Amounts are impacted by net unrealized gains on investments and derivative instruments designated as hedges totaling $82.3 million in 2005, $141.2 million in 2004, $121.6 million in 2003, $95.1 million in 2002 and $39.4 million in 2001. These amounts are net of deferred income taxes and other adjustments for assumed changes in the amortization of deferred policy acquisition costs, deferred sales inducements, unearned revenue reserves and value of insurance in force acquired.
Effective January 1, 2004, we changed our method of computing reserves for guaranteed minimum death benefits and incremental death benefits associated with our variable annuities and changed our presentation of deferred expenses and related amortization relating to sales inducements.
Effective December 31, 2003, we deconsolidated the trust that issued the company-obligated mandatorily redeemable preferred stock. The effect of this deconsolidation is to replace the obligations of the trust to the preferred security holders with our subordinated debt obligation to the trust.
At December 31, 2005, we had 517 fixed maturity and equity securities with gross unrealized losses totaling $71.1 million. Included in the gross unrealized losses are losses attributable to both movement in market interest rates as well as temporary credit issues. Details regarding these securities are included in the “Financial Condition - Investments” section that follows. Net income would have been reduced by approximately $24.6 million if all these securities were deemed to be other than temporarily impaired on December 31, 2005.
We have assumed the expected long-term rate of return on plan assets will be 7.00%. In estimating the discount rate (5.75% for 2005), we based it on the rate of return currently available on high quality, fixed-income investments.
The increase in volume of business in force is quantified in the detailed discussion that follows by summarizing the face amount of insurance in force for life products or account values of contracts in force for interest sensitive
The weighted average yield on cash and invested assets represents the yield on cash and investments backing the universal life and individual traditional annuity products, net of investment expenses. The weighted average crediting rate/index cost and spread are computed including the impact of the amortization of deferred sales inducements. With respect to our index annuities, index costs represent the expenses we incur to fund the annual income credits through the purchase of options and minimum guaranteed interest credited on the index business. See the “Segment Information” section that follows for additional discussion of our spreads.
We periodically revise the key assumptions used in the calculation of the amortization of deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenues for participating life insurance, variable and interest sensitive and index products, as applicable, through an “unlocking” process. Revisions are made based on historical results and our best estimate of future experience. The impact of unlocking on our results is as follows:
Mortality and expense fees totaled $6.9 million in 2005, $5.8 million in 2004 and $4.4 million in 2003. Mortality and expense fees increased due to increases in the separate account balances on which fees are based. The average separate account balance increased to $588.0 million for 2005, from $500.9 million for 2004 and $391.3 million for 2003 due to the impact of new sales and favorable investment results. Transfers of premiums to the separate accounts totaled $118.2 million for 2005, $96.6 million for 2004 and $71.6 million for 2003. Net investment income and net realized and unrealized gains on separate account assets totaled $37.7 million for 2005, $49.0 million for 2004 and $89.6 million for 2003.
Net investment income, which excludes investment income on separate account assets relating to variable products, increased 14.3% in 2005 to $475.4 million and increased 5.1% in 2004 to $416.1 million. These increases are due to an increase in average invested assets of 13.5% to $7,645.4 million (based on securities at amortized cost) in 2005 and 15.5% to $6,734.7 million in 2004. Average invested assets totaled $5,828.5 million in 2003. The increases in average invested assets in 2005 and 2004 are due principally to net premium inflows, summarized above, from the Life Companies. The annualized yield earned on average invested assets was 6.22% in 2005, 6.18% in 2004 and 6.79% in 2003. Fee income from bond calls, tender offers and mortgage loan prepayments totaled $8.4 million in 2005, $2.5 million in 2004 and $9.7 million in 2003. Net investment income includes ($0.6) million in 2005, ($0.5) million in 2004 and $3.3 million in 2003 representing acceleration (reversal) of net discount accretion on mortgage and asset-backed securities resulting from changing prepayment speed assumptions during the respective periods. See “Financial Condition - Investments” section that follows for a description of how changes in prepayment speeds impact net investment income. Market conditions in 2005, 2004 and 2003 decreased our investment portfolio yield as market investment rates were, in general, lower than our portfolio yield or yield on investments maturing or being paid down. The average yields on fixed maturity securities purchased were 5.44% for 2005, 5.56% for 2004 and 5.85% for 2003. The average yields on fixed maturity securities maturing or being paid down were 6.10% for 2005, 6.34% for 2004 and 7.21% for 2003. For 2005, the impact of these market conditions on our portfolio yield was offset by increased fee income and a decrease in our cash position and increased investment in corporate bonds.
The level of realized/unrealized gains (losses) is subject to fluctuation from period to period depending on the prevailing interest rate and economic environment and the timing of the sale of investments. See “Financial Condition - Investments” for details regarding our unrealized gains and losses at December 31, 2005 and 2004.
In September, additional adverse financial details regarding the company became available and the company filed for bankruptcy protection.
In September, issuer filed for bankruptcy after unsuccessful attempts to restructure. This reduced estimates on potential recovery.
In June, based on the company’s revenues and negative operating margins, we determined there was a high probability of restructuring and possible bankruptcy filing.
In March, the aircraft on one bond issue was returned to bondholders while other bond issues missed two consecutive debt payments. We determined there was a high probability of restructuring and possible bankruptcy filing.
In March, we wrote down due to restructuring in power generator sector and revised expectation of the length of time to recover full value.
