-term care and home health care products designed principally for senior citizens. Long-term care policies generally provide specified per day benefits for nursing home confinements, within prescribed limits. Home health care policies provide specified per day benefits for required health services received in the home and comprehensive coverages which provide benefits for all levels of nursing home care, home health care and adult day care. In 1995, the Company developed and introduced a new series of "Independent Choice" long-term care and home health care plans which provide greater flexibility of benefit use and include care coordination features to help lower benefit costs. The Company's strategy is to cross-sell these products to customers who have already purchased the Company's Medicare supplement product.
The Company believes that the market for long-term care and home health care insurance could increase due to federal tax legislation to provide tax deductibility for long-term care insurance premiums. See "--Health Care Reform".
Specialty Health and Other. The Senior Health Division offers various specialty health products which typically are sold in conjunction with the Company's principal health products. These policies include hospital indemnity, private duty nursing and cancer plans. Additionally, the Company intends to develop and market managed care organizations for seniors as the demand for such products expands. The Company believes that the market for senior managed care products will grow as health care costs continue to grow. It is estimated that approximately 10% of Medicare beneficiaries in the nation participate in HMOs. There are many states with very low penetration of managed care in the senior market, including states with a high concentration of Medicare beneficiaries. The Company intends to take advantage of this opportunity by utilizing its position in the senior market and its managed care experience to market managed care products to senior citizens.
Life Insurance and Annuities. The Senior Health Division markets life insurance and annuities which are issued by the Life Insurance Division to individuals age 65 and over. In 1994, the Company began selling smaller face- amount whole life insurance policies specifically designed to cover final expenses for senior citizens, including funeral expenses and other expenses that otherwise would be paid by the insured's family. As part of its cross-selling strategy, the Company automatically offers a pre-approved (already underwritten for issue) cash burial life insurance policy with all Medicare supplement policies issued to customers age 66-79. The Company also offers annuity products specifically designed for seniors. These products provide an attractive investment alternative to seniors, offering higher interest rates than bank savings accounts and certificates of deposit and the ability to receive monthly payouts during retirement years.
Marketing. The Senior Health Division markets its products and services primarily to individuals age 65 and older through a distribution system of nearly 25,000 agents. The Company intends to enhance the Company's cross-selling capabilities through increased agent training and packaging of products. The agents receive extensive product and marketing information from the Company. They also have access, through the Company, to lists of prospective customers turning age 65 in their respective geographic areas and to a direct-mail lead-generation system. By providing its agents with training, sales materials, lead-generation programs and a full range of health and life insurance products designed for senior citizens, the Company intends to increase both sales to new customers and cross-sales to existing policyholders. The agents receive commissions on each sale based on the type of product sold.
Group Medical Division
The Group Medical Division underwrites and markets small group and individual hospital and medical products, including major hospital and specialty health insurance policies, individually underwritten and issued. This division's products and services are targeted primarily to individuals and small business owners. The insureds in this division also become prospects for the Senior Health Division -- when they reach age 65, the Company automatically provides for conversion to a Medicare supplement policy.
As in the Senior Health Division, the Company may, in the Group Medical Division, adjust health insurance premium rates by class, policy form and state in which the policy is issued, subject to applicable regulation, in order to maintain anticipated loss ratios. Since premium rate adjustments can have the tendency to increase policy lapses, conservation and customer service activities are emphasized. As with the Senior Health Division, the Group Medical Division follows a proactive approach involving the examination of health premium rates on a monthly basis. The matching of pricing structure with actual claims experience varies by product line and state. This ongoing analysis provides lead time for the orderly adjustment of premiums.
The Group Medical Division intends to focus its efforts on increasing administrative efficiency and claims-cost containment on its existing block of business through, among other things, continued development of medical provider networks and continued migration of its fee-for-service indemnity health insurance customers to managed care products. As the regulatory environment evolves, the Company will evaluate growth opportunities in this market.
Major Hospital. The Company offers major hospital insurance plans on an individual basis and on a group trust (multiple employer trust) and association basis and has issued master policies for such plans to several trusts and associations. These plans are designed to cover in-hospital expenses for self- employed individuals, small business owners, employees and their families. Hospital, surgical and other medical expenses are covered on an expense incurred basis with certain benefit limits after a prescribed deductible. The Company provides products with alternatives such as increased deductibles and different benefit structures designed to enable policyholders to maintain insurance protection without increased premium rates. The Company also has introduced a product which combines HMO-type wellness features within a specific provider network along with in-network and out-of-network indemnity benefits.
Marketing. The Group Medical Division markets its products and services primarily to self-employed individuals and small business owners. In 1996, approximately 73% of this division's business was sold through a sales force of approximately 1,200 career agents, 15% was sold through a brokerage system of 14,000 independent agents and the remaining 12% was sold through 40,000 independent brokers in a distribution system related to the block of business acquired in August 1996 from Washington National Insurance Company.
Life Insurance Division
The Life Insurance Division's products include traditional life (term and whole life), universal life and interest sensitive insurance and annuities. Substantially all of the Company's life insurance policies are individually underwritten and issued. This division's products and services are targeted primarily to the middle income market. In addition, this division underwrites, issues and administers the life insurance and annuity products marketed by the Senior Health and Life Division. This division grew significantly when the Company acquired Connecticut National Life (CNL) in January 1995.
The following table sets forth the breakdown of collected premiums (computed on a statutory basis) among traditional life policies, interest sensitive and universal life policies and annuities for the years shown:
For the fiscal year 1994, premiums collected from the Company's life insurance products were approximately 28% first year and 72% renewal, the fiscal year 1995 premiums were approximately 32% first year and 68% renewal, and for fiscal year 1996 premiums collected were approximately 35% first year and 65% renewal.
The Company's gross life insurance in force was as follows at the dates shown:
Traditional Life. The largest portion of the Life Insurance Division's business is in term life insurance. The Company specializes in face amounts of $100,000 to $500,000, sold to middle income families. Marketed under the name "Super Saver Term," this series features low cost 5-, 10- and 15-year term life insurance products.
For a number of years, the Company has offered individually underwritten insurance on lives of persons who, to varying degrees, do not meet the requirements of standard insurability. Higher premiums are charged for these "impaired" or "substandard" lives, and, where the amount of insurance is large or the risk is significant, a portion of the risk is reinsured. Approximately 10% of the Company's in-force life insurance could be categorized as "impaired risk."
Interest Sensitive Life and Universal Life. The Company's interest sensitive and universal life insurance products provide life insurance with rates of return which are adjusted in relation to prevailing interest rates. The policies permit the Company to change the rate of interest credited to the policy from time to time subject to certain minimum guaranteed rates. Universal life insurance products credit current interest rates to cash value accumulations, permit adjustments in benefits and premiums at the policyholder's option, and deduct mortality and expense charges monthly. Under other interest sensitive policies, premiums are flexible, allowing the policyholders to vary the frequency and amount of premium payments, but typically death benefit changes are not made by the policyholders. Some universal life products offer lower premiums for non-smokers in good health. For both universal life and other interest sensitive policies, surrender charges, if any, are deducted from the policyholder's account value at the time of surrender. No surrender charges are deducted if death benefits are paid or if the policy remains in-force for a specified period.
The Company's "Interest Sensitive Series" includes whole life policies ideally suited for the impaired risk market. This product series provides permanent protection with a fixed, guaranteed level premium and an interest rate persistency bonus. The "Financial Lifestyle II" is a highly flexible back-load universal life policy providing low-cost protection with tax-deferred cash accumulation.
Annuities. The Company offers single and flexible premium deferred annuities. An annuity contract generally involves the accumulation of premiums at a compound interest rate until the maturity date, at which time the policyholder can choose one of the various payment options. Options include periodic payments during the annuitant's lifetime or the lifetime of the annuitant and spouse, with or without a guaranteed minimum period; periodic payments for a fixed period regardless of the survival of the annuitant; or lump sum cash payment of the accumulated value. The Company's annuities typically provide for the crediting of interest at rates set from time to time by the Company, subject to certain minimum guaranteed rates.
Marketing. The Life Insurance Division markets its products primarily to individuals in middle income levels through a nationwide network of BGAs and MGAs who in turn contract with approximately 15,000 brokers and general agents. The Company's BGAs, MGAs and agents receive compensation through sales commissions.
PREMIUM DISTRIBUTION
The Company's insurance subsidiaries collectively are licensed to sell insurance in 49 states and the District of Columbia. The importance to the Company of particular states may vary over time as the composition of its agency network changes. The geographic distribution of collected premiums (before reinsurance) of the Company's subsidiaries in 1996 was as follows:
UNDERWRITING
A major portion of the Company's insurance coverages are individually underwritten to assure that policies are issued by the Company's insurance subsidiaries based upon the underwriting standards and practices established by the Company. Applications for insurance are reviewed to determine if any additional information is required to make an underwriting decision, which depends on the amount of insurance applied for and the applicant's age and medical history. Such additional information may include medical examinations, statements from doctors who have treated the applicant in the past and, where indicated, special medical tests. If deemed necessary, the Company uses investigative services to supplement and substantiate information. For certain coverages, the Company may verify information with the applicant by telephone. After reviewing the information collected, the Company either issues the policy as applied for, issues the policy with an extra premium charge due to unfavorable factors, issues the policy excluding benefits for certain conditions for a period of time or rejects the application. For certain of its coverages, the Company has adopted simplified policy issue procedures in which the applicant submits a simple application for coverage typically containing only a few health related questions instead of a complete medical history.
In common with other life and health insurance companies, the Company may be exposed to the risk of claims based on AIDS. The Company's AIDS claims to date have been insignificant. Because of its emphasis on policies written for the senior citizen market and its underwriting procedures and selection processes, the Company believes its risk of AIDS claims is less than the risk to the industry in general.
REINSURANCE
The Company's insurance subsidiaries reinsure portions of the coverages provided by their insurance products with other insurance companies on both an excess of loss and co-insurance basis. Co-insurance generally transfers a fixed percentage of the Company's risk on specified coverages to the reinsurer. Excess of loss insurance generally transfers the Company's risk on coverages above a specified retained amount. Under its excess of loss reinsurance agreements, the maximum risk retained by the Company on one individual in the case of life insurance and accident and health insurance is $250,000.
The Company acquired CNL in January 1995 which had an existing modified coinsurance arrangement with Reassurance Company of Hannover (RCH) ceding 90% of all its retained business issued prior to December 31, 1994. CNL received an initial ceding allowance of $15 million which was included in an experience refund account. The experience refund account will be reduced by profits from the reinsured business. The Company will share profits on the reinsured business thereafter on a 50-50 basis with RCH. CNL is indemnified for losses on the business reinsured.
Reinsurance agreements are intended to limit an insurer's maximum loss on the specified coverages. The ceding of reinsurance does not discharge the primary liability of the original insurer to the insured, but it is the practice of insurers (subject to certain limitations of state insurance statutes) to account for risks which have been reinsured with other approved companies, to the extent of the reinsurance, as though they are not risks for which the original insurer is liable. At December 31, 1996 approximately 28% of reinsurance receivables and amounts on deposit with reinsurers were due from RCH, 23% from Lincoln National Life Insurance Company, and 16% from Employers Reinsurance Corporation. Amounts due from any one other reinsurer were immaterial. See Note 7 of Notes to Consolidated Financial Statements.
The Company has occasionally used assumption reinsurance to acquire blocks of business from other insurers. In addition, the Company has from time to time entered into agreements to assume certain insurance business from companies for which it is marketing insurance products. The Company intends to continue these programs if they assist in expanding product lines and marketing territories and contribute to profitability. In August 1996, the Company assumed the individual and small group health business of Washington National Insurance Company (WNIC). The total premiums assumed were approximately $100 million for the five months ended Decemer 31, 1996. As of December 31, 1996, policy liabilities were increased as a result of the treaty by $66.3 million. The Company entered into a 50% quota share treaty with RCH on the business assumed from WNIC.
ACQUISITIONS
The Company believes that current trends in the life and health insurance industry will provide opportunities for continued acquisitions and consolidations. Larger companies are reducing administrative costs by divesting divisions and blocks of life and health insurance business which do not fit their overall strategies and are focusing on two or three core product lines to improve efficiency and gain competitive advantage. Additionally, smaller, less efficient companies with less capital at their disposal are experiencing increasing difficulty in remaining competitive; regulatory requirements add significant costs which may not be able to be absorbed by smaller companies; capital requirements have increased due to the imposition of risk-based capital ratios by regulatory agencies; state healthcare reform programs are reducing health insurance profit margins; the costs of necessary information processing systems have increased; and smaller companies cannot access capital markets to finance additional growth.
The following table summarizes the recent significant acquisitions made by the Company:
In August 1993, the Company acquired, and added to the Group Medical Division, CLAC, a small group medical insurer. In 1994 and 1995, the administration of this subsidiary was consolidated with the Company's other health insurance operations. In addition to CLAC, this acquisition included the purchase of Continental Marketing Corporation which added an efficient broker- to-broker telemarketing distribution system to the Group Medical Division.
In January 1995, the Company acquired, and added to the Life Insurance Division, CNL, a $350 million asset company, which had issued primarily interest sensitive and universal life insurance products. This acquisition increased the distribution system of the Life Insurance Division.
In July 1995, the Company acquired, and consolidated into the Group Medical Division's administrative facility in Dallas, Western Fidelity Insurance Company's $42 million block of major medical policies. The Company was able to integrate substantially all of this business into its operations within one month.
In March 1996, the Company acquired Universal Fidelity, a company which markets and underwrites primarily Medicare supplement products to senior citizens in Oklahoma and Texas. Universal Fidelity generated approximately $33 million of annualized premium. The approximately 30,000 Universal Fidelity Medicare supplement policyholders also provide potential for increased profitability through cross-selling of long-term care, home health care and other products.
In August 1996, the Company acquired,and added to the Group Medical Division, a block of individual and small group health insurance business from Washington National Insurance Company (WNIC).
In December 1996, the Company acquired, and added to the Life Insurance Division, SLIC, a $119 million asset company which had issued primarily term life insurance products.
INVESTMENTS
The Company's investment policy is to balance its portfolio between long-term and short-term investments so as to achieve investment returns consistent with preservation of capital and maintenance of liquidity adequate to meet payment of policy benefits and claims. Current policy is to invest primarily in fixed income securities of the U.S. government and its agencies and authorities, and in fixed income corporate securities with investment grade ratings of Baa3 and/or BBB- or better. At December 31, 1996, less than 2.9% of the Company's total investment portfolio and less than 2.6% of its statutory admitted assets were below-investment grade or unrated. The Company has a policy to invest no more than 4% of its statutory admitted assets in fixed income securities below-investment grade or unrated. At December 31, 1996, the Company had invested assets of $1,195.5 million, compared to $1,042.6 million at December 31, 1995. The Company manages all of its investments internally with resource and evaluation assistance provided by independent investment consultants.
The following table provides information on the Company's investments as of the dates indicated:
The following table provides information on the credit quality and average lives of the Company's fixed maturity portfolio as of December 31, 1996.
Fixed Maturity Investments. With the adoption of risk-based capital rules and consumer concerns over insurance company solvency and financial stability, the asset quality of insurance companies' investment portfolios has become of greater concern to policyholders and has come under closer scrutiny by insurance regulators and investors. The investment objectives of the Company are to maximize investment yield without sacrificing high investment quality and matched liquidity.
