As shown in the Selected Financial Data above, during recent years the Company has achieved a substantial year-to-year growth in the sales of its annuity and insurance product, the proceeds of which have been placed in the investment portfolio. This portfolio has been managed by the Company with the objective of seeking the highest possible returns while investing primarily in investment grade debt securities.
2003 recoveries in the market values were experienced which resulted in the Company achieving record high levels of capital and improved capital ratios. As described under “Ratings” and “Regulation” the Company’s business is substantially affected by such capital ratios and their impact on its rating. Consequently, the Company’s management established a policy of reducing the level of sales increases until capital and surplus ratios are further improved. Sales will also be made with a greater selectivity based on a profit review. Recently, as a result of such a review, the Company has taken a planned emphasis on annuity products and a de-emphasis, and in some cases, a discontinuance, of sales of the traditional life insurance of term and whole life.
Profitability in the Company’s individual annuities and individual life insurance depends largely on the size of its inforce block, the adequacy of product pricing and underwriting dicipline, the efficiency of its claims and expense management, and the performance of the investment portfolio.
In this discussion we have included statements that may constitute “forward-looking statements” within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control. These statements may relate to our future plans and objectives. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from the results indicated in these forward-looking statements. Important factors, among others, that could cause our results to differ from those indicated in the forward-looking statements are discussed under “Certain Factors That May Affect Our Business.”
The Company’s performance in 2003 results primarily from the improved performance of our investment portfolio and our continuing efforts to reduce expenses and to reduce risk and exposure in our portfolio. The improvement of global capital and equity markets in 2003 also contributed significantly to our financial performance.
There are numerous factors, some of which are outside our control, which could have a material impact on our business. These factors include market conditions, legal and regulatory changes and operational risks. A summary of these factors is set forth below:
Legal and Regulatory Risk: As an insurance company, we are subject to substantial regulatory control. Any material change in the regulatory framework in which we operate could have a material impact on our business. For further discussion on how we deal with our regulatory requirements, see “Business - Insurance Regulation.”
Management believes that the Company is able to offer its products at competitive prices to its targeted markets as a result of: (i) maintaining relatively low issuance costs by selling through the independent general agency system; (ii) minimizing home office administrative costs; and (iii) utilizing appropriate underwriting guidelines.
The following table summarizes the Company's investment results for the periods indicated, as determined in accordance with GAAP.
<F1> Average of cash and aggregate invested amounts at the beginning and end of period.
<F3> Net investment income divided by average cash and total invested assets minus net investment income.
<F4> Net realized investment gains (losses) include provisions for impairment in value that are considered other than temporary and exclude provisions for income taxes.
Mortality is the rate of death experienced by life insurance policyholders and certain annuitants taken as a group. For calculating premiums, the Company uses actuarial assumptions with margins added to allow for adverse statistical variations. Actual mortality experience in a particular period may be different than actuarially expected mortality experience and, consequently, may adversely affect the Company's operating results for such period.
The Company¢s 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. Management evaluates whether impairments have occurred case-by-case. Management considers a wide range of factors about the security issuer and uses its best judgment in evaluating the cause and decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in management¢s evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Considerations used by the Company in the impairment evaluation process include, but are not limited to: (i) the length of time and the extent to which the market value has been below amortized cost; (ii) the potential for impairments of securities when the issuer is experiencing significant financial difficulties; (iii) the potential for impairments in an entire industry sector or sub-sector; (iv) the potential for impairments in certain economically depressed geographic locations; (v) the potential for impairments of securities where the issuer, series of issuers or industry has a catastrophic type of loss or has exhausted natural resources; and (vi) other subjective factors, including concentrations and information obtained from regulators and rating agencies. In addition, the earnings on certain investments are dependent upon market conditions, which could result in prepayments and changes in amounts to be earned due to changing interest rates or equity markets. The determination of fair values in the absence of quoted market values is based on valuation methodologies, securities the Company deems to be comparable and assumptions deemed appropriate given the circumstances. The use of different methodologies and assumptions may have a material effect of the estimated fair value amounts.
