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SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q  (Mark One)/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 OR  /  / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 Commission File No. 33-5014 FIRST SUNAMERICA LIFE INSURANCE COMPANY Incorporated in New York
    
    06-0992729
IRS Employer
Identification No.
 733 Third Avenue, 4th Floor, New York, New York 10017
Registrants telephone number, including area code: (800) 272-3007 INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS
REQUIRED TO BE FILED BY SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF
1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE
REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH
FILING REQUIREMENTS FOR THE PAST 90 DAYS Yes /X/
No  /  / INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS
DEFINED IN RULE 12b-2 OF THE SECURITIES EXCHANGE ACT OF 1934). Yes
/  /  No  /X/ THE NUMBER OF SHARES OUTSTANDING OF THE REGISTRANTS COMMON STOCK ON AUGUST
13, 2004 WAS AS FOLLOWS:  Common Stock (par value $10,000.00 per share)
    
    300 shares outstanding
 REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION H(1)(a) AND
(b) OF FORM 10-Q AND IS THEREFORE FILING THIS FORM 10-Q WITH THE REDUCED
DISCLOSURE FORMAT.




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FIRST SUNAMERICA LIFE INSURANCE COMPANY INDEX PageNumber(s)Part I - Financial InformationBalance Sheet (Unaudited) - June 30, 2004 and December 31, 2003
    
    2Statement of Income and Comprehensive Income (Unaudited)- Three Months and Six Months Ended June 30, 2004 and 2003
    
    3-4Statement of Cash Flows (Unaudited) - Six Months Ended June 30, 2004 and 2003
    
    5-6Notes to Financial Statements (Unaudited)
    
    7-10Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    11-26Quantitative and Qualitative Disclosures About Market Risk
    
    27Disclosure Controls & Procedures
    
    27Part II - Other Information
    
    28-29Exhibits and Reports on Form 8-K
    
    30Certifications Pursuant to Section 302Certifications Pursuant to Section 302Certifications Pursuant to Section 906
  1




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##### Table of Contents



FIRST SUNAMERICA LIFE INSURANCE COMPANY 
 
 June 30,
    
    December 31,2004
    
    2003(in thousands)ASSETSInvestments and cash:Cash and short-term investments
    
    $
    23,176
    
    
    $
    104,011Bonds, notes and redeemable preferred stocks available for sale, at
fair value (amortized cost: June 30, 2004, $2,848,329;
December 31, 2003, $2,617,647)
    
    
    2,832,198
    
    
    
    2,657,812Mortgage loans
    
    
    257,534
    
    
    
    215,521Policy loans
    
    
    34,276
    
    
    
    35,251Common stocks available for sale, at fair value (cost: June 30, 2004,
$888; December 31, 2003, $291)
    
    
    891
    
    
    
    295Securities lending collateral
    
    
    522,883
    
    
    
    154,756Total investments and cash
    
    
    3,670,958
    
    
    
    3,167,646Variable annuity assets held in separate accounts
    
    
    453,317
    
    
    
    438,224Accrued investment income
    
    
    30,936
    
    
    
    27,577Deferred acquisition costs
    
    
    183,663
    
    
    
    161,356Other
deferred expenses
    
    
    19,254
    
    
    
    16,570Income taxes currently receivable from Parent
    
    
    
    
    
    
    1,360Receivable from brokers
    
    
    194
    
    
    
    Other assets
    
    
    2,115
    
    
    
    1,749TOTAL ASSETS
    
    $
    4,360,437
    
    
    $
    3,814,482LIABILITIES AND SHAREHOLDERS EQUITYReserves, payables and accrued liabilities:Reserves for fixed annuity contracts
    
    $
    2,762,747
    
    
    $
    2,490,145Reserves for universal life insurance contracts
    
    
    228,698
    
    
    
    232,271Income taxes currently payable to Parent
    
    
    11,577
    
    
    
    Securities lending payable
    
    
    522,883
    
    
    
    154,756Payable to brokers
    
    
    
    
    
    
    40,852Other liabilities
    
    
    28,181
    
    
    
    66,814Total reserves, payables and accrued liabilities
    
    
    3,554,086
    
    
    
    2,984,838Variable annuity liabilities related to separate accounts
    
    
    453,317
    
    
    
    438,224Deferred income taxes
    
    
    22,826
    
    
    
    41,895Total liabilities
    
    
    4,030,229
    
    
    
    3,464,957Shareholders equity:Common stock
    
    
    3,000
    
    
    
    3,000Additional paid-in capital
    
    
    259,428
    
    
    
    259,428Retained earnings
    
    
    74,167
    
    
    
    68,657Accumulated other comprehensive income (loss)
    
    
    (6,387
    )
    
    
    18,440Total shareholders equity
    
    
    330,208
    
    
    
    349,525TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    4,360,437
    
    
    $
    3,814,482
 See accompanying notes to financial statements.  2




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FIRST SUNAMERICA LIFE INSURANCE COMPANY 
 
 Three Months
    
    Six Months2004
    
    2003
    
    2004
    
    2003(in thousands)REVENUESFee income:Variable annuity policy fees
    
    $
    2,170
    
    
    $
    1,989
    
    
    $
    4,367
    
    
    $
    3,879Universal life insurance policy fees, net of reinsurance
    
    
    630
    
    
    
    632
    
    
    
    2,156
    
    
    
    2,017Surrender charges
    
    
    757
    
    
    
    350
    
    
    
    1,306
    
    
    
    831Total fee income
    
    
    3,557
    
    
    
    2,971
    
    
    
    7,829
    
    
    
    6,727Investment income
    
    
    40,810
    
    
    
    26,875
    
    
    
    80,812
    
    
    
    51,761Net realized investment gains (losses)
    
    
    (934
    )
    
    
    3,547
    
    
    
    (2,091
    )
    
    
    4,702Total revenues
    
    
    43,433
    
    
    
    33,393
    
    
    
    86,550
    
    
    
    63,190BENEFITS AND EXPENSESInterest expense:Fixed annuity contracts
    
    
    22,421
    
    
    
    14,787
    
    
    
    44,092
    
    
    
    28,307Universal life insurance contracts
    
    
    2,718
    
    
    
    2,748
    
    
    
    5,421
    
    
    
    5,490Total interest expense
    
    
    25,139
    
    
    
    17,535
    
    
    
    49,513
    
    
    
    33,797General and administrative expenses
    
    
    1,604
    
    
    
    1,805
    
    
    
    4,629
    
    
    
    4,277Amortization of deferred acquisition costs and
other deferred expenses
    
    
    8,425
    
    
    
    6,000
    
    
    
    16,403
    
    
    
    11,250Annual commissions
    
    
    231
    
    
    
    273
    
    
    
    725
    
    
    
    455Claims on universal life contracts, net of reinsurance
recoveries
    
    
    290
    
    
    
    327
    
    
    
    1,580
    
    
    
    1,603Guaranteed benefits
    
    
    496
    
    
    
    243
    
    
    
    979
    
    
    
    458Total benefits and expenses
    
    
    36,185
    
    
    
    26,183
    
    
    
    73,829
    
    
    
    51,840PRETAX INCOME BEFORE CUMULATIVE
EFFECT OF ACCOUNTING CHANGE
    
    
    7,248
    
    
    
    7,210
    
    
    
    12,721
    
    
    
    11,350Income tax expense
    
    
    2,937
    
    
    
    2,993
    
    
    
    5,197
    
    
    
    4,679INCOME BEFORE CUMULATIVE EFFECT
OF ACCOUNTING CHANGE
    
    
    4,311
    
    
    
    4,217
    
    
    
    7,524
    
    
    
    6,671Cumulative effect of accounting change, net of tax
    
    
    
    
    
    
    
    
    
    
    (2,014
    )
    
    
    NET INCOME
    
    $
    4,311
    
    
    $
    4,217
    
    
    $
    5,510
    
    
    $
    6,671
 See accompanying notes to financial statements. 3




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
STATEMENT OF INCOME AND COMPREHENSIVE INCOME
For the three months and six months ended June 30, 2004 and 2003
(Unaudited) Three Months
    
    Six Months2004
    
    2003
    
    2004
    
    2003(in thousands)OTHER COMPREHENSIVE INCOME, NET OF TAX:Net unrealized gains (losses) on
debt and equity securities
available for sale identified in
the current period less related
amortization of deferred
acquisition costs and other
deferred expenses
    
    $
    (81,394
    )
    
    $
    5,607
    
    
    $
    (39,696
    )
    
    $
    8,212Less reclassification adjustment
for net realized (gains) losses
included in net income
    
    
    653
    
    
    
    (187
    )
    
    
    1,500
    
    
    
    (769
    )Income tax (expense) benefit
    
    
    28,260
    
    
    
    (1,897
    )
    
    
    13,369
    
    
    
    (2,605
    )OTHER COMPREHENSIVE INCOME (LOSS)
    
    
    (52,481
    )
    
    
    3,523
    
    
    
    (24,827
    )
    
    
    4,838COMPREHENSIVE INCOME (LOSS)
    
    $
    (48,170
    )
    
    $
    7,740
    
    
    $
    (19,317
    )
    
    $
    11,509
 See accompanying notes to financial statements. 4




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FIRST SUNAMERICA LIFE INSURANCE COMPANY 
 
 2004
    
    2003(in thousands)CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    5,510
    
    
    $
    6,671Adjustments to reconcile net income to
net cash provided by operating activities:Cumulative effect of accounting change, net of tax
    
    
    2,014
    
    
    
    Interest credited to:Fixed annuity contracts
    
    
    44,092
    
    
    
    28,307Universal life insurance contracts
    
    
    5,421
    
    
    
    5,490Net realized investment (gains) losses
    
    
    2,091
    
    
    
    (4,702
    )Accretion of net discounts on investments
    
    
    3,363
    
    
    
    55Amortization of deferred acquisition costs and
other deferred expenses
    
    
    16,403
    
    
    
    11,250Acquisition costs deferred
    
    
    (19,664
    )
    
    
    (31,753
    )Sales inducements deferred
    
    
    (3,846
    )
    
    
    Provision for deferred income taxes
    
    
    (4,616
    )
    
    
    1,554Change in:Accrued investment income
    
    
    (3,359
    )
    
    
    (4,317
    )Income taxes currently payable to Parent
    
    
    12,937
    
    
    
    4,966Other assets
    
    
    (1,957
    )
    
    
    (1,131
    )Other liabilities
    
    
    (4,071
    )
    
    
    7,154Other, net
    
    
    465
    
    
    
