The Company is primarily engaged in traditional individual life, asset-intensive, critical illness and financial reinsurance. RGA and its predecessor, the Reinsurance Division of General American, have been engaged in the business of life reinsurance since 1973. Approximately 71.0% of the Company’s 2006 net premiums were from its more established operations in North America, which include its U.S. and Canada segments.
As previously indicated, the Company generally starts new operations in these markets from the ground up as opposed to acquiring existing operations, and it often enters these markets to support its large international clients as they expand into additional markets. Many of the markets that the Company has entered since 1994, or may enter in the future, are not utilizing life reinsurance, including facultative life reinsurance, at the same levels as the North American market, and therefore, the Company believes represent opportunities for increasing reinsurance penetration. Additionally, the Company believes that in certain markets, ceding companies may want to reduce counterparty exposure to their existing life reinsurers, creating opportunities for the Company.
Consolidated investment income increased 22.0% and 10.1% during 2006 and 2005, respectively. These increases related to a growing invested asset base due to positive cash flows from the Company’s mortality operations and deposits from several annuity reinsurance treaties, offset, in part, by slightly declining invested asset yields primarily due to a decline in prevailing interest rates. The cost basis of invested assets increased by $2.3 billion, or 19.7%, in 2006 and increased $1.6 billion, or 15.9%, in 2005. A significant portion of the increase in invested assets in 2006 is related to the Company’s investment of the net proceeds from its collateral finance facility in June 2006 (See “Liquidity and Capital Resources - Collateral Finance Facility”) and the issuance of $400 million of Junior Subordinated Debentures in December 2005. The average yield earned on investments, excluding funds withheld, was 5.81% in 2006, compared with 5.89% in 2005 and 5.91% in 2004. The Company expects the average yield to vary from year to year depending on a number of variables, including the prevailing interest rate environment, and changes in the mix of the underlying investments. Funds withheld assets are primarily associated with the reinsurance of annuity contracts on which the Company earns a spread. Fluctuations in the yield on funds withheld assets are generally offset by a corresponding adjustment to the interest credited on the liabilities. Investment income and investment related gains and losses are allocated to the operating segments based upon average assets and related capital levels deemed appropriate to support the segment business volumes.
Income before income taxes increased in 2006 to $20.2 million compared to $16.3 million in 2005 and $11.7 million in 2004. Issue B36 contributed $2.3 million of the increase over 2005. The remaining $1.6 million increase over 2005 is primarily due to the growth in the asset base and improved spreads earned on those assets. Income from a new variable annuity transaction also contributed to the increase year over year. Income before tax in 2005 increased $4.6 million compared to 2004. This increase can be primarily attributed to a decrease in investment related losses of $6.2 million somewhat offset by a reduction of $2.7 million in the gain realized from Issue B36.
Other operating expenses increased $1.1 million in 2006 and $4.0 million in 2005 compared to their respective prior-year periods. However, other operating expenses as a percentage of net premiums decreased to 3.8% in 2006, compared to 4.4% and 4.4% in 2005 and 2004, respectively.
The following table displays DAC balances for asset-intensive business and non-asset-intensive business by segment as of December 31, 2006:
On June 28, 2006, RGA’s subsidiary, Timberlake Financial, issued $850.0 million of Series A Floating Rate Insured Notes due June 2036 in a private placement. The notes were issued to fund the collateral requirements for statutory reserves required by the U.S. Valuation of Life Policies Model Regulation (commonly referred to as Regulation XXX) on specified term life insurance policies reinsured by RGA Reinsurance. Proceeds from the notes, along with a $112.7 million direct investment by the Company, collateralize the notes and are not available to satisfy the general obligations of the Company. As of December 31, 2006, the Company held assets in trust of $864.8 million for this purpose. In addition, the Company held $83.8 million in custody as of December 31, 2006. Interest on the notes will accrue at an annual rate of 1-month LIBOR plus a base rate margin, payable monthly. 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 had total cash and invested assets of $14.8 billion and $12.5 billion at December 31, 2006 and 2005, respectively. All investments held by RGA and its subsidiaries are monitored for conformance to the qualitative and quantitative limits prescribed by the applicable jurisdiction’s insurance laws and regulations. In addition, the operating companies’ boards of directors periodically review their respective investment portfolios. The Company’s investment strategy is to maintain a predominantly investment-grade, fixed maturity portfolio, to provide adequate liquidity for expected reinsurance obligations, and to maximize total return through prudent asset management. The Company’s asset/liability duration matching differs between operating segments. Based on Canadian reserve requirements, a portion of the Canadian liabilities is strictly matched with long-duration Canadian assets, with the remaining assets invested to maximize the total rate of return, given the characteristics of the corresponding liabilities and Company liquidity needs. The duration of the Canadian portfolio exceeds twenty years. The duration for all the Company’s portfolios when consolidated range between eight and ten years. The Company’s average yield earned on investments, excluding funds withheld, was 5.81% in 2006, compared with 5.89% in 2005, and 5.91% in 2004. See Note 4 - “Investments” in the Notes to Consolidated Financial Statements for additional information regarding the Company’s investments.