Interest sensitive and index product benefits increased 7.8% in 2005 to $289.0 million and 2.9% in 2004 to $268.1 million. The increases in interest sensitive and index product benefits for 2005 and 2004 are due primarily to an increase in volume of annuity business in force, partially offset by the impact of decreases in interest crediting rates on many of our products during 2005 and 2004. Higher interest sensitive death benefits contributed to the increase in interest sensitive and index product benefits in 2005, however, these death benefits were lower and partially offset the increase in total benefits from 2003 to 2004. Interest sensitive and index product benefits can tend to fluctuate from period to period primarily as a result of changes in mortality experience (the rate and timing that individuals die) and the impact of changes in the equity markets on index credits and the value of the embedded derivatives for our index annuities.
The average account value of annuity contracts in force, which increased due to increases in premiums collected as summarized in the “Other data” table above, totaled $4,637.6 million for 2005, $3,762.0 million for 2004 and $2,959.4 million for 2003. These account values include values relating to index contracts totaling $2,299.1 million for 2005, $1,593.6 million for 2004 and $1,105.7 million for 2003.
embedded derivative is also impacted by the timing of the posting of index credits and changes in reserve discount rates and assumptions used in estimating future call option costs.
million charge for severance, early retirement benefits and other costs relating to the closing of a life insurance processing unit in Manhattan, Kansas and other unrelated terminations during 2005. As a result of closing this unit, we expect to achieve annual pre-tax savings of approximately $4.0 million. We started experiencing these savings during the fourth quarter of 2005. Other underwriting, acquisition and insurance expenses increased in 2004 due partially to expenses relating to the expansion of our EquiTrust Life distribution through independent agents and brokers totaling $4.1 million in 2005 and $4.0 million in 2004. The expansion related costs are comprised primarily of salaries and related benefits due to increased staffing levels to manage and service this business. The increase in 2004 was also impacted by a $0.7 million loss on the sale of fixed assets and a $1.2 million increase in advertising expense. In addition, costs increased $1.4 million in connection with a project to image policy files. Furthermore, other operating expenses increased as a result of the growth of our business and increased costs for regulatory compliance.
Equity income, net of related income taxes, totaled $1.2 million in 2005, $1.4 million in 2004 and $5.8 million in 2003. Equity income includes our proportionate share of gains and losses attributable to our ownership interest in partnerships, joint ventures and certain companies where we exhibit some control but have a minority ownership interest. Equity income decreased in 2004 due primarily to no longer recording equity income from our investment in American Equity Investment Life Holding Company (AEL). In the fourth quarter of 2003, our share of percentage ownership in AEL decreased resulting from AEL’s initial public offering of common stock and we discontinued applying the equity method of accounting for this investment. Our share of AEL’s net income totaled $4.4 million in 2003.
We analyze operations by reviewing financial information regarding products that are aggregated into four product segments. The product segments are: (1) Traditional Annuity - Exclusive Distribution (“Exclusive Annuity”), (2) Traditional Annuity - Independent Distribution (“Independent Annuity “), (3) Traditional and Universal Life Insurance and (4) Variable. We also have various support operations and corporate capital that are aggregated into a Corporate and Other segment.
We analyze our segment results based on pre-tax operating income (loss). Accordingly, income taxes are not allocated to the segments. In addition, operating results are analyzed net of any transactions between the segments. Operating income (loss) represents net income excluding the impact of realized and unrealized gains and losses on investments and changes in net unrealized gains and losses on derivatives. Prior to 2005, operating income included the changes in net unrealized gains and losses on derivatives that were not designated as hedges. The operating results for 2004 and 2003 have been modified to conform to the 2005 presentation. The impact of realized and unrealized gains and losses on investments and unrealized gains and losses on derivatives includes adjustments for income taxes and that portion of amortization of deferred policy acquisition costs, deferred sales inducements, unearned revenue reserve and value of insurance in force acquired attributable to such gains or losses.
Pre-tax operating income for the Exclusive Annuity segment increased 31.0% in 2005 to $34.4 million and 4.4% in 2004 to $26.3 million primarily due to an increase in spreads earned in 2005 and an increase in the volume of
The increases in benefits and expenses attributable to the increases in the volume of business in force are partially offset by the impact of reductions in interest crediting rates. In addition, benefits and expenses for these periods were impacted by changes in the assumptions used to calculate deferred policy acquisition costs as discussed under “Significant Accounting Policies and Estimates.” Amortization of deferred policy acquisition costs increased $2.4 million in 2005, decreased $0.3 million in 2004 and increased $1.4 million in 2003 due to changes in the assumptions used to calculate deferred policy acquisition costs. The 2005 unlocking adjustment is primarily due to a change in the premium persistency assumption on our flexible premium deferred annuity business. Amortization of value of insurance in force acquired was reduced $0.7 million in 2005 and 2004 as a result of changes in the assumptions used in the underlying calculation.
The changes in the weighted average yield on cash and invested assets are primarily attributable to the items affecting net investment income noted above. We reduced the crediting rates on most of our annuity products in 2004 and 2003 in response to the impact of declining market interest rates on our investment portfolio yield. We decreased crediting rates on our primary annuity contract by 25 basis points in 2004 and 65 basis points during 2003. We utilize interest rate swaps to hedge a portion of our annuity portfolio. Income from these swaps totaled $1.0 million in 2005, compared to a net cost of $1.6 million in 2004 and $1.2 million in 2003. See “Market Risks of Financial Instruments” following and Note 3 to the consolidated financial statements for additional information regarding these hedges. Our spreads earned were primarily impacted by the changes in fee income from bond calls and mortgage loan prepayments and the acceleration (reversal) of net discount accretion on mortgage and asset-backed securities.