    1,866NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    54,783
    
    
    
    25,410CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of:Bonds, notes and redeemable preferred stocks
    
    
    (656,385
    )
    
    
    (625,465
    )Mortgage loans
    
    
    (48,559
    )
    
    
    (27,598
    )Other investments, excluding short-term investments
    
    
    (8
    )
    
    
    (3
    )Sales of:Bonds, notes and redeemable preferred stocks
    
    
    285,662
    
    
    
    150,293Other investments, excluding short-term investments
    
    
    102
    
    
    
    Redemptions and maturities of:Bonds, notes and redeemable preferred stocks
    
    
    93,071
    
    
    
    100,397Mortgage loans
    
    
    6,642
    
    
    
    4,816Other investments, excluding short-term investments
    
    
    658
    
    
    
    1,397NET CASH USED IN INVESTING ACTIVITIES
    
    $
    (318,817
    )
    
    $
    (396,163
    )
 See accompanying notes to financial statements. 5




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
STATEMENT OF CASH FLOWS (Continued)
For the six months ended June 30, 2004 and 2003
(Unaudited) 2004
    
    2003(in thousands)CASH FLOWS FROM FINANCING ACTIVITIES:Deposits received on:Fixed annuity contracts
    
    $
    285,691
    
    
    $
    472,098Universal life insurance contracts
    
    
    3,725
    
    
    
    3,889Net exchanges to (from) the fixed accounts of
variable annuity contracts
    
    
    (7,555
    )
    
    
    2,851Withdrawal payments on:Fixed annuity contracts
    
    
    (71,357
    )
    
    
    (53,352
    )Universal life insurance contracts
    
    
    (4,438
    )
    
    
    (4,693
    )Claims and annuity payments on:Fixed annuity contracts
    
    
    (17,202
    )
    
    
    (15,037
    )Universal life insurance contracts
    
    
    (5,665
    )
    
    
    (6,432
    )NET CASH PROVIDED BY FINANCING ACTIVITIES
    
    
    183,199
    
    
    
    399,324NET INCREASE (DECREASE) IN CASH AND SHORT-TERM
INVESTMENTS
    
    
    (80,835
    )
    
    
    28,571CASH AND SHORT-TERM INVESTMENTS AT BEGINNING OF
PERIOD
    
    
    104,011
    
    
    
    37,955CASH AND SHORT-TERM INVESTMENTS AT END OF PERIOD
    
    $
    23,176
    
    
    $
    66,526SUPPLEMENTAL CASH FLOW INFORMATION:Interest paid on indebtedness
    
    $
    
    
    
    $
    34$
    
    
    
    $Income taxes paid to Parent
    
    
    2,822
    
    
    
    1,841
 See accompanying notes to financial statements. 6




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FIRST SUNAMERICA LIFE INSURANCE COMPANY 
 
  1.
    
    BASIS OF PRESENTATIONFirst SunAmerica Life Insurance Company (the Company) is a direct
wholly owned subsidiary of SunAmerica Life Insurance Company (the
Parent), which is a wholly owned subsidiary of AIG Retirement Services,
Inc. (AIGRS) (formerly AIG SunAmerica Inc.), a wholly owned subsidiary
of American International Group, Inc. (AIG). AIG is a holding company
which through its subsidiaries is engaged in a broad range of insurance
and insurance-related activities, financial services, retirement services
and asset management. The Company is a New York-domiciled life insurance
company principally engaged in the business of writing fixed and variable
annuities for retirement savings in the State of New York.In the opinion of the Company, the accompanying unaudited financial
statements contain all adjustments necessary, consisting of normal
recurring items, to present fairly the Companys financial position as of
June 30, 2004 and December 31, 2003, the results of its operations for
the three months and six months ended June 30, 2004 and 2003 and its cash
flows for the six months ended June 30, 2004 and 2003. The results of
operations for the three months and six months ended June 30, 2004 are
not necessarily indicative of the results to be expected for the full
year. The accompanying unaudited financial statements should be read in
conjunction with the audited financial statements for the year ended
December 31, 2003, contained in the Companys 2003 Annual Report on Form
10-K. Certain prior period amounts have been reclassified to conform to
the current periods presentation.2.
    
    RECENTLY ISSUED ACCOUNTING STANDARDSIn July 2003, the American Institute of Certified Public Accountants
issued Statement of Position 03-1, Accounting and Reporting by Insurance
Enterprises for Certain Nontraditional Long-Duration Contracts and for
Separate Accounts (SOP 03-1). This statement was effective as of
January 1, 2004, and requires the Company to recognize a liability for
guaranteed minimum death benefits and other living benefits related to
its variable annuities and modifies certain disclosures and financial
statement presentations for these products. In addition, SOP 03-1
addresses the presentation and reporting of separate accounts and the
capitalization and amortization of sales inducements. The Company
reported for the first quarter of 2004 a one-time cumulative accounting
charge upon adoption of $2,014,000 ($3,098,000 pre-tax) to reflect the
liability and the related impact of deferred acquisition costs (DAC) as
of January 1, 2004.The Company issues variable annuities for which the investment risk is
generally borne by the contract holder, except with respect to amounts
invested in the fixed-rate account options. For many of the Companys
variable annuities, the Company offers contractual guarantees in the
event of death or at specified dates during the accumulation period.
Such benefits are referred to as guaranteed minimum death benefits
(GMDB) and guaranteed minimum account value benefits (GMAV),
respectively.The assets supporting the variable portion of variable annuities are
carried at fair value and reported as summary total variable annuity
assets held in separate accounts with an equivalent summary total
reported for liabilities. Amounts assessed against the contract holders
for mortality, administrative, other services and certain features are
included in variable annuity policy fees in the statement of income and
comprehensive income. Changes in liabilities for minimum guarantees are
included in guaranteed benefits, in the statement of income and
comprehensive income. Separate account net investment income, net
investment gains and losses and the related liability charges are offset
within the same line item in the statement of income and comprehensive
income.The Company offers GMDB options that guarantee for virtually all contract
holders, upon the death, the contract holders beneficiary will receive
the greater of (1) the contract holders account value, or (2) a
guaranteed minimum death benefit that varies by product and election
by policy owner. The GMDB
liability is determined each period end by estimating the expected value
of death benefits in excess of the projected account balance and
recognizing the excess ratably over the accumulation period based on
total expected assessments. The Company regularly evaluates estimates
used and adjusts the additional liability balance, with a related charge
or credit to benefit expense, if actual experience or other evidence
suggests that earlier assumptions should be revised. 7




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
NOTES TO FINANCIAL STATEMENTS
(Unaudited)  2.
    
    RECENTLY ISSUED ACCOUNTING STANDARDS (Continued)If elected by the contract holder at the time of contract issuance, GMAV
guarantees that the account value under the contract will at least equal
the amount of initial principal invested during the first 90 days, adjusted for withdrawals, at
the end of a ten-year waiting period. GMAVs are considered to be
derivatives under Financial Accounting Standards Board Statement of
Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities, and are recognized at fair value in
the balance sheet through investment income in the statement of income
and comprehensive income. In 2004, variable annuity deposits with the
GMAV option were immaterial.Details concerning the Companys guaranteed benefit exposures as of June
30, 2004 are as follows: Highest SpecifiedAnniversary AccountValue MinusReturn of Net
    
    Withdrawals PostDeposits
    
    Anniversary(dollars in thousands)In the event of death:Account value
    
    $
    145,516
    
    
    $
    615,848Net amount at risk (a)
    
    
    647
    
    
    
    73,849Average attained age of contract holders
    
    
    65
    
    
    
    62Range of guaranteed minimum return rates
    
    
    0
    %
    
    
    0
    %
  (a)
    
    Net amount at risk represents the guaranteed benefit
exposure in excess of the current account value, if all contract
holders died at the same balance sheet date.  The following summarizes the reserve for guaranteed benefits on variable
contracts reflected in the general account: (in thousands)Balance at January 1, 2004 (b)
    
    $
    1,640Guaranteed benefits incurred
    
    
    979Guaranteed benefits paid
    
    
    (619
    )Balance at June 30, 2004
    
    $
    2,000
  (b)
    
    Includes amounts from the one-time cumulative accounting
change resulting from the adoption of SOP 03-1.  The following assumptions and methodology were used to determine the
reserve for guaranteed benefits at June 30, 2004:  
    
    Data used was 5,000 stochastically generated investment performance scenarios.
    
    Mean investment performance assumption was 10%.
    
    Volatility assumption was 16%.
    
    Mortality was assumed to be 64% of the 75-80 ALB table.
    
    Lapse rates vary by contract type and duration and range from 1% to 30%.
    
    The discount rate was approximately 8%. 8




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
NOTES TO FINANCIAL STATEMENTS
(Unaudited)  2.
    
    RECENTLY ISSUED ACCOUNTING STANDARDS (Continued)The Company currently offers enhanced crediting rates or bonus payments
to contract holders on certain of its products. These sales inducements
are deferred and amortized over the life of the policy using the same
methodology and assumptions used to amortize DAC. The Company previously
deferred these sales inducements as part of DAC and reported the
amortization of such amounts as part of DAC amortization. Upon
implementation of SOP 03-1, the Company reclassified sales inducements of
$16.6 million from DAC to other deferred expenses, which is reported
on the balance sheet. For the six months ended June 30, 2004, sales
inducements of $3.8 million was deferred. Amortization of the deferred
sales inducements is reported as part of amortization of deferred
acquisition costs and other deferred expenses on the statement of income
and comprehensive income. For the six months ended June 30, 2004,
amortization of sales inducements was $1.2 million. Prior period balance
sheet and statement of income and comprehensive income presentation has
been reclassified to conform to the new presentation.3.
    
    CONTINGENT LIABILITIESAt June 30, 2004, the Company has commitments to purchase approximately
$6,000,000 of asset backed securities in the ordinary course of business.
The expiration dates of these commitments are as follows: $1,000,000 in
2004 and $5,000,000 in 2007.Various lawsuits against the Company have arisen in the ordinary course
of business. Contingent liabilities arising from litigation, income
taxes and regulatory and other matters are not considered material in
relation to the financial position, results of operations or cash flows
of the Company. 9




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
NOTES TO FINANCIAL STATEMENTS (Continued)
(Unaudited)  4.
    
