Allstate Life Insurance Company of New York Management's Discussion and Analysis of Financial Condition and Results of Operations
The Company, which is wholly owned by a wholly owned subsidiary of Allstate Insurance Company ("AIC"), an affiliate of The Allstate Corporation, markets a broad line of life insurance and annuity products in the State of New York. Life insurance includes traditional products such as whole life and term life insurance, as well as universal life and other interest-sensitive life products. Annuities include deferred annuities, such as variable annuities and fixed rate single and flexible premium annuities, and immediate annuities such as structured settlement annuities. The Company distributes its products using a combination of Allstate agents which include life specialists, banks, independent agents, brokers and direct response marketing.
Operating costs and expenses increased $5.3 million, or 22.6%, for the year ended December 31, 1997. The increase is related to growth in business and the recognition of costs related to the relocation of the policy administration function, offset by a reduction in amortization of deferred acquisition costs due to the revised estimates of future gross profits on interest-sensitive life products.
In 1997, the Company received approval from the State of New York Insurance Department to relocate its policy administration function to an affiliate's facility in Illinois. The move is scheduled for the second quarter of 1998. The Company recognized an after-tax charge of $1.9 million in 1997 for certain costs relating to the consolidation of these operations.
Operating income increased 3.1% in 1997 and 4.2% in 1996. The increase in 1997 is primarily due to favorable mortality experience on the structured settlement annuity business and higher investment margins due to additional sales of structured settlement annuities. The increase in 1996 is the result of growth in investments partially offset by less favorable mortality experience on life-contingent structured settlement annuities.
The Company had realized capital gains of $456 thousand after tax in 1997 compared with realized capital losses of $1.0 million after tax in 1996. In 1997, increased gains on fixed income securities and reduced losses on other investments were partially offset by increased writedowns on mortgage loans. Realized capital losses in 1996 were 14.3% lower than those reported in 1995. Reduced mortgage losses were partially offset by losses incurred on the sale of fixed income securities to reposition a portion of the investment portfolio to improve overall yield in 1996.
Fixed income securities (1) $ 1,756,257 92.0% Mortgage loans 114,627 6.0 Policy loans 27,600 1.5 Short-term 9,513 0.5 ------------------ ------
The Company's fixed income securities portfolio consists of privately-placed securities, U.S. government bonds, publicly traded corporate bonds, mortgage-backed securities, asset-backed securities and tax-exempt municipal bonds. The Company generally holds its fixed income securities for the long term, but has classified all of these securities as available for sale to allow maximum flexibility in portfolio management. At December 31, 1997, unrealized net capital gains on the fixed income securities portfolio were $246.1 million compared to $122.6 million as of December 31, 1996. The increase in the unrealized gain position is primarily attributable to lower interest rates.
At the end of 1997, substantially all of the Company's fixed income securities portfolio is rated investment grade, which is defined by the Company as a security having a National Association of Insurance Commissioners ("NAIC") rating of 1 or 2, a Moody's rating of Aaa, Aa, A or Baa, or a comparable Company internal rating.
As of December 31, 1997, the fixed income securities portfolio contained $540.9 million of privately-placed corporate obligations, compared with $492.8 million at December 31, 1996. The benefits of privately-placed securities as compared to public securities are generally higher yields, improved cash flow predictability through pro-rata sinking funds on many bonds, and a combination of covenant and call protection features designed to better protect the holder against losses resulting from credit deterioration, reinvestment risk and fluctuations in interest rates. A relative disadvantage of privately-placed securities as compared to public securities is reduced liquidity. All of the privately-placed securities are rated as investment grade by either the NAIC or the Company's internal ratings. The Company determines the fair value of privately-placed fixed income securities based on discounted cash flows using current interest rates for similar securities.
MBS, however, are subject to interest rate risk as the duration and ultimate realized yield are affected by the rate of repayment of the underlying mortgages. The Company attempts to limit interest rate risk by purchasing MBS whose cost does not significantly exceed par value, and with repayment protection to provide a more certain cash flow to the Company. At December 31, 1997, the amortized cost of the MBS portfolio was below par value by $7.4 million and over 40% of the MBS portfolio was invested in planned amortization class bonds. This type of MBS is purchased to provide additional protection against rising interest rates.
