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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 September 30, 2004 Commission File No. 33-5014 FIRST SUNAMERICA LIFE INSURANCE COMPANY Incorporated in New York
    
    06-0992729IRS EmployerIdentification 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 REGISTRANTS COMMON STOCK ON
NOVEMBER 12, 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) -
September 30, 2004 and December 31, 2003
    
    
    2Statement of Income and Comprehensive Income (Unaudited) -
Three Months and Nine Months Ended September 30, 2004 and 2003
    
    
    3-4Statement of Cash Flows (Unaudited) -
Nine Months Ended September 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 and Procedures
    
    
    27Part II  Other Information
    
    
    28Exhibit 31.1Exhibit 31.2Exhibit 32
  1




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
BALANCE SHEET
(Unaudited) September 30,
    

December
31,2004
    
    2003(in thousands)ASSETSInvestments and cash:Cash and short-term investments
    
    $
    41,767
    
    
    $
    104,011Bonds, notes and redeemable preferred stocks available
for sale, at fair value (amortized cost: September 30,
2004, $2,884,241;
December 31, 2003, $2,617,647)
    
    
    2,937,472
    
    
    
    2,657,812Mortgage loans
    
    
    267,377
    
    
    
    215,521Policy loans
    
    
    33,222
    
    
    
    35,251Common stocks available for sale, at fair value (cost:September 30,
2004, $700; December 31, 2003, $291)
    
    
    703
    
    
    
    295Securities lending collateral
    
    
    631,107
    
    
    
    154,756Total investments and cash
    
    
    3,911,648
    
    
    
    3,167,646Variable annuity assets held in separate accounts
    
    
    445,670
    
    
    
    438,224Accrued investment income
    
    
    31,911
    
    
    
    27,577Deferred acquisition costs
    
    
    156,899
    
    
    
    161,356Other deferred expenses
    
    
    19,669
    
    
    
    16,570Income taxes currently receivable from Parent
    
    
    
    
    
    
    1,360Other assets
    
    
    3,369
    
    
    
    1,749TOTAL ASSETS
    
    $
    4,569,166
    
    
    $
    3,814,482LIABILITIES AND SHAREHOLDERS EQUITYReserves, payables and accrued liabilities:Reserves for fixed annuity contracts
    
    $
    2,813,326
    
    
    $
    2,490,145Reserves for universal life insurance contracts
    
    
    227,047
    
    
    
    232,271Income taxes currently payable to Parent
    
    
    915
    
    
    
    Securities lending payable
    
    
    631,107
    
    
    
    154,756Payable to brokers
    
    
    24,518
    
    
    
    40,852Other liabilities
    
    
    24,859
    
    
    
    66,814Total reserves, payables and accrued liabilities
    
    
    3,721,772
    
    
    
    2,984,838Variable annuity liabilities related to separate
accounts
    
    
    445,670
    
    
    
    438,224Deferred income taxes
    
    
    37,066
    
    
    
    41,895Total liabilities
    
    
    4,204,508
    
    
    
    3,464,957Shareholders equity:Common stock
    
    
    3,000
    
    
    
    3,000Additional paid-in capital
    
    
    259,428
    
    
    
    259,428Retained earnings
    
    
    79,717
    
    
    
    68,657Accumulated other comprehensive income
    
    
    22,513
    
    
    
    18,440Total shareholders equity
    
    
    364,658
    
    
    
    349,525TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    4,569,166
    
    
    $
    3,814,482
 See accompanying notes to financial statements. 2




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
STATEMENT OF INCOME AND COMPREHENSIVE INCOME
For the three months and nine months ended September 30, 2004 and 2003
(Unaudited) Three Months
    
    Nine Months2004
    

2003
    

2004
    

2003(in thousands)REVENUESFee income:Variable annuity policy fees
    
    $
    2,190
    
    
    $
    2,082
    
    
    $
    6,557
    
    
    $
    5,961Universal life insurance policy fees, net of reinsurance
    
    
    1,451
    
    
    
    1,773
    
    
    
    3,607
    
    
    
    3,790Surrender charges
    
    
    787
    
    
    
    392
    
    
    
    2,093
    
    
    
    1,223Total fee income
    
    
    4,428
    
    
    
    4,247
    
    
    
    12,257
    
    
    
    10,974Investment income
    
    
    42,567
    
    
    
    29,797
    
    
    
    123,379
    
    
    
    81,558Net realized investment gains (losses)
    
    
    (212
    )
    
    
    (2,311
    )
    
    
    (2,303
    )
    
    
    2,391Total revenues
    
    
    46,783
    
    
    
    31,733
    
    
    
    133,333
    
    
    
    94,923BENEFITS AND EXPENSESInterest expense:Fixed annuity contracts
    
    
    23,124
    
    
    
    17,057
    
    
    
    67,216
    
    
    
    45,364Universal life insurance contracts
    
    
    2,726
    
    
    
    2,793
    
    
    
    8,147
    
    
    
    8,283Total interest expense
    
    
    25,850
    
    
    
    19,850
    
    
    
    75,363
    
    
    
    53,647General and administrative expenses
    
    
    1,951
    
    
    
    1,267
    
    
    
    6,580
    
    
    
