We are a diversified insurance and financial services company. Chartered in 1905, we are headquartered in Galveston, Texas. We offer a broad spectrum of life, annuity, health, and property and casualty insurance products. We also offer mutual fund investments through our broker dealer subsidiary. We operate in all 50 states, the District of Columbia, Guam, American Samoa and Puerto Rico.
net premiums earned on individual term and whole life insurance, property and casualty insurance, credit insurance, health insurance and single premium immediate annuity products;
insurance and investment product fees and other income, including surrender charges, mortality and expense risk charges, primarily from variable life and annuity, deferred annuities, and universal life insurance policies, management fees and commissions from other investment products, and other administrative charges.
benefits provided to policyholders and contract holders and changes in reserves held for future benefits;
acquisition and operating expenses, including commissions, marketing expenses, policy and contract servicing costs, overhead and other general expenses that are not capitalized (shown net of deferrals);
“The Outlook” sections contain many forward-looking statements, particularly relating to our future financial performance. These forward-looking statements are estimates based on information currently available to us, are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and are subject to the precautionary statements set forth in the introduction to MD&A above. Actual results are likely to differ materially from those forecast by us, depending on the outcome of various factors.
Challenging Financial and Economic Environment: The current financial crisis that began in mid-2007 is having adverse economic and financial market consequences around the world. In spite of government efforts, economic indicators remain mixed. During 2009, these market conditions contributed to an other-than temporary impairment loss of $98.9 million in our $16.6 billion investment portfolio. While we expect to experience continued volatility in the valuation of our investments, we believe that the current credit environment also provides us with opportunities to invest in select asset classes and sectors that may enhance our investment performance over time because of our intent and ability to hold these securities to maturity. Our ability to do so is supported by our strong liquidity position, which cushions us from the need to liquidate securities with significant unrealized losses to meet cash obligations. Due to acquisitions and consolidations principally among financial institutions, we have experienced credit concentrations beyond our normal guidelines. However, we believe those concentrations are manageable as we work to rebalance our investment portfolio to manage risk and investment returns.
We believe that as expectations for global economic growth are lowered, factors such as consumer spending, business investment, the volatility and condition of the capital markets and inflation, will affect the business and economic environment and, in turn, impact the demand for the type of financial and insurance products we offer. Adverse changes in the economy could affect earnings negatively and have a material adverse effect on our business, results of operations and financial condition. However, we believe those risks are somewhat mitigated by our financial strength, active risk management and disciplined underwriting for all of our products. Our diverse product mix across multiple lines of business (life, annuity, health, property and casualty) is a key strength that will help us adapt to current economic times and give us the ability to serve the changing needs of our customer base. For example, recent fluctuations in the stock market have led investors to search for financial products that are insulated from the volatility of the markets. We are well positioned to serve the demand in this marketplace given our success with fixed annuity products. Also, through our conservative business approach, we believe we remain financially strong and we are committed to providing a steady and reliable source of financial protection for policyholders and investors alike.
Effective management of billions of dollars of invested assets and associated liabilities involving credited rates and, where applicable, financial hedging instruments (which are utilized as hedges of equity-indexed annuity sales), is crucial to our success in the annuity segment. Asset “disintermediation”, the risk of large outflows of cash at times when it is disadvantageous to us to dispose of invested assets, is a major risk associated with this segment. This risk is monitored and managed in the Asset Liability Management (“ALM”) Committee. The ALM Committee monitors asset disintermediation risk through the use of statistical measures such as duration and projected future cash flows based on large numbers of possible future interest environments and the use of modeling to identify potential risk areas. These techniques are designed to manage asset/liability cash flow and minimize potential losses.
Competitive Pressures: The life insurance industry remains highly competitive. Product development and product life cycles have shortened in many products, leading to more intense competition with respect to product features. In addition, several of the industry’s products can be quite homogeneous and subject to intense price competition. We believe that we possess sufficient scale, financial strength and flexibility to effectively compete in this market.
The annuity market is also highly competitive. In addition to aggressive annuity rates and new product features such as guaranteed living benefit riders, within the industry there is growing competition from other financial service firms. Insurers continue to evaluate their distribution channels and the way they deliver products to consumers. At this time, we have elected not to provide guaranteed living benefits as a part of our variable annuity products. While this may have impeded our ability to sell variable annuities in the short run, this strategy has given us an advantage in terms of profitability in the long run. We believe that these products were not adequately priced historically, and many of our competitors are facing the consequences of mispricing the product.
We believe that we will continue to be competitive in the life and annuity markets through our broad line of products, our distinct distribution channels, and our consistent high level of customer service. We continue to modify our products to meet customer needs and to expand our reach where we believe we can obtain profitable growth. Some of the steps we have taken to improve our competitive position in the market include:
We believe there will be a continuing shift in sales emphasis to utilizing the Internet, endorsed direct mail and innovative product/distribution combinations. Although our direct sales of life insurance products were lower in 2009, we remain committed to traditional life insurance products (term life and whole life) through our Internet and third-party marketing distribution channels.
We experienced a slight reduction in Medicare Supplement policies in-force in 2009 as the industry continued to move toward Medicare Advantage plans and Part D plans, which redirected much of our agents’ focus. We chose to remain committed to the traditional Medicare Supplement plans, which we consider to be viable for the long term. Sales of traditional products decreased during 2009; however, the trend of decreased sales reversed in 2007 and in 2008.
The number of hospital surgical health insurance policies in-force decreased in 2009. The decrease was mainly a result of rate increases. Profitability for our products is dependent on diligent management of policy premiums, relative to benefits paid, and rigid attention to underwriting the health risks of each policyholder. Maintaining adequate scale is a significant contributor to profitability as it allows us to negotiate better arrangements with healthcare providers, thus decreasing unit costs. We consider both new and existing health products on a case-by-case basis, in light of current market and regulatory environments, as well as management expectations.
We anticipate government involvement in healthcare to increase in the coming years, as it attempts to provide minimum coverage to all individuals. We believe that our focus on hospital surgical products may provide additional opportunities as individuals attempt to supplement that basic coverage.
Despite the challenging pricing environment, we expect to identify profitable opportunities through our strong distribution channels, expanding geographic coverage, target marketing effects and new product development. Through our multiple-line exclusive agents, we will continue to focus on increasing the percentage of clients that buy their home, auto, business, and life insurance from us. Introduction of new products, such as one targeted toward the young family market in 2007, has been a main driver for increased policy counts in homeowners and auto insurance. The integration of the Farm Family companies over the last nine years has allowed us to expand our geographic coverage into the Northeast and our product portfolio to include agribusiness and commercial insurance. Similarly, Farm Family has expanded its product portfolio to include additional personal line property and casualty products. We expect that our agribusiness product will continue to be a leading seller in the Northeast United States. Agribusiness sales in other states are expected to show steady growth.
We have identified the following estimates as critical in that they involve a high degree of judgment and are subject to a significant degree of variability:
Due to the inherent uncertainty when using assumptions and estimates, the effect of certain accounting policies under different conditions or assumptions could be different from those reported in the consolidated financial statements. We believe that the estimates used in our deferred acquisition cost calculations provide a representative example of how variations in assumptions and estimates would affect our business. Please see the sensitivity table in the Deferred Acquisition Costs section below for further information on how changes in assumptions and estimates would affect our business.
We incur significant costs in connection with acquiring insurance business, including commissions and certain other expenses. Such costs are generally deferred and amortized. The deferred costs are recorded as an asset commonly referred to as deferred policy acquisition costs (“DAC”). The DAC asset balance is subsequently charged to income (i.e., amortized) over the lives of the underlying contracts in relation to the anticipated emergence of premiums, gross margins, or gross profits, depending on the type of product.
Costs deferred on universal life, variable universal life, limited pay life and investment-type deferred annuity contracts are amortized as a level percentage of the present value of estimated gross profits. These gross profits are dependent principally upon revenues in excess of the amounts credited to policyholders, death benefits, surrender benefits and expenses to administer the business. Our estimates of future gross profits are influenced by our assumptions including mortality, investment return, expenses and persistency. These assumptions are developed based on our experience. We review and update our assumptions at least annually. Changes to these assumptions result in adjustments which increase or decrease DAC amortization (i.e., they are not “locked in”). Actual gross profits in a given reporting period can vary from our initial estimates resulting in an increase or decrease in the rate of amortization. We regularly evaluate the gross profits to determine if actual experience or other evidence suggests that earlier estimates should be revised. See the Life and Annuity Reserves discussion below for additional details.
DAC associated with acquisitions of certain blocks of in-force business is referred to as the present value of profits asset. Such DAC consists of the unamortized portion of the present value of profits asset as of the statement date. The initial present value of profits assets were determined based on the present value of projected earnings from the block(s) of business acquired as of the acquisition date. Subsequent to the acquisition date, the present value of profits asset is then amortized in proportion to premiums, gross profits, or gross margins from the acquired block of business.
DAC associated with property and casualty insurance business consist of commissions, underwriting and issue costs. These costs are amortized over the coverage period of the related policies in relation to premium revenue recognized.
We had a total DAC asset of approximately $1.33 billion and $1.48 billion at December 31, 2009 and 2008, respectively.
The following table displays the sensitivity of reasonably likely changes in assumptions included in the amortization of the DAC balance of our long-tail business as of December 31, 2009 (in thousands):
Liability for Future Policy Benefits and Policy Account Balances - For traditional life products, liabilities for future policy benefits have been calculated based on a net level premium method using estimated investment yields, withdrawals, mortality and other assumptions that were appropriate at the time that the policies were issued. Estimates used are based on our experience, adjusted with a provision for adverse deviation. Investment yields used for traditional life products range from 3.0% to 8.0% and vary by issue year. We review experience assumptions at least annually and compare them with our actual experience. When we determine that future expected experience differs such that the DAC asset is not recoverable and/or reserves are not sufficient to provide for policy benefits (after any applicable DAC has been written off), a loss event is recognized, as discussed below.
Interest assumptions used for future policy benefits on health policies are calculated using graded interest rates ranging from 3.5% to 8.0%. Morbidity and termination assumptions are based on our experience.
At least annually, we test the net benefit reserves (policy benefit reserves less DAC) established for life insurance products, including consideration of future expected premium payments, to determine whether they are adequate to provide for future policyholder benefit obligations. The testing process is referred to as “Loss Recognition” for traditional products or “Unlocking” for non-traditional products. The assumptions used to perform the tests are our current best-estimate assumptions as to policyholder mortality, persistency, company maintenance expenses and invested asset returns.
For non-traditional business, best-estimate assumptions are updated to reflect the observed changes based on experience studies and current economic conditions. We reflect the effect of such assumption changes in DAC and reserve balances accordingly. Due to the long-term nature of many of the liabilities, small changes in certain assumptions may cause large changes in the degree of reserve adequacy or DAC recoverability. In particular, changes in estimates of the future invested asset return assumption have a large effect on the degree of reserve adequacy.
For non-participating traditional life insurance policies, future policy benefits are calculated consistent with Accounting Standards Codification (“ASC”) 944-40 (formerly “FAS 60”), Accounting and Reporting by Insurance Enterprises, and are equal to the aggregate of the present value of expected future benefit payments and related expenses, less the present value of expected future net premiums. Assumptions as to mortality and persistency are based upon our experience, with provisions for adverse deviation, when the basis of the liability is established. Interest rates for the aggregate future policy benefit liabilities range from 3.0% to 8.0% and vary by issue year.
