The Company's home office consists of four buildings located in Wellesley Hills, Massachusetts. The Company owns this facility and leases it to SLOC for lease terms not exceeding five years. During 2001, the operations of the Company's Wealth Management segment were moved to the home office in Wellesley Hills. Prior to May 2001, the Wealth Management operations were primarily conducted from office space in Boston, Massachusetts, which was leased by the Company from unrelated parties. The home office of SLNY consists of office space in New York, New York, and is leased from an unrelated party. The home office of SLFSL consists of office space in Hamilton, Bermuda, and is leased from an unrelated party. Vision leases office space in Keene, New Hampshire from an unrelated party.
The results for the year ended December 31, 2002, 2001 and 2000 reflect $51 million, $51 million and $1.4 million, respectively, of interest earned on $600 million of affiliated notes owned by the Company through a limited partnership, the Partnership, controlled by a subsidiary, the General Partner. The interest earned is completely offset by interest expense on Partnership capital securities that were issued by the Partnership. The Company acquired the General Partner during December 2000 and recorded the acquisition using the purchase method of accounting; therefore, only $1.4 million of interest income and offsetting interest expense were consolidated in the Company's financials for the year ended December 31, 2000.
This discussion includes forward-looking statements by the Company under the Private Securities Litigation Reform Act of 1995. These statements are not matters of historical fact; they relate to such topics as future product sales, volume growth, market share, market risk and financial goals. It is important to understand that these forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those that the statements anticipate. These risks and uncertainties may concern, among other things:
The consolidated financial statements are prepared in accordance with GAAP, which require the Company to make estimates and assumptions (see Note 1 to the consolidated financial statements included in Item 8). The Company believes that of its significant accounting policies (see Note 1 to the consolidated financial statements included in Item 8), the following may involve a higher degree of judgement and complexity.
Acquisition costs related to fixed and variable annuities and life insurance products are deferred and amortized, generally in proportion to the ratio of annual gross profits to the estimated total gross profits over the lives of the contracts. Estimated gross profits are reviewed quarterly and adjusted retrospectively when the Company revises its estimates. Estimated gross profits include assumptions related to mortality, lapse, expense, and asset growth rates. Although realization of deferred policy acquisition costs ("DAC") is not assured, the Company believes it is more likely than not that all of these costs will be realized. The amount of DAC considered realizable, however, could be reduced in the near term if the estimates of gross profits or total revenues discussed above are reduced. The average long-term rate of assumed separate account fund performance used in estimating gross profits for the variable annuity products was 9% at December 31, 2002 and 2001.
The Company uses derivative financial instruments for risk management purposes to hedge against specific interest rate risk, to alter investment rate exposures arising from mismatches between assets and liabilities, and to minimize the Company's exposure to fluctuations in interest rates, foreign currency exchange rates and general market conditions. The derivative instruments used by the Company include swaps and options. The Company does not employ hedge accounting treatment. The Company believes that these derivatives provide economic hedges and the cost of formally documenting the effectiveness of the fair value of the hedged assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 133, was not justified. As a result, the unrealized gains and losses are recognized immediately in net investment income. Changes in the level of interest rates or equity markets will cause the value of these derivatives to change and can cause quarterly fluctuations in earnings.
The Company believes that its derivatives provide economic hedges against the risks noted. Since the majority of the liabilities that are being hedged are not carried at fair value, the changes in the fair value of the derivatives will cause fluctuation in the reported earnings from period to period as interest rates and equity markets change.
The Company's accounting policy for impairment requires recognition of an other-than-temporary impairment write-down on a security if it is determined that the Company is unable to recover all amounts due under the contractual obligations of the security. In addition, for securities expected to be sold, an other-than-temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover to cost or amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, the Company continues to review the other-than-temporarily impaired securities for additional impairment, if necessary.
During 2002 and 2001 and 2000, the Company incurred realized losses totaling $27.5 million, $5.5 million and $15.0 million, respectively, for other-than-temporary impairment of value of some of its fixed maturities after determining that not all of the unrealized losses were temporary in nature. During 2002, $1.4 million of the 2001 losses were recovered and are included in realized gains. The Company has stopped accruing income on several of its holdings for issuers that are in default. $1.9 million, $0.4 million and $0.2 million of interest income on these holdings was not accrued during 2002, 2001, and 2000, respectively.
The Company's net (loss) income was $(19.2), $(12.7) and $2.5 million for the years ended December 31, 2002, 2001 and 2000, respectively. The 2002 pretax loss before the cumulative change in accounting principle was $18.8 million greater than 2001. This increased loss was primarily due to a $183.3 million increase in benefits and expenses, and a $17.2 million decrease in net investment income in 2002, offset by a $113.0 million increase in net realized investment gains and a $68.3 million increase in fee income over 2001. The 2001 loss before cumulative effect of change in accounting principle and income taxes was an improvement of $16.0 million over 2000. This increase was primarily due to net realized investment gains of $23.7 million in 2001 compared to net realized investment losses of $20.0 million in 2000. A decrease of $13.1 million in other operating expenses also contributed to the pretax increase in 2001. Offsetting these increases were unfavorable decreases in net investment income and fee income.
