ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS SBM Certificate Company (the "Company") was incorporated in Minnesota in June of 1990, to assume the face-amount certificate business of SBM Company ("SBM"). Effective December 31, 1993, SBM transferred all of the Company's shares of common stock to its wholly owned subsidiary, State Bond and Mortgage Life Insurance Company ("SBM Life"). On June 14, 1995, the Company became a wholly owned subsidiary of ARM Financial Group, Inc. ("ARM") pursuant to ARM's purchase of substantially all of the assets and business operations of SBM (the "Acquisition"). ARM specializes in the asset accumulation business, providing retail and institutional customers with products designed to serve the growing retirement and long-term savings markets as well as providing other asset management services. At December 31, 1996 ARM had $7.6 billion of assets under management.
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. The Company has one business segment.
(c) NARRATIVE DESCRIPTION OF BUSINESS The Company is an issuer of fixed-rate face-amount certificates registered under the Investment Company Act of 1940 (the "1940 Act"). A face-amount certificate is an obligation of the Company requiring the Company to pay certificate holders the original invested amount of the certificate, plus a three-year fixed-rate return, at a given maturity date. The Company selects the interest rate offered on the face-amount certificates based on the short to intermediate term sections of the yield curve. Face-amount certificates, which are similar to bank certificates of deposit, generally compete with various types of individual savings products offered by banks and insurance companies that provide a fixed rate of return on investors' money. The Company's face-amount certificates are sold primarily in Minnesota, Iowa, South Dakota and California.
The Company's face-amount certificates are distributed by ARM Securities Corporation ("ARM Securities"), a wholly owned subsidiary of ARM, pursuant to an Underwriting Agreement. Prior to November 29, 1996, ARM Securities operated under the name SBM Financial Services, Inc. ARM Securities currently uses a network of independent agents to sell and service the business. The Company continues to investigate opportunities to expand upon its distribution channels. ARM Securities is registered with the Securities and Exchange Commission (the "SEC") as a broker-dealer under the provisions of the Securities Exchange Act of 1934.
The Company's gross margin is derived primarily from the margin between earnings on investments and amounts paid or credited on its fixed- rate certificate deposits ("net investment spread"). The Company's net income is determined by deducting investment and other expenses and federal income taxes from gross margin. The net investment spread is affected by general economic conditions, government monetary policy, the policies of regulatory authorities that
influence market interest rates, and the Company's ability to respond to changes in such rates. Changes in market interest rates may have a negative impact on the Company's earnings.
The Company's face-amount certificate business competes in general with various types of individual savings products which offer a fixed rate of return on investors' money, especially insurance and bank products. Some of these other products are insured by governmental agencies or funds or independent third parties. The certificates offered by the Company are not guaranteed or insured by any governmental agency or fund or independent third party. The Company's business is highly competitive and the Company competes with many other companies having greater financial resources, larger sales forces, and greater access to customers. The Company's ability to offer competitive interest rates, attractive terms, and efficient service are the Company's primary basis for meeting competition. The Company has no employees. Pursuant to an Investment Services Agreement and an Administrative Services Agreement, the Company's operations are managed by ARM.
Like many financial services companies which offer investment opportunities to the public, the Company is subject to regulation and supervision by federal and state regulators. The 1940 Act and rules issued by the SEC thereunder specify certain terms for face-amount certificates, the method for calculating reserve liabilities on outstanding certificates, the minimum amounts and types of investments to be deposited with a qualified custodian to support such reserve liabilities, and a variety of other restrictions on the operation and governance of a face-amount certificate company. Pursuant to statutory authority, the Minnesota Department of Commerce ("MDC") and the Illinois Secretary of State exercise supervisory powers over the Company's face-amount certificate business similar to those under the 1940 Act. In addition, the MDC conducts examinations of the Company on a periodic basis. The offer and sale of the Company's face-amount certificates also are subject to federal and state securities laws.
(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES
The Company has no foreign operations.
ITEM 2.
ITEM 2. PROPERTIES
The Company's and ARM's corporate executive offices (the "Corporate Offices") are located at 515 West Market Street, Louisville, Kentucky. The main telephone number for the Corporate Offices is (502) 582-7900. The Corporate Offices are the location of the Company's executive officers and the primary location for ARM's accounting, legal and marketing activities and various other support personnel.