Investments in below-investment grade fixed maturity securities generally have greater risks (and potentially greater returns) than other corporate fixed maturity investments. Risk of loss upon default by the issuer is significantly greater for these securities because they are often unsecured and are often subordinated to other creditors of the issuer, and because these issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. Also, the market for below-investment grade securities is less liquid and not as actively traded as the market for investment grade securities.
The Company continually evaluates the creditworthiness of each issuer of securities held in its portfolio. When the fair value of an individual security declines materially, or when the Company's ongoing evaluation indicates that it may be likely that the Company will be unable to realize the carrying value of its investment, a determination is made as to the extent to which such declines are attributable to changing market expectations regarding general interest rates and inflation and other factors, such as a perceived increase in the credit risk of the issuer, a general decrease in a particular industry sector or an overall economic decline. If the decline in value is other than temporary, and the carrying amount of the investment is reduced to its fair value based principally on available market prices, the amount of the reduction is reported as a realized loss on investments and the net fair value becomes the new cost basis of the investment. In addition, the Company reverses any accrued interest income previously recorded for the investment and records future interest income only when cash is received.
Yields recognized in future periods on such investments may be less than yields recognized on other investments and will be less than the yield expected when the fixed maturity security was originally purchased. The effect on net income from declines in interest income and portfolio yield from impaired securities in future periods will depend on many factors, including, for life insurance business, the level of interest rates credited to policyholder account balances. Inasmuch as interest rates credited to the Company's policyholders are typically guaranteed only for one year, the Company does not expect any material adverse effect on net income in future periods from declines in yields from impaired securities.
Mortgage-Related Securities. At December 31, 1996, the Company had $400.3 million (or 39% of its fixed maturities portfolio) in mortgage-related securities compared to $408.0 million at December 31, 1995 (or 47% of its fixed maturities portfolio). The mortgage-related securities are invested primarily in U.S. government agency and non-agency pass-through certificates and various components of U.S. government agency and non-agency collateralized mortgage obligations ("CMOs"). CMOs are bonds that are collateralized by U.S. government agency or non-agency whole loan mortgages and mortgage pass-through securities. The yield characteristics of mortgage-related securities differ from those of traditional fixed income securities. The major differences typically include more frequent interest and principal payments, usually monthly, and the possibility that prepayments of principal may be made at any time. Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic, social and other factors and cannot be predicted with certainty. The yields to maturity of the mortgage-related securities will be affected by the actual rate of payment (including prepayments) of principal of the underlying mortgage loans. In general, prepayments on the underlying mortgage loans, and subsequently the mortgage-related securities backed by these loans, increase when the level of prevailing interest rates declines significantly below the interest rates on such loans. When declines in interest rates occur, the proceeds from the prepayment of such securities may be reinvested at lower rates than the Company was earning on such securities.
The Company's mortgage-related securities portfolio is well diversified as to collateral, maturity, duration and other characteristics. The majority of the mortgage-related securities portfolio has the guarantee or backing of agencies of the United States government. Generally, the mortgage-related securities consist of pools of single-family, residential mortgages. At December 31, 1996, the Company's mortgage-related securities portfolio included $143.3 million of CMOs and pass-through certificates issued by non-government agencies (35.8% of total mortgage-backed securities) compared to $136.9 million at December 31, 1995 (33.6% of total mortgage-backed securities). The majority of these holdings are senior securities in the CMO structures which are collateralized by first mortgage liens on single-family residences and which have investment grade ratings of Baa3 and/or BBB- or higher. The creditworthiness of these securities is based solely on the underlying mortgage loan collateral and credit enhancements in the form of senior/subordinated structures, letters of credit, mortgage insurance or surety bonds. The underlying mortgage loan collateral principally consists of whole loan mortgages that exceed the maximum imposed by both the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Therefore, the collateral tends to be concentrated in states with the greatest number of higher priced single family residences, including California, New York, New Jersey, Maryland, Virginia and Illinois.
At December 31, 1996, the Company held $10.5 million carrying value of inverse floater and interest-only tranches of CMOs. These derivative securities were acquired to protect the Company in the event of adverse interest rate fluctuations. The yields and fair values of these securities are generally more sensitive to changes in interest rates and prepayments than other mortgage- related securities.
The following table summarizes the components of the Company's mortgage- related securities portfolio at December 31, 1996, and December 31, 1995:
Since investment income is an important component of revenue and profitability for the Company; significant focus is placed on the analysis of both asset and liability characteristics in the investment process. Profitability is impacted by spreads between yields earned on investments and rates credited on annuities, interest sensitive and life insurance liabilities. Although substantially all credited rates on these liabilities can be changed annually, changes in interest rates credited may not be sufficient to maintain targeted investment spreads in all economic and market environments. In addition, other factors including competition, the impact of the level of surrenders and withdrawals may limit the Company's ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions.
The Company, in recognizing this importance of interest rate managment, seeks to balance the duration of its invested assets with the expected duration of benefit payments arising from insurance liabilities. At December 31, 1996, the duration of the Company's fixed maturity portfolio is 4.5 years and the duration of the Company's insurance liabilities is 4.1 years. The Company meets at least monthly to review the asset and liability position in order to make necessary adjustments including adjustments to investment activity or crediting rates or both.
The Company's investment portfolio used to support this asset and liability management is comprised of fixed maturity investments. These fixed maturity investments are comprised primarily in investment grade debt securities of the United States government, public utilities and other corporations, and mortgage- backed securities (MBS).
Mortgage-backed securities included collateralized mortgage obligations (CMOs) and mortgage-backed pass-through securities. CMOs are securities backed by pools of pass-through securities and/or mortgages that are segregated into sections or "tranches" which provide for sequential retirement of principal rather than the pro rata share of principal return which occurs through regular monthly principal payments on pass-through securities. Interest and principal payments occur more frequently than those of traditional fixed income securities. Almost all mortgage-backed securities are subject to risks associated with variable prepayments.
Prepayment rates are influenced by a number of factors which cannot be predicted with certainty including the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures.
In general, prepayments on the underlying mortgage loans, and the securities backed by these loans, increase when the level of prevailing interest rates declines significantly below the interest rates on such loans. MBS purchased at a discount to par will experience an increase in yield when the underlying mortgages prepay faster than expected. Those securities purchased at a premium that prepay faster than expected will incur a reduction in yield.
The degree to which a MBS is susceptible to income fluctuations is influenced by (i) the difference between its cost and par; (ii) the relative sensitivity of the underlying mortgages backing the security to prepayment in a changing interest environment; and (iii) the repayment priority of hte security in the overall securitization structure. The Company limits the extent of these risks and the impact they may have on asset/liability management by: (I) generally purchasing securities which are backed by collateral with lower prepayments sensitivity (such as seasoned mortgages or MBS priced at a discount to par); (ii) avoiding securities whose values are heavily influenced by changes in prepayments (such as interest-only and principal-only securities); and (iii) investing in securities structured to reduce prepayment risk.
POLICY LIABILITIES
The Company records reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are amounts which are calculated to be sufficient to meet policy and contract obligations as they mature. The amount of reserves for insurance policies is calculated using assumptions for interest, mortality and morbidity, expenses and withdrawals. Reserves are established at the time the policy is issued and adjusted periodically based on reported and unreported claims or other information. See Note 2 of Notes to Consolidated Financial Statements.
COMPETITION
The insurance business is highly competitive and includes a large number of insurance companies, many of which have substantially greater financial resources and larger and more experienced staffs than the Company. The Company competes with other insurers to attract and retain the allegiance of its independent agents and marketing organizations who at this time are responsible for a significant portion of the Company's premiums. Methods of competition include the Company's ability to offer competitive products and to service these programs efficiently. Other competitive factors applicable to the Company's business include policy benefits, service to policyholders and premium rates.
GOVERNMENT REGULATION
The Company and its insurance subsidiaries are subject to extensive governmental regulation and supervision in each of the jurisdictions in which it or its subsidiaries conduct business. Such regulation vests in governmental agencies broad regulatory, supervisory and administrative power with respect to the Company's business, including premium rate levels, premium rate increases, policy forms, minimum loss ratios, dividend payments, claims settlement, licensing of insurers and their agents, capital adequacy, transfer of control, the amount and type of investments the Company may have, reserve requirements, solvency standards, trade practices and periodic examinations. Such regulations are primarily intended to protect policyholders and not investors. The Company's accident and health coverages generally are subject to rate regulation by state insurance departments which in certain cases require that certain minimum loss ratios be maintained.
The states in which the Company is licensed have the authority to change the minimum mandated statutory loss ratios to which the Company is subject, the manner in which these ratios are computed and the manner in which compliance with these ratios is measured and enforced. Loss ratios are commonly defined as incurred claims and increases in policy reserves divided by earned premiums. Most states in which the Company writes insurance have adopted the loss ratios recommended by the National Association of Insurance Commissioners (NAIC). The Company is unable to predict the impact of (i) any changes in the mandatory statutory loss ratios for individual or group policies to which the Company may become subject, (ii) any changes in the minimum loss ratios for individual, group or Medicare supplement policies, or (iii) any change in the manner in which these minimums are computed or enforced in the future. The Company has not been informed by any state that it does not meet mandated minimum ratios, and the Company believes that it is in compliance with all such minimum ratios. In the event the Company is not in compliance with minimum statutory loss ratios mandated by regulatory authorities with respect to certain policies, the Company may be required to reduce or refund premiums, which could have a material adverse effect upon the Company.
Certain states also have insurance holding company laws which require registration and periodic reporting by insurance companies controlled by other corporations licensed to transact business within their respective jurisdictions. The Company's insurance subsidiaries are subject to such laws and are registered as controlled insurers in those jurisdictions in which such registration is required. Such laws vary from state to state but typically require periodic disclosure concerning the corporation which controls the registered insurers and all subsidiaries of such corporation, and prior notice to, or approval by, the state insurance department of intercorporate transfers of assets and other transactions (including payments of dividends in excess of specified amounts by the insurance subsidiary) within the holding company system.
The federal government does not directly regulate the insurance business. However, federal legislation and administrative policies in several areas, including pension regulation, age and sex discrimination, financial services regulation and federal taxation, do affect the insurance business. Recently, a number of state legislatures have considered or have enacted legislative proposals that alter, and in many cases increase, the authority of state agencies to regulate insurance companies and holding company systems. In addition, legislation has been introduced from time to time in recent years which, If enacted, could result in the federal government assuming a more direct role in the regulation of the insurance industry.
State insurance regulators and the NAIC periodically re-examine existing laws and regulations and their application to insurance companies. In recent years, the NAIC has approved, the recommended to the states for adoption and implementation, several regulatory initiatives designed to decrease the risk of insolvency of insurance companies. These initiatives include risk based capital ("RBC") requirements for determining the levels of capital and surplus an insurer must maintain in relation to its insurance and investment risks. Other NAIC regulatory initiatives impose restrictions on an insurance company's ability to pay dividends to its stockholders. These initiatives may be adopted by the various states in which the Company's subsidiaries are licensed; the ultimate content and timing of any statutes and regulations adopted by the states cannot be determined at this time. It is not possible to predict the future impact of changing state and federal regulation on the Company's operations, and there can be no assurance that existing insurance related laws and regulations will not become more restrictive in the future or that laws and regulations enacted in the future will not be more restrictive.
The NAIC's RBC requirements are intended to be used as an early warning tool to help insurance regulators identify deteriorating or weakly capitalized companies in order to initiate regulatory action. Such requirements are not intended as a mechanism for ranking adequately capitalized companies. The formula defines a new minimum capital standard which supplements the low, fixed minimum capital and surplus requirements previously implemented on a state-by- state basis.
The NAIC's RBC requirements provide for four levels of regulatory attention, varying with the ratio of the company's total adjusted capital (defined as the total of its statutory capital, surplus, asset valuation reserve and certain other adjustements) to its RBC. If a company's total adjusted capital is less than 100 percent but greater than or equal to 75 percent of its RBC, or if a negative trend (as defined by the regulators) has occurred and total adjusted capital is less than 125 percent of RBC (the "Company Action Level"), the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position. If a company's total adjusted capital is less than 75 percent but greater than or equal to 50 percent of its RBC (the "Regulatory Action Level"), the regulatory authority will perform a special examination of the company and issue an order specifying corrective actions that must be followed. If a company's total adjusted capital is less than 50 percent but greater than or equal to 35 percent of its RBC (the "Authorized Control Level"), the regulatory may take any action it deems necessary, including placing the company under regulatory control. If a company's total adjusted capital is less than 35 percent of its RBC (the "Mandatory Control Level") the regulatory authority must place the company under its control. At December 31, 1996 the total RBC based on company action level were as follows for the company's significant insurance subsidiaries:
Pioneer Life Insurance Company 138% Manhattan National Life 217 Connecticut National Life 583 SECURA Life 274 National Group Life 175 Continental Life & Accident 200 Universal Fidelity 435
Under statutory accounting, insurance companies are required to establish an asset valuation reserve ("AVR") consisting of two components: a "default component" which provides for future credit-related losses on fixed maturity investments and an "equity component" which provides for losses on all types of equity investments, including real estate. Insurers are also required to establish an interest maintenance reserve ("IMR") for fixed maturity realized capital gains and losses, net of tax, related to changes in interest rates. The IMR must be amortized into earnings on a basis reflecting the remaining period to maturity of the fixed maturity securities sold. State regulatory authorities require that these reserves be established as a liability on a life insurer's statutory financial statements. These reserves do not affect financial statements of the Company prepared in accordance with generally accepted accounting principles ("GAAP").
Under the solvency or guaranty laws of most states in which they do business, the Company's insurance subsidiaries may be required to pay guaranty fund assessments (up to certain prescribed limits). Guaranty funds are established by various states to fund policyholder losses or the liabilities of insolvent or rehabilitated insurance companies. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength. In certain instances, the assessments may be offset against future premium taxes. The amount of such assessments has increased in recent years, however, and may increase in future years. The likelihood and amount of any other future assessments in addition to estimated amounts accrued at December 31, 1996, cannot be estimated. Such assessments are beyond the control of the Company.
Approximately once every three years, as part of their routine regulatory oversight process, insurance departments conduct detailed examinations of the books, records and accounts of insurance companies domiciled in their states. Such examinations are generally conducted in cooperation with the departments of two or three other states, under guidelines promulgated by the NAIC. Several examinations of the Company's life insurance subsidiaries have been recently completed. The preliminary conclusions reached do not have a material adverse effect on the Company or its business and operations.
Federal and state regulations have had, and are expected to continue to have, the effect of increasing the regulation of Medicare supplement plans in all states. In July 1991, the NAIC implemented regulations creating 10 model Medicare supplement plans (Plans A throught J). Plan A provides the least extensive coverage, while Plan J provides the most extensive coverage. Under NAIC regulations, Medicare insurers must offer Plan A, but may offer any of the other plans at their option. The Company currently offers eight of the model plans.
