In October 2002, we entered into a lease agreement for office space in Duluth, Georgia. The initial lease term, as amended, is twenty-four months, with the option to extend the term an additional thirty-nine months, expiring in January 2008. Payments under this lease are $122,177 annually through October 2004. The lease payments are subject to an annual increase of approximately 3%. We do not own or lease any other properties.
Although our reinsurance business is directed to us through these independent agent relationships, the life insurance and annuity policies that we currently reinsure are underwritten and issued by various ceding life companies. In the insurance industry, the term “ceding” refers to the use of reinsurance to transfer from one insurance company to another some or all of the risks associated with one or more insurance policies. We often refer to a life insurance company that reinsures life insurance and annuity policies through us as a “ceding life company.” The strength of our current reinsurance business is based on our historical relationship with the independent agents of World Financial Group, which is an indirect subsidiary of AEGON USA, Inc. and an IMO that markets the products we currently reinsure.
The ceding life companies retain responsibility for the payment of all claims, surrender values, commissions, and expenses involved in issuing and maintaining the policies we reinsure. In addition, the ceding life companies administer the reinsurance contracts and, on a monthly and quarterly basis, provide
us with information regarding premiums, reserves and benefits and the amounts we owe to the ceding life company for claims and settlement expenses on the policies we reinsure.
Renewable Term. Renewable term, also referred to as risk premium reinsurance, which includes monthly renewable term and yearly renewable term, is a plan of reinsurance in which the premium rates are not directly related to the premium rates on the original plan of insurance. Under renewable term reinsurance, the ceding life company reinsures a portion of the mortality risk with us. The amount reinsured in any one period is not based on the face amount of the policy, but rather on the portion of the net amount at risk we reinsure. The net amount at risk is typically defined as the difference between the death benefit and the cash value of a policy. The ceding life company establishes the policy reserves, which are reduced for the mortality risk reinsured with us, and pays all policy benefits, commissions and expenses involved in issuing and maintaining the business. Correspondingly, we establish reserves specific to the mortality risk reinsured.
Under renewable term reinsurance, we may also be subject to the effects of persistency risk. Persistency risk is the risk that a policyholder either stops paying premiums, which would cause the policy to lapse, or chooses to surrender the policy for the cash surrender value. The effect of persistency risk on us is that possible future revenue will be reduced, potentially reducing profits.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions regarding uncertainties that affect certain amounts in the consolidated financial statements and related footnotes. Accounts that we deem to be sensitive to changes in estimates include deferred acquisition costs and future policy benefits. In all instances, actual results could differ from estimates. A summary of significant accounting policies is included in Note 2 to the Consolidated Financial Statements.
Reinsurance Revenues. For renewable term reinsurance, we record as “premiums” the amount of reinsurance premiums we receive over the payment periods of the reinsured policies. For policies reinsured on a coinsurance or modified coinsurance basis, we record as “reinsured policy revenues” our proportionate share of the gross revenues received by the ceding life company over the payment periods of the reinsured
Upon election to convert certain reinsured policies from a renewable term basis to a coinsurance or modified coinsurance basis, the associated premium revenues for those policies will discontinue, and our proportionate share of the associated mortality and expense charges, asset based allowances and deferred sales charges will be recorded as reinsured policy revenues.
change in assumptions used with regard to future experience, the amortization of the deferred acquisition cost will be recalculated and reflected during the then current accounting period.
The life insurance and annuity policies that we have reinsured to date are underwritten and issued by Western Reserve, American Skandia, Kemper, and Pacific Life. The following table indicates the percentage of our reinsurance revenues derived from our ceding life companies:
Under our reinsurance agreements with the ceding life companies, we currently reinsure variable life insurance and variable annuity policies on either a renewable term basis or a coinsurance and modified coinsurance basis. The policies we reinsure on a renewable term basis represented 58% of our reinsurance revenues for the year ended December 31, 2003. The policies we reinsure on a coinsurance and modified coinsurance basis represented 42% of our reinsurance revenues for the same period. Of the 42%, 25% relates to variable life insurance policies and 17% relates to variable annuity policies.
Following World Financial Group’s purchase of certain assets of WMA Agency in June 2001, we entered into certain agreements with Western Reserve that provides us a first right to reinsure certain new products issued by Western Reserve or its U.S. affiliates that are sold by agents associated with World Financial Group. Concurrently, we entered into a best efforts agreement with World Financial Group in July 2001 to help us attain the opportunity to reinsure all insurance products sold by its agents for insurance companies other than Western Reserve and Western Reserve’s affiliates. Refer to Note 5 to the Consolidated Financial Statements for further discussion.
