Management's discussion and analysis of financial condition and results of operations of First SunAmerica Life Insurance Company (the "Company") for the three years in the period ended September 30, 1998 follows. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the "SEC"). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Statements using verbs such as "expect," "anticipate," "believe" or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward- looking statements include statements which represent the Company's beliefs concerning future levels of sales and redemptions of the Company's products, investment spreads and yields, or the earnings and profitability of the Company's activities.
NET INCOME totaled $16.5 million in 1998, compared with $8.9 million in 1997 and $0.7 million in 1996. On October 31, 1997, John Alden Life Insurance Company of New York ("JANY") was merged with and into the Company. JANY was acquired by SunAmerica Life Insurance Company, the Company's parent, on March 31, 1997 in a transaction accounted for under the purchase method of accounting. Therefore, the results of operations include those of JANY only from the date of acquisition. The income statement for 1998 includes the results of JANY's operations for the full period, and the income statement for 1997 includes JANY's operating results only for the period of April 1, 1997 through September 30, 1997. Consequently, operating results for the fiscal years 1998, 1997 and 1996 are not comparable. On a pro forma basis, using the historical operating results of JANY and assuming the merger had been consummated on October 1, 1995, the beginning of the earliest period presented, net income would have been $12.4 million in 1997 and $6.7 million in 1996.
$1.2 million in 1996 and reflect the merger with JANY. The improvement in 1998 over 1997 and the improvement in 1997 over 1996 resulted primarily from increased net investment income and fee income, partially offset by increased amortization of deferred acquisition costs. The improvement in 1997 over 1996 was also due to an increase in net realized investment gains, partially offset by increased general and administrative expenses.
Investment income (and the related yields on average invested assets) totaled $117.5 million (7.56%) in 1998, compared with $65.6 million (7.39%) in 1997 and $10.0 million (7.40%) in 1996. The invested assets associated with the merger included high-grade corporate, government and government/agency bonds and cash and short-term investments, all of which are generally lower yielding than a significant portion of the invested assets that comprise the remainder of the Company's portfolio. On a pro forma basis, assuming the merger had been consummated on October 1, 1995, the yield on related average invested assets would have been 7.37% in 1997 and 7.41% in 1996. Thus, the increased yield in 1998, when compared to the pro forma 1997 and 1996 yields, reflect a partial reallocation of the lower-yielding invested assets into generally higher-yielding asset classes in which the Company has historically invested a portion of its portfolio.
Average invested assets also increased as a result of sales of the Company's fixed-rate products (including those for the fixed accounts of variable annuity products). Fixed annuity premiums totaled $130.9 million in 1998, compared with $131.7 million in 1997 and $45.4 million in 1996. These
amounts represent 8%, 9%, and 43% of the fixed annuity reserve balance at the beginning of the respective periods. On a pro-forma basis, assuming the merger had been consummated on October 1, 1995, fixed annuity premiums would have represented 14% of fixed annuity reserves for 1997 and 1996. These premiums include premiums for the fixed accounts of variable annuities totaling $77.3 million, $68.9 million and $41.2 million, in 1998, 1997 and 1996, respectively.
The Company sold or redeemed invested assets, principally bonds and notes, aggregating $985.1 million, $634.8 million and $80.0 million in 1998, 1997 and 1996, respectively. Sales of investments result from the active management of the Company's investment portfolio. Because redemptions of investments are generally involuntary and sales of investments are made in both rising and falling interest rate environments, net gains and losses from sales and redemptions of investments fluctuate from period to period, and represent 0.33%, 0.57% and 0.27% of average invested assets for 1998, 1997 and 1996, respectively. Active portfolio management involves the ongoing evaluation of asset sectors, individual securities within the investment portfolio and the reallocation of investments from sectors that are perceived to be relatively overvalued to sectors that are perceived to be relatively undervalued. The intent of the Company's active portfolio management is to maximize total returns on the investment portfolio, taking into account credit, option, liquidity and interest-rate risk.
VARIABLE ANNUITY FEES are based on the market value of assets in separate accounts supporting variable annuity contracts. Such fees totaled $3.6 million in 1998, $1.7 million in 1997 and $0.7 million in 1996. These increased fees reflect growth in average variable annuity assets, due to increased market values, the receipt of variable annuity premiums and net exchanges into the separate accounts from the fixed accounts of variable annuity contracts, partially offset by surrenders. Variable annuity fees represent 1.5% of average variable annuity assets for each of 1998, 1997 and 1996. Variable annuity assets averaged $234.1 million during 1998, $111.8 million during 1997 and $46.2 million during 1996. Variable annuity premiums, which exclude premiums allocated to the fixed accounts of variable annuity products, aggregated $80.2 million in 1998, $56.3 million in 1997 and $28.6 million in 1996. These amounts represent 47%, 82% and 87% of variable annuity reserves at the beginning of the respective periods.