The Company's administrative offices are located in New Ulm, Minnesota, at 100 North Minnesota Street, in a building owned by the Company. The building has a total office space of approximately 49,000 square feet. A significant portion of the building (approximately 15,000 square feet) is leased exclusively to State Bank & Trust Company of New Ulm, a former subsidiary of SBM. Parts of the building are leased to other persons.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to, nor is any of the Company's property the subject of, any material pending legal proceedings, other than ordinary litigation routine to the Company's business.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
This information is omitted in accordance with Instruction (J)(2)(c) to Form 10-K.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
There is currently no public market or trading in the common stock of the Company. All of the Company's 250,000 outstanding shares of common stock are held by ARM as of December 31, 1996. The Company has never paid cash dividends on its common stock.
The Company is subject to two principal restrictions on its ability to pay dividends in addition to the generally applicable restrictions and requirements of Minnesota corporate law. First, pursuant to Section 28(b) of the 1940 Act, the Company is required to establish and maintain qualified assets having a value not less than the aggregate of certificate reserves plus $250,000. Second, the MDC has determined that face-amount certificate companies such as the Company should maintain a ratio of shareholder's equity to total assets of a minimum of 5%. For purposes of determining compliance with both requirements, assets are based upon a valuation of available-for-sale securities reflected at amortized cost. The Company could not pay dividends if it did not meet both of these two requirements or if payment of a dividend would cause it not to meet such requirements. As of December 31, 1996, the Company had qualified assets in excess of certificate reserves plus $250,000 of $4.6 million and assets in excess of the 5% ratio of $2.1 million.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
This information is omitted in accordance with Instruction (J)(2)(a) to Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
GENERAL
The Company was acquired by ARM in connection with ARM's acquisition of substantially all of the assets and business operations of SBM effective May 31, 1995. The results of operations for the year ended December 31, 1995 represent the historical results of the Company for the period from January 1, 1995 to May 31, 1995 combined with the results of operations of the Company subsequent to the Acquisition from June 1, 1995 to December 31, 1995. Historical results of operations are not completely comparable with results of operations subsequent to the Acquisition primarily due to differing asset/liability management strategies and expense allocation methodologies of ARM and SBM management. Therefore, results of operations for the year ended December 31, 1996, are not completely comparable with the prior year.
RESULTS OF OPERATIONS
1996 COMPARED WITH 1995
During 1996, net income was $731,981 compared to $776,739 in 1995. Net investment income (net income excluding realized investment gains and losses net of tax) was $414,670 and $595,354 for 1996 and 1995, respectively. The decrease in net investment income was primarily attributable to a decrease in net investment spread, partially offset by lower investment and other expenses and lower federal income tax expense.
Net investment spread, which is the difference between investment income and interest credited on certificate reserves, decreased to $1.5 million during 1996 from $2.0 million in 1995. These amounts reflect net investment spread of 2.23% and 2.97% during 1996 and 1995, respectively, between the Company's investment yield on average cash and investments and the average rate credited on certificate reserves. The Company's investment income decreased to $4.3 million from $4.9 million for 1996 and 1995, respectively. These amounts represent investment yields of 7.73% and 8.21% on average cash and investments of $54.9 million and $56.3 million for 1996 and 1995, respectively. This decrease in investment yield on cash and investments was primarily attributable to a reduction in the average duration of the investment portfolio during 1996 and to the December 1995 sale of the Company's mortgage loan portfolio. The proceeds from the sale of mortgage loans were invested in fixed maturities of a generally higher quality, but with lower yields.
Interest credited on certificate reserves was $2.8 million and $2.9 million for 1996 and 1995, respectively. These amounts represent average rates of interest credited of 5.50% and 5.24% on average certificate reserves of $50.4 million and $52.9 million for 1996 and 1995, respectively. The majority of the Company's outstanding face-amount certificates are fixed-rate three year contracts. The Company monitors credited interest rates for new and renewal issues against competitive products, mainly bank certificates of deposit. Credited interest rate adjustment, up or down, on new certificates are made as the Company deems necessary. New and renewal contracts issued and outstanding during the past year have crediting rates that are generally higher than contracts that matured or surrendered during the period, resulting in the overall increase in the average crediting rate.
Investment and other expenses were $815,094 and $957,593 for 1996 and 1995, respectively. The decrease in investment and other expenses was primarily attributable to the decrease in management and investment advisory fees. Currently, management and investment advisory fees are computed as a percentage of average certificate reserves and qualified assets. Such fees have been lower since the Acquisition primarily as a result of ARM's lower marginal operating cost attributable to greater economies of scale since the Acquisition.
Realized investment gains were $485,135 and $283,885 for 1996 and 1995, respectively. These realized investment gains were interest-rate related and attributable to the asset/liability management strategies of the Company. Fixed maturities and equity securities (i.e., non-redeemable preferred stock) are sold during rising and falling interest rate environments which can result in period- to-period swings in realized investment gains and losses.
