The Company believes that such properties, including the equipment located therein, are suitable and adequate to meet the requirements of its business.
The financial position of the Company as of December 31, 1999 is affected by the acquisition of business from MBL Life which occurred on July 1, 1999. (See Note 3 of the accompanying financial statements.)
VALUATION OF CERTAIN FINANCIAL INSTRUMENTS: Gross unrealized losses on the debt and equity securities available for sale amounted to $28.4 million at December 31, 2002. In determining if and when a decline in fair value below
amortized cost is other-than-temporary, the Company evaluates at each reporting period the market conditions, offering prices, trends of earnings, price multiples, and other key measures for our investments in debt and marketable equity securities. In particular, for debt securities, the Company assesses the probability that all amounts due are collectible according to the contractual terms of the obligation. When such a decline in value is deemed to be other-than-temporary, the Company recognizes an impairment loss in the current period operating results to the extent of the decline.
Securities in our portfolio with a carrying value of approximately $334.9 million at December 31, 2002 do not have readily determinable market prices. For these securities, we estimate their fair value with internally prepared valuations (including those based on estimates of future profitability). Otherwise, we use our most recent purchases and sales of similar unquoted securities, independent broker quotes or comparison to similar securities with quoted prices when possible to estimate the fair value of those securities. All such securities are classified as available for sale. Our ability to liquidate our positions in these securities will be impacted to a significant degree by the lack of an actively traded market, and we may not be able to dispose of these investments in a timely manner. Although we believe our estimates reasonably reflect the fair value of those securities, our key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral, if any, and other factors may not reflect those of an active market.
DAC amortization is sensitive to surrender rates and the actual and assumed future growth rate of the assets supporting the Company’s obligations under annuity policies. With respect to fixed annuities, the growth rate depends on the yield on the general account assets supporting those annuities. With respect to variable annuities, the growth rate depends on the performance of the investment options available under the annuity contract and the allocation of assets among these various investment options.
The assumption we use for the long-term annual net growth of the separate account assets in the determination of DAC amortization with respect to our variable annuity policies is 10% (the “long-term growth rate assumption”). We use a “reversion to the mean” methodology which allows us to maintain this 10% long-term growth rate assumption, while also giving consideration to the effect of short-term swings in the equity markets. For example, if performance were 15% during the first year following the introduction of a product, the DAC model would assume that market returns for the following five years (the “short-term growth rate assumption”) would approximate 9%, resulting in an average annual growth rate of 10% during the life of the product. Similarly, following periods of below 10% performance, the model will assume a short-term growth rate higher than 10%. A DAC unlocking will occur if management deems the short-term growth rate assumption (i.e., the growth rate required to revert to the mean 10% growth rate over a five-year period) to be unreasonable. The use of a reversion to the mean assumption is common within the industry; however, the parameters
used in the methodology are subject to judgment and vary within the industry.
NET INVESTMENT INCOME, which is the spread between the income earned on invested assets and the interest paid on fixed annuities and other interest bearing liabilities, totaled $38.7 million in 2002, $37.8 million in 2001 and $42.3 million in 2000. These amounts equal 2.67% on average invested assets (computed on a daily basis) of $1.45 billion in 2002, 2.65% on average invested assets of $1.43 billion in 2001 and 2.50% on average invested assets of $1.69 billion in 2000.
Net investment spreads include the effect of income earned or interest paid on the difference between average invested assets and average interest-bearing liabilities. Average invested assets exceeded average interest-bearing liabilities by $108.7 million in 2002, compared with $85.6 million in 2001 and $79.6 million in 2000. The difference between the Company’s yield on average invested assets and the rate paid on average interest-bearing liabilities (the “Spread Difference”) was 2.34% in 2002, 2.37% in 2001 and 2.28% in 2000.
Investment income (and the related yields on average invested assets) totaled $97.4 million (6.73%) in 2002, compared with $101.0 million (7.07%) in 2001 and $119.7 million (7.09%) in 2000. The decrease in the investment yield in 2002 compared to 2001 and 2000 primarily reflects a lower prevailing interest rate environment. Expenses incurred to manage the investment portfolio amounted to $0.6 million in 2002, $1.2 million in 2001 and $1.9 million in 2000. These expenses are included as a reduction of investment income in the statement of income and comprehensive income.
Interest expense totaled $58.7 million in 2002, $63.1 million in 2001 and $77.5 million in 2000. The average rate paid on all interest-bearing
liabilities was 4.39% in 2002, compared with 4.70% in 2001 and 4.81% in 2000. Interest-bearing liabilities averaged $1.34 billion during 2002, $1.34 billion during 2001 and $1.61 billion during 2000. The decline in overall rates paid in 2002 compared to 2001 and 2000 resulted primarily from the impact of a declining interest rate environment, the continued reduction of crediting rates on certain closed blocks of business and the impact of securities lending in 2002 at short-term rates.
