Operations in Concord, NH are conducted in two buildings on approximately 196 acres owned by JPFIC.
Management's discussion and analysis of financial condition and results of operations for the three years ended December 31, 1998 analyzes the results of operations, consolidated financial condition, liquidity and capital resources of Jefferson-Pilot Corporation and consolidated subsidiaries (collectively referred to as JP or Company). The discussion should be read in conjunction with the Consolidated Financial Statements and Notes. All dollar amounts are in millions except per share amounts. Prior share amounts have been restated to give retroactive effect to the Company's three-for-two stock split, which was effective in April 1998. All references to Notes are to Notes to the Consolidated Financial Statements.
Excluding realized gains, JP's revenues are derived 69% from Life Insurance Products, 20% from AIP, 8% from Communications and 3% from Corporate and Other.
The following tables illustrate JP's results before and after the inclusion of realized investment gains.
Net realized gains in 1998 declined 21.0% in comparison to the 1997 increase of 139.1% as a result of selling investments in 1997 to finance the acquisition of JP Financial. Approximately 60%, 90% and 60% of pre-tax realized gains in 1998, 1997 and 1996 were due to sales of investments in common stocks.
Individual life insurance products include traditional life and health products, as well as universal life (UL) and variable universal life (VUL), together referred to as UL-type products. The operating cycle for life insurance products is long-term in nature; therefore, actuarial assumptions are important to financial reporting for these policies. Traditional products require the policyholder to pay scheduled premiums over the life of the coverage. Traditional premium receipts are recognized as revenues and profits are expected to emerge in relation thereto. Interest-sensitive product premiums may vary over the life of the policy at the discretion of the policyholder and are not recognized as revenues. Rather, revenues and operating income on these products arise from mortality, expense and surrender charges to policyholder fund balances (policy charges). Additionally, JP earns interest spreads and investment advisory fees on policyholder fund balances. Operating income for both traditional and UL-type products also includes earnings on assigned capital.
Group insurance products include life and disability products sold through employers, primarily in the Southeastern U.S. It also includes a block of medical policies which are being underwritten by a national managed care company as policy renewal dates arise over the next twelve months, on an "as-rated" basis. This will result in invested capital formerly assigned to these medical policies being reinvested in other life insurance products or other reportable segments during 1999 and 2000, as the Company exits the group medical business.
During 1998, JP took aggressive action to restore the profitability of the in-force group medical business and then announced its intention to cease offering group medical policies beginning April 1, 1999. A full line of group life and disability policies are still offered through existing distribution channels. The following table illustrates amounts included in Life Insurance results attributable to group medical contracts for the years presented:
Life Insurance traditional insurance premiums declined 23.6% in 1998 due to group medical products and increased 4.6% in 1997. Individual traditional premiums improved 4.6% in 1998 and 42.3% in 1997 due in large part to the acquisition of JP Financial. Group traditional premiums declined 36.5% in 1998 and 6.9% in 1997. Including equivalent premiums on self-insured health policies, group premiums were down 30.8% and 5.9%. Policy charges improved 18.6% in 1998 and 49.4% in 1997, in relation to growth in UL-type products, especially as a result of the JP Financial acquisition.
Expenses (including the net deferral and amortization of policy acquisition costs) increased 6.8% and 32.5% in 1998 and 1997 due to acquisitions. Expenses on individual traditional products were 31.27%, 32.76% and 32.66% of premiums in 1998, 1997 and 1996. For UL-type products, expenses as a percentage of policyholder funds and separate accounts, were 2.94%, 3.14% and 3.20% in 1998, 1997 and 1996. The improvement in 1998's maintenance expenses is a result of integration savings from the JP Financial acquisition. The increase in 1997 is due to the addition of equity-based variable products. For group policies, expenses declined 21.3% in 1998 and increased 1.1% in 1997. The 1998 decline was due to management actions to maintain profitability, and due to lower commissions, as revenues declined. As a percentage of premiums and equivalents, expenses increased to 15.4% in 1998 versus 13.6% and 12.6% in 1997 and 1996, due to severance benefits and lease cancellation costs associated with the non-renewal of health policies.