    RELATED-PARTY MATTERSOn October 31, 2003, the Company entered into an existing credit
agreement under which the Company agreed to make loans to AIG in an
aggregate amount of $5,000,000. This commitment expires on October 30,
2004. There was no outstanding balance under this agreement at June 30,
2004.On February 1, 2004, the Company entered into an administrative services
agreement with its affiliate AIG SunAmerica Asset Management Corp.
(SAAMCo), whereby SAAMCo will pay to the Company a fee based on a
percentage on all assets invested through the Companys variable annuity
products in exchange for services performed. SAAMCo is the investment
advisor for certain trusts that serve as investment options for the
Companys variable annuity products. Amounts paid or accrued to the
Company under this agreement totaled $0.9 million in 2004 and are included
in variable annuity policy fees in the statement of income and
comprehensive income. A fee of $0.8 million was paid under a different
agreement in 2003.The Companys insurance policy obligations are guaranteed by American
Home Assurance Company (American Home), a subsidiary of AIG, and a
member of an AIG intercompany pool. This guarantee is unconditional and
irrevocable, and the Companys policyholders have the right to enforce
the guarantee directly against American Home.The Company has a support agreement in effect between the Company and AIG
(the Support Agreement), pursuant to which AIG has agreed that AIG will
cause the Company to maintain a policyholders surplus of not less than
$1,000,000 or such greater amount as shall be sufficient to enable the
Company to perform its obligations under any policy issued by it. The
Support Agreement also provides that if the Company needs funds not
otherwise available to it to make timely payment of its obligations under
policies issued by it, AIG will provide such funds at the request of the
Company. The Support Agreement is not a direct or indirect guarantee by
AIG to any person of any obligations of the Company. AIG may terminate
the Support Agreement with respect to outstanding obligations of the
Company only under circumstances where the Company attains, without the
benefit of the Support Agreement, a financial strength rating equivalent
to that held by the Company with the benefit of the Support Agreement.
Policyholders have the right to cause the Company to enforce its rights
against AIG and, if the Company fails or refuses to take timely action to
enforce the Support Agreement or if the Company defaults in any claim or
payment owed to such policyholder when due, have the right to enforce the
Support Agreement directly against AIG.American Home does not publish financial statements prepared on the basis
of U.S. generally accepted accounting principles, although it files
statutory annual and quarterly reports with the New York State Insurance
Department, where such reports are available to the public. AIG is a
reporting company under the Securities Exchange Act of 1934, and files
annual reports on Form 10-K and quarterly reports on Form 10-Q, which are
available from the Securities and Exchange Commission. 10




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FIRST SUNAMERICA LIFE INSURANCE COMPANY 
 
 Managements discussion and analysis of financial condition and results of
operations of First SunAmerica Life Insurance Company (the Company) for the
three months and six months ended June 30, 2004 and June 30, 2003 follows.
Certain prior period amounts have been reclassified to conform to the current
periods presentation. In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, the Company cautions readers regarding certain
forward-looking statements contained in this report and in any other statements
made by, or on behalf of, the Company, whether or not in future filings with
the Securities and Exchange Commission (the SEC). Forward-looking statements
are statements not based on historical information and which relate to future
operations, strategies, financial results, or other developments. Statements
using verbs such as expect, anticipate, believe or words of similar
import generally involve forward-looking statements. Without limiting the
foregoing, forward-looking statements include statements which represent the
Companys beliefs concerning future levels of sales and redemptions of the
Companys products, investment spreads and yields, or the earnings and
profitability of the Companys activities. Forward-looking statements are necessarily based on estimates and
assumptions that are inherently subject to significant business, economic and
competitive uncertainties and contingencies, many of which are beyond the
Companys control and many of which are subject to change. These uncertainties
and contingencies could cause actual results to differ materially from those
expressed in any forward-looking statements made by, or on behalf of, the
Company. Whether or not actual results differ materially from forward-looking
statements may depend on numerous foreseeable and unforeseeable developments.
Some may be national in scope, such as general economic conditions, changes in
tax law and changes in interest rates. Some may be related to the insurance
industry generally, such as pricing, competition, regulatory developments and
industry consolidation. Others may relate to the Company specifically, such as
credit, volatility and other risks associated with the Companys investment
portfolio. Investors are also directed to consider other risks and
uncertainties discussed in documents filed by the Company with the SEC. The
Company disclaims any obligation to update forward-looking information. The Company has one business segment, annuity operations, which consists
of the sale and administration of deposit-type insurance contracts, such as
fixed and variable annuities and universal life insurance contracts. The
Company focuses primarily on the marketing of fixed annuity products. On February 1, 2004, the Company entered into an administrative services
agreement with its affiliate AIG SunAmerica Asset Management Corp. (SAAMCo),
whereby SAAMCo will pay to the Company a fee based on a percentage on all
assets invested through the Companys variable annuity products in exchange for
services performed (Administrative Service Agreement). SAAMCo is the
investment advisor for certain trusts that serve as investment options for the
Companys variable annuity products. Amounts paid or accrued to the Company
under this agreement totaled $0.9 million in 2004 and are included in variable
annuity policy fees in the statement of income and comprehensive income. A fee
of $0.8 million was paid under a different agreement in 2003. CRITICAL ACCOUNTING POLICIES The Company considers among its most critical accounting policies those
policies with respect to valuation of certain financial instruments,
amortization of deferred acquisition costs and other deferred expenses and
valuation of the reserve for guaranteed benefits. In the implementation of
each of the aforementioned policies, management is required to exercise its
judgment on both a quantitative and qualitative basis. Further explanation of
how management exercises that judgment follows: VALUATION OF CERTAIN FINANCIAL INSTRUMENTS: Gross unrealized losses on
debt and equity securities available for sale amounted to $56.0 million at June
30, 2004. In determining if and when a decline in fair value below amortized
cost is other-than-temporary, the Company evaluates at each reporting period
the market conditions, offering prices, trends of earnings, price multiples,
and other key measures for investments in debt and equity securities. In
particular, for debt securities, the Company assesses the probability that all 11




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##### Table of Contents



amounts due are collectible according to the contractual terms of the
obligation. When such a decline in value is deemed to be other than temporary,
the Company recognizes an impairment loss in the current period operating
results to the extent of the decline (See also discussion within Capital
Resources and Liquidity herein). Securities in the Companys portfolio with a carrying value of
approximately $495.0 million at June 30, 2004 do not have readily determinable
market prices. For these securities, the Company estimates the fair value with
internally prepared valuations (including those based on estimates of future
profitability). Otherwise, the Company uses its most recent purchases and
sales of similar unquoted securities, independent broker quotes or comparison
to similar securities with quoted prices when possible to estimate the fair
value of those securities. All such securities are classified as available for
sale. The Companys ability to liquidate its positions in these securities will
be impacted to a significant degree by the lack of an actively traded market,
and the Company may not be able to dispose of these investments in a timely
manner. Although the Company believes its estimates reasonably reflect the fair
value of those securities, the key assumptions about the risk-free interest
rates, risk premiums, performance of underlying collateral, if any, and other
factors may not reflect those of an active market. AMORTIZATION OF DEFERRED ACQUISITION COSTS AND OTHER DEFERRED EXPENSES:
The Company amortizes deferred acquisition costs (DAC) and other deferred
expenses based on a percentage of expected gross profits (EGPs) over the life
of the underlying policies over the estimated lives of the fund deposits on a
straight-line basis. EGPs are computed based on assumptions related to the
underlying policies written, including their anticipated duration, net spreads
earned during the life of the contracts, costs of providing policy guarantees
and the level of expenses necessary to maintain the policies. The Company
adjusts amortization of DAC and other deferred expenses (a DAC unlocking)
when estimates of future gross profits to be realized on its annuity policies
are revised. Increases in future EGPs may result from higher interest spread
and/or lower surrender rate assumptions, while decreases in future EGPs may
result from lower interest spread and/or higher surrender rate assumptions.
DAC amortization for the current period is reduced when future EGPs are
increased and increased when future EGPs are decreased. Approximately 74% of
the Companys DAC balance at June 30, 2004 related to fixed annuity and
universal life products and 26% related to variable annuity products. RESERVE FOR GUARANTEED BENEFITS: Pursuant to the adoption of Statement of
Position 03-1, Accounting and Reporting by Insurance Enterprises for Certain
Nontraditional Long-Duration Contracts and for Separate Accounts (SOP 03-1)
on January 1, 2004, the Company is required to recognize a liability for
guaranteed minimum death benefits (GMDB) and other guaranteed benefits. In
calculating the projected liability, five thousand stochastically generated
investment performance scenarios were developed with a mean investment
performance of 10%. Additional assumptions are made for mortality, lapse rates
of return and the volatility of equity markets. RESULTS OF OPERATIONS NET INCOME totaled $4.3 million in the second quarter of 2004 compared
with $4.2 million in the second quarter of 2003. For the six months ended
June 30, 2004, net income amounted to $5.5 million, compared to $6.7 million in
2003. CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET OF TAX reflected the adoption
of SOP 03-1 on January 1, 2004. The Company recorded a loss of $2.0 million,
net of tax, which is recognized in the statement of income and comprehensive
income as a cumulative effect of accounting change for the six months ended
June 30, 2004. PRETAX INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE totaled $7.2
million in the second quarters of 2004 and 2003. For the six months, pretax
income before cumulative effect of accounting change totaled $12.7 million in
2004, compared to $11.4 million in 2003. The increase in the six months of
2004 compared to 2003 was primarily due to higher net investment spread,
partially offset by higher DAC amortization and net realized investment losses. INCOME TAX EXPENSE totaled $2.9 million in the second quarters of 2004 and
2003, $5.2 million in the six months of 2004 and $4.7 million in the six months
of 2003 representing effective tax rates of 41%, 42%, 41% and 41%, respectively. 12




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NET INVESTMENT SPREAD, a non-GAAP measure, which represents investment
income earned on invested assets less interest credited to fixed annuity
contracts and universal life insurance contracts, is a key measurement used by
the Company in evaluating the profitability of its business. Accordingly, the
Company presents an analysis of net investment spread because the Company has
determined this measure to be useful and meaningful. In evaluating its investment yield and net investment spread, the Company
calculates average invested assets using the amortized cost of bonds, notes and
redeemable preferred stock. This basis does not include unrealized gains and
losses, which are reflected in the carrying value (i.e., fair value) of those
investments pursuant to Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity Securities. In the
calculation of average invested assets, the Company excludes cash collateral
received from the securities lending program, which is offset by a securities
lending payable in the same amount. The Company participates in a securities
lending program with an affiliated agent, pursuant to which it lends its
securities and primarily takes cash as collateral with respect to the
securities lent. Participation in securities lending agreements provides
additional net investment income for the Company, resulting from investment
income earned on the collateral, less interest paid on the securities lending
agreements and the related management fees paid to an affiliate to administer
the program. An analysis of net investment spread and a reconciliation to pretax income
before cumulative effect of accounting change is presented in the following
table: Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(in thousands)Investment income
    