    5,544Amortization of deferred acquisition costs and other deferred expenses
    
    
    7,917
    
    
    
    7,050
    
    
    
    24,320
    
    
    
    18,300Annual commissions
    
    
    345
    
    
    
    352
    
    
    
    1,070
    
    
    
    807Claims on universal life contracts, net of reinsurance recoveries
    
    
    950
    
    
    
    608
    
    
    
    2,530
    
    
    
    2,211Guaranteed benefits
    
    
    403
    
    
    
    125
    
    
    
    1,382
    
    
    
    583Total benefits and expenses
    
    
    37,416
    
    
    
    29,252
    
    
    
    111,245
    
    
    
    81,092PRETAX INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE
    
    
    9,367
    
    
    
    2,481
    
    
    
    22,088
    
    
    
    13,831Income tax expense
    
    
    3,817
    
    
    
    980
    
    
    
    9,014
    
    
    
    5,659INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE
    
    
    5,550
    
    
    
    1,501
    
    
    
    13,074
    
    
    
    8,172Cumulative effect of accounting change, net of tax
    
    
    
    
    
    
    
    
    
    
    (2,014
    )
    
    
    NET INCOME
    
    $
    5,550
    
    
    $
    1,501
    
    
    $
    11,060
    
    
    $
    8,172
 See accompanying notes to financial statements. 3




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
STATEMENT OF INCOME AND COMPREHENSIVE INCOME (Continued)
For the three months and nine months ended September 30, 2004 and 2003
(Unaudited) Three Months
    
    Nine Months2004
    

2003
    

2004
    

2003(in thousands)OTHER COMPREHENSIVE INCOME (LOSS),
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
    
    $
    44,969
    
    
    $
    (770
    )
    
    $
    5,273
    
    
    $
    7,443Less reclassification adjustment
for net realized (gains) losses
included in net income
    
    
    (507
    )
    
    
    (594
    )
    
    
    993
    
    
    
    (1,363
    )Income tax (expense) benefit
    
    
    (15,562
    )
    
    
    478
    
    
    
    (2,193
    )
    
    
    (2,128
    )OTHER COMPREHENSIVE INCOME (LOSS)
    
    
    28,900
    
    
    
    (886
    )
    
    
    4,073
    
    
    
    3,952COMPREHENSIVE INCOME
    
    $
    34,450
    
    
    $
    615
    
    
    $
    15,133
    
    
    $
    12,124
 See accompanying notes to financial statements. 4




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
STATEMENT OF CASH FLOWS
For the nine months ended September 30, 2004 and 2003
(Unaudited) 2004
    
    2003(in thousands)CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    11,060
    
    
    $
    8,172Adjustments 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
    
    
    67,216
    
    
    
    45,364Universal life insurance contracts
    
    
    8,147
    
    
    
    8,283Net realized investment (gains) losses
    
    
    2,303
    
    
    
    (2,391
    )Amortization (accretion) of net premiums (discounts) on investments
    
    
    4,850
    
    
    
    (470
    )Amortization of deferred acquisition costs and other deferred
expenses
    
    
    24,320
    
    
    
    18,300Acquisition costs deferred
    
    
    (26,721
    )
    
    
    (47,456
    )Other expenses deferred
    
    
    (4,848
    )
    
    
    (9,925
    )Provision for deferred income taxes
    
    
    (5,938
    )
    
    
    11,476Change in:Accrued investment income
    
    
    (4,334
    )
    
    
    (4,873
    )Income taxes currently payable to Parent
    
    
    2,275
    
    
    
    (387
    )Other assets
    
    
    (1,620
    )
    
    
    (292
    )Other liabilities
    
    
    788
    
    
    
    594Other, net
    
    
    (970
    )
    
    
    2,341NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    78,542
    
    
    
    28,736CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of:Bonds, notes and redeemable preferred stocks
    
    
    (797,603
    )
    
    
    (974,206
    )Mortgage loans
    
    
    (65,151
    )
    
    
    (43,070
    )Other investments, excluding short-term investments
    
    
    
    
    
    
    (749
    )Sales of:Bonds, notes and redeemable preferred stocks
    
    
    333,354
    
    
    
    173,976Other investments, excluding short-term investments
    
    
    112
    
    
    
    Redemptions and maturities of:Bonds, notes and redeemable preferred stocks
    
    
    169,271
    
    
    
    199,681Mortgage loans
    
    
    13,474
    
    
    
    17,478Other investments, excluding short-term investments
    
    
    1,494
    
    
    
    1,402NET CASH USED IN INVESTING ACTIVITIES
    
    $
    (345,049
    )
    
    $
    (625,488
    )
 See accompanying notes to financial statements. 5




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
STATEMENT OF CASH FLOWS (Continued)
For the nine months ended September 30, 2004 and 2003
(Unaudited) 2004
    
    2003(in thousands)CASH FLOWS FROM FINANCING ACTIVITIES:Deposits received on:Fixed annuity contracts
    
    $
    356,564
    
    
    $
    808,160Universal life insurance contracts
    
    
    5,929
    
    
    
    7,427Net exchanges to (from) the fixed accounts of
variable annuity contracts
    
    
    (8,965
    )
    