The increase in interest sensitive and index product charges in 2005 and 2004 is due to an increase in surrender charges. Surrender charges increased due to an increase in surrenders relating to growth in the volume and aging of business in force. The increases in net investment income in 2005 and 2004 are attributable to growth in invested assets due principally to net premium inflows, partially offset by the impact of a decline in our investment yield. Net investment income for 2005 was also positively impacted by the change in allocation of capital discussed above. Net investment income includes $0.5 million in 2005, ($0.1) million in 2004 and $3.1 million in 2003 in fee income from bond calls, tender offers and mortgage loan prepayments and the acceleration (reversal) of net discount accretion on mortgage and asset-backed securities. The changes in derivative income are primarily due to increases in the cost of money for call options, partially offset by increases in proceeds from option settlements as discussed under “Derivative income (loss)” above.
Pre-tax operating income for the Traditional and Universal Life Insurance segment increased 5.3% in 2005 to $54.8 million and decreased 4.5% in 2004 to $52.1 million. As discussed below, the increase for 2005 is driven by an increase in the volume of business in force, increased spreads on our interest sensitive life business and the impact of unlocking on deferred policy acquisition costs. The decrease for 2004 is driven by a decrease in investment fee income, an increase in death benefits and the impact of a reserve adjustment made in 2003.
Traditional life insurance premiums increased in 2005 and 2004 due primarily to sales of whole life products by our Farm Bureau Life agency force, partially offset by an increase in term life premiums ceded. Net investment income includes $1.7 million in 2005, $1.1 million in 2004 and $2.9 million in 2003 in fee income from bond calls, tender offers and mortgage loan prepayments and the acceleration (reversal) of net discount accretion on mortgage and asset-backed securities as noted in the investment income discussion above. Net investment income was positively impacted in 2005 by a decrease in our cash position and increased investment in corporate bonds. Net investment income for 2005 and 2004 was also impacted by the decline in market interest rates during these periods. These decreases are partially offset by decreases in interest credited to policyholders and policy dividends paid due to reductions in interest and dividend crediting rates.
Interest expense includes $4.3 million in 2005 and $3.1 million in 2004 from our Senior Notes offering. Interest expense also increased in 2005 and 2004 due to an increase in the variable rate on our line of credit. In addition, interest expense increased and minority interest decreased in 2004 due to the reclassification of certain dividends to interest expense in connection with the adoption of Statement No. 150 and FASB Interpretation No. 46. See “Interest expense” for additional details regarding these reclassifications. The decrease in benefits and expenses in 2005 is attributable to an estimated $4.0 million reduction in insurance-related expenses due to the change in the method of allocating indirect expenses among the segments as discussed above. Benefits and expenses increased in 2004 due to increases in other expenses relating primarily to our non-insurance operations. The decrease in equity income in 2004 is due primarily to no longer recording equity income from our investment in AEL as discussed in the equity income section above.
As described in more detail in Note 1 to the consolidated financial statements, we will be subject to certain pending accounting changes beginning in 2006. Effective January 1, 2006, we will adopt Statement of Financial Accounting Standards (Statement) No. 123(R), “Share-Based Payment,” regarding the accounting for stock-based compensation. We estimate that if Statement No. 123(R) would have been adopted as of January 1, 2005, net income would have been decreased by $0.7 million ($0.02 per basic and diluted share) for the year ended December 31, 2005. This includes a cumulative effect adjustment of $0.1 million (less than $0.01 per basic and diluted share) relating to a change in accounting for forfeitures. The impact of adopting Statement No. 123(R) on operating and financing cash flows is not expected to be material since the cash flow from excess tax deductions for the year ended December 31 totaled $1.4 million for 2005 and $1.8 million for 2004. Effective January 1, 2007, we will adopt Statement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts,” regarding the accounting for internal replacements of one insurance contract for another insurance contract. The impact of adopting this SOP is not expected to be material as our current accounting policy for internal replacements substantially conforms to the new guidance.
In June 2005, the Financial Accounting Standards Board issued Statement No. 154, “Accounting Changes and Error Corrections”, a replacement of Accounting Principles Board Opinion No. 20, “Accounting Changes” and Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” Statement No. 154 requires retrospective application to prior periods’ financial statements for all voluntary changes in accounting principle, unless impracticable. Statement No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. Statement No. 154 will have no immediate impact on our consolidated financial statements, though it will impact our presentation of future voluntary accounting changes, if any such changes occur.
Corporate securities: The unrealized losses on corporate securities totaled $39.0 million, or 55.0% of our total unrealized losses. The largest losses were in the manufacturing sector ($335.4 million carrying value and $17.4 million unrealized loss) and in the financial services sector ($604.2 million carrying value and $11.1 million unrealized loss). The largest unrealized losses in the manufacturing sector were in the transportation manufacturing sector ($47.9 million carrying value and $5.7 million unrealized loss) and the paper and allied products sector ($58.7 million carrying value and $4.8 million unrealized loss). The unrealized loss in the transportation manufacturing industry is mainly due to credit spread widening on issues involved in automobile manufacturing and automobile parts manufacturing. These sectors have been hurt by poor operating results and weak competitive positions due to high operating cost structures. The unrealized loss in the paper and allied products sector is mainly due to spread widening that is the result of weaker operating results. In addition, we believe there are concerns that the sector may experience increased equity enhancing activity by management, such as common stock buybacks, which could be detrimental to credit quality. The unrealized loss in the financial sector and the remaining corporate sectors was caused primarily by a rise in market interest rates. Because we have the ability and intent to hold these investments
until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than temporarily impaired at December 31, 2005.
Mortgage and other asset-backed securities comprised 31.8% at December 31, 2005 and 40.6% at December 31, 2004 of our total available-for-sale fixed maturity securities. These securities are purchased when we believe these types of investments provide superior risk-adjusted returns compared to returns of more conventional investments such as corporate bonds and mortgage loans. These securities are diversified as to collateral types, cash flow characteristics and maturity. During 2005 and 2004, we reduced our allocation of assets to mortgage and other asset-backed securities to reduce our exposure to unwanted changes in the duration of our investment portfolio with changes in market interest rates.