Average Life Insurance assets grew 24.8% in 1998, primarily due to ownership of JP Financial for all of 1998, sales of UL-type products, and growth in existing policyholder funds, from interest credited and equity returns. 1997 average assets grew 41.3% from internal growth and acquisitions. The return on average Life Insurance assets was 2.02%, 1.99% and 2.18% in 1998, 1997 and 1996. The improvement in 1998 relates to the profitable growth of UL-type assets and the return to profitability of group health policies. The decline in 1997 is due to diminished group health results and the addition of JP Financial equity-based variable products.
Annuity and Investment Products (also referred to as AIP) offers its products through financial institutions, independent agents, career agents, investment professionals and broker-dealers. Operating results were:
Operating income increased 12.0% in 1998 and 15.2% in 1997. The following table summarizes key information for AIP:
Operating income from the Communications segment increased $4.8 or 17.5% in 1998 compared to a decline of 2.5% in 1997. Results for 1997 and 1996 were positively impacted by tax refunds and related interest income of $0.3 and $2.6. Excluding the impact of these refunds, operating income for 1998 increased 18.8% over 1997. Net interest expense in 1998 and 1997 reflects increased interest expense on debt to finance acquisitions made since June 30, 1996, versus interest income from the tax refund in 1996.
The Company's broadcasting properties continued to benefit from the generally favorable advertising environment and the strong local economies in which they operate. Combined revenues for Radio and Television grew 8.9% and 14.0% in 1998 and 1997, respectively. Radio experienced strong revenue growth in 1998, resulting from programming changes made in 1997 and increased demand for local advertising. Two of the television stations are CBS affiliates and benefited from robust winter Olympic related advertising during first quarter 1998. However, Television revenues declined for much of 1998 as national agency sales continued to be sluggish, consistent with a nationwide trend.
Revenue from Sports operations decreased 25.6% during 1998. The decline is primarily a result of first quarter factors, including a non-recurring sporting event held in the first quarter of 1997 and a decrease in collegiate- related basketball sales in 1998. Revenues declined 24.7% during 1997 as a result of non-recurring Olympic revenues realized in 1996 and declines in advertising revenues.
Activities of the parent company and passive investment affiliates, surplus of the life insurance subsidiaries not allocated to other reportable segments including earnings thereon, financing expenses on Corporate debt and debt securities including Capital Securities and mandatorily redeemable preferred stock, and federal and state income taxes not otherwise allocated to business segments are reported in this segment. The following table summarizes the operating results.
Total assets for the Corporate and Other segment grew 7.2% in 1998 and 8.2% in 1997 primarily due to retention of earnings less capital reinvested in the Life Insurance Products and Annuities and Investment Products segments.
Total assets increased $1,207 or 5.2% in 1998. This growth resulted from cash provided by operating activities, increases in Separate Account assets and increases in the market values of available for sale investments, an increase in policyholder contract deposits (despite being adversely impacted by a $146 decline related to business that is 100% coinsured to a third party), offset in part by redemption of $50 of preferred stock and payment of dividends. Total assets increased $5,569 or 31.7% in 1997 due mainly to the JP Financial acquisition. Excluding incremental total assets of JP Financial as of the acquisition date, the 1997 increase was $1,689 or 9.6%.
Carrying amounts of goodwill, VOBA and DAC are regularly reviewed for indications of value impairment, with consideration given to the financial performance of acquired properties, future gross profits of insurance in force and other factors.
At December 31, 1998 and 1997, JP had recorded reinsurance receivables of $1,072 and $1,250 and policy loans of $831 and $834 which are related to the businesses of AH Life that were coinsured with Household International (HI) affiliates. HI has provided payment, performance and capital maintenance guarantees with respect to the balances receivable. JP also had a recoverable of $95 and $97 as of December 31, 1998 and 1997 from a single reinsurer related to a block of business of JP Financial that is 50% reinsured. JP and the reinsurer are joint and equal owners of $191 and $195 of securities and short-term investments as of December 31, 1998 and 1997 which support the block. JP regularly evaluates the financial condition of its reinsurers and monitors concentrations of credit risk related to reinsurance activities. No significant credit losses have resulted from reinsurance activities during the three years ended December 31, 1998.