Annuity Reserving Methodology - We establish liabilities for amounts payable under annuity contracts including fixed payout annuities and deferred annuities. An immediate or payout annuity is an annuity contract in the benefit or “payout” phase. In a fixed payout annuity contract, the insurance company agrees, for a cash consideration, to make specified benefit payments for a fixed period, or for the duration of a designated life or lives. The cash consideration can be funded with a single payment, as is the case with single premium immediate annuities, or with a schedule of payments, as is the case with “limited pay” products.
Payout annuities with more than an insignificant amount of mortality risk are calculated consistent with guidance under ASC 940-40 for limited pay insurance contracts. Benefit and maintenance expense reserves are established by using assumptions reflecting our expectations, including an appropriate margin for adverse deviation. Payout annuities are reserved using standard industry mortality tables specified for statutory reporting and an interest rate of 5% for life annuities and 3% for shorter duration contracts, such as term certain payouts. If the resulting reserve would otherwise cause profits to be recognized at the issue date, additional reserves are established. The resulting recognition of profits would be gradual over the expected life of the contract.
Overview - We establish policy reserves and claims reserves for known policy-specific liabilities. Further, we establish liabilities for the payment of medical expenses, which have been incurred during the reporting period but have not yet been paid. Additionally, Incurred But Not Reported (“IBNR”) amounts are determined using actuarial standards of practice which look at the time elapsed between when a claim is first incurred and when the final payment has been made (a completion factor analysis).
As of year-end 2009 the Health total claim reserve and liability was $115.9 million, versus $112.8 million at year-end 2008.
Liability for Future Policy Benefits - Liabilities for future policy benefits have been calculated based on a net level premium method. Future policy benefits are calculated consistent with ASC 944-40 (formerly “FAS 60”) and are equal to the aggregate of the present value of expected future benefit payments, less the present value of expected future premiums. Morbidity and termination assumptions are based on our experience or published valuation tables when available and appropriate. Interest rates for the aggregate future policy benefit liabilities range from 3.5% to 8.0% and vary by issue year.
Reserves for IBNR - anticipated cost of claims incurred but not reported. IBNR reserves include a provision for potential development on case reserves, losses on claims currently closed which may reopen in the future and claims, which have been incurred but not yet, reported.
IBNR: IBNR reserves are estimated based on many variables, including historical statistical information, inflation, legal developments, economic conditions, and general trends in claim severity, frequency and other factors that could affect the adequacy of loss reserves.
Loss and premium data is aggregated by exposure class and by accident year (i.e., the year in which losses were incurred). IBNR reserves are calculated by projecting ultimate losses on each class of business and subtracting paid losses and case reserves. Unlike case reserves, IBNR is generally calculated at an aggregate level and cannot usually be directly identified as reserves for a particular loss or contract. Our overall reserve practice provides for ongoing claims evaluation and adjustment (if necessary) based on the development of related data and other relevant information pertaining to such claims. Adjustments in aggregate reserves, if any, are reflected in the operating results of the period during which such adjustments are made.
The evaluation process to determine recorded loss and loss adjustment expense reserves involves the collaboration of underwriting, claims and internal actuarial departments. The process also includes consultation with independent actuarial firms on an annual basis. Work performed by independent actuarial firms is an important part of our process of gaining reassurance that loss and loss adjustment expense reserves determined by our internal actuarial department sufficiently meet all present and future obligations arising out of all claims incurred as of year-end, both reported and unreported. Additionally, the independent actuarial firms complete the Statements of Actuarial Opinion at each year-end, required by state insurance regulators certifying that the recorded loss and loss adjustment expenses reserves appear reasonable.
Initial Expected Loss Ratio method: This method calculates an estimate of ultimate losses by applying an estimated loss ratio to an estimate of ultimate earned premium for each accident year. This method is appropriate for classes of business where the actual paid or reported loss experience is not yet mature enough to override initial expectations of the ultimate loss ratios.
Loss or Expense Development (Chain Ladder): This method uses actual loss or defense and cost containment expense data and the historical development profiles on older accident periods to project more recent, less developed periods to their ultimate position. This method is appropriate when there is a relatively stable pattern of loss and expense emergence and a relatively large number of reported claims.
Ratio of Paid Defense and Cost Containment Expense to Paid Loss Development: This method uses the ratio of paid defense and cost containment expense to paid loss data historical development profiles on older accident periods to project more recent, less developed periods to their ultimate position. In this method, an ultimate ratio of paid defense and cost containment expense to paid loss is selected for each accident period. The selected paid defense and cost containment expense to paid loss ratio is then applied to the selected ultimate loss for each accident period to estimate the ultimate defense and cost containment expense. Paid defense and cost containment expense is then subtracted from the ultimate defense and cost containment expense to calculate the unpaid defense and cost containment expense for that accident period.
No significant prospective changes in workers’ compensation laws that would significantly affect future payouts.
For non credit lines of business, our claims handling process is the most likely of those assumptions noted above to vary from the consistency we expect. This assumption was determined to most likely impact our reported results, financial position and liquidity, and we chose to measure the sensitivity to this assumption. The following table presents the range of likely scenarios related to a speed-up or slow-down of five days in the claims handling process and its subsequent impact on our estimate of gross loss reserves. Without certainty of future reporting patterns, we do not consider any change within the range displayed as more reasonably likely than any other.
The analysis of our Credit Insurance lines of business quantifies the estimated impact on gross loss reserves of a reasonably likely scenario of varying the ratio applied to the unearned premium to determine the IBNR reserves at December 31, 2009. IBNR reserving methodology for this line of business focuses primarily on the use of a ratio applied to the unearned premium for each Credit Insurance product. The selected ratios are based on historical loss and claim data. In our analysis, we varied this ratio by +/- 5% across all Credit Insurance products combined. The results of our analysis show an increase or decrease, respectively, in gross reserves across all accident years combined of approximately $6.7 million.
The weight given to a particular actuarial method is dependent upon the characteristics specific to each class of business, including the types of coverage and the expected claim-tail.
Credit business - For credit lines of business, the IBNR is estimated either by applying a selected ratio to the unearned premium reserve or by using the loss development methods described above.
Loss adjustment expenses - We estimate adjusting and other expense separately from loss reserves using the Calendar Year Paid-to-Paid method. Reserves for defense and cost containment expense are estimated separately from loss reserves, using either the Loss or Expense Development method or Ratio of Paid Defense and Cost Containment Expense to Paid Loss method.
Recoveries on our gross ultimate losses are determined using distributions of gross ultimate loss by layer of loss retention to estimate ceded IBNR as well as through the review of individual large claims. The most significant assumption we use is the average size of the individual losses for those claims that have occurred but have not yet been recorded by us. The reinsurance recoverable is based on what we believe are reasonable estimates and is disclosed separately in the consolidated financial statements. However, the ultimate amount of the reinsurance recoverable is not known until all losses are settled.
We manage counterparty risk by entering into agreements with reinsurers we generally consider to be highly rated. However, we do not require a specified minimum rating. We monitor the concentrations of the reinsurers and reduce the participation percentage of lower-rated companies when appropriate. We believe we currently have no reinsurance amounts with any significant risk of becoming unrecoverable due to reinsurer insolvency.
We maintain one open qualified defined benefit pension plan and one qualified defined benefit pension plan that is closed to new participants. In addition, we also sponsor three non-qualified defined benefit pension plans that restore benefits that would otherwise be curtailed by statutory limits on qualified plan benefits for certain key executives. We also provide certain health and life insurance benefits to qualified current and former employees.
The pension benefit and postretirement benefit obligations and related costs for all plans are calculated using actuarial concepts in accordance with the relevant GAAP pronouncements. Two key assumptions, the discount rate and the expected return on plan assets, are important elements of expense and/or liability measurement. We evaluate these key assumptions annually. Other assumptions involve demographic factors such as retirement age, mortality, turnover and rate of compensation increases.
We use a discount rate to determine the present value of future benefits on the measurement date. The guideline for setting this rate is a high-quality long-term corporate bond rate. A higher discount rate decreases the present value of benefit obligations and decreases pension expense. To determine the expected long-term rate of return on plan assets, a building-block method is used. The expected rate of return on each asset is broken down into three components: (1) inflation, (2) the real risk-free rate of return (i.e. the long-term estimate of future returns on default-free U.S. government securities), and (3) the risk premium for each asset class (i.e. the expected return in excess of the risk-free rate). Using this approach, the precise expected return derived will fluctuate somewhat from year to year; however, it is our policy to hold this long-term assumption relatively constant.
The assumptions used in the measurement of our pension benefit obligations for 2009 and 2008 are as follows:
Our accounting policy requires that a decline in the fair value of investment securities below their amortized cost basis be evaluated to determine if the decline is other-than-temporary. There are a number of assumptions and estimates inherent in evaluating impairments to determine if they are other-than-temporary including 1) our ability and intent to hold the investment for a period of time sufficient to allow for an anticipated recovery in value; 2) the expected recoverability of principal and interest; 3) the length of time and extent to which the fair value has been less than amortized cost for fixed income securities or less than cost for equity securities; 4) the financial condition, near-term and long-term prospects of the issue or issuer, including relevant industry conditions and trends and implications of rating agency actions and offering prices; and 5) the specific reasons that a security is in a significant unrealized loss position, including market conditions, which could affect liquidity.
Our effective tax rate is based on income, non-taxable and non-deductible items, statutory tax rates and tax planning opportunities available. Inherent in determining our annual tax rate are judgments regarding business plans, planning opportunities and expectations about future outcomes.
Our liability for income taxes includes the liability for unrecognized tax benefits, interest and penalties, which relate to tax years, still subject to review by the IRS or other taxing authorities. Audit periods remain open for review until the statute of limitations has passed. Generally, for tax years, which produce net operating losses, capital losses or tax credit carryforwards, or tax attributes, the statute of limitations does not close, to the extent of these tax attributes, until the expiration of the statute of limitations for the tax year in which they are fully utilized. The completion of review or the expiration of the statute of limitations for a given audit period could result in an adjustment to our liability for income taxes. The statute of limitations for the examination of federal income tax returns by the Internal Revenue Service for years 2005 to 2008 has either been extended or has not expired. In the opinion of management, all prior year deficiencies have been paid or adequate provisions have been made for any tax deficiencies that may be upheld.
The following is a discussion of our consolidated results of operations for the years ended December 31, 2009, 2008 and 2007 and should be read in conjunction with the Outlook section. For a discussion of our segment results, see Results of Operations and Related Information by Segment. The following table sets forth the consolidated results of operations (in thousands):
Consolidated revenues increased during 2009 compared to those in 2008 primarily due to:
Consolidated revenues declined in 2008 compared to those in 2007 primarily due to:
Investment losses realized during 2008, including $367.0 million in other-than-temporary impairment write-downs;
The declines were partially offset by other policy revenues arising primarily from mortality charges and fees on the in-force block of universal life policies 2008 witnessed a continuation of increased sales of universal life products experienced in 2007.
Consolidated benefits and expenses increased for the year ended December 31, 2009, compared to the same period in 2008 primarily due to:
Increased policy benefits in annuities due to strong single premium immediate annuity sales resulting in an increase of the related reserve balance;
Consolidated benefits and expenses increased for the year ended December 31, 2008, compared to the same period in 2007, primarily due to:
The impact of increased catastrophe losses in our Property and Casualty business; and
Additional operating expenses incurred due to non-recurring litigation costs and costs for preparing for compliance with SEC and Sarbanes-Oxley requirements.
An increase in benefits paid on the growing block of annuity business.
