1This table includes restated financial results for the Company for the years ended 2009. See Note 15 in Notes to Consolidated Financial Statements for the effects of the restatement on the Company’s Balance Sheet as of December 31, 2009. Fiscal Years 2008, 2007 and 2006 have also been corrected to conform to the restated accounting treatment of our limited partnership investments.
2Net investment income divided by average cash and total invested assets, based on book value (including accrued investment income).
The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included under Item 8 of this Form 10-K.
the Company applies the fair value method of accounting consistent with ASC 944, Financial Services-Insurance, to those limited partnerships in which the Company holds less than a five percent interest and does not have more than virtually no influence over the operating or financial policies of the limited partnership. The Company recognizes the unrealized change in fair value of a partnership interest as a component of equity (other comprehensive income or loss) each period and recognizes distributed gains and losses in realized gains (losses) each period.
The Company considers certain qualitative factors in assessing whether it has more than virtually no influence for partnership interests of less than five percent.
The following table presents the effects of the restatement on the Company’s statement of shareholder’s equity:
We are engaged in the sale of insurance products including individual annuities, individual life insurance and accident and health insurance. Our revenues are derived primarily from premiums received from the sale of annuity contracts and life, accident and health products, and from gains (net of losses) from our investment portfolio.
Under GAAP, our revenues from the sale of whole life insurance products and annuity contracts with life contingencies are treated differently from our revenues from the sale of annuity contracts without life contingencies, deferred annuities and universal life insurance products. Premiums from the sale of whole life insurance products and life contingent annuities are reported as premium income on our income statement. Premiums from the sale of deferred annuities, universal life insurance products and annuities without life contingencies are not reported as revenues, but rather are reported as additions to policyholders’ account balances on our balance sheet. For these products, revenues are recognized over time in the form of policy fee income, surrender charges and mortality and other charges deducted from policyholders’ account balances.
As described under “Ratings” and “Regulation,” the Company’s business is substantially affected by capital ratios and their impact on the Company’s ratings. Insurance sales are being made with a greater selectivity based on increased profit level requirements for new business. We have determined that the level of competition in the sale of traditional and universal life insurance products has made it very difficult for smaller insurance companies to participate in that business in a profitable way. Accordingly, under the current market conditions, we are not engaged in the sale of traditional and universal life policies.
Unless specifically stated otherwise, all references to 2010, 2009 and 2008 refer to our fiscal years ended, or the dates, as the context requires, December 31, 2010, December 31, 2009 and December 31, 2008, respectively.
There are numerous factors, some of which are outside our control, which could have a material impact on our business. We have described these factors in detail under the heading “Risk Factors.” Certain of these factors, which include market conditions, legal and regulatory changes, operational risk and interest rate risk, have a particular impact on our business:
Market Conditions. Like all companies, we are affected by the general state of financial markets and economic conditions in the U.S. and elsewhere. The pressures related to the recent recession and slow recovery, coupled with the significant dislocation in the capital markets during late 2008 and 2009 have resulted in a historically difficult business environment and the ability to obtain desired returns on the investment portfolio, without exposing the Company to excess risk, has never been more challenging.
Operational Risk. Our business is dependent on our ability to process, on a daily basis, our payment obligations under outstanding policies and the condition of the investment portfolio. Any failures in our internal processes, people or systems could lead to material, adverse consequences to the Company. In addition, despite the contingency plans in place, the ability to conduct business may be adversely impacted by a significant disruption in the infrastructure that supports our business and the community in which we are located.
Interest Rate Risk. Our principal product is deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates, annuity holders are less likely to seek to surrender their annuities prior to maturity due to the absence of alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2010, the existence of surrender fees on approximately 42.5% of the Insurance Company’s outstanding deferred annuities acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. Moreover, the surrender fees are only in effect primarily for up to the first seven years of each annuity policy. In the event of a substantial increase in surrenders during a short period of time, we may have to sell longer-term assets to pay current surrender liabilities. We continually develop strategies to address the match between the timing of our assets and liabilities. To that end, in 2006, 2007 and 2008, a significant number of policies came off surrender charge and a significant portion of this business did surrender. The Company anticipated this event and maintained a significant level of cash equivalents to fund surrenders, avoiding the need to sell long-term assets at a loss. The Company believes that the heavy surrender activity associated with the 2006-2008 period is now largely behind us. Additionally, management has increased the incentive for agents to retain this business with the Company by paying full first year compensation on internal rollovers. Since 2008, a significantly smaller amount of business has been coming off surrender charge. The table below shows the in-force deferred annuities that are within the surrender charge period and the projected timing regarding the expiration of these surrender charges.