The Company's ratio of capital to assets has declined over time as a result of acquisitions, except in 1998 when no new acquisitions occurred.
The Life Insurance and AIP segments are subject to regulatory constraints. The Company's insurance subsidiaries have statutory surplus and risk based capital levels well above required levels. These capital levels together with the rating agencies' assessments of the Company's business strategies have enabled JP Life, AH Life and JP Financial to attain the following claims paying ratings:
In January and March 1997, the Company privately placed $200 of 8.14% Capital Securities Series A and $100 of 8.285% Capital Securities Series B. The discussion of these issuances in Note 9 is incorporated herein by reference.
Net cash provided by financing activities was $293, $561 and $109 for 1998, 1997 and 1996. Proceeds from the issuance of securities of $450 related to funding of the JP Financial acquisition drove the 1997 totals, while 1998 reflects the redemption of $50 of preferred stock and repurchases of Company common stock of $27. Net borrowings/(repayments) from short-term debt and securities sold under repurchase agreements were $201, $(138) and $40 for 1998, 1997 and 1996. Cash inflows from changes in policyholder contract deposits were $318, $374 and $193 for 1998, 1997 and 1996. Cash was used to pay dividends of $149, $129 and $103 during 1998, 1997 and 1996.
JP's Investment Policy Statement (Policy) requires an average quality fixed income portfolio (excluding mortgage loans) of "A" or higher. Currently, the average quality is "A1", excluding mortgage loans. The Policy also imposes limits on the amount of lower quality investments and requires diversification by issuer and asset type. The Company monitors "higher risk" investments for compliance with the Policy and for proper valuation. Securities that experience other than temporary declines in value are adjusted to net realizable values through a charge to earnings. Commercial mortgage loans in foreclosure are carried at the net present value of expected future cash flows. The Company has established a reserve to account for impaired mortgage loans which was $31 and $27 as of December 31, 1998 and 1997.
The Policy permits the use of derivative financial instruments such as futures contracts and interest rate swaps in conjunction with specific direct investments. The Company's actual use of derivative financial instruments has been limited, using them to manage well-defined interest rate risks. Interest rate swaps with a notional value of $186, $200 and $254 were open as of December 31, 1998, 1997 and 1996. Termination of these arrangements under year end 1998 interest rates would result in a gain of $13. The periodic cash settlements under these arrangements are reflected as an adjustment to investment income.
The Company's investment strategy with respect to CMO's focuses on actively- traded, less volatile issues that produce relatively stable cash flows. The majority of CMO holdings are sequential tranches of federal agency issuers. The CMO portfolio has been constructed with underlying mortgage collateral characteristics and structure in order to lower cash flow volatility over a range of interest rate levels.
The project has four phases: assessment of systems and equipment affected by the Year 2000 issue; definition of strategies to address affected systems and equipment; remediation of affected systems and equipment; and certification that each is Year 2000 compliant. To certify that all IT systems (internally developed or purchased) are Year 2000 compliant, each system is tested using a standard testing methodology which includes regression testing, millennium testing, millennium leap year testing and cross over year testing. Certification testing is performed on each system as soon as remediation is completed.
The target for completion of all phases and categories is September 30, 1999. The Company has completed the assessment and strategy phases for mainframe applications, operating systems and hardware and is executing the remediation and certification phases. The Company's new business and policyholder administration systems and the general ledger are on the mainframe. The Company has determined that approximately 62% of all mainframe systems are compliant. The Company does not deem a system to be compliant until the completion of remediation and certification to confirm that its performance will not be affected by dates extending after 1999. With respect to significant policyholder systems, all required remediation has been completed on all systems. The majority of these systems, including all systems which support products the Company is currently marketing, have been certified as Year 2000 compliant. Completion of certification of remaining systems for some closed blocks of business is expected by April 1999. Other non- policyholder mainframe systems have either been certified or are on schedule. For PC and LAN systems, the Company has completed the strategy phases and is executing the assessment, remediation and certification phases concurrently and intends to complete these phases during the third quarter of 1999.