    
    1,520Withdrawal payments on:Fixed annuity contracts
    
    
    (106,020
    )
    
    
    (78,347
    )Universal life insurance contracts
    
    
    (6,691
    )
    
    
    (6,141
    )Claims and annuity payments on:Fixed annuity contracts
    
    
    (28,594
    )
    
    
    (23,153
    )Universal life insurance contracts
    
    
    (7,960
    )
    
    
    (9,251
    )Capital contributions
    
    
    
    
    
    
    40,000NET CASH PROVIDED BY FINANCING ACTIVITIES
    
    
    204,263
    
    
    
    740,215NET INCREASE (DECREASE) IN CASH AND SHORT-TERM
INVESTMENTS
    
    
    (62,244
    )
    
    
    143,463CASH AND SHORT-TERM INVESTMENTS AT BEGINNING OF
PERIOD
    
    
    104,011
    
    
    
    37,955CASH AND SHORT-TERM INVESTMENTS AT END OF PERIOD
    
    $
    41,767
    
    
    $
    181,418SUPPLEMENTAL CASH FLOW INFORMATION:Interest paid on indebtedness
    
    $
    
    
    
    $
    470Income taxes paid to Parent
    
    $
    2,757
    
    
    $
    5,430
 See accompanying notes to financial statements. 6




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FIRST SUNAMERICA LIFE INSURANCE COMPANY
NOTES TO FINANCIAL STATEMENTS
(Unaudited)  1.
    
    BASIS OF PRESENTATION First 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. (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
September 30, 2004 and December 31, 2003, the results of its operations
for the three months and nine months ended September 30, 2004 and 2003
and its cash flows for the nine months ended September 30, 2004 and 2003.
The results of operations for the three months and nine months ended
September 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 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). 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 certain other expenses. 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, that upon 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 guaranteed benefits, 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 (Continued)
(Unaudited)  2.
    
    RECENTLY ISSUED ACCOUNTING STANDARDS (Continued) GMAV is a feature offered on certain variable annuity products. If
available and 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 deposits invested during the first ninety days,
adjusted for subsequent 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 and through investment income in the
statement of income and comprehensive income. The Company began offering
the GMAV option in 2004. To date, variable annuity deposits with the
GMAV option were immaterial. Details concerning the Companys guaranteed benefit exposures as of
September 30, 2004 are as follows: Highest SpecifiedAnniversary AccountValue MinusReturn of Net
    
    Withdrawals PostDeposits
    
    Anniversary(dollars in thousands)In the event of death (GMDB):Account value
    
    $
    142,725
    
    
    $
    612,765Net amount at risk (a)
    
    
    1,044
    
    
    
    76,609Average 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
    
    
    1,382Guaranteed benefits paid
    
    
    (722
    )Balance at September 30, 2004
    
    $
    2,300
  (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 September 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  (Continued)
(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. Such amounts 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
expenses 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 $16.6 million of these expenses from DAC to other deferred
expenses, which is reported on the balance sheet. For the nine months
ended September 30, 2004, $4.8 million of these expenses were deferred.
For the nine months ended September 30, 2004, amortization of these
deferred expenses was $1.7 million. Amortization of other deferred
expenses is reported as part of amortization of deferred acquisition
costs and other deferred expenses on the statement of income and
comprehensive income. Prior period balance sheet and statement of
income and comprehensive income presentation has been reclassified to
conform to the new presentation.  3.
    
    CONTINGENT LIABILITIES At September 30, 2004, the Company has commitments to purchase
approximately $7,000,000 of asset-backed securities in the ordinary
course of business. The expiration dates of these commitments are as
follows: $2,000,000 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 MATTERS On October 31, 2003, the Company became a party to an existing credit
agreement under which the Company agreed to make loans to AIG in an
aggregate amount of up to $5,000,000. This commitment expires on October
28, 2005. There was no outstanding balance under this agreement at
September 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 earned by the Company under
this agreement totaled $1.3 million in 2004 and are included in variable
annuity policy fees in the statement of income and comprehensive income.
A fee of $1.2 million was paid under a different agreement in 2003. 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. 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. 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 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 nine months ended September 30, 2004 and 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. 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 $1.3
million in 2004 and are included in variable annuity policy fees in the
statement of income and comprehensive income. A fee of $1.2 million was paid
under a different agreement in 2003. CRITICAL ACCOUNTING POLICIES The Company considers 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 $18.0 million at
September 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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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 $473.2 million at September 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 69% of
the Companys DAC balance at September 30, 2004 related to fixed annuity and
universal life products and 31% 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 using the Companys best estimates. These assumptions included, among others, mean equity return and volatility,
mortality rates and lapse rates. The estimation of cash flow and the determination of the assumptions used require judgement, which can, at times, be subjective. RESULTS OF OPERATIONS NET INCOME totaled $5.6 million in the third quarter of 2004 compared with
$1.5 million in the third quarter of 2003. For the nine months ended
September 30, 2004, net income amounted to $11.1 million, compared to $8.2
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 nine months ended
September 30, 2004. PRETAX INCOME BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGE totaled $9.4
million in the third quarter of 2004, compared with $2.5 million in the third
quarter of 2003. For the nine months, pretax income before cumulative effect
of accounting change totaled $22.1 million in 2004, compared to $13.8 million
in 2003. The increase in the third quarter and nine 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 $3.8 million in the third quarter of 2004
compared with $1.0 million in the third quarter of 2003, $9.0 million in the
nine months of 2004 and $5.7 million in the nine months of 2003 representing
effective tax rates of 41%, 40%, 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 a 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 reconciliation to pretax income
before cumulative effect of accounting change is presented in the following
table: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands)Investment income
    
