Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the consolidated financial condition, changes in financial position and results of operations for the three years ended December 31, 2008 of Kansas City Life Insurance Company and its consolidated subsidiaries. The discussion should be read in conjunction with the Consolidated Financial Statements and Notes. All dollar amounts are in thousands except share data.
Kansas City Life markets individual insurance products, including traditional, interest sensitive and variable products through a nationwide sales force of independent general agents and third-party marketing arrangements. Kansas City Life also markets group insurance products, which include life, dental and disability products through a nationwide sales force of independent general agents, group brokers and third-party marketing arrangements. Kansas City Life operates in 48 states and the District of Columbia.
The Company offers investment products and broker dealer services through its subsidiary Sunset Financial Services, Inc. (SFS) for both proprietary and non-proprietary variable insurance products, mutual funds and other securities.
The Company operates in the life insurance sector of the financial services industry in the United States. This industry is highly competitive with respect to pricing, selection of products and quality of service. No single competitor or any small group of competitors dominates any of the markets in which the Company operates. General economic conditions may affect future results.
On January 23, 2006, the Company entered into a definitive agreement to sell its bank subsidiary, Generations Bank, for $10.1 million in cash. On January 8, 2007, the Company completed the sale of Generations Bank after receiving regulatory approval from the Office of Thrift Supervision. The gain on the sale was $1.9 million and is included in realized investment gains. The bank subsidiary and the results of operations were not material to the financial statements of the Company and are not disclosed separately.
The accounting policies below have been identified as critical to the understanding of the results of operations and financial position. The application of these critical accounting policies in preparing the financial statements requires management to use a variety of assumptions and estimates, in particular expectations of current and future mortality, morbidity, persistency, expenses, interest rates and equity market performance. Actual results may differ from these estimates under different assumptions or conditions. The profitability of life insurance and annuity products is dependent on actual experience, and differences between actual experience and pricing assumptions may result in variability of net income in amounts which may be material. On an ongoing basis, the Company evaluates the estimates, assumptions and judgments based on historical experience and other information that the Company believes to be reasonable under the circumstances. A detailed discussion of significant accounting policies is provided in Note 1 - Nature of Operations and Significant Accounting Policies in the Notes to Consolidated Financial Statements.
The fixed maturity securities, which are typically classified as available for sale, are carried at their fair value in the Company’s balance sheet, with unrealized gains or losses recorded in accumulated other comprehensive loss. The unrealized gains or losses are recorded net of the adjustment to deferred acquisition costs, policyholder account balances and taxes to reflect what would have been earned had those gains or losses been realized and the proceeds reinvested. The Company’s fair value of fixed maturity and equity securities are determined by management, utilizing external pricing sources, brokers, and internal matrices and calculations. Approximately 90% of these investments are from external pricing services while 10% are derived from brokers and internal matrices and calculations. The investment portfolio is monitored regularly to ensure that investments which may be other-than-temporarily impaired are identified in a timely fashion and properly valued, and that impairments are charged against earnings as realized investment losses. The valuation of the investment portfolio involves a variety of assumptions and estimates, especially for investments that are not actively traded.
The Company has a policy and process in place to identify securities that could potentially have an impairment that is other-than-temporary. This process involves monitoring market events that could impact issuers’ credit ratings, business climate, management changes, litigation and government actions, and other similar factors. This process also involves monitoring late payments, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts, asset quality and cash flow projections as indicators of credit issues.
There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other-than-temporary. These risks and uncertainties include but are not limited to:
At least quarterly, the Company performs a review and at least annually, a detailed analysis is performed of the models and the assumptions used to develop expected future profits, based upon management’s current view of future events. DAC is reviewed on an ongoing basis to determine that the unamortized portion does not exceed the expected recoverable amounts. Management’s view primarily reflects Company experience but can also reflect emerging trends within the industry. Short-term deviations in experience affect the amortization of DAC and VOBA in the period, but do not necessarily indicate that a change to the long-term assumptions of future experience is warranted. If it is determined that it is appropriate to change the long-term assumptions of future experience, then an unlocking adjustment is recognized for the block of business being evaluated. Certain assumptions, such as interest spreads and surrender rates, may be interrelated. As such, unlocking adjustments often reflect revisions to multiple assumptions. The balances of DAC and VOBA are immediately impacted by any assumption changes, with the change reflected through the income statement as an unlocking adjustment in the amount of DAC or VOBA amortized. These adjustments can be positive or negative. The impact of unlocking adjustments from the changes in estimates for the periods reported are included in the Consolidated Results of Operations and Operating Results by Segment sections of Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations contained within this document.
A 2.5% increase in expected mortality experience for all future years would result in a reduction in DAC and VOBA, and an increase in current period amortization expense of $4.7 million.
A 10 basis point reduction in future interest rate spreads would result in a reduction in DAC and VOBA, and an increase in current period amortization expense of $3.7 million.
A 10% increase in future maintenance expenses would result in a reduction in DAC and VOBA, and an increase in current period amortization expense of $2.4 million.
Policyholder account balances include universal life insurance, fixed deferred annuity contracts and investment-type contracts. Liabilities for these policyholder account balances are included without reduction for potential surrender charges and deferred front-end contract charges. The account balances for universal life contracts are equal to cumulative premiums, less contract charges and withdrawals, plus interest credited. The account balances for fixed deferred annuities and investment-type contracts are equal to the cumulative deposits, less any applicable contract charges and withdrawals, plus interest credited. Policyholder benefits incurred in excess of related policyholder account balances are charged to policyholder benefits expense. Interest on policyholder account balances is credited as earned.
On an ongoing basis, the Company performs testing and analysis on its blocks of business to ensure that both the assumptions made when the Company purchases a block of business or when the Company sells new policies remain viable. The Company also periodically performs sensitivity testing on these blocks of business to ensure it maintains the capacity to meet an increase in demand in policyholder benefits, namely increased surrenders, policy loans or other policyholder elective withdrawals, especially given the difficult financial markets.
The measurement of pension and other postretirement benefit obligations and costs depends on a variety of assumptions. Assumptions are made regarding the discount rate, expected long-term rate of return on plan assets, employee turnover, expected compensation increases, health care claim costs, heath care cost trends, retirement rates and mortality. The discount rate and the expected return on plan assets have the most significant impact on the level of cost. See Note 8 - Pensions and Other Postretirement Benefits in the Notes to Consolidated Financial Statements for further details.
The Company incurred a net loss of $17.1 million in 2008 compared to $35.7 million in net income in 2007. Net income decreased $1.3 million in 2007 from $36.9 million in 2006. Net loss per share was $1.47 in 2008 versus net income per share of $3.01 in 2007 and $3.11 in 2006. The decline in net income in 2008 largely resulted from increased realized investment losses, reduced net investment income, and increases in policyholder benefits and operating expenses. These were partially offset by an increase in insurance revenues and a decrease in interest credited to policyholder account balances. The decrease in net income for the year ended 2007 included declines in insurance revenues and net investment income and an increase in income tax expense. These were partially offset by decreases in policyholder benefits, interest credited to policyholder account balances, amortization of DAC and VOBA and operating expenses.
Total new deposits decreased $0.4 million or 1% in 2008, after increasing $5.3 million or 8% in 2007. The slight decline in 2008 was largely due to a $3.9 million or 13% decline in new variable annuity deposits and a $0.5 million or 22% decline in new variable universal life deposits. These declines reflect the difficult economic environment, increased competition, and the continued impact of alternative products in the marketplace. Mostly offsetting these declines, new fixed deferred annuity deposits increased $4.1 million or 15%. This increase was largely due to an increase in sales that can be partially attributed to changes in consumer preferences resulting from the volatility in the equity markets. The increase in new deposits in 2007 was largely the result of a $7.9 million or 37% increase in new variable annuity deposits and a $0.8 million or 7% increase in new universal life insurance deposits. These increases were partially offset by a $3.5 million or 12% decrease in new fixed deferred annuity deposits.
Renewal deposits declined $4.9 million or 4% in 2008 and $2.5 million or 2% in 2007. The decline in 2008 was largely due to a $4.5 million or 30% decline in variable annuity deposits and a $2.1 million or 2% decline in universal life deposits. These declines were partially offset by a $2.3 million or 16% increase in fixed deferred annuity deposits. The decline in 2007 primarily resulted from a $5.1 million or 25% decrease in fixed deferred annuity deposits that was partially offset by a $4.6 million or 44% increase in variable annuity deposits.