The most significant category of key business partners is financial institutions. Their critical functions include safeguarding and managing investment portfolios, processing of the Company's operating bank accounts, and sales/distribution. All of the Company's business partner financial institutions that have responded to the Company's inquiries have indicated they are on schedule for Year 2000 compliance. The Company continues to follow up with business partner financial institutions that have not yet responded. Other partner categories include insurance agents and marketing organizations, and suppliers of communication services, utilities, materials and supplies. The Company has conducted surveys of all its software and hardware vendors, and certification is underway. In addition to financial institutions, other critical business partners have been identified and surveys initiated. Results of these surveys are being analyzed in the first quarter of 1999 and appropriate testing or other due diligence will be conducted in the second and third quarters of 1999.
The Company has investments in publicly and privately placed securities and loans. The Company may be exposed to credit risk to the extent that related borrowers are materially adversely impacted by the Year 2000 issue. Portfolio diversification reduces the overall risk. The Company is in compliance with the NAIC Securities Valuation Office's Due Diligence Guidelines for analyzing these risks.
Although the Company expects to certify that its critical policyholder systems are compliant by the end of April 1999, there is no guarantee that these results will be achieved. Specific factors that give rise to this uncertainty include a possible loss of technical resources to perform the work (not yet encountered), failure to identify all susceptible systems, non-compliance by third parties whose systems and operations impact the Company, and other similar uncertainties.
Although the Company is on schedule to complete certification of all internal systems and non-IT equipment well in advance of January 1, 2000, the Company recognizes the need to plan for unanticipated problems resulting from failure of internal systems or equipment or from failures by the Company's business partners, providers, suppliers or other critical third parties. The Company has begun work on contingency plans for all mission critical functions.
Since JP's assets and liabilities are largely monetary in nature, the Company's financial position and earnings are subject to risks resulting from changes in interest rates at varying maturities, changes in spreads over U.S. Treasuries on new investment opportunities, changes in the yield curve and equity pricing risks. Continued favorable economic conditions in the U.S. contributed to a decline in 10 year U.S. Treasury rates of 110 basis points in 1998 versus a 68 basis point decline in 1997. These forces contributed to an increase in unrealized gains on securities available for sale of $53 and $174 in 1998 and 1997. Further, in 1997, various forces in the fixed income markets resulted in a compression of risk premiums over Treasury securities that can be earned on new investments. In 1998, risk premiums widened significantly in the third and fourth quarters.
The Company employs various methodologies to manage its exposure to interest rate risks. The asset/liability management process focuses primarily on the management of interest rate risk of the Company's insurance operations. JP monitors the duration of insurance liabilities compared to the duration of
assets backing the insurance lines, giving measurement to the optionality of cash flows. The Company's goal in such analysis is to prudently balance profitability and risk for each insurance product category, and for the Company as a whole. At December 31, 1998 and 1997, 88% and 87% of policy liabilities related to interest-sensitive portfolios.
These estimates were derived by modeling estimated cash flows of the Company's market risk sensitive instruments and insurance portfolios. Changes in interest rates illustrated above assume parallel shifts in the yield curve graded pro-rata over four quarters. Incremental income or loss is net of taxes at 35%. Estimated cash flows produced in the model assume reinvestments representative of JP's current investment strategy and calls/prepayments include scheduled maturities as well as those expected to occur when issuers can benefit financially based on the difference between prepayment penalties and new money rates under each scenario. Assumed lapse rates among insurance portfolios give consideration to relationships expected between crediting rates and market interest rates, as well as the level of surrender charges inherent in individual contracts. The illustrated incremental income or loss also includes the expected impact on amortization of DAC and VOBA. The model is based on the Company's existing business in force as of December 31, 1998 and does not consider new sales of life and annuity products or the potential impact (as discussed above) of interest rate fluctuations on sales.