    $
    40,810
    
    
    $
    26,875
    
    
    $
    80,812
    
    
    $
    51,761Interest credited to fixed annuity contracts
    
    
    (22,421
    )
    
    
    (14,787
    )
    
    
    (44,092
    )
    
    
    (28,307
    )Interest credited to universal life
insurance contracts
    
    
    (2,718
    )
    
    
    (2,748
    )
    
    
    (5,421
    )
    
    
    (5,490
    )Net investment spread
    
    
    15,671
    
    
    
    9,340
    
    
    
    31,299
    
    
    
    17,964Net realized investment gain (losses)
    
    
    (934
    )
    
    
    3,547
    
    
    
    (2,091
    )
    
    
    4,702Fee income, net of reinsurance
    
    
    3,557
    
    
    
    2,971
    
    
    
    7,829
    
    
    
    6,727General and administrative expenses, net
of deferrals
    
    
    (1,604
    )
    
    
    (1,805
    )
    
    
    (4,629
    )
    
    
    (4,277
    )Amortization of DAC
    
    
    (8,425
    )
    
    
    (6,000
    )
    
    
    (16,403
    )
    
    
    (11,250
    )Annual commissions
    
    
    (231
    )
    
    
    (273
    )
    
    
    (725
    )
    
    
    (455
    )Claims on UL contracts, net of reinsurance
recoveries
    
    
    (290
    )
    
    
    (327
    )
    
    
    (1,580
    )
    
    
    (1,603
    )Guaranteed benefits, net of
reinsurance recoveries
    
    
    (496
    )
    
    
    (243
    )
    
    
    (979
    )
    
    
    (458
    )Pretax income before cumulative effect of
accounting change
    
    $
    7,248
    
    
    $
    7,210
    
    
    $
    12,721
    
    
    $
    11,350
 Net investment spread totaled $15.7 million in the second quarter of 2004,
compared to $9.3 million in the second quarter of 2003. These amounts equal
2.01% on average invested assets (computed on a daily basis) of $3.11 billion
in the second quarter of 2004 and 1.99% on average invested assets of $1.88
billion in the second quarter of 2003. For the six months, net investment
spread increased to $31.3 million in 2004 from $18.0 million in 2003
representing 2.04% of average invested assets of $3.07 billion in 2004 and
2.00% of average invested assets of $1.80 billion in 2003 on an annualized
basis. The increase in the net investment spread rate was primarily due to the
decline in overall rates paid in 2004 compared to 2003, as the Company issued
new fixed annuities at rates below the prior year average rates. 13




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##### Table of Contents



The components of net investment spread were as follows: Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(in thousands)Net investment spread
    
    $
    15,671
    
    
    $
    9,340
    
    
    $
    31,299
    
    
    $
    17,964Average invested assets
    
    
    3,113,428
    
    
    
    1,875,738
    
    
    
    3,072,402
    
    
    
    1,800,825Average interest-bearing liabilities
    
    
    2,940,424
    
    
    
    1,769,760
    
    
    
    2,892,082
    
    
    
    1,686,267Yield on average invested assets
    
    
    5.24
    %
    
    
    5.73
    %
    
    
    5.26
    %
    
    
    5.75
    %Rate paid on average interest-bearing liabilities
    
    
    3.42
    
    
    
    3.96
    
    
    
    3.42
    
    
    
    4.01Difference between yield and interest rate paid
    
    
    1.82
    %
    
    
    1.77
    %
    
    
    1.84
    %
    
    
    1.74
    %Net investment spread as a percentage of
average invested assets
    
    
    2.01
    %
    
    
    1.99
    %
    
    
    2.04
    %
    
    
    2.00
    %
 Growth in average invested assets resulted primarily from sales of fixed
annuities since June 30, 2003 through an increased number of fixed annuity
distribution partners in New York. Changes in average invested assets also
reflect sales of fixed account options of the Companys variable annuity
products, and renewal deposits on its universal life products (UL Deposits).
Sales of fixed annuities and fixed account options (Fixed Annuity Deposits)
and UL Deposits totaled $106.3 million in the second quarter of 2004 and $310.0
million in the second quarter of 2003, $333.8 million in the six months of 2004
and $479.9 million in the six months of 2003. The decline in sales from both
the first quarter of 2004 and from the prior year level resulted from the
Companys pricing action in response to an extremely low interest rate
environment. In response to the low interest rate environment, the Company
reduced the minimum rate paid on its fixed annuity products below the
historically prevailing rate in order to maintain the appropriate margin. The
Company does not intend to write business below its targeted rates of return to
gain market and anticipates continued lower sales levels in Fixed Annuity
Deposits in coming months until the interest rate environment improves. Net investment spreads include the effect of income earned or interest
paid on the difference between average invested assets and average
interest-bearing liabilities. Average invested assets exceeded average
interest-bearing liabilities by $173.0 million in the second quarter of 2004,
compared with $106.0 million in the second quarter of 2003. For the six
months, average invested assets exceeded average interest-bearing liabilities
by $180.3 million in 2004, compared with $114.6 million in 2003. The
difference between the Companys yield on average invested assets and the rate
paid on average interest-bearing liabilities was 1.82% in the second quarter of
2004, 1.77% in the second quarter of 2003, 1.84% in the six months of 2004 and
1.74% in the six months of 2003. Investment income (and the related yields on average invested assets)
totaled $40.8 million (5.24%) in the second quarter of 2004, $26.9 million
(5.73%) in the second quarter of 2003, $80.8 million (5.26%) in the six months
of 2004 and $51.8 million (5.75%) in the six months of 2003. The decrease in
the investment yield in 2004 compared to 2003 primarily reflects a lower
prevailing interest rate environment. Expenses incurred to manage the
investment portfolio amounted to $0.3 million in the second quarter of 2004,
$0.2 million in the second quarter of 2003, $0.6 million in the six months of
2004 and $0.3 million in the six months of 2003. These expenses are included
as a reduction of investment income in the statement of income and
comprehensive income. Interest expense totaled $25.1 million in the second quarter of 2004 and
$17.5 million in the second quarter of 2003. For the six months, interest
expense aggregated $49.5 million in 2004, compared with $33.8 million in 2003.
The average rate paid on all interest-bearing liabilities was 3.42% in the
second quarter of 2004 compared with 3.96% in the second quarter of 2003. For
six months, the average rate paid on all interest-bearing liabilities was 3.42%
for 2004 and 4.01% for 2003. Interest-bearing liabilities averaged $2.94
billion during the second quarter of 2004, $1.77 billion during the second
quarter of 2003, $2.89 billion during the six months of 2004 and $1.69 billion
during the six months of 2003. The decline in overall rates paid in 2004
compared to 2003 resulted primarily from the impact of a lower interest rate
environment, as the Company issued new fixed annuities at rates substantially
below the prior year average rates. 14




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##### Table of Contents



NET REALIZED INVESTMENT GAINS (LOSSES) totaled $0.9 million of losses in
the second quarter of 2004, compared to net realized investment gains of $3.5
million in the second quarter of 2003 and include impairment writedowns of $0.3
million in each quarter. For the six months, net realized investment losses
totaled $2.1 million in 2004, compared with net realized investment gains of
$4.7 million in 2003 and include impairment writedowns of $0.7 million and $0.3
million, respectively. Thus, net realized losses from sales and redemptions of
investments totaled $0.6 million in the second quarter of 2004, compared to net
realized gains of $3.8 million in the second quarter of 2003. For the six
months, net realized losses from sales and redemptions of investments totaled
$1.4 million in 2004, compared to net realized gains of $5.0 million in 2003. The Company sold or redeemed invested assets, principally bonds and notes,
aggregating $157.2 million in the second quarter of 2004, $106.5 million in the
second quarter of 2003, $387.7 million in the six months of 2004 and $251.6
million in the six months of 2003. Sales of investments result from the active
management of the Companys investment portfolio. Because redemptions of
investments are generally involuntary and sales of investments are made in both
rising and falling interest rate environments, net gains and losses from sales
and redemptions of investments fluctuate from period to period, and represent
0.08%, 0.81%, 0.09% and 0.56% of average invested assets in the second quarter
of 2004, the second quarter of 2003, the six months of 2004 and the six months
of 2003, respectively. Active portfolio management involves the ongoing
evaluation of asset sectors, individual securities within the investment
portfolio and the reallocation of investments from sectors that are perceived
to be relatively overvalued to sectors that are perceived to be relatively
undervalued. The intent of the Companys active portfolio management is to
maximize total returns on the investment portfolio, taking into account credit,
option, liquidity and interest-rate risk. Impairment writedowns include $0.3 million, $0.3 million, $0.7 million and
$0.3 million of provisions applied to bonds in the second quarter of 2004, the
second quarter of 2003, the six months of 2004 and the six months of 2003,
respectively. On an annualized basis, impairment writedowns represent 0.04%,
0.06%, 0.05% and 0.03% of average invested assets in the respective periods.
For the twenty quarters ended June 30, 2004, impairment writedowns as an
annualized percentage of average invested assets have ranged from 0.00% to
3.99% and have averaged 0.74%. Such writedowns are based upon estimates of the
fair value of invested assets and recorded when declines in the value of such
assets are considered to be other than temporary. Actual realization will be
dependent upon future events. VARIABLE ANNUITY POLICY FEES are primarily based on the market value of
assets in separate accounts supporting variable annuity contracts. Such fees
totaled $2.2 million in the second quarter of 2004 and $2.0 million in the
second quarter of 2003. For the six months variable annuity policy fees
totaled $4.4 million in 2004 and $3.9 million in 2003. The increased fees in
2004 as compared to 2003 primarily reflect the improving equity market
conditions since the first quarter of 2003, and the resulting favorable impact
on market values of assets in the separate accounts. On an annualized basis,
variable annuity policy fees represent 1.9%, 2.0%, 2.0% and 2.0% of average
variable annuity assets in the second quarters and six months of 2004 and 2003,
respectively. Variable annuity assets averaged $446.1 million, $406.2 million,
$447.2 million and $397.8 million during the respective periods. Variable
annuity deposits, which exclude deposits allocated to the fixed accounts of
variable annuity products, totaled $14.3 million and $5.8 million in the second
quarters of 2004 and 2003, respectively. For the six months, variable annuity
deposits totaled $24.4 million and $11.8 million in 2004 and 2003,
respectively. On an annualized basis, these amounts represent 13%, 6%, 11% and
6% of variable annuity reserves at the beginning of the respective periods.
Transfers from the fixed accounts of the Companys variable annuity products to
the separate accounts are not classified as variable annuity deposits.
Accordingly, changes in variable annuity deposits are not necessarily
indicative of the ultimate allocation by customers among fixed and variable
account options of the Companys variable annuity products. Sales of variable annuity products (which include deposits allocated to
the fixed accounts) (Variable Annuity Product Sales) amounted to $25.6
million, $29.5 million, $53.5 million and $45.2 million in the second quarters
and the six months of 2004 and 2003, respectively. The increase in Variable
Annuity Product Sales for the six months reflects the improving equity market
conditions since the first quarter of 2003. The Company has encountered increased competition in the variable annuity
marketplace during recent years and anticipates that the market will remain
highly competitive for the foreseeable future. Also, from time to time,
Federal initiatives are proposed that could affect the taxation of annuities
(see Regulation). 15