Certificate reserves decreased $2.3 million or 4.3% during 1996, as maturities and surrenders exceeded sales and renewals. The Company believes a significant factor leading to the decrease was the certificate of deposit marketplace currently being very competitive, as many financial institutions are offering special high rates to induce customers to open new accounts. For face- amount certificates reaching their maturity date during 1996 and 1995, 73% and 72%, respectively, were renewed.
1995 COMPARED WITH 1994
During 1995, net income was $776,739 compared to $383,203 in 1994. Net investment income was $595,354 and $363,420 for 1995 and 1994, respectively. The increase in net investment income was primarily attributable to a higher net investment spread and lower investment and other expenses.
Net investment spread increased to $2.0 million during 1995 from $1.8 million in 1994. These amounts reflect net investment spread of 2.97% and 2.10% during 1995 and 1994, respectively, between the Company's investment yield on average cash and investments and the average rate credited on certificate reserves. The Company's investment income decreased to $4.9 million from $5.3 million for 1995 and 1994, respectively. The investment yields for 1995 and 1994 were 8.21% and 7.63% on average cash and investments of $56.3 million and $66.1 million, respectively. This increase in investment yield was attributable to higher yields attained as a result of a restructuring of the investment portfolio subsequent to the Acquisition, as well as accretion resulting from purchase accounting adjustment.
Interest credited on certificate reserves was $2.9 million and $3.6 million for 1995 and 1994, respectively. These amounts represent average rates of interest credited of 5.24% and 5.53% on average certificate reserves of $52.9 million and $62.2 million for 1995 and 1994, respectively. This decrease is a result of new and renewal certificates issued during 1995 accumulating interest at rates lower than contracts that matured or surrendered.
The decrease in investment and other expenses was primarily attributable to the decrease in management and investment advisory fees since the Acquisition and lower amortization of deferred charges.
Realized investment gains were $283,885 and $29,783 for 1995 and 1994, respectively. Realized investment gains were interest-rate related and attributable to the asset/liability management strategies of the Company.
ASSET PORTFOLIO REVIEW
The Company primarily invests in securities with fixed maturities with the objective of providing reasonable returns while limiting liquidity and credit risks. The Company's investments in fixed maturities were 98% investment grade for the years ended December 31, 1996 and 1995. Investment grade securities are those classified as 1 or 2 by the National Association of Insurance Commissioners, or where such classifications are not available, having a rating on the scale used by Standard & Poor's Corporation of BBB- or above. Additionally, the Company's investment portfolio has minimal exposure to real estate, mortgage loans and common equity securities, which represented 1.0% and 1.1% of qualified assets at December 31, 1996 and 1995, respectively. As of December 31, 1996, the Company held no securities which had defaulted on principal or interest payments.
Fixed maturities include mortgage-backed and asset-backed securities, corporate securities, U.S. Treasury securities and other government obligations. Mortgage-backed securities ("MBSs"), which include pass-through securities and collateralized mortgage obligations ("CMOs"), totaled $32.6 million at December 31, 1996, representing 58.9% of total qualified assets (61.4% at December 31, 1995). The Company's investments in CMOs, which are primarily backed by the U.S. Government or U.S. Government agencies, represented 52.8% and 47.3% of the Company's qualified assets as of December 31, 1996 and 1995, respectively. MBSs, including CMOs, are subject to risks associated with prepayments of the underlying mortgage loans. Prepayments cause these securities to have actual maturities different from those expected at the time of purchase. The degree to which a security is susceptible to either gains or losses due to prepayment speed adjustments is influenced by the difference between its amortized cost and par, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. Prepayment sensitivity is evaluated and monitored, giving full consideration to the collateral characteristics such as weighted average coupon rate, weighted average maturity and the prepayment history of the specific loan pool. Also, the Company monitors three year cash flow projections with the goal of maintaining an adequate level of liquidity for maturing face-amount certificates. The Company's asset/liability management strategies not only allow the Company to monitor its short-term liquidity needs but also aim to provide protection to the investment portfolio from adverse changes in interest rates.
In December 1995, the Company sold virtually all of its mortgage loan portfolio resulting in a loss of approximately $65,000.
Based on the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," adopted as of January 1, 1994, the Company currently classifies its fixed maturity and equity securities as available-for-sale. Such securities are carried at fair value and changes in fair value, net of related deferred income taxes, are charged or credited directly to shareholder's equity. The decrease in interest rates after the Acquisition, at which time the Company's invested assets were restated to fair value in accordance with purchase accounting rules, and then the subsequent rise in interest rates during the year ended December 31, 1996, have resulted in unrealized gains of $231,541 (net of $124,676 in deferred income taxes) compared to unrealized gains of $885,878 (net of $477,011 in deferred income taxes)
as of December 31, 1995. Volatility in reported shareholder's equity occurs as a result of SFAS No. 115 which requires some assets to be carried at fair value while other assets and all liabilities are carried at historical values.