The value of separate account assets totaled $258.6 million at December 31, 2008, a 38% decrease from $420.4 million at December 31, 2007. This decrease reflects the decline in the financial markets. The Company offers three variable annuity products and five variable universal life products, with 43 investment options for each of these products. While these options offer a variety of choices from which to diversify, consumer preferences have shifted away from these types of products due to the depth of the decline in the financial markets.
Insurance revenues are affected by the level of new sales, the type of products sold, the persistency of policies, general economic conditions, and competitive forces. Consumers continue to desire a broad portfolio of products with safety and competitive return objectives, which the Company strives to provide. The Company offers a broad range of products, including variable insurance products, which allow policyholders to participate in both the equity and fixed income markets. Interest sensitive and traditional insurance products combine safety of principal with competitive interest returns.
Contract charges declined 2% in 2008 and 3% in 2007. Policy charges declined due to a decline in policyholder account balances and increased sales of certain products where the contract charges are not recognized into income immediately. Instead, such charges are deferred as unearned revenues and amortized into income similar to the amortization of deferred acquisition costs (DAC). Another contributing factor in the decrease in year-to-date contract charges was the unlocking of DAC assumptions in the second quarter of 2008, which further reduced current period recognition of these revenues. The resulting increase in unearned revenues will be recognized into income in proportion to the expected future gross profits of the business. Partially offsetting these, surrender charges increased, largely due to higher surrenders on variable products.
Reinsurance ceded declined $1.4 million to $53.6 million in 2008 from $55.0 million in 2007. In 2006, reinsurance ceded was $55.2 million. The Company uses reinsurance as a means to mitigate its risks and to reduce the earnings volatility from claims.
Net investment income is stated net of investment expenses. Net investment income decreased 7% in 2008, following a 3% decline in 2007 from 2006. Net investment income was $177.4 million in 2008, compared with $190.4 million in 2007 and $196.3 in 2006. Net investment income results were primarily impacted by declines in the Company’s invested asset base and reduced yields from the portfolio. In addition, expenses associated with investment income declined, favorably impacting results.
Gross investment income is largely composed of interest and dividends on fixed maturity securities, equity securities and short-term investments, mortgage loans, real estate and policy loans. Gross investment income declined $13.7 million or 7% in 2008 compared with 2007. This decrease primarily resulted from a $7.2 million decline in gross investment income on reduced investment assets and a $6.5 million decline from lower investment yields. The decline in investment assets includes declines in book value due to sales, maturities and calls along with a decline in fair values. The decline from lower yields was largely due to a reduction in income from an alternative investment fund. In 2007, this investment added gross investment income of $2.7 million. However, as a result of the significant decline in the economic environment, this investment resulted in a decline in gross investment income of $4.0 million in 2008. Gross investment income declined $5.3 million in 2007 compared with 2006, largely due to reduced investment assets.
Investment income is stated net of investment expenses. Investment income from securities declined $9.1 million or 6% in 2008 compared with 2007. This decline was due to reduced yields earned on the portfolio and a reduction of income from an alternative investment fund. Income from securities declined $4.4 million or 3%, largely due to reduced investment assets. Income from short-term investments declined $2.7 million or 72% in 2008 versus 2007, while almost doubling during 2007 from 2006. The decline in 2008 was largely due to lower short-term invested assets and a decline in short-term yields. The increase in 2007 was due to improved short-term yields and increased purchase of short-term investments during the first quarter of 2007.
Mortgage loans comprised 15% of the investment portfolio at December 31, 2008, up from 13% at the end of 2007. Almost all of the mortgages were commercial loans on industrial warehouses and office properties. None of the loans have been restructured nor have there been any loans in foreclosure over the past three years. No mortgage loans were delinquent as of December 31, 2008. The Company does not hold mortgage loans of any borrower that exceed 5% of stockholders’ equity.
The following table provides asset class detail of the investment portfolio. Fixed maturity and equity securities represented 78% of the entire investment portfolio at December 31, 2008, approximately the same as December 31, 2007.
The Company recorded net realized investment losses of $52.3 million in 2008, net realized investment gains of $5.4 million in 2007 and $5.6 million in 2006. During 2008, investment losses of $62.7 million were due to write-downs of investment securities, including $20.0 million from the fourth quarter, $32.5 million from the third quarter and $10.2 million from the second quarter. The financial sector has been hit hard by economic pressures and residential mortgage issues. These pressures have resulted in large price dislocations that have affected many securities and companies in the financial sector. These losses were partially offset by $5.2 million of investment gains realized on the sale of real estate and $2.7 million of investment gains realized on securities called, put and other. The net realized investment gain in 2007 was largely the result of the sale of real estate investment properties, which resulted in a $7.1 million gain, and a $1.9 million gain from the sale of Generations Bank. Partially offsetting these, investment losses of $4.0 million were due to write-downs of investment securities during 2007. The net realized investment gain in 2006 was primarily the result of the sale of real estate investment properties, which resulted in gross gains of $4.2 million.
Concerns arose during the second half of 2007 regarding subprime mortgage loan defaults. The concerns deepened and expanded broadly during 2008. Market dislocations have exacerbated credit issues as some historically liquid markets such as asset-backed commercial paper, auction-rate securities and bank financing have contracted. Demand for securitized investments, including home loans, has also fallen significantly. Home prices continue to fall, which hinders potential sales and loan refinancings that might otherwise avert defaults. These issues have largely been centered around increasing delinquencies and default rates by subprime borrowers. The Company closely monitors its investments in securities classified as subprime. Subprime securities include all bonds or portions of bonds where the underlying collateral is made up of home equity loans or first mortgage loans to borrowers whose credit scores at the time of origination were lower than the level recognized in the market as prime. The Company’s classification of subprime does not include Alt-A or jumbo loans, unless the collateral otherwise meets the preceding definition. The Company had investments with subprime residential mortgage exposure of $23.8 million and $37.3 million at December 31, 2008 and 2007, respectively. The related unrealized losses were $8.9 million and $1.8 million at December 31, 2008 and 2007, respectively. This exposure amounted to 1% or less of the Company’s invested assets for both years. These investments fall under the Company’s normal process for evaluation of other-than-temporarily impaired securities.
The Company’s analysis of securities for the quarter ended December 31, 2008 resulted in the determination that 16 securities (14 issuers) had other-than-temporary impairments and were written down by a combined $20.0 million. The fair value of the investments after the write-downs was $11.3 million.
The Company’s analysis of securities for the quarter ended September 30, 2008 resulted in the determination that ten fixed-maturity issuers (twelve specific securities) had other-than-temporary impairments and were written down by a combined $32.5 million in the third quarter. The total fair value of the affected securities after the write-downs was $17.9 million.
The Company’s analysis of securities for the quarter ended June 30, 2008 resulted in the determination that seven fixed-maturity issuers had other-than-temporary impairments. These securities were written down by a combined $10.2 million in the second quarter. The total fair value of the affected securities after the write-downs was $16.8 million.
Liquidity risk, relating to the risk that investments cannot be converted into cash when needed or that the terms for conversion have a negative effect of the Company.
At December 31, 2008, the Company’s unrealized losses on fixed maturities had increased to $230.1 million and were partially offset by $38.6 million in gross unrealized gains. At December 31, 2007, the Company had $45.2 million in gross unrealized losses on fixed maturities which were offset by $57.1 million in gross unrealized gains. The category of corporate obligations was the area of greatest increase in unrealized loses for the two comparative year-end dates, as this figure increased from $30.4 million to $138.0 million. The financial sector had the single largest increase by sector within the corporate obligations category, rising from $13.4 million to $45.8 million, primarily due to the direct and indirect impact of the troubled residential real estate and mortgage markets. After corporate obligations, the corporate private-labeled mortgage-backed securities category experienced the next largest increase in gross unrealized losses, moving from $4.9 million to $52.8 million.
Virtually all of the Company’s residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities were rated investment grade at both year-end 2008 and 2007. The Company’s below investment grade fixed maturity securities at December 31, 2008 included 98% corporate obligations and 2% collateralized debt obligations. At December 31, 2007, all below investment grade fixed maturity securities were corporate obligations.
Intent and ability to make all principal and interest payments when due
Risk that the economic outlook will be worse or longer than expected or have more of an impact on the issuer than anticipated;
Risk that new information obtained by the Company or changes in other facts and circumstances may lead the Company to change its intent to hold the security to maturity or until it recovers in value;
Any of these situations could result in a charge to income in a future period. If the Company determines that a security is other-than-temporarily impaired, the difference between amortized cost and fair value is charged to income as a realized investment loss, resulting in a permanent reduction to the cost basis of the underlying investment.