The NAIC model regulation concerning Medicare supplement policies also regulates the profits that insurance companies may earn in respect of any such policies by providing that Medicare supplement policies may not be issued unless it can be expected, as estimated for the period for which the prescribed rate thereunder is to provide coverage, to return to policyholders aggregate benefits equal to at least: (I) 75 percent of the aggregate amount of premiums earned on group policies; and (ii) 65 percent of the aggregate amount of premiums earned on individual policies. Technical corrections to OBRA mandate compliance with these calculations for policies issued prior to the original OBRA regulations. Under this regulation, the Company must file a Medicare Supplement Refund Calculation Form each year. If the Company's actual loss ratio falls below ratios prescribed by the Form by more than a de minimis amount, the Company must make a refund to policyholders. The Company has reviewed the loss ratios on business subject to the NAIC model regulations and currently believes that no significant refunds will be required.
HEALTH CARE REFORM
Many proposals have been introduced in Congress and various state legislatures to reform the present health care system. Most of these proposals are specifically directed at the small group health care market, a significant portion of the Company's health business. A number of states have passed or are considering legislation that would limit the differentials in rates that insurers could charge between new business and renewal business with respect to similar demographic groups. State legislation also has been adopted or is being considered that would make health insurance available to all small groups by requiring coverage of all employees and their dependents, by limiting the applicability of pre-existing conditions exclusions, by requiring insurers to offer a basic plan exempt from certain mandated benefits as well as a standard plan and by establishing a mechanism to spread the risk of high risk employees to all small group insurers.
At the federal level, the Health Insurance Portability and Accountability Act of 1996 includes provisions which permit premiums paid for long-term care insurance to be treated as tax-deductible medical expenses, with the amount of the deduction increasing with the age of the taxpayer. The Company has responded to this legislation by developing new tax-qualified long-term care policies which are being introduced in 1997.
The Health Insurance Portability and Accountability Act of 1996 also includes provisions affecting group and individual health insurance products, including requirements for guaranteed portability, specifications of coverage for pre-existing conditions and a test program for medical savings accounts. The Company has developed a medical savings account plan to be marketed in conjunction with one of its high-deductible major medical policies which is expected to be introduced in the second quarter of 1997. Other provisions of this Act will require modifications of existing products and marketing in the Company's Group Medical Division. The Company cannot predict with certainty the effect legislative developments could have on its business and operations. It is likely that health care reform at the federal and state levels will require the Company to make significant changes to the way it conducts its health insurance business. The Company has already initiated activity to prepare for expected legislation.
EMPLOYEES
As of December 31, 1996, the Company employed approximately 1,700 persons on a full-time basis. The Company considers its employee relations to be good.
DIRECTORS AND EXECUTIVE OFFICERS
The executive officers and directors of the Company are as follows:
All executive officers are elected annually and serve at the pleasure of the Board of Directors. Certain of the executive officers have employment agreements with the Company. The Company's Board of Directors is divided into three classes, each of which serves for a three year term.
Peter W. Nauert has been Chief Executive Officer and a director of the Company since its incorporation in 1982. He was President of the Company from 1982 to 1988 and 1991 to 1995, and became Chairman of the Company in 1988. Since 1968, Mr. Nauert has been employed in an executive capacity by one or more of the Company's insurance subsidiaries.
Charles R. Scheper was elected President--Life Insurance Operations of the Company in March 1995. He was Vice President of the Company from 1991 to March 1995 and was Chief Financial Officer from May 1993 to December 1993. In March 1992, he was elected Executive Vice President. Since February 1992, he has been President and Vice Chairman of the Board of Manhattan National Life, a subsidiary of the Company. Prior to the Company's acquisition of Manhattan National Life, Mr. Scheper was Manhattan National Life's Senior Vice President and Chief Financial Officer, a position which he held from May 1987 until the acquisition. Prior to joining Manhattan National Life, Mr. Scheper was with Union Central Life Insurance Company from 1979, having served as Vice President and Controller since 1985.
Thomas J. Brophy was elected President--Health Insurance Operations of the Company in March 1995. He was Senior Vice President since joining the Company in November 1993. Prior to joining the Company, Mr. Brophy was President and Chief Operating Officer of Southwestern Life Insurance Company from June 1990 to September 1993. Mr. Brophy also held senior executive positions with various I.C.H. Corporation (now known as Southwestern Life Corp.) subsidiaries from March 1974 to his joining the Company in November 1993.
Mark S. Fischer has been a Vice President of the Company since December 1994 and has been a Vice President of one of the Company's subsidiaries since May 1993. Prior to joining the Company, he had been a consultant to the Company and was with the public accounting firm of Ernst & Young LLP from May 1978 to October 1992 where he was a Senior Manager in the Insurance Division.
Billy B. Hill, Jr. was elected Executive Vice President and General Counsel of the Company on May 23, 1996. Prior to that time, he acted as outside legal counsel to the Company and others and functioned as a legal consultant to, and Acting General Counsel of, the Company from January 1, 1996 to May 23, 1996. Mr. Hill has served as a director of a subsidiary of the Company since 1995.
David I. Vickers has been with the Company since June 1992 and has been a Vice President of the Company since December 1992, Treasurer since May 1993 and Chief Financial Officer since January 1994. He is also an officer and director of several subsidiaries of the Company. Prior to joining the Company, he was with the public accounting firm of Ernst & Young LLP since 1983 where he was a Senior Manager in the Insurance Division.
Philip J. Fiskow has been Senior Vice President since May 1993 and the Chief Investment Officer since joining the Company in 1991. He was Vice President of the Company from June 1991 until May 1993. He is also an officer of other subsidiaries of the Company. Mr. Fiskow was with Asset Allocation and Management Company as an Investment Advisory Portfolio Manager from January 1989 to June 1991. From May 1987 to December 1988 he was an Investment Advisor with Van Kampen Merritt and a Portfolio Manager with Aon Corporation from May 1981 to May 1987.
Michael A. Cavataio has been a director of the Company since 1986 and Vice Chairman since December 1995. Mr. Cavataio is a real estate developer in Northern Illinois and Southern Wisconsin. His business experience also includes 25 years as an owner and manager of a regional clothing store chain. He has also been a member of the board of directors of Today's Bank East since 1987.
William B. Van Vleet has been a director of the Company since 1982. He was Executive Vice President of the Company from 1986 to 1995 and General Counsel of the Company from 1982 to 1988. In June 1991, he was again elected General Counsel and served until his retirement from that position in 1995. Mr. Van Vleet had served Pioneer Life Insurance Company, a subsidiary of the Company, from 1948 until 1995 as General Counsel and a director. Mr. Van Vleet also serves as a director of other subsidiaries of the Company.
R. Richard Bastian, III has been a director of the Company since December 1994. Mr. Bastian is a management consultant, specializing in strategic planning and organizational development. Mr. Bastian's career includes over 28 years in the financial services industry, most recently as President and Chief Executive Officer of Heritage Bank & Trust of Racine, Wisconsin. Prior to Heritage, he served as Chairman, President and Chief Executive Officer of Bank One, Rockford and its predecessor, First Community Bancorp, an $800 million multi bank holding company. He has also held management positions at banks in Tulsa and Philadelphia where his banking career began in 1966.
Karl Heinz Klaeser has been a director of the Company since 1986. Mr. Klaeser has also been a director of LSW Holding Corporation and Insurance Investors Life Insurance Company and the Chairman of the Board of Life Insurance Company of the Southwest since 1989 and a director of Personal Assurance Company PLC (United Kingdom) since 1991.
Michael K. Keefe has been a director of the Company since March 1994. Mr. Keefe has been Chief Executive Officer and Chairman of the Board of Keefe Real Estate, Inc., a family owned real estate brokerage operation since 1982. Mr. Keefe has also been Chairman of the Board of Southern Wisconsin Bankshares, Inc. since 1988.
Robert F. Nauert has been a director of the Company since November 1991. Mr. Nauert is also a director and officer of various subsidiaries of the Company. Mr. Nauert is the brother of Peter W. Nauert.
Carl A. Hulbert was elected director of the Company in March 1995 and has been a director of a subsidiary of the Company since 1990. Mr. Hulbert is a management consultant, specializing in the insurance industry. Mr. Hulbert is a past Insurance Commissioner of the state of Utah. He has also been a director for numerous insurance companies during his 49 year business career.
John W. Gardiner was elected director of the Company in May 1996. Mr. Gardiner was a director, President and Chief Operating Officer of Life Partners Group and a director and Chairman and Chief Executive Officer of Massachusetts General Life Insurance Company and Philadelphia Life Insurance Company, two subsidiaries of Life Partners, from March 1990 to his retirement in May 1995.
ITEM 2.

ITEM 2. PROPERTIES
The principal executive offices of the Company are located in Schaumburg, Illinois in a building purchased by the Company in January 1994. The Company, through a subsidiary, owns three buildings in Rockford, Illinois and, through another subsidiary, also owns a building in the Dallas, Texas metropolitan area which currently serves as the main administrative office for the Group Medical Division. The Company leases the offices of its other regional service centers. The executive and administrative offices of Manhattan National Life are located in Cincinnati, Ohio, in leased space. The Company believes these facilities will adequately serve its needs for the foreseeable future and could accommodate expansion of the Company's business.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are named as defendants in various legal actions, some claiming significant damages, arising primarily from claims under insurance policies, disputes with agents, and other matters. The Company's management and its legal counsel are of the opinion that the disposition of these actions will not have a material adverse effect on the Company's consolidated financial condition, cash flows, or results of operations.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
NONE
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS
The Common Stock is traded on the NYSE and the Chicago Stock Exchange under the symbol "PFS." The following table sets forth for the fiscal periods indicated the high and low last reported sale prices per share of the Common Stock, as reported by the NYSE and the dividends paid per share of the Common Stock.
As of February 29, 1996, there were approximately 555 holders of record of the Common Stock.
On March 18, 1997 the Company's Board of Directors announced a quarterly common stock dividend of 5.5 cents per share to be paid in April 1997 to stockholders of record on March 31, 1997.
The ability of the Company to pay dividends will depend primarily on the receipt of cash dividends and other cash payments from its subsidiaries. The Company's insurance subsidiaries are subject to state laws and regulations which limit their ability to pay dividends or make other payments to the Company. Certain of the Company's credit agreements also limit its ability to pay dividends. See "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Liquidity and Capital Resources."
ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA (A)
The following selected consolidated financial data for the five years ended December 31, 1996, are derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Fiscal Year 1996 Compared to Fiscal Year 1995
Overview
PFS has three business segments: Group Medical, Senior Health, and Life Insurance. The segments are based on PFS' main Divisions. Allocations of investment income and certain general expenses are based on various assumptions and estimates, and reported operating results by segment would change if different methods were applied. Investment income is allocated based primarily on the policy liabilities and capital supporting the segment. General expenses are determined based on cost center and functional expense analysis prepared in conjunction with the monthly budgeting process. Assets are not individually identifiable by segment and have been allocated based on the amount of policy liabilities by segment and by other formulas. Depreciation expense and capital expenditures are not considered material. Realized investment gains and losses are allocated to the appropriate segment.
General corporate expenses are not allocated to the individual segments. Revenues, income or loss before income taxes, and identifiable assets by business segment are as follows:
Group Medical Division
Revenue. Total revenue in the Group Medical Division increased $9.0 million, or 2%, from $430.9 million to $439.9 million. The increase was due to the assumption of the small group and individual health business of Washington National Insurance Company (WNIC) which added net of reinsurance $50.2 million in revenue during 1996. The increase in revenue from the WNIC block offset the decline in the Company's direct major medical business. The division continued to scale back marketing in certain states due to regulatory concerns.
Net investment income increased $1.7 million, or 21%, from $7.7 million to $9.4 million due to the increase in invested assets associated with the WNIC block of business.
Other income decreased $3.7 million, or 21%, from $18.9 million to $15.2 million due to a reduction in commission overrides at the Company's marketing subsidiaries.
Benefits. The following table sets forth the earned premium, benefits, and loss ratios for products issued by the Group Medical Division:
The increase in loss ratio is due to the assumed block of WNIC business which has a higher ultimate loss ratio and a shift to a low commission and higher benefit product structure due to small group reform. The loss ratio on the assumed block of WNIC business was 77.2% for 1996.
Insurance and General Expenses. Insurance and general expenses decreased $11.4 million, or 10%, from $119.5 million to $108.1 million. The expense decreased in 1996 primarily due to lower average commission rates resulting from non-commissionable rate increases and a marginal improvement in administration efficiencies. The remaining decrease was due to the reduction in new business from historical distribution channels.
The amortization of DAC decreased $3.8 million, or 10%, from $38.0 million to $34.2 million. The decrease was due to the lower 1996 new business levels.
Senior Health Division
Revenue. Total revenue in the Senior Health Division increased $60.6 million, or 26%, from $236.6 million to $297.2 million. Senior health premium increased $50.4 million, or 23%, from $221.0 million to $271.4 million. The increase was due to the acquisition of Universal Fidelity in March 1996 and an increase in new business sales.
Net investment income increased $5.4 million, or 61%, from $8.8 million to $14.2 million, primarily due to the acquisition of Universal Fidelity and an overall increase in invested assets. The investment yields remained relatively unchanged during 1996. The total realized gains decreased $1.0 million from $5.1 million to $4.1 million.
Benefits. The following table sets forth the earned premium, benefits, and loss ratios for senior health products:
The loss ratio on the renewal block of medicare supplement business acquired from Universal Fidelity was 71.9% which is higher than the Company's historical loss ratios. The remaining increase in loss ratio in 1996 is due to the runoff of the pre-standardized medicare supplement products which carry a lower loss ratio than the Company's standardized forms.
Insurance and General Expenses. The expense ratio remained relatively unchanged. The decline in administrative expense levels was offset by a continued increase in marketing expenses associated with new marketing initiatives.
The amortization of DAC decreased $3.6 million, or 17%, from $21.6 million to $18.0 million. The decreased level of amortization was due to improved persistency on the in-force Medicare supplement business.
Life Insurance Division
Revenue. Total revenue in the Life Insurance Division increased $20.3 million, or 18%, from $115.5 million to $135.8 million. The increase was due primarily to a 28% increase in new business sales.
Net investment income decreased $3.6 million, or 7%, from $54.4 million to $50.8 million. This decrease was primarily due to a decrease in the investment income allocated to the senior life product line.
Benefits. Total life and annuity policy benefits increased $13.9 million, or 18%, from $76.8 million to $90.7 million due primarily to a 23% increase in life insurance in-force and $1.6 million associated with higher than expected claims on the Company's senior life products. The senior life mortality continued to exceed that which was developed in pricing and the Company has continued to initiate rate increases and modify underwriting procedures to improve profitability. The mortality experience on the remaining block of business was consistent with projected levels.
Insurance and General Expenses. Insurance and general expenses decreased $4.2 million, or 19%, from $22.0 million to $17.8 million. The decrease was due primarily to $1.6 million associated with a reinsurance litigation settlement included in the 1995 amount, an overall reduction in commissions associated with the senior life products, and a 14% reduction in the maintenance unit cost per policy.
The amortization of DAC increased $3.8 million, or 40%, from $9.6 million to $13.4 million with the increased life insurance in force.
