In June 2002, our warehouse lease was renegotiated from 16,000 to 10,000 square feet of space located at 2525 North Shadeland, Indianapolis, Indiana. The lease expires on September 30, 2004.
Savers Marketing leases approximately 4,000 square feet in an office building located at 8064 North Point Boulevard, Winston-Salem, North Carolina, which was renegotiated in March 2002 and expires on March 31, 2005.
Operating income is commonly used as a meaningful measure of reporting results as a supplemental disclosure to net income. Operating income is not a generally accepted accounting principle (“GAAP”) measure of performance and may not be comparable to similarly titled measures used by other companies. Operating income represents net income before 1) extraordinary gains (losses), 2) net realized investment gains (losses) (less related income taxes (benefits) and amortization), 3) gain on the sale of discontinued operations and 4) cumulative effect of accounting change for goodwill impairment. Operating income should be reviewed in conjunction with net income and cash flow information included elsewhere in this report.
The risk factors or uncertainties listed from time to time in any document incorporated by reference herein.
The long-term profitability of life insurance and annuity products depends on the accuracy of the actuarial assumptions that underlie the pricing of such products. Actuarial calculations for such insurance products, and the ultimate profitability of such products, are based on four major factors: 1) persistency, 2) mortality, 3) return on cash invested by the insurer during the life of the policy and 4) expenses of acquiring and administering the policies.
Interest spreads represent a major profit source on interest sensitive life and annuity products, so margins on these products are sensitive to interest rate fluctuations. In general, we are able to maintain spreads by adjusting credited interest rates for changes in our earned rates, subject to competitive and timing constraints. However, there are corollary effects of interest rate changes.
Rising interest rates result in a decline in the market value of assets, and also tend to result in increased policyholder surrenders as other investment options become relatively more attractive. The effect of increased surrenders is to reduce earnings over the long term. Current period earnings effect may vary depending on the level of surrender charges and deferred policy acquisition costs (“DAC”) and present value of future profits (“PVFP”) assets. In addition, increasing interest rates give rise to disintermediation risk, the risk that assets must be sold at depressed values in order to fund increased surrender payments. This risk is mitigated by properly matching assets and liabilities.
The average expected remaining life of Standard Life’s traditional life and annuity business in force at December 31, 2002 was 7.5 years. This calculation was determined based upon our actuarial models and assumptions as to expected persistency and mortality. Persistency is the extent to which insurance policies sold are maintained by the insured. The persistency of life insurance and annuity products is a critical element of their profitability. However, a surrender charge often applies in the early contract years and declines to zero over time.
Costs relating to the acquisition of new business, primarily commissions paid to agents, which vary with and are directly related to the production of new business, are deferred to the extent that such costs are recoverable from future profit margins. At the time of issuance, the acquisition expenses, approximately 12% of our initial annuity premium deposits are capitalized as DAC. In accordance with SFAS No. 97, DAC with interest is amortized over the lives of the policies in a constant relationship to the present value of estimated future gross profits.
Accounting for Equity Indexed Annuities. Revenues and expenses for equity-indexed annuities are recognized in accordance with the SFAS No. 97 model, described above. Policy liabilities for equity-indexed annuities are computed in accordance with SFAS No. 133 which requires that an equity-indexed annuity liability be bifurcated into a “host contract” and a “derivative contract”. The host contract liability is a book value liability providing for the equity-indexed annuity policy’s guaranteed benefits. The derivative contract liability is a market value liability providing for the equity-linked benefits available in the policy. The derivative liability includes a liability for equity-linked benefits accruing during the current contract year, as well as liability amounts for future equity benefits which have not yet been granted.
We amortize premiums and discounts as yield adjustments over the contractual lives of fixed maturity securities. We consider anticipated prepayments on mortgage-backed securities in determining estimated future yields on such securities.
The combined balance of our DAC and PVFP was $168.9 million. The recovery of these costs is dependent on the future profitability of the related business at December 31, 2002.
The assumptions we use to amortize and evaluate the recoverability of the DAC and PVFP involve significant judgment. A significant revision to these assumptions will impact future financial results.
No valuation allowance has been provided on our deferred income tax assets at December 31, 2002, as we believe it is more likely than not that all such assets will be realized. We reached this conclusion after considering the availability of taxable income in prior carryback years, tax planning strategies, and the likelihood of future taxable income exclusive of reversing temporary differences and carryforwards. Differences between forecasted and actual future operating results could adversely impact our ability to realize our deferred income tax assets.
process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our financial results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, negatively affecting our operating results.
