The Company has five main geographic-based operational segments, each of which is a distinct reportable segment: U.S., Canada, Europe & South Africa, Asia Pacific and Corporate and Other. The U.S. operations provide traditional life, asset-intensive, and financial reinsurance primarily to domestic clients. The Canada operations provide insurers with reinsurance of traditional life products as well as creditor reinsurance, group life and health reinsurance and non-guaranteed critical illness products. Europe & South Africa operations include traditional life reinsurance and critical illness business from Europe & South Africa, in addition to other markets the Company is developing. Asia Pacific operations provide primarily traditional and group life reinsurance, critical illness and, to a lesser extent, financial reinsurance. The Corporate and Other segment results include the corporate investment activity, general corporate expenses, interest expense of RGA, operations of RTP, a wholly-owned subsidiary that develops and markets technology solutions for the insurance industry, Argentine business in run-off, and the investment income and expense associated with the Company’s collateral finance facility. The Company’s discontinued accident and health business is excluded from continuing operations. The Company measures segment performance based on profit or loss from operations before income taxes.
Consolidated investment income, net of related expenses, decreased $36.6 million, or 4.0%, and increased $128.2 million, or 16.4%, in 2008 and 2007, respectively. The decrease in 2008 is primarily due to market value changes related to the Company’s funds withheld at interest investment related to the reinsurance of certain equity indexed annuity products, which are substantially offset by a corresponding change in interest credited to policyholder account balances resulting in a negligible effect on net income. Largely offsetting the decrease in investment income in 2008 was a larger invested asset base and a higher effective investment portfolio yield. The increase in 2007 is related to a larger invested asset base and a higher effective investment portfolio yield. The cost basis of invested assets, including funds withheld, were $16.5 billion, $15.9 billion and $14.0 billion at December 31, 2008, 2007 and 2006, respectively. The average yield earned on the cost basis of investments, excluding funds withheld, was 6.02%, 5.96% and 5.81% in 2008, 2007 and 2006, respectively. The Company expects the average yield to vary from year to year depending on a number of variables, including the prevailing interest rate and credit spread environment, changes in the mix of the underlying investments, and the timing of dividends and distributions on certain investments.
Other operating expenses decreased $1.8 million, or 3.6%, and increased $7.9 million, or 18.8% in 2008 and 2007, respectively. Other operating expenses, as a percentage of net premiums, were 1.6%, 1.7% and 1.6% in 2008, 2007 and 2006, respectively. The expense ratio tends to fluctuate only slightly from period to period due to maturity and scale of this operation.
The recent market conditions have adversely affected the Company’s results of operations and financial position. During the third quarter of 2008, the Company incurred significant investment related losses as a result of impairments. In addition, results of operations in 2008 reflected a significant increase in unrealized losses due to an unfavorable change in the value of embedded derivatives which are a direct result of widening credit spreads and changes in the risk-free rates in the U.S. debt markets. Additionally, gross unrealized losses in the Company’s fixed maturity and equity securities available-for-sale increased significantly to $1,416.4 million at December 31, 2008 from $198.2 million at December 31, 2007.
The Company has selectively reduced its exposure to distressed security issuers through security sales. In addition, the U.S. government, and governments in many foreign markets where the Company operates, have responded to address market imbalances and taken meaningful steps intended to eventually restore confidence. Although management believes the Company’s current capital base is adequate to support its business at current operating levels, it continues to monitor new business opportunities and any associated new capital needs that could arise from the changing financial landscape.
See Note 3 - “Stock Transactions” in the Notes to Consolidated Financial Statements for additional information regarding the Company’s stock transactions.
Based on data provided by the ceding companies at December 31, 2008, the maturity distribution of the segregated portfolio portion of funds withheld at interest was approximately (dollars in thousands):
Interest rate sensitivity analysis is also used to measure the Company’s interest rate cash flow risk by computing estimated changes in the cash flows expected in the near term attributable to floating rate assets and liabilities in the event of a range of assumed changes in market interest rates. This analysis assesses the risk of loss in cash flows in the near term in market risk sensitive floating rate instruments in the event of a hypothetical 10% change (increase or decrease) in market interest rates. The Company does not have variable rate instruments classified as trading securities. The Company’s projected decrease in cash flows in the near term associated with floating rate instruments in the event of a 10% unfavorable change in market interest rates at its fiscal years ended December 31, 2008 and 2007 was $2.7 million and $4.1 million, respectively.
During 2008, poor investment fund performance, increases in capital market implied volatility and reductions in interest rates resulted in a significant increase in the fair value of liabilities associated with guaranteed minimum living benefits. The following table presents the Company’s estimates of the effect from variable annuity business on 2009 pretax income based on various levels of the S&P 500 Index and the Company’s net hedging results. The calculations assume that all investment funds underlying the variable annuities, including bonds and money markets, move in line with the S&P 500 Index performance. The net hedging results included in the table can be independent of the capital market movements, and are calculated as the difference between the change in fair value of the guaranteed minimum living benefit liabilities and the change in the fair value of the derivative instruments used to economically hedge the guaranteed minimum living benefit liabilities. Additionally, the projected results include the Company’s estimate of related DAC amortization and unlocking. These estimates are based upon the recorded liabilities for guaranteed minimum living benefits as of December 31, 2008 and do not include projections for new business. In addition to the assumptions about the S&P 500 Index and net hedging results, the estimates below include the Company’s expectations regarding policyholder behavior, mortality, internal allocation of expenses and investment income, as well as other actuarial assumptions.