Net investment income (loss) divided by average cash and total invested assets, based on book value (including accrued investment income).
Net realized investment gains (losses) include provisions for impairment in value that are considered other than temporary and exclude provisions for income taxes.
The Company’s goal in managing its investment portfolio is to meet the diversification, yield and liquidity requirements of its insurance policy and annuity contract obligations. The Company's liquidity requirements are monitored regularly so that cash flow needs are satisfied. Adjustments periodically are made to the Company's investment policies to reflect changes in the Company's short-and long-term cash needs, as well as changing business and economic conditions.
The Companys principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of impairments and income, as well as the determination of fair values. When assessing our intent to sell a fixed maturity security or if it is more likely that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio and sale of securities to meet cash flow needs. In order to determine the amount of the credit loss for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying fixed maturity security. The effective interest rate is the original yield or the coupon if the fixed maturity security was previously impaired. If an other than temporary impairment (“OTTI”) exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our Consolidated Statements of Income. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Consolidated Statements of Income, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to other comprehensive income (“OCI”), as an unrealized OTTI loss on our Consolidated Balance Sheets, as this is considered a noncredit (i.e., recoverable) impairment.
recoveries or additional declines in fair value subsequent to the balance sheet date.
As of December 31, 2010, 2.9% of the Company’s invested assets (approximately $108.0 million) consisted of short-term commercial paper with maturities of less than 45 days. This compares to 8.1% of the Company’s invested assets (approximately $293.1 million) as of December 31, 2009. This commercial paper consisted of direct obligations of various corporations rated a minimum of A1 by Standard and Poor’s and P1 by Moody’s. This cash balance was reduced by $185.2 million during 2010, as the Company determined that its cash balances were more than sufficient to cover projected cash needs from annuity surrenders and required payments. As part of its asset-liability management strategy, the Insurance Company had kept elevated levels of cash investments since 2005, but management currently believes that its excess cash should be invested in additional fixed income investments to augment investment income.
The following table presents the total gross unrealized losses for fixed maturities where the estimated fair value had declined and remained below amortized cost by December 31, 2010.
Total unrealized losses decreased from $102.9 million at December 31, 2009 to $44.1 million at December 31, 2010. This decrease in the unrealized losses resulted from the significant decline in U.S. Treasury yields in 2010, especially in Treasuries maturing in less than 5 years, combined with a narrowing of corporate spreads against Treasuries. Five-year Treasuries declined in yield to 2% at year-end 2010 vs. 2.67% at year-end 2009. Ten-year Treasuries declined to 3.29% at year-end 2010 from 3.83% at year-end 2009 and 30-year Treasuries declined to 4.34% at year-end 2010 from 4.63% at year-end 2009. Ten-year corporate spreads tightened by approximately 10 basis points and 30-year corporate spreads tightened by approximately 15 basis points during 2010. The Company carefully examines each issue where the market value has fallen below 70% of book value to determine if the bonds are not-other-than-temporarily impaired. Consistent with the Company’s OTTI Policy as discussed above, the Company will recognize a write-down of book value to current market value, if warranted. Four securities were written down during 2010, producing an OTTI charge of $1,392,236.
Through the “Build-America” bond program subsidized by the U.S. Federal Government in 2009 and 2010, the Company has significantly increased its exposure to taxable municipal bonds, which totaled $278.2 million (cost) at December 31, 2010. Municipal bonds had a greater-than-12-month loss of $4.6 million on a fair value of $122.9 million. Approximately $354,000 of the losses represented three purchases of Fulton County, Georgia General Obligation Bonds (total market value of $5,096,213) purchased in September 2010, near the low in interest rates for 2010. Approximately $305,000 of the unrealized loss represented a single position in General Obligation Bonds of the State of Wisconsin (market value of $4,694,100) and $256,000 of the unrealized loss represented a single position in a General Obligation Bond for Spokane County, Washington (market value of $3,308,961), both purchased in August 2010 near the low in interest rates.