The following table provides information on fixed maturity securities with gross unrealized losses by rating as of December 31, 2007.
The following tables provide the distribution of maturities for fixed maturity securities with unrealized losses as of December 31, 2008 and December 31, 2007. Expected maturities may differ from these contractual maturities since borrowers may have the right to call or prepay obligations.
Following is a discussion of securities whose fair value had been less than 80% of amortized cost for at least six months at December 31, 2008. The Company has evaluated eleven fixed-maturity securities in this category, and prepared detailed analyses on these positions. The Company has considered a wide variety of factors to determine that these positions were not other-than-temporarily impaired. Two securities from one issuer are Alt-A mortgage-backed securities. Mortgage-backed securities have suffered indiscriminate price depreciation in the current market, regardless of individual performance or vintage. These securities are senior tranches, which continue to perform within expectations and are highly rated despite the decline in fair value. Four securities are large financial institutions that have been impacted by the housing and mortgage credit crisis. The government has supported these institutions through TARP (Troubled Assets Relief Program) funds. These securities are rated as investment grade, are backed by adequate capital positions and have continued to perform within expectations. Two securities are trust preferred securities that have also been negatively impacted by the housing and mortgage credit crisis and whose issuers have received TARP funds. These securities continue to be rated as investment grade, have sufficient near-term capital positions and should continue to receive TARP consideration and assistance, as necessary. One security is a subprime asset-backed security. Rising delinquencies and defaults in the subprime and non-conforming mortgage markets have resulted in a severe decline in the fair value for these securities. This security is a senior tranche, continues to be rated investment grade, has a 100% third- party monoline guarantee and continues to perform within expectations. One security is an international banking institution that has been negatively impacted by the effects of both the global credit deterioration and the U.S. housing and mortgage credit crisis. This is a floating rate note suffering price fluctuations due to changes in credit spreads, but it has excellent liquidity, strong financial fundamentals, is an investment grade security and continues to perform within expectations. One security is a mortgage insurer that has been impacted by increased mortgage defaults. This issuer has been evaluated as having adequate capital and liquidity and continues to perform within expectations.
The Company has written down certain investments in previous periods. Securities previously written down and still owned at December 31, 2008 had an amortized cost of $31.4 million with a net unrealized loss of $2.2 million. Comparatively, securities written down and still owned at December 31, 2007 had an amortized cost of $6.6 million and a net unrealized gain of $0.5 million.
Policyholder benefits consist of death benefits (mortality), annuity benefits, accident and health benefits, surrenders and the associated increase or decrease in reserves for future policy benefits. Death benefits reflect mortality results. Although mortality increased in 2008 and decreased in 2007, it has remained within pricing expectations for the periods presented.
Policyholder benefits increased $12.3 million or 8% in 2008 compared to a $1.4 million or 1% decline in 2007. The increase in 2008 was due to several factors. Death benefits increased $4.4 million or 4% compared to the prior year, reflecting adverse mortality. Higher dental benefits reflected the increase in new dental business during 2008 over the past year. Benefit and contract reserves increased due to higher annuity sales, as reserves are established virtually on a one-for-one basis with premiums. In 2007, the Company introduced a guaranteed minimum withdrawal benefit (GMWB) rider for variable annuity contracts that is considered to be a financial derivative and as such is accounted for at fair value. The change in the value of this liability is reported in policyholder benefits in the Consolidated Statements of Income. These annuity riders had an increase in value of $0.8 million during 2008, largely due to changes in the equity and credit markets, along with changes in interest rates and volatility. The value of the riders will fluctuate depending on market conditions.
The decrease in policyholder benefits in 2007 was primarily due to declines in death benefits and surrenders. These declines were partially offset by an increase in reserves established for these benefits. The increase in immediate annuity premiums in 2007 contributed to the increase in reserves.
Interest is credited to policyholder account balances according to terms of the policies or contracts. There are minimum levels of interest crediting assumed in certain policies or contracts, as well as allowances for adjustments to be made to reflect current market conditions in certain policies or contracts. Accordingly, the Company reviews and adjusts crediting rates as necessary and appropriate. Interest credited to policyholder account balances decreased $4.3 million or 5% in 2008 and $3.4 million or 4% in 2007. Amounts credited are a function of account balances available multiplied by an appropriate crediting rate. As account balances decline, so will the amount of interest credited to policyholder account balances. In addition, the Company has reduced crediting rates on selected products to remain in line with rates available in the market. Interest was credited to policyholder account balances for universal life, fixed deferred annuities and other investment-type products. The average interest rate credited to policyholder account balances was 4.28% in 2008, 4.30% in 2007 and 4.32% in 2006.
Certain life insurance and annuity products require that DAC is amortized in proportion to the expected future gross profits. Profit expectations are based upon assumptions of future interest spreads, mortality margins, expense margins and policy and premium persistency experience. At least annually, a review is performed of the assumptions related to profit expectations. If it is determined the assumptions should be revised, the impact of the changes is recorded as a change in DAC amortization in the current period due to an unlocking adjustment. A similar analysis is performed on VOBA at least annually and, if necessary, adjustments are made in the current period VOBA amortization.
The amortization of DAC was $35.0 million in 2008 compared with $31.1 million in 2007 and $34.9 million in 2006. The increase in 2008 was due to several factors. First, DAC amortization increased on variable products due to increased surrenders and a decline in the market value of the account balances. Second, Old American increased commission schedules in 2007. Accordingly, as policies terminated in 2008, an increase in DAC amortization resulted from the increased commission costs that had been deferred. In addition, DAC amortization was reduced $3.0 million in the second quarter of 2008 due to unlocking, primarily related to interest margins and mortality experience on selected products. The unlocking adjustments for 2007 and 2006 totaled $3.4 and $0.7 million, respectively, and were primarily related to adjustments for interest spreads. Partially offsetting these, the amortization of DAC decreased in 2008 compared to 2007 due to a large number of policy surrenders that occurred in 2007, resulting in additional DAC amortization in 2007.
Operating expenses consist of commissions and production allowances, net of the capitalization of commission and production allowances, and expenses from the Company’s operations. In total, operating expenses increased $4.5 million or 5% in 2008 but decreased $4.8 million or 5% in 2007 compared to 2006. The primary factors contributing to the increase in2008 were increased employee and agent medical plan and benefit costs largely resulting from a reduction of accruals in the prior year, expense associated with affordable housing tax credits, travel expenses, premium taxes and consulting services. The decline in operating expenses in 2007 largely resulted from reduced employee benefit accruals and reduced outside legal costs.
The Company has three reportable business segments, which are defined based on the nature of the products and services offered: Individual Insurance, Group Insurance and Old American. The Individual Insurance segment consists of individual insurance products for both Kansas City Life and Sunset Life. The Individual Insurance segment is marketed through a nationwide sales force of independent general agents and third-party marketing arrangements. The Group Insurance segment consists of sales of group life, group disability and dental products. This segment is marketed through a nationwide sales force of independent general agents, group brokers and third-party marketing arrangements. Old American consists of individual insurance products designed primarily as final expense products. These products are marketed through a nationwide general agency sales force with exclusive territories, using direct response marketing to supply agents with leads. For more information, refer to Note 10 - Segment Information in the Notes to Consolidated Financial Statements.
The net loss for this segment in 2008 was $15.8 million, a decrease of $50.6 million from $34.8 million of net income in 2007. Net income for this segment increased 5% in 2007 from $33.2 million in 2006. The largest contributor to the loss for 2008 was $50.0 million in realized investment losses. Also contributing to the loss in 2008 was a $12.4 million decrease in net investment income, an $8.1 million increase in policyholder benefits and a $5.7 million increase in operating expenses. Partially offsetting these changes, premiums increased $4.8 million, other revenues increased $1.5 million and interest credited to policyholder account balances decreased $4.3 million in 2008. The improved results for 2007 were due to decreases in policyholder benefits, interest credited to policyholder account balances, amortization of DAC and VOBA and operating expenses. Partially offsetting these improvements were decreases in contract charges and net investment income and an increase in income tax expense. The increase in tax expense was due, in part, to a reduction in affordable housing tax credits.