We are involved in various legal proceedings in the normal course of business. The ultimate outcome of these legal proceedings cannot be predicted with certainty. We recognize an estimated loss from these loss contingencies when we believe it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. However, it is difficult to measure the actual loss that might be incurred related to legal proceedings. The ultimate outcome of these lawsuits are not expected to have a material adverse effect on our consolidated results of operations and financial position based on our current understanding of the relevant facts and laws.
Results of operations by segment for the three years ended December 31, 2002:
Our 2002 net loss was $1.1 million, or $.14 per diluted share. The results for 2002 were impacted by 1) accelerated amortization of deferred acquisition costs on fixed annuity products of $5.1 million, 2) a reserve strengthening adjustment of $1.5 million, 3) write-off and legal costs related to the recovery of agency receivable balances of $.9 million, 4) operating expenses related to the development of our new U.S. Health Services Corporation subsidiary of $1.1 million, and 5) an increase in net realized investment losses, less related amortization and taxes, attributable to write-downs on the value of collateralized debt obligations due to increased default rates and weaknesses in the energy and telecommunications sectors of $6.9 million. The above decreases in net income were partially offset by a $2.6 million tax benefit over the prior year.
Our 2001 net income was $1.8 million, or $.23 per diluted share, down 65% per share over the comparable 2000 period. The results for 2001 were impacted by 1) an increase in the Company’s effective tax rate resulting in $.6 million; 2) an increase in net realized investment losses, less related amortization and taxes, attributable to the sale of Enron bonds and write-downs on the value of collateralized debt obligations due to increased default rates from the economic slow down of $3.8 million; 3) litigation settlement costs of $.3 million, and 4) reduced spread on interest sensitive products of $.4 million. These above decreases in net income were somewhat offset by paid life insurance claims, less related reserves, of $.9 million. No extraordinary losses occurred in 2001.
General: Our Domestic operations (Continuing operations) segment consists of revenues earned and expenses incurred from our United States operations. Our primary products include deferred annuities, equity-indexed annuities and single premium immediate annuities. The profitability of this segment is primarily a function of net investment spread (the difference between the investment income earned on our investments less the interest we credit to our policyholders), persistency of the in force business, mortality experience and management of our operating expenses.
Premium deposits consist of deposits from our flexible premium deferred annuities, equity-indexed annuities, single premium immediate annuities and other financial products that do not incorporate significant mortality features. For GAAP, these premium deposits are not shown as premium income in the income statement. A change in premium deposits in a single period does not directly cause our operating income to change, although continued increases or decreases in premiums may affect the growth rate of assets on which investment spreads are earned.
Premium deposits for 2002 increased $276.3 million or 86%, to $598.8 million. Deferred annuities increased $142.4 million or 80%, to $320.6 million. Equity indexed annuities increased $58.8 million or 88%, to $126.0 million. Single premium immediate annuities and other deposits increased $75.1 million or 98%, to $151.5 million.
Premium deposits for 2001 increased $126.0 million or 64%, to $322.5 million. Deferred annuities increased $83.5 million or 88%, to $178.2 million. Equity indexed annuities decreased $6.0 million or 8%, to $67.2 million. Single premium immediate annuities and other deposits increased $48.6 million or 175%, to $76.4 million.
The increase for 2002 relates to 1) an expanded geographical presence, 2) favorable agent retention, 3) enhanced presence in the single premium immediate annuity market, and 4) the development of an interactive agent website.
Premium income for 2002 decreased $.2 million or 3%, to $9.2 million.
During 2002, policy income increased $.4 million or 5%, to $8.1 million.
During 2001, policy income decreased $.5 million or 6%, to $7.7 million, which includes a $.3 million decline in surrender income. Generally, during a declining interest rate environment, policyholders are less likely to terminate existing annuity policies, therefore, resulting in less surrender income.
During 2002, net investment income increased $17.3 million or 30% to $75.9 million. Average cash and invested assets, at book value, increased by $347.2 million or 39% due to the growth in insurance liabilities from annuity sales in recent periods.
During 2001, net investment income increased $8.3 million or 16% to $58.5 million. Average cash and invested assets, at book value, increased by $145.0 million or 20% due to the growth in insurance liabilities from annuity sales in recent periods.
