This Management’s Discussion and Analysis should be read in its entirety, since it contains detailed information that is important to understanding Protective’s results and financial condition. The Overview below is qualified in its entirety by the full Management’s Discussion and Analysis.
Protective Life Insurance Company (Protective) and its subsidiaries provide financial services through the production, distribution, and administration of insurance and investment products. Protective operates five business segments. An operating segment is generally distinguished by products and/or channels of distribution. Protective’s operating segments are Life Marketing, Acquisitions, Annuities, Stable Value Products, and Asset Protection. In addition, Protective has another segment referred to as the Corporate and Other segment.
The segment had pretax operating income of $10.6 million in 2003. Pretax operating income for the segment’s core lines of business was $17.0 million in 2003 as compared to $18.4 million in 2002. Lower credit insurance results in 2003, caused by reduced sales, were partially offset by improved results on service contract lines in 2003. The vehicle service contract line of business improved to contribute pretax operating income of $3.7 million in 2003, as compared to a pretax operating loss of $2.8 million in 2002, due to improving loss ratios caused by the effect of increasing prices in 2000 through 2003. The marine service contract line’s pretax operating income improved to $6.0 million in 2003, $1.2 million better than in 2002. Other core lines of business contributed $7.3 million of pretax operating income. Included in pretax operating income in 2003, was the sale of an inactive charter which contributed $6.9 million of income. Non-core lines of business and all other items decreased operating income by $13.3 million in 2003.
In the third quarter of 2002, Protective discovered that the rates payable on certain life insurance policies were incorrectly entered into its reinsurance administrative system in 1991. As a result, Protective overpaid to several reinsurance companies the reinsurance premiums related to such policies of approximately $94.5 million over a period of 10 years beginning in 1992. Protective has received payment from substantially all of the affected reinsurance companies.
At December 31 Amount Percent Change ---------------------------------------------------------------------- (in millions) Fixed maturities $11,084.3 (4.9)% Mortgage loans 2,690.5 (4.8)
There are certain risks and uncertainties associated with determining whether declines in market values are other-than-temporary. These include significant changes in general economic conditions and business markets, trends in certain industry segments, interest rate fluctuations, rating agency actions, changes in significant accounting estimates and assumptions, commission of fraud and legislative actions. Protective continuously monitors these factors as they relate to the investment portfolio in determining the status of each investment. Provided below are additional facts concerning the potential effect upon Protective’s earnings should circumstances lead management to conclude that some of the current declines in market value are other-than-temporary.
Many of Protective’s products contain surrender charges and other features that reward persistency and penalize the early withdrawal of funds. Certain stable value and annuity contracts have market-value adjustments that protect Protective against investment losses if interest rates are higher at the time of surrender than at the time of issue.
Combinations of interest rate swap contracts, futures contracts, and option contracts are sometimes used to mitigate or eliminate certain financial and market risks, including those related to changes in interest rates for certain investments, primarily outstanding mortgage loan commitments and mortgage-backed securities. Interest rate swap contracts generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. Interest rate futures generally involve exchange traded contracts to buy or sell treasury bonds and notes in the future at specified prices. Interest rate options allow the holder of the option to receive cash or purchase, sell or enter into a financial instrument at a specified price within a specified period of time. Protective used interest rate swap contracts, swaptions (options to enter into interest rate swap contracts), caps, and floors to modify the interest characteristics of certain investments, and liabilities. Swap contracts are also used to alter the effective durations of assets and liabilities. Protective uses foreign currency swaps to reduce its exposure to currency exchange risk on certain stable value contracts denominated in foreign currencies, primarily the European euro and the British pound.
Fair Value Resulting From an Immediate +/-10% Change in Notional Fair Value at Foreign Currency Exchange Rates Amount December 31 +10% -10% --------------------------------------------------------------------------------------------------- (in millions) Stable Value Contracts $ 539.2 $ (86.5) $ (149.1) $ (24.0) Foreign Currency Swaps 539.2 78.4 124.5 32.3 --------------------------------------------------------------------------------------------------- $ 1,078.4 $ (8.1) $ (24.6) $ 8.3 --------------------------------------------------------------------------------------------------- 2003 $ 416.1 $ (151.8) $ (208.6) $ (95.0) Stable Value Contracts Foreign Currency Swaps 416.1 154.4 180.6 128.2 --------------------------------------------------------------------------------------------------- $ 832.2 $ 2.6 $ (28.0) $ 33.2 ---------------------------------------------------------------------------------------------------
The table above excludes liabilities related to separate accounts of $2,220.8 million. Separate account liabilities represent funds maintained for contract holders who bear the related investment risk. These liabilities are supported by assets that are legally segregated and are not subject to claims that arise from other business activities of Protective. These assets and liabilities are separately identified on the consolidated balance sheets of Protective. The table also excludes future cash flows related to certain insurance liabilities due to the uncertainty with respect to the timing of the cash flows.
