The Insurance Company is engaged in the sale of insurance products with three primary lines of business: individual annuities, individual life insurance, and group accident and health. Revenues are derived primarily from premiums received from the sale of annuity contracts, life and accident and health products, and gains (or losses), from our investment portfolio. As described in Item 1A, since 2004 the Insurance Company has suspended the sale of traditional and universal life insurance due to existing market conditions.
Unless specifically stated otherwise, all references to 2006, 2005 and 2004 refer to our fiscal years ended, or the dates, as the context requires, December 31, 2006, December 31, 2005 and December 31, 2004, respectively.
The Corporation’s earnings per share were $1.69 for 2006, as compared to $3.12 in 2005 and $2.25 in 2004. Results in 2006 reflect decreases in both investment income and net realized investment gains from the prior years. Our total revenues in 2006 were $359 million, compared to $459 million in 2005 and $396 million in 2004. The Corporation’s decreases in earning and revenues in 2006 resulted primarily from decreases in net investment income and realized capital gains. In 2006, the lower yields from the portfolio rebalancing (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset/Liability Management.”), a loss on the payor swaptions (reflected in the realized capital gains), and decreased investment income from the Corporation’s partnership investments all contributed to lower revenues in 2006.
There are numerous factors, some of which are outside our control, which could have a material impact on our business. These factors include market conditions, legal and regulatory changes and operational risk. A summary of these factors is set below:
Interest Rate Risk: The Insurance Company’s principal products are deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates the Insurance Company’s annuity holders are less likely to seek to surrender their annuities prior to maturity to seek alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2006, the existence of surrender fees on approximately 53% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect for up to the first 7 years of each annuity policy and, therefore, disappear over time (see table below). In the event of a substantial increase in surrenders during a short period of time, the Insurance Company may have to sell off longer-term assets to pay current surrender liabilities. The Insurance Company continually develops strategies to address the match between the timing of its assets and liabilities. To that end, during 2005 and 2006, especially in light of the substantial number of policies coming off surrender charges in those years and in 2007, the Insurance Company reduced the amount of assets invested in longer-term investments by approximately $1,239 million and reinvested in short and intermediate return investments at reduced yields. These reduced yields were partially offset by the gains recognized by the Insurance Company from the sale of the longer-term assets. To protect against a substantial sudden increase in rates (300 basis points), the Company has entered into a series of payor swaption investments. Under these investments, the Company obtained the right to enter into interest rate swap agreements with counterparties under which the Company’s interest rate obligations are fixed and the counterparties’ obligations are variable, thus protecting the Company from sudden rate increases. (See, Item 7, Management’s Discussion and Analysis, Liquidity and Capital Resources, “Asset /Liability Management.”)
Another major factor affecting profitability is the level of expenses. Management believes that one of the Insurance Company's strengths is its concentration on minimizing expenses through periodic review and adjustment of general and administrative costs.
accordingly, has adopted strategies that are designed to address either an increase or decrease in prevailing rates. These strategies included the investments in Payor Swaptions, described below.
As of December 31, 2006, approximately 7.1% of the Insurance Company's total invested assets were invested in limited partnerships and equity securities. Investments in limited partnerships are included in the Corporation's consolidated balance sheet under the heading “Other long-term investments.” See “Note 2 to the Notes to Consolidated Financial Statements.” The Insurance Company is committed, if called upon during a specified period, to contribute an aggregate of approximately $111.6 million of additional capital to certain of these limited partnerships. $12.9 million in commitments will expire in 2007, $13.3 million in 2008, $4.6 in 2009, $13.9 in 2010 and $66.9 in 2011. The Insurance Company may make selective investments in additional limited partnerships as opportunities arise. In general, risks associated with such limited partnerships include those related to their underlying investments (i.e., equity securities, debt securities and real estate), plus a level of illiquidity, which is mitigated by the ability of the Insurance Company to take quarterly distributions of partnership earnings. There can be no assurance that the Insurance Company will continue to achieve the same level of returns on its investments in limited partnerships as it has historically. Further, there can be no assurance that the Insurance Company will receive a return of all or any portion of its current or future capital investments in limited partnerships. The failure of the Insurance Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Corporation's financial condition and results of operations.
U.S. Treasury Obligations and Direct Obligations of U.S. Agencies: The unrealized loss on U.S. Treasuries and U.S. Agencies, totaling $5.329 million or 2.45% of cost at December 31, 2006, reflects a loss of market value of these fixed rate investments due to an overall increase in interest rates since the original purchase date. Because the Company has the ability and intent to hold these securities until maturity and due to the fact that these securities generally carry Aaa ratings by Moody’s and AAA by Standard and Poor’s, the Company does not consider these securities to be other than temporarily impaired.
