In 2001 and 2002, the general economic recession caused a severe deterioration in many investment grade companies such as Owens Corning, Pacific Gas and Electric, Southern California Edison and US Airways. While some actually went bankrupt, many others lost their investment grade debt ratings with resulting market declines. The Insurance Company’s investment portfolio realized losses from sales and from recognition of other than temporary impairment charges, with the result that net losses were encountered in 2001 and 2002. In 2001, these losses were $65.1 million with an increase to a loss of $146.7 million in 2002. A corollary impact of these was that capital ratios were adversely affected in both years. In 2003, recoveries in the market values were experienced, which resulted in the Corporation achieving record high levels of capital and improved capital ratios.
As described under “Ratings” and “Regulation,” the Corporation’s business is substantially affected by such capital ratios and their impact on its ratings. Consequently, the Insurance Company’s management established a policy of reducing the level of sales increases until capital and surplus ratios are further improved. Sales are also being made with a greater selectivity based on increased profit level requirements for new business. The Insurance Company has determined that the level of competition in the sale of traditional and universal life insurance products has made it very difficult for smaller insurance companies, such as the Insurance Company, to participate in this business in a profitable way. Accordingly, the Insurance Company has determined that, under the current market conditions, it will not participate in the sale of traditional and universal life policies.
Unless specifically stated otherwise, all references to 2005, 2004 and 2003 refer to our fiscal years ended, or the dates, as the context requires, December 31, 2005, December 31, 2004 and December 31, 2003, respectively.
Market Conditions: The Corporation, like all companies, is affected by the general state of financial markets and economic conditions in the U.S. and elsewhere. Despite certain recent improvements in business conditions, the business environment in recent years has been difficult and the ability to obtain desired returns on the investment portfolio without exposing the Corporation to excess risk has been challenging. This, in turn, has had an impact on our willingness to expand sales of our single premium annuity products.
Operational Risk: Business is dependent on our ability to process, on a daily basis, our payment obligations under outstanding policies and the condition of the investment portfolio. Any internal failures in the internal processes, people, or systems could lead to adverse consequences to the Corporation. In addition, despite the contingency plans in place, the ability to conduct business may be adversely impacted by the disruption in the infrastructure that supports our business and the community in which we are located.
Management believes that the Insurance Company is able to offer its products at competitive prices to its targeted markets as a result of: (i) maintaining relatively low issuance costs by selling through the independent general agency system; (ii) minimizing home office administrative costs; and (iii) utilizing appropriate underwriting guidelines.
Net investment income divided by average cash and total invested assets minus net investment income.
The reduction in the net investment income ratios from 2001 to 2003 was attributable to the low interest rate environment and overall economic conditions, which led to defaults or write-downs within the Company’s investment portfolio. During periods of declining interest rates, paydowns on mortgage-backed securities with higher interest rates and callable debt securities increased. During such periods, the Insurance Company will likely not be able to reinvest the proceeds at comparable yields. A general improvement in market conditions and an increase in net investment income were the primary factors in the 2003 to 2004 increase, while the rebalancing of the portfolio into lower yield, short-term investments caused a decrease in the net investment income ratio in 2005. (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset /Liability Management.”)
The Insurance Company manages its investment portfolio to meet the diversification, yield and liquidity requirements of its insurance policy and annuity contract obligations. The Insurance Company's liquidity requirements are monitored regularly so that cash flow needs are satisfied. Adjustments periodically are made to the Insurance Company's investment policies to reflect changes in the Insurance Company's short-and long-term cash needs, as well as changing business and economic conditions.
The Insurance Company seeks to manage its investment portfolio in part to reduce its exposure to interest rate fluctuations. In general, the market value of our fixed maturity portfolio increases or decreases in an inverse relationship with fluctuations in interest rates, and our net investment income increases or decreases in direct relationship with interest rate changes. For example, if interest rates decline, the Insurance Company's fixed maturity investments generally will increase in market value, while net investment income will decrease as fixed income investments mature or are sold and proceeds are reinvested at the declining rates, and vice versa. Management is aware that prevailing market interest rates frequently shift and, accordingly, has adopted strategies that are designed to address either an increase or decrease in prevailing rates. These strategies included the investments in Payor Swaptions, described below.
