Due to the recovery of the financial markets after 2002, the Company has experienced a gradual recovery in profitability and Shareholders’ Equity. In 2005 and 2006, the Company undertook 2 programs designed to rebalance a portion of its fixed income portfolio (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset/Liability Management.”) This portfolio rebalancing resulted in a decreased yield on assets, as long-term, higher yielding assets were sold with the proceeds being reinvested in shorter term assets with lower yields. The sale of the long-term assets resulted in approximately $75 million of capital gains in 2005. In 2006 and 2007, the purchases of new fixed income assets from portfolio rebalancing resulted in decreased income from investments. Also, during 2006 and 2007, the Company experienced a decline in overall assets due to a substantial increase in annuity surrenders ($480.1 million in 2006 and $535.2 million in 2007, compared to $151.2 million in 2005) resulting in an overall decline in Total Assets. Despite these trends, net income improved to $64.4 million in 2007 from $49.7 million in 2006, as invested yields stabilized while credited rates on rollover annuities fell substantially. This improvement in net investment margin combined with an increase in income from the Company’s limited partnership investments resulted in improved earnings performance in 2007.
The primary market risks in the Insurance Company’s investment portfolio are interest rate risk (discussed above), credit risk and, to a lesser degree, equity price risk. Changes in credit risk are generally measured by changes in corporate yields in relation to the underlying Treasuries (“corporate spreads”) as well as changes in the Credit Default Swap (“CDS”) market, although the Company is a cash investor and does not buy or sell credit default swaps. The Insurance Company's exposure to foreign exchange risk is insignificant. The Insurance Company has no direct commodity risk. Changes in interest rates can potentially impact the Corporation’s profitability. In certain scenarios where interest rates are volatile, the Insurance Company could be exposed to disintermediation risk (asset/liability mismatch) and reduction in net interest rate spread or profit margin. [See “Interest Rate Risk” above.]
The following table presents the amortized cost and gross unrealized losses for fixed maturities and common stock where the estimated fair value had declined and remained below amortized cost at December 31, 2007:
The following table presents the total gross unrealized losses for fixed maturities where the estimated fair value had declined and remained below amortized cost by December 31, 2007.
U.S. Treasury Obligations and Direct Obligations of U.S. Agencies: The net unrealized loss on U.S. Treasuries and U.S. Agencies totaled $789,000 on a fair value position of $30.755 million at December 31, 2007. This represented a substantial improvement from the $5.329 million unrealized loss at year-end 2006, reflecting the substantial decline in Treasury yields during 2007.
Preferred Stocks: The Preferred Stock Category, which totaled $112.0 million at December 31, 2007, consists primarily of banks, financial companies, electric utilities and REIT’s (real estate investment trusts). Unrealized losses totaled $16.2 million at year-end 2007, primarily reflecting the decline in the market value of financial company preferreds. The market also experienced a significant decline due to year-end tax loss selling. The 5 largest unrealized loss positions consisted of the following holdings: Royal Bank of Scotland, 5 ¾% PFD L; Lehman Brothers Capital Trust V; Equity Residential 6.48% PFD Series N; BRE Properties 6 ¾% PFD Series C; and Duke Realty 6 ½% PFD Series K. The Royal Bank of Scotland and the Lehman Brothers positions were affected by general concerns about the U.S. residential real estate market and the effect on loans and investments in sub-prime mortgages and collateralized bond obligations backed by sub-prime mortgages. The Equity Residential, BRE Properties and Duke Realty issues were generally affected by the tax loss selling noted previously. All three of these preferreds are currently trading at market values that are more than 10% higher than December 31, 2007.
In July 2007, Fitch Ratings assigned the Insurance Company an Aq rating, “Strong,” - possessing strong capacity to meet policyholder and contract obligations based solely on the Company’s stand-alone financial statement characteristics. Fitch Ratings found that risk factors are moderate, and the impact of any adverse business and economic factors is expected to be small.
Comparison of Fiscal Year 2007 to Fiscal Year 2006 and Fiscal Year 2006 to Fiscal Year 2005.
Universal life and investment type policy fee income remained stable at approximately $2.9 million in fiscal years 2006 and 2005, but decreased to approximately $2.6 million in fiscal year 2007. Policy fee income consists principally of amounts assessed during the period against policyholders' account balances for mortality charges and surrender charges.
General expenses, taxes and commissions to agents totaled $28.3 million in 2007 as compared to $27.0 million in 2006 and $25.0 million in 2005. This represents an increase of 4.9% comparing 2007 to 2006 and an increase of 8.2% comparing fiscal 2006 to fiscal 2005. The increase in 2007 was primarily due to 2006 refunds in state and franchise taxes, which reduced the taxes in that year. Consultant fees paid in connection with the Company’s ERM project also contributed to the increase in 2007. The increase in 2006 was primarily due to increased commissions paid on internal rollovers in an effort to keep policies in-force.