Liabilities for future policy benefits on traditional life insurance products have been computed using a net level method including assumptions as to investment yields, mortality, persistency, and other assumptions based on Protective’s experience, modified as necessary to reflect anticipated trends and to include provisions for possible adverse deviation. Reserve investment yield assumptions on December 31, 2003 were 6.98%. The liability for future policy benefits and claims on traditional life, health, and credit insurance products includes estimated unpaid claims that have been reported to Protective and claims incurred but not yet reported. Policy claims are charged to expense in the period that the claims are incurred.
Statutory federal income tax rate applied to pretax income 35.0% 35.0% 35.0% Dividends received deduction and tax-exempt income (1.2) (2.3) (1.7) Low-income housing credit (0.2) (0.5) (0.5) Other. (0.2) 2.1 (0.1) State income taxes 0.3 0.6 0.2 ------------------------------------------------------------------------------------------------------- Effective income tax rate 33.7% 34.9% 32.9% -------------------------------------------------------------------------------------------------------
Under revolving line of credit arrangements with several banks, PLC can borrow up to $200 million on an unsecured basis. No compensating balances are required to maintain the line of credit. These lines of credit arrangements contain, among other provisions, requirements for maintaining certain financial ratios, and restrictions on indebtedness incurred by PLC’s subsidiaries including Protective. Additionally, PLC, on a consolidated basis, cannot incur debt in excess of 40% of its total capital. At December 31, 2003, PLC had $25.0 million of borrowings outstanding under these credit arrangements at an interest rate of 1.64%.
Protective uses the same accounting policies and procedures to measure operating segment income and assets as it uses to measure its consolidated net income and assets. Operating segment income is generally income before income tax, adjusted to exclude any pretax minority interest in income of consolidated subsidiaries. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of deferred policy acquisition costs are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner which most appropriately reflects the operations of that segment.
Operating Segment Assets December 31, 2003 ----------------------------------------------------------------------------------------------------------------------------------- Life Stable Value Marketing Acquisitions Annuities Products ----------------------------------------------------------------------------------------------------------------------------------- Investments and other assets $4,986,789 $4,373,737 $4,725,242 $4,520,955 Deferred policy acquisition costs 1,185,102 385,042 101,096 7,186 Goodwill ----------------------------------------------------------------------------------------------------------------------------------- Total assets $6,171,891 $4,758,779 $4,826,338 $4,528,141 -----------------------------------------------------------------------------------------------------------------------------------
At December 31, 2003, PLC estimated that its 2004 defined benefit pension plan expense will be $6.4 million, which is PLC’s estimate of its expected contributions for 2004. The measurement date used to determine the benefit expense and benefit obligations of the plan is December 31, 2003.
2003 2002 -------------------------------------------------------------------------------------------------- Projected benefit obligation, beginning of the year $62,179 $50,869 Service cost - benefits earned during the year 4,513 3,723 Interest cost - on projected benefit obligation 4,666 4,111 Actuarial loss 7,531 6,353 Benefits paid (1,435) (2,877) -------------------------------------------------------------------------------------------------- Projected benefit obligation, end of the year 77,454 62,179 -------------------------------------------------------------------------------------------------- Fair value of plan assets beginning of the year 49,450 44,024 Actual return on plan assets 12,886 (7,845) Employer contribution 13,170 16,149 Benefits paid (1,435) (2,878) -------------------------------------------------------------------------------------------------- Fair value of plan assets end of the year 74,071 49,450 -------------------------------------------------------------------------------------------------- Plan assets less than the projected benefit obligation (3,383) (12,729) Unrecognized net actuarial loss from past experience different from that assumed 27,453 28,252 Unrecognized prior service cost 1,672 1,886 Other adjustments 684 -------------------------------------------------------------------------------------------------- Net pension asset $26,426 $17,409 -------------------------------------------------------------------------------------------------- Accumulated benefit obligation $60,984 $47,707 Fair value of assets 74,071 49,450 Unfunded accumulated benefit obligation $ 0 $ 0 --------------------------------------------------------------------------------------------------
2003 2002 2001 --------------------------------------------------------------------------------------- Service cost $4,513 $3,723 $ 3,739 Interest cost 4,666 4,111 3,531 Expected return on plan assets (5,604) (4,265) (3,669) Amortization of prior service cost 214 263 176 Amortization of losses 1,049 302 141 Cost of divestiture 186 --------------------------------------------------------------------------------------- Net pension cost $4,838 $4,134 $ 4,104 ---------------------------------------------------------------------------------------