In September of 2002 the Company launched its new Regatta Masters product series. Regatta Masters is a multi-manager offering combining MFS fund options with non-affiliated fund options. The Regatta Masters product offerings include products with a seven-year, four-year or no contingent deferred sales charge. Additionally, in October 2002, the product series was expanded to include a bonus variable annuity product.
The Wealth Management segment has been significantly impacted by unfavorable changes in the financial markets. The pre-tax loss of $112.1 million for the year ended December 31, 2002 was $82.4 million greater than the $29.7 million pre-tax loss for the year ended December 31, 2001. The increased loss over 2001 is primarily due to increased amortization of deferred acquisition costs, changes in the market values of derivatives used to manage Wealth Management liabilities, and increased policyholder benefits offset by increased net realized gains on investments.
Surrenders for 2002 were $183 million greater than 2001. The surrenders are primarily attributable to a mature block of business emerging from its surrender charge period.
Net investment income and realized gains for the Wealth Management segment increased by $58.6 million for the year ended December 31, 2002 as compared to 2001. This is primarily attributed to the following:
Net realized investment gains increased $80 million over the prior year. This increase is attributed to a $124 million gain on the sale of S&P 500 put options during the third quarter. The proceeds of this sale were used to purchase similar options with a longer term. Offsetting this gain is a $24 million increase in realized losses related to other-than-temporary declines in the value of certain fixed maturities, and a $14 million increased loss on the disposal of fixed maturity investments in the trading portfolio. Continued unfavorable market conditions could produce additional losses.
Total unrealized losses on derivatives in the investment portfolio decreased Wealth Management net investment income by $106 million for the year ended December 31, 2002, as compared to a total reduction of $84 million for the year ended December 31, 2001. The majority of the derivative instruments swap fixed for floating rates and reflected unrealized losses as a result of decreasing floating rates. Corporate bond spreads in the portfolio widened significantly and swap spreads tightened despite decreasing interest rates. As a result, the trading portfolio did not have offsetting appreciation of its bonds, thereby reducing investment income. Despite significant losses on derivatives associated with the GIC's, the Company's exposure is limited due to the structure of payment terms at maturity. The contract liabilities are carried at account value and are included with policyholder liabilities.
Total benefits and expenditures were $696.5 million and $530.7 million for the years ended December 31, 2002 and 2001, respectively. The increase of $165.8 million is primarily due to the following:
Fee income for the year 2001 was lower than 2000 by approximately $20 million, primarily as a result of lower variable annuity account balances. Market depreciation and reduced net deposit activity were key factors in the decline in the account balances. Variable annuity assets decreased by approximately $1.5 billion since December 31, 2000. Since fees are determined based on the average net assets held in these accounts, fee income decreased. Net deposits of annuity products decreased by $1.0 billion compared with 2000. The decrease in net deposits results primarily from decreased variable annuity sales. The successful introduction of new products during 2000 significantly increased deposits into the variable accounts, particularly in the fourth quarter of 2000. Sales during 2001 were not strong due to the unfavorable condition of the equity markets in general. The Company's results followed that of the variable annuity marketplace, which experienced a decrease in sales during 2001 as compared to 2000.
Policyholder benefits decreased by approximately $32 million for the year ended December 31, 2001, as compared to 2000. As U.S. issued GICs matured and were surrendered, related reserves decreased by $8 million and interest credited on deposits also declined by $20 million despite the $18 million increase on interest credited to policyholders of the new GIC contracts. Also contributing to the decrease in policyholder benefits were lower bonus payments credited to policyholder accounts. One set of annuity products credit the policyholder's account with a bonus payment upon receipt of the deposit; the expense is included in annuity payments. As a result of the reduced sales of the annuity products, bonus payments of $25 million for the year 2001 were a $19 million decrease from the $44 million of bonus payments made during the year 2000. Partially offsetting these decreases in policyowner benefits were increases in death benefits paid over policyholder account balances.
The Group Protection segment focuses on providing life, disability and stop loss insurance to small and medium sized employers as part of those companies' employee benefit plans. This segment operates only in the state of New York through a subsidiary, SLNY. Effective December 31, 2002, SLNY's operations were merged with another affiliate, KBL. As a result of this merger, Keyport, the former parent company of KBL and an affiliate of the Company, owns 67% of the combined entity and the Company retained a 33% interest in the combined entity. As of December 31, 2002, the assets and liabilities of SLNY are no longer consolidated with the Company.
The following provides a summary of operations for the Group Protection Segment for the years ended
Net income from the Group Protection segment increased by $0.6 million for the year ended December 31, 2002 as compared to 2001. Rate increases on renewals and new business, together with increased volume associated with the entrance of stop loss business sold in New York, effective June 2001, resulted in increased premiums of $0.7 million. Improvements in policy reserves and commission expense also contributed to the increased earnings.
Net income from the Group Protection segment increased by $1.4 million for the year ended December 31, 2001 as compared to 2000 due to increased premiums. Rate increases on renewals and new business, together with increased volume in the life products and persistency in the in-force block of life business, resulted in increased premiums. Claims were comparable to 2000.
