The change in fair value of the embedded derivative also impacts the emergence of expected gross profits for purposes of amortizing deferred acquisition costs associated with our annuity reinsurance agreement with Lafayette. The application of this accounting policy has increased the volatility of our reported results of operations. While we have made an estimate of the fair value of the embedded derivative using a model that we believe to be appropriate and based upon reasonable assumptions, the assumptions used are subjective and may require adjustment in the future. Changes in our assumptions could have a significant impact on the fair value of the embedded derivative and our reported results of operations.
agreed to a mutual release of all past, present and future claims under the GMDB/GMIB agreement, including all obligations for claims and premiums that had accrued under the agreement since July 1, 2004. Our obligations arising from our fixed annuity reinsurance agreements in 2004 came from our agreement with Transamerica and our agreement with Lafayette. Our obligations for these fixed annuity agreements were reflected on our balance sheet as “Interest sensitive contracts liability.” On December 31, 2004, we entered into a binding letter of intent with Transamerica which provided that it would terminate its annuity reinsurance agreement with us and recapture all business ceded under the agreement effective as of December 1, 2004. Pursuant to this letter of intent, on January 31, 2005, we executed definitive documents and completed the termination and recapture of our annuity reinsurance agreement with Transamerica.
Surrender Fees and Other Revenue. Surrender fees and other revenue for the year ended December 31, 2004 were $4,475,691 as compared with $7,297,015 for the year ended December 31, 2003. This income was primarily derived from surrender fees related to our fixed annuity agreement with Transamerica. The decrease in revenue is mainly due to a smaller policyholder base resulting in a lower absolute level of withdrawals. Lower surrender fee rates charged to the policyholders upon surrendering their policies also contributed to the decrease in surrender fees. In light of the termination and recapture of our annuity reinsurance agreement with Transamerica, effective as of December 1, 2004, we do not expect to report significant surrender fee revenue in future periods.
approximately $20,400,000 associated with Hartford Life’s recapture of our then largest GMDB agreement, the net costs of approximately $11,680,000 due to the recapture of our 50% quota share reinsurance agreement with XL Life, a net charge of $5,020,000 related to the termination of our annuity reinsurance agreement with Ohio National, the recapture cost of our MetLife agreement of approximately $3,540,000 and the cost of recapture transactions completed with 25 additional ceding companies that totaled approximately $50,190,000 in the aggregate.
only include net realized capital gains and losses as reported by us through our settlements with our ceding companies. Net investment income for 2003 related to agreements that were recaptured or terminated in 2003 was $4,777,000. Because the amount of our cash and invested assets has decreased significantly due to operating losses, and because the amount of invested assets underlying our Funds withheld receivable has decreased significantly due to the recapture and termination of certain of our reinsurance agreements, we expect our net investment income for 2004 to be less than 2003.
Surrender Fees and Other Revenue. Surrender fees and other revenue were $7,297,015 for the year ended December 31, 2003, as compared with $16,156,437 for the year ended December 31, 2002. This income is primarily derived from surrender fees related to our annuity reinsurance agreement with Transamerica. The decrease in revenue is due to a smaller policyholder base resulting in a lower absolute level of withdrawals and lower surrender rates during 2003, both as compared with the prior year.
Operating Expenses. Operating expenses were $18,034,021 or 9% of total revenue (excluding the net change in fair value of embedded derivatives) for the year ended December 31, 2003, as compared to $22,577,792 or 5% of total revenue (excluding the net change in fair value of embedded derivatives) for the year ended December 31, 2002. Our expense ratio deteriorated due to our significantly reduced revenue base. Operating expenses for 2003 include the write off of approximately $2,100,000 of goodwill associated with our United States operating subsidiary in the second quarter of 2003, costs associated with renegotiating employment arrangements and other employee compensation, increased costs of directors and officers liability insurance coverage and increased legal and audit fees.
We separately track financial results of our life and annuity operations in segments. Each segment is defined by a dominant risk characteristic inherent in products in that segment. The life segment consists of all products where the dominant risk characteristic is mortality risk. The annuity segment comprises all products where the dominant risk characteristic is investment risk. In addition, our remaining modified coinsurance annuity reinsurance agreement has features that constitute embedded derivatives that require bifurcation and separate accounting under SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities. The change in the fair value of these embedded derivatives is included in the annuity segment. Both the life and annuity segments have specific assets, liabilities, stockholders’ equity, revenue, benefits and expenses that apply only to them. The corporate segment contains all stockholders’ equity not otherwise deployed to the life or annuity segment. In addition, the corporate segment includes all capital gains and losses from sales of securities in our portfolio and investment income on undeployed invested assets. Operating expenses are generally allocated to the segments proportionately based upon the amount of stockholders’ equity deployed to the segment. Costs associated with our efforts to raise capital and pursue other strategic alternatives and the anticipated costs of settling the purported shareholder class action lawsuit have been completely allocated to the corporate segment. Segment results are reported in Note 15 to our consolidated financial statements.