    $
    42,567
    
    
    $
    29,797
    
    
    $
    123,379
    
    
    $
    81,558Interest credited to fixed annuity contracts
    
    
    (23,124
    )
    
    
    (17,057
    )
    
    
    (67,216
    )
    
    
    (45,364
    )Interest credited to universal life
insurance contracts
    
    
    (2,726
    )
    
    
    (2,793
    )
    
    
    (8,147
    )
    
    
    (8,283
    )Net investment spread
    
    
    16,717
    
    
    
    9,947
    
    
    
    48,016
    
    
    
    27,911Net realized investment gains (losses)
    
    
    (212
    )
    
    
    (2,311
    )
    
    
    (2,303
    )
    
    
    2,391Fee income, net of reinsurance
    
    
    4,428
    
    
    
    4,247
    
    
    
    12,257
    
    
    
    10,974General and administrative expenses, net of
deferrals
    
    
    (1,951
    )
    
    
    (1,267
    )
    
    
    (6,580
    )
    
    
    (5,544
    )Amortization of DAC and other deferred
expenses
    
    
    (7,917
    )
    
    
    (7,050
    )
    
    
    (24,320
    )
    
    
    (18,300
    )Annual commissions
    
    
    (345
    )
    
    
    (352
    )
    
    
    (1,070
    )
    
    
    (807
    )Claims on UL contracts, net of reinsurance
recoveries
    
    
    (950
    )
    
    
    (608
    )
    
    
    (2,530
    )
    
    
    (2,211
    )Guaranteed benefits
    
    
    (403
    )
    
    
    (125
    )
    
    
    (1,382
    )
    
    
    (583
    )Pretax income before cumulative effect of
accounting change
    
    $
    9,367
    
    
    $
    2,481
    
    
    $
    22,088
    
    
    $
    13,831
 Net investment spread totaled $16.7 million in the third quarter of 2004,
compared to $9.9 million in the third quarter of 2003. These amounts equal
2.09% on average invested assets (computed on a daily basis) of $3.20 billion
in the third quarter of 2004 and 1.83% on average invested assets of $2.18
billion in the third quarter of 2003. For the nine months, net investment
spread increased to $48.0 million in 2004 from $27.9 million in 2003
representing 2.06% of average invested assets of $3.11 billion in 2004 and
1.93% of average invested assets of $1.93 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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The components of net investment spread were as follows: Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands)Net investment spread
    
    $
    16,717
    
    
    $
    9,947
    
    
    $
    48,016
    
    
    $
    27,911Average invested assets
    
    
    3,197,305
    
    
    
    2,176,691
    
    
    
    3,114,340
    
    
    
    1,927,491Average interest-bearing liabilities
    
    
    3,019,150
    
    
    
    2,087,403
    
    
    
    2,934,747
    
    
    
    1,821,448Yield on average invested assets
    
    
    5.33
    %
    
    
    5.48
    %
    
    
    5.28
    %
    
    
    5.64
    %Rate paid on average
interest-bearing liabilities
    
    
    3.42
    
    
    
    3.80
    
    
    
    3.42
    
    
    
    3.93Difference between yield and
interest rate paid
    
    
    1.91
    %
    
    
    1.68
    %
    
    
    1.86
    %
    
    
    1.71
    %Net investment spread as a
percentage of average invested
assets
    
    
    2.09
    %
    
    
    1.83
    %
    
    
    2.06
    %
    
    
    1.93
    %
 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 $73.0 million in the third quarter of 2004 and $339.6
million in the third quarter of 2003, $362.0 million in the nine months of 2004
and $815.6 million in the nine months of 2003. The Companys fixed annuity
sales have declined each quarter since the fourth quarter of 2003 due to the
Companys pricing action in response to an extremely low interest rate
environment, as well as the impact of increased rates on other competing
savings alternatives, including bank certificates of deposit. 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 $178.2 million in the third quarter of 2004,
compared with $89.3 million in the third quarter of 2003. For the nine months,
average invested assets exceeded average interest-bearing liabilities by $179.6
million in 2004, compared with $106.0 million in 2003. The difference between
the Companys yield on average invested assets and the rate paid on average
interest-bearing liabilities was 1.91% in the third quarter of 2004, 1.68% in
the third quarter of 2003, 1.86% in the nine months of 2004 and 1.71% in the
nine months of 2003. Investment income (and the related yields on average invested assets)
totaled $42.6 million (5.33%) in the third quarter of 2004, $29.8 million
(5.48%) in the third quarter of 2003, $123.4 million (5.28%) in the nine months
of 2004 and $81.6 million (5.64%) in the nine months of 2003. The decrease in
the investment yield in 2004 compared to 2003 primarily reflects the
historically low prevailing interest rate environment that has persisted
throughout 2003 and 2004. Expenses incurred to manage the investment portfolio
amounted to $0.3 million in the third quarter of 2004, $0.2 million in the
third quarter of 2003, $0.9 million in the nine months of 2004 and $0.5 million
in the nine months of 2003. These expenses are included as a reduction of
investment income in the statement of income and comprehensive income. Interest expense totaled $25.9 million in the third quarter of 2004 and
$19.9 million in the third quarter of 2003. For the nine months, interest
expense aggregated $75.4 million in 2004, compared with $53.6 million in 2003.
The average rate paid on all interest-bearing liabilities was 3.42% in the
third quarter of 2004 compared with 3.80% in the third quarter of 2003. For
nine months, the average rate paid on all interest-bearing liabilities was
3.42% for 2004 and 3.93% for 2003. Interest-bearing liabilities averaged $3.02
billion during the third quarter of 2004, $2.09 billion during the third
quarter of 2003, $2.93 billion during the nine months of 2004 and $1.82 billion
during the nine months of 2003. The decline in overall rates paid in 2004
compared to 2003 resulted 14