The following provides a summary of operations for the Corporate Segment for the years ended December 31:
The Corporate segment had a net loss of $12.9 million for the year ended December 31, 2001, as compared to net income of $7.4 million for the year 2000. This $20.3 million decrease reflects an income tax benefit realized in 2000 related to issues in tax years which had been examined by the Internal Revenue Service. During 2001, the Company purchased put options on the S&P 500 index as part of its overall risk management strategy. A $29 million unfavorable change in the fair value of these options, included in investment income, was partially offset by increases of $4 million in net realized gains.
The Company regularly reviews its bond portfolios relative to any change in specific issuer performance, external and internal ratings, industry conditions, financial ratios, and changes in investment value. Such analysis is undertaken to determine that the integrity of the Company's investments remains sound and to review for other-than-temporary impairments.
The composition of the investments in the general account portfolio is as follows as of December 31, (in 000's):
As of December 31, 2002, the portfolio carried $263.3 million in gross unrealized gains relative to $89.2 million in unrealized losses. As a percent of carrying value, the largest contributors of unrealized losses were found in the Transportation, Utilities, Consumer-Noncyclical, and Energy sectors. Finance and Basic Industries stand out as experiencing the smallest gross unrealized losses as a percent of total carrying value. Below is a brief discussion concerning the industry segments of the Company's corporate bond holdings:
: Capital Goods is a large, diverse industrial sector encompassing the aerospace and defense, building material, construction machinery, diversified manufacturing, and environmental sectors. In 2002, aerospace continued to be negatively effected by the events of September 11 further exacerbated by weak economic conditions. Defense, on the other hand, benefited from the recent military buildup and increased budgets for homeland defense. Building materials was weaker due to reduced commercial construction. Although
: The Communications sector is made up of media-cable, media-non cable, telecom-wireless, and telecom-wireline. Communications, especially telecommunications, came under severe pressure in 2002. Significant overcapacity in certain business lines, technological substitution, intense competition, general economic weakness, and, accounting scandals led to extreme volatility in bond prices and high-profile defaults. The Company's portfolio was not immune to these developments. The Company's overall strategy has been to overweight companies with stronger and improving balance sheets, such as the regional bell operating companies and rural local exchange carriers; wireless companies with better competitive positions; diversified telecommunication and media companies; and the more recession-resistant cable sector. A significant portion of the portfolio is invested at the operating company level, which generally fares better under difficult scenarios. Pressures on these sectors have moderated to a significant extent, and the Company expects to see further improvements to credit quality from increased free cash flows, further boosted by any improvement in the economy. The Company intends to hold stressed but performing investments until they recover.
: Consumer Cyclicals is a large diverse industrial category comprising the automotive, entertainment, gaming, home construction, service, and textile sectors. In 2002, the automotive sector experienced significant pricing pressures, reduced earnings and balance sheet problems. Automotive companies suffered significant balance sheet deterioration from underfunded pension plans resulting from declining capital markets. Although auto demand in 2003 is expected to be similar to 2002, improvement is expected for 2004. Many retailers experienced a particularly challenging environment due to industry consolidation, guarded consumer spending, increased competition, and limited pricing power. Entertainment and gaming sectors had a relatively strong year. The Company has no exposure to the textile industry and limited exposure to the services industry. The Company continues to closely watch sector performance and has positioned the portfolio to focus on industry leaders or bond issues with attractive collateral.
: The Consumer Noncyclical sector is comprised of consumer product, food and beverage, healthcare, pharmaceutical, and supermarket companies. In a year of economic weakness and record debt defaults, the consumer products sector continued to be characterized as one of a safe haven, and, thus outperformed most sectors in 2002. The Company's analysis suggests that the broad sector will continue be a good relative performer under most economic scenarios. Sector weakness was concentrated in the supermarket sub sector for 2002. Supermarkets suffered from both a weaker economy and a change in the competitive structure of the industry. As consumers have become price sensitive in weak economic times, many have turned away from traditional grocers and turned to non-traditional food retailers such as supercenters and membership clubs. Yet, healthy free cash flow levels provide supermarket operators with financial flexibility and support investment stability.
: The Finance sector encompasses banks, independent and captive finance companies, insurance companies, broker-dealers and real estate investment trusts ("REITs"). With a few notable exceptions, bonds in this broad sector performed well in 2002. Banks benefited from near historic low interest rates, which served to improve net interest margins. Banks continued to show restraint in commercial lending, focusing on consumer lending for growth. Deteriorating credit quality, especially in commercial and industrial portfolios, led to marked increases in provisioning and charge-offs. Bonds of independent finance companies were quite volatile in 2002,
owing mostly to the on-again, off-again divestiture of one large commercial finance company and to the myriad of negative headlines of one large consumer finance company. Bond prices rallied in the latter part of 2002. Finance companies exposed to aircraft leasing suffered the effects of the downturn in air travel and the bankruptcies of major airlines. The performance of the captive finance bonds largely followed that of their parents. The bonds of life insurance companies under-performed in 2002 owing mostly to the dismal stock market performance which eroded variable annuity sales and account values. Life insurers were forced to accelerate deferred costs and to increase reserves for guaranteed minimum death benefits. Life insurers were also affected by lower interest rates, which lowered the yield on bond portfolios, and by the wave of downgrades and defaults of corporate bonds. Property-casualty insurers benefited from a hardening of prices, tempered somewhat by renewed asbestos headline risk, lower interest rates which lowered bond portfolio yields, and downgrades and defaults of corporate bond portfolios.