Total insurance revenues increased 2% in 2008, following a 2% decline in 2007. The increase in 2008 reflected a 9% increase in premiums. The premium growth reflected a 55% increase in immediate annuity sales, reflecting consumer preferences. The decline in 2007 was primarily due to a reduction in contract charges, resulting from the unearned revenue correction discussed below.
This segment’s products are primarily marketed through a nationwide sales force of independent general agents. The Individual Insurance segment is central to the Company’s overall performance and produced 53% of consolidated insurance revenues in 2008, the same as in 2007.
The following table reconciles premiums included in insurance revenues and provides detail by new and renewal business over the three years ended December 31. New premiums are also detailed by product.
Total new deposits decreased 1% in 2008 compared to an 8% increase in 2007. New fixed deferred annuity deposits increased 15% in 2008 versus a 12% decline in 2007. New variable annuity deposits decreased 13% in 2008 following a 37% increase in 2007. New universal life deposits were flat in 2008 compared to a 7% increase in 2007, and new variable universal life deposits decreased 22% in 2008 versus a 5% increase in 2007. The extremely difficult market conditions were the primary driver in the decrease in variable life and annuity sales during 2008. Total renewal deposits decreased 4% in 2008, reflecting a 30% decline in variable annuity deposits, a 5% decline in variable universal life deposits and a 2% decrease in universal life deposits that were partially offset by a 16% increase in fixed deferred annuity deposits. Total renewal deposits decreased 2% in 2007, as a 44% increase in variable annuity deposits was offset by a 25% decrease in fixed deferred annuity deposits and a 2% decrease in universal life deposits. The increase in fixed deferred annuity deposits in 2008 reflected an increase in sales that can, in part, be attributed to changes in consumer preferences resulting from the volatility in the equity markets and changes in interest rates. The decline in the deposits of other products in 2008 can largely also be attributed to the difficult economic environment.
Contract charges consist of cost of insurance, expense loads, unearned revenues and surrender charges. Certain contract charges for universal life insurance are not recognized in income immediately but are deferred as unearned revenues and are amortized into income in a manner similar to the amortization of DAC. These contract charges, which are recorded as unearned revenues, are recognized into income in proportion to the expected future gross profits of the business. In the same manner as DAC, profit expectations are based upon assumptions of future interest spreads, mortality margins, expense margins and policy and premium persistency experience. At least annually, a review is performed of the assumptions related to profit expectations. If it is determined the assumptions should be revised, the impact is recorded as a change in the revenue reported in the current period as an unlocking adjustment.
Contract charges declined $2.4 million in 2008 and $3.1 million in 2007. While total contract charges did not fluctuate significantly in 2008, three of the components had fluctuations. Amortization of deferred revenue declined compared to a year ago, as the Company has experienced increased sales of certain products where expense loads are deferred and amortized into earnings in future periods. Changes in unlocking in the second quarter of 2008 also contributed to the decrease in year-to-date deferred revenue. Reserve loads decreased, also resulting from increased sales of products where expense loads are deferred. Partially offsetting these changes, surrender charges increased from increased surrenders on variable products. Contract charges were reduced by $1.7 million during the second quarter of 2007, resulting from a correction of the unearned revenue portion of a universal life product. The amount of the correction attributable to prior periods was $1.1 million, including $0.2 million in 2005 and $0.9 million in 2006.
Net investment income decreased 7% in 2008 and 3% in 2007. Investment income is primarily driven by changes in interest rates, asset levels and investment expenses. The decline in 2008 was primarily due to reduced investment assets and lower yields from the investment portfolio. The decline from lower yields was largely due to a reduction in income from an alternative investment fund. In 2007, this investment added gross investment income of $2.5 million. However, as a result of the significant decline in the economic environment, this investment resulted in a decline in gross investment income of $3.7 million in 2008. While investment yields increased in 2007, the impact of lower assets caused total net investment income to decline. The Individual Insurance segment had realized investment losses of $50.0 million in 2008 compared to $5.8 million in realized investment gains in 2007.
Following is a description of the securities that were written down during the third quarter of 2008. 1) Two of the securities were preferred stocks of government-sponsored agencies that were written down by a total of $6.5 million. These entities buy and hold mortgages and issue and sell guaranteed mortgage-backed securities to facilitate housing ownership. They are now operated in conservatorship by the U.S. government and their existing common and preferred stock securities are severely diluted. Dividend payments have been suspended, driving the fair value of these securities down. 2) Two securities from the same issuer were from an investment banking firm that filed for bankruptcy during the third quarter of 2008 and was written down by a total of $9.2 million. This firm was part of the financial industry that was hit hard by the mortgage credit crisis. After a severe decline in equity valuations, the inability to obtain short-term funding and the failure to find an acquirer forced this firm to file for Chapter 11 bankruptcy. 3) Two securities were collateralized debt obligations (CDOs) that were written down by a total of $5.1 million. These securities had been impacted by the rapid rise in delinquencies and foreclosures in the sub-prime and Alt-A mortgage markets, along with a decline in the fair value of securities issued by financial institutions. Ongoing CDO liquidations and investor selling had caused extreme declines in market valuations, regardless of individual security performance. 4) Two securities, one issuer a parent organization of the other, are financial guarantee insurance companies that provide credit enhancement for bond issuers as well as investment management services and were written down by a total of $3.9 million. These issuers have also experienced declines in value related to the mortgage credit crisis and have recently been downgraded to a negative outlook. 5) One security was from the auto industry and is a supplier of auto parts for light trucks and sport-utility vehicles. The deteriorating truck and sport-utility vehicle markets of the auto industry combined with the sharp decline in value and recent ratings declines resulted in a $2.1 million write-down. 6) One security was written down $1.1 million as continued price deterioration occurred on this security that was previously written down. The issuer is primarily in the radio and advertising business. 7) One security provided custom-tailored financing to private and corporate owners of real estate nationwide. This security had a recent rating decline to below investment grade status combined with continued price deterioration and was written down $2.3 million. 8) One security was a bank holding company that recently filed for bankruptcy. This holding company was the parent of a large nationwide bank that was recently taken over by the Office of Thrift Supervision who appointed the FDIC as its receiver. As a result of the bankruptcy filing, this security was written down $0.8 million.
Other revenues increased $1.5 million or 14% in 2008 versus 2007. This increase was largely due to additional sales of LIHTC credits. Other revenues increased $0.5 million or 5% in 2007 compared to 2006 also primarily a result of increased sales of LIHTC investments.
Policyholder benefits consist of death benefits (mortality), annuity benefits, individual accident and health benefits, surrenders and the associated increase or decrease in reserves for future policy benefits. Policyholder benefits increased $8.1 million or 9% in 2008 compared to a $2.4 million or 3% decrease in 2007. The increase was primarily due to two factors. First, death benefits increased $2.8 million or 5% compared to a year ago, reflecting adverse mortality. While mortality results were different for 2008 and 2007, both years were within the range of anticipated mortality. Second, benefit and contract reserves increased, largely due to two items. The first item was higher annuity sales, as reserves are established virtually on a one-for-one basis with premiums. The second item was due to the guaranteed minimum withdrawal benefit (GMWB) rider for variable annuity contracts that the Company introduced during 2007. This rider is considered to be a financial derivative and is accounted for at fair value. These annuity riders had an increase in value of $0.8 million during 2008, largely due to changes in the equity and credit markets, along with changes in interest rates and volatility. The value of the riders will fluctuate depending on market conditions. The decline in 2007 was largely due to a decrease in both death benefits and surrenders of individual life insurance.
The amortization of DAC and VOBA increased 5% in 2008 compared to 2007, following a 10% decline in 2007 compared with 2006. DAC amortization increased 17% in 2008, primarily related to negative market performance on variable products. DAC amortization was reduced $3.0 million in the second quarter of 2008 due to unlocking, primarily related to interest margins and mortality experience on selected products. In the second quarter of 2007, unlocking totaled $3.4 million and was primarily related to unlocking adjustments for interest spreads. Partially offsetting these changes, the amortization of DAC decreased in 2008 compared to 2007 due to several large policy surrenders that occurred in 2007 resulting in additional DAC amortization in 2007.
VOBA is amortized in concert with each purchased block of business. Accordingly, as policies run off, the amortization will decline over time. VOBA amortization decreased 32% in 2008 compared with 2007. This decline can largely be attributed to a decrease in the unlocking adjustment from $1.0 million in the second quarter of 2007 to $0.2 million in the second quarter of 2008. The unlocking adjustment in the second quarter of 2007 was related to the assumptions for mortality margins. The unlocking adjustment in the second quarter of 2008 was primarily related to a change in the policy surrender assumptions. There were no VOBA unlocking adjustments during 2006.