Premiums. Premiums decreased $584,000, or 3%, from $18.0 million for the year ended December 31, 2002 to $17.4 million for the same period in 2003. The majority of the premium decrease was due to the decreasing business in force under our renewable term agreements, which is partially offset by an increase in the average premium per policy. Policies in force are decreasing because the number of policy surrenders and lapses currently exceeds the number of new policies reinsured. Average premiums per policy increase as the insured grows older.
Net realized gain on investments decreased $406,000, from $428,000 for the year ended December 31, 2002 to $21,000 for the same period in 2003. The decrease was due to the sale of $9.9 million of fixed maturity securities in 2002 as compared to sales of only $421,000 of securities in 2003. Net realized gains are caused by a decline in market yields, which resulted in an increase in the fair value of the fixed maturity securities in our portfolio.
Benefits, Claims and Settlement Expenses. Benefits, claims, and settlement expenses increased $840,000, or 10%, from $8.4 million for the year ended December 31, 2002 to $9.3 million for the same period in 2003. The increase was primarily associated with a lower incidence of life insurance death claims in 2002 compared to the incidence of death claims in 2003, an increase in the average death claim size, and the increasing age of the policies reinsured, partially offset by a decline in the aggregate face value of insurance. The aggregate face value of insurance underlying the polices we reinsured at December 31, 2002 was $8.5 billion compared to $7.6 billion at December 31, 2003.
Amortization of Deferred Acquisition Costs. Amortization of deferred acquisition costs decreased $1.5 million, or 21%, from $7.0 million for the year ended December 31, 2002 to $5.5 million for the same period in 2003. The decrease in amortization primarily resulted from additional amortization in 2002 due to the then higher than expected surrender experience, including “unlocking” our near term surrender assumptions to reflect the increase in our surrender experience (akin to industry-wide surrender experience).
Under current assumptions, and all else being equal, we do not expect that there would be increased amortization in 2004 from “unlocking” due to lower than expected equity market performance unless separate account fund yields were to decline by 20% or more in 2004.
In accordance with Statements of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes, we have $2.4 million of net operating loss carryforwards, which begin to expire in 2018. These net operating loss carryforwards at a 34% effective tax rate are included as an offset to the deferred tax liability. It is our belief that it is more likely than not that the deferred tax assets will be realized as an offset against future taxable income, however, if we do not have sufficient taxable income in the future to utilize this asset, a write-off may result, thereby reducing our net income.
Premiums. Premiums decreased $1.2 million, or 6%, from $19.2 million for the year ended December 31, 2001 to $18.0 million for the comparable period in 2002. The majority of this decrease was due to the conversion of all Western Reserve Financial Freedom Builder variable universal life policies and riders, issued from April 1, 2001 through December 31, 2001, which had been reinsured by us on a monthly renewable term basis, to a coinsurance and modified coinsurance basis, effective January 1, 2002.
Reinsurance Expense Allowances, Net. Net reinsurance expense allowances increased $17,000, or less than 1%, for the year ended December 31, 2001 compared to the same period in 2002. These amounts are reflective of the increase in business in force primarily attributable to the amendments to our reinsurance agreements effective January 1, 2002, offset by the decrease in business in force due to lapse and surrender activity.
Under current assumptions, and all else being equal, if separate account fund yields exceed 5% for 2003, we do not expect that there would be increased amortization in 2003 from “unlocking” due to lower than expected equity market performance. If separate account fund yields are 0% for 2003 we would expect additional amortization of approximately $500,000 for 2003 from “unlocking” due to lower than expected equity market performance.
Interest Expense. Interest expense increased $2,000, or less than 1%, from $378,000, for the year ended December 31, 2001 to $380,000 for the comparable period in 2002. The increase was due to the interest associated with the $7.2 million settlement paid to Western Reserve on April 2, 2002 to fund the reinsurance amendments that were effective January 1, 2002.
The following table presents certain unaudited quarterly consolidated statements of income data for the eight-quarter period ended December 31, 2003, as well as the percentage of total revenue represented by each item. The information has been derived from the unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on substantially the same basis as the audited consolidated financial statements contained herein and all adjustments, consisting only of normal recurring adjustments, which we consider to be necessary to present fairly this information when read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere herein. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.
The following table summarizes the fair value of our invested assets at the dates indicated.
Our primary sources of liquidity were $15.3 million in fixed maturity securities available for sale, $11.6 million in consolidated cash and cash equivalents, and $2.5 million of equity securities at December 31, 2003. The effective duration of our fixed maturity portfolio is 3.3 years with 100% of the fixed maturity securities having an effective maturity of less than 10 years. Our fixed maturity portfolio represents 50% of our total invested assets, and has an average Moody’s quality rating of Aa3. We have gross unrealized losses of $16,000 and gross unrealized gains of $217,000 on our fixed maturity and equity securities as of December 31, 2003. For additional information pertaining to our investments, refer to Note 3 to the Consolidated Financial Statements.