During 2002, Moody's Investor Services (“Moody's”) lowered the Insurance Company's insurance financial strength rating from Baa1 to Ba1 (“Questionable financial security”). Standard & Poor's Corporation (“Standard & Poor's”) lowered the Insurance Company's insurance financial strength from A- to BB+ and is defined as “Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions”. The credit rating of the Company's Senior Notes, due February 15, 2009 (the “Senior Notes”), was lowered to a B+ (More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial requirements) from a BBB- by Standard & Poor's and to a B1 (“Poor financial security”) from Ba1 by Moody's.
Comparison of Fiscal Year 2003 to Fiscal Year 2002 and Fiscal Year 2002 to Fiscal Year 2001.
Total annuity considerations and life insurance premiums decreased to approximately $43.6 million in fiscal 2003 from approximately $81.0 million in fiscal 2002, a decrease of approximately 46.2%. This decrease is attributable to a decrease in sales of the Insurance Company¢s Single Premium immediate annuities with life contingencies. Annuity considerations decreased to approximately $32.6 million in fiscal 2003 from approximately $69.4 million in fiscal 2002, a decrease of approximately $36.8 million. In accordance with GAAP, sales of single premium deferred annuities are not reported as annuity considerations, but rather as additions to policyholder account balances. Based on statutory accounting, revenue from sales of single premium annuities were approximately $243.1 million, $815.8 million and $700.1 million in fiscal 2003, 2002 and 2001, respectively. The decrease is attributable to many factors, including management’s intent to preserve and build the Insurance Company’s capital and surplus ratios.
The reduction in the net investment income ratios is attributable to the low interest rate environment and other economic conditions. During periods of declining interest rates, paydowns on mortgage-backed securities with higher interest rates and callable debt securities increase. During such periods the Company, for the most part, will not be able to reinvest the proceeds at comparable yields.
Net realized investment gains (pre-tax) amounted to approximately $10.3 million in fiscal 2003, as compared to approximately $146.7 million of losses in fiscal 2002 and losses of approximately $65.1 million in fiscal 2001. Realized investment losses for years ended December 31, 2003, 2002 and 2001 include realized investment losses of approximately $31.8 million, $147.3 million and $50.7 million, respectively, attributable to writedowns of certain securities contained in the Company's investment portfolio. Investment securities with unrealized losses are placed on an internal watch list and are carefully evaluated to determine whether such losses are other than temporary. Evaluations of watch list securities are monitored on an ongoing basis. Various criteria are utilized in the evaluation of the financial performance of the issuer, including capital structure, debt maturities, earnings trends, asset quality, Industry trends, regional and economic trends and specific events including: a) company specific event, such as missed interest payments, accounting issues, gain or loss of major revenue generating contract(s), significant change in availability and cost of raw material or labor; and, b) specific market-driven events such as dramatic changes in interest rates or geo-political events. We then evaluate these results in the context of our general intent to hold the investments to maturity barring any significant adverse change in credit conditions, as well as our need for liquidity. When we determine that such conditions are not simply temporary, we adjust the book value to reflect the net realizable value or fair value, as appropriate, on a quarterly basis. Realized investment gains (losses) also result from sales of certain equities and convertible securities, and calls and sales of fixed maturity investments in the Company's investment portfolio.
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, 2003.
The interest expense on the Company's notes payable amounted to approximately $9.64 million in fiscal 2003, approximately $10.63 million in fiscal 2002 and approximately $8.84 million in fiscal 2001.
The decrease in interest expense in fiscal 2003 is attributable to lower interest rates on the Company’s $50 million line of credit with the Bank of New York.
General expenses, taxes and commissions to agents totaled approximately $29.6 million in fiscal 2003 as compared to approximately $47.2 million in fiscal 2002 and approximately $50.3 million in fiscal 2001. This represents a decrease of approximately 37.3% comparing fiscal 2003 to fiscal 2002 and a decrease of approximately 6.2% comparing fiscal 2002 to fiscal 2001. The decrease in fiscal 2003 compared to 2002, is principally attributable to lower costs associated with lower commissions and selling expenses incurred associated with the lower level of sales of single premium annuities offset by the company¢s general expenses and taxes. The decrease in fiscal 2002 compared to fiscal 2001 is attributable to a reduction in the Company’s general expenses due to expense controls initiated in 2002.
The change in the net DAC for fiscal 2003 resulted in a credit of approximately $2.5 million, as compared to a credit of approximately $30.6 million in fiscal 2002 and a credit of approximately $23.5 million in fiscal 2001. Such changes are due (i) to the decrease in costs associated with product sales which have been deferred and are amortized in proportion to the recognition of earned revenue and (ii) to the effect of revisions to estimated gross profits on unamortized deferred acquisition costs which are reflected in the year such estimated gross profits are revised.