Operating expenses include commissions, net of the capitalization of certain commissions, expenses from operations and other expenses. In total, operating expenses increased 10% in 2008 but decreased 8% in 2007 compared to 2006. The primary factors contributing to the increase in 2008 were employee and agent medical plan and benefit costs largely resulting from a reduction of accruals in the prior year, expense associated with LIHTC credits, travel expenses, premium taxes and consulting services. The decrease in operating expenses in 2007 was largely due to reductions in employee benefits, legal fees and guaranty assessments.
The Group Insurance segment experienced net losses in each of the three years presented. The net loss in the Group Insurance segment decreased $0.4 million or 22% in 2008. This decrease was largely the result of an increase in insurance revenues and a decrease in operating expenses. These were partially offset by an increase in policyholder benefits. The net loss for this segment increased $0.5 million or 28% in 2007. This increase was largely due to increased policyholder benefits and increased operating expenses that were partially offset by an increase in insurance revenues.
Renewal premiums increased $0.7 million or 2% in 2008 and $0.8 million or 2% in 2007. Excluding the adjustment for unrecorded premiums discussed below, renewal premiums increased $1.4 million or 3% in 2007. An adjustment was reflected in 2006 that related to renewal premiums attributable to years 2003 through 2006. The unrecorded premiums in 2003, 2004 and 2005 were $0.1 million, $0.2 million and $0.3 million, respectively.
Operating expenses consist of commissions, fees to third party marketing and administrative organizations, and expenses from the Company’s operations. Expenses associated with operations in this segment are specifically and directly identified, but also include allocated expenses. Operating expenses in this segment decreased 1% in 2008, following a 1% increase in 2007. The reduction in 2008 was largely due to a $0.4 million release in legal contingency reserves as a result of a settlement of pending litigation. The increase in 2007 reflected charges incurred for enhancements made to operating systems and software. This was partially offset by a reduction in legal fees as 2006 legal expense included a contingency reserve expense.
The Old American segment sells final expense insurance products nationwide through its general agency system with exclusive territories. This segment provides agents with sales leads using direct response marketing. This segment produced 26% of consolidated insurance revenues in 2008, down slightly from 27% in 2007.
Net income for this segment decreased 87% in 2008 to $0.4 million. Net income decreased 46% to $2.9 million in 2007. The decline in 2008 was primarily due to increased realized investment losses, increased policyholder benefits, a decline in insurance revenues and a decline in net investment income. Partially offsetting these changes was a decline in operating expenses. The decline in net income in 2007 largely resulted from a decrease in insurance revenues and increases in realized investment losses and amortization of DAC. Also in 2007, this segment recorded a $0.7 million increase in income tax expense, reflecting corrections in estimates from tax years prior to 2005.
Total new premiums increased 11% in 2008, compared to a 5% increase in 2007. Total renewal premiums decreased 4% in both 2008 and 2007. The increase in new premiums reflects a combination of product, compensation and distribution changes which have improved the Company’s competitive position. Old American continues to focus on the recruitment and development of new agencies and agents, along with improved production from existing agencies and agents.
Net investment income decreased 5% in 2008 compared to a 1% increase in 2007. The decrease in 2008 primarily reflects reduced investment assets and a reduction in yields from the investment portfolio. The decline from lower yields was largely due to a reduction in income from an alternative investment fund. In 2007, this investment added gross investment income of $0.2 million. However, as a result of the significant decline in the economic environment, this investment resulted in a decline in gross investment income of $0.2 million in 2008. The increase in net investment income that occurred in 2007 can primarily be attributed to increased investment yields. Old American had realized investment losses of $2.3 million in 2008 and $0.4 million in 2007.
The Company had no securities that it identified as other-than-temporarily impaired in the first quarter of 2008 for this segment.
Policyholder benefits consist of death benefits (mortality), accident and health benefits, surrenders, and the associated increase or decrease in reserves for future policy benefits. Policyholder benefits increased 3% in 2008 following a 1% decline in 2007. The increase in 2008 was largely due to higher death benefits and surrenders, but these changes were partially offset by reserve release. The increase in death benefits reflects adverse mortality. While mortality results were different for 2008 and 2007, both years were within the range of anticipated mortality. In 2007, a decrease in death benefits, reflecting reduced mortality, was partially offset by an increase in reserves.
The policyholder benefit ratio (policyholder benefits divided by total revenues, excluding realized investment gains and losses) was higher in 2008 but remained consistent in 2007 and 2006. Lower revenues, primarily from reduced renewal premiums, combined with increased policyholder benefits contributed to the increase in the policyholder benefits ratio in 2008.
The Company performs cash flow testing and adds various levels of stress testing to potential surrender and policy loan levels in order to assess current and near-term cash and liquidity needs. In the event of increased surrenders and other cash needs, the Company has several sources of cash flow, as mentioned above, to meet these needs.
The Company has the ability to increase its borrowings with the FHLB, primarily based upon the amount of collateral provided. In addition, the Company has access to unsecured revolving lines of credit of $60.0 million with two major commercial banks with no balances outstanding. Lines of credit totaling $20.0 million will expire in May of 2009 and the remaining $40.0 million will expire in June of 2009. The Company anticipates renewing these lines of credit as they become due.
Unrealized losses on available for sale securities, which are included as a component of stockholders’ equity (net of securities gains and losses, related taxes, policyholder account balances and deferred acquisition costs), totaled $82.3 million at December 31, 2008. This represents an increase of $89.9 million in net unrealized losses from the $7.6 million in net unrealized investment gains at December 31, 2007.
The Company has defined contribution plans for employees and agents whereby shares of Company stock may be purchased or sold. Also, the Company makes contributions to these plans through Company stock. These transactions are accounted for as purchases and sales of treasury stock. Accordingly, in 2008, the benefit plans purchased 375,763 shares of treasury stock for $17.7 million (2007 - 140,240 shares for $6.7 million) and sold 222,687 shares of treasury stock for $9.2 million (2007 - 140,121 for $6.3 million).
Insurance liabilities consist primarily of future policy benefits and policyholder account balances for which the timing of cash flows is uncertain and which have life contingencies. The schedule of payments for these liabilities can vary significantly because of the uncertainty of the timing of cash flows, which depend upon insurable events or policyholder surrenders.
Kansas City Life Insurance Company (the Company) is a Missouri domiciled stock life insurance company which, with its subsidiaries, is licensed to sell insurance products in 49 states and the District of Columbia. The Company offers a diversified portfolio of individual insurance, annuity and group products through three life insurance companies. Kansas City Life Insurance Company (Kansas City Life) is the parent company. Sunset Life Insurance Company of America (Sunset Life) and Old American Insurance Company (Old American) are wholly owned subsidiaries.
Investment income on mortgage-backed securities is initially based upon yield, cash flow, and prepayment assumptions at the date of purchase. Subsequent revisions in those assumptions are recorded using the retrospective method, except for
The Company’s principal investments are in fixed maturity securities, mortgage loans and real estate; all of which are exposed to three primary sources of investment risk: credit, interest rate and liquidity. The fixed maturity securities, which are all classified as available for sale, are carried at their fair value in the Company’s balance sheet, with unrealized gains or losses recorded in accumulated other comprehensive loss. The unrealized gains or losses are recorded net of the adjustment to policyholder account balances to reflect what would have been earned had those gains been realized and the proceeds reinvested. The Company’s fair value of fixed maturity and equity securities are derived from external pricing sources, brokers, internal matrices and calculations. Approximately 90% of these investments are from external pricing services while 10% are derived from brokers, internal matrices and calculations. The investment portfolio is monitored regularly to ensure that investments which may be other-than-temporarily impaired are identified in a timely fashion and properly valued, and that impairments are charged against earnings as realized investment losses. The valuation of the investment portfolio involves a variety of assumptions and estimates, especially for investments that are not actively traded.
At the end of each quarter, all securities are reviewed to determine whether impairments exist and whether other-than-temporary impairments should be recorded. This quarterly process includes an assessment of the credit quality of each investment in the entire securities portfolio. Additional reporting and review procedures are conducted for those securities where fair value is less than 90% of amortized cost. Further, detailed analysis is performed for each issue or issues having experienced a formal restructuring or where the security has experienced material deterioration in fair value.