Operating Cash Flows. Under the renewable term reinsurance agreements, premiums typically vary in proportion with the expected mortality claims reinsured. Our cash inflows under the renewable term agreements are premiums for the mortality risk reinsured. Our cash outflows are reinsurance expense allowances and death benefit claims. The reinsurance expense allowances represent our share of acquisition and maintenance expenses incurred by the ceding life company that are attributable to the risks reinsured by us.
Under the coinsurance and modified coinsurance agreements, since we are reinsuring risks on essentially the same basis as that of the original policy, reinsurance premiums are materially greater than premiums received on the renewable term reinsurance. During the first year in which a policy is reinsured on a coinsurance basis, we are required to reimburse the ceding life company for our share of acquisition costs, including first year commissions and issuance expenses. Thereafter, we reimburse the ceding life company for our share of renewal commissions and maintenance expenses. Further, under modified coinsurance, the ceding life company does not transfer the reserves or the invested assets related to reserves in support of reinsured policy benefits (e.g., cash values). Accordingly, because of the type of reinsurance and the basis reinsured, the net first year cash outlays could be as much as, or more than, that year’s premiums paid for variable universal life insurance, and as much as 10% of variable annuity premiums. After the first policy year, our cash outlays for reinsurance allowances are significantly lower.
by operations for policies previously in force under coinsurance and modified coinsurance and by all policies reinsured under renewable term reinsurance of $12.0 million. Other cash flows used in operating activities of $1.0 million in 2003 were the result of cash payments for operating expenses and interest expenses.
Net cash flows provided by (used in) investing activities were ($6.2 million), $9.3 million and ($15.0 million) for the years ended December 31, 2001, 2002 and 2003, respectively. The cash flows used in investing activities of $15.0 million in 2003 primarily related to our purchase of $14.3 million of fixed maturity securities and $2.5 million of equity securities. The cash flows provided by investing activities of $9.3 million in 2002 were the primarily the result of $10.5 million of proceeds generated from the sale and maturity of available for sale securities. The cash flows used in investing activities of $6.2 million in 2001 primarily related to our purchase of $8.1 million of fixed maturity securities. We have incurred no significant capital expenditures during 2003.
common stock. The registration statement was withdrawn due to unfavorable market conditions. Cash flows used in financing activities resulted in $1.7 million of deferred offering costs expenses in 2002, offset by $577,000 of cash paid for deferred offering costs in 2001, which had been previously recorded as prepaid expenses on the consolidated balance sheet. Cash flows used in financing activities in 2001 related to principal payments on the Money Services line of credit, dividends paid on our preferred stock and cash paid for deferred offering costs which had been recorded as prepaid expenses.
Restrictions. Global Preferred Holdings, Inc. is a holding company with no direct operations, and whose principal assets are the capital stock of its subsidiaries and $4.0 million of cash and invested assets, as of December 31, 2003. Global Preferred Holdings, Inc. relies primarily on funds retained at the holding company level, debt service on amounts loaned to Global Preferred Re, management service fees from its subsidiaries and potential dividends from Global Preferred Re to meet ongoing cash requirements. The ability of Global Preferred Re to pay dividends to Global Preferred Holdings is subject to, among other things, regulatory restrictions under the insurance laws of Bermuda, which are discussed in Note 9 to the Consolidated Financial Statements. As of December 31, 2003, Global Preferred Re had total statutory capital and surplus of $22.6 million, which includes up to $7.4 million available to distribute in dividends without seeking regulatory approval. During the year ended December 31, 2003, Global Preferred Re paid no dividends to Global Preferred Holdings, Inc.
Under our reinsurance agreements, we are required to provide security through a letter of credit for the benefit of the ceding life companies. We have three letters of credit issued by Comerica Bank, our custodian, for the benefit of Western Reserve, Pacific Life and Kemper, in the amounts of $5.5 million, $50,000 and $300,000, respectively. We assess our letter of credit needs in support of each reinsurance agreement. If determined to be necessary, we will undertake to develop facilities for future letters of credit and trust arrangements in support of additional reinsurance agreements.
We have no obligations, assets or liabilities other than those disclosed in our financial statements, no trading activities involving non-exchange traded contracts accounted for at fair value, and no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.
Extent to which we are able to develop new reinsurance programs;
Consolidated Statements of Income for the years ended December 31, 2001, 2002 and 2003