Equity securities totaled $82.5 million at December 31, 2005 and $71.2 million at December 31, 2004. Gross unrealized gains totaled $28.1 million and gross unrealized losses totaled $0.2 million at December 31, 2005. At December 31, 2004, gross unrealized gains totaled $15.9 million and gross unrealized losses totaled $0.1 million on these securities. Included in equity securities is the value of our investment in AEL which increased to $72.0 million at December 31, 2005 from $59.5 million at December 31, 2004 due to market appreciation.
Mortgage loans totaled $840.5 million at December 31, 2005 and $740.9 million at December 31, 2004. These mortgage loans are diversified as to property type, location and loan size, and are collateralized by the related properties. Mortgages more than 60 days delinquent accounted for less than 0.3% of the carrying value of the mortgage portfolio at December 31, 2005. There were no mortgages more than 60 days delinquent at December 31, 2004. Our mortgage lending policies establish limits on the amount that can be loaned to one borrower and require diversification by geographic location and collateral type. Information regarding the collateral type and related geographic location within the United States follows:
Policy liabilities and accruals and other policyholders’ funds increased 13.8% to $8,195.8 million at December 31, 2005 primarily due to increases in the volume of business in force. Short-term debt of $46.0 million at December 31, 2004 relating to our outstanding borrowings on the line of credit agreement that was amended and restated in October 2005 is classified as long-term debt at December 31, 2005. In addition, long-term debt decreased due to the final redemption of our Series C preferred stock in December 2005. Other liabilities increased 25.4% to $151.8 million at December 31, 2005, due to a $50.1 million increase in negative cash balances at December 31, 2005 compared to December 31, 2004. This increase is primarily due to a $46.3 million outstanding check relating to our Series C preferred stock redemption at the end of 2005.
Stockholders’ equity increased 1.4%, to $844.2 million at December 31, 2005, compared to $832.6 million at December 31, 2004. This increase is principally attributable to net income for the year and proceeds from stock option exercises, substantially offset by the change in unrealized appreciation/depreciation on fixed maturity securities and dividends paid.
At December 31, 2005, common stockholders’ equity was $841.2 million, or $28.88 per share, compared to $829.6 million, or $28.87 per share at December 31, 2004. Included in stockholders’ equity per common share is $2.83 at
A majority of our insurance liabilities are backed by fixed maturity securities and mortgage loans. The weighted average life of the fixed maturity and mortgage loan portfolio, based on market values and excluding convertible bonds, was approximately 8.9 years at December 31, 2005 and 7.8 years at December 31, 2004. Accordingly, the earned rate on the portfolio lags behind changes in market yields. The extent that the portfolio yield lags behind changes in market yields generally depends upon the following factors:
rates in reaction to portfolio yield. Most of the traditional annuity and universal life insurance contracts assumed through the coinsurance agreements have guaranteed minimum crediting rates. For contracts assumed from American Equity, these rates range from 2.25% to 4.00%, with a weighted average guaranteed crediting rate of approximately 3.02% at December 31, 2005. For contracts assumed from EMCNL, these rates range from 2.50% to 4.00% with a weighted average guaranteed crediting rate of approximately 3.66% at December 31, 2005. The following table sets forth account values broken out by the excess of current interest crediting rates over guaranteed rates for fixed rate annuities and universal life business assumed through the coinsurance agreements at December 31, 2005.
Profitability on the portion of the index annuities tied to market indices is significantly impacted by the spread on interest earned on investments and the sum of (1) cost of underlying call options purchased to fund the credits owed to contract holders and (2) minimum interest guarantees owed to the contract holder, if any. The cost of the call options is managed through the terms of the index annuities, which permit adjustments to annual participation rates, asset fees, and/or caps, subject to guaranteed minimums. The minimum guaranteed contract values for the majority of index annuities sold by our EquiTrust Life distribution in 2005 are equal to 87.5% of the premium collected plus interest credited at 2.30%. A few state variations exist where the minimum guaranteed contract values are based on 100% of premium accumulated at 1.50% or 2.00%. The minimum guaranteed contract values for index annuities assumed under the coinsurance agreement are equal to 80% to 100% of the premium collected plus interest credited at rates ranging between 2.25% to 3.50%. Profitability on the index annuities in any given year is also impacted by changes in the fair value of the embedded option which provides the contract holder the right to participate in market index returns after the next index reset date of the contract. This impacts profitability because only one or two-year call options are purchased to fund the index credits owed to the contract holders at the inception of each reset period. This practice matches well with the contract holders’ rights to switch to different indices on each reset date. The value of the forward starting options embedded in the index annuities can fluctuate with changes in assumptions as to the expected cost of the options, which is driven by expectations as to the future volatility of the market indices, risk free interest rates, market returns, contractual features such as participation rates, asset fees, and/or caps and the lives of the contracts.
We design our products and manage our investment portfolio in a manner to encourage persistency and to help ensure targeted spreads are earned. In addition to the ability to change interest crediting rates on our direct products, certain interest sensitive and index contracts have surrender and withdrawal penalty provisions. The following is a summary of the surrender and discretionary withdrawal characteristics of our interest sensitive and index products and supplementary contracts without life contingencies at December 31, 2005.
As of December 31, 2005, we have six interest rate swaps to manage interest rate risk associated with a portion of our flexible premium deferred annuity contracts. Under the interest rate swaps, we pay a fixed rate of interest and receive a floating rate of interest on a notional amount totaling $300.0 million. These interest rate swaps effectively fix the interest crediting rate on a portion of our flexible premium deferred annuity contract liabilities thereby hedging our exposure to increases in market interest rates. For additional discussion of these interest rate swaps, see Note 3 to the consolidated financial statements.