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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. NET REALIZED INVESTMENT GAINS (LOSSES) totaled $0.2 million of losses in
the third quarter of 2004, compared to $2.3 million in the third quarter of 2003 and include impairment writedowns of $0.04
million and $2.3 million, respectively. For the nine months, net realized
investment losses totaled $2.3 million in 2004, compared with net realized
investment gains of $2.4 million in 2003 and include impairment writedowns of
$0.8 million and $2.6 million, respectively. Thus, net realized gains from
sales and redemptions of investments totaled $0.2 million in the third quarter
of 2004, compared to no realized gains or losses in the third quarter of 2003.
For the nine months, net realized losses from sales and redemptions of
investments totaled $1.5 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 $131.5 million in the third quarter of 2004, $136.5 million in the
third quarter of 2003, $519.2 million in the nine months of 2004 and $387.7
million in the nine 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
0.02%, 0.00%, 0.07% and 0.35% of average invested assets in the third quarter
of 2004, the third quarter of 2003, the nine months of 2004 and the nine 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 $0.04 million, $2.3 million, $0.8 million
and $2.6 million of provisions applied to bonds in the third quarter of 2004,
the third quarter of 2003, the nine months of 2004 and the nine months of 2003,
respectively. On an annualized basis, impairment writedowns represent 0.01%,
0.43%, 0.03% and 0.18% of average invested assets in the respective periods.
For the twenty quarters ended September 30, 2004, impairment writedowns as an
annualized percentage of average invested assets have ranged from 0.00% to
3.99% and have averaged 0.73%. 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 third quarter of 2004 and $2.1 million in the third
quarter of 2003. For the nine months variable annuity policy fees totaled $6.6
million in 2004 and $6.0 million in 2003. The increased fees in 2004 as
compared to 2003 primarily reflect the improved equity market conditions in
early 2004 and the latter part 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 2.0%, of average variable annuity assets
in all periods presented. Variable annuity assets averaged $438.3 million,
$418.9 million, $444.2 million and $404.9 million during the respective
periods. Sales of variable annuity products (which include deposits allocated
to the fixed accounts) amounted to $18.2 million, $52.8 million, $71.7 million and $98.0 million in the third quarters
and the nine months of 2004 and 2003, respectively. The decrease in 2004 is
due to lower sales on certain products with features that have been
discontinued. 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). UNIVERSAL LIFE INSURANCE POLICY FEES, NET OF REINSURANCE amounted to $1.5
million in the third quarters of 2004 and $1.8 million in the third quarter of
2003 net of reinsurance premiums of $1.7 million and $1.4 million respectively.
For the nine months, universal life insurance policy fees totaled $3.6 million
in 2004 and $3.8 million in 2003, net of reinsurance premiums of $5.7 million
and $5.5 million respectively. 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 15




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contracts. Such fees represent annualized 2.6%, 3.0%, 2.1% and 2.2% 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 third quarter of 2004 and $0.4 million in
the third quarter of 2003. For the nine months, such surrender charges totaled
$2.1 million in 2004 and $1.2 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 $2.0 million in the third
quarter of 2004 and $1.3 million in the third quarter of 2003. For the nine
months, general administrative expenses totaled $6.6 million in 2004 and $5.5
million in 2003. The increase in 2004 results from significantly larger blocks
of administrative expenses related to fixed contracts. 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 $7.9 million in the third quarter of 2004, compared to $7.1 million in
the third quarter of 2003. For the nine months, such amortization totaled
$24.3 million in 2004, compared to $18.3 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 the decrease in
amortization related to the higher net realized investment losses. ANNUAL COMMISSIONS totaled $0.3 million in the third quarter of 2004 and
$0.4 million in the third quarter of 2003. For the nine months, annual
commissions totaled $1.1 million in 2004 and $0.8 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
$1.0 million in the third quarters of 2004, compared to $0.6 million in 2003
(net of reinsurance recoveries of $ 2.1 million in the third quarter of 2004
and $1.2 million in the third quarter of 2003). For the nine months, such
claims totaled $2.5 million in 2004, compared to $2.2 million in 2003 (net of
reinsurance recoveries of $4.2 million in 2004 and $3.1 million in 2003). With respect to its reinsurance agreements, the Company could become
liable for all obligations of the reinsured policies if the reinsurers were to
become unable to meet the obligations assumed under the respective reinsurance
agreements. The Company monitors its credit exposure with respect to these
agreements. Due to the high credit ratings and periodic monitoring of these
ratings of the reinsurers, such risks are considered to be minimal. GUARANTEED BENEFITS on variable annuity contracts totaled $0.4 million in
the third quarter of 2004 compared with $0.1 million in the third quarter of
2003. For the nine months, guaranteed benefits paid or accrued amounted to
$1.4 million in 2004 and $0.6 million in 2003. Downturns in the equity markets
could increase these expenses. Guaranteed minimum death benefits (GMDB) are issued on a majority of the
Companys variable annuity products. GMDB provides that upon 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 the contract holder. 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) is a feature the Company began
offering on certain variable annuity products in June of 2004. If available
and elected by the contract holder at the time of contract issuance, this
feature guarantees that the account value under the contract will at least
equal the amount of the deposits invested during the first ninety days of the
contracts, adjusted for subsequent 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 16