The net investment yield earned on our average invested assets was 6.53%, 7.14% and 7.26% for the years ended 2002, 2001 and 2000, respectively. Investment yields fluctuate from period to period and include changes in the general interest rate environment.
Net investment income for 2002 was unfavorably impacted by defaulted bonds and lower earned rates on current year investment purchases.
During 2002, fee and other income decreased by $4.1 million or 56% to $3.3 million. This decrease results from the termination of a marketing and administration contract in 2002.
During 2001, fee and other income increased by $1.4 million or 23% to $7.3 million. This increase includes commission income from Savers Marketing of $6.2 million, an increase of $1.5 million compared to the 2000 period.
Our weighted average credited rate was 4.23%, 4.30% and 4.90% for the years ended 2002, 2001 and 2000, respectively.
The decrease in our weighted average crediting rate for 2002 is primarily due to credited rate reductions on in force business as well as lower credited rates on new sales in the current environment.
Amortization in 2001 decreased by $.7 million or 8%, to $8.9 million. This decline relates to 1) lower amortization of $.7 million from our purchased insurance business, 2) $.4 million from lower surrenders and 3) $.4 million as a result of adopting FASB 133. These decreases were offset by $.7 million of additional amortization related to annuity sales in recent periods.
Interest expense and financing costs represent interest expense incurred and the amortization of related debt issuance costs.
In 2001, interest expense and financing costs increased by $.1 million or 2%, to $3.5 million. Average borrowings for the period increased $1.5 million primarily due to the Trust Preferred Offering completed in August 2001.
The weighted average interest rate for the 2002 and 2001 periods was 9.65% and 9.72%, respectively.
Net realized investment losses for 2001, net of DAC amortization of $3.8 million, were $6.5 million. The majority of the loss was attributable to the sale of Enron bonds and write-downs on the value of collateralized debt obligations due to increased default rates. In addition, losses for the 2001 period included the write-off of an investment in an internet based business.
We maintain a high quality investment portfolio with 97% and 95% of our fixed maturity securities classified as investment grade securities as of December 31, 2002 and 2001, respectively.
Primarily unit-linked assurance products. The sale of the International Operations occurred in 2002 and as a result, there are no separate account contracts or separate account liabilities at December 31, 2002.
Separate account deposits consist of deposits from our unit-linked assurance products. For GAAP these separate account deposits are not shown as premium income in the income statement. A change in separate account deposits in a single period does not cause our operating income to change, although continued increases or decreases in separate account deposits may affect the growth rate of separate account assets on which fees are earned.
The net investment yields earned on average invested assets were 2.58%, 3.80% and 4.31% for the years ended 2002, 2001 and 2000, respectively.
Fees from separate accounts represent the net fees earned on our unit-linked assurance products. The fees include asset based administrative fees, premium based administrative fees and the amortization of front end loads (deferred revenue) into income. Asset based fees fluctuate in relation to separate account assets, and premium based fees fluctuate in relation to premium collections for certain products. Deferred revenue amortization fluctuates subject to the amortization rules of SFAS 97.
Amortization decreased $3.9 million in 2002 to $.3 million as a result of the decline in fees from separate accounts, and is offset by a corresponding decrease in deferred revenue amortization. The sale of the international operations in the second and third quarter of 2002 contributed to the decrease in amortization.
Commission expenses were $.1 million and $.2 million for the years ended December 31, 2002 and 2001. Due to the nature of our business, most incurred commissions are deferred.
Management Fees. Pursuant to a management services agreement, Standard Life paid $3.0 million during 2002 for certain management services related to the production of business, investment of assets and evaluation of acquisitions. In addition, Dixie Life paid Standard Life $1.1 million in 2002, respectively, for certain management services provided. Both of these agreements provide that they may be modified or terminated by the applicable Departments of Insurance in the event of financial hardship of Standard Life or Dixie Life. In 2003, we expect to receive management fees of $3.6 million from Standard Life.
Tax Sharing Payments. Effective January 1, 2000 we entered into a tax sharing agreement with Savers Marketing and Standard Management International that allocates the consolidated federal income tax liability. In 2002, Savers Marketing paid $.1 million and Standard Management paid $.6 million in accordance with this agreement. In 2001, Savers
The following are characteristics of our mortgage payable agreement at December 31, 2002:
interest payments required in 2003 based on current balances will be $.5 million;
principal and interest payments: $30 thousand interest per year in 2003 and 2004; principal payments thereafter beginning in 2005 through 2007;
The following are characteristics of our amended credit agreement at December 31, 2002:
principal payments: $.6 million paid in March 2002, $3.75 million paid in September 2002, $2.0 million paid in October 2002 and $.25 million paid in December 2002. The remaining principal payment of $1.5 million is due in August 2003.