If interest rates were to increase 10% from levels at December 31, 2005 and 2004, the market value of our fixed maturity securities and short-term investments would decrease approximately $192.8 million at December 31, 2005 and $158.9 million at December 31, 2004, while the value of our interest rate swaps would increase approximately $3.5 million at December 31, 2005 and $1.4 million at December 31, 2004. These hypothetical changes in value do not take into account any offsetting change in the value of insurance liabilities for investment contracts since we estimate such value to be the cash surrender value for a majority of the underlying contracts. If interest rates were to decrease 10% from levels at December 31, 2005 and 2004, the fair value of our debt would increase $4.8 million at December 31, 2005 and $5.5 million at December 31, 2004.
The computer models used to estimate the impact of a 10% change in market interest rates use many assumptions and estimates that materially impact the fair value calculations. Key assumptions used by the models include an immediate and parallel shift in the yield curve and an acceleration of bond calls and principal prepayments on mortgage and other asset-backed securities. The above estimates do not attempt to measure the financial statement impact on the resulting change in deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired, unearned revenue reserves and income taxes. Due to the subjectivity of these assumptions, the actual impact of a 10% change in rates on the fair market values would likely be different from that estimated.
Parent company cash inflows from operations consists primarily of (i) dividends from subsidiaries, if declared and paid, (ii) fees that it charges the various subsidiaries and affiliates for management of their operations, (iii) expense reimbursements from subsidiaries and affiliates, (iv) proceeds from the exercise of employee stock options, (v) proceeds from borrowings and (vi) tax settlements between the parent company and its subsidiaries. Cash outflows are principally for salaries, taxes and other expenses related to providing these management services, dividends on outstanding stock and interest on our parent company debt.
For the life insurance operations, cash outflow requirements for operations are typically met from normal premium and deposit cash inflows. This has been the case for all reported periods as the Life Companies’ continuing operations and financing activities relating to interest sensitive and index products provided funds totaling $892.2 million in 2005, $833.4 million in 2004 and $711.2 million in 2003. Positive cash flow from operations is generally used to increase the Life Companies’ fixed maturity securities and other investment portfolios. In developing their investment strategy, the Life Companies establish a level of cash and securities which, combined with expected net cash inflows from operations, maturities of fixed maturity investments and principal payments on mortgage and asset-backed securities and mortgage loans, are believed adequate to meet anticipated short-term and long-term benefit and expense payment obligations.
We anticipate that funds to meet our short-term and long-term capital expenditures, cash dividends to stockholders and operating cash needs will come from existing capital and internally generated funds. We believe that the current level of cash and available-for-sale and short-term securities, combined with expected net cash inflows from operations, maturities of fixed maturity investments, principal payments on mortgage and asset-backed securities, mortgage loans and our insurance products, are adequate to meet our anticipated cash obligations for the foreseeable future. Our investment portfolio at December 31, 2005, included $179.3 million of short-term investments, $5.1 million of cash and $1,068.2 million in carrying value of U.S. Government and U.S. Government agency backed securities that could be readily converted to cash at or near carrying value.
In the normal course of business, we enter into insurance contracts, financing transactions, lease agreements or other commitments which are necessary or beneficial to our operations. These commitments may obligate us to certain cash flows during future periods. The following table summarizes such obligations as of December 31, 2005:
Interest on the revolving line of credit is assumed to be 5.51% until maturity.
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a - 15(f). Under the supervision and the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2005.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 has been attested to by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report that follows.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that FBL Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). FBL Financial Group, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that FBL Financial Group, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, FBL Financial Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets as of December 31, 2005 and 2004, and the related statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005 of FBL Financial Group, Inc. and our report dated February 3, 2006 expressed an unqualified opinion thereon.
As discussed in Note 1 to the consolidated financial statements, in 2004 the Company changed its method of accounting for guaranteed minimum death benefits and incremental death benefits on its variable annuities and in 2003 the Company changed its method of accounting for its Series C redeemable preferred stock and the subsidiary trust that issued the company-obligated mandatorily redeemable preferred stock.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts.” The SOP provides guidance on the accounting for internal replacements of one insurance contract for another insurance contract. Under the SOP, an internal replacement that is determined to result in a replacement contract that is substantially changed from the replaced contract is accounted for as an extinguishment of the replaced contract. As an extinguishment, the unamortized deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserves from the replaced contract are written off at the time of the extinguishment. An internal replacement that is determined to result in a replacement contract that is substantially unchanged from the replaced contract is accounted for as a continuation of the replaced contract. The SOP is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier application encouraged. The impact of adoption is not expected to be material as our current accounting policy for internal replacements substantially conforms to the guidance outlined in the SOP. We plan to adopt SOP 05-1 in 2007.
In December 2004, the FASB issued Statement No. 123(R), “Share-Based Payment,” which is a revision of Statement No. 123, “Accounting for Stock-Based Compensation.” Statement No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The stock option expense is recognized over the shorter of our five-year vesting schedule or the period ending when the employee becomes eligible for retirement. In addition, the impact of forfeitures is estimated and compensation expense is recognized only for those options expected to vest. Statement No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow. This statement is effective for fiscal years beginning after June 15, 2005. Details regarding the impact of changes in accounting for stock-based compensation and our application of the modified-prospective-transition method of adoption are outlined in the “Stock-Based Compensation” section of this Note.
Effective January 1, 2004, we adopted SOP 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts,” issued by the AcSEC. The SOP provides guidance on separate account presentation and valuation and the classification and valuation of long-duration contract liabilities. To comply with this SOP, we changed our method of computing reserves for guaranteed minimum death benefits (GMDB) and incremental death benefits (IDB) associated with our variable annuities.