Sales of variable annuity products (which include premiums allocated to the fixed accounts) ("Variable Annuity Product Sales") amounted to $157.5 million, $125.2 million and $69.8 million in 1998, 1997 and 1996, respectively, and primarily reflect sales of the Company's flagship variable annuity, Polaris. Polaris is a multimanager variable annuity that offers investors a choice of 26 variable funds and 7 guaranteed fixed-rate funds. Increases in Variable Annuity Product Sales are due, in part, to market share gains through enhanced distribution efforts and growing consumer demand for flexible retirement savings products that offer a variety of equity, fixed income and guaranteed fixed account investment choices. In recent weeks, subsequent to the Company's fiscal year end, sales of variable annuities have slowed as
SURRENDER CHARGES on fixed and variable annuities totaled $4.4 million (including $3.9 million attributable to the merger) in 1998, $1.8 million (including $1.5 million attributable to the merger) in 1997 and $0.2 million in 1996. Surrender charges generally are assessed on annuity withdrawals at declining rates during the first seven years of an annuity contract. Withdrawal payments, which include surrenders and lump-sum annuity benefits, totaled $234.4 million (including $198.3 million attributable to the merger) in 1998, compared with $93.5 million (including $72.9 million attributable to the merger) in 1997 and $12.7 million in 1996. These payments represent 14.0% (15.5% of average fixed annuity reserves associated with the merger), 9.9% and 8.1%, respectively, of average fixed and variable annuity reserves. Withdrawals include variable annuity withdrawals from the separate accounts totaling $12.8 million (5.5% of average variable annuity reserves), $5.3 million (4.8% of average variable annuity reserves) and $2.8 million (6.2% of average variable annuity reserves) in 1998, 1997 and 1996, respectively. Consistent with the assumptions used in connection with the merger, management anticipates that the level of withdrawal payments will continue to reflect higher relative withdrawal rates in the near future because of higher surrenders on the acquired annuity business.
AMORTIZATION OF DEFERRED ACQUISITION COSTS totaled $17.1 million in 1998, compared with $10.4 million in 1997 and $0.5 million in 1996. The increases in amortization primarily reflect the amortization of the deferred acquisition costs attributable to the merger, which aggregated $15.7 million in 1998 and $9.2 million in 1997. Amortization has also increased due to additional fixed and variable annuity sales and the subsequent amortization of related deferred commissions and other direct selling costs.
INVESTED ASSETS at September 30, 1998 totaled $1.55 billion, compared with $1.69 billion at September 30, 1997. The Company manages most of its invested assets internally. The Company's general investment philosophy is to hold fixed-rate assets for long-term investment. Thus, it does not have a trading portfolio. However, the Company has determined that all of its portfolio of bonds and notes (the "Bond Portfolio") is available to be sold in response to changes in market interest rates, changes in relative value of asset sectors and individual securities, changes in prepayment risk, changes in the credit quality outlook for certain securities, and the Company's need for liquidity and other similar factors.
At September 30, 1998, the Bond Portfolio included $1.26 billion of bonds rated by Standard & Poor's Corporation ("S&P"), Moody's Investors Service ("Moody's"), Duff & Phelps Credit Rating Co. ("DCR"), Fitch Investors Service, L.P. ("Fitch") or the National Association of Insurance Commissioners ("NAIC"), and $43.9 million of bonds rated by the Company pursuant to statutory ratings guidelines established by the NAIC. At September 30, 1998, approximately $1.21 billion of the Bond Portfolio was investment grade, including $473.1 million of U.S. government/agency securities and mortgage-backed securities ("MBSs").
At September 30, 1998, the Bond Portfolio included $97.0 million of bonds that were not investment grade. These non-investment-grade bonds accounted for 5.0% of the Company's total assets and 6.2% of its invested assets.
Non-investment-grade securities generally provide higher yields and involve greater risks than investment-grade securities because their issuers typically are more highly leveraged and more vulnerable to adverse economic conditions than investment-grade issuers. In addition, the trading market for these securities is usually more limited than for investment-grade securities. The Company had no material concentrations of non-investment-grade securities at September 30, 1998.