The Insurance Company prepares its statutory financial statements in accordance with accounting practices prescribed by the New York State Insurance Department. Prescribed SAP include state laws, regulations and general administrative rules, as well as a variety of publications from the NAIC. Accounting principles used to prepare statutory financial statements differ from financial statements prepared on the basis of GAAP. (See Item 1, Business, Insurance Regulation, Statutory Reporting Practices.) The restatement did not affect the statutory financial statements.
A reconciliation of the Insurance Company’s net income as filed with regulatory authorities to net income reported in the accompanying financial statements for the years ended December 31, 2010, 2009 and 2008, is set forth in the following table:
1As restated, see explanatory note regarding restatement and Note 15 to the Consolidated Financial Statements.
Ratings are an important factor in establishing the competitive position in the insurance and financial services marketplace. There can be no assurance that the Company’s ratings will continue for any given period of time or that they will not be changed. In the event the ratings are downgraded, the level of revenues or the prospects of our business may be adversely impacted.
In May 2010, the A.M. Best Company removed from under review with negative implications and affirmed the financial strength rating of B+ (Good) and issuer credit rating (“ICR”) of “bbb-” (Good) of Presidential Life Insurance Company (“Presidential Life”) and the ICR of “bb-” (Fair) of Presidential Life Corporation. The ratings have been assigned a stable outlook.
The stable outlook reflects Presidential Life’s increase in new business writings, continued profitable operating postures and favorable capitalization ratios.
Total annuity considerations and life insurance premiums increased to approximately $70.5 million in 2010 from approximately $55.6 million in 2009, an increase of approximately 26.9% and increased from approximately $46.8 million in 2008 to $55.6 million in 2009, an increase of approximately 18.6%. Life insurance premiums were $19.3 million, $16.1 million and $16.2 million in 2010, 2009 and 2008 respectively. Annuity considerations increased to approximately $51.2 million in 2010 from approximately $39.4 million in 2009, an increase of approximately $11.8 million, and increased from approximately $30.7 million in 2008 to $39.4 million in 2009, an increase of approximately $8.7 million. These amounts do not include consideration from the sales of deferred annuities or immediate annuities without life contingencies. Under GAAP, such sales are reported as additions to policyholder account balances. Consideration from such sales was approximately $82.2 million, $185.9 million and $143.2 million in 2010, 2009 and 2008, respectively.
In 2010, annuity sales decreased dramatically by over $100 million as a direct result of the low interest rate environment. Fixed interest rates hit their lowest levels in decades. As a result, the book value fixed annuity market collapsed. In contrast, investors saw modest returns in the variable and equity index markets.
Net investment income and equity in earnings on limited partnerships totaled $193.1 million in 2010, as compared to $197.8 million in 2009 and $206.4 million in 2008. This represents a 2.4% decrease comparing 2010 to 2009 and a 4.2% decrease comparing 2009 to 2008. The decrease in 2010 was largely due to lower income on our limited partnership portfolio. The decrease in 2009 was largely due to lower returns on the short-term commercial paper portfolio.
In 2010, 2009 and 2008, the Insurance Company’s average credited rate for reserves and account balances was less than the Company’s ratio of net investment income to mean assets based on book value (rate on investments) for the same period as noted above under “Net Investment Income”. There can be no assurance that the Company's ratio of net investment income to book value mean assets (the "spread") will not decline in future periods or that such decline will not have a material adverse effect on the Company's financial condition and results of operations. Depending, in part, upon competitive factors affecting the industry in general, and the Company, in particular, the Company may, from time to time, change the average credited rates on certain of its products. There can be no assurance that the Company will be able to reduce such rates or that any such reductions will broaden the Spread. The Company has performed an updated loss recognition test to re-confirm the recoverability of Deferred Acquisition Costs, with best estimate actuarial assumptions. The actual spread, excluding capital gains, for the 12 months ended December 31, 2010, 2009 and 2008 was 0.94%, .77% and .99%, respectively.
Under applicable accounting rules, DAC related to deferred annuities is amortized in proportion to the estimated gross profits over the estimated lives of the contracts. Essentially, as estimated profits of the Insurance Company related to these assets increase, the amount and timing of amortization is accelerated. The difference between the Net Change in DAC in 2010 and in 2009 is primarily attributable to the lower level of deferred costs associated with product sales during 2010.