The bonds of broker-dealers fared well despite a very difficult operating environment characterized by a drought of equity initial public offerings ("IPOs"), equity underwriting and merger and acquisition activity. Broker-dealers were also plagued by negative headlines concerning biased research reports, conflicts of interest and IPO allocation processes. The recent performance of REITs has been strong, due to the defensive nature of the underlying assets and the sector's adherence to conservative credit covenants and policies. While real estate fundamentals may continue to weaken, it is anticipated that REIT debt will continue to be insulated from any significant credit or market value deterioration.
The Securities Valuation Office ("SVO") of the NAIC evaluates all public and private bonds purchased as investments by insurance companies. The SVO assigns one of six investment categories to each security it reviews. Category 1 is the highest quality rating, and Category 6 is the lowest. Categories 1 and 2 are the equivalent of investment grade debt as defined by rating agencies such as Standard & Poor's ("S&P") and Moody's (i.e., BBB-/Baa3 or higher), while Categories 3-6 are the equivalent of below-investment grade securities.
The majority of the Company's fixed maturity investments are investment grade, with 92.6% of fixed maturity securities classified as Category 1 and 2 by the SVO as of December 31, 2002. Below investment grade bonds were 7.4% of fixed maturity investments, and 5.6 % of total invested assets as of December 31, 2002. The following table provides the SVO ratings for the Company's bond portfolio along with an equivalent S&P rating designation as of December 31, 2002 (in 000's):
At December 31, 2002, $22.4 million, or 25.2%, of the gross unrealized losses are on securities that are rated investment grade. In general, unrealized losses on investment grade securities reflect changes in interest rates or changes in credit spreads since the securities were acquired and are generally temporary. The Company's policy is to subject any security with a gross unrealized loss of greater than 20% to a comprehensive asset impairment process. Securities at any level of the SVO rating scale would be subject to such review should a drop in market valuation or any other event signal a potential problem.
The Company's mortgage holdings amounted $779.0 million at December 31, 2002, representing 14.0% of total invested assets. All but one of the Company's mortgage holdings at December 31, 2002 were in good standing. The one restructured mortgage carried at $6.7 million is current on all principal and interest payments.
Liabilities decreased 11.2% during the year ended December 31, 2002. As with separate account assets, the separate account liabilities decreased during 2002 due to the unfavorable financial market conditions. Most of the Company's liabilities comprise reserves for life insurance and for annuity contracts and deposit funds. The Company would expect the general account liabilities to decline more than separate account liabilities because it believes that in the future, net deposits to variable products will exceed net deposits for the fixed contracts associated with these liabilities. During 2002, however, the GIC products marketed overseas increased general account liabilities by $501 million (for a total net deposits of approximately $1.5 billion from inception to date).
See Item 7A, "Quantitative and Qualitative Disclosures About Market Risk", in this Annual Report on Form 10-K for a discussion of the Company's capital markets risk management.
The NAIC adopted regulations at the end of 1993 that established minimum capitalization requirements for insurance companies, based on risk-based capital (''RBC'') formulas applied to statutory surplus. These requirements are intended to identify undercapitalized companies, so that specific regulatory actions can be taken on a timely basis. The RBC formula for life insurance companies calculates capital requirements related to assets, insurance, interest rates, and business risks. According to the RBC calculation, the Company met its capital requirements at December 31, 2002 and 2001. During the year ended December 31, 2002, the Company's parent contributed an additional $100 million to the paid in capital of the Company to strengthen its RBC position.
The Company has syndicated two lines of credit each in the amount of $250 million. There are 15 banks in the syndicate of lenders. The banks have committed to lend funds upon request by the Company at prevailing rates determined in accordance with the line of credit agreements. One line of credit terminates October 2003, the other in October 2007. As of December 31, 2002, no amounts have been borrowed.
The Company's ultimate parent as of December 31, 1999, SLOC, completed its demutualization on March 22, 2000. As a result of the demutualization, a new holding company, SLF, is now the ultimate parent of SLOC and the Company. SLF, a corporation organized in Canada, is a reporting company under the Securities Exchange Act of 1934, as amended, with common shares listed on the Toronto, New York, London, and Manila stock exchanges.
On March 12, 2001, the Company purchased all of the outstanding shares of Vision for approximately $5 million. Vision is a third party administrator incorporated in New Hampshire that provides insurance services throughout the United States.
In October 2001, SLC (U.S.) Holdings transferred its ownership in the Company's surplus notes totaling $565 million to Sun Life Financial (U.S.) Finance, Inc., an affiliate of the Company, at book value.
On December 21, 2000, the Company's parent, SLC (U.S.) Holdings, transferred its 100% ownership in the General Partner to the Company in exchange for 537 shares of the Company's common stock totaling $537,000 plus $65.5 million of additional paid in capital. There was no gain or loss realized on this transaction. The General Partner is the sole general partner of the Partnership which holds, as an investment, $600 million of subordinated debentures of SLC (U.S.) Holdings, the Company's parent. The Partnership also has $607.8 million of Partnership capital securities issued to an affiliated business trust, representing the limited partner interest.