Corporate Expenses
Corporate expenses increased $3.7 million, or 132% during 1996 due to executive officer bonuses of $1.5 million, increased outside consulting expenses of $0.9 million, and a general increase in other corporate expenses. Interest expense increased $1.6 million or 34% due primarily to the March 1996 issuance of the convertible subordinated notes. The operations of the managed care division included in the corporate segment did not have a material effect on operating income in 1996 or 1995.
Consolidated Financial Condition and Results of Operations
Fiscal Year 1996 Compared to Fiscal Year 1995
Net income. The Company's consolidated net income increased $9.5 million, or 45%, from $21.0 million to $30.5 million. This increase was due primarily to improved operating profitability in the Senior Health and Life Divisions.
Premiums and policy charges. Total premiums and policy charges increased $83.9 million, or 12%, from $687.0 million to $770.9 million. Accident and health premiums increased $60.9 million, or 10% due to the acquisition of UFLIC and the small group and individual health reinsurance agreement with WNIC. Life and annuity premiums increased $22.9 million or 38% due to the significant growth in new business during 1996.
Net investment income. Net investment income increased $3.8 million, or 5%, from $71.0 million to $74.8 million. Invested assets increased 15% to $1,196 million and annualized investment yields decreased slightly from 7.0% to 6.9%.
Other revenue. Other income and realized investment gains and losses remained relatively unchanged.
Benefits. Total benefits increased $81.6 million, or 17%, from $475.8 million to $557.4 million. Accident and health benefits, which include the change in unearned premiums, increased $67.8 million, or 17%, from $399.0 million to $466.7 million. Life and annuity benefits increased $13.8 million, or 18%.
Insurance and general expenses. Insurance and general expenses (which include non-deferred commission compensation to agents) decreased $6.1 million, or 3%, from $218.4 million to $212.3 million. The commission compensation is expected to continue to decline on the Company's small group major medical products.
Amortization of DAC. Amortization of DAC decreased $3.7 million, or 5%, from $69.2 million to $65.5 million. The decrease was primarily due to a lower level of group major medical new business and improved persistency on Medicare supplement business.
Income tax rate. The effective federal income tax rate was 34% due to the investment in tax-exempt securities included in the Company's portfolio.
Other. Investments, premiums and other receivables, amounts on deposit and due from reinsurers, accrued investment income and other assets increased principally due to the acquisitions of SLIC, UFLIC and the WNIC block of business. DAC increased as a result of the significant increase in life and long-term care production. The decrease in short-term notes payable resulted from the use of proceeds from the Company's public offering in the first quarter of 1996. General expenses and other liabilities, and amounts due to reinsurers increased due primarily to the acquisition of SLIC and the WNIC block of business. The remaining balance sheet amounts remained relatively consistent with the amounts at December 31, 1995.
Fiscal Year 1995 Compared to Fiscal Year 1994
Net income. The Company's consolidated net income increased $3.9 million, or 21%, from $17.1 million to $21.0 million. This increase was due primarily to improved profitability in the Group Medical Division as a result of improved loss ratios and a lower level of DAC amortization.
Premiums and policy charges. Total premiums and policy charges decreased $17.1 million, or 2%, from $704.1 million to $687.0 million. This decrease was due to the decrease in accident and health premiums of $33.2 million, or 5%, which was due primarily to a decrease in premiums from major medical products of $26.9 million, or 6%. The decrease in premiums was primarily due to the Company's decision to market unaffiliated companies' HMO products in states such as California, where competitive pressures and state reforms made it difficult to underwrite the Company's indemnity products on a profitable basis. Total health insurance premiums attributable to Medicare supplement and long-term care products remained relatively constant. Life insurance premiums increased $16.2 million, or 36%, primarily due to the acquisition of CNL and new business sales.
Net investment income. Net investment income increased $28.2 million, or 66%, from $42.8 million to $71.0 million. Invested assets increased 44% to $1,043 million and annualized investment yields increased from 6.3% to 7.0%. These increases were primarily due to the acquisition of CNL.
Other revenue. Other income and realized investment gains and losses increased $14.8 million, or 54%, from $27.3 million to $42.1 million. The increase in other income was due to increased sales to unaffiliated clients by the Company's managed care subsidiaries and the acquisition of ACMG, Inc. in July 1995. The remaining other income generated by the Company's non-insurance subsidiaries remained relatively unchanged.
Benefits. Total benefits increased $25.6 million, or 6%, from $450.2 million to $475.8 million. Accident and health benefits, which include the change in unearned premiums, decreased $8.2 million, or 2%, from $407.2 million to $399.0 million. Life and annuity benefits increased $33.9 million, or 79%. This increase was due to the acquisition of CNL and increased senior life insurance in-force.
Insurance and general expenses. Insurance and general expenses (which includes non-deferred commission compensation to agents) increased $25.6 million, or 13%, from $192.8 million to $218.4 million. Expenses for the managed care subsidiaries increased due to the increase in sales and the acquisition of ACMG. Expenses in the insurance divisions increased due to the development of new marketing and sales incentive programs, system development costs, and the acquisition of CNL. Corporate expenses increased $4.0 million primarily due to $5.2 million in payments made to converting bondholders and other expenses relating to the August 1995 conversion of the Company's 8% Debentures.
Amortization of DAC. Amortization of DAC decreased $30.9 million, or 31%, from $100.1 million to $69.2 million. The decrease was primarily due to an adjustment in 1994 to the DAC asset related to certain group and individual medical business, a lower level of group major medical new business and improved persistency on Medicare supplement business.
Income tax rate. The effective federal income tax rate was 34% due to the increased investment in tax-exempt securities included in the Company's portfolio.
Other. Investments, premiums and other receivables, amounts on deposit and due from reinsurers, accrued investment income and other assets increased principally due to the acquisition of CNL. The decrease in short-term notes payable and the increase in long-term notes payable resulted from the conversion of the Company's line of credit agreement at December 31, 1994 to a term loan during the first quarter of 1995. General expenses and other liabilities, and amounts due to reinsurers increased due primarily to the acquisition of CNL. The remaining balance sheet amounts remained relatively consistent with the amounts at December 31, 1994.
DEFERRED POLICY ACQUISITION COSTS
Under generally accepted accounting principles, a DAC asset is established to match properly the costs of writing new business against the expected future revenues or gross profits from the policies. The costs which are capitalized and amortized consist of first-year commissions in excess of renewal commissions and certain home office expenses related to selling, policy issue, and underwriting.
The deferred acquisition costs for accident and health policies and traditional life policies are amortized over future premium revenues of the business to which the costs are related. The rate of amortization depends on the expected pattern of future premium revenues for the block of policies. The scheduled amortization for a block of policies is established when the policies are issued. However, the actual amortization of DAC will reflect the actual persistency and profitability of the business. For example, if actual policy terminations are higher than expected or if future losses are anticipated, DAC could be amortized more rapidly than originally scheduled or written-off, which would reduce earnings in the applicable period.
EFFECT OF INFLATION
In pricing its insurance products, the Company gives effect to anticipated levels of inflation; however, the Company believes that the high rate of medical cost inflation during recent years has had an adverse impact on its major hospital accident and health claims experience. The Company continues to implement rate increases, as permitted by state regulations, in response to this experience.
LIQUIDITY AND CAPITAL RESOURCES
The Company's consolidated liquidity requirements are created and met primarily by operations of its subsidiaries. The insurance subsidiaries' primary sources of cash are premiums, investment income, and investment sales and maturities. The insurance subsidiaries' primary uses of cash are operating costs, policy acquisition costs, payments to policyholders and investment purchases. In addition, liquidity requirements of the holding company are created by dividends, interest payments on the 6.5% Notes and other debt service requirements.
The ability of the insurance subsidiaries to pay dividends and make other payments to the Company is subject to state insurance department regulations which generally permit dividends and other payments to be paid for any twelve month period in amounts equal to the greater of (i) net gain from operations in the case of a life insurance company or net income in the case of all other insurance companies for the preceding calendar year or (ii) 10% of surplus as of the preceding December 31st. Any dividends in excess of these levels require the prior approval of the Director or Commissioner of the applicable state insurance department. The amount of dividends that the Company's insurance subsidiaries could pay in 1997 without prior approval is approximately $5.6 million. These liquidity requirements of the holding company have historically been met through dividends from the non-insurance subsidiaries which receive payments primarily from fees charged for administrative and marketing services provided to the Company's insurance subsidiaries and other unaffiliated companies. Dividends from the insurance subsidiaries could be required in the future to meet such liquidity requirements.
Notwithstanding the foregoing, if insurance regulators otherwise determine that payment of a dividend or any other payment to an affiliate would be detrimental to an insurance subsidiary's policyholders or creditors because of the financial condition of the insurance subsidiary or otherwise, the regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval.
The Company's insurance subsidiaries require capital to fund acquisition costs incurred in the initial year of policy issuance and to maintain adequate surplus levels for regulatory purposes. These capital requirements have been met principally from internally generated funds, including premiums and investment income, and capital contributions from the holding company.
The Company has offered commission advances to certain of its agents and marketing organizations which consist primarily of annualization of first year commissions. This means that when the first year premium is paid in installments, the Company will advance a percentage of the commissions that the agent would otherwise receive over the course of the first policy year. The Company, through a subsidiary, has entered into agreements with an unaffiliated corporation to provide financing for a portion of its agent commission advance program through the sale of agent receivables. Proceeds from such sales for 1996 and 1995 were $26.2 million and $20.9 million, respectively. The termination date of the current program is December 31, 1997, subject to extension or termination as provided therein. The Company has retained approximately $14.2 million of agent advances at December 31, 1996.
In July 1993 the Company issued $57.5 million of its 8% Debentures. Net proceeds from the offering totaled approximately $54.0 million. The 8% Debentures were convertible into the Company's Common Stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.75 per share. In August 1995, the Company accepted the conversion of $46.9 million of the outstanding 8% Debentures. The effect of the conversion was an increase in stockholders' equity of $45.3 million and a charge to income of $3.5 million, net of taxes, for payments to converting bondholders and other expenses relating to the conversion. In August 1996, the Company completed the redemption of the remaining outstanding debentures. The effect of the conversion was an increase in stockholders' equity of $9.0 million.
In January 1995, an insurance subsidiary of the Company issued a note in the amount of $1.7 million as a portion of the acquisition price of CNL. The principal balance of the note may be reduced by the amount of capital losses incurred by the Company on mortgage loan and real estate holdings of CNL through January 31, 1997. During 1996, a net capital loss reduced the principal balance to $1.0 million. Interest is payable on the note at the average earnings rate of these investments, currently 8.7%. The note matures in November 1997.
In September 1995, a non-insurance subsidiary of the Company borrowed $3.3 million from a finance company to finance the purchase of certain equipment. The note, which is secured by the equipment purchased, bears interest at a fixed rate of 7.81% and has principal and interest payments of $40,000 payable monthly through August 2005.
In March 1996, the Company issued $86.25 million of its 6 1/2% Notes. Net proceeds from the offering totaled $83.0 million. The notes are convertible into the Company's Common Stock at any time prior to maturity, unless previously redeemed, at a conversion price of $20 per share.
In August 1996, the Company borrowed $25.0 million under a term loan agreement with six banks to fund the acquisition of the WNIC block of business and to repay the notes issued as a portion of the acquisition price of UFLIC. Interest is payable quarterly and is based upon either a corporate base rate, LIBOR, or a prime rate plus a margin. The loan bore interest at 6.875% per annum at March 1, 1997, and requires principal payments of $1.25 million per quarter with a final payment on July 31, 2001.
The Company has a line of credit arrangement for short-term borrowings with six banks amounting to $30.0 million through July 1999, all of which was unused at December 31, 1996 (the "Credit Facility"). Amounts borrowed under the Credit Facility accrue interest at a rate per annum based upon either a corporate base rate, LIBOR, or a prime rate plus a margin. The line of credit arrangement can be terminated, in accordance with the agreement, at the Company's option.
The Company's debt agreements include provisions requiring maintenance of minimum working capital and risk based capital and limiting the Company's ability to incur additional indebtedness. The Company's debt agreements also restrict the amount of retained earnings which is available for dividends and require the maintenance of certain minimum insurance company ratings at the Company's subsidiaries.
In March, June, September and December 1996, the Company's Board of Directors announced a quarterly Common Stock dividend of $.055 per share, for a total of 22 cents per share in 1996.
In March 1997 the Board of Directors announced a quarterly stock dividend of $.055 per share to be paid in April, 1997.
Management believes that the diversity of the Company's investment portfolio and the liquidity attributable to the large concentration of investments in highly liquid United States government agency securities provide sufficient liquidity to meet foreseeable cash requirements. See "Business- Investments." Because the Company's insurance subsidiaries experience strong positive cash flows, including monthly cash flows from mortgage-backed securities, the Company does not expect its insurance subsidiaries to be forced to sell the held-to-maturity investments prior to their maturities and realize material losses or gains. Although the Company has the ability and intent to hold those securities to maturity, there could occur infrequent and unusual conditions under which it would sell certain of these securities. Those conditions would include a significant deterioration of the issuer's creditworthiness, significant changes in tax law affecting the taxation of securities, a significant business acquisition or disposition, and changes in regulatory capital requirements or permissible investments.
Life insurance and annuity liabilities are generally long-term in nature although subject to earlier surrender as a result of the policyholder's ability to withdraw funds or surrender the policy, subject to surrender and withdrawal penalties. The Company believes its policyholder liabilities should be backed by an investment portfolio that generates predictable investment returns. The Company seeks to limit exposure to risks associated with interest rate fluctuations by concentrating its invested assets principally in high quality, readily marketable debt securities of intermediate duration and by attempting to balance the duration of its invested assets with the estimated duration of benefit payments arising from contract liabilities.
Since investment income is an important component of revenue and profitability for the Company; significant focus is placed on the analysis of both asset and liability characteristics in the investment process. Profitability is impacted by spreads between yields earned on investments and rates credited on annuities, interest sensitive and life insurance liabilities. Although substantially all credited rates on these liabilities can be changed annually, changes in interest rates credited may not be sufficient to maintain targeted investment spreads in all economic and market environments. In addition, other factors including competition, the impact of the level of surrenders and withdrawals may limit the Company's ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions.
The Company, in recognizing this importance of interest rate management, seeks to balance the duration of its invested assets with the expected duration of benefit payments arising from insurance liabilities. At December 31, 1996, the duration of the Company's fixed maturity portfolio is 4.5 years and the duration of the Company's insurance liabilities is 4.1 years. The Company meets at least monthly to review the asset and liability position in order to make necessary adjustments including adjustments to investment activity or crediting rates or both.
The majority of the Company's fixed maturity investments are classified as "available-for-sale" for purposes of SFAS 115. Impact on the market valuation of securities classified in such a manner is reflected through an adjustment to surplus, but not through income. Since the asset valuations are adjusted in such a manner, while accounting standards do not allow such an adjustment for the Company's insurance liabilities; a subsequent significant move in interest rates could result in a positive or negative impact on the Company's shareholders' equity.