For derivatives not designated as a hedging instrument, the change in fair value is recognized in earnings in the period of change. See Note 3, “Derivative Instruments,” and Note 7, “Credit Arrangements,” for more information regarding our derivative instruments and embedded derivatives.
Investment real estate is reported at cost less allowances for depreciation. Real estate acquired through foreclosure, which is included with investment real estate in our consolidated balance sheets, is recorded at the lower of cost (which includes the balance of the mortgage loan, any accrued interest and any costs incurred to obtain title to the property) or estimated fair value on the foreclosure date. The carrying value of these assets is subject to regular review. For properties not held for sale, if indicators of impairment are present and a property’s expected undiscounted cash flows are not sufficient to recover the property’s carrying value, an impairment loss is recognized and the property’s cost basis is reduced to fair value. If the fair value, less estimated sales costs, of real estate held for sale decreases to an amount lower than its carrying value, the carrying value of the real estate is reduced by the establishment of a valuation allowance, changes to which are recognized as realized gains or losses on investments.
For participating traditional life insurance, interest sensitive and index products, these costs are being amortized generally in proportion to expected gross profits (after dividends to policyholders, if applicable) from surrender
Property and equipment, comprised primarily of furniture, equipment and capitalized software costs, are reported at cost less allowances for depreciation and amortization. Depreciation and amortization expense is computed primarily using the straight-line method over the estimated useful lives of the assets. Furniture and equipment had a carrying value of $36.3 million at December 31, 2005 and $35.7 million at December 31, 2004, and estimated useful lives that generally range from two to ten years. Capitalized software costs had a carrying value of $10.5 million at December 31, 2005 and $7.7 million at December 31, 2004, and estimated useful lives that range from two to five years. Depreciation expense for furniture and equipment was $8.7 million in 2005, $8.2 million in 2004 and $7.4 million in 2003. Amortization expense for capitalized software was $4.8 million in 2005, $4.1 million in 2004 and $4.7 million in 2003.
For our direct business, interest crediting rates for interest sensitive products ranged from 2.40% to 4.50% in 2005, from 1.75% to 4.50% in 2004 and from 2.55% to 5.55% in 2003. For interest sensitive products assumed through coinsurance agreements, interest crediting rates ranged from 3.00% to 11.50% in 2005 and 2004 and from 3.25% to 12.00% in 2003. A portion of the interest credited on our direct business and assumed through the coinsurance agreement ($1.2 million in 2005, $9.5 million in 2004 and $19.8 million in 2003) represents an additional interest credit on first-year premiums, payable at policy issue or until the first contract anniversary date (first-year bonus interest). These amounts are included as deferred sales inducements.
The liability for future policy benefits for direct participating traditional life insurance is based on net level premium reserves, including assumptions as to interest, mortality and other factors underlying the guaranteed policy cash values. Reserve interest assumptions are level and range from 2.00% to 6.00%. The average rate of assumed investment yields used in estimating gross margins was 6.28% in 2005, 6.51% in 2004 and 6.87% in 2003. Accrued dividends for participating business are established for anticipated amounts earned to date that have not been paid. The declaration of future dividends for participating business is at the discretion of the Board of Directors of Farm Bureau Life. Participating business accounted for 43% of direct receipts from policyholders during 2005, 2004 and 2003 and represented 14% of life insurance in force at December 31, 2005 (2004 and 2003 - 15%). The liability for future policy benefits for non-participating traditional life insurance is computed using a net level method, including assumptions as to mortality, persistency and interest and includes provisions for possible unfavorable deviations.
Components of our underwriting, acquisition and insurance expenses are as follows:
We currently follow the prospective method under Statement No. 123, which we adopted effective January 1, 2003. Under the prospective method, expense is recognized for those options granted, modified or settled after the date of adoption. The expense is generally recognized ratably over our five-year vesting period without regard to when an employee becomes eligible for retirement and immediate vesting. In addition, the impact of forfeitures is recognized when they occur and benefits of tax deductions in excess of recognized compensation cost are reported as an operating cash flow.
Restricted stock awards that vest based on meeting performance standards and the passage of time are charged to expense using the straight-line method over the required service period. The value of the awards is based on the grant date fair value of the restricted stock adjusted for expected forfeitures and an estimate of the number of shares expected to vest. The estimate for the number of shares to vest is reviewed each period and the impact of any changes in the estimate on expense is recorded in the current period.
The non-employee directors on our Board may elect to receive a portion of their compensation in the form of cash, Class A common shares or deferred stock units pursuant to the Director Compensation Plan. In addition, certain members of management may defer a portion of their compensation in the form of deferred stock units. The fair value of Class A common shares and deferred stock units, as measured by the fair value of the underlying Class A common stock, are charged to expense in the period they are earned.
The carrying value and estimated market value of our portfolio of available-for-sale fixed maturity securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
The changes in net unrealized investment gains and losses are recorded net of deferred income taxes and other adjustments for assumed changes in the amortization pattern of deferred policy acquisition costs, deferred sales inducements, value of insurance in force acquired and unearned revenue reserve totaling ($66.4) million in 2005, $24.4 million in 2004 and ($1.6) million in 2003.
The following tables set forth the estimated market value and unrealized losses of available-for-sale fixed maturity securities in an unrealized loss position that are not deemed to be other-than-temporarily impaired. These are listed by investment category and the length of time the securities have been in an unrealized loss position:
Included in the above table are 515 securities from 328 issuers at December 31, 2005 and 169 securities from 130 issuers at December 31, 2004. These increases are primarily due to the impact of increases in market interest rates during 2005. The following summarizes the details describing the more significant unrealized losses by investment category as of December 31, 2005.