On December 31, 2002, prior to the completion of the merger, the Company contributed capital in the amount of $14.85 million to SLNY.
On July 25, 2002, the Company issued an $80 million promissory note at 5.71% to an affiliate, Sun Life (Hungary) Group Financing Limited Liability Company (" Sun Life (Hungary) Ltd"). The Company pays interest semi-annually to Sun Life (Hungary), Ltd. On December 31, 2002 the Company paid $1.9 million in interest. The proceeds of the note were used to purchase fixed rate government and corporate bonds.
On December 21, 2000, the Company's parent, Sun Life of Canada (U.S.) Holdings, Inc., transferred its 100% ownership in Sun Life of Canada (U.S.) Holdings General Partner, Inc. to the Company in exchange for 537 shares of the Company's common stock totaling $537,000 plus $65.5 million of additional paid in capital.
The Company is a wholly-owned subsidiary of Sun Life of Canada (U.S.) Holdings, Inc. ("SLC (U.S.) Holdings"), which is an indirect wholly-owned subsidiary of Sun Life Assurance Company of Canada ("SLOC"). SLOC is a life insurance company domiciled in Canada that reorganized from a mutual life insurance company to a stock life insurance company on March 22, 2000. As a result of the demutualization, a new holding company, Sun Life Financial Services of Canada Inc. ("SLF"), is now the ultimate parent of SLOC.
The consolidated financial statements include the accounts of the Company and its subsidiaries. As of December 31, 2002, the Company owned all of the outstanding shares of Sun Life Financial Services Limited ("SLFSL"), Sun Benefit Services Company, Inc. ("SBSC"), Sun Capital Advisers, Inc. ("SCA"), Sun Life of Canada (U.S.) SPE 97-1, Inc. ("SPE 97-1), Sun Life of Canada (U.S.) Holdings General Partner, Inc. ("the General Partner"), Vision Financial Corporation ("Vision") and Clarendon Insurance Agency, Inc ("Clarendon"). The results are also consolidated with Sun Life of Canada Funding, LLC ("SLOC Funding"), which is owned by a trust sponsored by the Company and Sun Life of Canada (U.S.) Limited Partnership I ("the Partnership"), for which the General Partner is the sole general partner.
On December 31, 2002, the operations of SLNY were merged with another affiliated company, Keyport Benefit Life Insurance Company, ("KBL"). As a result of this merger Keyport Life Insurance Company ("Keyport"), the former parent company of KBL and an affiliate of the Company, owns 67% of the combined entity and the Company retained a 33% interest in the combined entity. For the year ended December 31, 2002, the results of operations for SLNY were consolidated with the Company's results. As of December 31, 2002, the assets and liabilities of SLNY are no longer consolidated with the Company.
On March 12, 2001, the Company purchased Vision for approximately $5.0 million. Vision, based in Keene, N.H., is a third-party administrator that specializes in the administration of insurance products sold at the worksite. The Company has recorded the acquisition using the purchase method of accounting and in connection with the acquisition recorded approximately $1.6 million of goodwill. The results of operations of Vision for the years ended December 31, 2002 and 2001 were not material to the consolidated financial statements.
In June 2000, the Company sold Sun Life Information Services Ireland, Limited ("SLISL") to SLOC. SLISL provides information systems development services to SLOC and its subsidiaries.
The Company's accounting policy for impairment requires recognition of an other-than-temporary impairment write-down on a security if it is determined that the Company is unable to recover all amounts due under the contractual obligations of the security. In addition, for securities expected to be sold, an other-than-temporary impairment charge is recognized if the Company does not expect the fair value of a security to recover to cost or amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, the Company then continues to review the other-than-temporarily impaired securities for additional impairment, if necessary.
Future policy benefits are liabilities for traditional life and, health products. Such liabilities are established in amounts adequate to meet the estimated future obligations of policies in force. The liabilities associated with traditional life insurance, annuity and disability insurance products are computed using the net level premium method based on assumptions about future investment yields, mortality, morbidity and persistency. The assumptions used are based upon the Company's experience and industry standards.
Premiums for traditional individual life products are considered revenue when due. Premiums related to group life, stop loss, and group disability insurance are recognized as revenue pro-rata over the contract period. The unexpired portion of these premiums is recorded as unearned premiums. Revenue from universal life-type products and investment-related products includes charges for cost of insurance (mortality), initiation and administration of the policy and surrender charges. Revenue is recognized when the charges are assessed except that any portion of an assessment that relates to services to be provided in future years is deferred and recognized over the period during which the services are provided.
Certain amounts in the prior years' financial statements have been reclassified to conform to the 2002 presentation.
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities including fair value hedges and cash flow hedges. All derivatives, whether designated in hedging relationships or not, will be required to be recorded on the balance sheet at fair value. For a derivative that does not qualify as a hedge, changes in fair value are recognized in earnings.