DAC is reviewed on an ongoing basis to determine that the unamortized portion does not exceed the expected recoverable amounts. If it is determined from emerging experience that the premium margins or gross profits are insufficient to amortize deferred acquisition costs, then the asset will be adjusted downward with the adjustment recorded as an expense in the current period. No impairment adjustments have been recorded in the years presented. The DAC asset is adjusted to reflect the impact of unrealized gains and losses on fixed maturity securities available for sale, as described in the Investments section of Note 1. The DAC increase from unrealized losses on fixed maturity securities was $51.2 million for year ended 2008 (2007 - $(0.7) million).
When a new block of business is acquired or when an insurance company is purchased, a portion of the purchase price is allocated to a separately identifiable intangible asset, called the value of business acquired (VOBA). VOBA is established as the actuarially determined present value of future gross profits of the business acquired and is amortized in proportion to future premium revenues or the expected future profits, depending on the type of business acquired. Amortization of VOBA occurs with interest over the anticipated lives of the underlying business to which it relates, initially 15 to 30 years. Similar to DAC, the assumptions regarding future experience can affect the carrying value of VOBA, including interest spreads, mortality, expense margins and policy and premium persistency experience. Significant changes in these assumptions can impact the carrying balance of VOBA and produce changes that are reflected in the current period’s income as an unlocking adjustment. A VOBA unlocking adjustment was made in the second quarter of 2008, which increased the amortization of VOBA in the amount of $0.2 million for surrenders (2007 - $1.1 million; 2006 - no adjustment).
VOBA is reviewed on an ongoing basis to determine that the unamortized portion does not exceed the expected recoverable amounts. If it is determined from emerging experience that the premium margins or gross profits are insufficient to support the value of VOBA, then the asset will be adjusted downward with the adjustment recorded as an expense in the current period. No impairment adjustments have been recorded in the years presented. The VOBA asset is adjusted to reflect the impact of unrealized gains and losses on fixed maturity securities available for sale, as described in the Investments section of Note 1. The VOBA asset increased $15.2 million (2007 - $0.1 million) from unrealized losses on fixed maturity securities.
The accrual of interest for Old American VOBA was calculated at a 13.0% interest rate for the life block and a 7.0% rate for the accident and health block. In 2008, interest accrued on the GuideOne acquisition VOBA at the rates of 4.53% on the interest sensitive life block, 4.05% on the deferred annuity block and 5.25% on the traditional life block. The VOBA on a separate acquired block of business used a 7.0% interest rate on the traditional life portion and a 5.4% interest rate on the interest sensitive portion. The interest rates used in the calculation of VOBA are based on rates appropriate at the time of acquisition. The expected amortization of VOBA each year over the next five years, 2009 through 2013, is $7,385, $7,057, $6,480, $4,394, and $4,170, respectively.
The total separate account assets were $258.6 million as of December 31, 2008. Variable life and variable annuity assets comprised 29% and 71% of this amount, respectively. Guarantees are offered under variable life and variable annuity contracts: a guaranteed minimum death benefit rider is available on certain variable universal life contracts, and guaranteed minimum death benefits are provided on variable annuities. The guaranteed minimum death benefit rider for variable universal life contracts guarantees the death benefit for specified periods of time, regardless of investment performance, provided cumulative premium requirements are met. The Company introduced a guaranteed minimum withdrawal benefit (GMWB) rider in 2007 that can be added to new or existing variable annuity contracts. The rider provides a minimum guarantee that the owner can make annual withdrawals equal to 5% of the initial annuity deposit for twenty years, or for life if withdrawals were started at age 65 or later, regardless of market returns. The value of variable annuity separate accounts with the GMWB rider was $31.1 million and the liability was $0.8 million at December 31, 2008. The value of the GMWB rider is recorded at fair value. The change in this liability is included in policyholder benefits in the Consolidated Statements of Income.
The Company establishes liabilities for amounts payable under insurance policies, including traditional life insurance, annuities and accident and health insurance. Generally, amounts are payable over an extended period of time. Liabilities for future policy benefits of traditional life insurance have been computed by a net level premium method based upon estimates at the time of issue for investment yields, mortality and withdrawals. These estimates include provisions for experience less favorable than initially expected. Mortality assumptions are based on Company experience expressed as a percentage of standard mortality tables. The 2001 VBT and the 1975-1980 Select and Ultimate Basic Table serve as the basis for mortality assumptions.
Policyholder account balances include universal life insurance, fixed deferred annuity contracts and investment-type contracts. Liabilities for these policyholder account balances are included without reduction for potential surrender charges and deferred front-end contract charges. The account balances for universal life contracts are equal to cumulative premiums, less contract charges and withdrawals, plus interest credited. The account balances for fixed deferred annuities and investment-type contracts are equal to the cumulative deposits, less any applicable contract charges and withdrawals, plus interest credited. Front-end contract charges are amortized over the term of the policies. Policyholder benefits incurred in excess of related policyholder account balances are charged to policyholder benefits expense. Interest on policyholder account balances is credited as earned.
Deposits related to universal life, fixed deferred annuity contracts and investment-type products are credited to policyholder account balances. Revenues from such contracts consist of amounts assessed against policyholder account balances for mortality, policy administration and surrender charges, and are recognized in the period in which the benefits and services are provided. The cash flows from deposits are credited to policyholder account balances. Deposits are not recorded as revenue under FASB Statement No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments.” Deposits are shown as a Financing Activity in the Consolidated Statements of Cash Flows.
Deferred income tax assets are subject to ongoing evaluation of whether such assets will be realized. The ultimate realization of deferred income tax assets generally depends on the reversal of deferred tax liabilities and the generation of future taxable income and realized gains during the periods in which temporary differences become deductible. A valuation allowance against deferred income tax assets may be required if future taxable income of the correct character is not expected.
Due to the Company's capital structure and the absence of other potentially dilutive securities, there is no difference between basic and diluted earnings per common share for any of the years reported. The average number of shares outstanding during the year was 11,566,805 shares (2007 - 11,836,213 shares; 2006 - 11,883,830 shares). The number of shares outstanding at year-end was 11,430,300 (2007 - 11,765,037).
The Company has some insurance contracts where the policyholder is entitled to share in the entity’s earnings through dividends that reflect the difference between the premium charged and the actual experience. Participating business at year-end 2008 approximated 5% of statutory premiums and 6% of the life insurance in force. The amount of dividends to be paid is determined annually by the Board of Directors. Provision has been made in the liability for future policy benefits to allocate amounts to participating policyholders on the basis of dividend scales contemplated at the time the policies were issued. Additional provisions have been made for policyholder dividends in excess of the original scale, which have been declared by the Board of Directors.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (SFAS 161). This statement amends and expands the disclosure requirements of Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS 161 requires companies with derivative instruments to disclose information about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under Statement 133, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. This statement shall be effective for financial statements issued for fiscal years beginning after November 15, 2008. The Company adopted SFAS 161 on January 1, 2009 with no material impact on the consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of SFAS No. 115” (SFAS 159). SFAS 159 permits an entity to measure certain financial assets and liabilities at fair value. Under SFAS 159, entities that elect the fair value option will report unrealized gains and losses in earnings at each subsequent reporting date. The fair value option may be elected on an instrument-by-instrument basis, with a few exceptions, as long as it is applied to the instrument in its entirety. Once adopted, the fair value option election is irrevocable, unless a new election date occurs. This statement became effective for years beginning after November 15, 2007. Upon the adoption of SFAS 159, the Company was also required to adopt SFAS No. 157 concurrently. The Company elected to not measure financial assets and liabilities at fair value other than those already prescribed, such as securities available for sale, securities identified in trading portfolios and certain derivatives and hedging activity that the Company participates in. The Company adopted SFAS 159 on January 1, 2008 with no material impact to the consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS 158). SFAS 158 requires calendar year-end companies with publicly traded equity securities that sponsor postretirement benefit plans to fully recognize, as an asset or liability, the funded status of the benefit plans measured as of the sponsor’s fiscal year-end as of December 31, 2006. The funded status is to be measured as the difference between the fair value of the plan assets and the projected benefit obligation at year-end. The Company adopted this statement as of December 31, 2006. Please see Note 8 - Pensions and Other Postretirement Benefits.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 “Accounting Changes and Error Corrections” (SFAS 154). The Statement replaces APB Opinion No. 20 and SFAS 3. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle. However, if it is impracticable to determine the effects of such changes, then other rules apply. SFAS 154 became effective January 1, 2006. The Company adopted this standard on January 1, 2006. SFAS 154 had no immediate impact on the Company’s consolidated financial statements, though it will impact the presentation of future voluntary accounting changes, should such changes occur.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123 (revised 2004) "Share-Based Payment" (SFAS 123R). This statement requires recognition in the financial statements of the fair-value-based measurement method of stock-based compensation issued to employees. SFAS 123R became effective January 1, 2006. Historically, the Company had expensed all stock-based compensation using a fair-value-based measurement method. The Company adopted this standard on January 1, 2006 with no material impact to the consolidated financial statements. Please see Note 9 - Share-Based Payment.