The Insurance Company¢s principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. Management evaluates whether other than temporary impairments have occurred on a case-by-case basis. Inherent in management¢s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by the Insurance Company in the other than temporary impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has a catastrophic type of loss or has exhausted natural resources; (vi) consistency with accounting treatment applicable to other similarly situated investments; and (vii) other subjective factors, including concentrations and information obtained from regulators and rating agencies. In addition, the earnings on certain investments are dependent upon market conditions, which could result in prepayments and changes in amounts to be earned due to changing interest rates or equity markets. The determination of fair values in the absence of quoted market values is based on valuation methodologies, securities the Insurance Company deems to be comparable and assumptions deemed appropriate given the circumstances. There can be no assurance that the assumptions relied upon by the Insurance Company will yield accurate assessments of the fair value of these investments. As such, the Insurance Company reassesses its assumptions regularly.
The primary market risks in the Insurance Company’s investment portfolio are interest rate risk (discussed above), credit risk and, to a lesser degree, equity price risk. Changes in credit risk are generally measured by changes in corporate yields in relation to the underlying Treasuries (“corporate spreads”) as well as changes in the Credit Default Swap (“CDS”) market. The Insurance Company's exposure to foreign exchange risk is insignificant. The Insurance Company has no direct commodity risk. Changes in interest rates can potentially impact the Corporation’s profitability. In certain scenarios where interest rates are volatile, the Insurance Company could be exposed to disintermediation risk (asset/liability mismatch) and reduction in net interest rate spread or profit margin. [See “Interest Rate Risk” above.]
U.S. Treasury Obligations and Direct Obligations of U.S. Agencies: The unrealized loss on U.S. Treasuries and U.S. Agencies, totaling $ 4.845 million or 1.55% of cost at December 31, 2005, reflects a loss of market value of these fixed rate investments due to an overall increase in interest rates during the year. Because the Company has the ability and intent to hold these securities until maturity and due to the fact that these securities generally carry Aaa ratings by Moody’s and AAA by Standard and Poor’s, the Company does not consider these securities to be other than temporarily impaired.
Common Stocks: The Company had $524,000 of losses at December 31, 2005, none of which individually exceeded $500,000 and 10% of book value. Most of these equities have readily available markets, trading on national stock exchanges, including the New York Stock Exchange and NASDAQ.
The Insurance Company prepares its statutory financial statements in accordance with accounting practices prescribed by the New York State Insurance Department. Prescribed SAP include state laws, regulations and general administrative rules, as well as a variety of publications from the NAIC. Accounting principles used to prepare statutory financial statements differ from financial statements prepared on the basis of GAAP.
A reconciliation of the Insurance Company’s shareholders’ equity as filed with regulatory authorities to shareholders’ equity reported in the accompanying financial statements as of December 31 follows:
In February 2006, A.M. Best Company reaffirmed the Insurance Company’s rating at “B+” (Very Good) with a stable outlook.
In May 2004, Moody's Investor Services (“Moody's”) lowered the Insurance Company's insurance financial strength rating from Ba1 (“Questionable financial security”) to Ba2 (“Questionable financial security”). In May 2004, Moody’s lowered its rating on the Corporation’s Senior Notes from B1 (“Poor financial security”) to B2 (“Poor financial security”), but raised the outlook on the rating from negative to stable. In June 2005, Standard & Poor's Corporation (“Standard & Poor's”) lowered the Insurance Company's insurance financial strength rating from a BB+, which is defined as “less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions” to a BB- which is defined as “a vulnerability to the broad array of risks that are embedded in its investment and operational profile.” In June 2005, Standard & Poors lowered the credit rating of the Senior Notes from a B+ (more vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial requirements) to a B- (weak financial security, adverse business conditions will likely impair its ability to meet financial commitments) but raised the Credit Watch rating from negative to stable.
Total annuity considerations and life insurance premiums decreased to approximately $39.1 million in fiscal 2005 from approximately $40.4 million in fiscal 2004, a decrease of approximately 3.1% and decreased from approximately $43.6 million in fiscal 2003 to $40.4 million in fiscal 2004, a decrease of approximately 7.3%. Annuity considerations decreased to approximately $27.4 million in fiscal 2005 from approximately $28.4 million in fiscal 2004, a decrease of approximately $1.0 million and from approximately $32.6 million in 2003 to $28.4 million in fiscal 2004, a decrease of $4.2 million. Life insurance premiums were $11.8 million, $12.1 million and $11 million in 2005, 2004 and 2003 respectively. These amounts do not include consideration from the sales of deferred annuities or immediate annuities without life contingencies. Under GAAP, such sales are reported as additions to policyholder account balances. Consideration from sales of single premium annuities were approximately $156.9 million, $248.8 million and $243.1 million in fiscal 2005, 2004 and 2003, respectively. The 2005 decrease was primarily attributable to management’s decision to reduce sales in order to conserve capital and improve the company’s capital and surplus ratios.