RECENTLY ISSUED ACCOUNTING STANDARDS
For a discussion of a new accounting standard relating to transfers and servicing of financial assets and extinguishments of liabilities and a new stock-based employee compensation accounting standard and the impact of these standards on the financial statements of the Company, see Note 2 of Notes to Consolidated Financial Statements.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Consolidated Financial Statements are included in Part IV, Item 14 of this report.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
For information on directors and executive officers of the registrant, reference is made to the item entitled "Directors and Executive Officers" in Part I of this report.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Directors and officers of the Company file periodic reports regarding ownership of Company securities with the Securities and Exchange Commission pursuant to section 16(a) of the Securities Exchange Act of 1934, as amended, and the rules promulgated thereunder. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required during the fiscal year ended December 31, 1996, all of its officers, directors and greater than ten percent beneficial owners complied with all filing requirements applicable to them expect that Messrs. Cavataio and Klaeser were each late in filing a Form 4, each reporting one transaction, and Mr. John Gardiner was late in filing his initial Form 3.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
The table below sets forth certain information concerning compensation received for services in all capacities to the Company or its subsidiaries for the fiscal years ended December 31, 1996, 1995 and 1994, of those persons (the "Named Officers"), who were, at December 31, 1996 (i) the chief executive officer, and (ii) the other four most highly compensated executive officers of the Company.
The following tables summarize option grants during the fiscal year ended December 31, 1996, to the Named Officers and the value of the options held by such persons at the end of such fiscal year. Other than Mr. Nauert, none of the Named Officers exercised any stock options during the fiscal year ended December 31, 1996. The Company does not maintain any pension plans or any supplementary pension award plans.
AGGREGATE OPTION EXERCISES IN 1996 AND OPTION VALUES AT DECEMBER 31, 1996
DIRECTORS' COMPENSATION
Directors of the Company currently receive fees of $25,000 per year. Directors who are chairmen of the Company's Executive, Investment, Audit and Compensation Committees receive additional fees of $25,000 per year; provided, however, that no employee-director is entitled to receive directors fees of more than $25,000 in any one year and no nonemployee director is entitled to receive directors fees of more than $50,000 in any one year. All directors are reimbursed for travel expenses. In addition, each Director, upon his initial election as a director, receives options to purchase 25,000 shares of the Company's Common Stock at an exercise price equal to fair market value on the date of grant. Further, each member of the Option Committee, upon his initial election as a member, receives options to purchase 8,000 of the Company's Common Stock at an exercise price equal to fair market value on the date of grant.
The Company has adopted a compensation deferral plan (the "Deferral Plan") for members of the Board of Directors. The Deferral Plan was established in order to encourage the attraction and retention of qualified Directors by allowing Directors to irrevocably elect deferral of payment of a certain portion of the compensation they receive as Directors and thereby defer taxes. The Deferral Plan provides benefits at retirement, disability or death for Directors who elect to defer payments under the Deferral Plan. The Deferral Plan permits Directors to elect investment options at the same time deferrals are elected. Under the Deferral Plan, the Company makes an unsecured promise to pay deferred amounts together with investment gains and losses, at a future time. The deferred amounts are not funded as with a pension or profit sharing plan. However, under the Deferral Plan a trust has been established with respect to the amounts allocated to the Deferral Plan.
EMPLOYMENT AND OTHER AGREEMENTS
Effective September 1, 1995, Mr. Nauert entered into an employment agreement with the Company (the "Current Agreement") which superseded the then existing employment agreements between Mr. Nauert and the Company and two of its subsidiaries (the "Prior Agreements") except for the loan provisions described below.
The Current Agreement provides for a three year term, commencing September 1, 1995, which continues indefinitely until terminated by the Board of Directors upon three years notice. Under the Current Agreement Mr. Nauert is entitled to a minimum annual base salary of $1,000,000, which amount is equal to the aggregate minimum annual salaries which he was entitled to receive under the Prior Agreements and which can be increased at the discretion of the Board of Directors, and an annual bonus determined by the Compensation Committee, based upon the Company's achieving performance standards established by the Committee.
In addition, under the Current Agreement, Mr. Nauert was granted options to purchase an aggregate of 500,000 shares of the Company's Common Stock, exercisable as follows: 100,000 on or after the date of the execution and delivery of the Current Agreement at $15.25 per share; 100,000 on or after September 1, 1996 at $16.75 per share; 100,000 on or after September 1, 1997 at $18.50 per share; 100,000 on or after September 1, 1998 at $20.25 per share; and 100,000 on or after September 1, 1999 at $22.25 per share; provided, however, that none of such options are exercisable within six months of the date of grant and are exercisable only if Mr. Nauert is employed by the Company or one of its subsidiaries at the time they can first be exercised.
The Current Agreement is terminable by the Company with or without cause. In the event of termination with cause, the Current Agreement provides that Mr. Nauert will receive his then current compensation through the date of termination. In the event of the termination by the Company without cause or termination by Mr. Nauert for good reason, Mr. Nauert, in lieu of the compensation that would have been paid to him during the balance of the three- year term, will receive the present value, discounted at an annual rate of 8%, of the salary which would have been payable during a period equal to the remainder of the term of the agreement, commencing on the date of termination at the rate of annual base salary payable to Mr. Nauert at the date of termination. In the event Mr. Nauert's employment is terminated by the Company without cause or by Mr. Nauert for good reason within 180 days following a change of control of the Company, and in lieu of the termination payments described above, the Company would pay Mr. Nauert an amount equal to three times the average income reflected on the W-2 form or forms issued to Mr. Nauert by the Company or its subsidiaries for services performed for them for the five calendar years preceding the year in which such change of control occurs.
Pursuant to the Current Agreement, Mr. Nauert has agreed not to compete with the Company for a period of twelve months after the termination of his employment unless he is terminated without cause or there has been a change in control of the Company prior to such termination. Mr. Nauert has also agreed that during the term of his employment he will retain, directly or indirectly, ownership of not less than one million shares of Common Stock. In addition, Mr. Nauert has agreed that until his employment is terminated and so long as the market price of the Common Stock of the Company is less than $12 per share, he will not sell or transfer his shares of Common Stock (other than transfers to family members) without first offering such shares to the Company.
Prior to September 1, 1995, Mr. Nauert served as Chairman and Chief Executive Officer of the Company and as President and Chief Executive Officer of two of its subsidiaries under employment agreements which, unless earlier terminated by either the Company or Mr. Nauert, would have been automatically renewed on December 31, 1996 and every three years thereafter.
Pursuant to the Prior Agreement with the Company, the Company extended to Mr. Nauert a three year term loan in the amount of $1,300,000 which accrues interest at an annual rate of 3.71%. Up to 50% of the principal amount of this loan may be forgiven if the following goals are achieved. If the Company had aggregate fully diluted net income per common share of $4.50 during the period from January 1, 1994 to December 31, 1996, then $325,000 in principal amount of the loan was to be forgiven. If, during this same period, the Company has aggregate fully diluted net income per common share in excess of $4.50, then, in addition to the $325,000 previously forgiven, an amount of the loan equal to the amount by which net income per common share exceeds $4.50, divided by $3.00 and multiplied by $975,000 was to be forgiven, provided that in no event shall more than $650,000 of the loan be forgiven. Pursuant to such Prior Agreement, $650,000 of the loan has been forgiven. The remaining balance of such loan continues in effect under the Current Agreement.
Effective September 1, 1995, the Company entered into three-year employment agreements with Messrs. Brophy and Scheper which provide for minimum annual base salaries of $300,000, which amounts can be increased at the discretion of the Board of Directors of the Company, and such annual bonuses as may be determined by the Compensation Committee based upon the achievement of such Company-wide performance based standards as may be established by the Committee. The employment agreements are terminable by the Company with or without cause. In the event of termination with cause, the agreements provide for the payment of the employee's then current base salary through the date of termination. In the event of termination by the Company without cause or termination by the employee for good reason, the employee would be entitled to receive an amount equal to the present value, discounted at an annual rate of 8%, of an amount equal to the lesser of (x) the salary which would have been payable during a period equal to the remainder of the term of the agreement, commencing on the date of termination at the rate of annual base salary payable to the employee at the date of termination, or (y) two times the employee's then current annual base salary. The agreements also provide for the payment, under certain circumstances, of certain health insurance benefits until the employee reaches the age of 65 in the event that the agreement is not terminated by the Company for cause or by the employee without good reason.
In addition, the agreements provide for the grant to each employee, on terms substantially similar to those in Mr. Nauert's Current Agreement and subject to stockholder approval of the amendment to the Company's 1994 Stock Incentive Program referred to below, of options to purchase an aggregate of 75,000 shares of the Company's Common Stock, exercisable as follows: 25,000 on or after the date of the execution and delivery of the agreement at $15.25 per share; 25,000 on or after September 1, 1996 at $16.75 per share; and 25,000 on or after September 1, 1997 at $18.50 per share.
Upon consummation of the acquisition of the Company by Conseco, Inc., as contemplated in the Agreement and Plan of Merger dated as of December 15, 1996 by and among the Company, Conseco, Inc. and Rock Acquisition Company, Mr. Nauert's Current Agreement will terminate, he will be entitled to receive $4.5 million and he will enter into an employment agreement with Conseco and Messrs. Scheper's and Brophy's employment agreements will terminate and each will be entitled to receive amounts equal to the present value, discounted at an annual rate of 8%, of an amount equal to the salary which would have been payable to such officer during the period from the effective time of the merger through August 31, 1998 based on rates of annual base salary payable to Messrs. Scheper and Brophy of $425,000 and $325,000, respectively.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During 1996, the Messrs. Bastian, Gardiner, Keefe and Klaeser served as members of the Company's Compensation Committee. None of the Compensation Committee members is, or formerly was, an officer or employee of the Company or any of its subsidiaries. Pursuant to a reinsurance agreement effective December 3, 1994, an insurance subsidiary of the Company reinsures a percentage of the business written by Philadelphia Life and sold by a marketing subsidiary of the Company. As of December 3,1 996, the face amount reinsured under the agreement by the Company's insurance subsidiary was $261.1 million. Mr. Gardiner served as a director and executive officer of Philadelphia Life until May 1995.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth, as of March 21, 1997 (unless otherwise indicated), the number and percentage of outstanding shares of any class of voting securities of the Company beneficially owned by each Company director, named executive officer and all executive officers and directors as a group, and by all persons known by the Company to own more than five percent of any class of voting securities of the Company as of such date.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In 1996, Mr. Cavataio, a director of the Company, was engaged by the Company as an investment advisor to assist in the management of the Company's investment portfolio. Pursuant to this arrangement, Mr. Cavataio received compensation of $100,000 in 1996.
Commencing July 1, 1995, Mr. Van Vleet, a director of the Company, was engaged by the Company as a consultant for a two-year term pursuant to an arrangement under which Mr. Van Vleet is to receive aggregate compensation (including directors fees) of $100,000 per year.
Prior to his employment with the Company in May 1996, Mr. Hill, an executive officer of the Company, was engaged by the Company as a legal consultant. Pursuant to this arrangement, Mr. Hill received consulting fees of $150,000 in 1996. Mr. Hill is also a partner in a law firm which rendered legal services to the Company and its subsidiaries for which the firm was paid $114,815.76 in 1996.
In 1996, Mr. Hulbert, a director of the Company, was engaged by the Company as a consultant to assist in insurance related matters. Pursuant to this arrangement, Mr. Hulbert received compensation of $9,000 in 1996.
On December 31, 1996, CPM Investors L.L.C. ("CPM"), an Illinois limited liability company, purchased certain real estate related invested assets from Pioneer Life Insurance Company ("PLI"), a subsidiary of the Company, at PLI's best estimate of fair market value. Mr. Cavataio, a director of the Company, and certain officers of the Company are partners in CPM. The assets were purchased for a total purchase price of approximately $3.4 million.
Pursuant to a reinsurance agreement, effective December 31, 1994, an insurance subsidiary of the Company reinsures a percentage of the business written by Philadelphia Life and sold by a marketing subsidiary of the Company. As of December 31, 1996, the face amount reinsured under the agreement by the Company's insurance subsidiary was $261.1 million. Mr. Gardiner, a director of the Company, served as a director and executive officer of Philadelphia Life until May, 1995.
Any future transactions between the Company and its officers, directors, principal stockholders or affiliates of any of them will be on negotiated terms no less favorable to the Company than could be obtained from unaffiliated parties.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as a part of this report:
PIONEER FINANCIAL SERVICES, INC.
1. Financial Statements
Report of Independent Auditors . . . . . . . . . . . . . . . . . . Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . Statements of Consolidated Income . . . . . . . . . . . . . . Consolidated Balance Sheets . . . . . . . . . . . . . . . . . Statements of Consolidated Stockholders' Equity . . . . . . . Statements of Consolidated Cash Flows . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . .
2. Financial Statement Schedules
Schedule I - Consolidated Summary of Investments - Other Than Investments in Related Parties . . . . . . . . . . . .
Schedule II - Condensed Financial Information of Registrant - Condensed Balance Sheets . . . . . . . . . . . . . .
Schedule II - Condensed Financial Information of Registrant - Condensed Statements of Income . . . . . . . . . . .
Schedule II - Condensed Financial Information of Registrant - Condensed Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . .
Schedule II - Note to Condensed Financial Statements . . . . . . Schedule III - Supplementary Insurance Information . . . . . . . Schedule IV - Reinsurance . . . . . . . . . . . . . . . . . . . .
Schedule V - Valuation and Qualifying Accounts . . . . . . . . .
All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the financial statements or notes thereto.
3. Exhibits
See Exhibit Index below.
(b) Reports on Form 8-K
The Company filed a Form 8-K dated December 15, 1996 (regarding the proposed merger with Conseco, Inc.).
(c) Index to Exhibits
Exhibit Sequentially Number Description of Document Numbered Page
2 Agreement and Plan of Merger dated as of December 15, 1996 by and among the Company, Conseco, Inc. and Rock Acquisition Company (filed as Exhibit 2.9 to the Company's Form 8-K dated December 15, 1996 and incorporated herein by reference)
3 (a) Certificate of Incorporation of the Company (filed as Exhibit 3(a) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference)
3 (b) Amended Bylaws of the Company (filed as Exhibit 3(b) to Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference)
4 (a) Certificate of Designations with respect to the Company's $2.125 Cumulative Convertible Exchangeable Preferred Stock ("Preferred Stock") (filed as Exhibit 4(a) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference)
4 (b) Rights Agreement dated as of December 12, 1990 between the Company and First Chicago Trust Company of New York as Rights Agent (including exhibits thereto) (filed as Exhibit 1 to the Company's registration statement on Form 8-A dated December 14, 1990 and incorporated herein by reference)
4 (c) Amendment to Rights Agreement dated as of December 13, 1996 between the Company and First Chicago Trust Company of New York as Rights Agent (filed as Exhibit 1 to the Company's Amendment No. 1 to Form 8-A dated January 27, 1997 and incorporated herein by reference).