The Insurance Company is subject to various regulatory restrictions on the maximum amount of payments, including loans or cash advances, that it may make to us without obtaining prior regulatory approval. Under the New York Insurance Law, the Insurance Company is permitted without prior insurance regulatory clearance to pay a stockholder dividend to the Company as long as the aggregate amount of all such dividends in any calendar year does not exceed the lesser of (i) 10% of its surplus as of the immediately preceding calendar year and (ii) its net gain from operations for the immediately preceding calendar year (excluding realized capital gains and losses). The Insurance Company will be permitted to pay a stockholder dividend to the Company in excess of the lesser of such two amounts only if it files notice of its intention to declare such a dividend and the amount thereof with the Superintendent and the Superintendent does not disapprove the distribution. Under the New York Insurance Law, the Superintendent has broad discretion in determining whether the financial condition of a stock life insurance company would support the payment of such dividends to its stockholders. The NYSID has established informal guidelines for such determinations. The guidelines, among other things, focus on the insurer's overall financial condition and profitability under statutory accounting practices. Management of the Company cannot provide assurance that the Insurance Company will have statutory earnings to support payment of dividends to the Company in an amount sufficient to fund its cash requirements and pay cash dividends or that the Superintendent will not disapprove any dividends that the Insurance Company must submit for the Superintendent's consideration. To preserve capital, the Insurance Company paid no dividends in fiscal 2003 or 2002. In 2001, the Insurance Company paid dividends of $27.7 million. The Company’s other insurance subsidiary is also subject to restrictions on the payment of dividends to their respective parent companies.
Net cash provided by the Company's operating activities was approximately $15.7 million, $26.8 million and $104.1 million in fiscal 2003, 2002 and 2001, respectively. The decrease from 2001 is largely attributable to the reduction in annuity considerations. Net cash provided by /(used) in the Company's investing activities (principally reflecting investments purchased less investments called, redeemed or sold) was approximately $76.9 million, $(684.6) million and $(815.4) million in fiscal 2003, 2002 and 2001, respectively.
For purposes of the Company's consolidated statements of cash flows, financing activities relate primarily to “dollar roll” repurchase transactions, and to sales and surrenders of the Company's annuity and universal life insurance products. The payment of dividends by the Company to its stockholders also is considered to be a financing activity. Net cash (used)/ provided by the Company's financing activities amounted to approximately $(92.8) million, $668.9 million and $711.9 million in fiscal 2003, 2002 and 2001, respectively. These fluctuations primarily are attributable to higher policyholder account balances (as a result of sales), the new line of credit established in 2001, partially offset by the payment of dividends to the Company's shareholders during fiscal year 2003.
The indenture governing the Senior Notes contains covenants relating to limitations on liens and sale or issuance of capital stock of the Insurance Company. In the event the Company violates such covenants as defined in the indenture, the Company may be obligated to offer to repurchase all of the outstanding principal amount of such notes. As of December 31, 2003, the Company believes that it is in compliance with all of the covenants.
There were no capital expenditures during fiscal 2003 and no outstanding commitments as of December 31, 2003.
Investments in below investment grade debt securities have different risks than investments in corporate debt securities rated investment grade. Risk of loss upon default by the borrower is significantly greater with respect to below investment grade debt securities than with respect to other corporate debt securities because below investment grade debt securities generally are unsecured and often are subordinated to other creditors of the issuer. Also, issuers of below investment grade debt securities usually have high levels of indebtedness and often are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. Typically, there is only a thinly traded market for such securities and recent market quotations may not be available for some of these securities. Market quotes generally are available only from a limited number of dealers and may not represent firm bids of such dealers or prices for actual sales. The Company attempts to reduce the overall risk in its below investment grade portfolio, as in all of its investments, through detailed credit analysis, investment policy limitations, and diversification by company and by industry. Below investment grade debt investments, as well as other investments, are being monitored on an ongoing basis. 33.
