The following discussion and analysis should be read in conjunction with the financial statements and related notes found on pages 35-66, as they contain important information that is helpful in evaluating the Company’s operating results and financial condition.
The Company makes estimates and assumptions that can have a significant effect on amounts and disclosures reported in the financial statements. The most significant estimates relate to valuation of investments, reserves for policy liabilities and the capitalization and recoverability of deferred policy acquisition costs. While management believes its estimates are appropriate, the ultimate amounts may differ from the estimates provided. The methods for making these estimates are continually reviewed and any adjustments considered necessary are reflected in current earnings.
guaranteed rates for the entire level term period and conversion privileges until the end of the level term period or insured age 70.
In order to price competitively and reduce claims volatility, the Company reinsures a large portion of its traditional products. Under the reinsurance treaty for the ERIE Flagship Term Plus product, the reinsurers assume 75% of mortality risk on policies up to $1.2 million (the Company’s retention limit is $300,000) and assume all mortality risk above that amount. The reinsurance treaty for the ERIE Flagship Term2 product provides that the reinsurer assumes 50% of mortality risk on policies up to $600,000 (the Company’s retention limit is $300,000) and assumes all mortality risk above that amount. ERIE Target Term, which was discontinued July 1, 2005, had 90% of the mortality risk ceded to reinsurers.
Net death benefits on life insurance policies increased $1.8 million, or 10.1%, to $19.3 million in 2005, and increased $2.4 million in 2004 when compared to 2003. Death benefits reflect reinsurance recoveries of $9.4 million, $6.2 million and $4.7 million in 2005, 2004 and 2003, respectively. As noted previously in the “Analysis of Policy Revenue” section, the Company’s principal term products are substantially reinsured. As the Company’s life insurance in force continues to grow, death benefits can be expected to increase. Net life insurance in force has grown from $17.6 billion at December 31, 2004 to $18.0 billion at December 31, 2005. As confirmed by the Company’s most recent mortality study, management believes its underwriting philosophy and practices are sound.
Commission expense, net of DAC, increased $0.6 million to $1.8 million in 2005, and decreased to $1.2 million in 2004. The increase in 2005 over the 2004 totals can be attributed to an agent bonus program established by the Company in 2004. The non-deferrable expense portion for this program increased $0.7 million in 2005 when compared to 2004. The decrease in 2005 and 2004 from the 2003 levels was partially attributable to the decline in annuity sales and a decrease in the annuity commission rates in 2004. Commissions and bonuses on annuity premiums, net of DAC, were $0.7 million in 2005 and 2004 and $2.4 million in 2003. In addition, the 2004 commission expense was reduced by a $0.7 million adjustment to the reinsurance expense allowance reimbursements due to reinsurance administration system corrections described previously.
The Company’s investment strategies provide that portfolios are structured to match the features of the life insurance and deposit products sold by the Company. Annuities and life insurance policies are long-term products; therefore, the Company’s investment strategy takes a long-term perspective emphasizing investment quality, diversification and superior investment returns. The Company’s investments are managed on a total return approach that focuses on current income and capital appreciation.
Contractual obligations on gross long-term liabilities represent estimated benefit payments from insurance policies and annuity contracts including claims currently payable. Actual obligations in any single year will vary based on actual mortality, morbidity, lapse, and withdrawal experience. The sum of these obligations exceeds the liability on the balance sheet of $1,352,653 due to expected future premiums, deposits and investment income that, along with invested assets backing the liabilities, will be used to fund these obligations.
In accordance with FAS 60, Accounting and Reporting by Insurance Enterprises, the DAC related to traditional life insurance products is amortized in proportion to premium revenues over the premium-paying period of related policies using assumptions consistent with those used in computing policy liability reserves. Assumptions used for a specific era of issued policies are “locked-in;” therefore, amortization in subsequent years is not adjusted for changing assumptions. In any period where the Company’s actual policy terminations are higher (lower) than anticipated policy terminations, DAC amortization will be accelerated (decelerated) in that period.
Position. Amounts recoverable for incurred claims and expense reimbursements are included as an asset under “Reinsurance Recoverable” in the Statements of Financial Position.
Fixed maturities and equity securities in a gross unrealized loss position are as follows. Data is provided by length of time securities were in a gross unrealized loss position.
There are $110.7 million in investment grade fixed maturity securities at fair value that at December 31, 2005, had been below amortized cost for 12 months or longer. These fixed maturities had unrealized losses as of December 31, 2005, of $4.1 million. These unrealized losses are due to higher market interest rates and greater spread requirements in the market in general and are not related to the credit quality of specific issuers.
In 2005, the Company adjusted its income tax liability to reflect the difference in the December 31, 2004 income tax expense provision and the actual federal income tax return filed in September 2005. This adjustment decreased the tax expense for the period by $0.7 million.
The Company owns certain real estate it leases to EIC. Rentals paid by EIC to the Company totaled $0.3 million each year in 2005, 2004 and 2003, respectively.