Level 2 - Valuations are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Valuations are obtained from third party pricing services or inputs that are observable or derived principally from or corroborated by observable market data. Level 2 assets include debt securities, preferred stocks and asset-backed securities that are model priced by vendors using observable inputs.
Level 3 - Valuations are generated from techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s assumptions that market participants would use in pricing the asset or liability. Valuation techniques include the use of option pricing models, discounted cash flow models, spread-based models, and similar techniques, using the best information available in the circumstances. Level 3 assets include primarily private placements.
Under SFAS 157, the Company bases fair values on the price that would be received to sell an asset (exit price) or paid to transfer a liability in an orderly transaction between market participants at the measurement date. It is the Company’s policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy in SFAS 157. Accordingly, the Company uses an independent third party pricing service to price a significant portion of its fixed maturity securities and equity securities.
The Company’s own estimates of fair value are derived in a number of ways including, but not limited to: 1) pricing provided by brokers, where the price indicates reliability as to value; 2) fair values of comparable securities incorporating a spread adjustment for maturity differences, collateralization, credit quality, liquidity and other items, if applicable; 3) discounted cash flow models and margin spreads; 4) bond yield curves; 5) Trace trade quotes; 6) observable market prices and exchange quotes not provided by our pricing service; 7) statement values provided to the Company by fund managers; and 8) option pricing models.
Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are determined as described in the preceding paragraphs.
The Company does not record loans at fair value. As such, valuation techniques discussed herein for loans are primarily for estimating fair value for SFAS No. 107 disclosure purposes.
Fair values of mortgage loans on real estate properties are calculated by discounting contractual cash flows, using discount rates based on current industry pricing or the Company’s estimate of an appropriate risk-adjusted discount rate for loans of similar size, type, remaining maturity and repricing characteristics.
Fair values for liabilities under investment-type insurance contracts are based upon account value. The fair values of investment-type insurance contracts included with policyholder account balances for fixed deferred annuities and other policyholder funds for supplementary contracts without life contingencies are estimated to be their cash surrender values. In accordance with SFAS No. 107, the fair values of deposits with no stated maturity are equal to the amount payable on demand at the measurement date.
All of the amounts included within Notes Payable were in short-term borrowings at December 31, 2008 and December 31, 2007. The carrying amount of these borrowings was a reasonable estimate of fair value because of the relatively short time between the origination of the borrowings and their expected repayment and maturities. Please see Note 5 - Notes Payable for an explanation of the terms of the debt outstanding.
The roll forward of Level 3 assets begins with the prior period balance and adjusts the balance for the gains or losses (realized and unrealized) that occurred during the current period. Any new purchases that are identified as Level 3 securities are then added and any sales of securities which were previously identified as Level 3 are subtracted. Next, any securities which were previously identified as Level 1 or Level 2 securities and which are currently identified as Level 3 are added. Securities which were previously identified as Level 3 and which are now designated as Level 1 or as Level 2 are subtracted. Finally, the non-trading activity adjustment represents the net amortization of premium and/or discount associated with the Level 3 securities. The ending balance represents the current fair value of securities which are designated as Level 3.
The Company has a policy and process in place to identify securities that could potentially have an impairment that is other-than-temporary. This process involves monitoring market events and other items that could impact issuers. The evaluation includes but is not limited to such factors as the issuer’s stated intent and ability to make all principal and interest payments when due, near-term business prospects, cash flow and liquidity, credit ratings, business climate, management changes and litigation and government actions. This process also involves monitoring several factors including late payments, downgrades by rating agencies, key financial ratios, financial statements, revenue forecasts, asset quality and cash flow projections, as indicators of credit issues.
The Company considers relevant facts and circumstances in evaluating whether the impairment of a security is other-than-temporary. Relevant facts and circumstances considered include but are not limited to: (1) the current fair value of the security as compared to cost; (2) the extent and the length of time the fair value has been below cost; (3) the financial position of the issuer, including the current and future impact of any specific events, material declines in the issuer’s revenues, margins, cash positions, liquidity issues, asset quality, debt levels and income results; (4) consideration of information or evidence that supports timely recovery; and (5) other business factors related to the issuer’s industry.
There are a number of significant risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other-than-temporary. These risks and uncertainties include but are not limited to: (1) the risk that the Company’s assessment of an issuer’s ability to meet all of its contractual obligations will change based on changes in the credit characteristics of that issuer; (2) the risk that the economic outlook will be worse than expected or have more of an impact on the issuer than anticipated; (3) the risk that the performance of the underlying collateral for securities could deteriorate in the future and the Company’s credit enhancement levels and recovery values do not provide sufficient protection to the Company’s contractual principal and interest; (4) the risk that fraudulent information could be provided to the Company’s credit, investment and accounting professionals who determine the fair value estimates and accounting treatment for securities; and (5) the risk that inaccurate or misleading information could be provided to the Company’s investment professionals who determine the fair value estimates. Any of these situations could result in a charge to income in a future period. If the Company determines that a security is other-than-temporarily impaired, the difference between amortized cost and fair value is charged to income as a realized investment loss, resulting in a reduction to the cost basis of the underlying investment.
During 2008, losses of $62.7 million were due other-than-temporarily impaired write-downs of investments securities, compared to $4.0 million in 2007.
The Company had no securities that it identified as other-that-temporarily impaired in the first quarter of 2008.
The Company had no securities that it identified as other-than-temporarily impaired during the first, second and third quarters of 2007. The Company’s analysis of fixed maturity securities at year-end 2007 resulted in the determination that two securities had other-than-temporary declines which were written down by $4.0 million. One of the two securities was below cost by 20% or more for more than six consecutive months and was the subject of a recent leveraged buyout that was finalized during the fourth quarter of 2007, which greatly increased the debt level of the company. Accordingly, the Company wrote down this security $3.3 million at year-end 2007. The second security filed for Chapter 11 protection and indicated that it would not be able to fully meet all of the obligations of its borrowings. The Company recognized an other-than-temporary impairment on this security at year-end 2006 of $1.1 million. As a result of this new action, the Company recognized an additional $0.7 million impairment in 2007. At December 31, 2006, this security was below cost by 20% or more for more than twelve consecutive months. It was in a highly competitive and cyclical industry that was experiencing weakened demand and overcapacity. Capital expenditures for equipment upgrades were exceeding cash generation.
In addition, the Company also considers as part of its monitoring and evaluation process the length of time a security is below cost. At December 31, 2008, the Company had unrealized losses on its investment portfolio for fixed maturities and equity securities as follows:
125 security issues representing 26% of the issues with unrealized losses, including 92% being rated as investment grade, were below cost for three years or more.
The Company has assessed securities for other-than-temporary impairment in accordance with the process described above. Based upon this assessment the Company believes that it is probable that all contractual maturities of principal and interest will be collected. The Company has the ability and intent to hold its fixed maturity investments until recovery of fair values, which may be maturity, and does not consider these investments to be other-than-temporarily impaired at December 31, 2008.
As part of the required accounting for unrealized gains and losses, the Company also adjusts the DAC and VOBA assets to recognize the adjustment to those assets as if the unrealized gains and losses from securities classified as available-for-sale actually had been realized.
Securities with unrealized losses greater than 20% are also monitored based upon whether the securities are investment grade or below investment grade. Securities in the investment grade category had $108.1 million in unrealized losses, while securities rated below investment grade had $19.7 million in unrealized losses at December 31, 2008.
The following table provides amortized cost and fair value for securities by sector at December 31, 2008.
The following table provides information regarding fixed maturity securities by sector at December 31, 2008.
1 Federal agency securities are not backed by the full faith and credit of the U.S. Government.
The Company did not hold securities of any corporation and its affiliates that exceeded 10% of stockholders' equity at December 31, 2008 or December 31, 2007.