The Company manages assets and liabilities in a closely integrated manner to minimize the volatility of margins. As a result, adjusting the shareholder's equity for changes in the fair value of the Company's fixed maturities and equity securities without reflecting offsetting changes in the value of the Company's liabilities or other assets creates volatility in reported shareholder's equity but does not reflect the underlying economics of the Company's business.
LIQUIDITY AND FINANCIAL RESOURCES
The Company has never paid cash dividends on its common stock in order to maintain and increase capital resources. The Company will, however, evaluate this on an ongoing basis.
As of December 31, 1996, the Company had $4.6 million of qualified assets in excess of the minimum amount required by the 1940 Act and the rules and regulations promulgated thereunder by the SEC, as computed in accordance with Section 28(b) of the 1940 Act. In addition, the MDC has certain regulatory authority over the Company. The MDC has historically recommended to the Company that face-amount certificate companies should maintain a ratio of shareholder's equity to total assets of a minimum of 5% based upon a valuation of available- for-sale securities reflected at amortized cost for purposes of this calculation. Under this formula, the Company's capital ratio was 8.7% at December 31, 1996.
The primary liquidity requirement of the Company relates to its payment of certificate maturities and surrenders. The principal sources of cash to meet such liquidity requirements are investment income and proceeds from maturities and redemptions of investments.
At December 31, 1996, cash and cash equivalents totaled $3.2 million, a decrease of $0.7 million from December 31, 1995. The Company's aim is to manage its cash and cash equivalents position so as to satisfy short-term liquidity needs. In connection with this management of cash and cash equivalents, the Company may invest idle cash in short duration fixed maturities to capture additional yield when short-term liquidity requirements permit.
Cash flows of $3.6 million, $4.1 million, and $4.2 million were generated from operating activities in 1996, 1995, and 1994, respectively. These cash flows resulted principally from investment income, less management and investment advisory fees and commissions paid. Proceeds from sales, redemptions and maturities of investments generated $39.4 million, $51.8 million, and $10.6 million in cash flows during 1996, 1995, and 1994, respectively, which were offset by purchases of investments of $38.5 million, $44.2 million, and $5.1 million, respectively. The higher purchases and sales of investments during 1995 were a result of the initial restructuring of the Company's investment portfolio following the Acquisition.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX
FINANCIAL STATEMENTS
Reports of Independent Auditors. . . . . . . . . . . . . . . . . . . . . . 12 Balance Sheets as of December 31, 1996 and 1995. . . . . . . . . . . . . . 14 Statements of Operations for the Years Ended December 31, 1996, 1995, and 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Statements of Shareholder's Equity for the Years Ended December 31, 1996, 1995 and 1994. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Statements of Cash Flows for the Years Ended December 31, 1996, 1995 and 1994 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Notes to Financial Statements. . . . . . . . . . . . . . . . . . . . . . . 19
SUPPLEMENTARY DATA None
REPORT OF INDEPENDENT AUDITORS
Board of Directors SBM Certificate Company
We have audited the accompanying balance sheets of SBM Certificate Company as of December 31, 1996 and 1995, and the related statements of income, shareholder's equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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 financial position of SBM Certificate Company at December 31, 1996 and 1995, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Louisville, Kentucky February 12, 1997
INDEPENDENT AUDITORS' REPORT
Board of Directors SBM Certificate Company
We have audited the statements of income and of cash flows of SBM Certificate Company (the "Company") for the year ended December 31, 1994. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the results of SBM Certificate Company's operations and its cash flows for the year ended December 31, 1994 in conformity with generally accepted accounting principles.
The financial statements have been prepared on a historical basis and do not include any purchase accounting or other adjustments resulting from the sale of the Company as discussed in Note 2 to the financial statements.
As discussed in Note 1 to the financial statements, in 1994 the Company adopted Statement of Financial Accounting Standards No. 115, ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES.
/s/ Deloitte and Touche LLP Minneapolis, Minnesota March 29, 1995
SEE ACCOMPANYING NOTES.
SEE ACCOMPANYING NOTES.
SEE ACCOMPANYING NOTES.
SEE ACCOMPANYING NOTES.
SBM CERTIFICATE COMPANY NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION SBM Certificate Company (the "Company") was incorporated in 1990 for the purpose of acquiring the face-amount certificate business of SBM Company ("SBM"). Effective December 31, 1993, SBM transferred all of the Company's shares of common stock to its wholly owned subsidiary, State Bond and Mortgage Life Insurance Company ("SBM Life"), and the Company became a wholly owned subsidiary of SBM Life.