For the reasons discussed above, income (loss) before income taxes amounted to approximately $34.8 million in 2010, as compared to approximately $16.1 million in 2009 and approximately $(15.5 million) in 2008.
Income tax expenses of approximately $13.3 million and $1.4 million were generated in 2010 and 2009, respectively, as compared to a benefit of approximately $13.0 million in 2008. Higher income in 2010 and 2009 generated higher income taxes. The benefit in 2008 was primarily attributable to a lower net income and a deferred tax benefit realized on other than temporary impairments incurred on the Company’s investment portfolio.
The Company was able to meet all its liquidity needs in 2010, including the payment of dividends, and anticipates being able to meet those needs in 2011 and for the reasonably foreseeable future.
The Insurance Company’s inability to upstream a dividend could have an adverse material impact on the Company. With no debt on the balance sheet, currently the Company’s biggest cash outlay is to its shareholders in the form of cash dividends, which at the current level of $.25 per share annually, total approximately $7.4 million per year. The Insurance Company’s current capital and surplus level does not trigger an urgent need for capital raising at the Company. However, the Company, from time to time, explores capital raising options for various reasons, including, but not limited to, the following:
Possible additional restrictions by the NYSID on dividends that could be up streamed from the Insurance Company.
Should the Company decide to raise capital subject to current financial and economic environments, it will be challenging and expensive. Several options are available including, but not limited to, the following:
If the Insurance Company does not have the financial flexibility to upstream a dividend to the Company and the Company is restricted in its ability to raise capital, the Board of Directors may decide to reduce or suspend the payment of dividends to shareholders until capital conditions improve.
Under GAAP, net cash provided by (used in) the Company’s operating activities was approximately $24.8 million, $17.9 million and $(31.3 million) in 2010, 2009 and 2008, respectively. Net cash provided by the Company's investing activities (principally reflecting investments purchased, called, redeemed or sold) was approximately $25.0 million, $49.1 million and $234.8 million in 2010, 2009 and 2008, respectively.
Another element of the asset liability management strategy is to hedge against the risks posed by a rapid and sustained rise in interest rates by entering into a form of derivative transaction known as a Payor Swaption. The effect of this transaction would be to lessen the negative impact on the Company of a significant increase in interest rates. With Payor Swaptions, the Company should be able to maintain more competitive crediting rates to policyholders when interest rates rise.
(1) See Note 1D “Summary of Significant Accounting Policies, Investments”, of the consolidated financial statements
Of the total payment of $4,613.1 million, $2,987.8 million, or 64.8% is from the Company’s deferred annuity, life, and accident and health business. Determining the timing of these payments involves significant uncertainties, including mortality, morbidity, persistency, investment returns, and the timing of policyholder surrender. Notwithstanding these uncertainties, the table reflects an estimate of the timing of such payments.
In a rising interest rate environment, the Company's average cost of funds would be expected to increase over time, as it prices its new and renewing annuities to maintain a generally competitive market rate. In addition, the market value of the Company's fixed maturity portfolio would be expected to decrease, resulting in a decline in shareholders' equity. Concurrently, the Company would attempt to place new funds in investments that were matched in duration to, and higher yielding than, the liabilities associated with such annuities. Moreover, surrenders of its outstanding annuities would likely accelerate. Management believes that liquidity necessary in such an interest rate environment to fund withdrawals, including surrenders, would be available through income, cash flow, the Company's cash reserves and, if necessary, proceeds from the monetization of the Payor Swaption investments described above and the sale of short-term and long-term investments.
The preparation of financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported in the consolidated financial statements. The critical accounting policies, estimates and related judgments underlying the Companys consolidated financial statements are summarized below. In applying these accounting policies, management makes subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to the Company’s business operations.