Senior secured loans ("Secured Loans") are included in the Bond Portfolio and aggregated $77.6 million at September 30, 1998. Secured Loans are senior to subordinated debt and equity, and are secured by assets of the issuer. At September 30, 1998, Secured Loans consisted of $58.2 million of publicly traded securities and $19.4 million of privately traded securities. These Secured Loans are composed of loans to 59 borrowers spanning 16 industries, with 30% of these assets concentrated in utilities, 11% concentrated in air transportation and 10% concentrated in business services. No other industry constituted more than 8% of these assets.
MORTGAGE LOANS aggregated $187.9 million at September 30, 1998 and consisted of 183 commercial first mortgage loans with an average loan balance of approximately $1.0 million, collateralized by properties located in 28 states. Approximately 36% of this portfolio was retail, 26% was office, 15% was industrial, 13% was multifamily residential and 10% was other types. At September 30, 1998, approximately 16%, 15% and 10% of this portfolio was secured by properties located in New York, California and Michigan, respectively, and no more than 8% of this portfolio was secured by properties located in any other single state. At September 30, 1998, there was one mortgage loan with an outstanding balance of $10 million or more, which represented approximately 6% of the portfolio. At September 30, 1998, approximately 31% of the mortgage loan portfolio consisted of loans with balloon payments due before October 1, 2001. During 1998, 1997 and 1996, loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
At September 30, 1998, approximately 60% of the mortgage loans were seasoned loans underwritten to the Company's standards and purchased at or near par from other financial institutions. Such loans generally have higher average interest rates than loans that could be originated today. The balance of the mortgage loan portfolio has been originated by the Company under strict underwriting standards. Commercial mortgage loans on properties such as offices, hotels and shopping centers generally represent a higher level of risk than do mortgage loans secured by multifamily residences. This greater risk is due to several factors, including the larger size of such loans and the more immediate effects of general economic conditions on these commercial property types. However, due to the seasoned nature of the Company's mortgage loan portfolio and its strict underwriting standards, the Company believes that it has prudently managed the risk attributable to its mortgage loan portfolio while maintaining attractive yields.
There are risks associated with some of the techniques the Company uses to provide liquidity, enhance its spread income and match its assets and liabilities. The primary risk associated with the Company's Reverse Repos is counterparty risk. The Company believes, however, that the counterparties to its Reverse Repos are financially responsible and that the counterparty risk associated with those transactions is minimal. It is the Company's policy that these agreements are entered into with counterparties who have a debt rating of A/A2 or better from both S&P and Moody's. The Company continually monitors its credit exposure with respect to those agreements. The primary risk associated with MBSs is that a changing interest rate environment might cause prepayment of the underlying obligations at speeds slower or faster than anticipated at the time of their purchase. As part of its decision to purchase an MBS, the Company assesses the risk of prepayment by analyzing the security's projected performance over an array of interest-rate scenarios. Once an MBS is purchased, the Company monitors its actual prepayment experience monthly to reassess the relative attractiveness of the security with the intent to maximize total return.
DEFAULTED INVESTMENTS, comprising all investments that are in default as to the payment of principal or interest, totaled $1.2 million of mortgage loans at September 30, 1998, and constituted 0.1% of total invested assets. At September 30, 1997, defaulted investments totaled $2.3 million, and constituted 0.1% of total invested assets.
SOURCES OF LIQUIDITY are readily available to the Company in the form of the Company's existing portfolio of cash and short-term investments, Reverse Repo capacity on invested assets and, if required, proceeds from invested asset sales. At September 30, 1998, approximately $1.18 billion of the Company's Bond Portfolio had an aggregate unrealized gain of $52.8 million, while approximately $123.9 million of the Bond Portfolio had an aggregate unrealized loss of $11.7 million. In addition, the Company's investment portfolio currently provides approximately $14.4 million of monthly cash flow from scheduled principal and interest payments. Historically, cash flows from operations and from the sale of the Company's annuity products have been more than sufficient in amount to satisfy the Company's liquidity needs.
The Company relies significantly on computer systems and applications in its daily operations. Many of these systems and applications are not presently year 2000 compliant. The Company's business, financial condition and results of operations could be materially and adversely affected by the failure of the Company's systems and applications (and those operated by third parties interfacing with the Company's systems and applications) to properly operate or manage dates beyond the year 1999. The Company's parent has a coordinated plan to repair or replace these noncompliant systems and to obtain similar assurances from third parties interfacing with the Company's systems and applications and expects to significantly complete its plan by the end of the calendar year 1998. Testing of both the repaired and replacement systems will be conducted during calendar 1999. The cost of these changes will be substantially borne by the Company's affiliates and will not have a material impact on the Company's results of operations.
In addition, the Company has distributed a year 2000 questionnaire to certain of its significant suppliers, distributors, financial institutions,