The Company closely monitors its fixed income securities portfolio for declines in value that are other than temporary. Securities are placed on non-accrual status when they are in default or when the receipt of interest payments is in doubt.
Market risk is the risk that the Company will incur losses due to adverse changes in market rates and prices. The Company's primary market risk exposure is to changes in interest rates.
The active management of market risk is integral to the Company's operations. The Company may use the following approaches to manage its exposure to market risk within defined tolerance ranges: 1) rebalance its existing asset or liability portfolios, 2) change the character of future investments purchased or 3) use derivative instruments to modify the market risk characteristics of existing assets and liabilities or assets expected to be purchased. See Note 5 to the financial statements for a more detailed discussion of these instruments.
AIC administers and oversees investment risk management processes primarily through three oversight bodies: the Boards of Directors and Investment Committees of its operating subsidiaries, and the Credit and Risk Management Committee ("CRMC"). The Boards of Directors and Investment Committees provide executive oversight of investment activities. The CRMC is a senior management committee consisting of the Chief Investment Officer, the Investment Risk Manager, and other investment officers who are responsible for the day-to-day management of market risk. The CRMC meets at least monthly to provide detailed oversight of investment risk, including market risk.
AIC has investment guidelines that define the overall framework for managing market and other investment risks, including the accountabilities and controls over these activities. In addition, AIC has specific investment policies for each of its affiliates, including the Company, that delineate the investment limits and strategies that are appropriate given each entity's liquidity, surplus, product and regulatory requirements.
AIC manages its exposure to market risk through asset allocation limits, duration limits, value-at-risk limits, and, as appropriate, stress tests. Asset allocation limits place restrictions on the aggregate fair value which may be invested within an asset class. Duration limits on the life and annuity investment portfolios, and, as appropriate, on individual components of these portfolios (such as those of the Company), place restrictions on the amount of interest rate risk which may be taken. Value-at-risk measures the potential loss in fair value that could arise from adverse movements in the fixed income, equity, and currency markets over a time interval, based on historical volatilities and correlations between market risk factors. Stress tests measure downside risk to fair value and earnings over longer time intervals and/or for adverse market scenarios.
To calculate duration, the Company projects asset and liability cash flows, and discounts them to a net present value basis using a risk-free market rate adjusted for credit quality, sector attributes, liquidity and other specific risks. Duration is calculated by revaluing these cash flows at an alternative level of interest rates, and determining the percentage change in fair value from the base case. The cash flows used in the model reflect the expected maturity and repricing characteristics of the Company's derivative financial instruments, all other financial instruments (see Note 5 to the financial statements), and certain non-financial instruments including interest-sensitive annuity liabilities. The projections include assumptions (based upon historical market and Company specific experience) reflecting the impact of changing interest rates on the prepayment, lapse, leverage and/or option features of instruments, where applicable. Such assumptions relate primarily to mortgage-backed securities, collateralized mortgage obligations, municipal bonds, municipal and corporate obligations, and fixed rate single and flexible premium deferred annuities.
To the extent that actual results differ from the assumptions utilized, the Company's duration and rate shock measures could be significantly impacted. Additionally, the Company's calculation assumes that the current relationship between short-term and long-term interest rates (the term structure of interest rates) will remain constant over time. As a result, these calculations may not fully capture the impact of non-parallel changes in the term structure of interest rates and/or large changes in interest rates.
Claims-paying ability ratings at December 31, 1997 assigned to the Company include AA+, A+(g) and Aa2 from Standard & Poor's, A.M. Best and Moody's, respectively.
The maturity structure of the Company's fixed income securities, which represent 92.0% of the Company's total investments, is managed to meet the anticipated cash flow requirements of the underlying liabilities. A portion of the Company's product portfolio, primarily fixed deferred annuity and universal life insurance products, is subject to discretionary surrender and withdrawal by contractholders. Management believes its assets are sufficiently liquid to meet future obligations to its life and annuity contractholders under various interest rate scenarios.