Universal life and investment type policy fee income was approximately $2.9 million in fiscal 2005, $2.9 million in 2004 and approximately $1.0 million in fiscal 2003. The increased amounts of policy fee income in 2004 and 2005 were primarily the result of increased surrender charges collected by the Company during those years. Policy fee income consists principally of amounts assessed during the period against policyholders' account balances for mortality charges and surrender charges.
Net realized investment gains (pre-tax) amounted to $75.0 million in fiscal 2005, as compared to $15.3 million in fiscal 2004 and $10.3 million in fiscal 2003. The increase in 2005 was largely attributable to gains from the portfolio rebalancing activities. Net realized investment gains for years ended December 31, 2005, 2004 and 2003 include realized investment losses of approximately $10.3 million, $4.6 million, and $31.8 million, respectively, attributable to writedowns of certain securities contained in the Insurance Company's investment portfolio that were deemed by management to be other than temporarily impaired. For a discussion of the procedure by which such determinations were made, see “Investments” above. Realized investment gains (losses) also resulted from sales of certain equities and convertible securities and calls and sales of fixed maturity investments in the Company’s investment portfolio.
The interest expense on the Corporation's notes payable amounted to approximately $9.6 million in fiscal 2005, approximately $9.8 million in fiscal 2004 and approximately $9.6 million in fiscal 2003.
General expenses, taxes and commissions to agents totaled $25.0 million in fiscal 2005 as compared to $28.0 million in fiscal 2004 and $29.6 million in fiscal 2003. This represents a decrease of 8.9% comparing fiscal 2005 to fiscal 2004 and a decrease of 5.5% comparing fiscal 2004 to fiscal 2003. The decreases in both 2005 and 2004 were principally attributable to lower costs associated with lower commissions and selling expenses incurred associated with the lower level of sales of single premium annuities. The decreases were also attributable to a reduction in the Insurance Company’s general expenses due to expense controls initiated in 2003.
The change in the net DAC for the twelve months ended December 31, 2005 resulted in a charge of approximately $20.0 million, as compared to a charge of approximately $4.5 million and a credit of approximately $2.7 million for the twelve months ended December 31, 2004 and 2003, respectively. Changes in deferred policy acquisition costs consist of three elements: deferred costs associated with product sales, amortization of the DAC on deferred annuity business and amortization of the DAC on the remainder of the Company’s business. Deferred costs consisted of credits of $8.4 million, $11.4 million and $10.5 million for 2005, 2004 and 2003 respectively. Amortization of the DAC on deferred annuity business consisted of charges of $23.2 million, $11.0 million and $3.0 million in 2005, 2004 and 2003 respectively. Amortization of the DAC on the remainder of the Company’s business consisted of charges of $5.2 million, $4.9 million and $4.8 million in 2005, 2004 and 2003 respectively.
For the reasons discussed above, income (loss) before income taxes amounted to approximately $148.2 million in fiscal 2005, as compared to approximately $100.0 million in fiscal 2004 and approximately $60.2 million in fiscal 2003.
Income tax expense was approximately $56.6 million for fiscal 2005, as compared to an expense of approximately $34.1 million for fiscal 2004 and approximately $22.0 million in fiscal 2003. The increase in income taxes in fiscal 2005 was primarily attributable to an increase in net investment gains as compared to 2004. The increase in 2004 from 2003 was primarily attributable to an increase in investment income.
For the reasons discussed above, the Corporation had net income of approximately $91.6 million in fiscal 2005, as compared to net income of approximately $66.0 million in fiscal 2004 and a net income of approximately $38.3 million in fiscal 2003.
We believe that a portfolio composed principally of fixed-rate investments that generate predictable rates of return should back our fixed-rate liabilities. We do not have a specific target rate of return. Instead, our rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, and general economic conditions. Our portfolio strategy is designed to achieve adequate risk-adjusted returns consistent with our investment objectives of effective asset-liability matching, liquidity and safety.
In order to maintain consistency in our portfolio, our deferred annuity products incorporate surrender charges to discourage surrenders or withdrawals. Annuitants may not terminate or withdraw funds from their annuity contracts for a significant initial period (generally seven years) without incurring substantial penalties in the form of surrender charges. These surrender charges generally range from 1% to 7% of the investment. Approximately 33.5%, 25.4% and 25.1% of the Insurance Company's deferred annuity contracts in force (measured by reserves) as of December 31, 2005, 2004, and 2003 were surrenderable without charge.