CHANGE IN AVERAGE INVESTED ASSETS largely resulted from the surrenders of certain closed blocks of fixed annuity policies. Changes in average invested assets also reflect net exchanges to fixed accounts from the separate accounts of variable annuity contracts, sales of fixed annuities and the fixed account options of the Company’s variable annuity products (“Fixed Annuity Deposits”), and renewal deposits on its universal life products (“UL Deposits”). Fixed Annuity Deposits and UL Deposits totaled $400.0 million in 2002, $80.8 million in 2001 and $63.9 million in 2000. These deposits represents 31%, 6% and 5%, respectively, of the related reserve balances at the beginning of the respective periods. The increase in Fixed Annuity Deposits in 2002 is due primarily to increased sales relating to the marketing of fixed annuities through new distribution relationships. The environment for fixed annuity sales remains very favorable, with alternative fixed income products at very low rates (e.g., bank CDs) and very low surrender rates as investors continue to seek safety and quality away from the equity markets.
The Company sold or redeemed invested assets, principally bonds and notes, aggregating $370.9 million in 2002, $427.5 million in 2001 and $389.1 million in 2000. Sales of investments result from the active management of the Company’s investment portfolio. Because redemptions of investments are generally involuntary and sales of investments are made in both rising and falling interest rate environments, net gains and losses from sales and redemptions of investments fluctuate from period to period, and represent 0.04%, 0.14% and 0.00% of average invested assets for 2002, 2001 and 2000, respectively. Active portfolio management involves the ongoing evaluation of asset sectors, individual securities within the investment portfolio and the reallocation of investments from sectors that are perceived to be relatively overvalued to sectors that are perceived to be relatively undervalued. The intent of the Company’s active portfolio management is to maximize total returns on the investment portfolio, taking into account credit, option, liquidity and interest-rate risk.
The Company has encountered increased competition in the variable annuity marketplace during recent years and anticipates that the market will remain highly competitive for the foreseeable future. Also, from time to time, Federal initiatives are proposed that could affect the taxation of annuities. (See “Regulation” in Item 1).
UNIVERSAL LIFE INSURANCE FEES, NET amounted to $3.3 million, $3.4 million and $2.2 million in 2002, 2001 and 2000, respectively. Universal life insurance fees consist of mortality charges, up-front fees earned on deposits received and administrative fees, net of excess mortality expense on these contracts. The administrative fees are assessed based on the number of policies in force as of the end of each month. The Company acquired its universal life contracts as part of the acquisition of business from MBL Life which occurred on July 1, 1999 and does not actively market such contracts. Such fees represent 1.34%, 1.39% and 0.84% of average reserves for universal life insurance contracts in the respective periods. The increase in such fees for 2001 resulted principally from improved mortality experience (See Note 3 of the accompanying financial statements.)
declining rates during the first seven years of a contract. Withdrawal payments, which exclude claims and lump-sum annuity benefits, totaled $212.9 million in 2002, compared with $257.3 million in 2001 and $409.2 million in 2000. These payments, when expressed as a percentage of average related reserves, represent 12.1%, 14.2% and 19.1% for 2002, 2001 and 2000, respectively. Withdrawal rates declined in 2002 and 2001 principally due to a lower level of surrenders on certain closed blocks of fixed annuity business due to consumer preference for guaranteed fixed rate investments in light of uncertainty regarding U.S. equity market performance. Withdrawals include variable annuity payments from the separate accounts totaling $61.5 million (13.3% of average variable annuity liabilities), $38.6 million (7.5% of average variable annuity liabilities) and $36.6 million (6.2% of average variable annuity liabilities) in 2002, 2001 and 2000, respectively. The increases in variable annuity withdrawal rates in 2002 and 2001 are due to unfavorable equity market conditions in both years.
GENERAL AND ADMINISTRATIVE EXPENSES totaled $8.1 million in 2002, $4.3 million in 2001 and $5.0 million in 2000. General and administrative costs were unusually low in 2001 due to certain guarantee fund credits which reduced overall expenses. Excluding the impact of this item, general and administrative expenses increased approximately 20% in 2002, representing the additional costs of selling and servicing a growing fixed annuity block of business. General and administrative expenses remain closely controlled through a company-wide cost containment program and continue to represent less than 1% of average total assets.
A majority of the Company’s variable annuity products are issued with a death benefit feature which provides that, upon the death of a contractholder, the contractholder’s beneficiary will receive the greater of (1) the contractholder’s account value, or (2) a guaranteed minimum death benefit that varies by product (the “GMDB”). Depending on the product, the GMDB may equal the principal invested, adjusted for withdrawals; or an amount equal to the highest account value in effect on any anniversary date under the contract. These benefits have issue age and other restrictions to reduce mortality risk exposure. The Company bears the risk that death claims following a decline in the financial markets may exceed contractholder account balances, and that the fees collected under the contract are insufficient to cover the costs of the benefit to be provided. In accordance with Generally Accepted Accounting Principles, the Company expenses such benefits in the period incurred, and therefore does not provide reserves for future benefits.