Final approval of the NAIC's proposed "Comprehensive Guide" on statutory accounting principles is expected in early 1998. Implementation could be as early as January 1, 1999. The requirements of the Comprehensive Guide are not expected to have a material impact on statutory surplus.
The Company is heavily dependent upon complex computer systems for all phases of its operations, including customer service, risk management and policy and contract administration. Since many of the Company's older computer software programs recognize only the last two digits of the year in any date, some software may fail to operate properly in or after the year 1999, if the software is not reprogrammed or replaced, ("Year 2000 Issue"). The Company believes that many of its counterparties and suppliers also have Year 2000 Issues which could affect the Company. In 1995, AIC commenced a plan intended to mitigate and/or prevent the adverse effects of Year 2000 Issues. These strategies include normal development and enhancement of new and existing systems, upgrades to operating systems already covered by maintenance agreements and modifications to existing systems to make them Year 2000 compliant. The plan also includes the Company actively working with its major external counterparties and suppliers to assess their compliance efforts and the Company's exposure to them. The Company presently believes that it will resolve the Year 2000 Issue in a timely manner, and the financial impact will not materially affect its results of operations, liquidity or financial position. Year 2000 costs are and will be expensed as incurred.
SFAS No. 131 redefines how segments are determined and requires additional segment disclosures for both annual and quarterly reporting. Under this statement, segments are determined using the "management approach" for financial statement reporting. The management approach is based on the way an enterprise makes operating decisions and assesses performance of its businesses. The Company is currently reviewing the requirements of this SFAS and has yet to determine its impact on its current reporting segments. The requirements of this statement will be adopted effective December 31, 1998.
In March 1998, the Accounting Standards Executive Committee of the AICPA issued SOP 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." The SOP provides guidance on accounting for the costs of computer software developed or obtained for internal use. Specifically, certain external, payroll and payroll related costs should be capitalized during the application development state of a project and depreciated over the computer software's useful life. The Company currently expenses these costs as incurred and is evaluating the effects of this SOP on its accounting for internally developed software. The SOP is expected to be adopted in 1998.
Statements of Shareholder's Equity for the Years Ended December 31, 1997, 1996 and 1995.........................F-4
In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. Also, in our opinion, Schedule IV - Reinsurance and Schedule V - Valuation and Qualifying Accounts, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK STATEMENTS OF FINANCIAL POSITION
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS ($ IN THOUSANDS)
The Company utilizes various modeling techniques in managing the relationship between assets and liabilities. The fixed income securities supporting the Company's obligations have been selected to meet, to the extent possible, the anticipated cash flow requirements of the related liabilities. The Company employs strategies to minimize its exposure to interest rate risk and to maintain investments which are sufficiently liquid to meet obligations to contractholders in various interest rate scenarios.
The Company monitors economic and regulatory developments which have the potential to impact its business. There continues to be new and proposed federal and state regulation and legislation that would allow banks greater participation in the securities and insurance businesses, which will present an increased level of competition for sales of the Company's life and annuity products. Furthermore, the market for deferred annuities and interest-sensitive life insurance is enhanced by the tax incentives available under current law. Any legislative changes which lessen these incentives are likely to negatively impact the demand for these products.
Enacted and pending state legislation to permit mutual insurance companies to convert to a hybrid structure known as a mutual holding company could have a number of significant effects on the Company by (1) increasing industry competition through consolidation caused by mergers and acquisitions related to the new corporate form of business; (2) increasing competition in capital markets; and (3) reopening stock/mutual company disagreements related to such issues as taxation disparity between mutual and stock insurance companies.
Investments Fixed income securities include bonds and mortgage-backed and asset-backed securities. All fixed income securities are carried at fair value and may be sold prior to their contractual maturity ("available for sale"). The difference between amortized cost and fair value, net of deferred income taxes, certain deferred acquisition costs, and reserves for life-contingent contract benefits, is reflected as a component of shareholder's equity. Provisions are recognized for declines in the value of fixed income securities that are other than temporary. Such writedowns are included in realized capital gains and losses.
Short-term investments are carried at amortized cost which approximates fair value. Policy loans are carried at the unpaid principal balances.