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##### Table of Contents



UNIVERSAL LIFE INSURANCE POLICY FEES, NET OF REINSURANCE amounted to $0.6
million in the second quarters of 2004 and 2003 and are net of reinsurance
premiums of $2.4 million in each quarter. For the six months, universal life
insurance policy fees totaled $2.2 million in 2004 and $2.0 million in 2003 and
are net of reinsurance premiums of $4.0 million for each period. Universal
life insurance policy fees consist of mortality charges, up-front fees earned
on deposits received and administrative fees, net of reinsurance premiums. The
administrative fees are assessed based on the number of policies in force as of
the end of each month. The Company acquired its universal life contracts as
part of the acquisition of business from MBL Life Assurance Corporation on July
1, 1999 and does not actively market such contracts. Such fees represent
annualized 1.1%, 1.1%, 1.9% and 1.7% of average reserves for universal life
insurance contracts in the respective periods. SURRENDER CHARGES on fixed annuity, variable annuity and universal life
contracts totaled $0.8 million in the second quarter of 2004 and $0.4 million
in the second quarter of 2003. For the six months, such surrender charges
totaled $1.3 million in 2004 and $0.8 million in 2003. Surrender charge
periods range from zero to nine years from the date a deposit is received.
Surrender charges generally are assessed on withdrawals at declining rates. GENERAL AND ADMINISTRATIVE EXPENSES totaled $1.6 million in the second
quarter of 2004 and $1.8 million in the second quarter of 2003. For the six
months, general administrative expenses totaled $4.6 million in 2004 and $4.3
million in 2003. General and administrative expenses remain closely controlled
through a company-wide cost containment program and continue to represent less
than 1% of average total assets. AMORTIZATION OF DEFERRED ACQUISITION COSTS AND OTHER DEFERRED EXPENSES
totaled $8.4 million in the second quarter of 2004, compared to $6.0 million in
the second quarter of 2003. For the six months, such amortization totaled
$16.4 million in 2004, compared to $11.3 million in 2003. The increase in
amortization in 2004 was primarily related to the increase in investment spread
from a growing block of fixed annuities, partially offset by higher net
realized investment losses. ANNUAL COMMISSIONS totaled $0.2 million in the second quarter of 2004 and
$0.3 million in the second quarter of 2003. For the six months, annual
commissions totaled $0.7 million in 2004 and $0.5 million in 2003. Annual
commissions represent renewal commissions paid quarterly in arrears to maintain
the persistency of certain of the Companys products. Substantially all of the
Companys currently available annuity products allow for an annual commission
payment option in return for a lower immediate commission. CLAIMS ON UNIVERSAL LIFE CONTRACTS, NET OF REINSURANCE RECOVERIES totaled
$0.3 million in the second quarters of 2004 and 2003 (net of reinsurance
recoveries of $0.7 million in the second quarter of 2004 and $0.3 million in
the second quarter of 2003). For the six months, such claims totaled $1.6
million in 2004 and 2003 (net of reinsurance recoveries of $2.0 million in 2004
and $1.9 million in 2003). GUARANTEED MINIMUM DEATH BENEFITS (GMDB) on variable annuity contracts
totaled $0.5 million in the second quarter of 2004 compared with $0.2 million
in the second quarter of 2003. For the six months, GMDB amounted to $1.0
million in 2004 and $0.5 million in 2003. Downturns in the equity markets
could increase this expense. A majority of the Companys variable annuity products are issued with a
death benefit feature, which provides that, upon the death of a contract
holder, the contract holders beneficiary will receive the greater of (1) the
contract holders account value, or (2) a guaranteed minimum death benefit that
varies by product. The Company bears the risk that death claims following a
decline in the equity markets may exceed contract holder account balances, and
that the fees collected under the contract are insufficient to cover the costs
of the benefit to be provided. On January 1, 2004, the Company recorded a
liability for GMDB (see Note 2 of Notes to Financial Statements) pursuant to
adoption of a new accounting standard, SOP 03-1. GUARANTEED MINIMUM ACCOUNT VALUE (GMAV): In June of 2004, the Company
began issuing certain variable annuity products that offer an optional GMAV.
If elected by the policyholder at the time of contract issuance, this feature
guarantees that the account value under the contract will at least equal the
amount of the initial principal invested, adjusted for withdrawals, at the end
of a ten-year waiting period. The Company bears the risk that protracted
under-performance of the financial markets could result in GMAV benefits being
higher than the underlying contract holder account balance and that the fees
collected under the contract are insufficient to cover the costs of the benefit
to be provided. Changes in the market value of the GMAV benefit is 16




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##### Table of Contents



recorded in investment income in the accompanying statement of income and
comprehensive income. In 2004, variable annuity deposits with the GMAV option
were immaterial. CAPITAL RESOURCES AND LIQUIDITY SHAREHOLDERS EQUITY decreased to $330.2 million at June 30, 2004 from
$349.5 million at December 31, 2003, due to $24.8 million decrease in
unrealized gains, net of the effect on taxes and DAC, partially offset by $5.5
million of net income. INVESTMENTS AND CASH at June 30, 2004 totaled $3.67 billion, compared with
$3.17 billion at December 31, 2003. The Companys invested assets are managed
by an affiliate of AIG. The following table summarizes the Companys Bond
Portfolio and other investments and cash at June 30, 2004 and December 31,
2003: June 30, 2004
    
    December 31, 2003Percent of
    
    
    
    
    
    Percent ofFair Value
    
    Portfolio
    
    Fair Value
    
    Portfolio(in thousands, except for percentages)Bond Portfolio:U.S. government securities
    
    $
    21,371
    
    
    
    0.6
    %
    
    $
    18,054
    
    
    
    0.6
    %Mortgage-backed securities
    
    
    709,319
    
    
    
    19.3
    
    
    
    634,640
    
    
    
    20.0Securities of public utilities
    
    
    147,644
    
    
    
    4.0
    
    
    
    131,158
    
    
    
    4.1Corporate bonds and notes
    
    
    1,480,740
    
    
    
    40.4
    
    
    
    1,248,590
    
    
    
    39.4Other debt securities
    
    
    473,124
    
    
    
    12.9
    
    
    
    625,370
    
    
    
    19.8Total Bond Portfolio
    
    
    2,832,198
    
    
    
    77.2
    
    
    
    2,657,812
    
    
    
    83.9Mortgage loans
    
    
    257,534
    
    
    
    7.0
    
    
    
    215,521
    
    
    
    6.8Common stocks
    
    
    891
    
    
    
    0.0
    
    
    
    295
    
    
    
    0.0Cash and short-term investments
    
    
    23,176
    
    
    
    0.6
    
    
    
    104,011
    
    
    
    3.3Securities lending collateral
    
    
    522,883
    
    
    
    14.3
    
    
    
    154,756
    
    
    
    4.9Other
    
    
    34,276
    
    
    
    0.9
    
    
    
    35,251
    
    
    
    1.1Total investments and cash
    
    $
    3,670,958
    
    
    
    100.0
    %
    
    $
    3,167,646
    
    
    
    100.0
    %
 The Companys general investment philosophy is to hold fixed-rate assets
for long-term investment. Thus, it does not have a trading portfolio. However,
the Company has determined that all of the Bond Portfolio is available to be
sold in response to changes in market interest rates, changes in relative value
of asset sectors and individual securities, changes in prepayment risk, changes
in the credit quality outlook for certain securities, the Companys need for
liquidity and other similar factors. THE BOND PORTFOLIO, which constituted 77% of the Companys total
investment portfolio at June 30, 2004, had an amortized cost that was $16.1
million greater than its aggregate fair value at June 30, 2004, compared with
an aggregate fair value that was $40.2 million greater than its amortized cost
at December 31, 2003. The decrease in net unrealized gains on the Bond
Portfolio during 2004 principally reflected the impact of the increase in
prevailing interest rates and the corresponding effect on the fair value of the
Bond Portfolio at June 30, 2004. At June 30, 2004, the Bond Portfolio had an aggregate fair value of $2.83
billion and an aggregate amortized cost of $2.85 billion. At June 30, 2004,
the Bond Portfolio included $2.71 billion of bonds rated by Standard & Poors
(S&P), Moodys Investors Services (Moodys), Fitch (Fitch) or the
National Association of Insurance Commissioners (NAIC), and $118.8 million of
bonds rated by the Company pursuant to statutory ratings guidelines established
by the NAIC. At June 30, 2004, approximately $2.67 billion of the Bond
Portfolio was investment grade, including $730.7 million of U.S.
government/agency securities and mortgage-backed securities (MBS). 17




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##### Table of Contents



At June 30, 2004, the Bond Portfolio included $162.9 million of bonds that
were not investment grade. These non-investment-grade bonds accounted for
approximately 3.7% of the Companys total assets and approximately 4.4% of its
invested assets. Non-investment-grade securities generally provide higher
yields and involve greater risks than investment-grade securities because their
issuers typically are more highly leveraged and more vulnerable to adverse
economic conditions than investment-grade issuers. In addition, the trading
market for these securities is usually more limited than for investment-grade
securities. An economic downturn could produce higher than average issuer
defaults on the non-investment-grade securities, which could cause the
Companys investment returns and net income to decline. At June 30, 2004, the
Companys non-investment-grade portfolio consisted of 53 issues with no single
issuer representing more than 10% of the total non-investment grade bond
portfolio. These non-investment-grade securities are comprised of bonds
spanning 11 industries with 18% of these assets concentrated in financial
institutions, 18% concentrated in utilities, 15% concentrated in
telecommunications, 13% concentrated in noncyclical consumer products, 13%
concentrated in cyclical consumer products and 11% concentrated in
transportation. No other industry concentration constituted more than 10% of
these assets. The table on the following page summarizes the Companys rated bonds by
rating classification as of June 30, 2004. 18