The Company is exposed to equity price risk on its equity securities (other than trading). JP holds common stock with a fair value of $949. Approximately $500 of such value is represented by investments in a single issuer, BankAmerica. The Company's Exchangeable Securities are exchangeable into shares of BankAmerica common stock. Had the Exchangeable Securities been redeemable as of year end, the redemption value would have been $325 (see Notes 8 and 18). If the market value of the S&P 500 Index, and of BankAmerica common stock specifically, decreased 10% from their December 31, 1998 values, the fair value of the Company's common stock and Exchangeable Securities would change as follows:
JP operates largely in the U. S. Financial Services market, which is subject to general economic conditions in the U.S. During 1998 and 1997, the U.S. economy exhibited continued favorable trends including low inflation with minimal risk of price increases, moderate business growth and increases in productivity through technological innovation. However, this environment has resulted in a scarcity of quality investments at favorable yields, in part due to abundant liquidity among corporate borrowers. Also, a robust domestic economy creates pressure on wages for skilled workers. There are certain secular forces driving economic results including aging of baby-boomers, an increase in the supply of investable funds, increased global competition and increasing use of technology. These forces impact JP in various ways such as demand for its products (especially savings-oriented products), competition for new investments, mergers and consolidations within the financial services sector and costs inherent in administering complex financial products.
Medical inflation and utilization of medical services affect the profitability of health products offered through the individual and group distribution systems. In the event that premium rates are not adequately adjusted in anticipation of medical trends, profitability of health insurance products is adversely affected. JP has elected to non-renew its group medical coverages beginning April 1999, but will continue to offer individual and group disability insurance.
The U.S. insurance industry has experienced an increasing number of mergers, acquisitions, consolidations and sales of business lines. These activities have been driven by a need to reduce costs of distribution and by the need to increase economies of scale in the face of growing competition from larger foreign, domestic and mutual insurers, and from non-traditional players such as banks, securities brokers and mutual funds. Consolidation is expected to continue and may be heightened by federal legislation. HR 10 or some variant will likely be passed in Congress, perhaps in 1999, and would allow banks, insurance companies and investment banks to affiliate.
2. A proposal to require recapture of policyholder surplus accounts as taxable income over ten years.
In recent years, the life insurance industry has experienced increased litigation in which large jury awards including punitive damages have occurred. See Note 19, which is incorporated herein by reference, for discussion of the Company's contingent liabilities.
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward looking statements. Certain information contained herein or in any other written or oral statements made by, or on behalf of JP are or may be viewed as forward looking. Although the Company has used appropriate care in developing any such forward looking information, forward looking information involves risks and uncertainties that could significantly impact actual results. These risks and uncertainties include, but are not limited to, the matters discussed in "Year 2000 Issue", "Market Risk Exposures", "External Trends and Forward Looking Information" and other risks detailed from time to time in the Company's SEC filings; to the risks that JP might fail to successfully complete strategies for cost reductions and for growth in sales of products through all distribution channels; to business interruption risks if the Company does not timely complete its Year 2000 compliance project; and more generally to: general economic conditions; competitive factors, including pricing pressures, technological developments, new product offerings and the emergence of new competitors; interest rate trends and fluctuations; and changes in federal and state laws and regulations, including, without limitation, changes in financial services industry or tax laws and regulations. The Company undertakes no obligation to publicly update or revise any forward looking statements, whether as a result of new information, future developments or otherwise.
Business Acquisitions: In May 1997, the Company acquired all the outstanding shares of JP Financial from The Chubb Corporation (Seller). JP Financial's operations, principally universal life, variable universal life and term insurance, are conducted nationwide through JP Financial and JPLA. JP Financial and its subsidiaries, as of the acquisition date, are collectively referred to as "JP Financial." Jefferson Pilot Securities Corporation (formerly Chubb Securities Corporation) is a full service NASD registered broker-dealer. The cost of the acquisition consisted of $775 cash paid by JP to Seller at closing, plus other acquisition costs. In addition, JP Financial paid a $100 special dividend to Seller which was funded through liquidation of short-term investments. The $775 was financed through the liquidation of invested assets, various securities offerings (see Notes 8 and 9) and the issuance of commercial paper. The acquisition, which was effective as of April 30, 1997, was accounted for using the purchase method. As a result, JP Financial's results of operations from May 1, 1997 forward are included in the accompanying financial statements. The purchase price was subject to certain post-closing adjustments, none of which had a material impact on the balance sheet or results of operations. In 1998, the final allocation of purchase price to JP Financial's tangible and identifiable intangible assets and liabilities was completed, based on their fair values. The resulting adjustments were not material. The acquisition resulted in $163 of cost in excess of net assets acquired (i.e. goodwill) and $494 of value of business acquired. Goodwill arising from the acquisition is being amortized over a period of 35 years.
purchased substantially all of the broadcast assets of two radio stations in San Diego, California for $59 in cash, resulting in cost in excess of net assets acquired of $26. All three acquisitions were accounted for as purchases, and the results of operations of the acquisitions have been included in the consolidated operations of the Company since the respective dates of acquisition. Pro-forma financial information for these acquisitions has not been presented, as the pro-forma impact on consolidated operations for 1997 and 1996 is not significant.