Under deferral accounting, gains and losses on derivatives are deferred on the statement of financial position and recognized in earnings in conjunction with earnings on the hedged item. The Company accounts for interest rate futures contracts as hedges using deferral accounting for anticipatory investment purchases and sales when the criteria for futures (discussed above) are met. In addition, anticipated transactions must be probable of occurrence and their significant terms and characteristics identified.
Changes in fair values of these types of derivatives are initially deferred as other liabilities and accrued expenses. Once the anticipated transaction occurs, the deferred gains or losses are considered part of the cost basis of the asset and reported net of tax in shareholder's equity or recognized as a gain or loss from disposition of the asset, as appropriate. The Company reports initial margin deposits on futures in short-term investments. Fees and commissions paid on these derivatives are also deferred as an adjustment to the carrying value of the hedged item.
Reinsurance Certain premiums and contract benefits are ceded and reflected net of such cessions in the statements of operations. Reinsurance recoverable and the related reserves for life-contingent contract benefits are reported separately in the statements of financial position. The Company continues to have primary liability as the direct insurer for risks reinsured.
Deferred acquisition costs Certain costs of acquiring life and annuity business, principally agents' remuneration, premium taxes, certain underwriting costs and direct mail solicitation expenses are deferred and amortized to income. For traditional life insurance, limited payment contracts and accident and disability insurance, these costs are amortized in proportion to the estimated revenues on such business. For universal life-type policies and investment contracts, the costs are amortized in relation to the present value of estimated gross profits on such business. Changes in the amount or timing of estimated gross profits will result in adjustments in the cumulative amortization of these costs. To the extent that unrealized gains or losses on fixed income securities carried at fair value would result in an adjustment of deferred acquisition costs had those gains or losses actually been realized, the related unamortized deferred acquisition costs are recorded as a reduction of the unrealized gains or losses included in shareholder's equity, net of deferred income taxes.
Separate Accounts The Company issues flexible premium deferred variable annuity contracts, the assets and liabilities of which are legally segregated and reflected in the accompanying statements of financial position as assets and liabilities of the Separate Accounts (Allstate Life of New York Variable Annuity Account, Allstate Life of New York Variable Annuity Account II and Allstate Life of New York Separate Account A, unit investment trusts registered with the Securities and Exchange Commission).
The assets of the Separate Accounts are carried at fair value. Investment income and realized capital gains and losses of the Separate Accounts accrue directly to the contractholders and, therefore, are not included in the Company's statements of operations. Revenues to the Company from the Separate Accounts consist of contract maintenance fees, administration fees and mortality and expense risk charges.
Off-balance-sheet financial instruments Commitments to extend mortgage loans have only off-balance-sheet risk because their contractual amounts are not recorded in the Company's statements of financial position.
Structured settlement annuities AIC, through an affiliate, purchased $12,766, $15,610 and $11,243 of structured settlement annuities from the Company in 1997, 1996 and 1995, respectively. Of these amounts, $3,468, $8,517 and $4,164 relate to structured settlement annuities with life contingencies and are included in premium income in 1997, 1996 and 1995, respectively. Additionally, the reserve for life-contingent contract benefits was increased by approximately 94% of such premium received in each of these years.
Scheduled maturities The scheduled maturities for fixed income securities are as follows at December 31, 1997:
Unrealized net capital gains Unrealized net capital gains on fixed income securities included in shareholder's equity at December 31, 1997 are as follows:
Investment loss provisions and valuation allowances Pretax provisions for investment losses, principally relating to other than temporary declines in value of fixed income securities and valuation allowances on mortgage loans were $261, $208 and $2,448 in 1997, 1996 and 1995, respectively.
Activity in the valuation allowance for all mortgage loans for the years ended December 31, 1997, 1996 and 1995 is summarized as follows:
Interest income is recognized on a cash basis for impaired loans carried at the fair value of the collateral, beginning at the time of impairment. For other impaired loans, interest is accrued based on the net carrying value. There were no impaired loans during 1997. The Company recognized interest income of $281 and $1,398 on impaired loans during 1996 and 1995, respectively, of which $281 and $1,194 was received in cash during 1996 and 1995, respectively. The average recorded investment in impaired loans was $5,154 and $8,900 during 1996 and 1995, respectively.