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##### Table of Contents



RATED BONDS BY RATING CLASSIFICATION
(Dollars in thousands) Issues not rated by S&P/Moodys/Issues rated by S&P/Moodys/Fitch
    
    Fitch, by NAIC category
    
    TotalPercentEstimated
    
    NAIC
    
    
    
    
    
    Estimated
    
    
    
    
    
    Estimated
    
    of totalS&P/Moodys/Fitch
    
    Amortized
    
    fair
    
    Category
    
    Amortized
    
    fair
    
    Amortized
    
    fair
    
    investedCategory (1)
    
    cost
    
    value
    
    (2)
    
    Cost
    
    value
    
    cost
    
    value
    
    assetsAAA+ to A-
(Aaa to A3)
[AAA to A-]
    
    $
    1,743,459
    
    
    $
    1,728,905
    
    
    
    1
    
    
    $
    218,514
    
    
    $
    220,361
    
    
    $
    1,961,973
    
    
    $
    1,949,266
    
    
    
    53.10
    %BBB+ to BBB-
(Baa1 to Baa3)
[BBB+ to BBB-]
    
    
    586,644
    
    
    
    585,173
    
    
    
    2
    
    
    
    133,572
    
    
    
    134,857
    
    
    
    720,216
    
    
    
    720,030
    
    
    
    19.61
    %BB+ to BB-
(Ba1 to Ba3)
[BB+ to BB-]
    
    
    49,995
    
    
    
    50,912
    
    
    
    3
    
    
    
    16,138
    
    
    
    16,342
    
    
    
    66,133
    
    
    
    67,254
    
    
    
    1.83
    %B+ to B-
(B1 to B3)
[B+ to B-]
    
    
    28,665
    
    
    
    25,953
    
    
    
    4
    
    
    
    7,911
    
    
    
    8,219
    
    
    
    36,576
    
    
    
    34,172
    
    
    
    0.93
    %CCC+ to CCC-
(Caa1 to Caa3)
[CCC+ to CCC-]
    
    
    8,410
    
    
    
    6,918
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    8,410
    
    
    
    6,918
    
    
    
    0.19
    %CC to D
(Ca to C)
[CC to D]
    
    
    380
    
    
    
    831
    
    
    
    6
    
    
    
    54,641
    
    
    
    53,727
    
    
    
    55,021
    
    
    
    54,558
    
    
    
    1.49
    %TOTAL RATED
ISSUES
    
    $
    2,417,553
    
    
    $
    2,398,692
    
    
    
    
    
    
    $
    430,776
    
    
    $
    433,506
    
    
    $
    2,848,329
    
    
    $
    2,832,198
 Footnotes
to the table of Rated Bonds by Rating Classification  (1)
    
    S&P and Fitch rate debt securities in rating categories ranging from AAA
(the highest) to D (in payment default). A plus (+) or minus (-)
indicates the debts relative standing within the rating category. A
security rated BBB- or higher is considered investment grade. Moodys
rates debt securities in rating categories ranging from Aaa (the highest)
to C (extremely poor prospects of ever attaining any real investment
standing). The number 1,2 or 3 (with 1 the highest and 3 the lowest)
indicates the debts relative standing within the rating category. A
security rated Baa3 or higher is considered investment grade. Issues are
categorized based on the highest of the S&P, Moodys, and Fitch ratings if
rated by multiple agencies.(2)
    
    Bonds and short-term promissory instruments are divided into six
quality categories for NAIC rating purposes, ranging from 1 (highest) to 5
(lowest) for non-defaulted bonds plus one category, 6, for bonds in or near
default. These six categories correspond with the S&P/Moodys/Fitch rating
groups listed above, with categories 1 and 2 considered investment grade. The
NAIC categories include $118.8 million of assets that were rated by the Company
pursuant to applicable NAIC rating guidelines. 19




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##### Table of Contents



The valuation of invested assets involves obtaining a fair value for each
security. The source for the fair value is generally from market exchanges,
with the exception of non-traded securities. Another aspect of valuation pertains to impairment. As a matter of
policy, the determination that a security has incurred an other-than-temporary
decline in value and the amount of any loss recognition requires the judgment
of the Companys management and a continual review of its investments. In
general, a security is considered a candidate for impairment if it meets any of
the following criteria:  
    
    Trading at a significant discount to par, amortized cost (if lower)
or cost for an extended period of time;
    
    The occurrence of a discrete credit event resulting in: (i) the
issuer defaulting on a material outstanding obligation; (ii) the issuer
seeking protection from creditors under the bankruptcy laws or similar
laws intended for the court supervised reorganization of insolvent
enterprises; or (iii) the issuer proposing a voluntary reorganization
pursuant to which creditors are asked to exchange their claims for cash
or securities having a fair value substantially lower than the par
value of their claims; or
    
    In the opinion of the Companys management, it is unlikely the
Company will realize a full recovery on its investment, irrespective of
the occurrence of one of the foregoing events. Once a security has been identified as potentially impaired, the amount of
such impairment is determined by reference to that securitys contemporaneous
market price. The Company has the ability to hold any security to its stated maturity.
Therefore, the decision to sell reflects the judgment of the Companys
management that the security sold is unlikely to provide, on a relative value
basis, as attractive a return in the future as alternative securities entailing
comparable risks. With respect to distressed securities, the sale decision
reflects managements judgment that the risk-discounted anticipated ultimate
recovery is less than the value achieved on sale. As a result of these policies, the Company recorded pretax impairment
writedowns of $0.7 million and $0.3 million in the six
months of 2004 and 2003,
respectively. No individual impairment loss exceeded 10% of the Companys net
income for the six months ended June 30, 2004. Excluding the impairments noted above, the changes in fair value for the
Companys Bond Portfolio, which constitutes the vast majority of the Companys
investments, were recorded as a component of other comprehensive income in
shareholders equity as unrealized gains or losses. At June 30, 2004, the fair value of the Companys Bond Portfolio
aggregated $2.83 billion. Of this aggregate fair value, approximately 0.2%
represented securities trading at or below 75% of amortized cost. The impact
of unrealized losses on net income will be further mitigated upon realization,
because realization will result in current decreases in the amortization of
certain deferred acquisition costs and decreases in income taxes. At June 30, 2004, approximately $1.11 billion, at amortized cost, of the
Bond Portfolio had a fair value of $1.14 million resulting in an aggregate
unrealized gain of $39.9 million. At June 30, 2004, approximately $1.74
billion, at amortized cost, of the Bond Portfolio had a fair value of $1.69
million resulting in an aggregate unrealized loss of $56.0 million. No single
issuer accounted for more than 10% of unrealized losses. Unrealized losses for
the Bond Portfolio and equity securities did not reflect any significant
industry concentrations. 20




---



##### Table of Contents



The amortized cost of the Bond Portfolio in an unrealized loss position at
June 30, 2004, by contractual maturity, is shown below. Amortized Cost(in thousands)Due in one year or less
    
    $
    29Due after one year through five years
    
    
    329,258Due after five years through ten years
    
    
    693,399Due after ten years
    
    
    718,781Total
    
    $
    1,741,467
 The aging of the Bond Portfolio in an unrealized loss position at June 30,
2004 is shown below: Less than or Equal to 20%
    
    Greater than 20% to 50%
    
    Greater than 50%(dollars in thousands)
    
    of Amortized Cost
    
    of Amortized Cost
    
    of Amortized Cost
    

TotalAmortized
    
    Unrealized
    
    
    
    
    
    Amortized
    
    Unrealized
    
    
    
    
    
    Amortized
    
    Unrealized
    
    
    
    
    
    Amortized
    
    UnrealizedMonths
    
    Cost
    
    Loss
    
    Items
    
    Cost
    
    Loss
    
    Items
    
    Cost
    
    Loss
    
    Items
    
    Cost
    
    Loss
    
    ItemsInvestment Grade Bonds0-6
    
    $
    1,106,605
    
    
    $
    (29,141
    )
    
    
    185
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    1,106,605
    
    
    $
    (29,141
    )
    
    
    1857-12
    
    
    517,978
    
    
    
    (17,522
    )
    
    
    96
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    517,978
    
    
    
    (17,522
    )
    
    
    96>12
    
    
    33,866
    
    
    
    (1,154
    )
    
    
    5
    
    
    
    5,000
    
    
    
    (1,190
    )
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    38,866
    
    
    
    (2,344
    )
    
    
    6Total
    
    $
    1,658,449
    
    
    $
    (47,817
    )
    
    
    286
    
    
    $
    5,000
    
    
    $
    (1,190
    )
    
    
    1
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    
    1,663,449
    
    
    
    (49,007
    )
    
    
    287Below
Investment GradeBonds0-6
    
    $
    62,573
    
    
    $
    (2,487
    )
    
    
    12
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    62,573
    
    
    $
    (2,487
    )
    
    
    127-12
    
    
    931
    
    
    
    (133
    )
    
    
    2
    
    
    
    14,419
    
    
    
    (4,298
    )
    
    
    4
    
    
    
    29
    
    
    
    (29
    )
    
    
    1
    
    
    
    15,379
    
    
    
    (4,460
    )
    
    
    7>12
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    66
    
    
    
    (29
    )
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    66
    
    
    
    (29
    )
    
    
    1Total
    
    $
    63,504
    
    
    $
    (2,620
    )
    
    
    14
    
    
    $
    14,485
    
    
    $
    (4,327
    )
    
    
    5
    
    
    $
    29
    
    
    $
    (29
    )
    
    
    1
    
    
    $
    78,018
    
    
    $
    (6,976
    )
    
    
    20Total
Bonds0-6
    
    $
    1,169,178
    
    
    $
    (31,628
    )
    
    
    197
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    1,169,178
    
    
    $
    (31,628
    )
    
    
    1977-12
    
    
    518,909
    
    
    
    (17,655
    )
    
    
    98
    
    
    
    14,419
    
    
    
    (4,298
    )
    
    
    4
    
    
    
    29
    
    
    
    (29
    )
    
    
    1
    
    
    
    533,357
    
    
    
    (21,982
    )
    
    
    103>12
    
    
    33,866
    
    
    
    (1,154
    )
    
    
    5
    
    
    
    5,066
    
    
    
    (1,219
    )
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    38,932
    
    
    
    (2,373
    )
    