Revenues for interest-sensitive and investment-type products consist of investment income, policy charges for the cost of insurance, policy administration, and surrenders that have been assessed against policy account balances during the period. Interest-sensitive contract liabilities for these products represent policy account balances before applicable surrender charges. Deferred policy acquisition costs are recognized as expenses over the term of the policies. Policy benefits and claims that are charged to expenses include claims incurred in the period in excess of related policy account balances and interest credited to policy account balances. The weighted average interest-crediting rates for interest-sensitive products were 3.3%, 3.8% and
The following table presents the total gross unrealized losses for 1,716 and 1,105 fixed maturity securities and equity securities at December 31, 2008 and 2007, respectively, where the estimated fair value had declined and remained below amortized cost by the indicated amount (dollars in thousands):
The investment securities in an unrealized loss position as of December 31, 2008 consisted of 1,716 securities accounting for unrealized losses of $1,416.4 million. Of these unrealized losses 92.7% were investment grade and 22.9% were less than 20% below cost. The amount of the unrealized loss on these securities was primarily attributable to increases in interest rates, including a widening of credit default spreads.
All of the Company’s mortgage loans are amortizing loans. As of December 31, 2008 and 2007, the Company’s mortgage loans were distributed throughout the United States as follows (dollars in thousands):
Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or market standard valuation methodologies and assumptions with significant inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Such observable inputs include benchmarking prices for similar assets in active, liquid markets, quoted prices in markets that are not active and observable yields and spreads in the market. The Company’s Level 2 assets and liabilities include investment securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose values are determined using market standard valuation methodologies. This category primarily includes U.S. and foreign corporate securities, Canadian and Canadian provincial government securities, and residential and commercial mortgage-backed securities, among others. Management values most of these securities using inputs that are market observable.
As a result of the adoption of FIN 48 on January 1, 2007, the Company recognized a $17.3 million increase in the liability for unrecognized tax benefits, a $5.3 million increase in the interest liability for unrecognized tax benefits, and a corresponding reduction to the January 1, 2007 balance of retained earnings of $22.6 million. The Company’s total amount of unrecognized tax benefits upon adoption of FIN 48 was $196.3 million. The Company reclassified, at adoption, $9.1 million of current income tax payables to the liability for unrecognized tax benefits, included within other liabilities. The Company also reclassified, at adoption, $169.9 million of deferred income tax liabilities for which the ultimate deductibility is highly certain but for which there is uncertainly about the timing of such deductibility, to the liability for unrecognized tax benefits. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to the taxing authority to an earlier period. The total amount of unrecognized tax benefits as of January 1, 2007 that would affect the effective tax rate if recognized was $26.4 million. The Company also had $29.8 million of accrued interest, included within other liabilities, as of January 1, 2007. The Company classifies interest accrued related to unrecognized tax benefits in interest expense, while penalties are included within income tax expense.
held $9.7 million in custody as of December 31, 2008. Interest on the notes accrues at an annual rate of 1-month LIBOR plus a base rate margin, payable monthly and totaled $28.7 million and $52.0 million in 2008 and 2007, respectively. The payment of interest and principal on the notes is insured through a financial guaranty insurance policy with a third party. The notes represent senior, secured indebtedness of Timberlake Financial with no recourse to RGA or its other subsidiaries. Timberlake Financial will rely primarily upon the receipt of interest and principal payments on a surplus note and dividend payments from its wholly-owned subsidiary, Timberlake Re, a South Carolina captive insurance company, to make payments of interest and principal on the notes. The ability of Timberlake Re to make interest and principal payments on the surplus note and dividend payments to Timberlake Financial is contingent upon South Carolina regulatory approval and the performance of specified term life insurance policies with guaranteed level premiums retroceded by RGA’s subsidiary, RGA Reinsurance, to Timberlake Re.
The Company has five main geographic-based operational segments, each of which is a distinct reportable segment: U.S., Canada, Europe & South Africa, Asia Pacific and Corporate and Other. The U.S. operations market traditional life reinsurance, reinsurance of asset-intensive products and financial reinsurance, primarily to large U.S. market life insurance companies. Asset-intensive products primarily include reinsurance of corporate-owned life insurance and annuities. The Canada operations provide insurers with reinsurance of traditional individual life products as well as creditor reinsurance, group life and health reinsurance and non-guaranteed critical illness products. Europe & South Africa operations include traditional life reinsurance and critical illness business from Europe & South Africa, in addition to other markets being developed by the Company. Asia Pacific operations provide primarily traditional life reinsurance, critical illness and, to a lesser extent, financial reinsurance through RGA Australia and RGA Reinsurance. The Company’s discontinued accident and health operations are not reflected in the continuing operations of the Company. The Company measures segment performance based on income or loss before income taxes.
Prior to January 1, 2003, the Company applied APB Opinion No. 25 in accounting for its Stock Plans and, accordingly, no compensation cost was recognized for its stock options in the consolidated financial statements. For grants from 2003 through 2005, the Company determined compensation cost based on the fair value at the grant date for its stock options using the “prospective” approach under FASB Statement No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123”. Beginning January 1, 2006, the Company was required to use the “modified prospective” method for recording compensation expense in accordance with SFAS 123(r), a revision of SFAS 123. The modified prospective approach requires compensation cost on all unvested options to be recorded in the income statement over its remaining vesting period, regardless of when the options were granted. Had the Company applied the modified prospective approach in the comparable prior-year periods, net income and earnings per share would not have changed by a material amount.