Investment concentration for municipal bond and commercial mortgage portfolios and other investment information The Company maintains a diversified portfolio of municipal bonds. The largest concentrations in the portfolio are presented below. Except for the following, holdings in no other state exceeded 5% of the portfolio at December 31, 1997 and 1996:
Ohio 28.4% 25.9% California 22.7 24.3 Illinois 19.8 19.0 Maryland 8.0 7.8 Maine 5.6 5.7 Minnesota 5.5 5.3 New York 5.4 5.3
The Company's mortgage loans are collateralized by a variety of commercial real estate property types located throughout the United States. Substantially all of the commercial mortgage loans are non-recourse to the borrower. The states with the largest portion of the commercial mortgage loan portfolio are listed below. Except for the following, holdings in no other state exceed 5% of the portfolio at December 31, 1997 and 1996:
Retail 38.8% 39.1% Warehouse 25.4 24.2 Office buildings 15.3 14.3 Apartment complex 14.9 14.6 Industrial 4.9 6.8 Other 0.7 1.0 ------ ------ 100.0% 100.0% ====== ======
In the normal course of business, the Company invests in various financial assets, incurs various financial liabilities and enters into agreements involving derivative financial instruments and other off-balance-sheet financial instruments. The fair value estimates of financial instruments presented below are not necessarily indicative of the amounts the Company might pay or receive in actual market transactions. Potential taxes and other transaction costs have not been considered in estimating fair value. The disclosures that follow do not reflect the fair value of the Company as a whole since a number of the Company's significant assets (including deferred acquisition costs and reinsurance recoverables) and liabilities (including reserve for life-contingent contract benefits and deferred income taxes) are not considered financial instruments and are not carried at fair value. Other assets and liabilities considered financial instruments, accrued investment income and cash are generally of a short-term nature. It is assumed that their carrying value approximates fair value.
Fair values for fixed income securities are based on quoted market prices where available. Non-quoted securities are valued based on discounted cash flows using current interest rates for similar securities. Mortgage loans are valued based on discounted contractual cash flows. Discount rates are selected using current rates at which similar loans would be made to borrowers with similar characteristics, using similar properties as collateral. Loans that exceed 100% loan-to-value are valued at the estimated fair value of the underlying collateral. Short-term investments are highly liquid investments with maturities of less than one year whose carrying value approximates fair value.
The carrying value of policy loans approximates its fair value. Separate Accounts assets are carried in the statements of financial position at fair value.
Derivative financial instruments The Company primarily uses derivative financial instruments to reduce its exposure to market risk, specifically interest rate risk, in conjunction with asset/liability management. The Company does not hold or issue these instruments for trading purposes.
Off-balance-sheet financial instruments Commitments to extend mortgage loans are agreements to lend to a borrower provided there is no violation of any condition established in the contract. The Company enters these agreements to commit to future loan fundings at a predetermined interest rate. Commitments generally have fixed expiration dates or other termination clauses. Commitments to extend mortgage loans, which are secured by the underlying properties, are valued based on estimates of fees charged by other institutions to make similar commitments to similar borrowers. At December 31, 1997 and 1996, the Company had $18,000 and $6,190 in mortgage loan commitments which had a fair value of $180 and $62, respectively.
The Company joins the Corporation and its other eligible domestic subsidiaries in the filing of a consolidated federal income tax return (the "Allstate Group") and is party to a federal income tax allocation agreement (the "Tax Sharing Agreement"). Under the Tax Sharing Agreement, the Company paid to or received from the Corporation the amount, if any, by which the Allstate Group's federal income tax liability was affected by virtue of inclusion of the Company in the consolidated federal income tax return. Effectively, this results in the Company's annual income tax provision being computed, with adjustments, as if the Company filed a separate return.