Use of Estimates: The preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are asset valuation allowances, policy liabilities, deferred policy acquisition costs, value of business acquired and the potential effects of resolving litigated matters.
Cash and Cash Equivalents: The Company includes with cash and cash equivalents its holdings of highly liquid investments which mature within three months of the date of acquisition.
Deferred Policy Acquisition Costs and Value of Business Acquired: Costs related to obtaining new business, including commissions, certain costs of underwriting and issuing policies, certain agency office expenses, and first year bonus interest on annuities, all of which vary with and are primarily related to the production of new business, have been deferred.
Income Taxes: The Company and most of its subsidiaries file a consolidated life/nonlife federal income tax return. Currently, AH Life and JP Financial each file a separate consolidated return with their respective subsidiaries. Deferred income taxes are recorded on the differences between the tax bases of assets and liabilities and the amounts at which they are reported in the consolidated financial statements. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted.
New Accounting Pronouncements: As of January 1, 1998, the Company adopted SFAS 130, "Reporting Comprehensive Income", which sets standards for the reporting and display of comprehensive income and its components in financial statements. Adoption had no impact on the Company's net income or stockholders' equity. Comprehensive income consists of net income plus other comprehensive income. Under SFAS 130, one of the items included in other comprehensive income is unrealized gains and losses on available for sale securities. Prior year financial statements have been reclassified to conform with the requirements of SFAS 130. See Note 17.
Effective January 1, 1998, the Company adopted SFAS 131, "Disclosures about Segments of an Enterprise and Related Information". This pronouncement superseded SFAS 14, "Financial Reporting for Segments of a Business Enterprise". SFAS 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The adoption of SFAS 131 did not affect results of operations or financial position, but did affect the disclosure of segment information. See Note 16.
Contractual Maturities: Aggregate amortized cost and aggregate fair value of debt securities as of December 31, 1998, according to contractual maturity date, are as indicated below. Actual future maturities will differ from the contractual maturities shown because the issuers of certain debt securities have the right to call or prepay the amounts due the Company, with or without penalty.
Investment Concentration, Risk, and Impairment: Investments in debt and equity securities include 1,518 issuers, with only one corporate issuer representing more than one percent of the aggregate reported amounts of these investments. Included with equity securities is an investment in BankAmerica Corporation of $500 as of December 31, 1998 and 1997. Debt securities considered less than investment grade approximated 4.5% and 5.4% of the total debt securities portfolio as of December 31, 1998 and 1997.
The Company's mortgage loan portfolio is comprised primarily of conventional real estate mortgages collateralized by retail (44%), apartment (15%), industrial (13%), office (11%) and hotel (11%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value relationships. Approximately 39% of stated mortgage loan balances as of December 31, 1998 are due from borrowers in South Atlantic states and approximately 23% are due from borrowers in West South Central states. No other geographic region represents as much as 10% of December 31, 1998 mortgage loans.
Net Investment Income: The details of investment income, net of investment expenses, follow:
Investment expenses include salaries, interest, expenses of maintaining and operating investment real estate, real estate depreciation and other allocated costs of investment management and administration.
Other Information: During 1998 and 1997, the Company sold certain securities that had been classified as held to maturity, due to significant declines in credit worthiness. Total proceeds were $13 and $10 in 1998 and 1997, respectively.
Modifying Annuity Crediting Rates: Interest rate swaps are used to modify the interest characteristics of certain blocks of annuity contract deposits. Interest is exchanged periodically on the notional value, with the Company receiving a fixed rate and paying various short-term LIBOR rates on a net exchange basis. The net amount received or paid under these swaps is reflected as an adjustment to insurance and annuity benefits.