Subprime securities include all bonds or portion of bonds where the underlying collateral is made up of home equity loans or first mortgage loans to borrowers whose credit scores at the time of origination were lower than the level recognized in the market at prime. The Company’s classification of subprime does not include Alt-A or jumbo loans, unless the collateral otherwise meets the preceding definition. At December 31, 2008, the Company had investments with subprime residential mortgage exposure of $23.8 million and a related $8.9 million unrealized loss. This exposure amounted to approximately 1% of the Company’s invested assets.
Most of the Company’s mortgage loans are secured by commercial real estate and are carried net of a valuation reserve of $3,410 (2007 - $3,410). The valuation reserve for mortgage loans is maintained at a level believed adequate by management to absorb estimated credit losses. Management’s periodic evaluation and assessment of the adequacy of the valuation reserve is based on known and inherent risks in the portfolio, historical and industry data, current economic conditions and other relevant factors. No mortgage loans were foreclosed upon and transferred to real estate investments during the past two years. Also, there were no delinquent mortgage loans at December 31, 2008 and there was one delinquent mortgage loan at December 31, 2007. The Company does not hold mortgage loans of any borrower that exceeds 5% of stockholders’ equity.
The Company had commitments to originate mortgage loans of $6.9 million at December 31, 2008. These commitments expire in 2009.
Investment real estate is depreciated on a straight-line basis over periods ranging from 10 to 60 years.
The Company had commitments to sell real estate investments of $1.4 million at December 31, 2008. These commitments expire in 2009.
The Company has unsecured revolving lines of credit of $60.0 million with two major commercial banks with no balances outstanding, and which are at variable interest rates - currently at 0.95% (2007 - 3.76%, 2006 - 6.075%). Lines of credit totaling $20.0 million will expire in May of 2009 and the remaining $40.0 million will expire in June of 2009. The Company anticipates renewing these lines of credit as they come due.
All borrowings are used to enhance liquidity and investment strategies. Interest paid on all borrowings equaled $1.1 million (2007 - $1.6 million; 2006 - $1.0 million). The interest expense on all borrowings totaled $1.1 million (2007 - $1.6 million; 2006 - $0.9 million).
The Company is required to deposit a defined amount of assets with state regulatory authorities. Such assets had an aggregate carrying value of $12.0 million at December 31, 2008 (2007 - $13.0 million; 2006 - $12.0 million).
Presented below are tax effects of temporary differences that result in significant deferred tax assets and liabilities at December 31.
Federal income taxes paid this year were $9,927 (2007 - $14,572; 2006 - $8,121).
The assumed discount rate used to determine the benefit obligation for pension benefits is 6.00% and 5.75% for other postretirement benefits. The discount rates were determined by reference to the Citigroup Pension Liability Yield Curve on December 31, 2008. Specifically, the spot rate curve represents the rates on zero coupon securities of the quality and type included in the pension index at various maturities. By discounting benefit cash flows at these rates, a notional amount equal to the market value of a cash flow defeasing portfolio of bonds was determined. The discount rate for benefits was calculated as a single rate giving the same discounted value as the notional amount.
The postretirement medical plans for the employees, full-time agents, and their dependents are contributory with contributions adjusted annually. The benefits expected to be paid in each year from 2009 through 2013 are $1,030, $1,090, $1,170, $1,170, and $1,200, respectively. The aggregate benefits expected to be paid in the five years from 2014 through 2018 are $7,510. The expected benefits to be paid are based on the same assumptions used to measure the Company’s benefit obligation at December 31, 2008. The 2009 contribution for the plan is estimated to be $1,030. The Company pays these medical costs as they become due and the plan incorporates cost-sharing features.
Savings plans for eligible employees and agents match employee and agent contributions up to 6% of salary and 2.5% of agents’ prior year paid commissions, respectively. Contributions to the plan were $1,763 (2007 - $1,167; 2006 - $1,683). The Company may contribute an additional profit sharing amount up to 4% of salary for eligible employees, depending upon corporate profits. The Company made no profit sharing contribution in 2008 or in the prior two years.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” SFAS No. 158. SFAS No. 158 requires calendar year-end companies with publicly traded equity securities that sponsor postretirement benefit plans to fully recognize, as an asset or liability, the overfunded or underfunded status of the benefit plans as of December 31, 2006. The funded status is measured as the difference between the fair value of the plan’s assets and its benefit obligation. The Company adopted SFAS No. 158 as of December 31, 2006.
On January 1, 2008, the Agents are covered under a fully insured United HealthCare Choice Plus plan. This plan includes Medicare prescription drug coverage.
The estimated net loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive income (loss) into net periodic benefit cost over the next year is $4,949 and ($646), respectively.
Information about the outstanding three-year intervals as of December 31, 2008, was as follows:
Insurance revenues, as shown in the Consolidated Statements of Income, consist of premiums and contract charges, less reinsurance ceded. Insurance revenues are defined as “customer revenues” for segment reporting purposes. Other revenues consist primarily of supplemental contact considerations, dividends left with the Company to accumulate and income received on the sale of low income housing tax credit investments. Customer revenues are added to other revenues, net investment income and realized investment gains (losses) to reconcile to the Company’s total revenues.
Separate investment portfolios are maintained for each of the three life insurance companies of the Company. However, investment assets and income are allocated to the Group Insurance segment based upon its cash flows and future policy benefit liabilities. Home office functions are fully integrated for all segments in order to maximize economies of scale. Therefore, operating expenses are allocated to the segments based upon internal cost studies, which are consistent with industry cost methodologies.
1 Elimination entries to remove intercompany transactions for life and accident and health insurance were as follows: insurance revenues from the Group Insurance segment and operating expenses from the Individual Insurance segment to arrive at Consolidated Statements of Income.
Old American has a coinsurance agreement that reinsures certain whole life policies issued by Old American prior to December 1, 1986. These policies had a face value of $45.8 million as of December 31, 2008. The reserve for future policy benefits ceded under this agreement was $24.0 million (2007 - $26.2 million).
Kansas City Life acquired a block of traditional life and universal life products in 1997. As of December 31, 2008, the block had $1.6 billion of life insurance in force (2007 - $1.7 billion). The block generated life insurance premiums of $3.3 million (2007 - $3.4 million) and had reinsurance ceded of $1.0 million (2007 - $1.3 million).
Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes the unrealized investment gains or losses on securities available for sale (net of adjustments for realized investment gains or losses) net of adjustments to DAC, VOBA and policyholder account balances. In addition, other comprehensive income (loss) includes the change in the additional minimum pension liability, and the adjustment to adopt SFAS No. 158. The adjustment to adopt SFAS No. 158 consists of pension and postretirement net losses and prior service costs. Other comprehensive income (loss) also includes deferred income taxes on these items. The table below provides information about comprehensive income (loss) for the years ended December 31.
In the normal course of business, the Company has open purchase and sale commitments. At December 31, 2008, the Company had purchase commitments to fund mortgage loans and other investments of $7.3 million. Subsequent to December 31, 2008, the Company entered into commitments to fund additional mortgage loans of $4.7 million, purchase of affordable housing real estate investments of $4.5 million and sales of real estate investments for $1.4 million.
The Company is subject to various indemnification obligations issued in conjunction with certain transactions, primarily assumption reinsurance agreements, stock purchase agreements, mortgage servicing agreements, construction and lease guarantees and borrowing agreements whose terms range in duration and often are not explicitly defined. Generally, a maximum obligation is not explicitly stated. Therefore, the overall maximum amount of the obligation under the indemnifications cannot be reasonably estimated. The Company is unable to estimate with certainty the ultimate legal and financial liability with respect to these indemnifications. The Company believes that the likelihood is remote that material payments would be required under such indemnifications and therefore such indemnifications would not result in a material adverse effect on the financial position or results of operations.
On January 26, 2009, the Kansas City Life Board of Directors declared a quarterly dividend of $ 0.27 per share, paid on February 10, 2009 to stockholders of record on February 5, 2009.
2 Allocations of operating expenses are based on a number of assumptions and estimates, and the results may change if different methods were applied.
1 Elimination entries to remove intercompany transactions for life and accident and health insurance were as follows: insurance revenues from the Group Insurance segment to arrive at Consolidated Statements of Income.
All other information required by this Schedule is shown in Note 12-Reinsurance in the Notes to
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audits of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal controls based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kansas City Life Insurance Company and subsidiaries as of December 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Also, in our opinion, Kansas City Life Insurance Company and subsidiaries maintained, in all material respects, effective internal controls over financial reporting as of December 31, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).