Overall, 2008 earnings decreased compared to 2007. The decrease in earnings primarily resulted from certain non-recurring expenses, an increase in the benefit to revenue ratio, a decrease in net investment income, and the declining credit market. The non-recurring expenses related to lawsuit settlements and initial SEC registration expenses and implementation costs related to Sarbanes-Oxley compliance. The life benefits to revenue ratio increased from 49.6% for 2007 to 52.3% for 2008. An unexpected sales increase of higher issue age policies in 2007 resulted from one plan that was very competitively price at those higher ages. During 2008, we implemented a re-pricing of lifetime guarantee universal life plans to include increases in premiums at the higher issue ages to be more conservatively priced. Also, the declining credit market indirectly caused the loss of funding for a sizable number of life policies that were using a low-interest bank loan program to reduce the net insurance cost of the policies. The source of funding for a portion of the bank loans was discontinued, resulting in the withdrawal of cash values and the subsequent loss of gross margins of the related policies. In addition to the above, net investment income decreased due to a continued decline in overall portfolio rates on investments of the Life segment.
Premiums decreased for the years ended December 31, 2009 compared to 2008 and during 2008 compared to 2007. Related to the previously noted settlement payments, we recorded a reversal of $4.5 million. Excluding the effect of the settlement payments, premiums decreased $10.3 million for the year ended December 31, 2009. The decrease in premiums can be attributable to an increase in ordinary life ceded reinsurance premiums, which is the result of increasing YRT (“Yearly Renewable Term”) renewal premiums on the higher face amounts issued in 2007 and 2008. We do not expect to see this trend towards higher utilization of reinsurance on large face amounts to continue for new business issued in 2010. Also adding to the decrease was a drop in credit insurance premiums, which was a result of lower credit sales in the declining auto industry.
Net investment income decreased for the year ended December 31, 2009 compared to 2008. The decrease reflects the increased amount of cash we held during the year and the lower yields on the cash. We will continue to hold onto our cash position until appropriate long-term investment opportunities arise. The significant cash position we hold in excess of normal liquidity needs are generally of short duration.
Policy benefits include death claims, surrenders and other benefits paid to traditional whole life and term life policyholders (net of reserves released on terminated policies), reserve increases on existing traditional life policies (reflecting the passage of time on persisting policies in anticipation of future claims), claim benefits in excess of account balances returned to interest sensitive life policyholders, and interest credited on account balances.
Other operating costs and expenses decreased for the year ended December 31, 2009 compared to 2008. Related to the previously noted settlement payments, we recorded a reversal of $4.5 million in previously accrued expenses. Excluding the effect of the settlement payments, other operating costs and expenses decreased $33.4 million for the year ended December 31, 2009. The decrease was primarily due to a decrease in production bonuses, which is directly a result of lower sales in 2009. Additionally, there was a reduction in marketing expenses for our Direct Marketing channel. Other operating costs and expenses increased for the year ended December 31, 2008, compared to 2007. Much of this increase resulted from the non-recurring legal costs related to the two lawsuits, the Farm Bureau litigation in our multiple line marketing division and the Perkins litigation in the credit life marketing line. See Note 16 to the Consolidated Financial Statements in our amended Form 10 Registration Statement, filed with the SEC on July 1, 2009 for a discussion on these cases.
An increase in the lapse rate would cause acceleration in DAC amortization; therefore, the lapse rate is an important measure of company performance. The average lapse/surrender rates in the Life segment were 10.7%, 10.5% and 10.1% for the years ended December 31, 2009, 2008 and 2007, respectively. These combined rates reflected both first year and renewal business. First year lapse rates are typically much higher on traditional life business than in later years. In general, stable or lower lapse rates are important toward maintaining profitability of the Life segment, as higher lapse rates will reduce the average life expectancy of the in-force block of business and could result in acceleration in the amortization of DAC. Over the course of 2007 through 2009, we experienced normal fluctuations in lapse rates.
The table below summarizes reinsurance reserve and premium amounts assumed and ceded for the years ended December 31, 2009, 2008 and 2007 (in thousands):
In the case of credit life business, we use reinsurance primarily as a means to provide producers of credit-related insurance products the opportunity to participate in the underwriting risk through offshore producer-owned reinsurance companies. The reinsurance treaties entered into by the Credit Insurance Division are normally written on a 100% coinsurance basis with benefit limits of $100,000 on credit life.
We develop, sell and support a variety of immediate and deferred annuities, including fixed, equity-indexed and variable products. We sell these products through independent agents, brokers, financial institutions, and multiple line and employee agents. Segment financial results for the periods indicated were as follows (in thousands, except percentages):
Surrender charge revenue decreased in 2009 compared to 2008 as a result of lower surrender volume. Also, our products with defined market value adjustment formulas, applicable to surrenders in the first ten years, had larger reductions to 2009 surrender charges due to positive market value adjustments. Surrender charge revenue also decreased in 2008 compared to 2007, despite the fact that total withdrawals increased from 2007 to 2008. This was a result of a shift in the proportion of surrenders that incurred surrender charges versus surrenders that did not incur charges. There was a larger number of policyholders who took advantage of an option provided under certain contracts that permits a withdrawal without penalty during a thirty-day window following the end of a guaranteed interest period. We expect to continue to see policyholders reaching their guarantee period surrender window and electing to surrender without penalty. As a result of the higher level of surrender activity on fixed deferred annuities in 2008 compared to 2007, DAC amortization expense increased, further contributing to the decrease in earnings.
Annuity premium and deposit amounts received during the last three years are shown in the table below (in thousands, except percentages):
Amounts received on single premium immediate annuities are classified as premiums and are taken immediately into income. Amounts received from deferred annuity policyholders and equity-indexed annuity policyholders are classified as deposits and are not immediately taken into income. Interest earned on the policyholder’s deposits is classified as income. Fees assessed against variable annuity policyholder funds are reported as income.
Fixed deferred annuity receipts increased in 2008 compared to 2007. The increase in premiums was the result of the economic circumstances leading investors to seek safer, less volatile investment avenues. Equity-indexed annuity premiums for the year ended December 31, 2008 compared to 2007 were relatively flat.
Single premium immediate annuities increased in 2009 compared to 2008. The increase in sales is a direct result of consumers’ search for a more stable retirement income. We believe this upward trend will continue as more investors nearing retirement will change asset distribution strategies. Premiums from single premium immediate annuities decreased for the year ended December 31, 2008 compared to 2007. In 2007, premium income had increased by $49.8 million from a small group of very large policies sold.
Other policy revenues include surrender charges, variable annuity management and expense fees, other expense charges, and charges for riders on deferred annuities. Other policy revenues decreased for the year ended December 31, 2009 compared to 2008. We also experienced a decrease during 2008 compared to 2007. The decreases in other policy revenues are primarily a result of the decline in total collected surrender charges. The decrease in surrender charges in 2009 compared to 2008 resulted from lower surrenders. Also, in 2009 we had larger surrender charge reductions resulting from positive market value adjustments on contracts with defined market value adjustment formulas. In 2008, we had lower surrender charges compared to 2007, despite the fact that surrender volumes increased from 2007 to 2008. This was due to a change in the mix of surrenders between policyholders who incurred surrender charges and those where policyholders utilized their optional penalty-free withdrawal provisions. The annualized surrender rates on deferred annuities, which represent all withdrawals both full and partial, were 11.5%, 14.6% and 12.3% of account balances for 2009, 2008 and 2007, respectively.
Net investment income, which is a key component of the profitability of the Annuity segment increased for the year ended December 31, 2009 compared to 2008 and during 2008 compared to 2007. The increases were largely due to an increase in the asset base, brought about by an increase in the volume of in-force fixed deferred annuity account balances. In 2009, our fixed deferred annuity account values rose by $1.2 billion to $8.2 billion compared to an increase of $707.9 million in 2008 and $89.0 million in 2007. Also contributing to the increases in net investment income was the positive change in realized and unrealized gains on call option derivative. Call option derivative gains increased $29.8 million to $5.4 million during 2009. The increase in investment income in 2008 was partially offset by the $24.3 million negative market value adjustment on these call option derivatives. Note that the call option gains and losses are largely offset by related reserve adjustments on the embedded derivative in the associated equity-indexed annuity contracts. These embedded derivatives are reported as liabilities on the consolidated statement of financial position and are recorded and measured at fair value.
A portion of the variable deferred annuity policies in the table above include guaranteed minimum death benefits. The total account value related to variable deferred annuity policies with guaranteed minimum death benefit features was $66.8 million, $60.4 million, and $99.3 million as of December 31, 2009, December 31, 2008, and December 31, 2007 respectively.
The decrease in the guaranteed minimum death benefit amount at risk in 2009 compared to 2008 was due to the partial recovery in the equity market from the 2008 market downturn. The increase in the guaranteed minimum death benefit amount at risk in 2008 since December 31, 2007 reflects increased risk resulting from the poor equity market conditions experienced in 2008. See the Reinsurance discussion below for additional information on our risk management techniques utilizing reinsurance.
Account Values: In addition to interest margins, we monitor account values and changes in account values as a key indicator of the performance of our Annuity segment. The table below shows the account values and the changes in these values as a result of net inflows, fees, interest credited and market value changes for 2009, 2008 and 2007 (in thousands):
Fixed Deferred Annuity: Account values associated with fixed deferred annuities increased for the year ended December 31, 2009 compared to 2008. We experienced an increase in account values during 2008 compared to 2007. The changes in account values were a result of an increase in sales of fixed deferred annuity products.
Net inflows for the year ended December 31, 2009 were $930.4 million compared to net inflows of $487.4 million for the year ended December 31, 2008. The increase is a result of higher sales, as previously noted above, and a decrease in outflows as a result of lower surrenders. Net inflows for 2008 were $487.4 million compared to net outflows of $123.2 million for 2007. The net inflows in 2008 rose as investors elected the safety of fixed deferred annuities over the volatility of other investment vehicles.
Fees charged against account values decreased for the year ended December 31, 2009 compared to 2008 and during 2008 compared to 2007. These fees include withdrawal charges levied against policies being partially withdrawn or fully surrendered. The decrease in fees reflects our continuing decline in income from surrender charges. Refer to the Other Policy Revenues discussion noted above, for further analysis on the decrease in surrender charges.
Net inflows for the year ended December 31, 2009 were $20.5 million compared to net inflows of $24.4 million for the year ended December 31, 2008. Net inflows for 2007 were $66.6 million. Account values in 2008 were significantly affected by decreased equity values due to the significant declines in the financial markets that occurred during the fourth quarter. The average aggregate account values in-force in 2008 were, however, comparable to the average aggregate account values in-force in 2007.
Net inflows were $84.8 million compared to net outflows of $26.3 million, reflecting a higher amount of sales in 2009. Net outflows for the year ended December 31, 2008 were $26.3 million, compared to net inflows of $107.9 million for 2007. This decrease is consistent with the decrease in new premiums received during 2008 compared with 2007, resulting in a net outflow in which benefits paid exceed premiums received.
The increase in interest credited for the year ended December 31, 2009 compared to 2008 was primarily a result of increases in in-force fixed deferred annuity account balances due to new premiums and the change in embedded derivative gain/ (loss).
Commissions increased for the year ended December 31, 2009 compared to the year ended December 31, 2008. The increase was primarily due to increased sales. Commissions increased in 2008 compared to 2007, which was in line with the increase in premiums.