    
    7Total
    
    $
    1,721,953
    
    
    $
    (50,437
    )
    
    
    300
    
    
    $
    19,485
    
    
    $
    (5,517
    )
    
    
    6
    
    
    $
    29
    
    
    $
    (29
    )
    
    
    1
    
    
    $
    1,741,467
    
    
    $
    (55,983
    )
    
    
    307
 In 2004, the pretax realized losses incurred with respect to the sale of
fixed securities in the Bond Portfolio were $1.4 million. The aggregate fair
value of securities sold was $119.9 million, which was approximately 97.2% of
amortized cost. The average period of time that securities sold at a loss
during 2004 were trading continuously at a price below amortized cost was
approximately 8 months. The valuation for the Companys Bond Portfolio comes from market exchanges
or dealer quotations, with the exception of non-traded securities. The Company
considers non-traded securities to mean certain fixed income investments and
certain structured securities. The aggregate fair value of these securities at
June 30, 2004 was approximately $495.0 million. The methodology used to estimate fair value of non-traded fixed income
investments is by reference to traded securities with similar attributes and
using a matrix pricing methodology. This technique takes into account such
factors as the industry, the securitys rating and tenor, its coupon rate, its
position in the capital structure of the issuer and other relevant factors.
The change in fair value is recognized as a component of other comprehensive
income. 21




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##### Table of Contents



For certain structured securities, the carrying value is based on an
estimate of the securitys future cash flows pursuant to the requirements of
Emerging Issues Task Force Issue No. 99-20 Recognition of Interest Income and
Impairment on Purchased and Retained Beneficial Interests in Securitized
Financial Assets. The change in carrying value is recognized in income. Each of these investment categories is regularly tested to determine if
impairment in value exists. Various valuation techniques are used with respect
to each category in this determination. Senior secured loans (Secured Loans) are included in the Bond Portfolio
and aggregated $95.9 million at June 30, 2004. Secured Loans are senior to
subordinated debt and equity and are secured by assets of the issuer. At June
30, 2004, Secured Loans consisted of $53.3 million of privately traded
securities and $42.6 million of publicly traded securities. These Secured Loans
are composed of loans to borrowers spanning 9 industries, with 59% of these
assets concentrated in the utilities industry and 10% concentrated in basic
industrial products. No other industry concentration constituted more than 10%
of these assets. While the trading market for the Companys privately traded Secured Loans
is more limited than for publicly traded issues, participation in these
transactions has enabled the Company to improve its investment yield. As a
result of restrictive financial covenants, these Secured Loans involve greater
risk of technical default than do publicly traded investment-grade securities.
However, management believes that the risk of loss upon default for these
Secured Loans is mitigated by such financial covenants and the collateral
values underlying the Secured Loans. The Companys Secured Loans are rated by
S&P, Moodys, Fitch, the NAIC or by the Company, pursuant to comparable
statutory ratings guidelines established by the NAIC. MORTGAGE LOANS aggregated $257.5 million at June 30, 2004 and consisted of
81 commercial first mortgage loans with an average loan balance of
approximately $3.2 million, collateralized by properties located in 26 states.
Approximately 41% of this portfolio was office, 25% was multifamily
residential, 15% was industrial, 12% was retail and 7% was other types. At
June 30, 2004, approximately 26% and 16% of this portfolio was secured by
properties located in California and New York, respectively. No more than 10%
of this portfolio was secured by properties located in any other single state.
At June 30, 2004, four mortgage loans had an outstanding balance of $10 million
or more, which collectively aggregated approximately 22% of this portfolio. At
June 30, 2004, approximately 22% of the mortgage loan portfolio consisted of
loans with balloon payments due before July 1, 2007. During 2004 and 2003,
loans delinquent by more than 90 days, foreclosed loans and restructured loans
have not been significant in relation to the total mortgage loan portfolio. At June 30, 2004, approximately 16% of the mortgage loans were seasoned
loans underwritten to the Companys standards and purchased at or near par from
other financial institutions. Such loans generally have higher average
interest rates than loans that could be originated today. The balance of the
mortgage loan portfolio has been originated by the Company under strict
underwriting standards. Commercial mortgage loans on properties such as
offices, hotels and shopping centers generally represent a higher level of risk
than do mortgage loans secured by multifamily residences. This greater risk is
due to several factors, including the larger size of such loans and the more
immediate effects of general economic conditions on these commercial property
types. However, due to the seasoned nature of the Companys mortgage loan
portfolio and its strict underwriting standards, the Company believes that it
has prudently managed the risk attributable to its mortgage loan portfolio
while maintaining attractive yields. POLICY LOANS totaled $34.3 million at June 30, 2004, compared to $35.3
million at December 31, 2003, and primarily represent loans taken against
universal life insurance policies. SECURITIES LENDING COLLATERAL totaled $522.9 million at June 30, 2004,
compared to $154.8 million at December 31, 2003, and consisted of cash
collateral invested in highly rated short-term securities received in
connection with the Companys securities lending program. Although the cash
collateral is currently invested in highly rated short-term securities, the
applicable collateral agreements permit the cash collateral to be invested in
highly liquid short and long-term investment portfolios. At least 75% of the
portfolios short-term investments must have external issue ratings of A-1/P-1,
one of the highest ratings for short-term credit quality. Long-term
investments include corporate notes with maturities of five years or less and a
credit rating by at least two nationally 22




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##### Table of Contents



recognized statistical rating organizations (NRSRO), with no less than a
S&P rating of A or equivalent by any other NRSRO. ASSET-LIABILITY MATCHING is utilized by the Company in an effort to
minimize the risks of interest rate fluctuations and disintermediation. The
Company believes that its fixed-rate liabilities should be backed by a
portfolio principally composed of fixed-rate investments that generate
predictable rates of return. The Company does not have a specific target rate
of return. Instead, its rates of return vary over time depending on the current
interest rate environment, the slope of the yield curve, the spread at which
fixed-rate investments are priced over the yield curve, default rates, and
general economic conditions. Its portfolio strategy is constructed with a view
to achieve adequate risk-adjusted returns consistent with its investment
objectives of effective asset-liability matching, liquidity and safety. The
Companys fixed-rate products incorporate surrender charges or other
restrictions in order to encourage persistency. Approximately 82% of the
Companys fixed annuity and universal life reserves had surrender penalties or
other restrictions at June 30, 2004. As part of its asset-liability matching discipline, the Company conducts
detailed computer simulations that model its fixed-rate assets and liabilities
under commonly used interest rate scenarios. With the results of these
computer simulations, the Company can measure the potential gain or loss in
fair value of its interest-rate sensitive instruments and seek to protect its
economic value and achieve a predictable spread between what it earns on its
invested assets and what it pays on its liabilities by designing its fixed-rate
products and conducting its investment operations to closely match the duration
and cash flows of the fixed-rate assets to that of its fixed-rate liabilities.
The fixed-rate assets in the Companys asset-liability modeling include: cash
and short-term investments; bonds, notes and redeemable preferred stocks;
mortgage loans; and policy loans. At June 30, 2004, these assets had an
aggregate fair value of $3.16 billion with an option-adjusted duration of 4.8
years. The Companys fixed-rate liabilities include fixed annuity, fixed
options of variable annuity and universal life insurance contracts. At June
30, 2004, these liabilities had an aggregate fair value (determined by
discounting future contractual cash flows by related market rates of interest)
of $2.97 billion with an option-adjusted duration of 5.2 years. The Companys
potential exposure due to a relative 10% increase in prevailing interest rates
from its June 30, 2004 levels is a loss of approximately $1.4 million,
representing an increase in fair value of its fixed-rate liabilities that is
not offset by an increase in fair value of its fixed-rate assets. Because the
Company actively manages its assets and liabilities and has strategies in place
to minimize its exposure to loss as interest rate changes occur, it expects
that actual losses would be less than the estimated potential loss. Option-adjusted duration is a common measure for the price sensitivity of
a fixed-maturity portfolio to changes in interest rates. For example, if
interest rates increase 1%, the fair value of an asset with a duration of 5.0
years is expected to decrease in value by approximately 5%. The Company
estimates the option-adjusted duration of its assets and liabilities using a
number of different interest rate scenarios, assuming continuation of existing
investment and interest crediting strategies, including maintaining an
appropriate level of liquidity. Actual company and contract holder behaviors
may be different than was assumed in the estimate of option-adjusted duration
and these differences may be material. A significant portion of the Companys fixed annuity contracts (including
the fixed option of variable contracts) have reached or are near the minimum
contractual guaranteed rate (generally 3%). Continual declines in interest
rates could cause the spread between the yield on the portfolio and the
interest rate credited to policyholders to deteriorate. In 2003, the State of
New York adopted legislation reducing the minimum contractual rate that can be
credited to policyholders on new contracts to 1.5%. As a result, certain
contracts issued in 2004 and 2003 had a 1.5% minimum contractual guaranteed
rate. This will not impact the previously issued contracts. The Company has had the ability, limited by minimum interest rate
guarantees, to respond to the generally declining interest rate environment in
the last five years by lowering crediting rates in response to lower investment
returns. See the earlier discussion under Managements Discussion and
Analysis of Financial Condition and Results of Operations for additional
information on the calculation of investment yield and net investment spread
used by the Companys management as a key component in evaluating the
profitability of its annuity business. The trends experienced during the six
months ended June 30, 2004 and the three years ended December 31, 2003 in the
Companys yield on average invested assets and rate of interest credited on
average interest-bearing liabilities, compared to the market trend in long-term
interest rates as illustrated by the average ten-year U.S. Treasury bond rate,
are presented in the following table: 23




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##### Table of Contents



Six months endedJune 30,
    
    Year ended December 31,2004
    
    2003
    
    2002
    
    2001Average 10-year U.S. Treasury bond rate:
    
    
    4.29
    %
    
    
    4.01
    %
    
    
    4.61
    %
    
    
    5.02
    %First SunAmerica Life Insurance Company:Average yield on Bond Portfolio
    
    
    5.26
    
    
    
    5.77
    
    
    
    6.98
    
    
    
    7.01Rate paid on average interest-bearing liabilities
    
    
    3.42
    
    
    
    3.84
    
    
    
    4.39
    
    
    