The Companys principal investments are in fixed maturities, all of which are exposed to at least one of three primary sources of investment risk: credit, interest rate and market valuation. The financial statement risks are those associated with the recognition of other than temporary impairments and income, as well as the determination of fair values. Recognition of income ceases when a bond goes into default and management evaluates whether temporary or other than temporary impairments have occurred on a casebycase basis. When assessing our intent to sell a fixed maturity security or if it is more likely that we will be required to sell a fixed maturity security before recovery of its cost basis, we evaluate facts and circumstances such as, but not limited to, decisions to reposition our security portfolio and sale of securities to meet cash flow needs. In order to determine the amount of the credit loss for a fixed maturity security, we calculate the recovery value by performing a discounted cash flow analysis based on the current cash flows and future cash flows we expect to recover. The discount rate is the effective interest rate implicit in the underlying fixed maturity security. The effective interest rate is the original yield or the coupon if the fixed maturity security was previously impaired. If an OTTI exists and we have the intent to sell the security, we conclude that the entire OTTI is credit-related and the amortized cost for the security is written down to current fair value with a corresponding charge to realized loss on our Consolidated Statements of Income. If we do not intend to sell a fixed maturity security or it is not more likely than not we will be required to sell a fixed maturity security before recovery of its amortized cost basis but the present value of the cash flows expected to be collected is less than the amortized cost of the fixed maturity security (referred to as the credit loss), we conclude that an OTTI has occurred and the amortized cost is written down to the estimated recovery value with a corresponding charge to realized loss on our Consolidated Statements of Income, as this is also deemed the credit portion of the OTTI. The remainder of the decline to fair value is recorded to OCI, as an unrealized OTTI loss on our Consolidated Balance Sheets, as this is considered a noncredit (i.e., recoverable) impairment.
For all equity investments including limited partnerships, if we do not have the ability and intent to hold the security for a sufficient period of time to allow for a recovery in value, we conclude that an OTTI has occurred, and the cost of the equity security is written down to the current fair value, with a corresponding change to realized gain (loss) in our Consolidated Statements of Income. We base our review on a number of factors including, but not limited to, the severity and duration of the decline in fair value of the equity security as well as the cause of the decline, the length of time we have held the equity security, any third party research reports or analysis, and the financial condition and near-term prospects of the security’s issuer, taking into consideration the economic prospects of the issuer’s industry and geographical location.
The Company applies the fair value method of accounting consistent with ASC 944, Financial Services-Insurance, to those limited partnerships in which the Company holds less than a five percent interest and does not have more than virtually no influence over the operating or financial policies of the limited partnership. The Company recognizes the unrealized change in fair value of a partnership interest as a component of equity (other comprehensive income or loss) each period and recognizes cash distributions in earnings each period.
Premiums from universal life and investment-type contracts are reported as deposits to policyholders’ account balances. Revenues from these contracts consist of amounts assessed during the period against policyholders’ account balances for mortality charges and surrender charges. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policyholders’ account balances and interest credited to policyholders’ account balances.
The Insurance Company incurs significant costs in connection with acquiring new business. Under applicable accounting rules, these costs, which vary, are deferred. The recovery of such costs is dependent upon the future profitability of the related product, which in turn is dependent mainly on investment returns in excess of interest credited, as well as persistency and expenses. These factors enter into Managements estimate of future gross profits, which generally are used to amortize such costs. Changes in these estimates result in changes to the amounts expensed in the reporting period in which the revisions are made and could result in the impairment of the deferred acquisition cost asset and a charge to income if estimated future gross profits are less than amounts deferred.
Each year the company conducts testing to confirm that the DAC asset is recoverable and that no premium deficiency reserves are deemed necessary.
The Insurance Company establishes liabilities for amounts payable under life and health insurance policies and annuity contracts. Generally, these amounts are payable over a long period of time and the profitability of the products is dependent on the pricing. Principal assumptions used in pricing policies and in the establishment of liabilities for future policy benefits are investment returns, mortality, expenses and persistency.
The reserves reflected in the Company's consolidated financial statements are based upon the Company's best estimates of mortality, persistency, expenses and investment income, with appropriate provisions for adverse statistical deviation and the use of the net level premium method for all noninterest sensitive products. For all interest sensitive products, the policy account value is equal to the accumulation of gross premiums plus interest credited less mortality and expense charges and withdrawals. In determining reserves for its insurance and annuity products, the Insurance Company performs periodic studies to compare current experience for mortality, interest and lapse rates with expected experience in the reserve assumptions. Differences are reflected currently in earnings for each period.
For those annuities and supplementary contracts with life contingencies that comprise a portion of future policy benefits ($695 million of reserves), an increase in mortality experience of 1% per year for individual contracts would increase the present value of future benefits by approximately $36 million. Conversely, a decrease in mortality experience of 1% per year would decrease the present value of future benefits by approximately $34 million. We believe that any variation of our mortality estimates is likely to fall within this range.