A performance measure of the Annuity segment is amortization of DAC as a percentage of gross profits. The amortization of DAC as a percentage of gross profits for the years ended December 31, 2009, 2008 and 2007 were 63.7%, 68.9% and 61.6%, respectively. The change in the ratio was primarily due to a lower lapse rate. The increase in the ratio during 2008 compared to 2007 was primarily due to higher lapses. A more complete discussion of policyholder persistency is given in the Policy Benefits and Interest Credited to Policy Account Balances sections above.
Earnings for the Health lines of business experienced a slight decline in 2009 relative to 2008. During 2009, earnings were negatively impacted by one-time charges of $5.9 million which included a $2.8 million marketing expense (refer to the “other operating costs and expenses” section below) as well as several large claims incurred on our major medical product. Earnings for 2008 decreased from the relatively break-even earnings of 2007. The one-time charges during 2008 included legal settlements and reinsurance write offs that negatively impacted earnings by $19.8 million. Excluding one-time charges, earnings for 2008 would have approximated a break-even point.
The Health segment’s earned premiums increased for the year ended December 31, 2009 when compared to the same period in 2008. Related to the previously noted settlement payments, we recorded premium reversals of $4.3 million. Excluding the effect of the settlement payments, premiums increased approximately 7.9% during 2009. The increase was primarily driven by premium rate increases on our Medicare Supplement and hospital surgical products as well as the review adjustments described above. The aforementioned increase was partially offset by a decline in premiums earned on our major medical product. Our in-force product mix has continued to change by shifting away from our comprehensive, higher-priced major medical product to our less comprehensive lower-priced hospital surgical product; we expect this trend to continue in 2010 and beyond.
Our in-force policies as of the dates indicated are as follows:
The benefit ratio, measured as the ratio of claims and other benefits to premiums, increased slightly to 77.3% for 2009 from 76.7% for 2008. The hospital surgical and major medical lines were the largest drivers of the increase in benefit ratio. The MGU line had a decrease in benefit ratio, which helped offset the increase from the hospital surgical and major medical lines. The increase in benefit ratio on the hospital surgical line is primarily attributable to aggressive rates and underwriting practices in prior periods. Rate increases to this line were made over the last two years, and we anticipate that these rate increases will positively impact the benefit ratio on this line in 2010. The increase in benefit ratio on the major medical product line is primarily the result of several large claims incurred in early 2009. Corrective rate actions to this line continue to be made and we anticipate that these rate increases will positively impact the benefit ratio on this line in 2010 as well.
In 2009, the benefit ratio was positively impacted by the review adjustments described above. The 2008 benefit ratio was negatively impacted by expenses associated with litigation involving one MGU that resulted in $8.9 million of reinsurance write offs in the first quarter of 2008. We have terminated our relationship with this particular MGU.
The benefit ratio, increased to 76.7% for the year ended December 31, 2008 from 73.9% for the same period in 2007. Much of the $13.2 million increase from 2007 to 2008 was attributable to the $8.9 million of reinsurance write offs in 2008 (discussed in the above paragraph). Excluding the impact of these reinsurance write offs, the benefit ratio was flat year over year.
The Health claim reserve decreased $0.6 million to $112.8 million for 2008 as compared to $113.3 million for 2007. This decrease in Health claim reserves was due to the decline of the major medical business.
Commissions increased for the year ended December 31, 2009 as compared to the same period in 2008. The majority of the increase was attributed to the review adjustments described above. The increase was partially offset by lower commissions incurred on our credit accident and health product, which resulted from a decline in related earned premiums.
Health premiums are recognized as revenue when due, but certain expenses associated with the acquisition of new business, such as commissions, are incurred before premiums can be earned. In order to recognize profits over the life of the policy, the expenses are deferred as DAC and amortized over the life of the policy. Generally, we expect the change in DAC expense to continue to follow changes in the in-force block by policy duration.
The following table presents the components of change in DAC for the years ended December 31, 2009, 2008 and 2007 (in thousands, except percentages):
As of December 31, 2009, the Health related DAC balances were $69.9 million compared to $74.9 million as of December 31, 2008. The $5.0 million decrease in DAC reflects a reversal of acquisition costs previously capitalized and related amortization expense associated with the previously noted settlement payments as well as a reduction in the acquisition costs capitalized due to the decline in new production of our Medicare Supplement and credit accident and health products.
Reinsurance is also used in the credit accident and health business. In certain cases, and especially in the auto retail market, we may also reinsure the policy written with a dealer-owned (producer-owned) captive reinsurer. This arrangement allows the dealerships to also participate in the performance of these credit accident and health contracts.
Combined ratio, which is the sum of the loss ratio and the expense ratio.
A combined ratio under 100% generally indicates an underwriting profit, while a ratio greater than 100% indicates an underwriting loss. The combined ratio does not include net investment income, other income or federal income taxes.
Our Property and Casualty segment results for the periods indicated were as follows (in thousands, except percentages):
The near record level of catastrophe losses experienced in 2008 negatively impacted earnings compared to those in 2007. Hurricanes Gustav and Ike, along with the increased frequency of tornadoes and hailstorms in the Midwestern and Southeastern states, resulted in a $99.1 million increase in catastrophe losses, net of reinsurance, during 2008. Net loss for 2008 was also negatively impacted by a $21.9 million increase in other operating costs and expenses, largely due to litigation related costs.
Net premiums written increased in 2009 compared to 2008 due to increases in our homeowner and credit related property insurance products. These increases were offset by decreases in our personal auto and workers’ compensation insurance products. These are discussed in further detail in the “Products” discussions below.
Net premiums written decreased in 2008 compared to 2007, reflecting a $27.0 million decrease in personal and commercial auto net premiums written. The decrease was due to high levels of competition in these lines, combined with a $5.6 million reinsurance reinstatement premium and higher overall reinsurance costs. The decreases in net premiums written were partially offset by a $17.4 million increase in credit insurance for 2008 compared to 2007.
We continue to take a disciplined approach to evaluating and pricing risks. Disciplined underwriting, which seeks to accept suitable risks only at a fair price, will result in underwriting profitability in the long-term. We expect total property and casualty net premiums written to remain stable or slightly decrease in 2010, as a result of targeted rate activity in personal and commercial auto and homeowners, offset by a resulting slight decrease in policy counts. We expect increased or flat growth of our credit-related insurance products as the recession-driven decline in new car sales and other consumer goods, and the continued tight credit environment to begin to ease and some stabilization to return during 2010.
Reinsurance costs increased slightly, 0.9%, for 2009 renewals as the cost of additional catastrophe reinsurance coverage purchased was offset by lower costs due to an increase in catastrophe reinsurance market capacity and the Company’s management of its catastrophe exposure. Refer to the discussion of our reinsurance program and the effect on the consolidated financial statements, under Part I, Item 1, Business.
Net premiums earned decreased in 2009 compared to 2008 as a result of a $16.7 million and a $5.3 million decrease in our personal auto and workers’ compensation insurance products, respectively. These are discussed in further detail in the “Products” discussions below.
Net catastrophe losses contributed to a 7.8% increase and an 11.1% increase in the combined ratio during 2009 and 2008, respectively, compared to only a 2.7% increase in 2007. The property losses as a result of catastrophes are a part of the normal variability in this segment and are the result of differences in both the frequency and severity of catastrophic events. We continue to evaluate and manage our aggregate catastrophe risk exposures, and manage our risk with targeted rate activity and purchasing additional reinsurance coverage where we believe it is cost efficient to do so.
Commissions increased in 2008 compared to 2007 as the result of a $9.5 million increase in credit related insurance commissions due to an increase in net premiums earned, attributable to the growth of our credit-related property products, which generally have a higher commission rate than our other products. This increase was partially offset by lower commissions on personal and commercial auto policies, which reported lower net premiums earned in 2008 compared to 2007.
The increase at year end December 31, 2008 compared to the same period in 2007 was also a result of litigation related costs primarily in connection to the lawsuit noted above, as well as increased salary costs of $4.3 million, allocated pension costs of $2.5 million, and increased professional services fees of $2.2 million related to preparing for compliance with SEC and Sarbanes-Oxley requirements.
Personal Automobile: We continued to see reductions in our personal automobile premium rates due to a highly competitive marketplace during the first half of 2009. Net premiums earned decreased in 2009 compared to 2008, and during 2008 compared to 2007 despite flat policy counts during these periods. We implemented premium rate increases during the second half of 2009, and expect to see downward pricing pressures continue to ease as 2010 progresses. We will continue to concentrate on our strategy of improving profitability through disciplined underwriting and targeted rate activity.
The combined ratios for 2009 (projected), 2008 and 2007 are comparable to the industry-combined ratios per A.M. Best of 105.5% (projected), 117.0%, and 95.7%, respectively. Our combined ratio was negatively impacted in 2009 and 2008 due to our concentration of business in the Midwest, which experienced increased catastrophe losses, resulting in a combined ratio 17.3% and 21.0% above the industry average, respectively. Conversely, our combined ratio benefited from our geographic concentration and the unusually low level of catastrophe losses in 2007, resulting in a combined ratio below the industry average.
Net premiums earned increased significantly in 2009 after a slight increase in 2008 due to increasing numbers of policy counts each year in addition to increases in policy premiums. The loss ratio decreased significantly during 2009 as a result of the increasing net premiums as well as a decrease in claim frequency.
Commercial Automobile: While we continue to focus on strengthening underwriting and improving pricing, renewal prices continued to decrease in 2009 compared to 2008 and 2007, resulting in downward pressure on net premiums written and earned. Net premium earned decreased slightly in 2009 as rate decreases initiated in 2008 continue to be realized. We expect this downward trend to level off during 2010, and begin to reverse in the second half of 2010 as newly implemented rate increases begin to take effect.
Other Commercial: Net earned premiums have been decreasing since 2007, as a result of our workers’ compensation product and small business coverages continuing to decline in the current economic environment. Premiums for our workers’ compensation product are tied to company payrolls, which have been steadily decreasing since the middle of 2007 as unemployment continued to rise. Our small business coverages continue to lose policies as customers go out of business, as well as a lowering premium per policy as businesses reduce coverages and increase deductibles in an effort to cut costs.
The loss ratio has been steadily increasing during this period due to the change in premiums noted above in addition to the resultant higher claims as payrolls continued to contract. We expect some stabilization to return to the economy in 2010. The combined ratio has continued to increase due to the decline in premiums.
Credit related property insurance products are offered on automobiles, furniture, and appliances in connection with the financing of those items. The policies pay an amount if the insured property is lost or damaged and is not directly related to an event affecting the consumer’s ability to pay the debt. The primary distribution channel for credit related property insurance is general agents who market to auto dealers, furniture stores and financial institutions.
Net premiums earned increased to $138.1 million in 2009 after falling slightly in 2008 to $135.1 million due to increasing furniture and appliance business, while automobile products sales continue to remain low due to lower auto sales, a trend which began at the end of 2007 when net premiums earned was $137.4 million. However, as credit standards remain tight, we expect to write higher quality business and to add new business partners as the economy shows signs of recovery. In the current economic environment, we expect our collateral protection product to continue to grow until the economy begins to recover, at which time we expect the sales of our Guaranteed Auto Protection (“GAP”) products to increase as credit begins to normalize and new vehicle sales rebound.
The decrease in the loss ratio from 47.9% in 2007 to 2008 was the result of a large amount of claims in a discontinued product during 2007, resulting in a 63.4% decrease in premiums during the same year driving up the loss ratio.
The decrease in the combined ratio of 102.7% in 2009 mainly reflects a legal accrual in 2008 when the combined ratio was 104.2% and a decrease in commission expense relative to earned premium. This is attributable to a shift in product mix during 2009 out of the higher commission structured products. The increase in the combined ratio in 2008 from 102.2% during 2007 was primarily the result of the aforementioned legal accrual.