In July 2001, the FASB issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets". These Statements changed the accounting for business combinations and goodwill in two significant ways. First, SFAS No. 141 requires that the purchase method of accounting be used for all business combinations completed after June 30, 2001. Use of the pooling-of-interests method is prohibited. Second, SFAS No. 142 changed the accounting for goodwill from an amortization method to an impairment-only approach. Thus, amortization of goodwill, including goodwill recorded in past business combinations, ceased upon adoption of SFAS No. 142, which was January 1, 2002. Adopting SFAS No. 141 and SFAS No. 142 did not have a material impact on the Company.
In January of 2003 the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN No. 46"). FIN No. 46 addresses off-balance sheet financing entities. The Company will adopt FIN No. 46 as required in fiscal 2003 and is currently evaluating its effect on the consolidated financial statements. Although the Company is still evaluating the effect of FIN No. 46, it is reasonably possible that FIN No. 46 may require consolidation of, or additional disclosures related to, the entity described below.
Additionally, the Company and its affiliates act as collateral manager in several other collateralized debt and mortgage obligation transactions in which the Company is the transferor of assets to a Qualified SPE. In these transactions, the Company establishes a trust, as a Qualified SPE, that purchases a portfolio of assets and issues trust certificates that represent interests in the portfolio of assets. In addition to receiving variable compensation for managing the portfolio, the Company also may retain certain trust certificates. These transactions will not require consolidation because a Qualified SPE was used to facilitate the transactions.
On December 31, 2002, KBL, a wholly owned subsidiary of Keyport, an affiliate, merged with and into the Company's wholly-owned life insurance subsidiary, SLNY. Keyport and its subsidiaries, including KBL, were purchased on October 31, 2001 by SLC (U.S.) Holdings, an upstream parent of the Company. As a result of the merger, the Company continued to hold 2,000 shares of SLNY's common stock; however, the par value of the common stock was converted to $350 per share. In exchange for its investment in KBL, SLNY issued Keyport 4,001 shares of its common stock valued at $350 per share. As a result of the share issuance and change in par value, the Company's ownership percentage of SLNY became 33%, with Keyport holding the remaining 67%. The accounting for this transaction resulted in $23.3 million of additional paid-in-capital to the Company.
On December 31, 2002, prior to the completion of the merger, the Company contributed capital in the amount of $14.85 million to SLNY. Keyport contributed capital totaling $30.15 million to KBL. These contributions were approved by the respective boards of directors in anticipation of the merger transaction.
On December 18, 2002 the Company sold its' wholly-owned subsidiary, SLD to another affiliate, SLF Holdings, for $10.5 million. No gain or loss was realized on this transaction.
The Company has an administrative services agreement with Sun Life Assurance Company of Canada - U.S. Operations Holdings, Inc., under which the Company provides administrative and investor services with respect to certain open-end management investment companies for which MFS serves as the investment adviser, and which are offered to certain of the Company's separate accounts established in connection with the variable annuity contracts issued by the Company. Amounts received under this agreement amounted to approximately $24.0 million and $13.8 million for the years ended December 31, 2002 and 2001, respectively.
The Company has agreements with Keyport and certain of its subsidiaries under which the Company provides wholesale distribution services in connection with certain annuity products offered by Keyport. Amounts received under this agreement amounted to approximately $22.4 million for the year ended December 31, 2002.
On January 14, 2000, the Company purchased two separate $100 million notes from MFS, one with an interest rate of 8.60% due August 11, 2004, and the other with an interest rate of 7.93% due August 11, 2003. On November 1, 2000, MFS repaid the $100 million note with an original maturity of August 11, 2003.
On June 27, 2000, the Company sold SLISL to SLOC. The Company realized a pretax gain of $451,000 on the sale.
The Company and its subsidiaries have management services agreements with SLOC which provide that SLOC will furnish, as requested, certain services and facilities on a cost-reimbursement basis. Expenses under these agreements amounted to approximately $37.1 million in 2002, $40.3 million in 2001, and $31.9 million in 2000.
On December 21, 2000, the Company's parent, SLC (U.S.) Holdings, transferred its ownership in all 200 shares issued and outstanding of the General Partner to the Company in exchange for 537 shares of the Company's common stock totaling $537,000, plus $65.5 million of additional paid in capital. As a result of the acquisition of the General Partner on December 21, 2000, and its ownership interest in the Partnership, the Company became the owner of a $600 million 8.526% subordinated debenture due May 6, 2027 issued by the Company's parent, SLC (U.S.) Holdings. The Company also assumed the liability of the partnership capital securities issued to Capital Trust I, a Delaware business trust sponsored by the Company's parent. Partnership capital securities issued of $600.01 million accrue interest at 8.526% and have no scheduled maturity date. The partnership capital securities, which represent the limited partner interest of the Partnership, may be redeemed on or after May 6, 2027. The Company has accounted for the acquisition of the General Partner using the purchase method of accounting.
The Company has accrued $4.3 million for unpaid interest on surplus notes held by an affiliate at December 31, 2002 and 2001, respectively. The Company expensed $43.3 million for interest on these surplus notes for the years ended December 31, 2002, 2001 and 2000, respectively.