The following are characteristics of our subordinated debt agreement at December 31, 2002:
interest payments required in 2003 based on current balances will be $1.1 million.
distributions required in 2003 based on current balances will be $2.1 million;
At February 1, 2003, we had “parent company only” cash and short-term investments of $2.0 million. These funds are available for general corporate purposes. Our “parent company only” operating expenses (not including interest expense) were $5.5 million and $4.3 million for 2002 and 2001, respectively.
We believe that the operational cash flow of Standard Life will be sufficient to meet our anticipated needs for 2003. As of December 31, 2002, Standard Life had statutory capital and surplus for regulatory purposes of $58.9 million. As the annuity business produced by Standard Life increases, Standard Life expects to satisfy statutory capital and surplus requirements through statutory profits and through additional capital contributions by Standard Management. Net cash flow from operations on a statutory basis of Standard Life, after payment of benefits and operating expenses, was $343.2 million and $159.2 million for 2002 and 2001, respectively. If the need arises for cash, which is not readily available, additional liquidity could be obtained from the sale of invested assets.
Insurers compete with other insurance companies, financial intermediaries and other institutions on the basis of a number of factors, including the ratings assigned by A.M. Best. A.M. Best assigns ratings labeled (“A++”) through (“F”) (“Superior,” “Excellent,” “Very Good,” “Fair,” “Marginal,” “Weak,” “Poor,” “Under Regulatory Supervision,” and “In Liquidation”). Standard Life and Dixie Life have a rating of (“B+”) (Very Good) and (“B”) (Fair), respectively, by A.M. Best. A.M. Best’s ratings represent their opinion based on a comprehensive quantitative and qualitative review of our
financial strength, operating performance and market profile. A rating of (“B+”) is assigned by A.M. Best to companies that, in their opinion, have achieved very good overall performance when compared to the standards established by A.M. Best, and have a good ability to meet their obligations to policyholders over a long period of time. A rating of (“B”) is assigned by A.M. Best to companies that, in their opinion, have achieved good overall performance when compared to the standards established by A.M. Best. According to A.M. Best, these companies generally have an adequate ability to meet their obligations to policyholders, but their financial strength is vulnerable to unfavorable changes in underwriting or economic conditions. In evaluating a company’s financial and operating performance, A.M. Best reviews the company’s profitability, leverage and liquidity as well as the company’s book of business, the adequacy and soundness of its reinsurance, the quality and estimated market value of its assets, the adequacy of its reserves, and the experience and competence of its management. A.M. Best reviews its ratings of insurance companies from time to time. If the A.M. Best ratings were downgraded, sales of annuity products could be significantly impacted and the financial condition and results of operations could be materially adversely affected. See “Business of Standard Management-Competition.”
Significant changes in interest rates expose insurance companies to the risk of not earning anticipated spreads between the interest rate earned on investments and the credited interest rates paid on outstanding policies. Both rising and declining interest rates can negatively affect spread income. Although we develop and maintain asset/liability management programs and procedures designed to preserve spread income in rising or falling interest rate environments, changes in interest rates could adversely affect these spreads.
Our substantial reliance on reinsurers could cause our financial results to suffer.
Our policy claims fluctuate from year to year, and future benefit payments may exceed our established reserves, which would cause our earnings to suffer.
Volatility in benefit claims is common in the life insurance industry. While our reserves have been sufficient to cover policy claims in the past and we attempt to limit the risk by carefully underwriting new policies and sharing risks with reinsurance companies, we may still experience a period of higher than anticipated benefit claims that exceeds our established reserves. If this were to happen, it could result in increased operating losses.
Because a significant portion of our annuity contracts are surrenderable, any substantial increase in the level of surrenders could negatively affect financial results.
Our financial results could be materially adversely affected if our assumptions regarding the value of intangible assets prove to be incorrect.
Included in our financial statements are certain assets that are primarily valued, for financial statement purposes, on the basis of management’s assumptions. These assets include items such as:
The financial statements and supplementary data required with respect to this Item 8 are listed in Item 15(a)(1) and included in a separate section of this report.