For the reasons discussed above, income before income taxes amounted to approximately $96.7 million in 2007, as compared to approximately $70.2 million in 2006 and approximately $148.2 million in 2005.
Income tax expense was approximately $33.0 million in 2007, as compared to an expense of approximately $20.5 million in 2006 and approximately $56.6 million in 2005. Higher income in 2007 generated higher taxes. The decrease in income taxes in fiscal 2006 was primarily attributable to a net realized investment loss in 2006.
For the reasons discussed above, the Corporation had net income of approximately $63.7 million in 2007, as compared to $49.7 million in 2006 and $91.6 million in 2005.
Net cash provided by the Corporation’s operating activities was approximately $21.1 million, $77.4 million and $45.4 million in 2007, 2006 and 2005, respectively. Net cash provided by/(used in) in the Corporation's investing activities (principally reflecting investments purchased, called, redeemed or sold) was approximately $416.4 million, $236.6 million and $(60.8) million in 2007, 2006 and 2005, respectively.
The indenture governing the Senior Notes contains covenants relating to limitations on liens and sale or issuance of capital stock of the Corporation. In the event the Corporation violates such covenants, we may be obligated to offer to repurchase the entire outstanding principal amount of such notes. As of December 31, 2007, we believe that we are in compliance with all of the covenants.
Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. The following is a discussion of our primary market risk exposures and how those exposures are currently managed.
In order to maintain consistency in our portfolio, our deferred annuity products incorporate surrender charges to discourage surrenders or withdrawals. Annuitants may not terminate or withdraw funds from their annuity contracts for a significant initial period (generally seven years) without incurring penalties in the form of surrender charges. These surrender charges generally range from 1% to 7% of the investment. Approximately 56.8%, 46.9% and 33.5% of the Insurance Company's deferred annuity contracts in force (measured by reserves) as of December 31, 2007, 2006, and 2005 were surrenderable without charge.
A persistent concern of the Insurance Company’s management is maintaining the appropriate balance between the duration of its invested assets and the duration of its contractual liabilities to its annuity holders and credit suppliers. Prior to 2005, the Insurance Company had permitted the duration gap between its assets and liabilities to rise during a period in which it expected relatively stable interest rates and, most importantly, in which its liabilities were largely protected by significant annuity surrender charges. This strategy benefited the Company by allowing it to realize enhanced yield from longer duration assets. At the end of 2004, the Insurance Company determined that the prospect of rising rates and declining surrender charges necessitated a reduction in the duration mismatch, as well as increased management of extension risk in its investment portfolio. The Company developed a two-step asset liability management strategy. The first step involved a duration reduction strategy, which involved the sale of certain longer duration assets that were purchased at prices below current market prices and reinvestment in shorter duration assets. Since December 31, 2004, the Company has completed in excess of $1,238.9 million of asset repositioning.
As the second element of the asset liability management strategy, the Company hedged against the risks posed by a rapid and sustained rise in interest rates by entering into a form of derivative transaction known as Payor Swaptions. Swaptions are options to enter into an interest rate swap arrangement with a counterparty at a specified future date. At expiration, the counterparty would be required to pay the Insurance Company the amount of the present value of the difference between the floating rate of interest (based on 3-month LIBOR) on the swap agreement and a specified strike rate in the agreement multiplied by the notional amount of the swap agreement. The effect of these transactions would be to lessen the negative impact on the Insurance Company of a significant increase in interest rates. The Company may monetize the value of expiring Payor Swaptions prior to the expiration date. .
In July 2005, Presidential Life entered into a series of Payor Swaption investments designed to protect the Company against an instantaneous rise in interest rates of 300 basis points, as required by the New York State Insurance Department (Regulation 126). Six contracts against the 10-year swap rate were executed with one dealer and three banks at a total cost of $19,430,625. During the 3rd quarter of 2006 Presidential sold the expiring 2006 Payor Swaption for $5,930,000, realizing a capital gain of $3,186,000. The proceeds were reinvested into a new Payor Swaption with a notional value of $325,000,000 (increased from the $200,000,000 notional value for the expiring Payor Swaption) that expires on July 13, 2009, for a total cash consideration of $6,170,000. During the 2nd quarter of 2007, the Insurance Company sold 2 of the Swaptions set to expire in July 2007 realizing a capital loss of $1,396,875. These proceeds were reinvested into a new Payor Swaption with a notional amount of $400,000,000 that expires on June 21, 2010.