Upon the adoption of the SOP on January 1, 2004, the amount of reserves for future policy benefits for our GMDB/GMIB reinsurance agreement with CIGNA was reduced by $1,878,760, favorably impacting our results of operations. The impact of the adoption of the SOP on our accounting for the Transamerica annuity reinsurance agreement was a cumulative charge of $2,244,720 as a result of an increase in Interest sensitive contracts liability of $38,398,730 partially offset by an increase in deferred policy acquisition costs of $36,154,010. The cumulative effect of a change in accounting principle was a net loss of $365,960, resulting in net segment loss of $(60,024,690) for the year ended December 31, 2004.
Policy benefits and expenses for the annuity segment decreased 13% to $83,505,926 for the year ended December 31, 2004 compared to $96,493,357 for the year ended December 31, 2003. The primary components of these expenses are interest credited to policyholders, LMIG payments, payments and reserve changes for minimum guarantees associated with variable annuity contracts and write downs and amortization of deferred acquisition costs. The decline in policy benefits and expenses is primarily due the termination of several of our annuity reinsurance agreements during 2003. In addition, as a result of a smaller base of policyholders, improved investment returns and lower lapse rates on the Transamerica annuity reinsurance agreement, LMIG payments under the agreement declined from approximately $16,200,000 for 2003 to approximately $9,990,000 for 2004. Policy benefits and expenses for 2004 include a write-down of deferred acquisition costs of $63,100,000 and the termination premium of $14,000,000 in connection with the recapture of the Transamerica annuity reinsurance agreement, partially offset by the release of reserves for interest sensitive contract liabilities in excess of the write-down of funds withheld at interest assets of approximately $23,000,000. Policy benefits and expenses for 2003 included a charge of $20,400,000 for the recapture of our then largest GMDB agreement with Hartford Life.
The performance of the assets held and managed by our ceding companies depends to a great extent on the ability of the ceding company and its investment managers to make appropriate investments consistent with their investment guidelines. If these assets do not achieve investment returns sufficient to meet our obligations on the underlying policies, we could experience unexpected losses, as has happened under our annuity reinsurance agreement with Transamerica, where the minimum interest guarantees on the underlying policies have exceeded the underlying policyholder account values due to poor investment performance, and we have been forced to fund our proportionate share of the shortfall.
Under the terms of our reinsurance agreements, we are required to provide letters of credit or fund trust accounts with liquid assets to satisfy the collateral requirements of our ceding companies. At December 31, 2004 and December 31, 2003, letters of credit totaling $35,100,000 and $53,700,000, respectively, had been issued in the ordinary course of our business by our bankers in favor of certain ceding insurance companies (including our U.S. operating subsidiary) to provide security and meet regulatory requirements. At December 31, 2004 and December 31, 2003, cash and investments of approximately $41,300,000 and $56,800,000, respectively, were pledged as collateral for letters of credit. At December 31, 2004 and December 31, 2003, cash and investments of approximately $28,900,000 and $96,000,000, respectively, were held in trust for the benefit of certain of our ceding insurance companies to provide security and to meet regulatory requirements. At December 31, 2004, we had satisfied the collateral requirements of all of our ceding companies.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Annuity and Life Re (Holdings), Ltd. and its subsidiaries as of December 31, 2004 and the results of their operations and cash flows for the year ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information contained therein.
cash and securities previously posted as collateral were released to the Company.
There can be no assurance that the Company will be able to maintain its operations and liquidity. The Company’s plans involve repositioning its investment portfolio to achieve a substantially higher yield within its investment guidelines, and seeking to successfully defend itself against the pending purported shareholder class action suit, improve the performance of its reinsurance agreement with Transamerica and restructure its reinsurance agreement with CIGNA. If the Company is not successful in implementing its plans, management believes the Company may not be able to meet its obligations in 2004. The Company’s failure to achieve any one of the foregoing items could have a material adverse effect on its financial condition and results of operations. These aforementioned factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments that might be necessary should the Company be unable to continue as a going concern.