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the contract are insufficient to cover the costs of the benefit to be
provided. Changes in the market value of the GMAV benefit is recorded in
investment income in the accompanying statement of income and comprehensive
income. In 2004, variable annuity deposits with the GMAV option were
immaterial. However, they are expected to become a more significant component
of future sales. CAPITAL RESOURCES AND LIQUIDITY SHAREHOLDERS EQUITY increased to $364.7 million at September 30, 2004
from $349.5 million at December 31, 2003, due to $11.1 million of net income
and $4.1 million increase in unrealized gains, net of the effect on taxes and
DAC. INVESTMENTS AND CASH at September 30, 2004 totaled $3.91 billion, compared
with $3.17 billion at December 31, 2003. The Companys invested assets are
managed by an affiliate. The following table summarizes the Companys
portfolio of bonds, notes and redeemable preferred stocks (the Bond
Portfolio) and other investments and cash at September 30, 2004 and December
31, 2003: September 30, 2004
    
    
    
    
    
    December 31, 2003Fair
    

Percent
of
    
    
    
    
    
    Fair
    
    Percent ofValue
    
    Portfolio
    
    
    
    
    
    Value
    
    Portfolio(in thousands, except for percentages)Bond Portfolio:U.S. government securities
    
    $
    27,501
    
    
    
    0.7
    %
    
    
    
    
    
    $
    18,054
    
    
    
    0.6

%Mortgage-backed securities
    
    
    733,643
    
    
    
    18.8
    
    
    
    
    
    
    
    587,080
    
    
    
    18.5Securities of public utilities
    
    
    151,163
    
    
    
    3.9
    
    
    
    
    
    
    
    120,480
    
    
    
    3.8Corporate bonds and notes
    
    
    1,593,515
    
    
    
    40.7
    
    
    
    
    
    
    
    1,414,062
    
    
    
    44.6Other debt securities
    
    
    431,650
    
    
    
    11.0
    
    
    
    
    
    
    
    518,136
    
    
    
    16.4Total Bond Portfolio
    
    
    2,937,472
    
    
    
    75.1
    
    
    
    
    
    
    
    2,657,812
    
    
    
    83.9Mortgage loans
    
    
    267,377
    
    
    
    6.8
    
    
    
    
    
    
    
    215,521
    
    
    
    6.8Common stocks
    
    
    703
    
    
    
    0.0
    
    
    
    
    
    
    
    295
    
    
    
    0.0Cash and short-term investments
    
    
    41,767
    
    
    
    1.1
    
    
    
    
    
    
    
    104,011
    
    
    
    3.3Securities lending collateral
    
    
    631,107
    
    
    
    16.1
    
    
    
    
    
    
    
    154,756
    
    
    
    4.9Other
    
    
    33,222
    
    
    
    0.9
    
    
    
    
    
    
    
    35,251
    
    
    
    1.1Total investments and cash
    
    $
    3,911,648
    
    
    
    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 75% of the Companys total
investment portfolio at September 30, 2004, had an aggregate fair value that
was $53.2 million greater than its amortized cost at September 30, 2004,
compared with $40.2 million at December 31, 2003. The increase in net
unrealized gains on the Bond Portfolio during 2004 principally reflects the
decline in prevailing interest rates and the corresponding effect on the fair
value of the Bond Portfolio at September 30, 2004. At September 30, 2004, the Bond Portfolio had an aggregate fair value of
$2.94 billion and an aggregate amortized cost of $2.88 billion. At September
30, 2004, the Bond Portfolio included $2.85 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 $86.8 million
of bonds rated by the Company pursuant to 17




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##### Table of Contents



statutory ratings guidelines established by the NAIC. At September 30, 2004,
approximately $2.82 billion of the Bond Portfolio was investment grade,
including $761.1 million of mortgage-backed securities (MBS) and U.S.
government/agency securities. At September 30, 2004, the Bond Portfolio included $120.4 million of bonds
that were not investment grade. These non-investment-grade bonds accounted for
approximately 2.64% of the Companys total assets and approximately 3.08% 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 September 30, 2004,
the Companys non-investment-grade portfolio consisted of 47 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 10 industries with 27% concentrated in telecommunications, 17%
concentrated in cyclical consumer products, 15% concentrated in financial
institutions, 10% concentrated in transportation and 10% concentrated in basic
industrial. 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 September 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
    