On June 14, 1995, ARM Financial Group, Inc. ("ARM"), completed the acquisition of substantially all of the assets and business operations of SBM, including all of the issued and outstanding common stock of SBM's subsidiaries, SBM Life and SBM Financial Services, Inc (the "Acquisition"). On November 29, 1996, SBM Financial Services, Inc. changed its name to ARM Securities Corporation ("ARM Securities"). By virtue of the Acquisition, ARM acquired control of the Company, a wholly owned subsidiary of SBM Life. Concurrent with the Acquisition, ARM acquired all outstanding shares of the authorized common stock of the Company from SBM Life for a purchase price of $3.3 million.
NATURE OF OPERATIONS The Company is an issuer of face-amount certificates and is registered under the Investment Company Act of 1940 (the "1940 Act"). A face-amount certificate is an obligation of the Company requiring the Company to pay certificate holders the original invested amount of the certificate, plus a three-year fixed-rate return, at a given maturity date. The Company's face- amount certificates are sold primarily in Minnesota, Iowa, South Dakota and California. Face-amount certificates, which are similar to bank certificates of deposit, generally compete with various types of individual savings products offered by banks and insurance companies that provide a fixed rate of return on investors' money.
BASIS OF PRESENTATION The financial statements are prepared in accordance with generally accepted accounting principles. The 1995 financial statements reflect purchase accounting adjustments related to the Acquisition (see Note 2). For periods prior to the Acquisition, the financial statements reflect the historical basis of accounting. Certain amounts from prior years have been reclassified to conform to the current year's presentation. These reclassifications had no effect on previously reported net income or shareholder's equity.
INVESTMENTS Fixed maturities and equity securities are classified as available-for- sale. Available-for-sale securities are stated at fair value, with the unrealized gains and losses, net of taxes, reported as a separate component of shareholder's equity in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The amortized cost of fixed maturities classified as available-for-sale is adjusted for amortization
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
of premiums and accretion of discounts to maturity, or in the case of mortgage-backed securities, over the estimated life of the security. Such amortization or accretion is computed using the interest method and is included in investment income. Anticipated prepayments on mortgage-backed securities are considered in determining the effective yield on such securities. If a difference arises between anticipated and actual prepayments, the carrying value of the investment is adjusted with a corresponding charge or credit to investment income. Interest and dividends are included in investment income. Certificate loans are carried at their unpaid principal balances. Cash and cash equivalents consist of highly liquid investments with maturities of three months or less from the time of purchase. Security transactions are accounted for on the date the order to buy or sell is executed. Realized gains and losses on the sale of investments are determined based upon the specific identification method.
Other invested assets includes real estate, which is recorded at cost, less accumulated depreciation since the Acquisition.
The Company adopted the provisions of SFAS No. 115 for investments held as of or acquired after January 1, 1994. The adoption of SFAS No. 115 had no effect on net income. Upon the date of the Acquisition, the Company classified all fixed maturities classified as held-to-maturity to the available-for-sale category.
DEFERRED ACQUISITION COSTS Costs of issuing new face-amount certificates, principally commissions, have been deferred. These costs are amortized on a straight-line basis over the initial maturity period of the certificates which is three years.
FACE-AMOUNT CERTIFICATE RESERVES Face-amount certificates issued by the Company entitle certificate holders, who have made either single or installment payments, to receive a definite sum of money at maturity. Certificate reserves accrue interest, and cash surrender values are less than accumulated certificate reserves prior to maturity dates. The reserve accumulation rates, cash surrender values, and certificate reserves, among other matters, are governed by the 1940 Act.
INCOME TAXES In accordance with SFAS No. 109, "Accounting for Income Taxes", the Company uses the liability method of accounting for income taxes. The Company's taxable income or loss is included in the consolidated federal income tax return of ARM. The Company provides for income taxes based on a proportionate share of consolidated taxable income. Additionally, tax benefits are recognized for losses to the extent they can be used in the consolidated return. It is the Company's and ARM's policy that any tax benefit recorded by one entity will be reimbursed by the benefitted entity.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
2. ACQUISITION OF THE COMPANY
The Acquisition has been accounted for using the purchase method of accounting. Under purchase accounting, assets and liabilities are adjusted to their estimated fair value and reflect an allocation of the Company's portion of the cost of the Acquisition, commonly referred to as "push-down accounting."