10 (a) Form of contract with independent agents (filed as Exhibit 10(f) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference)
*10 (b) Nonqualified Stock Option Plan (filed as Exhibit 10(g) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference)
*10 (c) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(d) to the Company's Registration Statement on Form S-8 [No. 33-26455] and incorporated herein by reference)
*10 (d) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(c) to the Company's Registration Statement on Form S-1 [No. 33-17011] and incorporated herein by reference)
*10 (e) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(e) to the Company's registration statement on Form S-8 [No. 33-37305] and incorporated herein by reference)
*10 (f) Employment Agreement dated September 1, 1995 by and between the Company and Peter W. Nauert (filed as Exhibit 10(f) to the Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (g) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and Pioneer Life Insurance Company of Illinois (filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (h) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and National Group Life (filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
*10 (i) Employment Agreement dated September 1, 1995 by and between the Company and Thomas J. Brophy (filed as Exhibit 10(i) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference0
*10 (j) Employment Agreement dated September 1, 1995 by and between the Company and Charles R. Scheper (filed as Exhibit 10(j) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (k) Stock Purchase Agreement dated November 21, 1994 among the Company, United Life Holdings, Inc. and GRENEL Financial Corporation (filed as Exhibit 2(a) to the Company's Current Report on Form 8-K, dated January 31, 1995 and incorporated herein by reference)
10 (l) Third Amended and Restated Receivables Purchase Agreement dated as of November 1, 1995 by and between Design Benefit Plans, Inc. (formerly National Group Marketing Corporation) and National Funding Corporation (filed as Exhibit 10(m) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (m) First Amendment to Third Amended and Restated Receivables Purchase Agreement dated as of April 15, 1996 (filed herewith
10 (n) Second Amendment to Third Amended and Restated Receivables Purchase Agreement dated as of August 1, 1996 (filed herewith)
10 (o) Consent and Agreement dated as of October 1, 1994 among Design Benefit Plans, Inc., Pioneer Financial Services, Inc., American National Bank and Trust Company of Chicago, and National Funding Corporation (filed as exhibit 10(q) to the Company's Annual Report on Form 10-K [No. 1-10522] and incorporated herein by reference.
10 (p) Pioneer Financial Services, Inc. Employee Stock Purchase Plan (filed as Exhibit 10(o) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (q) Pioneer Financial Services, Inc. Directors Compensation Deferral Plan (filed as Exhibit 10(p) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (r) Pioneer Financial Services, Inc. Executive Deferred Compensation Program (filed as Exhibit 10(t) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference)
10 (s) Credit Agreement among Pioneer Financial Services, Inc and the First National Bank of Chicago dated July 30, 1996 (filed as Exhibit 10 to the Company's Form 10-Q for the quarterly period ended June 30, 1996 and incorporated herein by reference)
10 (t) First Amendment to Credit Agreement among Pioneer Financial Services, Inc. and the First National Bank of Chicago dated January 23, 1997 (filed herewith)
10 (u) Second Amendment to Credit Agreement among Pioneer Financial Services, Inc. and the First National Bank of Chicago dated March 21, 1997 (filed herewith)
*10 (v) Agreement dated December 26, 1995 between Pioneer Financial Services, Inc. and Billy B. Hill, Jr. (filed herewith)
*10 (w) Description of consulting agreement between Pioneer Financial Services, Inc. and Michael A. Cavataio (filed herewith)
*10 (x) Description of consulting agreement between Pioneer Financial Services, Inc. and William Van Vleet (filed herewith)
*10 (y) Consulting agreement dated September 24, 1996 between Pioneer Financial Services, Inc. and Carl Hulbert (filed herewith)
11 Statement of Computation of per share net income (filed herewith)
21 List of subsidiaries (filed herewith)
23 Consent of Ernst & Young LLP (filed herewith)
27 Financial Data Schedule (filed herewith)
* Indicates management employment contracts or compensatory plans or arrangements.
Report of Independent Auditors
Board of Directors Pioneer Financial Services, Inc.
We have audited the accompanying consolidated balance sheets of Pioneer Financial Services, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related statements of consolidated income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pioneer Financial Services, Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 3 to the consolidated financial statements, in 1994, the Company changed its method of accounting for investments in debt and equity securities.
ERNST & YOUNG LLP Chicago, Illinois March 21, 1997
Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Income (In Thousands, Except Per Share Amounts)
Pioneer Financial Services, Inc. and Subsidiaries Consolidated Balance Sheets (In Thousands, Except Share and Per Share Amounts)
Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Stockholders' Equity (In Thousands, Except Share and Per Share Amounts)
Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Cash Flows (In Thousands)
Pioneer Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
1. NATURE OF OPERATIONS
Pioneer Financial Services, Inc. (PFS) through its subsidiaries markets and underwrites life insurance, annuities, and health insurance in selected niche markets throughout the United States. PFS bases its operations on three core businesses: Life Insurance, Senior Health, and Group Medical.
Life Insurance products include traditional life (term and whole life), universal life, and interest sensitive life insurance and annuities sold primarily to the middle income market. Senior health products include Medicare supplement, long-term care, home health care and specialty health for individuals age sixty-five and older. Group medical business consists of small group and individual hospital and medical policies marketed primarily to self- employed individuals and small business owners. Approximately 40% of PFS' premiums are written in six states.
2. ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) and include the accounts and operations, after intercompany eliminations, of PFS and its subsidiaries.
USE OF ESTIMATES
The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates, and such differences may be material to the financial statements.
INVESTMENTS
Investments in fixed maturities include bonds and mortgage-backed securities with contractual maturities greater than one year. Fixed maturities classified as "available for sale" are carried at fair value and fixed maturities classified as "held to maturity" are carried amortized cost.
Although PFS has the ability and intent to hold held-to-maturity securities to maturity, there could occur infrequent and unusual conditions under which it would sell certain of those securities. Those conditions would include unforeseen changes in asset quality, significant changes in tax law affecting the taxation of securities, a significant business acquisition or disposition, and changes in regulatory capital requirements or permissable investments.
Changes in fair values of available-for-sale securities, after adjustment of deferred policy acquisition costs ("DAC"), if any, and deferred income taxes, are reported as unrealized appreciation or depreciation directly in stockholders' equity and, accordingly, have no effect on net income. DAC offsets to the unrealized appreciation or depreciation represent valuation adjustments or reinstatements of DAC that would have been required as a charge or credit to operations had such unrealized amounts been realized.
The amortized cost of fixed maturity investments classified as available-for- sale and as held-to-maturity is adjusted for amortization of premiums and accretion of discounts. That amortization or accretion is included in net investment income.
For the mortgage-backed portion of the fixed maturity securities portfolio, PFS recognizes income using a constant effective yield based on anticipated prepayments and the estimated economic life of the securities. When actual prepayments differ significantly from anticipated prepayments, the effective yield is recalculated to reflect actual payments to date and anticipated future payments. The net investment in the security is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the security. That adjustment is included in net investment income.
In December 1995, as a result of guidance issued by the Financial Accounting Standards Board ("FASB"), PFS transferred held-to-maturity fixed maturities with an amortized cost of $222,482,000 to available-for-sale, and also transferred $110,152,000 of available-for-sale fixed maturities to held-to-maturity. These transfers resulted in a $8,290,000 decrease to unrealized appreciation of securities.
For equity securities, changes in unrealized appreciation or temporary depreciation, after deferred income tax effects, are reported directly in stockholders' equity.
Realized gains and losses on the sale of investments, and declines in value considered to be other-than-temporary, are recognized in operations on the specific identification basis.
Short term investments have maturities of three months or less and are carried at cost which approximates fair value.
Accounting policies relating to derivative financial instruments are discussed in Note 21.
REVENUES
Revenues for interest-sensitive life insurance and annuities consist of charges assessed against policy account values. Premiums for traditional life insurance products are recognized as revenue when due. Accident and health insurance premiums for long duration policies are earned when due and for short-duration policies are earned on a pro-rata basis over the policy term. Accident and health group association dues and fees, included in other revenues, are recognized as revenue when received.
FUTURE POLICY BENEFITS
The liabilities for future policy benefits related to the annuity and interest- sensitive life insurance policies are calculated based on accumulated fund values. As of December 31, 1996, interest credited during the contract accumulation period ranged from 2.5% to 11.50%. Investment spreads and mortality gains are recognized as profits when realized, based on the difference between actual experience and amounts credited or charged to policies.
The liabilities for future policy benefits on other life insurance and accident and health insurance policies have been computed by a net level method based on estimated future investment yield, mortality or morbidity, and withdrawals, including provisions for adverse deviation. Interest rate assumptions range from 2.5% to 6.75% depending on the year of issue. The provisions for future policy benefits and the deferral and amortization of policy acquisition costs are intended to result in benefits and expenses being associated with premiums proportionately over the policy periods.
UNEARNED PREMIUMS
Unearned premiums are calculated using the monthly pro-rata basis.
DEFERRED POLICY ACQUISITION COSTS
Costs that vary with, and are primarily related to, the production of new business are deferred. Such costs are primarily related to accident and health business and principally include the excess of new business commissions over renewal commissions and underwriting and sales expenses.
For annuities and interest-sensitive life insurance policies, deferred costs are amortized generally in proportion to expected gross profits arising from the difference between investment and mortality experience and amounts credited or charged to policies. That amortization is adjusted when estimates of current or future gross profits (including the impact of realized investment gains and losses) to be realized from a group of products are revised. For other life and accident and health policies, costs are amortized over the premium-paying period of the policies, using the same mortality or morbidity, interest, and withdrawal assumptions that are used in calculating the liabilities for future policy benefits.
VALUE OF PURCHASED INSURANCE IN FORCE
Amortization of the value of purchased insurance in force is in relation to the present value of estimated gross profits over the estimated remaining life of the related insurance in force. Interest is credited to the unamortized balance based on interest rates ranging between 3.9% to 7.0%.
The changes in the unamortized value of purchased insurance in force for the years ended December 31 are as follows:
The estimated percentage of the December 31, 1996 balance to be amortized over the next five years is as follows:
1997 1998 1999 2000 2001
Percent 13.98% 16.93% 15.05% 13.87% 12.51% Amortization
POLICY AND CONTRACT CLAIMS
The liabilities for policy and contract claims, principally accident and health, are determined using case-basis evaluations and statistical analyses based on past experience and represent estimates of the ultimate net cost of incurred claims and the related claim adjustment expenses. Although considerable variability is inherent in such estimates, management believes that these liabilities are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations.
PFS maintains an additional provision for adverse deviation in its accident and health claim liability estimates.
REINSURANCE
Reinsurance premiums, commissions, expense reimbursements, and receivables related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums reinsured to other companies have been reported as reductions of premium revenues. Amounts recoverable for reinsurance related to future policy benefits, unearned premium reserves, and claim liabilities have been reported as reinsurance receivables; expense allowances received in connection with reinsurance have been accounted for as a reduction of the related DAC and are deferred and amortized accordingly.
FEDERAL INCOME TAXES
Federal income tax provisions are based on income or loss reported for financial statement purposes and tax laws and rates in effect for the years presented. Deferred income taxes have been provided for the effects of temporary differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates. A valuation allowance for deferred tax assets is provided where it is more likely than not that a portion of the asset will not be realized.
DEPRECIATION
Building, equipment and investment real estate are recorded at cost and are depreciated using principally the straight-line method. Capitalized internal- use computer software costs are amortized over the estimated useful lives of the software, principally three years.
NET INCOME PER COMMON SHARE
Primary net income per share of Common Stock is determined by dividing net income, less dividends on Preferred Stock, by the weighted-average number of Common Stock and Common Stock equivalents (dilutive stock options) outstanding. Where the effect of Common Stock equivalents on net income per share would be antidilutive, they are excluded from the average shares outstanding. Fully diluted net income per share is computed as if the Preferred Stock, Convertible Subordinated Debentures and Convertible Subordinated Notes had been converted to Common Stock.
COST IN EXCESS OF NET ASSETS OF COMPANIES ACQUIRED
The cost in excess of net assets of companies acquired (goodwill) ($5,796,000 and $5,017,000 at December 31, 1996 and 1995, respectively) is included in other assets and is being amortized principally on a straight-line basis over periods from five to forty years. Goodwill is periodically evaluated for impairment based principally on projected undiscounted net cash flows of the acquired companies.
TREASURY STOCK
The board of directors has authorized PFS to buy back shares of its own common and preferred stock on the open market from time to time. During 1996 PFS did not repurchase shares of its common stock or preferred stock. During 1995 and 1994 PFS repurchased 53,900 and 521,600 shares, respectively, of its common stock. During 1995 and 1994 PFS repurchased 18,400 and 78,900 shares of its preferred stock. Treasury stock is accounted for using the cost method.
CASH FLOW INFORMATION
Cash includes cash on hand and demand deposits.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In 1996, PFS adopted the disclosure requirements of FASB Statement 123 which relates to accounting for stock-based compensation. As permitted, PFS elected to continue to measure compensation cost for stock-based compensation under the expense recognition provisions prescribed by Accounting Principles Board Opinion No. 25. Therefore, the adoption of Statement 123 did not have an effect on PFS' financial position or results of operations. The required pro forma and fair value disclosures are reported in Note 17.
In 1996, the FASB issued Statement 125 which provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. Statement 125 also establishes new rules for determining whether a transfer of financial assets constitutes a sale and, if so, the determination of any resulting gain or loss. The provisions of Statement 125 were to be applied to transactions occurring after December 31, 1996. However, FASB Statement 127 was issued which defers the effective date one year for those provisions of Statement 125 that deal with securities lending, repurchase and dollar repurchase agreements, and the recognition of collateral. PFS is in the process of reviewing these statements.
RECLASSIFICATIONS
Certain amounts in the 1994 and 1995 financial statements have been reclassified to conform to the 1996 presentation.
3. CHANGES IN ACCOUNTING PRINCIPLES
In 1996 PFS adopted FASB Statement 121 which relates to accounting for impairment of long-lived assets. Implementation of this statement did not have an effect on PFS' financial statements.
In 1995 PFS adopted FASB Statements 114 and 118 which relate to accounting by creditors for impairment of a loan. Implementation of these statements did not have an effect on PFS' financial statements.
Effective January 1, 1994, PFS adopted FASB Statement 115, "Accounting for Certain Investments in Debt and Equity Securities." Under Statement 115, securities are classified as available-for-sale, held-to-maturity, or trading. PFS classified a portion of its fixed maturity securities portfolio as available-for-sale with the remainder classified as held-to-maturity. As a result of the adoption, PFS' stockholders' equity was increased by $3,605,000 (net of adjustments to deferred income taxes) to reflect the net unrealized gains on fixed maturity securities classified as available-for-sale that were previously carried at amortized cost.
4. BUSINESS COMBINATIONS
On January 31, 1995, Pioneer acquired for a cost of $24,000,000 (purchase price $23,700,000 and $300,000 of additional costs), the outstanding common shares of Connecticut National Life Insurance Company (CNL).
The acquisition was accounted for by the purchase method and, accordingly, the purchase price was allocated to assets and liabilities acquired based on estimates of their fair values. The value of insurance in force represents actuarially determined present value of the projected future cash flows from the retained portion of the acquired policies. All assets and liabilities related to reinsured insurance contracts are reported on a gross basis. The liabilities for future policy benefits related to interest-sensitive life and annuity insurance policies are calculated based on accumulated fund values. As of January 1, 1995, interest credited during the contract accumulation period ranged from 5% to 6.5%. The liabilities for future policy benefits on other life and accident and health insurance policies have been computed by a net level method based on estimated future investment yield, mortality or morbidity, and withdrawals, including provisions for adverse deviation. Interest rate assumptions range from 7% to 8% depending on the year of issue.