    TotalPercent ofEstimated
    
    NAIC
    
    
    
    
    
    Estimated
    
    
    
    
    
    Estimated
    
    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-]
    
    $
    1,780,809
    
    
    $
    1,811,352
    
    
    
    1
    
    
    $
    208,929
    
    
    $
    215,655
    
    
    $
    1,989,738
    
    
    $
    2,027,007
    
    
    
    51.82
    %BBB+ to BBB-
(Baa1 to Baa3)
[BBB+ to BBB-]
    
    
    599,527
    
    
    
    614,145
    
    
    
    2
    
    
    
    171,605
    
    
    
    175,873
    
    
    
    771,132
    
    
    
    790,018
    
    
    
    20.20
    %BB+ to BB-
(Bal to Ba3)
[BB+ to BB-]
    
    
    53,377
    
    
    
    54,053
    
    
    
    3
    
    
    
    30,963
    
    
    
    31,456
    
    
    
    84,340
    
    
    
    85,509
    
    
    
    2.19
    %B+ to B-
(B1 to B3)
[B+ to B-]
    
    
    28,242
    
    
    
    24,463
    
    
    
    4
    
    
    
    1,600
    
    
    
    2,028
    
    
    
    29,842
    
    
    
    26,491
    
    
    
    0.68
    %CCC+ to CCC-
(Caal to Caa3)
[CCC+ to CCC-]
    
    
    8,304
    
    
    
    6,627
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    8,304
    
    
    
    6,627
    
    
    
    0.17
    %CC to D
(Ca to C)
[CC to D]
    
    
    730
    
    
    
    1,079
    
    
    
    6
    
    
    
    155
    
    
    
    741
    
    
    
    885
    
    
    
    1,820
    
    
    
    0.05
    %TOTAL  RATED
  ISSUES
    
    $
    2,470,989
    
    
    $
    2,511,719
    
    
    
    
    
    
    $
    413,252
    
    
    $
    425,753
    
    
    $
    2,884,241
    
    
    $
    2,937,472
  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 $86.8 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 $0.8 million and $2.6 million in the nine months of 2004 and
2003, respectively. No individual impairment loss exceeded 10% of the
Companys net income for the nine months ended September 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 September 30, 2004, the fair value of the Companys Bond Portfolio
aggregated $2.94 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 September 30, 2004, approximately $2.10 billion, at amortized cost, of
the Bond Portfolio had a fair value of $2.17 billion resulting in an aggregate
unrealized gain of $71.2 million. At September 30, 2004, approximately $783.1
million, at amortized cost, of the Bond Portfolio had a fair value of $765.1
million resulting in an aggregate unrealized loss of $18.0 million. One issuer
accounted for 23% of unrealized losses. No other single issuer accounted for
more than 10% of unrealized losses. Approximately 25%, 24%, and 18% of
unrealized losses were on the financial institutions, transportation, and
telecommunications industries, respectively. No other industry accounted for
more than 10% of unrealized losses. 20




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##### Table of Contents



The amortized cost of the Bond Portfolio in an unrealized loss position at
September 30, 2004, by contractual maturity, is shown below. Amortized Cost(in thousands)Due in one year or less
    
    $
    Due after one year through five years
    
    
    168,218Due after five years through ten years
    
    
    312,335Due after ten years
    
    
    302,527Total
    
    $
    783,080


The aging of the Bond Portfolio in an unrealized loss position at
September 30, 2004 is shown below:

(dollars in
    
    Less than or Equal to 20%
    
    Greater than 20% to 50%
    
    Greater than 50%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
    
    $
    524,375
    
    
    $
    (6,050
    )
    
    
    83
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    524,375
    
    
    $
    (6,050
    )
    
    
    837-12
    
    
    100,261
    
    
    
    (2,681
    )
    
    
    20
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    100,261
    
    
    
    (2,681
    )
    
    
    20>12
    
    
    103,263
    
    
    
    (1,808
    )
    
    
    21
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    103,263
    
    
    
    (1,808
    )
    
    
    21Total
    
    $
    727,899
    
    
    $
    (10,539
    )
    
    
    124
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    727,899
    
    
    $
    (10,539
    )
    
    
    124Below
Investment
Grade
Bonds0-6
    
    $
    27,998
    
    
    $
    (1,032
    )
    
    
    9
    
    
    $
    350
    
    
    $
    (121
    )
    
    
    1
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    28,348
    
    
    $
    (1,153
    )
    
    
    107-12
    
    
    11,703
    
    
    
    (523
    )
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,703
    
    
    
    (523
    )
    
    
    1>12
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,086
    
    
    
    (1,674
    )
    
    
    4
    
    
    
    8,044
    
    
    
    (4,124
    )
    
    
    1
    
    
    
    15,130
    
    
    
    (5,798
    )
    
    
    5Total
    
    $
    39,701
    
    
    $
    (1,555
    )
    