A “top and drop” cover was purchased in 2008 and 2009 to provide an additional $20.0 million of coverage above the corporate catastrophe program for a total of $520.0 million per event, or it can be used to address frequency of events by providing protection for $20.0 million of losses above a $20.0 million retention after a $20.0 million annual aggregate deductible has been met. The top and drop cover in combination with the corporate catastrophe reinsurance program results in a $40.0 million retention for the first event and a $20.0 million retention for the second event in 2008 and 2009.
The Company also purchased an additional $125.0 million of protection for earthquake losses in the territorial limits of the United States, excluding California, thereby increasing our earthquake coverage to $645.0 million in 2008 and 2009.
Our credit related property insurance products do not employ reinsurance to manage catastrophe loss exposure, and we do not consider their reinsurers for risks other than catastrophes significant to our business.
The table below shows the development of our loss and loss adjustment expense reserves. The table does not present individual accident or policy year development data.
While we believe that our loss reserves at December 31, 2009 are adequate, new information, events or circumstances, unknown at the original valuation date, may lead to future developments in our ultimate losses significantly greater or less than the reserves currently provided. The actual final cost of settling both claims outstanding at December 31, 2009 and claims expected to arise from unexpired period of risk is uncertain. There are many other factors that would cause our reserves to increase or decrease, which include but are not limited to: changes in claim severity; changes in the expected level of reported claims; judicial action changing the scope and/or liability of coverage; changes in the regulatory, social and economic environment; and unexpected changes in loss inflation. The deficiency/(redundancy) for different balance sheet dates is cumulative and should not be added together.
Property and Casualty Loss and Loss Adjustment Expense Liability Development-Net of Reinsurance
Segment financial results for the periods indicated were as follows (in thousands, except percentages):
Income (loss) before other items and federal income taxes increased $260.9 million, from a loss of $289.4 million for 2008 to a loss of $28.6 million for 2009. We recorded $98.9 million of other-than-temporary impairments in 2009, $367.0 million and $7.2 million in 2008 and 2007, respectively. The other-than-temporary impairments are recorded in the “Gain (Loss) from investments, net” line.
On December 4, 2008, we sold our life insurance business in Mexico, American National de Mexico, Compania de Seguros de Vida, S.A. de C.V., along with non-insurance affiliates Servicios de Administracion American National S.A. de C.V. and American National Promotora de Ventas S.A. de C.V. to a third party for approximately $2.4 million. These operations were established in 1999 and reported losses in all years since inception. Management chose to sell these operations to prevent a continued negative impact on consolidated results of operations. See further detail regarding the discontinued operations disclosed in Note 17 to the Consolidated Financial Statements.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short-term and long-term cash requirements of our business operations. We meet our liquidity requirements primarily through positive cash flows from our insurance operations and investments. Premium deposits and annuity considerations, other policy revenue, investment income and investment maturities and prepayments are the primary sources of funds. Primary uses of funds are investment purchases, dividends, claims and payments to policyholders and contract holders in connection with surrenders, withdrawals and loans, as well as operating expenses (in thousands).
Cash flows from operating activities increased $319.7 million from 2008 to 2009. This was primarily due to the increase in net income from the net loss we recorded in 2008, in addition to the decrease in receivables during the year. This increase was partially offset by the related change in our tax position. The increased deposits from annuity sales are recorded as part of the cash flows from financing activities in accordance with U.S. GAAP rules. As such, they are not reflected in the cash flows from operating activities. Cash flows from operating activities decreased $291.2 million from 2007 to 2008 due to lower cash flows from premiums, coupled with increased claim experience due to catastrophe activity.
Cash flows used in investing activities increased $662.2 million from 2008 to 2009 and increased $253.8 million from 2007 to 2008. The change in net cash used in 2009 and 2008 was primarily due to increased investments in fixed income securities, real estate, and mortgage loans than each previous year. Total sales of all asset classes rebounded in 2009 from their significantly lower levels in 2008 due to markets improving from the depressed market prices from 2008. In 2007, more available-for-sale bond maturities occurred than in 2008, resulting in decreased cash received from maturities year over year.
We expect that our future liquidity needs will be adequately met from all of the above sources. Given our historical cash flows and current financial results, we believe that the cash flow from our operating activities over the next year will provide sufficient liquidity for our operations and will provide sufficient funds to enable us to make dividend and other payments as needed to support our operations.
We have notes payable on our consolidated statements of financial position that are not part of our capital resources. These notes payable represent amounts borrowed by real estate joint ventures that we are required to consolidate into our results in accordance with accounting rules. The lenders for the notes payable have no recourse to us in the event of default by the joint ventures. Therefore, the only amount of liability we have for these notes payable is limited to our investment in the respective affiliate, which totaled $33.3 million at December 31, 2009.
The following table summarizes our contractual obligations as of December 31, 2009 (in thousands):
Life and annuity obligations include estimated claim, benefit, surrender and commission obligations offset by expected future premiums and deposits on in-force insurance policies and contracts. All amounts are gross of reinsurance. Estimated claim, benefit and surrender obligations are based on mortality and lapse assumptions that are comparable with historical experience. Estimated payments on interest-sensitive life and annuity obligations include interest credited to those products. The interest crediting rates are derived by deducting current product spreads from a constant investment yield. The obligations shown in the table have not been discounted at present value. As a result, the estimated obligations for insurance liabilities included in the table exceed the liabilities recorded in reserves for future policy benefits and the liability for policy and contract claims. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results. Separate account obligations have not been included since those obligations are not part of the general account obligations and will be funded by cash flows from separate account assets. The general account obligations for insurance liabilities will be funded by cash flows from general account assets and future premiums and deposits. Participating policyholder dividends payable consists of liabilities related to dividends payable in the following calendar year on participating policies. As such, the contractual obligation related to participating policyholder dividends payable is presented in the table above in the less than one-year category at the amount of the liability presented in the consolidated balance sheet. All estimated cash payments represented in the table above are undiscounted as to interest, net of estimated future premiums on policies currently in-force and gross of any reinsurance recoverable. Estimated future premiums on participating policies currently in-force are net of future policyholder dividends payable. Future policyholder dividends, the participating policyholder share obligation on the consolidated balance sheet, represents the accumulated net income from participating policies and a pro-rata portion of unrealized investment gains (losses), net of tax, reserved for payment to such policyholders as policyholder dividends. Because of the nature of the participating policyholder obligation, the exact timing and amount of the ultimate participating policyholder obligation is subject to significant uncertainty and the amount of the participating policyholder obligation is based upon a long-term projection of the performance of the participating policy block.
Expected payments to fund investments based on capital commitments and other related contractual obligations.
Expected future payments to fund investments based on mortgage loan commitments and other related contractual obligations.
Represents estimated payments for pension benefit obligations for the non-qualified defined benefit pension plan. As such, these payments are funded through continuing operations. A liability has been established for the full amount of benefits accrued as per ASC 715-40 (formerly ”FAS 158”), Compensation-Retirement Benefits, including a provision for the effects of future salary inflation on the accrued benefits.
We have various agency, consulting and investment arrangements with individuals and corporations that are considered to be related parties. Each of these arrangements has been reviewed and approved by our Audit Committee. The total amount involved in these arrangements, both individually and in the aggregate, is not considered to be material to any segment or to our overall operations.
We invest directly in quality commercial mortgage loans when the yield and quality compare favorably with other fixed income securities. Investments in residential mortgage loans have not historically been part of our investment portfolio, and we do not anticipate investing in them in the future.
Our historically strong capitalization has enabled us to invest in equity securities and investment real estate where there are opportunities for enhanced returns. We invest in real estate and equity securities based on a risk/reward analysis.
The fair value of individual invested assets is determined by the use of third party pricing services, independent broker quotes and internal valuation methodologies. See Note 5 to the Consolidated Financial Statements for further discussion of the calculation of fair value for our investments. Below is a summary of the valuation techniques we utilize to measure fair value of the major investment types. There have been no material changes to our fair value methodologies during the year ending December 31, 2009.
We obtained publicly available prices from third party pricing services for our bonds investments. The typical inputs from pricing services include, but are not limited to, reported trades, bids, offers, issuer spreads, cash flow and performance data. These inputs are usually market observable; however, when trading volumes are low or non-existent, the pricing services may adjust these values. The adjustments made to the quoted prices are based on recently reported trades for comparable securities. We perform a periodic analysis of the prices received from the third parties to verify that the price represents a reasonable estimate of fair value. When prices are obtained from third party services, they are classified as Level 2.
All mortgage loan investments are classified as Level 2. Mortgage loan pricing is evaluated for consistency with our knowledge of the current market environment to ensure amounts are reflective of fair value.
New accounting regulations should result in significantly fewer bond impairments, however, stock impairments will continue to be impacted by the volatility in the stock markets. We will continue to analyze our investments and record any necessary impairment. A material (±10%) change in the fair value of securities might require additional impairments. These further impairments would have little or no effect on our liquidity. We do not rely on the sale of securities to meet our cash flow needs.
We determined if it is more likely than not that, we will have to sell the bond before maturity.
If it was determined, that we would hold the bond and we would not have to sell it, then we would determine the present value of the future cash flows of the bond.
If the cash flows were determined as equal to or greater than our amortized cost, then it was determined that we did not have an other-than-temporary impairment. If it was determined that we would sell the bond or be required to sell the bond, or if the present value of the cash flows was less than our amortized cost, then we determined that the bond was other-than-temporarily impaired. Once a bond was determined to be other-than-temporarily impaired, we used the present value of expected cash flows versus the market value to determine the amount of the credit loss versus the non-credit loss. The amount of credit loss was recorded as a realized loss in earnings, and the amount of non-credit loss was recorded as an unrealized loss as part of other comprehensive income.
We provide valuation allowances for mortgage loans on real estate based on a review by portfolio managers. Mortgage loans on real estate are considered impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. We closely monitor our commercial mortgage loan portfolio on a loan-by-loan basis. Loans with an estimated collateral value less than the loan balance, as well as loans with other characteristics indicative of higher than normal credit risks are reviewed at least quarterly for purposes of establishing valuation allowances and placing loans on non-accrual status as necessary. The valuation allowance account for mortgage loans on real estate is maintained at a level believed adequate by management and reflects management’s best estimate of probable credit losses, including losses incurred at the balance sheet date but not yet identified by specific loan. Management’s periodic evaluation of the adequacy of the allowance for losses is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of the underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors.
We periodically review our properties held-for-investment for impairment and test properties for recoverability whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable and the carrying value of the property exceeds its estimated fair value. Properties whose carrying values are greater than their discounted cash flows are written down to their estimated fair value, with the impairment loss included in net realized investment gains (losses). Impairment losses are based upon the estimated fair value of real estate, which is generally computed using the present value of expected future cash flows from the real estate discounted at a rate commensurate with the underlying risks. Real estate acquired upon foreclosure of commercial mortgage loans is recorded at the lower of estimated fair value or the carrying value of the mortgage loan at the date of foreclosure.
The following table identifies the bonds by type as of December 31, 2009 and December 31, 2008 (in thousands, except percentages):
The increase in bonds for the year ended December 31, 2009, was the result of purchases, net of maturities, made to support net annuity sales plus the increase in fair value of available-for-sale bonds.