The Company has established ISDA Credit Support Agreements with the three current counterparties. All of the counterparties have ratings equal to or higher than Aa3/AA- by Moody's and S&P, respectively. These contracts expire in July 2008, July 2009, and June 2010 at varying strike rates based on the 10-year swap rate. The Company has determined that the Payor Swaptions represent a "non-qualified hedge" and has adopted accounting procedures consistent with the provisions of FAS 133. The aggregate market value of the Payor Swaptions as of December 31, 2007 was $7,005,197. These investments are classified on the balance sheet as "Derivative Instruments". Under FAS 133, the value of the Payor Swaptions is recognized at "fair value" (market value), with the resulting change in fair value reflected in the statement of income as a realized loss or gain. The change in market value during the calendar year was a loss of $2,778,921. The Company has determined that the average fair value, based upon weekly market values for the period (January 1, 2007 to December 31, 2007), was $11,040,890.
(1) The difference between the recorded liability of $3,301.8 million, and the total payment obligation amount of $4,909.9 million, is $1,608.1 million and is comprised of (i) future interest to be credited; (ii) the effect of mortality discount for those payments that are life contingent; and (iii) the impact of surrender charges on those contracts that have such charges.
Of the total payment of $4,909.9 million, $3,174.6 million, or 64.7%, is from the Company’s deferred annuity, life, and accident and health business. Determining the timing of these payments involves significant uncertainties, including mortality, morbidity, persistency, investment returns, and the timing of policyholder surrender. Notwithstanding these uncertainties, the table reflects an estimate of the timing of such payments.
In a rising interest rate environment, the Insurance Company's average cost of funds would be expected to increase over time, as it prices its new and renewing annuities to maintain a generally competitive market rate. In addition, the market value of the Insurance Company's fixed maturity portfolio would be expected to decrease, resulting in a decline in shareholders' equity. Concurrently, the Insurance Company would attempt to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities associated with such annuities. Moreover, surrenders of its outstanding annuities would likely accelerate. Management believes that liquidity necessary in such an interest rate environment to fund withdrawals, including surrenders, would be available through income, cash flow, the Insurance Company's cash reserves and, if necessary, proceeds from the monetization of the Payor Swaption investments described above and the sale of short-term and long-term investments.
The Company uses the equity method of accounting for investments in limited partnership interests in which it has more than a minor equity interest, or more than a minor influence over the joint ventures and partnership’s operations, but does not have a controlling interest and is not the primary beneficiary. The Company routinely evaluates its limited partnership investments for impairments. The Company considers financial and other information provided by the investee and other known information and inherent risks in the underlying investments in determining whether an impairment has occurred. When an other-than-temporary impairment is deemed to have occurred, the Company records a realized capital loss within net investment income to record the investment at its fair value. Investment income from limited partnerships is recorded based on the Company’s share of earnings reported in the partnership’s most recent audited financial statements and income distributed by the partnerships. Management considers the quarterly financial information received from the limited partnerships to be unreliable or insufficient to record investment income, other than from distributions, on a quarterly basis. Management estimates the classification of cash distributions received between investment income and return of capital based on correspondence from the respective partnerships. The Company adjusts its estimate of investment income recorded during the year to the actual realized gains and other income reported in the limited partnerships’ most recent annual audited financial statements, which are generally received in the second quarter of the subsequent year. As a result, there may be up to a one year reporting lag for recording investment income that is not distributed during the year, which may result in significant adjustments. The Company records its share of net unrealized gains and losses (net of taxes) from the audited financial statements of the limited partnerships. As a result, there may be up to a one year reporting lag for reporting unrealized gains and losses, which may result in significant adjustments to other comprehensive income in 2008. Because it is not practicable to obtain an independent valuation for each limited partnership interest, for purposes of disclosure the market value of a limited partnership interest is estimated at book value based on the most recent available audited financial statements. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
For policies and contracts where the reserve is reported as the account balance ($2,579.9 million), a change in expected experience would have no effect on the reserve.
For those annuities and supplementary contracts with life contingencies that comprise a portion of future policy benefits ($672 million of reserves), an increase in mortality experience of 1% per year for individual contracts would increase the present value of future benefits by approximately $27 million. We believe that any variation of our mortality estimates is likely to fall within this range.
For traditional life insurance business ($39 million of reserves), establishing reserves requires the use of many assumptions. Due to the number of independent variables inherent in the calculation of these reserves, and because this business is not material to the overall Company results, it is not practical to perform a quantitative analysis on the impact of changes in underlying assumptions. However, the Insurance Company historically has not experienced significant adverse deviations from its assumptions and believes that its assumptions are realistic and produce reserves that are fairly stated in accordance with GAAP.