The following table lists the details of notes due to affiliates:
The amortized cost and fair value of fixed maturities were as follows:
As of December 31, 2002 and 2001, 93% and 96%, respectively, of the Company's fixed maturities were investment grade. Investment grade securities are those that are rated "BBB" or better by nationally recognized rating agencies. During 2002, 2001, and 2000 the Company incurred realized losses totaling $27.5 million, $5.5 million, and $15.0 million, respectively for other than temporary impairment of value of some of its fixed maturities after determining that not all of the unrealized losses were temporary in nature. During 2002, $1.4 million of the 2001 losses was recovered and is included in realized gains. The Company has stopped accruing income on several of its holdings for issuers that are in default. $1.9 million, $0.4 million and $0.2 million of interest income on these holdings was not accrued during 2002, 2001, and 2000, respectively.
The Company invests in commercial first mortgage loans and real estate throughout the United States. Investments are diversified by property type and geographic area. Mortgage loans are collateralized by the related properties and generally are no more than 70% of the properties' value at the time that the original loan is made. Real estate investments classified as held-for-sale have been obtained primarily through foreclosure. The carrying value of mortgage loans and real estate investments net of applicable reserves and accumulated depreciation on real estate were as follows:
The Company monitors the condition of the mortgage loans in its portfolio. In those cases where mortgages have been restructured, values are impaired or values are impaired but mortgages are performing, appropriate allowances for losses have been made. The Company has restructured mortgage loans, impaired mortgage loans and impaired but performing mortgage loans totaling $9.0 million and $17.9 million at December 31, 2002 and 2001, respectively, against which there are allowances for losses of $7.0 million and $7.1 million, respectively.
Mortgage loans and real estate investments comprise the following property types and geographic regions:
Key economic assumptions used in measuring the retained interests at the date of securitization resulting from securitizations completed during the year ended December 31, 2002 were as follows:
The Company uses derivative financial instruments for risk management purposes to hedge against specific interest rate risk, to alter investment rate exposures arising from mismatches between assets and liabilities, and to minimize the Company's exposure to fluctuations in interest rates, foreign currency exchange rates and general market conditions. The derivative financial instruments used by the Company include swaps and options. The Company does not hold or issue any derivative instruments for trading purposes.
In 2000, the Company launched a new GIC program. Each deal is highly-individualized but typically involves the issuance of foreign currency denominated contracts backed by cross currency swaps or equity linked cross currency swaps. The combination of these swaps with interest rate swaps allows the Company to lock in U.S. dollar fixed rate payments for the life of the contract.
The Company does not employ hedge accounting treatment. As a result, changes in the fair value of swaps are reported in current period operations as a component of net investment income. The net decrease to net investment income due to changes in the fair value of swaps was $73.1 million, $64.3 million and $53.4 million for the years ended December 31, 2002, 2001 and 2000, respectively.
The Company recognized gross realized gains on swaps of $3.9 million, $6.2 million and $3.9 million in 2002, 2001, and 2000, respectively, as well as gross realized losses of $12.0 million, $8.9 million, and $1.2 million during 2002, 2001, and 2000, respectively.
The Company recognized gross realized gains on options of $140.5 million, $4.0 million and $0 in 2002, 2001, and 2000, respectively, as well as gross realized losses of $10.9 million, $0, and $0 during 2002, 2001, and 2000, respectively.
At December 31, 2002, the net unrealized gains on derivatives are included with other invested assets. As of December 31, 2001, the net unrealized losses are included with other liabilities on the financial statements.
SFAS No. 107, "Disclosure about Fair Value of Financial Instruments", excludes certain insurance liabilities and other non-financial instruments from its disclosure requirements. The fair value amounts presented herein do not include the expected interest margin (interest earnings over interest credited) to be earned in the future on investment-type products or other intangible items. Accordingly, the aggregate fair value amounts presented herein do not necessarily represent the underlying value to the Company. Likewise, care should be exercised in deriving conclusions about the Company's business or financial condition based on the fair value information presented herein.
The Company has agreements with SLOC and several unrelated companies which provide for reinsurance of portions of the net-amount-at-risk under certain individual variable universal life, bank owned life insurance ("BOLI"), and corporate owned life insurance ("COLI") policies. These amounts are reinsured on either a monthly renewable or a yearly renewable term basis.
SLNY has an agreement with SLOC whereby SLOC reinsures the mortality risks of the group life insurance contracts. Under this agreement, certain death benefits are reinsured on a yearly renewable term basis. The agreement provides that SLOC will reinsure mortality risks in excess of $50,000 per claim for group life contracts ceded by SLNY.
SLNY has an agreement with an unrelated company whereby the unrelated company reinsures the morbidity risks of SLNY's group long-term disability contracts. Under this agreement, certain long-term disability benefits are reinsured on a yearly renewable term basis. The agreement provides that the unrelated company will reinsure amounts in excess of $4,000 per claim per month for long-term disability contracts ceded by SLNY.
Through December 31, 2001, the Company was a participant in a non-contributory defined benefit pension plan for employees sponsored by SLOC. Consistent with the transfer of all employees to Sun Life of Canada U.S. on January 1, 2002, the plan sponsorship for the employee and the agent pension plan was transferred to the Company. Expenses are allocated to participating companies based on a manner consistent with the allocation of employee compensation expenses.
required by the Employee Retirement Income Security Act of 1974 ("ERISA"); currently the plans are fully-funded. Most pension plan assets consist of separate accounts of SLOC or other insurance company contracts.