Mortgage and asset-backed securities: The unrealized losses on mortgage and asset-backed securities were caused primarily by increases in market interest rates. We purchased most of these investments at a discount to their face amount and the contractual cash flows of these investments are based on mortgages and other assets backing the securities. Because the decline in market value is attributable to changes in market interest rates and not credit quality, and because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2005.
State municipal and other governments: The unrealized losses on state, municipal and other governments were caused by increases in market interest rates. We purchased these investments at a discount to their face amount and the contractual cash flows of these investments are based on the taxing authority of a municipality or the revenues of a municipal project. Because the decline in market value is attributable to changes in market interest rates and not credit quality, and because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at December 31, 2005.
We do not have any impaired loans (those loans in which we do not believe we will collect all amounts due according to the contractual terms of the respective loan agreements) at December 31, 2005. The carrying value of impaired loans was $4.2 million at December 31, 2004.
We have provided an allowance for possible losses against our investment real estate. An analysis of this allowance, which consists of specific reserves, is as follows:
Realized/unrealized gains (losses), recorded as a component of income, and the change in unrealized appreciation/depreciation on investments and interest rate swaps, recorded as a component of the change in accumulated other comprehensive income, are summarized below:
The table above excludes amounts attributable to investments held by subsidiaries engaged in the broker/dealer industry. The entire realized/unrealized loss on fixed maturity securities classified as trading for 2005 relates to securities held as of December 31, 2005.
Realized losses on fixed maturities totaling $2.2 million in 2005, $6.3 million in 2004 and $9.2 million in 2003 were incurred as a result of writedowns for other than temporary impairment of fixed maturity securities.
We have a common stock investment in American Equity’s parent, American Equity Investment Life Holding Company (AEL), valued at $72.0 million at December 31, 2005 and $59.5 million at December 31, 2004. American Equity underwrites and markets life insurance and annuity products throughout the United States. In December 2003, AEL completed an initial public offering (IPO). Prior to the IPO, we accounted for AEL using the equity method and, due to the timing of the availability of financial information, we recorded our share of AEL’s results one quarter in arrears. As a result of the IPO, our percentage ownership interest in AEL decreased and we discontinued applying the equity method of accounting and began recording the investment at market value in the equity securities line on the consolidated balance sheet.
Summarized financial information for AEL and our common stock ownership percentage when the equity method of accounting applied is as follows:
At December 31, 2003, we also owned preferred stock issued by AEL with a carrying value totaling $2.3 million. During 2004, this investment was converted to common stock.
At December 31, 2005, affidavits of deposits covering investments with a carrying value totaling $7,718.5 million were on deposit with state agencies to meet regulatory requirements. Also, fixed maturity securities with a carrying value of $44.5 million were on deposit with the FHLB as collateral for our funding agreement.
At December 31, 2005, we had committed to provide additional funding for mortgage loans on real estate aggregating $24.9 million. These commitments arose in the normal course of business at terms that are comparable to similar investments.
No investment in any entity or its affiliates (other than bonds issued by agencies of the United States Government) exceeded ten percent of stockholders’ equity at December 31, 2005.
Other assets and other liabilities: Fair values for interest rate swaps are based on quoted market prices. Other assets or other liabilities also include the embedded derivatives in our modified coinsurance contracts under which we cede business. Market values for these embedded derivatives are based on the difference between the fair value and the cost basis of the underlying investments. We are not required to estimate fair value for the remainder of the other asset or other liabilities balances.
Short-term and long-term debt: The fair values for long-term debt are estimated using discounted cash flow analysis based on our current incremental borrowing rate for similar types of borrowing arrangements. For short-term debt, the carrying value approximates fair value.
We assume certain traditional life, universal life and annuity business issued through October 1, 2003 from EMC National Life Company (EMCNL). In addition, we also assume variable annuity business from alliance partners through modified coinsurance arrangements. Variable life business is also assumed from certain of the partners through similar modified coinsurance arrangements.
An analysis of the value of insurance in force acquired is as follows:
We had a $60.0 million revolving line of credit agreement with LaSalle Bank National Association and Bankers Trust Company, N.A. that was scheduled to mature on October 31, 2005. In October 2005, we amended and restated this agreement to make it effective through October 2010. Under this new agreement, which has terms similar to the previous agreement, we are required to meet certain financial covenants. In addition, we are prohibited from incurring additional indebtedness in excess of $25.0 million without prior approval from the banks while this line of credit is in effect. Debt outstanding on this line of credit totaled $46.0 million at December 31, 2005 and 2004. Interest on any borrowings accrued at a variable rate (5.13% at December 31, 2005 and 3.07% at December 31, 2004).
As multiemployer plans, the assets we contribute to the plans are commingled with the assets contributed by the other employers. Accordingly, unless noted otherwise, it is not practical to bifurcate the disclosure information below between amounts attributable to us and amounts attributable to the other employers. The measurement date for the plans is September 30. The plans’ funded status for all employers combined, compared to amounts recognized in our consolidated financial statements under rules for multiemployer plans follows:
The net amounts recognized for all employers noted above represent the amounts that would be recognized if the employers followed Statement No. 87 as a single employer plan. We record our proportionate share of prepaid or accrued pension cost and net periodic pension cost as follows:
Expected benefits to be paid for all employers are as follows: 2006 - $25.0 million, 2007 - $25.2 million, 2008 - $22.0 million, 2009 - $24.1 million, 2010 - $23.6 million and 2011 through 2015 - $117.9 million. We expect contributions to the plans for 2006 for all employers to be approximately $28.0 million, of which $9.8 million is expected to be contributed by us.