    4.70
 The Company seeks to enhance its spread income with dollar roll repurchase
agreements (Dollar Roll Repos). Dollar Roll Repos involve a sale of MBS by
the Company and an agreement to repurchase substantially similar MBS at a later
date at an agreed upon price. The Company also seeks to provide liquidity by
investing in MBS. MBS are generally investment-grade securities collateralized
by large pools of mortgage loans. MBS generally pay principal and interest
monthly. The amount of principal and interest payments may fluctuate as a
result of prepayments of the underlying mortgage loans. There are risks associated with some of the techniques the Company uses to
provide liquidity, enhance its spread income and match its assets and
liabilities. The primary risk associated with the Companys Dollar Roll Repos
is counterparty risk. The Company believes, however, that the counterparties
to its Dollar Roll Repos are financially responsible and that the counterparty
risk associated with those transactions is minimal. It is the Companys policy
that these agreements are entered into with counterparties who have a debt
rating of A/A2 or better from both S&P and Moodys. The Company continually
monitors its credit exposure with respect to these agreements. The primary
risk associated with MBS is that a changing interest rate environment might
cause prepayment of the underlying obligations at speeds slower or faster than
anticipated at the time of their purchase. As part of its decision to purchase
such a security, the Company assesses the risk of prepayment by analyzing the
securitys projected performance over an array of interest-rate scenarios.
Once such a security is purchased, the Company monitors its actual prepayment
experience monthly to reassess the relative attractiveness of the security with
the intent to maximize total return. INVESTED ASSETS EVALUATION is routinely conducted by the Company.
Management identifies monthly those investments that require additional
monitoring and carefully reviews the carrying values of such investments at
least quarterly to determine whether specific investments should be placed on a
nonaccrual basis and to determine declines in value that may be other than
temporary. In conducting these reviews for bonds, management principally
considers the adequacy of any collateral, compliance with contractual
covenants, the borrowers recent financial performance, news reports and other
externally generated information concerning the creditors affairs. In the case
of publicly traded bonds, management also considers market value quotations, if
available. For mortgage loans, management generally considers information
concerning the mortgaged property and, among other things, factors impacting
the current and expected payment status of the loan and, if available, the
current fair value of the underlying collateral. The carrying values of investments that are determined to have declines in
value that are other than temporary are reduced to fair value and, in the case
of bonds, no further accruals of interest are made. The provisions for
impairment on mortgage loans are based on losses expected by management to be
realized on transfers of mortgage loans to real estate, on the disposition and
settlement of mortgage loans and on mortgage loans that management believes may
not be collectible in full. Accrual of interest is suspended when principal and
interest payments on mortgage loans are past due more than 90 days. Impairment
losses on securitized assets are recognized if the fair value of the security
is less than its book value, and the net present value of expected future cash
flows is less than the net present value of expected future cash flows at the
most recent (prior) estimation date. DEFAULTED INVESTMENTS, comprising all investments that are in default as
to the payment of principal or interest, totaled $0.7 million of bonds at June
30, 2004, and constituted less than 0.02% of total invested assets. At December
31, 2003, defaulted investments totaled $0.2 million of bonds and constituted
less than 0.1% of total invested assets. 24




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SOURCES OF LIQUIDITY are readily available to the Company in the form of
the Companys existing portfolio of cash and short-term investments, repo
capacity on invested assets and if required, proceeds from invested asset
sales. The Companys liquidity is primarily derived from operating cash flows.
At June 30, 2004, approximately $1.15 billion of the Bond Portfolio had an
aggregate unrealized gain of $39.9 million while approximately $1.69 million of
the Bond Portfolio had an aggregate unrealized loss of $56.0 million. In
addition, the Companys investment portfolio currently provides approximately
$23.8 million of monthly cash flow from scheduled principal and interest
payments. Historically, cash flows from operations and from the sale of the
Companys annuity products have been more than sufficient in amount to satisfy
the Companys liquidity needs. Management is aware that prevailing market interest rates may shift
significantly and has strategies in place to manage either an increase or
decrease in prevailing rates. In a rising interest rate environment, the
Companys average cost of funds would increase over time as it prices its new
and renewing annuities to maintain a generally competitive market rate.
Management would seek to place new funds in investments that were matched in
duration to, and higher yielding than, the liabilities assumed. The Company
believes that liquidity to fund withdrawals would be available through incoming
cash flow, the sale of short-term or floating-rate instruments or repos on the
Companys substantial MBS segment of the Bond Portfolio, thereby avoiding the
sale of fixed-rate assets in an unfavorable bond market. In a declining rate environment, the Companys cost of funds would
decrease over time, reflecting lower interest crediting rates on its fixed
annuities. Should increased liquidity be required for withdrawals, the Company
believes that a significant portion of its investments could be sold without
adverse consequences in light of the general strengthening that would be
expected in the bond market. If a substantial portion of the Companys Bond Portfolio diminished
significantly in value and/or defaulted, the Company would need to liquidate
other portions of its investment portfolio and/or arrange financing. Such
events that may cause such a liquidity strain could be the result of economic
collapse or terrorist acts. Management believes that the Companys liquid assets and its net cash
provided by operations will enable the Company to meet any foreseeable cash
requirements for at least the next twelve months. RECENTLY ISSUED ACCOUNTING STANDARDS In July 2003, the American Institute of Certified Public Accountants
issued Statement of Position 03-1, Accounting and Reporting by Insurance
Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate
Accounts (SOP 03-1). (For further discussion see Note 2 of Notes to
Financial Statements.) REGULATION The Company, in common with other insurers, is subject to regulation and
supervision by the states and jurisdictions in which it does business. Within
the United States, the method of such regulation varies but generally has its
source in statutes that delegate regulatory and supervisory powers to an
insurance official. The regulation and supervision relate primarily to
approval of policy forms and rates, the standards of solvency that must be met
and maintained, including risk based capital measurements, the licensing of
insurers and their agents, the nature of and limitations on investments,
restrictions on the size of risks which may be insured under a single policy,
deposits of securities for the benefit of policyholders, methods of accounting,
periodic examinations of the affairs of insurance companies, the form and
content of reports of financial condition required to be filed, and reserves
for unearned premiums, losses and other purposes. In general, such regulation
is for the protection of policyholders rather than security holders. Risk based capital (RBC) standards are designed to measure the adequacy
of an insurers statutory capital and surplus in relation to the risks inherent
in its business. The standards are intended to help identify inadequately
capitalized companies and require specific regulatory actions in the event an
insurers RBC is deficient. The RBC formula develops a risk-adjusted target
level of adjusted statutory capital and surplus by applying certain factors to
various asset, premium and reserve items. Higher factors are applied to more
risky items and lower factors are 25




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applied to less risky items. Thus, the target level of statutory surplus
varies not only as a result of the insurers size, but also on the risk profile
of the insurers operations. The RBC Model Law provides four incremental
levels of regulatory attention for insurers whose surplus is below the
calculated RBC target. These levels of attention range in severity from
requiring the insurer to submit a plan for corrective action to actually
placing the insurer under regulatory control. The statutory capital and
surplus of the Company exceeded its RBC requirements as of June 30, 2004. The federal government does not directly regulate the business of
insurance, however, the Company and its products are governed by federal
agencies, including the SEC, the Internal Revenue Service and the
self-regulatory organization, the National Association of Securities Dealers,
Inc. (NASD). Federal legislation and administrative policies in several
areas, including financial services regulation, pension regulation and federal
taxation, can significantly and adversely affect the insurance industry. The
federal government has from time to time considered legislation relating to the
deferral of taxation on the accretion of value within certain annuities and
life insurance products, changes in ERISA regulations, the alteration of the
federal income tax structure and the availability of Section 401(k) and
individual retirement accounts. Although the ultimate effect of any such
changes, if implemented, is uncertain, both the persistency of our existing
products and our ability to sell products may be materially impacted in the
future. Recently there has been a significant increase in federal and state
regulatory activity relating to financial services companies, particularly
mutual fund companies and life insurers issuing variable annuity products.
These inquiries have focused on a number of issues including, among other
items, after-hours trading, short-term trading (sometimes referred to as market
timing), revenue sharing arrangements and greater transparency regarding
compensation arrangements. There are several rule proposals pending at the
SEC, the NASD and on a federal level, which, if passed, could have an impact on
the business of the Company. 26




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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The quantitative and qualitative disclosures about market risk are
contained in the Asset-Liability Matching section of Managements Discussion
and Analysis of Financial Condition and Results of Operations on pages 23 to 24
herein. 
 DISCLOSURE CONTROLS & PROCEDURES The Companys disclosure controls and procedures are designed to ensure
that information required to be disclosed in the reports that the Company files
or submits under the Securities Exchange Act of 1934, as amended (Exchange
Act), is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the Securities and Exchange Commission.
Disclosure controls and procedures include controls and procedures designed to
ensure that information required to be disclosed by the Company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the Companys management, including the Companys Chief Executive Officer
and Chief Financial Officer, as appropriate to allow timely decisions regarding
required disclosure. The Companys management, with the participation of the
Companys Chief Executive Officer and Chief Financial Officer, have evaluated
the effectiveness of the Companys disclosure controls and procedures as of the
end of the period covered by this report. Based on the evaluation, the
Companys Chief Executive Officer and Chief Financial Officer concluded that
the disclosure controls and procedures provide reasonable assurance of
effectiveness as of the end of the period covered by this report. In addition,
there has been no change in the Companys internal control over financial
reporting that occurred during the fiscal quarter covered by this report that
has materially affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting. 27




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PART II - OTHER INFORMATION Item 1. Legal
Proceedings Various lawsuits against the Company have arisen in the ordinary course of
business. Contingent liabilities arising from litigation, income taxes and
regulatory and other matters are not considered material in relation to the
financial position, results of operations or cash flows of the Company. Item 2. Changes in Securities and Use of Proceeds Not applicable. Item 3. Defaults Upon Senior Securities Not applicable. Item 4. Submissions of Matters to a Vote of Security Holders Not applicable. Item 5. Other Information Not applicable. Item 6. Exhibits and Reports on Form 8-K EXHIBITS None. 
 REPORTS ON FORM 8-K There were no current reports on Form 8-K filed during the three months ended
June 30, 2004. 28




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SIGNATURES Pursuant to the requirements 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. FIRST SUNAMERICA LIFE INSURANCE COMPANY
RegistrantDate:   August 13, 2004
    /s/ N. SCOTT GILLISN. Scott GillisSenior Vice President,
Chief Financial Officer
and Director Date:   August 13, 2004
    /s/ STEWART POLAKOVStewart PolakovSenior Vice President and Controller
(Principal Accounting Officer) 29




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Exhibit Index Exhibit  31.1
    
    Rule 13a-14(a)/15d-14(a) Certifications31.2
    
    Rule 13a-14(a)/15d-14(a) Certifications32
    
    Section 1350 Certifications 30