A persistent concern of the Insurance Company’s management is maintaining the appropriate balance between the duration of its invested assets and the duration of its contractual liabilities to its annuity holders and credit suppliers. In the past, the Insurance Company had permitted the duration gap between its assets and liabilities to rise during a period in which it expected relatively stable interest rates and, most importantly, in which its liabilities were largely protected by significant annuity surrender charges. This strategy benefited the Company by allowing it to realize enhanced yield from longer duration assets. At the end of 2004, the Insurance Company determined that the prospect of rising rates and declining surrender charges necessitated a reduction in the duration mismatch, as well as increased management of extension risk in its investment portfolio. The Company developed a two-step duration reduction strategy, which involved the sale of certain longer duration assets that were purchased at prices below current market prices and reinvestment in shorter duration assets. Since December 31, 2004, the Company has completed in excess of $778.3 million of long duration sales and $778.3 million of shorter duration reinvestments.
In July 2005, Presidential Life entered into a series of Payor Swaption investments designed to protect the Company against an instantaneous rise in interest rates of 300 basis points, as required by the New York State Insurance Department. Six contracts against the 10-year swap rate were executed with one dealer and three banks at a total cost of $19,430,625. The Company has established ISDA Credit Support Agreements with the four counterparties. Three of the counterparties have ratings higher than Aa3/AA- by Moody’s and S&P, respectively, and one counterparty carries an A1/A+ rating. These contracts expire in July 2006, July 2007 and July 2008 at varying strike rates based on the 10-year swap rate. The Company has determined that the Payor Swaptions represent a “non-qualified hedge” and has adopted accounting procedures consistent with the provisions of SFAS 133. The aggregate market value of the Payor Swaptions as of December 31, 2005 was $18,995,861. These investments are classified on the balance sheet as “Derivative instruments”. Under SFAS 133, the value of the Payor Swaptions is recognized at “fair value” (market value), with the resulting change in fair value reflected in the income statement as a realized gain or loss. The change in market value since purchase was a loss of $434,764. The Company has determined that the average fair value for the period that the Company has held these Swaptions (based upon weekly market values from July 31, 2005 to December 31, 2005) was $21,601,386.
(1) These liabilities are reflected within “Policyholder Liabilities” in the consolidated balance sheet, and amount to $974.7 Million as of December 31, 2005. The difference between the recorded liability and the total payment amount is $906.7 Million and is comprised of (i) future interest to be credited and (ii) the effect of mortality discount for those payments that are life contingent. Most of the remaining policyholder liabilities ($2,816.4 Million) involve deferred annuity contracts, which are contractually surrenderable at any time. Approximately 67% of these obligations have surrender penalties. These surrender charges, along with those contracts that involve contractual maturities, help to mitigate the asset/liability management process. (See discussion under Liquidity and Capital Resources Section.)
In a rising interest rate environment, the Insurance Company's average cost of funds would be expected to increase over time, as it prices its new and renewing annuities to maintain a generally competitive market rate. In addition, the market value of the Insurance Company's fixed maturity portfolio would be expected to decrease, resulting in a decline in shareholders' equity. Concurrently, the Insurance Company would attempt to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities associated with such annuities. Moreover, surrenders of its outstanding annuities would likely accelerate. Management believes that liquidity necessary in such an interest rate environment to fund withdrawals, including surrenders, would be available through income, cash flow, the Insurance Company's cash reserves and, if necessary, proceeds from the cash surrender of the Payor Swaption investments described above and the sale of short-term and long-term investments.
purchasers of the Insurance Company's products until the Insurance Company increases the rates credited to holders of its annuity products. In contrast, as interest rates fall, we would attempt to lower our credited rates to compensate for the corresponding decline in net investment income. As a result, changes in interest rates could materially adversely affect the financial condition and results of operations of the Insurance Company depending on the attractiveness of alternative investments available to the Insurance Company's customers. In that regard, in the current interest rate environment, the Insurance Company has attempted to maintain it’s credited rates at competitive levels designed to discourage surrenders and also to be considered attractive to purchasers of new annuity products.
See Item O, “Notes to the Consolidated Financial Statements” for a full description of the new accounting pronouncements including the respective dates of adoption and the effects on the results of operations and financial condition.