The following unaudited pro-forma consolidated results of operations have been prepared as if the acquisition had been made as of January 1, 1994:
The foregoing pro-forma information is not necessarily indicative of either the results of operations that would have occurred had the acquisition been effective on Jauary 1, 1994, or of future results of operations of the consolidated companies.
In March 1996, PFS purchased the outstanding common shares of Universal Fidelity Life Insurance Company (UFLIC) for a cost of $26,500,000, principally cash. The acquisition was accounted for by the purchase method and, accordingly, the purchase price was allocated to assets and liabilities acquired based on estimates of their fair values. The total assets acquired at the purchase date were approximately $41,000,000. Revenues and expenses of UFLIC for the nine months after the acquisition are included in PFS' statements of consolidated income.
In August 1996, PFS acquired a block of individual and small group health insurance business from Washington National Insurance Company (WNIC) for a cost of $19,000,000 in cash. The acquisition was structured as a reinsurance transaction between WNIC and an insurance subsidiary of PFS (see Note 7). WNIC retained a portion of the assets and reserves supporting the block of business at the purchase date pursuant to the terms of the reinsurance agreement. Revenues and expenses for the five months after the transaction are included in PFS' statements of consolidated net income.
In December 1996, PFS purchased SECURA Life Insurance Company for a cost of $12,000,000, principally cash. The acquisition was accounted for by the purchase method and, accordingly, the purchase price was allocated to assets and liabilities acquired based on estimates of their fair values. The total assets acquired at the purchase date were approximately $93,000,000. The acquisition had no effect on PFS' 1996 net income or revenues.
5. INVESTMENTS
Realized investment gains (losses), including provisions for other-than- temporary impairments on investments held, and the change in unrealized appreciation (depreciation) on fixed maturities, equity securities, and other investments during the years shown are summarized as follows:
The cost of available-for-sale equity securities was $26,164,000 at December 31, 1996, and $13,333,000 at December 31, 1995. At December 31, 1996, gross unrealized appreciation on available-for-sale equity securities was $3,277,000 and gross unrealized depreciation was $811,000. At December 31, 1995, gross unrealized appreciation on equity securities was $2,781,000 and gross unrealized depreciation was $544,000.
In 1995, sales of two held-to-maturity securities with an amortized cost of $5,490,000 resulted due to a significant deterioration in creditworthiness. Sales of these securities resulted in a realized loss of $780,000.
Sales of two held-to-maturity securities in 1994 with an amortized cost of $9,803,000 resulted after discussions with an insurance rating agency regarding specific investments of PFS' insurance subsidiaries and evidence of a significant deterioration in credit worthiness. Sales of these securities resulted in a realized loss of $376,000.
A comparison of amortized cost to fair value of fixed maturity investments by category is as follows:
The carrying amount of PFS' available-for-sale fixed maturity investments can increase or decrease significantly in the near term as a result of changes in market interest rates.
Unrealized appreciation of available-for-sale securities at December 31, 1996 of $224,000 included gross appreciation of $8,241,000 less unrealized appreciation of $7,863,000 on investments in trust accounts that are guaranteed as to principal value by reinsurers and net of deferred taxes of $154,000. At December 31, 1995, the net unrealized appreciation of available-for-sale securities of $4,518,000 consisted of gross appreciation of $27,150,000 less unrealized appreciation of $17,397,000 on investments in the trust accounts guaranteed by reinsurers and net of deferred taxes and DAC adjustments of $5,235,000.
The amortized cost and fair value of fixed maturities at December 31, 1996, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties.
Proceeds from sales of investments (principally fixed maturities) during 1996, 1995, and 1994 were $167,035,000, $213,177,000 and $111,850,000, respectively. Gross gains of $1,758,000, $1,537,000 and $1,448,000 and gross losses of $1,271,000, $1,838,000 and $1,542,000 were realized on fixed maturity sales in 1996, 1995, and 1994, respectively.
Major categories of net investment income are summarized as follows:
At December 31, 1996, securities with a carrying value of $32,873,000 were on deposit with various government authorities to meet regulatory requirements, securities with a carrying value of $196,584,000 are held in trust accounts pursuant to reinsurance agreements (See Note 7), and securities with a carrying value of $5,231,000 are pledged as collateral to a repurchase agreement (See Note 10).
At December 31, 1996, the amortized cost of fixed maturity investments in any one entity, other than the U.S. government or a U.S. government agency or authority, which exceeded 10% of PFS' consolidated stockholders' equity were as follows:
GE Capital Mortgage Services, Inc. $34,123,000 GMAC 22,522,000
Investment real estate (net of accumulated depreciation of $1,957,000 in 1996 and $1,095,000 in 1995) at December 31, 1996 consists principally of land and a building used, in part, as PFS' corporate headquarters.
At December 31, 1996, PFS held unrated or less-than-investment-grade available- for-sale securities with a carrying value of $34,232,000. Those holdings amounted to less than 2.9% of PFS' total investments at December 31, 1996.
At December 31, 1996, fixed maturities with a carrying value of $6,312,000 had been non- income producing for the preceding 12-month period.
6. FEDERAL INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of PFS' deferred tax liabilities and assets are as follows:
The nature of PFS' deferred tax assets and liabilities are such that the reversal pattern for these temporary differences should generally result in realization of PFS' deferred tax assets.
PFS establishes a valuation allowance for any portion of the deferred tax asset that management believes may not be realized. In 1995 the valuation allowance increased $12,630,000 principally due to the acquisition of CNL (See Note 4). There was no change in the valuation allowance in 1996 and 1994.
PFS' effective federal income tax rate varied from the statutory federal income tax rate as follows:
Taxes paid amounted to $8,571,000, $8,257,000, and $9,731,000 for 1996, 1995, and 1994, respectively.
Under pre-1984 life insurance company income tax laws, a portion of a life insurance company's "gain from operations" was not subjected to current income taxation but was accumulated, for tax purposes, in a memorandum account designated as the "policyholders' surplus account." The balance in this account at December 31, 1996 for PFS' life insurance subsidiaries was $12,010,000. Should the policyholders' surplus accounts of PFS' life insurance subsidiaries exceed their respective maximums, or should distributions in excess of their tax-basis shareholders' surplus account be made by the life insurance subsidiaries, such excess or distribution would be subject to federal income taxes at rates then in effect. Deferred taxes of $4,200,000 have not been provided on amounts included in the policyholders' surplus accounts, since PFS contemplates no such taxable events in the foreseeable future.
As of December 31, 1996, PFS' life insurance subsidiaries had combined tax-basis shareholders' surplus accounts of $112,700,000. Distributions up to that amount would result in no income tax liability.
Certain of PFS' life insurance subsidiaries have tax basis operations loss carryforwards of $33,085,000 expiring in years 2003 through 2010.
7. REINSURANCE
PFS' insurance subsidiaries reinsure risks with other companies to permit the recovery of a portion of the direct losses. These reinsured risks are treated as though, to the extent of the reinsurance, they are risks for which the subsidiaries are not liable. PFS remains liable to the extent that the reinsuring companies do not meet their obligations under these reinsurance treaties.
PFS' premiums were reduced for reinsurance premiums ceded by $135,420,000, $66,193,000, and $37,273,000 in 1996, 1995, and 1994, respectively. Under various reinsurance arrangements, PFS' premiums were increased for reinsurance assumed by $117,925,000, $13,474,000, and $16,928,000 in 1996, 1995, and 1994, respectively. PFS' policy benefits have been reduced for reinsurance recoveries of $103,156,000 in 1996, $33,739,000 in 1995, and $23,319,000 in 1994. At December 31, 1996 approximately 28% of PFS' reinsurance receivables and amounts on deposit with reinsurers were due from Reassurance Company of Hannover, 23% from Lincoln National Life Insurance Company, and 16% from Employers Reinsurance Corporation.
In August 1996, PFS assumed the individual and small group health business of WNIC. The total premiums assumed were approximately $100,000,000 for the five months ended December 31, 1996. As of December 31, 1996 policy liabilities were increased as a result of the treaty by $66,315,000. PFS entered into a 50% quota share treaty with Reassurance Company of Hannover on the business assumed from WNIC.
Prior to the acquisition by PFS in January 1995, CNL had entered into certain reinsurance arrangements. PFS retains the assets and related policy liabilities associated with the reinsured business, but not the related risk associated with the business. In accordance with the reinsurance contracts, PFS does not participate in the realized gains and losses on the assets held in trust under these agreements. Accordingly, PFS has established an amount due to reinsurer at December 31, 1996 and 1995 and a reduction in the unrealized appreciation on available-for-sale securities for assets held in trust pursuant to these agreements.
8. SALE OF AGENT RECEIVABLES
In 1996, 1995, and 1994 a subsidiary of PFS sold agent receivables to an unaffiliated company for proceeds of $26,212,000, $20,851,000, and $24,393,000, respectively. The outstanding balances of such agent receivables sold that remained uncollected at December 31, 1996 and 1995 were $12,200,000 and $10,300,000, respectively. PFS remains subject to a maximum credit exposure under this agreement amounting to 10% of agent receivables at December 31, 1996.
9. RECONCILIATION OF LIABILITY FOR POLICY AND CONTRACT CLAIMS
The following table provides a reconciliation of the beginning and ending policy and contract claim liability balances reported in PFS' balance sheets:
Claim reserves are estimates of amounts needed to pay reported and unreported claims based on facts and circumstances known at the time the reserves are established. Reserves are based on historical claims information, industry statistics and other factors. The establishment of appropriate reserves is an inherently uncertain process, and there can be no assurance that the ultimate liability will not exceed recorded claim reserves.
PFS holds margins in its accident and health claim reserves to provide for potential adverse deviation. Claim reserve estimates are continually reviewed and adjusted as necessary
10. NOTES PAYABLE
At December 31, 1996, PFS had a loan of $23,750,000. The portion of the loan due in 1997 of $5,000,000 was included in short-term notes payable and the balance was included in long-term notes payable. The note bears interest at 7.06% and is payable quarterly with the final payment due July 2001.
At December 31, 1996, a PFS subsidiary had a secured loan totaling $3,014,000. The portion of the loan due in 1997 of $250,000 is included in short-term notes payable. The remainder of the note is included in long-term notes payable. The note bears interest at 7.8% and is payable monthly with the final payment due August 2005. PFS has guaranteed payment of the notes.
At December 31, 1995 a PFS subsidiary had a note in the amount of $1,660,000 as a portion of the acquisition price of CNL. The principal balance of the note may be reduced by the former parent of CNL for capital losses incurred on mortgage loan and real estate holdings until November 1, 1997. During 1996, a net capital loss reduced the principal balance to $998,000. Interest is payable at the average earnings rate of the investments, currently 8.7%.
The weighted average interest rate on short-term notes payable at year end was 8.7%, 8.4% and 7.7% in 1996, 1995 and 1994, respectively.
Interest paid amounted to $5,384,000, $6,629,000, and $4,950,000 for 1996, 1995, and 1994, respectively.
PFS has an outstanding repurchase agreement at an insurance subsidiary which is due October 1997. The total amount due under the repurchase agreement was $5,178,000 and $5,180,000 at December 31, 1996 and 1995, respectively. Interest at 5.95% is paid quarterly.
11. ACCIDENT AND HEALTH BUSINESS
In making the determination that policy liabilities, future premiums, and anticipated investment income will be adequate to provide for future claims and expenses (including the amortization of deferred policy acquisition costs), PFS has made assumptions with regard to each of these items. Although there is significant variability inherent in these estimates, management believes that these assumptions are reasonable.
The amortization of deferred policy acquisition costs is generally based on the expected pattern of future revenues or gross profits and on the expected persistency of the policies. PFS monitors the profitability and persistency of its policies on a monthly basis. In reviewing the recoverability of deferred policy acquisition costs related to medical insurance products, PFS has made assumptions relative to future rate increases, medical claim trends, lapse rates, expenses and investment income. Increased lapses or revised estimates of profitability anticipating future losses could result in an increase in the amortization rate or a write-off of deferred policy acquisition costs, which would adversely impact results of operations and financial condition.
Pursuant to a 1994 actuarial study, PFS revised assumptions relative to the ability to continue to receive regulatory approval for rate increases in excess of medical claim trends to maintain profitability on certain issues of group medical products. This study resulted in increased amortization of deferred policy acquisition costs in 1994 of $16,700,000. The projected premium deficiency was less than the unamortized policy acquisition costs and no additional policy liability accrual was required.
12. STATUTORY-BASIS FINANCIAL INFORMATION
The following tables compare combined net income and stockholders' equity for PFS' insurance subsidiaries determined on the basis as prescribed or permitted by regulatory authorities (statutory basis) with consolidated net income and stockholders' equity reported in accordance with GAAP. Statutory basis accounting emphasizes solvency rather than matching revenues and expenses during an accounting period. The significant differences between statutory basis accounting and GAAP are as follows:
Deferred Policy Acquisition Costs. Costs of acquiring new policies are expensed when incurred on a statutory basis rather than capitalized and amortized over the term of the related polices in the GAAP financial statements.
Policy Liabilities. Certain policy liabilities are calculated based on statutorily required methods and assumptions on a statutory basis rather than on estimated expected experience or, for annuity and interest-sensitive life insurance, actual account balances for GAAP.
12. STATUTORY-BASIS FINANCIAL INFORMATION (CONTINUED)
Financial Reinsurance. The effects of certain financial reinsurance transactions are included in the statutory basis financial statements but are eliminated from the GAAP financial statements.
Deferred Federal Income Taxes. Deferred federal income taxes are not provided on a statutory basis for differences between financial statement and tax return amounts.
Surplus Notes. Surplus notes are reported in capital and surplus on a statutory basis rather than as liabilities in the GAAP financial statements.
Non-insurance Companies' Equity. Contributions by PFS to the capital and surplus of its insurance subsidiaries increases the stockholders' equity of those insurance subsidiaries on a statutory basis but does not effect the consolidated stockholders' equity on a GAAP basis.
Unrealized Appreciation On Fixed Maturities Available-For-Sale. Fixed maturity securities classified as available-for-sale are carried principally at amortized cost on a statutory basis rather than at fair value with unrealized gains and losses on such securities reported as a separate component of stockholders' equity in the GAAP financial statements.
Dividends from PFS' insurance subsidiaries unassigned surplus are limited to the greater of the prior-year statutory-basis net gain from operations or 10% of statutory-basis surplus. The total amount of dividends that could be paid in 1997 without regulatory approval is $5,559,000. At December 31, 1996, PFS' direct insurance subsidiaries had a combined statutory basis unassigned surplus of $9,922,000.
PFS is required to maintain adequate amounts of statutory-basis capital and surplus to satisfy regulatory requirements and provide capacity for production of new business. Acquisition costs relating to the production of new business result in a reduction of statutory-basis net income and capital and surplus.
13. CONVERTIBLE SUBORDINATED DEBENTURES
In July 1993 PFS issued $57,477,000 of 8% convertible subordinated debentures due in 2000. Interest on the debentures was payable in January and July of each year. Net proceeds from the offering totaled approximately $54,000,000 and were used, in part, to repay long-term notes payable. The debentures were convertible into PFS' Common Stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.75 per share.