The following table sets forth the components of the net periodic pension cost for the year ended December 31 (in 000's)
The Company's share of the benefit obligation for the years ended December 31, 2001 and 2000 was $29.2 million and $17.1 million, respectively.
The Company and its subsidiaries file a consolidated federal income tax return with Sun Life Assurance Company of Canada- U.S. Operations Holdings, Inc. Federal income taxes are calculated as if the Company was filing a separate federal income tax return. A summary of the components of federal income tax expense (benefit) in the consolidated statements of income for the years ended December 31 was as follows:
Federal income taxes attributable to the consolidated operations are different from the amounts determined by multiplying income before federal income taxes by the expected federal income tax rate of 35%. The Company's effective rate differs from the federal income tax rate as follows:
The deferred income tax (asset) liability represents the tax effects of temporary differences between the carrying amounts of assets and liabilities used for financial reporting purposes and the amounts used for income tax purposes. The components of the Company's deferred tax (assets) and liabilities as of December 31, 2002 and 2001 were as follows:
The Company's federal income tax returns are routinely audited by the Internal Revenue Service, and provisions are made in the consolidated financial statements in anticipation of the results of these audits. The Company is currently under audit by the IRS for the years 1998 through 2000. In the Company's opinion, adequate tax liabilities have been established for all years and any adjustments that might be required for the years under audit will not have a material effect on the Company's financial statements. However, the amounts of these tax liabilities could be revised in the future if estimates of the Company's ultimate liability are revised.
Activity in the liability for unpaid claims and claims adjustment expenses related to the Company's group life and group disability products is summarized below:
The Group Protection segment markets and administers group life, long-term disability and stop loss insurance to small and mid-size employers in the State of New York. As of December 31, 2002, as a result of the SLNY/KBL merger, the results of the Group Protection segment will no longer be consolidated with the Company.
The Company prepares its statutory financial statements in conformity with accounting practices prescribed or permitted by the State of Delaware. Effective January 1, 2001, the State of Delaware required that insurance companies domiciled in the State of Delaware prepare their statutory basis financial statements in accordance with the NAIC Accounting Practices and Procedures manual, version effective January 1, 2001, subject to any deviations prescribed or permitted by the Delaware Commissioner of Insurance.
Accounting changes adopted to conform to the provisions of the NAIC Accounting Practices and Procedures manual, version effective January 1, 2001, are reported as changes in accounting principles in the statutory financial statements. The cumulative effect of changes in accounting principles is reported as an adjustment to unassigned funds (surplus) in the period of the change in accounting principle. The cumulative effect is the difference between the amount of capital and surplus at the beginning of the year and the amount of capital and surplus that would have been reported at that date if the new accounting principles had been applied retroactively for all prior periods. As a result of these changes, the Company reported a change of accounting principle in its statutory financial statements, as an adjustment that increased unassigned funds (surplus), by $25.9 million as of January 1, 2001. This adjustment is due to $25.5 million of net deferred tax assets established as of January 1, 2001, offset by a decrease of $470,000 in the valuation of the Company's obligation for post-retirement benefits other than pensions on an NAIC basis as of January 1, 2001.
On September 20, 2000, New York insurance law was amended to permit a domestic stock life insurance company to distribute a dividend to its shareholders, without notice to the New York Superintendent of Insurance, where the aggregate amount of such dividend in any calendar year does not exceed the lesser of: (1) ten percent of its surplus to policyholders as of the immediately preceding calendar year; or (2) its net gain from operations for the immediately preceding calendar year, not including realized capital gains. Under the previous law, domestic stock life insurers were prohibited from distributing any dividends to shareholders unless the insurer filed a notice of its intention to declare a dividend and its amount with the superintendent at least 30 days in advance of the proposed declaration, and such proposed distribution was not disapproved by the superintendent. No dividends were paid during 2002 or 2001. Dividends in the amount of $4.7 million were declared and paid during 2000 by the SLNY to the Company. These dividends were approved by the Board of Directors and the State of New York Insurance Department.
Unfavorable economic conditions may contribute to an increase in the number of insurance companies that are under regulatory supervision. This may result in an increase in mandatory assessments by state guaranty funds, or voluntary payments by solvent insurance companies to cover losses to policyholders of insolvent or rehabilitated companies. Mandatory assessments, which are subject to statutory limits, can be partially recovered through reduction in future premium taxes in some states. Under insurance guaranty fund laws in each state, the District of Columbia and Puerto Rico, insurers licensed to do business can be assessed by state insurance guaranty associations for certain obligations of insolvent insurance companies to policyholders and claimants. Most of these laws do provide, however, that an assessment may be excused or deferred if it would threaten an insurer's solvency and further provide annual limits on such assessments. Part of the assessments paid by the Company pursuant to these laws may be used as credits for a portion of the associated premium taxes.
The Company is not aware of any contingent liabilities arising from litigation, income taxes and other matters that could have a material effect upon the financial condition of the Company.
The Company leases various facilities and equipment under operating leases with terms of up to 25 years. As of December 31, 2002, minimum future lease payments under such leases are as follows:
Total rental expense for the years ended December 31, 2002, 2001 and 2000 was $7.6 million, $6.9 million and $5.0 million, respectively.