The Company's credit exposure on swaps is limited to the fair value of swap agreements that are favorable to the Company. The Company does not expect any counterparty to fail to meet its obligation. Currently, non-performance by a counterparty would not have a material adverse effect on the Company's financial position or results of operations.
The Company's exposure to market risk is mitigated by the offsetting effects of changes in the value of swap agreements and the related direct investments and credited interest on annuities. The Company routinely monitors correlation between hedged items and hedging instruments. In the event a hedge relationship is terminated or loses correlation, any related hedging instrument that remained would be marked to market through income. If the
Interest Rate Assumptions: The liability for future policy benefits associated with ordinary life insurance policies has been determined using initial interest rate assumptions ranging from 2% to 9.9% and, when applicable, uniform grading over 20 to 30 years to ultimate rates ranging from 2% to 6%. Interest rate assumptions for weekly premium, monthly debit and term life insurance products generally fall within the same ranges as those pertaining to individual life insurance policies.
Mortality and Withdrawal Assumptions: Assumed mortality rates are generally based on experience multiples applied to select and ultimate tables commonly used in the industry. Withdrawal assumptions for individual life insurance policies are based on historical company experience and vary by issue age, type of coverage and policy duration.
For immediate annuities issued prior to 1987, mortality assumptions are based on blends of the 1971 Individual Annuity Mortality Table and the 1969-71 U. S. Life Tables. For similar products issued after 1986, mortality assumptions are based on blends of the 1983a and 1979-81 U. S. Life Tables.
Accident and Health, and Disability Insurance Liabilities Activity: Activity in the liabilities for accident and health, and disability benefits, including reserves for future policy benefits and unpaid claims and claim adjustment expenses, is summarized below:
Commercial Paper and Revolving Credit Borrowings: The Company has entered into a bank credit agreement for $375 of unsecured revolving credit extending through May 2002, under which the Company has the option to borrow at various interest rates. Since the establishment of a commercial paper arrangement in 1996, the credit agreement has principally supported the issuance of commercial paper. As of December 31, 1998, outstanding commercial paper had various maturities, with none in excess of 90 days. The Company can issue commercial paper with maturities of up to 270 days. If the Company is not able to remarket its commercial paper on the respective maturity dates, the Company intends to borrow a like amount under the credit agreement. The weighted-average interest rate for commercial paper borrowings outstanding of $289 at December 31, 1998 was 5.61%. The weighted-average interest rate for $285 of commercial paper borrowings outstanding at December 31, 1997 was 6.02%.
The Company has issued 1,815,000 unsecured 7.25% ACES due January 21, 2000, having a principal amount of $72.50 per security. In the 30 days prior to, or at, maturity, the principal amount of the ACES will be mandatorily exchanged into either (1) a number of shares of BankAmerica stock determined based on an exchange rate reflecting the then trading price for the stock or (2) cash in an amount of equal value. Subject to adjustments to reflect future dilution, the exchange rate is equal to (1) 1.66 shares if the stock price is at least $43.50, (2) fractional shares of the stock having a value equal to $72.50 if the price is more than $36.25 but less than $43.50, or (3) two shares if the price is not more than $36.25.
Common Stock: On February 9, 1998, the Board authorized a three-for-two common stock split which was effected as a 50% stock dividend distributed on April 13, 1998 to shareholders of record as of March 20, 1998. The split-adjusted value of fractional shares was paid in cash. The par value of additional shares issued, which totaled $44, was reclassified from retained earnings to common stock. All share and per share information gives retroactive effect to the stock split.
A total of 6,109,001 shares are available for issuance pursuant to outstanding or future awards under the Employees' Plan as of December 31, 1998. The option price may not be less than the market value of the Company's common stock on the date awarded. Options are exercisable for periods determined by the Committee, not to exceed ten years from the award date, and vest immediately or over periods as determined by the Committee. Awards of restricted and unrestricted stock grants are limited to 10% of the total shares reserved for the Plan. The Employees' Plan will terminate as to further awards on May 1, 2005, unless terminated by the Board at an earlier date.