Michael P. Esposito, Jr., a director of the Company, currently serves as the non-executive Chairman of the Board of XL Capital Ltd (“XL Capital”). Henry C.V. Keeling is a former director of the Company and currently serves as an officer of XL Capital and is the Chief Executive Officer of XL Re Ltd, a subsidiary of XL Capital. Robert M. Lichten, a director of the Company, serves as a director of a United States-based subsidiary of XL Capital. XL Capital is a major stockholder of the Company.
On August 5, 2003, XL Life served the Company with notice of its intention to recapture the 50% quota share reinsurance agreement with the Company. As a result, the Company determined it would not be able to recover the deferred acquisition costs carried for this agreement from future expected income, and wrote down approximately $21.0 million of such deferred acquisition costs in the three months ended June 30, 2003.
At December 31, 2004, options to acquire 488,365 common shares were exercisable. The weighted average remaining contractual life of these exercisable options was approximately 7 years. The following table summarizes information about the Company’s stock options for options outstanding and exercisable as of December 31, 2004:
On January 1, 2003, the Company voluntarily adopted the fair value based method of accounting for stock-based employee compensation under the prospective method described in SFAS No. 148. Under this method, the Company applies fair value accounting to all grants of employee stock options subsequent to December 31, 2002. Accordingly, $348,000 has been recognized in stockholders equity as the fair value of the options granted at the measurement date and outstanding as of December 31, 2004. Based on the vesting of the options granted, and offset partially by cancellations of options, approximately $80,000 and $112,000 was expensed in 2004 and 2003, respectively. Approximately $156,000 is deferred and will be expensed over the remaining vesting period and is reflected as unamortized stock-based compensation at December 31, 2004. The fair value of stock options awarded to employees and new directors will be amortized into income over the three-year vesting period. The fair value of stock options awarded to all other directors will be expensed immediately as their options are exercisable on the day of grant and vest upon their award.
Prior to its acquisition by Annuity and Life Re America, Inc. on June 1, 2000, the in force insurance business of Capitol Bankers Life Insurance Company was 100% reinsured with its former owner, Reassure America Life Insurance Company (“Reassure”), a subsidiary of Swiss Reinsurance Company, who continues to administer the business reinsured. The amounts related to the reinsured business are included on the Company’s consolidated balance sheet in assets as receivable for reinsurance ceded and an identical amount in liabilities as reserves for future policy benefits. At December 31, 2004 and 2003, these amounts were $82.2 million and $88.2 million, respectively. Capital Bankers Life Insurance Company was renamed Annuity and Life Reassurance America, Inc. in December 2000.
On October 8, 2003, the Company was served with a statutory demand for $640,000 from Imagine Group Holdings Limited (“Imagine”), a Bermuda based reinsurance company, which was subsequently withdrawn. Imagine has since instituted a civil proceeding in the Bermuda Supreme Court against the Company, alleging that the Company is obligated to reimburse it for $640,000 of expenses incurred by Imagine in connection with a proposed December 2002 capital raising transaction that was not consummated. On March 11, 2004, the Company filed an amended defense with the court to which Imagine responded on April 26, 2004. The Company does not believe that Imagine is entitled to reimbursement of these expenses under the applicable agreement and is defending itself against Imagine’s claims.
The Company has a significant deferred annuity reinsurance agreement with Lafayette Life Insurance Company (“Lafayette”). Due to the size of this agreement, there is a material concentration of net investment income, interest credited to interest sensitive products, funds withheld at interest, deferred policy acquisition costs and interest sensitive contract liabilities. Approximately $51.3 million, or 91%, of the Company’s funds withheld at interest receivable, approximately $57.8 million, or 100%, of the Company’s interest sensitive contracts liability, and approximately $3.4 million, or 55%, of the deferred acquisition costs on the Company’s consolidated balance sheet was related to its reinsurance agreement with Lafayette as of December 31, 2004.
At December 31, 2004, the Company’s remaining modified coinsurance annuity reinsurance agreement had a feature that constitutes an embedded derivative that requires bifurcation and separate accounting under SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities. The valuation of this embedded derivative requires cash flow modeling that uses various assumptions regarding future cash flows under the agreement. The fair value of this derivative is reported as a component of Funds withheld at interest. At December 31, 2004, the fair value of this embedded derivative was a loss of approximately $(5,609,000). At December 31, 2003, the fair value of this embedded derivative was a loss of $(7,790,000).