Prior to the Distribution, the Corporation and all of its eligible domestic subsidiaries, including the Company, joined with Sears and its domestic business units (the "Sears Group") in the filing of a consolidated federal income tax return (the "Sears Tax Group") and were parties to a federal income tax allocation agreement (the "Sears Tax Sharing Agreement"). Under the Sears Tax Sharing Agreement, the Company, through the Corporation, paid to or received from the Sears Group the amount, if any, by which the Sears Tax Group's federal income tax liability was affected by virtue of inclusion of the Company in the consolidated federal income tax return. Effectively, this resulted in the Company's annual income tax provision being computed as if the Allstate Group filed a separate consolidated return, except that items such as net operating losses, capital losses or similar items, which might not be recognized in a separate return, were allocated according to the Sears Tax Sharing Agreement.
The Allstate Group and Sears Group have entered into an agreement which governs their respective rights and obligations with respect to federal income taxes for all periods prior to the Distribution ("Consolidated Tax Years"). The agreement provides that all Consolidated Tax Years will continue to be governed by the Sears Tax Sharing Agreement with respect to the Allstate Group's federal income tax liability.
The components of the deferred income tax assets and liabilities at December 31, are as follows:
Prior to January 1, 1984, the Company was entitled to exclude certain amounts from taxable income and accumulate such amounts in a "policyholder surplus" account. The balance in this account at December 31, 1997, approximately $389, will result in federal income taxes payable of $136 if distributed by the Company. No provision for taxes has been made as the Company has no plan to distribute amounts from this account. No further additions to the account are allowed under the Tax Reform Act of 1984.
Balance per generally accepted accounting principles $ 283,410 $ 233,067 Deferred acquisition costs (71,946) (61,559) Deferred income taxes 16,990 3,692 Unrealized gain/loss on fixed income securities (246,147) (122,628) Non-admitted assets (4,301) (2,739) Statutory reserves 207,163 115,725 Other postretirement and postemployment benefits 1,007 1,074 Other (1,556) (1,613) --------- --------- Balance per statutory accounting practices $ 184,620 $ 165,019 ========= =========
Permitted statutory accounting practices The Company prepares its statutory financial statements in accordance with accounting principles and practices prescribed or permitted by the New York Department of Insurance. Prescribed statutory accounting practices include a variety of publications of the National Association of Insurance Commissioners ("NAIC"), as well as state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. The Company does not follow any permitted statutory accounting practices that have a material effect on statutory surplus, statutory net income or risk-based capital.
Final approval of the NAIC's proposed "Comprehensive Guide" on statutory accounting principles is expected in early 1998. The requirements may be effective as early as January 1, 1999, and are not expected to have a material impact on statutory surplus of the Company.
ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK NOTES TO FINANCIAL STATEMENTS--(CONCLUDED) ($ IN THOUSANDS)
The Company's defined contribution to the Allstate Plan was $164 and $111 in 1997 and 1996, respectively.
Premiums and contract charges: Life and annuities $ 116,167 $ 2,185 $ 113,982 Accident and health 5,846 864 4,982 ----------- ----------- ----------- $ 122,013 $ 3,049 $ 118,964 =========== =========== ===========
Life insurance in force $ 9,962,300 $ 553,628 $ 9,408,672 =========== =========== ===========
Premiums and contract charges: $ 114,296 $ 1,398 $ 112,898 Life and annuities 5,044 834 4,210 Accident and health ----------- ----------- ----------- $ 119,340 $ 2,232 $ 117,108 =========== =========== ===========
Premiums and contract charges: Life and annuities $ 146,732 $ 1,246 $ 145,486 Accident and health 3,731 901 2,830 ----------- ----------- ----------- $ 150,463 $ 2,147 $ 148,316 =========== =========== ===========
Schedule IV - Reinsurance page Schedule V - Valuation and Qualifying Accounts page
By /s/ LOUIS G. LOWER, II ---------------------- Louis G. Lower, II President and Chairman (Principal Executive Officer)
By */s/ KEVIN R. SLAWIN ---------------------- Kevin R. Slawin Vice President and Director
By */s/ KEITH A. HAUSCHILDT ------------------------ Keith A. Hauschildt Assistant Vice President and Controller (Chief Accounting Officer)