Weighted average assumptions used to determine benefit obligations disclosed above are as follows:
We have a Director Compensation Plan under which non-employee directors on our Board may elect to receive a portion of their compensation in the form of cash, Class A common shares or deferred stock units. Under this plan, we have deferred stock units outstanding totaling 34,559 at December 31, 2005 and 26,912 at December 31, 2004. At December 31, 2005, shares of Class A common stock available for future issuance under the Director Compensation Plan totaled 14,791. Also, beginning in 2005, we have an Executive Salary and Bonus Deferred Compensation Plan under which officers of the company who are required to meet certain stated common stock ownership guidelines are allowed to use their base salary and annual cash bonus to purchase deferred stock units. Under this plan, we have deferred stock units outstanding totaling 2,111 at December 31, 2005. At December 31, 2005, shares of Class A common stock available for future issuance under this plan totaled 247,889.
We are licensed by the IFBF to use the “Farm Bureau” and “FB” designations in Iowa. In connection with this license, we incurred royalty expense totaling $0.4 million in 2005, 2004 and 2003. We have similar arrangements with the Kansas Farm Bureau and other state Farm Bureau organizations in our market territory. Total royalty expense to Farm Bureau organizations other than the IFBF totaled $1.1 million in 2005 and 2004 and $1.2 million in 2003.
We have an administrative services agreement with American Equity under which we provide investment accounting and claims processing, accounting, compliance and other administrative services. Fee income from performing these services totaled $0.4 million in 2005 and 2004 and $0.3 million in 2003.
We lease our home office properties under a 15-year operating lease from a wholly-owned subsidiary of the IFBF. Future remaining minimum lease payments under this lease, as of December 31, 2005, are as follows: 2006 - $2.4 million; 2007 - $2.4 million; 2008 - $2.6 million; 2009 - $2.7 million; 2010 - $2.7 million and thereafter, through 2013 - $6.0 million. Rent expense for the lease totaled $3.1 million in 2005 and 2004 and $3.0 million in 2003. These amounts are net of $1.4 million in 2005, 2004 and 2003 in amortization of a deferred gain on the exchange of our home office properties for common stock in 1998. The remaining unamortized deferred gain totaled $10.1 million at December 31, 2005 and $11.5 million at December 31, 2004.
Options to purchase 6,832 shares of common stock in 2004 at $27.15 to $28.25 per share were granted during 2004 but were not included in the computation of 2004 diluted earnings per share because the options’ exercise price was greater than the average market price of common shares during 2004. The options, which expire in 2014, were still outstanding at December 31, 2004.
The financial statements of the Life Companies included herein differ from related statutory-basis financial statements principally as follows: (a) the bond portfolio is classified as either available-for-sale or trading which are carried at fair value rather than generally being carried at amortized cost; (b) changes in the fair value of call options held directly by EquiTrust Life are recorded as a component of derivative income rather than directly to surplus; (c) acquisition costs of acquiring new business are deferred and amortized over the life of the policies rather than
Net income of the Life Companies, as determined in accordance with statutory accounting practices, was $66.1 million in 2005, $61.1 million in 2004 and $55.1 million in 2003. Statutory capital and surplus totaled $611.5 million at December 31, 2005 and $542.0 million at December 31, 2004.
We analyze our segment results based on pre-tax operating income (loss). Accordingly, income taxes are not allocated to the segments. In addition, operating results are generally reported net of any transactions between the segments. Operating income (loss) represents net income excluding the impact of realized and unrealized gains and losses on investments and changes in net unrealized gains and losses on derivatives. Prior to 2005, operating income included the changes in net unrealized gains and losses on derivatives that were not designated as hedges. The operating results for 2004 and 2003 have been modified to conform to the 2005 presentation.
impacted by the income on the investments transferred. An estimate of the impact of this asset transfer on operating revenues and pre-tax operating income (loss) for 2005 is as follows: Exclusive Annuity - $2.7 million; Independent Annuity - $1.3 million; Traditional and Universal Life Insurance - ($4.5) million; Variable - ($0.8) million and Corporate and Other - $1.3 million.
Our investment in equity method investees and the related equity income and interest expense are attributable to the Corporate and Other segment. Expenditures for long-lived assets were not significant during the periods presented above. Goodwill at December 31, 2005 and 2004 is allocated among the segments as follows: Exclusive Annuity ($3.9 million), Traditional and Universal Life Insurance ($6.1 million) and Variable ($1.2 million).
Net statutory premiums collected, which include premiums collected from annuities and universal life-type products that are not included in revenues for GAAP reporting, totaled $1,432.7 million in 2005, $1,223.7 million in 2004 and $1,177.7 million in 2003. Excluding the Independent Annuity segment, our total life and annuity collected premiums are concentrated in the following states: Iowa (2005 - 27%, 2004 - 28%, 2003 - 29%), Kansas (2005 - 19%, 2004 - 20%, 2003 - 20%) and Oklahoma (2005 - 7%, 2004 - 8%, 2003 - 9%). For the Independent Annuity segment, excluding reinsurance assumed, our annuity collected premiums are concentrated in the following states: Florida (2005 - 14%, 2004 - 13%), California (2005 - 10%, 2004 - 11%), North Carolina (2005 - 8%, 2004 - 6%,) and Michigan (2005 - 7%, 2004 - 11%).
The differences between the derivative income (loss) by quarter primarily correspond to the performance of the indices upon which our call options are based. Based on events and analysis performed during the respective periods, income taxes were reduced $0.5 million in the third quarter of 2005, $1.6 million in the second quarter of 2004, $0.3 million in the third quarter of 2004 and $2.6 million in the fourth quarter of 2004, as we determined that certain tax accruals were no longer necessary.