The purchase accounting adjustment reflected in the accompanying statement of shareholder's equity for the year ended December 31, 1995 was recorded on May 31, 1995, the effective date of the Acquisition. The adjustment restated shareholder's equity on that date to $3.3 million, the purchase price allocated to the Company by ARM. The December 31, 1995, balances for "retained earnings" and "net unrealized gains on available-for-sale securities" reflect net income and the change in the fair value of fixed maturities and equity securities subsequent to the Acquisition.
The following combined condensed statements of operations and cash flows present results for the five months ended May 31, 1995, prior to the Acquisition, and the seven months ended December 31, 1995, following the Acquisition. The combined amounts agree to the accompanying statements of operations and cash flows for the year ended December 31, 1995. The operating results subsequent to the Acquisition include the effect of new accounting values assigned to invested assets and intangibles and differing asset/liability management strategies and expense allocation methodologies of ARM and SBM management.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
3. Investments
The amortized cost and estimated fair values of available-for-sale securities were as follows:
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
The amortized cost and estimated fair value of securities by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties and because mortgage-backed and asset-backed securities provide for periodic payments throughout their life.
DECEMBER 31, 1996 ------------------------------------ ESTIMATED FAIR COST VALUE - -----------------------------------------------------------------------------
AVAILABLE-FOR-SALE: Due in one year or less $ 1,260,417 $ 1,271,617 Due after one year through five years 5,749,018 5,760,012 Due after five years through ten years 4,375,305 4,352,148 Due after ten years 1,059,450 1,072,391 Asset-backed securities 5,131,230 5,099,525 Mortgage-backed securities 32,288,406 32,613,668 Equity securities 493,912 544,594 ------------------------------------ Total available-for-sale securities $ 50,357,738 $ 50,713,955 ------------------------------------ ------------------------------------
Gross gains of $642,039, $815,733 and $7,399 and gross losses of $175,226, $148,041 and $321,399 were realized on sales of fixed maturities classified as available-for-sale for the year ended December 31, 1996, the seven months ended December 31, 1995 and the five months ended May 31, 1995, respectively.
Gross gains of $23,980 and zero and gross losses of zero and $5,075 were recognized on equity securities sold during 1996 and 1995, respectively. Gross losses of $64,732 were realized on the sale of substantially all mortgage loans in December 1995.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
4. CERTIFICATE RESERVES
Total certificate reserves at December 31 are summarized as follows:
* Minimum interest rates on advance payments are generally the same as the rates on scheduled installment payments. Interest credited on advance payments, however, is accruing at 5.00% and will continue at that rate through 1997.
5. FAIR VALUES OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair values of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments." The estimated fair value amounts have been determined using available market information and appropriate valuation methodologies. However, considerable judgement was required to develop these estimates. Accordingly, the estimates are not necessarily indicative of the amounts which could be realized in a current market exchange. The use of different market assumptions or estimation methodologies may have a material effect on the estimated fair value amounts.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
The following methods and assumptions were used in estimating fair values:
INVESTMENTS IN SECURITIES OF UNAFFILIATED ISSUERS Fair values for investments in securities of unaffiliated issuers are based on quoted market prices, where available. For investments in securities of unaffiliated issuers for which a quoted market price is not available, fair values are estimated using internally calculated estimates or quoted market prices of comparable instruments.
CERTIFICATE LOANS The carrying value of certificate loans approximates their fair value.
CASH AND CASH EQUIVALENTS The carrying amounts of cash and cash equivalents approximate their fair value given the short-term nature of these assets.
CERTIFICATE RESERVES The fair value of certificate reserves is based on a discounted cashflow analysis, using the current interest rate offered on new certificates of 5.25% and 5.60% at December 31, 1996 and 1995, respectively.
OTHER INVESTED ASSETS, OTHER ASSETS, ACCOUNTS PAYABLE AND OTHER LIABILITIES The financial statement carrying amounts of other invested assets, other assets, accounts payable and other liabilities are deemed to be a reasonable approximation of their fair value.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
6. FEDERAL INCOME TAXES
Deferred federal income taxes reflect the net tax effects of (i) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (ii) operating and capital losses. Significant components of the deferred tax liabilities and assets as of December 31, 1996 and December 31, 1995 were:
The components of the provision for federal income tax expense consist of the following:
Current and deferred federal income tax expenses for the seven months ended December 31, 1995 were $233,870 and $288,464, respectively. For the five months ended May 31, 1995 the current tax benefit was $19,760 and the deferred tax expense was $7,000.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
In the event that future tax assets are recognized on deductible temporary differences for which a valuation allowance was provided at the Acquisition date, such benefits will be applied to first reduce the balance of goodwill. No such benefits were realized in 1996. During 1995, goodwill was reduced by $189,251 as a result of realizing such benefits. Goodwill, with an unamortized balance of $113,095 at December 31, 1996, is being amortized straight-line over the three year period subsequent to the Acquisition.