We invest primarily in commercial mortgage loans that are diversified by property type and geography. We do not make residential mortgage loans; therefore, we have no direct exposure to sub-prime or Alt A mortgage loans. Generally, mortgage loans are secured by first liens on income-producing real estate with a loan-to-value ratio of up to 75%. Mortgage loans are used as a component of fixed income investments that support our insurance liabilities. Mortgage loans held-for-investment are carried at outstanding principal balances, adjusted for any unamortized premium or discount, deferred fees or expenses, net of valuation allowances. Our mortgage loan portfolio was $2.2 billion and $1.9 billion at December 31, 2009 and 2008, respectively. Mortgage loans comprised 13.4% of total invested assets at December 31, 2009. At December 31, 2009, 19.8%, 8.9% and 6.0% of the value of our mortgage loans were located in Texas, California, and New York, respectively.
As of December 31, 2009 and 2008, our mortgage loans classified as delinquent, in foreclosure and restructured were immaterial as a percentage of the total mortgage loan portfolio. A total of $24.6 million and $2.8 million mortgage loans were foreclosed upon and transferred to real estate investments during 2009 and 2008, respectively. Also, there were two delinquent mortgage loans at December 31, 2009 and there were five delinquent mortgage loans at December 31, 2008.
The average coupon yield on the principal funded for mortgage loans was 7.5% in 2009 and 6.6% in 2008.
The relative changes in sector weighting between the years ended December 31, 2009 and December 31. 2008 are the result of normal purchase and sale activity in concert with market movement. There has been no change in investment philosophy or diversification goals. Refer to the Other-Than-Temporary Impairments discussion above.
The following tables present the distribution across geographic regions and property types for real estate as of the periods indicated:
Certain life insurance products we offer permit policyholders to borrow funds from us using their policy as collateral. The maximum amount of the policy loan depends upon the policy’s surrender value and the number of years since policy origination. As of December 31, 2009, we had $364.4 million in policy loans with a loan to surrender value of 58.1%. Interest rates on policy loans primarily range from 4.5 % to 8.0% per annum. As of December 31, 2009 the average policy loan interest rate was 7.11%
Net investment income and realized investments gains/(losses), before federal income taxes, for the years ended December 31, 2009, 2008 and 2007 are summarized as follows (in thousands):
The dramatic swing in income from other invested assets over the period is normal during times of high stock market volatility. The derivative contracts (indexed options) used to back our equity-linked products are carried in this category, representing the majority of the assets in the category. These options are designed to mirror corresponding changes in our liability to policyholders. Refer to the Results of Operations - Annuity section for further discussion.
Mortgage loan interest income is accrued on the principal amount of the loan based on the loan’s contractual interest rate. Amortization of premiums and discounts is recorded using the effective yield method. Interest income, amortization of premiums and discounts, and prepayment fees are reported in net investment income. Interest income earned on impaired loans is accrued on the principal amount of the loan based on the loan’s contractual interest rate. However, interest ceases to be accrued for loans on which interest is generally more than 90 days past due and/or when the collection of interest is not considered probable. Loans in foreclosure are placed on non-accrual status. Interest received on non-accrual status mortgage loans on real estate is included in net investment income in the period received. We had $1.4 million and had $740,000 of realized losses related to valuation allowances on mortgage loans for the year ended December 31, 2009 and 2008, respectively.
Realized gains and losses and real estate investment income from sales in subsidiaries may fluctuate because they are the result of decisions to sell invested assets that depend on considerations of investment values, market opportunities and tax consequences.
The net change in unrealized gains/(losses) on marketable securities, as presented in the stockholders’ equity section of the consolidated statements of financial position, equaled a gain of $383.1 million in 2009, and a loss of $331.8 million and a gain of $0.3 million in 2008 and 2007, respectively.
See Part II - Item 8 - Financial Statements and Supplementary Data - Note 3 - Investments of this report for further discussion of the changes in unrealized gains and losses.
Consolidated Statements of Changes in Equity for the years ended December 31, 2009, 2008 and 2007
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of American National Insurance Company and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
In our opinion, American National Insurance Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by COSO.
American National Insurance Company and its consolidated subsidiaries (collectively “American National”) operate primarily in the insurance industry. Operating on a multiple product line basis, American National offers a broad line of insurance coverage, including individual and group life, health, and annuities; personal lines property and casualty; and credit insurance. In addition, through non-insurance subsidiaries, American National offers mutual funds and invests in real estate. The majority of revenues are generated by the insurance business. Business is conducted in all states and the District of Columbia, as well as Puerto Rico, Guam and American Samoa. Various distribution systems are utilized, including multiple line, independent third-party marketing organizations, home service, credit, and direct sales to the public.
These consolidated financial statements (“financial statements”) have been prepared in conformity with (i) U.S. generally accepted accounting principles (“GAAP”); and (ii) the rules and regulations of the U. S. Securities and Exchange Commission (“SEC”) regarding financial reporting. In addition to GAAP accounting literature, specific SEC regulation is also applied to the financial statements issued by insurance companies.
We consolidate all entities that are wholly owned and those in which we own less than 100% but control, as well as any variable interest entities in which we are the primary beneficiary. We evaluate our ability to control an entity and whether the entity is a variable interest entity and we are the primary beneficiary through the consideration of the following factors:
our ability to participate in policy making decisions, including but not limited to, the acquisition or disposition of investment properties and the incurrence or refinancing of debt;
the ability for other partners or owners to replace us as manager and/or liquidate the venture, if applicable.
The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the reported financial statement balances. Actual results could differ from those estimates. The following estimates have been identified as critical in that they involve a high degree of judgment and are subject to a significant degree of variability:
Bonds that are classified as held-to-maturity are carried at amortized cost. The carrying value of these debt securities is expected to be realized, due to American National’s ability and intent to hold these securities until maturity or market recovery. Bonds classified as available-for-sale are carried at fair value.
All common stocks are classified as available-for-sale and are carried at fair value.
For all investments carried at fair value (excluding derivative instruments), the unrealized gains or losses (differences between amortized cost and fair value), net of applicable federal income taxes, are reflected in stockholders’ equity as a component of accumulated other comprehensive income (loss).
Real estate acquired through foreclosure proceedings is recorded at the lesser of loan basis or fair value at the foreclosure date.
Real estate acquired through foreclosure proceedings is recorded at fair value at the settlement date.
For all debt securities in unrealized loss positions which American National does not intend to sell and for which it is not more likely than not that it will be required to sell before its anticipated recovery, American National assesses whether the amortized cost basis of the debt security will be recovered by comparing the net present value of cash flows expected to be collected from the debt security with its amortized cost basis. Management estimates cash flows expected to be collected from the debt security using information based on its historical experience as well as using market observable data, such as industry analyst reports and forecasts, sector credit ratings and other data relevant to the collectability of a security. The net present value of cash flows expected to be collected from the debt security is calculated by discounting management’s best estimate of cash flows expected to be collected on the debt security at the effective interest rate implicit in the debt security when acquired. If the net present value of the cash flows expected to be collected from the debt security is less than the amortized cost basis of the debt security, an OTTI has occurred in the form of a credit loss. The credit loss is recognized in earnings in the amount of excess amortized cost over the net present value of the cash flows expected to be collected from the debt security. If the fair value of the debt security is in excess of its net present value of the cash flows expected to be collected from the debt security at the impairment measurement date, a non-credit loss exists which is recorded in other comprehensive income (loss) in the amount of the fair value of the debt security in excess of the net present value of the cash flows expected to be collected from the debt security.
All equity securities, real estate and other invested assets are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds fair value, the duration of the market decline, and the financial health of and specific prospects for the issuer, borrower, or tenants. Losses that are determined to be other than temporary are recognized in current period income as a realized loss.
American National considers cash on-hand and in banks plus amounts invested in money market funds as cash for purposes of the consolidated statements of financial position and consolidated statements of cash flows.
These assets consist of buildings occupied by the Company, electronic data processing equipment, and furniture and equipment. These assets are carried at cost, less accumulated depreciation. Depreciation is provided using straight-line and accelerated methods that are allowed under GAAP over the estimated useful lives of the assets (3 to 50 years).
Certain costs of acquiring new insurance business have been deferred. For life, annuity and accident and health business, such costs consist of inspection report and medical examination fees, commissions, related fringe benefit costs and the present value of future profits resulting from the acquisition of life insurance portfolios. The amount of commissions deferred includes first-year commissions and certain subsequent year commissions that are in excess of ultimate level commission rates.
American National establishes property and casualty reserves to provide for the estimated costs of paying claims. These reserves include estimates for both case reserves and reserves for incurred but not reported (“IBNR”) claims. Case reserves include the liability for claims that were reported to American National, but not yet paid. IBNR reserves include a provision for potential development on case reserves, losses on claims currently closed which may reopen in the future as well as claims which have been incurred but not yet reported to American National. These reserves also include an estimate of the expense associated with settling claims, including legal and other fees and the general expenses of administering the claims adjustment process.
Property and casualty premiums are recognized as revenue proportionately over the contract period. Policy benefits consist of actual claims and the change in reserves for losses and loss adjustment expenses.
For the Farm Family Life participating business, profits earned on participating business are reserved for the payment of dividends to policyholders, except for the stockholders’ share of profits on participating policies, which is limited to the greater of 10% of the profit on participating business, or 50 cents per thousand dollars of the face amount of participating life insurance in force. Participating policyholders’ interest includes the accumulated net income from participating policies reserved for payment to such policyholders in the form of dividends (less net income allocated to stockholders as indicated above) as well as a pro rata portion of unrealized investment gains (losses), net of tax.
American National recognizes tax benefits on uncertain tax positions only if it is “more likely than not” that the tax position will be sustained by taxing authorities, based on the technical merits of the position. Tax benefits recognized in the financial statements are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Tax benefits not meeting the “more likely than not” threshold, if applicable, are included with “Other liabilities” in the consolidated statements of financial position.
American National uses the fair value method in accordance with Accounting Standards Codification (“ASC”) 718, Compensation - Stock Compensation, to account for stock-based compensation.
On January 1, 2009, American National adopted accounting guidance contained within ASC 805, “Business Combinations” (formerly FAS No. 141(R), “Business Combinations”), and (“ASC 805”). This guidance within ASC 805 was issued by the FASB in December 2007. This guidance addressed the accounting for business acquisitions, was effective for fiscal years beginning on or after December 15, 2008, and generally applies to business acquisitions completed after December 31, 2008. Among other things, the new guidance required that all acquisition-related costs be expensed as incurred, and that all restructuring costs related to acquire operations be expensed as incurred. This new guidance also addressed the current and subsequent accounting for assets and liabilities arising from contingencies acquired or assumed and, for acquisitions both prior and subsequent to December 31, 2008, required the acquirer to recognize changes in the amount of its deferred tax benefits that are recognizable because of a business combination either in income from continuing operations in the period of the combination or directly in contributed capital, depending on the circumstances. The adoption of ASC 805 did not have a material effect on American National’s consolidated financial statements.
On January 1, 2009, American National adopted accounting guidance contained within ASC 815, “Derivatives and Hedging” (formerly FAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities, an amendment of FAS No. 133”), (“ASC 815”). This guidance within ASC 815 was issued by the FASB in March 2008. This guidance which amended and expanded disclosures about an entity’s derivative and hedging activities with the intent of providing users of financial statements with an enhanced understanding of (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are to be accounted for, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. ASC 815 was effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. ASC 815 encourages, but does not require, comparative disclosures. The adoption of ASC 815 resulted in expanded disclosures related to derivative instruments and hedging activities. See related disclosures in Note 4 of the Notes to the Consolidated Financial Statements.