In August 1995, the Company accepted the conversion of $46,906,000 of the outstanding 8% convertible subordinated debentures pursuant to a special conversion offer. PFS paid a cash premium equal to $110 for each $1,000 in principal amount of the debentures accepted for conversion. The effect of the conversion was an increase in stockholders' equity of $44,754,000 and a charge to income for the cash premium of $3,457,000, net of taxes. An additional $826,000 of the debentures were converted in 1995 subsequent to the offer of premium. Had the conversions occurred at the beginning of the year, 1995 primary earnings per share would have decreased to $2.02. In August 1996, PFS completed the redemption of the remaining outstanding debentures. The effect of the conversion was an increase in stockholders' equity of $9,199,000. Had the conversion occurred at the beginning of the year, 1996 primary earnings per share would have decreased to $2.60.
14. REDEEMABLE PREFERRED STOCK
In 1989, PFS issued 1,000,000 shares of $2.125 Cumulative Convertible Exchangeable Preferred Stock. The Preferred Stock was carried on PFS' balance sheet at the redemption and liquidation value of $25 per share. Each share of Preferred Stock was convertible by the holders at any time into 1.6 shares of PFS Common Stock. Annual cumulative dividends of $2.125 per share were payable quarterly. The preferred stock was nonvoting unless dividends were in arrears.
In May 1996, PFS completed its offer to redeem the Preferred Stock. Approximately 326,000 shares of Preferred Stock were converted by shareholders into 521,000 shares of PFS' Common Stock. The cost to redeem the remaining shares of Preferred Stock was $13,600,000, which included a charge to income of $444,000. Had the redemption occurred at the beginning of the year, 1996 primary earnings per share would have decreased to $2.62.
15. CONVERTIBLE SUBORDINATED NOTES
In March 1996, PFS issued $86,250,000 of 6.5% convertible subordinated notes due in 2003. Interest on the notes is payable in April and October of each year. Net proceeds from the offering totaled $83,000,000 and were used, in part, to repay borrowings and redeem the outstanding shares of PFS' Preferred Stock (see Note 14). The notes are convertible into PFS' Common Stock at any time prior to maturity, unless previously redeemed, at a conversion price of $20 per share. The notes are redeemable by PFS under certain conditions after April 1999. At December 31, 1996, 4,312,500 shares of PFS' Common Stock were reserved for conversion of the outstanding convertible subordinated notes.
16. SHAREHOLDER RIGHTS AGREEMENT
In 1990, PFS distributed one preferred share purchase right for each outstanding share of Common Stock. The rights are intended to cause substantial dilution to a person or group that attempts to acquire PFS on terms not approved by PFS' directors. The acquisition of PFS by Conseco, Inc. as described in Note 24 will not result in the rights becoming exercisable. The rights expire in 2000 or PFS may redeem the rights prior to exercise for $.01 per right.
The rights are not exercisable unless a person or group acquires, or offers to acquire, 20% or more of PFS' Common Stock under certain circumstances. The rights, when exercisable, entitle the holder to purchase one-tenth of a share of a new series of PFS Series A Junior Preferred Stock at a purchase price of $45. Such preferred shares, of which 2,000,000 are authorized, would be voting and would be entitled to distributions that are ten times the distributions to common shareholders. Subsequent to exercise of the rights, in the event of certain business combinations involving PFS, a holder of rights would have the right to receive PFS Common Stock with a value of two times the exercise price of the rights.
17. STOCK OPTIONS AND RIGHTS
PFS has a nonqualified stock option plan and certain stock incentive programs principally for directors and key employees of PFS and its subsidiaries. PFS' Board of Directors grants the options and specifies the conditions of the options. The number of shares of common stock available for benefits under the plan is equal to 15% of the average fully diluted shares outstanding for the prior fiscal year. Options expire ten years after grant.
PFS accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and, accordingly, recognizes no compensation expense for stock options granted to employees. FASB Statement 123, "Accounting for Stock-Based Compensation", requires disclosure of pro forma information regarding net earnings and earnings per share, using pricing models to estimate the fair market value of stock option grants. Had compensation expense for PFS'
stock option plans been determined based on the estimated fair value at the date of grant consistent with the methodology prescribed under Statement 123, approximate net earnings and earnings per share would have been as follows:
For purposes of the pro forma disclosures, the estimated fair values of the option grants are amortized to expense over the options' expected lives. The fair value of options at the date of grant was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions:
The risk-free interest rate assumed was the rate at the date of grant. This rate varied from 7.01% to 5.99% in 1996 and from 7.54% to 5.95% in 1995.
The pro forma effects on income and earnings per share are not likely to be representative of the effects on reported net income in future years as 1995 and 1996 pro forma amounts do not include pro forma compensation expense related to grants made prior to 1995.
Transactions related to all stock options are as follows:
Options with respect to 1,972,000 shares were available for grant at December 31, 1996.
Information regarding options outstanding and exercisable at December 31, 1996 is summarized as follows:
The weighted average fair value per share of options granted was $7.82 and $5.96 in 1996 and 1995, respectively.
18. COMMITMENTS AND CONTINGENCIES
PFS and its subsidiaries are named as defendants in various legal actions, some claiming significant damages, arising primarily from claims under insurance policies, disputes with agents, and other matters. PFS' management and its legal counsel are of the opinion that the disposition of these actions will not have a material adverse effect on PFS' consolidated financial condition, cash flows, or results of operations.
PFS leases various office facilities furniture and equipment and computer equipment under noncancelable operating leases. Rent expense was $7,428,000, $7,140,000, and $4,530,000 in 1996, 1995, and 1994, respectively. Minimum future rental commitments in connection with noncancelable operating leases are as follows:
1997 $ 5,409,000 1998 3,913,000 1999 1,985,000 2000 744,000 2001 408,000
PFS has entered into employment agreements with certain officers.
PFS' insurance subsidiaries are subject to extensive governmental regulation and supervision at both federal and state level. Such regulation includes premium rate levels, premium rate increases, policy forms, minimum loss ratios, dividend payments, claims settlement, licensing of insurers and their agents, capital adequacy transfer of control, and amount and type of investments. Additionally, there are numerous health care reform proposals and regulatory initiatives under consideration which, if enacted, could have significant impact on PFS' revenues and results of operations.
The number of insurance companies that are under regulatory supervision has increased, which is expected to result in an increase in assessments by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated companies. Those mandatory assessments may be partially recovered through a reduction in future premium taxes in some states. For all assessment notifications received, PFS has accrued for those assessments net of estimated future premium tax reductions.
19. BENEFIT PLANS
PFS has a defined-contribution employee benefit plan that covers substantially all home office employees who have attained age 21 and completed one year of service. Plan participants may contribute from 1% to 10% of their total compensation subject to an annual maximum. The plan also provides for PFS to match participants' contributions up to 5% of the participants' salaries and 50% of the remaining contributions up to the annual Internal Revenue Service limit ($9,500 in 1996). PFS makes employer contributions to the plan in cash or in PFS Common Stock at the discretion of PFS' Board of Directors. At December 31, 1996, the Plan's assets included PFS Common Stock of $11,645,000 at fair value. PFS' contibutions charged to operations were $1,910,000 in 1996, $1,565,000 in 1995, and $1,365,000 in 1994.
A PFS subsidiary had a stock purchase plan that allowed certain eligible agents to purchase common stock in the subsidiary at the subsidiary's per share book value. The plan was terminated in November 1992, and in accordance with the plan's provisions, agents became fully vested. Eligible agents were given the option to participate in a new agent stock purchase plan which allows agents to purchase PFS Common Stock. Stock purchases are limited to a specific percentage of the agent's commission as determined by PFS but in no event to be less than 3%. Under the plan the agents are also credited with additional shares of PFS Common Stock as determined by PFS. In 1996, 1995 and 1994, 1,223 shares, 2,016 shares and 6,332 shares, respectively, of PFS Common Stock were issued under this plan.
20. ALLOWANCES AND ACCUMULATED DEPRECIATION
Allowances for doubtful accounts related to other receivables amounted to $4,294,000 at December 31, 1996, and $1,548,000 at December 31, 1995. Accumulated depreciation related to building and equipment amounted to $26,521,000 at December 31, 1996, and $23,370,000 at December 31, 1995.
21. FAIR VALUE INFORMATION
The following methods and assumptions were used by PFS in estimating its fair values for financial instruments:
Cash, short-term investments, short-term notes payable, and accrued investment income: The carrying amounts reported in the balance sheets for these instruments approximate their fair values.
Investment securities: Fair values for fixed maturity securities (including redeemable preferred stocks) are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services, or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield quality, and maturity of the investments. The fair values for equity securities are based on quoted market prices.
Mortgage loans and policy loans: The carrying amount of PFS' mortgage loans approximates their fair values. The fair values for policy loans are estimated using capitalization of earnings methods, using interest rates currently being offered for similar loans to borrowers with similar credit ratings.
Investment contracts: Fair values for PFS' liabilities under investment- type insurance contracts are based on current cash surrender values.
Fair values for PFS' insurance policies other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance policies are taken into consideration in PFS' overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance policies.
Long-term notes payable: The fair value of PFS' long-term notes payable approximates the carrying value.
Convertible subordinated debt: The fair value of PFS' convertible subordinated debt is based on quoted market prices.
The fair values of certain financial instruments along with their corresponding carrying values of December 31, 1996 and 1995 are as follows:
PFS uses interest rate derivative contracts, principally exchange-traded treasury futures, as part of its overall interest rate risk management strategy primarily for its life and annuity business. Derivative contracts are used as a hedge against the value of available-for-sale fixed maturity investments. PFS does not engage in trading derivatives. PFS performs frequent analysis to measure the degree of correlation associated with its derivative contracts to verify that the derivatives qualify for hedge accounting. Realized gains and losses on derivative hedges, which were immaterial in 1996, 1995, and 1994, are deferred and reported as an adjustment of the cost basis of the hedged investment. Deferred gains and losses are amortized into income over the life of the hedged item. PFS had no derivative contacts outstanding at December 31, 1996 and 1995.
22. SEGMENT INFORMATION
PFS has three business segments: Group Medical, Senior Health, and Life Insurance. The segments are based on PFS' main Divisions. Allocations of investment income and certain general expenses are based on various assumptions and estimates, and reported operating results by segment would change if different methods were applied. Investment income is allocated based primarily on the policy liabilities and capital supporting the segment. General expenses are determined based on cost center and functional expense anaylsis prepared in conjunction with the monthly budgeting process. Assets are not individually identifiable by segment and have been allocated based on the amount of policy liabilities by segment and by other formulas. Depreciation expense and capital expenditures are not considered material. Realized investment gains and losses are allocated to the appropriate segment. General corporate expenses are not allocated to the
individual segments. Revenues, amortization of deferred policy acquisition costs and value of purchased insurance, income or loss before income taxes, and identifiable assets by business segment are as follows:
In September 1996, PFS sold its managed care subsidiaries for proceeds of $7,800,000 including cash, notes receivable, and other consideration. Total assets of the subsidiaries at December 31, 1995 were $9,600,000. Operations of the subsidiaries for the first nine months of 1996 and for 1995 and 1994 did not have a material effect on PFS' net income. Revenues, income before income taxes, and identifiable assets of the managed care subsidiaries are included with corporate and other.
23. CREDIT ARRANGEMENTS
PFS has a line of credit arrangement for short-term borrowings with six banks amounting to $30,000,000 through July 1999, all of which was unused at December 31, 1996. The line of credit arrangement can be terminated, in accordance with the agreement, at PFS' option.
24. MERGER AGREEMENT
On December 15, 1996, PFS and Conseco, Inc. (Conseco) entered into an Agreement and Plan of Merger (the "Merger Agreement") pursuant to which PFS will become a wholly owned subsidiary of Conseco (the "Merger"). Under the Merger Agreement, each of the approximately 16.9 million shares of PFS common stock and common stock equivalents would be converted into the right to receive a fraction of a share of Conseco common stock having a value between $25 and $28, calculated as follows: (i) if the Conseco/PFS Share Price (as defined below) is greater than or equal to $28 per share and less than or equal to $31.36 per share, .8928 of a share of Conseco common stock; (ii) if the Conseco/PFS Share Price is less than $28 per share, the fraction (rounded to the nearest ten-thousandth) of a share of Conseco common stock determined by dividing $25 by the Conseco/PFS Share Price; or (iii) if the Conseco/PFS Share Price is greater than $31.36 per share, the fraction (rounded to the nearest the-thousandth) of a share of Conseco common stock determined by dividing $28 by the Conseco/PFS Share Price. The "Conseco/PFS Share Price" shall be equal to the average of the closing prices of Conseco common stock on the NYSE Composite Transactions Reporting System for the ten trading days immediately preceding the second trading day prior to the date of the Merger. The transaction is subject to PFS stockholder and regulatory approval.
25. QUARTERLY FINANCIAL DATA (UNAUDITED)
A summary of unaudited quarterly results of operations for 1996 and 1995 is as follows (in thousands, except per share amounts):
SCHEDULE I
PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES
December 31, 1996
SCHEDULE II
PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (In thousands, except share and per share amounts)
SCHEDULE II
PIONEER FINANCIAL SERVICES, INC. (Parent Company)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT--Continued
CONDENSED STATEMENTS OF INCOME (In thousands)
SCHEDULE II
PIONEER FINANCIAL SERVICES, INC. (Parent Company)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT--Continued
CONDENSED STATEMENTS OF CASH FLOWS (In thousands)
SCHEDULE II
PIONEER FINANCIAL SERVICES, INC. (Parent Company)
NOTE TO CONDENSED FINANCIAL STATEMENTS
The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Pioneer Financial Services, Inc.
At December 31, 1996 and 1995, the notes receivable from United Group Holdings of Delaware (UGH) represents the purchase of National Group Life Insurance Company from the parent company. The note bears interest at the rate of 8% and matures on December 31, 1998.
SCHEDULE III
PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION (In thousands)
SCHEDULE III (continued)
PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION (In thousands)
SCHEDULE IV
PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES
REINSURANCE (In thousands)
SCHEDULE V
PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS (In thousands)
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PIONEER FINANCIAL SERVICES, INC.
BY: /S/ Peter W. Nauert Peter W. Nauert, Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date: March 21, 1997
/S/ Peter W. Nauert /S/ Michael A. Cavataio Peter W. Nauert, Chairman, Michael A. Cavataio Chief Executive Officer, and Director and Vice Chairman Director
/S/ William B. Van Vleet /S/ R. Richard Bastian, III William B. Van Vleet, Director R. Richard Bastian, III Director
/S/ David I. Vickers /S/ Karl-Heinz Klaeser David I. Vickers, Treasurer Karl-Heinz Klaeser and Chief Financial Officer Director
/S/ Robert F. Nauert /S/ John W. Gardiner Robert F. Nauert John W. Gardiner Director Director
/S/ Charles R. Scheper /S/ Michael K. Keefe Charles R. Scheper Michael K. Keefe President - Life Division Director
/S/ Thomas J. Brophy /S/ Carl A. Hulbert Thomas J. Brophy Carl A. Hulbert President - Health Division Director
/S/ Billy B. Hill, Jr. Billy B. Hill, Jr. Executive Vice President and General Counsel