Federal income tax expense differs from that computed by using the federal income tax rate of 35%. The sources of the differences were:
7. RELATED PARTY TRANSACTIONS
For the periods presented, management and investment advisory fee expenses reflected in the accompanying financial statements represent allocations of expenses from SBM and ARM for the respective periods prior and subsequent to the Acquisition. These allocations include amounts for administrative and investment services, including use of property, equipment and facilities. The allocations are currently based on the proportion which such business and assets managed represents of all of ARM's and its subsidiaries business activities. Prior to the Acquisition, the allocations were primarily based on the amount of time spent by SBM employees on the face-amount certificate business and on the proportion which such business represents of all of SBM's and its subsidiaries' business activities. The allocations were $246,468, $151,967, $206,519 and $516,000 for the year ended December 31, 1996, the seven months ended December 31, 1995, the five months ended May 31, 1995 and for the year ended December 31, 1994, respectively. The Company owns and pays operating expenses for a building used by SBM (prior to the Acquisition) and its affiliates. The total rent and utilities reimbursement paid to the Company in 1994 by SBM and affiliates was $146,554. Management believes the foregoing allocations were made on a reasonable basis; however, they do
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
not necessarily equal the costs which would have been or will be incurred by the Company on a stand-alone basis.
The Company has paid ARM Securities, an affiliate, $263,089, $443,579 and $507,995 for the years ended 1996, 1995 and 1994, respectively, for sales commissions and other issuance, underwriting, and sales expenses.
8. SHAREHOLDER'S EQUITY AND REGULATORY MATTERS
The Company is subject to two principal restrictions relating to its regulatory capital requirements. First, under the 1940 Act, the Company is required to establish and maintain qualified assets (as defined in Section 28(b) of the 1940 Act) having a value not less than the aggregate of certificate reserves plus $250,000 ($50.4 million and $52.7 million at December 31, 1996 and 1995, respectively). The Company had qualified assets of $55.1 million and $58.9 million at those respective dates (before addition of $0.4 million and $1.4 million, respectively, for net unrealized pretax gains on fixed maturities and equity securities classified as available-for-sale).
For purposes of determining compliance with the foregoing provisions, qualified assets are valued in accordance with District of Columbia Insurance Laws (the "D.C. Laws") as required by the 1940 Act. Qualified assets for which no provision for valuation is made in the D.C. Laws are valued in accordance with rules, regulations, or orders prescribed by the Securities and Exchange Commission. These values are the same as the financial statement carrying values, except that for financial statement purposes, fixed maturities and equity securities classified as available-for-sale are carried at fair value. For qualified asset purposes, fixed maturities securities classified as available-for-sale are valued at amortized cost and equity securities are valued at cost.
Second, the Minnesota Department of Commerce ("MDC") has historically recommended to the Company that face-amount certificate companies should maintain a ratio of shareholder's equity to total assets of a minimum of 5% based upon a valuation of available-for-sale securities reflected at amortized cost for purposes of this calculation. Under this formula, the Company's capital ratio was 8.7% and 6.9% at December 31, 1996 and 1995, respectively. In November 1994, based on the decline in the value of the Company's investment portfolio, resulting from increasing interest rates in 1994 and the Company's decreasing liquidity resulting from reduced principal payments on the Company's collateralized mortgage obligations portfolio, the MDC recommended that the Company increase its capital level. The MDC's concern was influenced by the Company's capital ratio, calculated including the effects of unrealized investment losses. Therefore, on March 29, 1995, SBM Life, the former parent company of the Company, made a $1.5 million capital contribution to the Company.
Pursuant to the required calculations of various states, the provisions of the certificates, depository agreements, and the 1940 Act, qualified assets of the Company were deposited with independent custodians to meet certificate liability requirements as of December 31, 1996 and 1995 as shown in
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
the following table. Certificate loans, secured by applicable certificate reserves, are deducted from certificate reserves in computing deposit requirements.
Assets on deposit consisted of the following at December 31:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There have been no changes in or disagreements with accountants on accounting, auditing, or financial reporting matters.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
This information is omitted in accordance with Instruction (J)(2)(c) to Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
This information is omitted in accordance with Instruction (J)(2)(c) to Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
This information is omitted in accordance with Instruction (J)(2)(c) to Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
This information is omitted in accordance with Instruction (J)(2)(c) to Form 10-K.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED AS PART OF THIS REPORT
1. FINANCIAL STATEMENTS.
See financial statements index on page 11 of this document for a listing of financial statements and reports of independent auditors included in this report.
2. FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of the Company and the related Report of Independent Auditors are incorporated herein by reference and were previously filed as Part II Item 16(b) to Post Effective Amendment No. 8 to Registration Statement on Form S-1 of the Company filed February 28, 1997 (File No. 33-38066):
Report of Independent Auditors
Schedule I Investments in Securities of Unaffiliated Issuers--December 31, 1996 Schedule V Qualified Assets on Deposit--December 31, 1996 Schedule VI Certificate Reserves--Year Ended December 31, 1996
Schedules I, III, V and VI as of or for the year ended December 31, 1995, and related Report of Independent Auditors, included in the Company's Post Effective Amendment No. 7 to Registration Statement on Form S-1 filed March 5, 1996, Schedules III and VI for the year ended December 31, 1994, and related Independent Auditors' Report, included in the Company's Post Effective Amendment No. 6 to Registrant Statement on Form S-1 filed March 31, 1995, (File No. 33-38066), are incorporated herein by reference.
Schedules required by Article 6 of Regulation S-X for face-amount certificate investment companies other than those listed are omitted because they are not required, are not applicable, or equivalent information has been included in the financial statements and notes thereto, or elsewhere herein.
3. EXHIBITS
See Exhibit Index on page 36 of this report.
(b) REPORTS ON FORM 8-K
No reports on Form 8-K were filed by the Company during the fourth quarter of 1996.
SIGNATURES
Pursuant to the requirements of the 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, on February 26, 1997.
SBM Certificate Company
By: /S/ JOHN R. MCGEENEY
------------------------------------ John R. McGeeney Chairman of the Board of Directors and President
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 in the capacities indicated on the 26th day of February 1997.
Name Title ---- -----
/s/ JOHN R. McGEENEY Chairman of the Board of Directors - ------------------------------------- and President (Principal Executive John R. McGeeney Officer)
/s/ EDWARD L. ZEMAN Executive Vice President-Chief - ------------------------------------- Financial Officer (Principal Edward L. Zeman Financial Officer)
/s/ BARRY G. WARD Controller (Principal Accounting - ------------------------------------- Officer) Barry G. Ward
/s/ STEVEN B. BING Director - ------------------------------------- Steven B. Bing
/s/ THEODORE S. ROSKY Director - ------------------------------------- Theodore S. Rosky
/s/ MARTIN R. SNYDER Director - ------------------------------------- Martin R. Snyder
SBM CERTIFICATE COMPANY EXHIBIT INDEX
- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT NUMBER DESCRIPTION - --------------------------------------------------------------------------------
3.1 Articles of Incorporation-filed as Exhibit 3(a) to Registration Statement No. 33-38066 dated December 4, 1990.*
3.2 By-laws-filed as Exhibit 3(b) to Registration Statement No. 33-38066 dated December 4, 1990.*
4 Instruments defining the rights of security holders-Form of Series 503 Certificate filed as Exhibit 4 to Registration Statement on Form N-8B- 4, File No. 811-6268, filed April 1, 1991.*
10.1 Underwriting Agreement by and between the Company and SBM Financial Services, Inc. dated June 14, 1995, filed as Exhibit 10(b) to Amendment No. 7 to Registration Statement No. 33-38066 of the Company dated March 5, 1996.*
10.2 Administrative Services Agreement by and between the Company and ARM Financial Group, Inc. dated as of June 14, 1995, filed as Exhibit 10(c) to Amendment No. 7 to Registration Statement No. 33-38066 of the Company dated March 5, 1996.*
10.3 Investment Services Agreement by and between the Company and ARM Financial Group, Inc. dated as of June 14, 1995, filed as Exhibit 10(d) to Amendment No. 7 to Registration Statement No. 33-38066 of the Company dated March 5, 1996.*
10.4 Custody Agreement, as amended and supplemented, between the Company and First Bank National Association dated December 20, 1990, filed as Exhibit 10(b) to Amendment No. 1 to Registration Statement No. 33- 38066 of the Company dated January 2, 1991.*
10.5 Lease between the Company and State Bank & Trust Company of New Ulm dated August 13, 1992, filed as Exhibit 10A to Form 10-K of SBM Company filed March 31, 1993 (File No. 811-407).*
10.6 Form of Tax Allocation Agreement by and among the Company, ARM Financial Group, Inc. and certain ARM subsidiaries dated March 21, 1996, filed as Exhibit 10.1 to Form 10-Q of the Company, File No. 811-6268, filed May 14, 1996.*
23.1 Consent of Ernst & Young LLP, filed herewith.
23.2 Consent of Deloitte & Touche LLP, filed herewith.
27 Not applicable.
* Previously filed as indicated and incorporated herein by reference.