On January 1, 2009, American National adopted accounting guidance contained within ASC 350, “Intangibles” (formerly FASB Staff Position (“FSP”) Financial Accounting Standard (“FAS”) No. 142-3, “Determination of the Useful Life of Intangible Assets”), (“ASC 350”). This guidance within ASC 350 was issued by the FASB in April 2008. This guidance amended the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset. This change was intended to improve the consistency between the useful life of a recognized intangible asset under ASC 350, the period of expected cash flows used to measure the fair value of the asset under ASC 805 and other GAAP. ASC 350 was effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. American National has applied ASC 350 prospectively to intangible assets acquired as of, and subsequent to, January 1, 2009. The adoption of ASC 350 did not have a material effect on American National’s consolidated financial statements.
On January 1, 2009, American National adopted accounting guidance contained within ASC 323, “Investments - Equity Method and Joint Ventures” (formerly Emerging Issues Task Force (“EITF”) No. 08-6, “Equity Method Investment Accounting Considerations”), (“ASC 323”). This guidance within ASC 323 was issued by the FASB in November 2008. This guidance addressed the effects of the issuances of guidance contained within ASC 805 and ASC 810 on the application of the equity method of accounting for investments in common stock. ASC 323 required that: (a) an entity determine the initial carrying value of an equity method investment by applying the cost accumulation model; (b) an entity shall use the OTTI model within ASC 323; however, investors should adjust any impairments’ recorded by an investee for existing differences between the investor’s basis and the underlying investees’ basis in such impaired assets; (c) share issuances by an investee should be accounted for as if the equity method investor had sold a proportionate share of its investment; and (d) when an investment is no longer within the scope of equity method accounting and instead is within the scope of cost method accounting or ASC 320, “Investments - Debt and Equity Securities”, the investor should prospectively apply the provisions of ASC 320 or ASC 323 and use the current carrying amount of the investment as its initial cost. This guidance was effective on a prospective basis in fiscal years beginning on or after December 15, 2008 and interim periods within those fiscal years. The adoption of ASC 323 did not have a material effect on American National’s consolidated financial statements.
On January 1, 2009, American National adopted accounting guidance contained within ASC 715, “Compensation - Retirement Benefits” (formerly FSP FAS No.132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets”), (“ASC 715”). This guidance within ASC 715 was issued by the FASB in December 2008. This guidance enhanced the transparency surrounding the types of assets and associated risks in an employer’s defined benefit pension or other postretirement plan. It required an employer to disclose information about the valuation of plan assets similar to that required under ASC 820, “Fair Value Measurements and Disclosures”. ASC 715 was effective for fiscal years ending after December 15, 2009. American National has provided the required disclosure in accordance with the effective date. See related disclosures in Note 5 of the Notes to the Consolidated Financial Statements.
On April 1, 2009, American National adopted accounting guidance contained within ASC 855, “Subsequent Events” (formerly FAS No. 165, “Subsequent Events”), (“ASC 855”). This guidance within ASC 855 was issued by the FASB in May 2009. This guidance established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued. It required that an entity evaluate its subsequent events up through the date of issuance of its financial statements. ASC 855 was effective for interim and annual periods ending after June 15, 2009. Accordingly, American National adopted ASC 855 prospectively. The adoption of this guidance did not have a material effect on American National’s consolidated financial statements. (Refer below to ASU No. 2010-09 for related amendment of ASC 855).
On April 1, 2009, American National adopted accounting guidance contained within ASC 820, “Fair Value Measurements and Disclosures” (formerly FSP FAS No.157-4, “Determining Fair Value When Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are Not Orderly”), (“ASC 820”). Under this guidance, if an entity determines that there has been a significant decrease in the volume and level of activity for an asset or liability in relation to the normal market activity for the asset or liability (or similar assets or liabilities), and then transactions or quoted prices may not accurately reflect fair value. In addition, if there is evidence that, the transaction for the asset or liability is not orderly; the entity shall place little, if any weight on that transaction price as an indicator of fair value. ASC 820 was effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The adoption of this guidance did not have a material effect on American National’s consolidated financial statements.
In August 2009, the FASB issued ASU No. 2009-05, “Measuring Liabilities at Fair Value”, (“ASU 2009-05”) which amends ASC 820. ASU 2009-05 provided clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following methods: 1) a valuation technique that uses a) the quoted price of the identical liability when traded as an asset or b) quoted prices for similar liabilities or similar liabilities when traded as assets and/or 2) a valuation technique that is consistent with the principles of ASC 820 (e.g. an income approach or market approach). ASU 2009-05 also clarified that when estimating the fair value of a liability, a reporting entity is not required to adjust for the inclusion of inputs relating to the existence of transfer restrictions on that liability. ASU 2009-05 was effective for interim and annual periods beginning after September 30, 2009. Accordingly, American National adopted ASU 2009- 05 on October 1, 2009. The adoption of ASU 2009-05 did not have a material effect on American National’s consolidated financial statements.
In January 2010, the FASB issued ASU No. 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary - A Scope Clarification”, (“ASU 2010-02”) which amends ASC 810 - Consolidations (“ASC 810”). ASU 2010-02 changed ASC 810 by excluding some dispositions of not-for-profit activities and assets sales such as in-substance real estate from its scope. This guidance also required expanded disclosures about changes in ownership of subsidiaries. ASU 2010-02 was effective for annual and interim periods that commenced at the beginning of the first reporting period ending after December 15, 2009. Accordingly, this guidance was adopted on January 1, 2010 and did not have a material effect on American National’s consolidated financial statements.
In February 2010, the FASB issued ASU No. 2010-09, “Subsequent Events”, (“ASU 2010-09”) which amends ASC 855 - Subsequent Events (“ASC 855”). ASU 2010-09 amended ASC 855 by removing the requirement for an entity that files or furnishes financial statements with the SEC to disclose a date through which subsequent events have been evaluated in both originally issued and restated financial statements. This ASU removed potential conflicts with the SEC’s guidance. ASU 2010-09 was effective upon its issuance. Accordingly, this guidance was adopted on February 28, 2010 and did not have a material effect on American National’s consolidated financial statements.
In June 2009, the FASB issued ASU No. 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities” (formerly FAS No. 167, “Amendments to FASB Interpretation No. 46R”), (“ASU 2009-17”) which amended ASC 810. ASU 2009-17 pertains to the consolidation of variable interest entities and requires an analysis to be performed to determine whether a variable interest gives the entity a controlling financial interest in a variable interest entity. This standard requires an ongoing reassessment and eliminates the quantitative approach previously required for determining whether an entity is the primary beneficiary. This guidance is effective for interim and annual reporting periods beginning after November 15, 2009. Accordingly, American National will adopt this guidance effective January 1, 2010 and is currently evaluating the impact of its adoption on its consolidated financial statements.
In June 2009, the FASB issued ASU No. 2009-16, “Accounting for Transfers of Financial Assets” (formerly FAS No. 166, “Accounting for Transfers of Financial Assets”), and (“ASU 2009-16”) which amends ASC 860. ASU 2009-16 requires enhanced disclosure about transfers of financial assets when companies have continuing exposure to the risk related to transferred financial assets. It eliminates the concept of a qualifying special purpose entity and changes the requirements for derecognizing financial assets. This guidance is effective for interim and annual reporting periods beginning after November 15, 2009. Accordingly, American National will adopt this guidance effective January 1, 2010 and is currently evaluating the impact of its adoption on its consolidated financial statements.
In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements”, (“ASU 2010-06”) which amends ASC 820. ASU 2010-06 was issued to improve and expand fair value disclosures. Newly required disclosures are as follows: 1) provide information about movements of assets among Levels 1 and 2 of the three-tier fair value hierarchy established by ASC 820; 2) provide a reconciliation of purchases, sales, issuance, and settlements of anything valued with a Level 3 method; and 3) provide fair value disclosures for each class of assets and liabilities. This guidance is effective for interim and annual reporting periods that begin after December 15, 2010. Accordingly, American National will adopt this guidance on January 1, 2010 and is currently evaluating the impact of its adoption on its consolidated financial statements.
Available-for-sale securities are sold throughout the year for various reasons. Proceeds from the disposals of these securities, with the realized gains and losses, are shown below (in thousands).
In 2009, securities with amortized costs of $4,222,000 were transferred from held-to-maturity to available-for-sale due to evidence of a significant deterioration in the issuers’ creditworthiness. An unrealized loss of $407,330 was established at the time of the transfer.
In accordance with various government and state regulations, American National and its wholly-owned insurance subsidiaries had bonds with amortized costs of $35,822,000 at December 31, 2009, on deposit with appropriate regulatory authorities.
American National purchases derivative contracts (equity indexed options) that serve as economic hedges against fluctuations in the equity markets to which equity indexed annuity products are exposed. Equity indexed annuities include a fixed host annuity contract and an embedded equity derivative. These derivative instruments are not accounted for as hedging under accounting rules. The following tables detail the estimated fair value amounts and the gain or loss on derivatives related to equity indexed annuities (in thousands):
Unrealized gains (losses) on marketable equity securities and bonds available-for-sale, presented in the stockholders’ equity section of the consolidated statements of financial position, are net of deferred tax (benefit) expense of $101,408,000, $(84,029,000), and $101,244,000 for 2009, 2008, and 2007, respectively.
For all investment securities, including those securities in an unrealized loss position for 12 months or more, American National performs a quarterly analysis to determine if an other-than-temporary impairment loss should be recorded for any securities. As of December 31, 2009, the securities above did not meet the criteria for other-than-temporary impairment. Even though the duration of the unrealized losses on the securities exceeds one year, American National maintains the intent and ability to hold the security until its value recovers.
American National evaluates all marketable equity securities on a quarterly basis and recognizes an other-than-temporary impairment on all of those where a market price recovery is not expected in the near term. All securities, which have an unrealized loss, are also evaluated for credit quality, and impairments are recognized for any securities, regardless of the length of time that they have had an unrealized loss, where management believes the carrying value will not be realized. For the remaining securities with unrealized losses, management believes the losses are temporary, and American National has the ability and intent to hold these securities until a market price recovery. However, it is possible that the investee’s ability to perform in the future may be different from what American National determined during its analysis, which may lead to a different impairment conclusion in future periods.
In general, mortgage loans are secured by first liens on income-producing real estate. The loans are expected to be repaid from the cash flows or proceeds from the sale of real estate. American National generally allows a maximum loan-to-collateral-value ratio of up to 75% on newly funded mortgage loans. As of December 31, 2009, mortgage loans have fixed rates from 5.15% to 12.00%. The majority of the mortgage loan contracts require periodic payments of both principal and interest, and have amortization periods of 6 months to 30 years.
American National has investments in first lien mortgage loans on real estate with carrying values of $2,229,659,000 and $1,877,053,000 at December 31, 2009 and 2008, respectively. Non-performing loans, on which valuation allowances were established, totaled $13,691,000 and $13,824,000 at December 31, 2009 and 2008, respectively. The valuation allowances on those loans totaled $1,793,000 at December 31, 2009 and 2008.
All other-than-temporary impairments recognized on bonds were entirely comprised of credit losses; therefore, during the twelve months ended December 31, 2009, no non-credit loss was recognized in other comprehensive income.
Management believes American National’s bond portfolio is diversified and of investment grade. The bond portfolio distributed by quality rating at December 31, 2009 and 2008 is summarized as follows:
American National invests primarily in the commercial sector in areas that offer the potential for property value appreciation. Generally, mortgage loans are secured by first liens on income-producing real estate.