Substantially all of the Company’s funds withheld at interest receivable balance is associated with its reinsurance of annuity contracts. The funds withheld receivable balance totaled $4.1 billion and $3.5 billion at December 31, 2006 and 2005, respectively, of which $2.9 billion and $2.3 billion, respectively, were subject to the provisions of Issue B36. Under Issue B36, the Company’s funds withheld receivable under certain reinsurance arrangements incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the obligor and include an embedded derivative feature that is not clearly and closely related to the host contract. Therefore, the embedded derivative feature must be measured at fair value on the consolidated balance sheets and changes in fair value reported in income. See “Changes in value of embedded derivatives” in Note 2 - “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements for further discussion.
In addition to its annuity contracts, the Company has entered into various financial reinsurance treaties on a funds withheld and modified coinsurance basis. These treaties do not transfer significant insurance risk and are recorded on a deposit method of accounting with the Company earning a net fee. As a result of the experience refund provisions contained in these treaties, the value of the embedded derivatives in these contracts is currently considered immaterial. The Company monitors the performance of these treaties on a quarterly basis. Significant adverse performance or losses on these treaties may result in a loss associated with the embedded derivative.
Income Taxes. RGA and its eligible U.S. subsidiaries file a consolidated federal income tax return. The U.S. consolidated tax return includes RGA, RGA Americas, RGA Reinsurance, RGA Barbados, RGA Technology Partners, Inc., Reinsurance Company of Missouri, Incorporated, RGA Sigma Reinsurance SPC, Timberlake Financial L.L.C. (“Timberlake Financial”), Timberlake Reinsurance Company II (“Timberlake Re”), Fairfield Management Group, Inc., Reinsurance Partners, Inc. and RGA Worldwide Reinsurance Company, Ltd. (“RGA Worldwide”), formerly Triad Re, Ltd. The Company’s Argentine, Australian, Bermudian, Canadian, South African, Indian, Irish, and United Kingdom subsidiaries are taxed under applicable local statutes.
Net Earnings Per Share. Basic earnings per share exclude any dilutive effects of any outstanding options, warrants or units. Diluted earnings per share include the dilutive effects assuming outstanding stock options, warrants or units were exercised.
The Company participates in a securities lending program whereby blocks of securities, which are included in investments, are loaned to third parties, primarily major brokerage firms. The Company requires a minimum of 102% of the fair value of the loaned securities to be separately maintained as collateral for the loans. No securities were loaned to third parties as of December 31, 2006 or 2005. Securities loaned transactions are accounted for as financing arrangements on the Company’s consolidated balance sheets and consolidated statements of cash flow and the income and expenses associated with the program are reported in net investment income since such transactions are entered into for income generation purposes, not funding purposes.
The Company also provides certain health care and life insurance benefits for retired employees. The health care benefits are provided through a self-insured welfare benefit plan. Employees become eligible for these benefits if they meet minimum age and service requirements. The retiree’s cost for health care benefits varies depending upon the credited years of service. The Company recorded benefits expense of approximately $1.6 million, $1.3 million, and $0.7 million in 2006, 2005 and 2004, respectively that is related to these postretirement plans. Virtually all retirees, or their beneficiaries, contribute a portion of the total cost of postretirement heath benefits.
Certain subsidiaries of the Company also sponsor saving and investment plans under which a portion of employee contributions are matched. Subsidiary contributions to these plans, which are partially tied to RGA’s financial results, were $1.8 million, $2.3 million and $2.2 million in 2006, 2005 and 2004, respectively.
mandatorily deferred if the Company does not meet specified capital adequacy, net income and shareholders’ equity levels. Upon an optional or mandatory deferral of interest payments, RGA is generally not permitted to pay common-stock dividends or make payments of interest or principal on securities which rank equal or junior to the subordinated debentures, until the accrued and unpaid interest on the subordinated debentures is paid. The subordinated debentures are redeemable at RGA’s option. The net proceeds from the offering were approximately $394.6 million, a portion of which was used to purchase $76.1 million of RGA’s common stock under an ASR agreement with a financial counterparty. Additionally, RGA used a portion of the net proceeds from the sale of these debentures to repay approximately $100.0 million of its 7.25% senior notes when they matured in April 2006. Capitalized issue costs were approximately $5.5 million.
See “Shareholder Dividends” and “Debt and Trust Preferred Securities” in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources”.