    
    10
    
    
    $
    7,436
    
    
    $
    (1,795
    )
    
    
    5
    
    
    $
    8,044
    
    
    $
    (4,124
    )
    
    
    1
    
    
    $
    55,181
    
    
    $
    (7,474
    )
    
    
    16Total
Bonds0-6
    
    $
    552,373
    
    
    $
    (7,082
    )
    
    
    92
    
    
    $
    350
    
    
    $
    (121
    )
    
    
    1
    
    
    $
    
    
    
    $
    
    
    
    
    
    
    
    $
    552,723
    
    
    $
    (7,203
    )
    
    
    937-12
    
    
    111,964
    
    
    
    (3,204
    )
    
    
    21
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    111,964
    
    
    
    (3,204
    )
    
    
    21>12
    
    
    103,263
    
    
    
    (1,808
    )
    
    
    21
    
    
    
    7,086
    
    
    
    (1,674
    )
    
    
    4
    
    
    
    8,044
    
    
    
    (4,124
    )
    
    
    1
    
    
    
    118,393
    
    
    
    (7,606
    )
    
    
    26Total
    
    $
    767,600
    
    
    $
    (12,094
    )
    
    
    134
    
    
    $
    7,436
    
    
    $
    (1,795
    )
    
    
    5
    
    
    $
    8,044
    
    
    $
    (4,124
    )
    
    
    1
    
    
    $
    783,080
    
    
    $
    (18,013
    )
    
    
    140 In 2004, the pretax realized losses incurred with respect to the sale of
fixed securities in the Bond Portfolio were $1.5 million. The aggregate fair
value of securities sold was $146.3 million, which was approximately 97.4% 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 15 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
September 30, 2004 was approximately $473.2 million. 21




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##### Table of Contents



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. 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 $109.9 million at September 30, 2004. Secured Loans are senior
to subordinated debt and equity and are secured by assets of the issuer. At
September 30, 2004, Secured Loans consisted of $52.2 million of privately
traded securities and $57.7 million of publicly traded securities. These
Secured Loans are composed of loans to borrowers spanning 9 industries, with
68% of these assets concentrated in the utilities industry. 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 $267.4 million at September 30, 2004 and
consisted of 77 commercial first mortgage loans with an average loan balance of
approximately $3.5 million, collateralized by properties located in 26 states.
Approximately 40% of this portfolio was office, 24% was multifamily
residential, 16% was industrial, 14% was retail and 6% was other types. At
September 30, 2004, approximately 26% and 15% 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 September 30, 2004, six mortgage loans had an outstanding balance of $10
million or more, which collectively aggregated approximately 30% of this
portfolio. At September 30, 2004, approximately 17% of the mortgage loan
portfolio consisted of loans with balloon payments due before October 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 September 30, 2004, approximately 13% 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 $33.2 million at September 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 $631.1 million at September 30,
2004, compared to $154.8 million at December 31, 2003, and consisted of cash
collateral invested in highly rated short-term securities 22




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##### Table of Contents



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 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 (i.e.
the risk of being forced to sell investments during unfavorable market
conditions). 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 September 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 September 30, 2004, these assets had an
aggregate fair value of $3.30 billion with an option-adjusted duration of 4.8
years. The Companys fixed-rate liabilities include fixed annuity, fixed
options of variable annuities and universal life insurance contracts. At
September 30, 2004, these liabilities had an aggregate fair value (determined
by discounting future contractual cash flows by related market rates of
interest) of $3.00 billion with an option-adjusted duration of 5.2 years. The
Companys potential exposure due to a relative 10% decrease in prevailing
interest rates from its September 30, 2004 levels is a loss of approximately
$0.9 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 23




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##### Table of Contents



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 nine months ended September 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: Nine months endedSeptember 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
    
    
    5.28
    
    
    
    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 net realizable 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. 24




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DEFAULTED INVESTMENTS, comprising all investments that are in default as
to the payment of principal or interest, totaled $1.6 million of bonds at
September 30, 2004, and constituted less than 0.04% of total invested assets.
At December 31, 2003, defaulted investments totaled $0.2 million of bonds and
constituted less than 0.01% of total invested assets. 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 September 30, 2004, approximately $2.17 billion of the Bond Portfolio had
an aggregate unrealized gain of $71.2 million while approximately $765.1
million of the Bond Portfolio had an aggregate unrealized loss of $18.0
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. (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. 25




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##### Table of Contents



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 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 September 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 could have an impact on
the business of the Company. 26




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##### Table of Contents



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 AND 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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##### Table of Contents



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. Unregistered Sales of Equity 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 See accompanying Exhibit Index. 28




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##### Table of Contents



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: November 12, 2004
    
    /s/ N. SCOTT GILLIS

N. Scott Gillis
Senior Vice President,
Chief Financial Officer
and DirectorDate: November 12, 2004
    
    /s/ STEWART POLAKOV

Stewart Polakov
Senior Vice President and Controller
(Principal Accounting Officer)
 29




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Exhibit Index Exhibit31.1
    
    Rule 13a-14(a)/15d-14(a) Certifications31.2
    
    Rule 13a-14(a)/15d-14(a) Certifications32
    
    Section 1350 Certifications
 30