The carrying amounts and estimated fair values of financial instruments at December 31 are as follows (in thousands):
American National has analyzed the third-party pricing services valuation methodologies and related inputs, and has also evaluated the various types of securities in its investment portfolio to determine an appropriate fair value hierarchy level based upon trading activity and the observability of market inputs. Based on the results of this evaluation and investment class analysis, each price was classified into Level 1, 2, or 3.
American National utilizes a pricing service to estimate fair value measurements for approximately 99.0% of fixed maturity securities. The pricing service utilizes market quotations for fixed maturity securities that have quoted prices in active markets. Since fixed maturities generally do not trade on a daily basis, the pricing service prepares estimates of fair value measurements for these securities using its proprietary pricing applications, which include available relevant market information, benchmark curves, benchmarking of like securities, sector groupings and matrix pricing. Additionally, the pricing service uses an Option Adjusted Spread model to develop prepayment and interest rate scenarios.
The fair value estimates of most fixed maturity investments including municipal bonds are based on observable market information rather than market quotes. Accordingly, the estimates of fair value for such fixed maturities provided by the pricing service are included in the amount disclosed in Level 2 of the hierarchy.
For assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the period, a reconciliation of the beginning and ending balances, is as follows (in thousands):
There were no unrealized losses for the twelve months ended December 31, 2009 of Level 3 assets. The unrealized gains in Level 3 assets at December 31, 2009 were $9,022,000.
Deferred policy acquisition costs and premiums for the years ended December 31, 2009, 2008, and 2007 are summarized as follows (in thousands):
Acquisitions relate to the purchase of various insurance portfolios under assumption reinsurance agreements.
Prior to its sale (see Note 17), acquisition costs for American National’s Mexican subsidiary were maintained in their functional currency of Mexican pesos, and translated into U.S. dollars for reporting purposes. Part of the change in deferred acquisition cost balance was due to differences in the exchange rate applied to the balance from period to period. The entire amount of this difference was reported in the shareholders’ equity section of the consolidated statements of financial position.
The potential uncertainty generated by volatility in loss development profiles is adjusted for through the selection of loss development factor patterns for each line of insurance. The net and gross reserve calculations have shown redundancies for the last several year-ends as a result of losses emerging favorably compared to what was implied by the loss development patterns used in the original estimation of losses in prior years. Estimates for ultimate incurred losses and loss adjustment expenses attributable to insured events of prior years decreased by approximately $31,000,000 in 2009 and $43,000,000 in 2008.
For Property and Casualty, American National retains the first $1 million of loss per risk, reinsurance then covers the next $5 million of property and liability losses per risk. Additional excess property per risk coverage is purchased to cover risks up to $15 million, and excess casualty cash coverage is maintained to cover losses up to $50 million. Corporate catastrophe coverage is also in place for up to a $500 million event.
The federal income tax provisions vary from the amounts computed when applying the statutory federal income tax rate. A reconciliation of the effective tax rate for American National to the statutory federal income tax rate is as follows (in thousands, except percentages):
The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2009 and December 31, 2008 are as follows (in thousands):
Management believes that a sufficient level of taxable income will be achieved to utilize the net deferred tax assets of the companies in the consolidated federal tax return. However, a valuation allowance has been established for one company that files a stand-alone federal tax return. The valuation allowance is not material to the Consolidated Statements of Financial Position. Also, if not utilized beforehand, American National has approximately $1,548,000 in capital loss tax carryforwards that will expire at the end of tax year 2014 and approximately $7,118,000 in ordinary loss tax carryforwards that will expire at the end of tax year 2029.
In accordance with ASC 740-10, “Accounting for Uncertainty in Income Taxes”, American National maintained a reserve for unrecognized tax benefits in 2008 and 2007. The reserve was removed during 2009 because the tax was fully settled. The reserve was included in the “Other Liabilities” line in the Consolidated Statements of Financial Position as of December 31, 2008. The change in the reserve is as follows (in thousands):
American National has only one class of common stock with a par value of $1.00 per share and 50,000,000 authorized shares. The amounts outstanding at December 31, 2009, 2008 and 2007 were as follows:
American National has one stock-based compensation plan. Under this plan, American National can grant Non-Qualified Stock Options, Stock Appreciation Rights, Restricted Stock Awards, Restricted Stock Units, Performance Rewards, Incentive Awards and any combination of these. The number of shares available for grants under the plan cannot exceed 2,900,000 shares, and no more than 200,000 shares may be granted to any one individual in any calendar year.
SAR and Restricted Stock (RS) information for 2009, 2008 and 2007 follows:
The weighted-average contractual remaining life for the 161,449 SAR shares outstanding as of December 31, 2009, is 7.0 years. The weighted-average exercise price for these shares is $108.53 per share. Of the shares outstanding, 66,650 are exercisable at a weighted-average exercise price of $103.30 per share.
The weighted-average contractual remaining life for the 261,334 Restricted Stock shares outstanding as of December 31, 2009, is 5.6 years. The weighted-average exercise price for these shares is $0 per share. None of the shares outstanding was exercisable.
Basic earnings (loss) per share was calculated using a weighted average number of shares outstanding of 26,528,832 at December 31, 2009 and 26,479,832 at December 31, 2008 and 2007. The Restricted Stock resulted in diluted earnings per share as follows for years 2009 and 2007. Due to the net losses incurred in 2008, diluted earnings per share equaled basic earnings per share.
Generally, the same restrictions on amounts that can transfer in the form of dividends, loans, or advances to the parent company apply to American National’s insurance subsidiaries. Dividends received by American National from its non-insurance subsidiaries amounted to $5,000,000 in 2009, while no dividends were received during 2008 and 2007.
American National County Mutual Insurance Company (County Mutual) is a mutual insurance company that is owned by its policyholders. However, County Mutual has a management agreement, which effectively gives complete control of County Mutual to American National. As a result, County Mutual is included in the consolidated financial statements of American National. The interest that the policyholders of County Mutual have in the financial position of County Mutual is reflected as noncontrolling interest totaling $6,750,000 at December 31, 2009 and 2008.
American National’s wholly-owned subsidiary, ANTAC, Inc., is a partner in various joint ventures. ANTAC exercises significant control or ownership of these joint ventures, resulting in their consolidation into the American National consolidated financial statements. As a result of the consolidation, the interest of the other partners of the joint ventures is shown as noncontrolling interests. Noncontrolling interests were a net liability of $5,205,000 and $1,627,000 in 2009 and 2008, respectively.
The accompanying consolidated financial statement are presented in our reporting currency, the U.S. dollar. All material intercompany transactions with consolidated entities have been eliminated.
The Corporate and Other business segment consists of net investment income on the capital not allocated to the insurance lines and the operations of non-insurance lines of business.
Expenses are allocated to the lines based upon various factors, including premium and commission ratios within the respective operating segments.
The following tables summarizes American National’s key financial measures used by the chief operating decision makers, including operating results and allocation of assets as of and for the years ended December 31, 2009, 2008 and 2007 (in thousands):
The inactive tax-qualified defined-benefit pension plan covers employees of the Farm Family companies hired prior to January 1, 1997. Effective January 1, 1997, benefits through this plan were frozen, and no new participants have been added.
American National also sponsors for key executives three non-tax-qualified pension plans that restore benefits that would otherwise be curtailed by statutory limits on qualified plan benefits.
Amounts recognized in the consolidated statements of financial position as of December 31 consist of (in thousands):
The components of the combined net periodic benefit cost for the defined benefit pension plans for the years ended December 31 were as follows (in thousands):
Amounts related to the defined benefit pension plans recognized as a component of other comprehensive income (loss) for the years ended December 31 were as follows (in thousands):
Amounts recognized as a component of accumulated other comprehensive income (loss) for the years ended December 31 that have not been recognized as a component of the combined net periodic benefit cost of the defined benefit pension plans, are presented in the following table (in thousands). The estimated net loss and prior service cost for the plan that will be amortized out of accumulated other comprehensive income into the net periodic benefit cost over the next fiscal year are $7,530,000 and $2,324,000 respectively.
The weighted average assumptions used in the measurement of the Company’s benefit obligation are shown in the following table:
American National’s funding policy for the pension plans is to make annual contributions in accordance with the minimum funding standards of the Employee Retirement Income Security Act of 1974. The unfunded plans will be funded out of general corporate assets when necessary. American National contributed $24,930,000 and $19,700,000 to the qualified pension plan in 2009 and 2008, respectively. American National and its affiliates expect to contribute $16,000,000 to its qualified pension plan in fiscal year 2010.
The fair values of the Company’s pension plan assets at December 31, 2009 by asset category are as follows (in thousands):
Equity portfolio managers are allowed to choose the degree of concentration in various issues and industry sectors for the Marketable Equity Securities investments. However, the initial purchase of a single company should not exceed 5% of the equity portfolio market value. Permitted securities are those listed on the New York Stock Exchange, the American Stock Exchange, principal regional exchanges and in over-the-counter securities for which there is an active market providing ready marketability of the specific security.
The accrued postretirement benefit obligation, included in the liability for retirement benefits, was $5,100,000 and $5,200,000 at December 31, 2009 and 2008, respectively. These amounts were approximately equal to the unfunded accumulated postretirement benefit obligation. Since American National’s contributions to the cost of the retiree benefit plans are fixed, the health care cost trend rate will have no effect on the future expense or the accumulated postretirement benefit obligation.
Under American National and its subsidiaries’ various group benefit plans for active employees, life insurance benefits are provided upon retirement for eligible participants who meet certain age and length of service requirements.
American National and its subsidiaries lease insurance sales office space in various cities. The remaining long-term lease commitments at December 31, 2009, were approximately $4,124,000.
American National was a defendant in a lawsuit related to the alleged inducement of another company’s insurance agents to become agents of American National (Farm Bureau Life Insurance Company and Farm Bureau Mutual Insurance Company v. American National Insurance Company et al., United States District Court for the District of Utah, filed July 23, 2003). Plaintiffs initially alleged that American National improperly induced agents to leave Plaintiffs and join American National, asserting claims against American National for inducing one of Plaintiffs’ managers to breach duties allegedly owed to Plaintiffs as well as claims against American National for misappropriation of trade secrets, tortious interference with contractual relationships, business disparagement, libel, defamation, civil conspiracy, unjust enrichment and unfair competition. By the time of trial, some claims had been dismissed; however, Plaintiffs’ surviving claims continued to allege that their damages from the wrongful conduct exceeded $3.9 million, and Plaintiffs also sought punitive damages. The jury reached a verdict adverse to American National, and the court reduced the amount of such verdict as to American National to approximately $7.1 million. An appeal has been taken to the Tenth Circuit. American National has accrued an appropriate amount for resolution of this case, including attorneys’ fees, and believes that any additional amounts necessary will not be material to the consolidated financial statements.
On December 4, 2008, our life insurance business in Mexico, American National de Mexico, Compania de Seguros de Vida, S.A. de C.V., along with non-insurance affiliates Servicios de Administracion American National S.A. de C.V. and American National Promotora de Ventas S.A. de C.V. were sold to a third party for approximately $2,400,000. Accordingly, the business is accounted for as a discontinued operation within the life-operating segment.
American National has entered into recurring transactions and agreements with certain related parties as a part of its ongoing operations. These include mortgage loans, management contracts, agency commission contracts, marketing agreements, health insurance contracts, legal services, and insurance contracts. The impact on the consolidated financial statements of the significant related party transactions as of December 31, 2009, is shown below (in thousands):