Non-Employee Directors' Plan: Under the Non-Employee Directors' Stock Option Plan (Directors' Plan), 417,376 shares of the Company's common stock are reserved for issuance pursuant to outstanding or future awards as of December 31, 1998. Nonqualified stock options are automatically awarded, at market prices on specified award dates. The options vest over a period of one to three years, and terminate ten years from the date of award, but are subject to earlier vesting or termination under certain circumstances. The Directors' Plan will terminate as to further awards on March 31, 1999.
Summary Stock Option Activity: Summarized information about the Company's stock option activity follows:
weighted-average assumptions for 1998, 1997 and 1996: risk-free interest rates of 5.8%, 6.2% and 5.9%; volatility factors of the expected market price of the Company's common stock of 0.17; and a weighted-average expected life of the options of 9.9 years for 1998, 7.7 years for 1997 and 10 years for 1996. Dividends were assumed to increase by 10% annually.
The Company's life insurance subsidiaries prepare financial statements on the basis of statutory accounting practices (SAP) prescribed or permitted by the insurance departments of their states of domicile. Prescribed SAP include a variety of publications of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and administrative rules. Permitted SAP encompass all accounting practices not so prescribed. The impact of permitted accounting practices on statutory capital and surplus is not significant for the life insurance subsidiaries.
The principal differences between SAP and generally accepted accounting principles (GAAP) as they relate to the financial statements of the subsidiaries are (1) policy acquisition costs are expensed as incurred under SAP, whereas they are deferred and amortized under GAAP, (2) the value of business acquired is not capitalized under SAP but is under GAAP, (3) amounts collected from holders of universal life-type and annuity products are recognized as premiums when collected under SAP, but are initially recorded as contract deposits under GAAP, with cost of insurance recognized as revenue when assessed and other contract charges recognized over the periods for which services are provided, (4) the classification and carrying amounts of investments in certain securities are different under SAP than under GAAP, (5) the criteria for providing asset valuation allowances, and the methodologies used to determine the amounts thereof, are different under SAP than under GAAP, (6) the timing of establishing certain reserves, and the methodologies used to determine the amounts thereof, are different under SAP than under GAAP, (7) no provision is made for deferred income taxes under SAP, and (8) certain assets are not admitted for purposes of determining surplus under SAP.
The insurance statutes of the states of domicile limit the amount of dividends that the life insurance subsidiaries may pay annually without first obtaining regulatory approval. Generally, the limitations are based on a combination of statutory net gain from operations for the preceding year, 10% of statutory surplus at the end of the preceding year, and dividends and distributions made within the preceding twelve months. Approximately $205 of dividends could be paid by the life insurance subsidiaries in 1999 without regulatory approval.
Under prior federal income tax law, one-half of the excess of a life insurance company's income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as "Policyholders' Surplus." The Company has approximately $105 of untaxed "Policyholders' Surplus" on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. The current administration has proposed to tax, as part of its 1999 budget initiative, the "Policyholders' Surplus" over a ten year period. No related deferred tax liability has been recognized for the potential tax which would approximate $37 under the current proposal.
The Company and its subsidiaries have defined benefit pension plans which are funded through group annuity contracts with JP Life. The assets of the plans are those of the related contracts, and are primarily held in separate accounts of JP Life. Information regarding pensions plans is as follows:
The Company allocates depreciation expense to Life Insurance and AIP; however, the related fixed assets are not allocated to these operating segments.
The fair values of commercial paper and revolving credit borrowings approximate their carrying amounts due to their short-term nature. Similarly, the fair value of the liability for securities sold under repurchase agreements approximates its carrying amount, which includes accrued interest. With respect to the Exchangeable Securities, the fair value of the ACES is based on its nationally quoted market price. The fair value of the MEDS, which are not publicly traded, is estimated based on the value holders would have received had the MEDS been redeemable as of year end (which was derived based on the market price of BankAmerica stock as of year end).
The fair value of the Company's mandatorily redeemable preferred stock approximates its stated amount because its dividend rate is adjustable.
The Company routinely enters into commitments to extend credit in the form of mortgage loans and to purchase certain debt instruments for its investment portfolio in private placement transactions. The fair value of outstanding commitments to fund mortgage loans and to acquire debt securities in private placement transactions, which are not reflected in the consolidated balance sheet, approximates $148 as of December 31, 1998.