In January 2005, A.M. Best Company affirmed the Insurance Company’s rating at “B+” (Very Good). Publications of A.M. Best indicate that the “B+” rating is assigned to those companies that, in A.M. Best's opinion, have achieved a very good overall performance when compared to the norms of the insurance industry and that generally have demonstrated a good ability to meet their respective policyholder and other contractual obligations over a long period of time. The B+ rating is within A.M Best’s “Secure” classification, along with A++, A+, A, A-, and B++ ratings.
In June 2005, Moody's Investor Services (“Moody's”) affirmed the Insurance Company's insurance financial strength at Ba2 (“Questionable financial security”) with a stable outlook, and it’s rating on the Corporation’s Senior Notes at B2 (“Poor financial security”), with a stable outlook. In June 2005, Standard & Poor's Corporation (“Standard & Poor's”) lowered the Insurance Company's insurance financial strength rating from a BB+, which is defined as “less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions,” to a BB- which is defined as “a vulnerability to the broad array of risks that are embedded in its investment and operational profile.” In June 2005, Standard & Poors lowered the credit rating of the Senior Notes from a B+ (more vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial requirements) to a B- (weak financial security, adverse business conditions will likely impair its ability to meet financial commitments), but raised the Credit Watch rating from negative to stable.
Comparison of Fiscal Year 2006 to Fiscal Year 2005 and Fiscal Year 2005 to Fiscal Year 2004.
Total annuity considerations and life insurance premiums increased to approximately $41.4 million in 2006 from approximately $39.1 million in 2005, an increase of approximately 5.9% and decreased from approximately $40.4 million in 2004 to $39.1 million in 2005, a decrease of approximately 3.3%. Life insurance premiums were $13.8 million, $11.8 million and $12.1 million in 2006, 2005 and 2004 respectively. Annuity considerations increased to approximately $27.6 million in 2006 from approximately $27.4 million in 2005, an increase of approximately $0.2 million, and decreased from approximately $28.4 million in 2004 to $27.4 million in 2005, a decrease of approximately $1.0 million. These amounts do not include consideration from the sales of deferred annuities or immediate annuities without life contingencies. Under GAAP, such sales are reported as additions to policyholder account balances. Consideration from such sales was approximately $163.6 million, $139.7 million and $234.5 million in 2006, 2005 and 2004, respectively. The decrease from 2004 to 2005 was primarily attributable to management’s decision to reduce sales in order to conserve capital and improve the company’s capital and surplus ratios.
Universal life and investment type policy fee income remained stable at approximately $2.9 million in fiscal years 2006, 2005 and 2004. Policy fee income consists principally of amounts assessed during the period against policyholders' account balances for mortality charges and surrender charges.
Net investment income totaled $316.4 million in 2006, as compared to $339.7 million in 2005 and $339.4 million in 2004. This represents a 6.9% decrease comparing 2006 to 2005 and a .08% increase comparing 2005 to 2004. The decrease from 2005 to 2006 was largely attributable to a decrease in investment income from the Insurance Company’s limited partnership investments. Income from these investments amounted to approximately $47.0 million, $63.5 million and $57.5 million in 2006, 2005 and 2004, respectively. In 2005, increases in income from limited partnerships and short-term investments were largely offset by a decrease in income from bonds from $272.7 million in 2004 to $263.8 million in 2005. In 2006, income from both the limited partnerships and fixed maturities decreased. The decrease in the limited partnership income from 2005 to 2006 of $16.5 million was largely attributable to the inherent volatility of such investments. The decrease in income from fixed maturities from 2004 to 2005 and 2006 was largely the result of the portfolio rebalancing activities in 2005 and 2006, which resulted in the sale of higher yielding long-term investments and the reinvestment into lower yielding short-term investments. (See Item 7, Management’s Discussion and Analysis, Asset/Liability Management). In addition, the Company increased the portion of its portfolio invested in short-term assets in the latter part of 2006 to enhance liquidity. The Insurance Company's ratios of net investment income to average cash and invested assets less net investment income for the years ended December 31, 2006, 2005 and 2004 were approximately 7.06%, 7.45% and 7.78%, respectively. Without taking into account the Corporation’s returns on its limited partnership investments in those years, the respective ratios would have been 6.37%, 6.43% and 6.92% for the years ended December 31, 2006, 2005 and 2004. For additional information, please refer to “Note 2 of the Notes to Consolidated Financial Statements.”