THE BOND PORTFOLIO, which constituted 83% of the Company’s total investment portfolio at December 31, 2002, had an aggregate fair value that was $35.0 million greater than its amortized cost at December 31, 2002, compared with an aggregate fair value that was $5.6 million greater than its amortized cost at December 31, 2001. The increase in net unrealized gains on the Bond Portfolio during 2002 principally reflects the decline in prevailing interest rates and the corresponding effect on the fair value of the Bond Portfolio at December 31, 2002.
At December 31, 2002, the Bond Portfolio included $1.35 billion of bonds rated by Standard & Poor’s (“S&P”), Moody’s Investors Service (“Moody’s”), Fitch (“Fitch”) or the National Association of Insurance Commissioners (“NAIC”), and $61.8 million of bonds rated by the Company pursuant to statutory ratings guidelines established by the NAIC. At December 31, 2002, approximately $1.35 billion of the Bond Portfolio was investment grade, including $474.3 million of U.S. government/agency securities and mortgage-backed securities (“MBS”).
The table on the following page summarizes the Company’s rated bonds by rating classification as of December 31, 2002.
Bonds and short-term promissory instruments are divided into six quality categories for NAIC rating purposes, ranging from 1 (highest) to 5 (lowest) for nondefaulted bonds plus one category, 6, for bonds in or near default. These six categories correspond with the S&P/Moody’s/Fitch rating groups listed above, with categories 1 and 2 considered investment grade. The NAIC categories include $61.8 million of assets that were rated by the Company pursuant to applicable NAIC rating guidelines.
While the trading market for the Company’s privately traded Secured Loans is more limited than for publicly traded issues, management believes that participation in these transactions has enabled the Company to improve its investment yield. As a result of restrictive financial covenants, these Secured Loans involve greater risk of technical default than do publicly traded investment-grade securities. However, management believes that the risk of loss upon default for these Secured Loans is mitigated by such financial covenants and the collateral values underlying the Secured Loans. The Company’s Secured Loans are rated by S&P, Moody’s, Fitch, the NAIC or by the Company, pursuant to comparable statutory ratings guidelines established by the NAIC.
Duration is a common option-adjusted measure for the price sensitivity of a fixed-maturity portfolio to changes in interest rates. It measures the approximate percentage change in the market value of a portfolio if interest rates change by 100 basis points (i.e. 1%), recognizing the changes in cash flows resulting from embedded options such as policy surrenders, investment prepayments and bond calls. It also incorporates the assumption that the Company will continue to utilize its existing strategies of pricing its fixed annuity and universal life products, allocating its available cash flow amongst its various investment portfolio sectors and maintaining sufficient levels of liquidity. Because the calculation of duration involves estimation and incorporates assumptions, potential changes in portfolio value indicated by the portfolio’s duration will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.
There are risks associated with some of the techniques the Company uses to provide liquidity, enhance its spread income and match its assets and liabilities. The primary risk associated with MBSs is that a changing interest rate environment might cause prepayment of the underlying obligations at speeds slower or faster than anticipated at the time of their purchase. As part of its decision to purchase an MBS, the Company assesses the risk of prepayment by analyzing the security’s projected performance over an array of interest-rate scenarios. Once an MBS is purchased, the Company monitors its actual prepayment experience monthly to reassess the relative attractiveness of the security with the intent to maximize total return.
INVESTED ASSETS EVALUATION is routinely conducted by the Company. Management identifies monthly those investments that require additional monitoring and carefully reviews the carrying values of such investments at least quarterly to determine whether specific investments should be placed on a nonaccrual basis and to determine declines in value that may be other than temporary. In making these reviews for bonds, management principally considers the adequacy of any collateral, compliance with contractual
The carrying values of investments that are determined to have declines in value that are other than temporary are reduced to net realizable value and, in the case of bonds, no further accruals of interest are made. The provisions for impairment on mortgage loans are based on losses expected by management to be realized on transfers of mortgage loans to real estate, on the disposition and settlement of mortgage loans and on mortgage loans that management believes may not be collectible in full. Accrual of interest is suspended when principal and interest payments on mortgage loans are past due more than 90 days. Impairment losses on securitized assets are recognized if the fair value of the security is less than its book value, and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent(prior) estimation date.
SOURCES OF LIQUIDITY are readily available to the Company in the form of the Company’s existing portfolio of cash and short-term investments, and if required, proceeds from invested asset sales. The Company’s liquidity is primarily derived from operating cash flows. At December 31, 2002, approximately $1.22 billion of the Bond Portfolio had an aggregate unrealized gain of $62.9 million while approximately $194.1 million of the Company’s Bond Portfolio had an aggregate unrealized loss of $27.9 million. In addition, the Company’s investment portfolio currently provides approximately $13.2 million of monthly cash flow from scheduled principal and interest payments. Historically, cash flows from operations and from the sale of the Company’s annuity products have been more than sufficient in amount to satisfy the Company’s liquidity needs.