Net realized investment gains/(losses) (pre-tax) amounted to $(3.6 million) in fiscal 2006, as compared to $75.0 million in fiscal 2005 and $15.3 million in fiscal 2004. The decrease in 2006 was primarily attributable to recorded losses on the Insurance Company’s investment in Payor Swaptions. Due to accounting rules governing these investments, fluctuations in market value of these investments are realized in the income statement, even if the investments, as here, continued to be held by the Company. The values of the payor swaptions were $9.8 million and $19.0 million for year-end 2006 and 2005, respectively. The increase in investment gains from 2004 to 2005 was largely attributable to gains from the portfolio rebalancing activities in 2005. Net realized investment gains for years ended December 31, 2006, 2005 and 2004 include realized investment losses of approximately $4.5 million, $10.3 million, and $4.6 million, respectively, attributable to writedowns of certain securities contained in the Insurance Company's investment portfolio that were deemed by management to be other than temporarily impaired. For a discussion of the procedure by which such determinations were made, see “Investments” above. Realized investment gains (losses) also resulted from sales of certain equities and convertible securities and calls and sales of fixed maturity investments in the Company’s investment portfolio.
Under applicable accounting rules (FASB 97), DAC related to deferred annuities is amortized in proportion to the estimated gross profits over the estimated lives of the contracts. Essentially, as estimated profits of the Insurance Company related to these assets increase, the amount and timing of amortization is accelerated. The substantial increase in the DAC charge in 2005 was attributable principally to the high levels of realized gains from the Company’s portfolio rebalancing program and increased income from the Company’s limited partnership investments. (See also the discussion of Deferred Policy Acquisition Costs under Critical Accounting Policies below.)
For the reasons discussed above, income before income taxes amounted to approximately $70.2 million in 2006, as compared to approximately $148.2 million in 2005 and approximately $100.0 million in 2004.
For the reasons discussed above, the Corporation had net income of approximately $49.7 million in 2006, as compared to $91.6 million in 2005 and $66.0 million in 2004.
The Corporation was able to meet all its liquidity needs in 2006, including the payment of dividends, and anticipates being able to meet those needs in 2007 and the foreseeable future.
annuity surrender charges. This strategy benefited the Company by allowing it to realize enhanced yield from longer duration assets. At the end of 2004, the Insurance Company determined that the prospect of rising rates and declining surrender charges necessitated a reduction in the duration mismatch, as well as increased management of extension risk in its investment portfolio. The Company developed a two-step asset liability management strategy. The first step involved a duration reduction strategy, which involved the sale of certain longer duration assets that were purchased at prices below current market prices and reinvestment in shorter duration assets. Since December 31, 2004, the Company has completed in excess of $1,238.9 million of asset repositioning.
(1) The difference between the recorded liability of $3,695.3 million, and the total payment obligation amount of $5,425.1 million, is $1,729.8 million and is comprised of (i) future interest to be credited; (ii) the effect of mortality discount for those payments that are life contingent; and (iii) the impact of surrender charges on those contracts that have such charges.
Of the total payment of $5,425.1 million, $3,617.4 million, or 66.7%, is from the Company’s deferred annuity, life, and accident and health business. Determining the timing of these payments involves significant uncertainties, including mortality, morbidity, persistency, investment returns, and the timing of policyholder surrender. Notwithstanding these uncertainties, the table reflects an estimate of the timing of such payments.
Interest rate changes also may have temporary effects on the sale and profitability of our annuity products. For example, if interest rates rise, competing investments (such as annuity or life insurance products offered by the Insurance Company's competitors, certificates of deposit, mutual funds and similar instruments) may become more attractive to potential purchasers of the Insurance Company's products until the Insurance Company increases the rates credited to holders of its annuity products. In contrast, as interest rates fall, we would attempt to lower our credited rates to compensate for the corresponding decline in net investment income. As a result, changes in interest rates could materially adversely affect the financial condition and results of operations of the Insurance Company depending on the attractiveness of alternative investments available to the Insurance Company's customers. In that regard, in the current interest rate environment, the Insurance Company has attempted to maintain it’s credited rates at competitive levels designed to discourage surrenders and also to be considered attractive to purchasers of new annuity products.
For traditional life insurance business ($35 million of reserves), establishing reserves requires the use of many assumptions. Due to the number of independent variables inherent in the calculation of these reserves, and because this business is not material to the overall Company results, it is not practical to perform a quantitative analysis on the impact of changes in underlying assumptions. However, the Insurance Company historically has not experienced significant adverse deviations from its assumptions and believes that its assumptions are realistic and produce reserves that are fairly stated in accordance with GAAP.