As of December 31, 2003, approximately 8.0% of the Insurance Company's total invested assets were invested in limited partnerships and equity securities. Pursuant to NYSID regulations, the Company's investments in equity securities, including limited partnership interests, as well as below investment grade bonds may not exceed 20% of the Insurance Company's invested assets. Investments in limited partnerships are included in the Company's consolidated balance sheet under the heading “Other invested assets.” See “Note 2 to the Notes to Consolidated Financial Statements.” The Company is committed, if called upon during a specified period, to contribute an aggregate of approximately $90.0 million of additional capital to certain of these limited partnerships. $14.2 million in 2004, $20.3 million in 2005, $24.4 million in 2006 and $30.8 in 2007. The Company may make selective investments in additional limited partnerships as opportunities arise. In general, risks associated with such limited partnerships include those related to their underlying investments (i.e., equity securities, debt securities and real estate), plus a level of illiquidity, which is mitigated by the ability of the Company to take annual distributions of partnership earnings. There can be no assurance that the Company will continue to achieve the same level of returns on its investments in limited partnerships as it has historically. Further, there can be no assurance that the Company will receive a return of all or any portion of its current or future capital investments in limited partnerships. The failure of the Company to receive the return of a material portion of its capital investments in limited partnerships, or to achieve historic levels of return on such investments, could have a material adverse effect on the Company's financial condition and results of operations.
As previously discussed, in fiscal 2003 and 2002 the Company participated in “dollar roll” repurchase agreement transactions. Amounts outstanding to repurchase securities under such agreements were approximately $0 and $262.5 million at December 31, 2003 and 2002, respectively. The Company may engage in selected “dollar roll” transactions as market opportunities arise.
The accompanying Notes to Consolidated Financial Statements contain information regarding payments required under existing long-term borrowing arrangements. The following presents a summary of the Company’s significant contractual obligations.
Long-term debt obligations consist of $100 million, 7 7/8% senior notes due February 15, 2009. See “Note 3 in Notes to the Consolidated Financials Statements” for additional discussion concerning both long-term and short-term obligations.
In a declining interest rate environment, the Company's cost of funds would be expected to decrease over time, reflecting lower interest crediting rates on its fixed annuities. Should increased liquidity be required for withdrawals in such an interest rate environment, management believes that the portion of the Company's investments which are designated as available for sale in the Company's consolidated balance sheet could be sold without materially adverse consequences in light of the general strengthening in market prices which would be expected in the fixed maturity security market.
Interest rate changes also may have temporary effects on the sale and profitability of our universal life and annuity products. For example, if interest rates rise, competing investments (such as annuity or life insurance products offered by the Company's competitors, certificates of deposit, mutual funds and similar instruments) may become more attractive to potential purchasers of the Company's products until the Company increases the rates credited to holders of its universal life and annuity products. In contrast, as interest rates fall, we would attempt to lower our credited rates to compensate for the corresponding decline in net investment income. As a result, changes in interest rates could materially adversely effect the financial condition and results of operations of the Company depending on the attractiveness of alternative investments available to the Company's customers. In that regard, in the current interest rate environment, the Company has attempted to maintain its credited rates at competitive levels designed to discourage surrenders and also to be considered attractive to purchasers of new annuity products. In addition, because the level of prevailing interest rates impacts the Company’s competitors in the same fashion, management does not believe that the current interest rate environment will materially affect the Company's competitive position vis a vis other life insurance companies that emphasize the sale of annuity products.
December 31, 2003. This table consists primarily of fixed maturity investments available for sale, which are carried at fair value.
<F1> All fixed maturity and equity securities are classified as available for sale; accordingly total carrying value equals estimated fair value. Independent pricing services provide market prices for over 98% of the publicly traded securities. Where prices are unavailable from pricing services, prices are obtained from securities dealers and valuation methodologies. For other long-term investments, estimated market value either approximates estimated carrying value or was not readily ascertainable. See “Note 1(c) to the Notes to the Consolidated Financial Statements for an explanation of the methodology used to value "Other Investments."”
<F5> Consist principally of investments in limited partnerships, which are accounted for under the equity method.
The 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 following section discusses the Company’s policy and practices regarding life insurance and annuity reserves.
In accordance with applicable insurance regulations, the Company has established and carries as liabilities in its statutory financial statements actuarially determined reserves that are calculated to satisfy its policy and contract obligations. Reserves, together with premiums to be received on outstanding policies and contracts and interest thereon at certain assumed rates, are calculated to be sufficient to satisfy policy and contract obligations. The actuarial factors used in determining such reserves are based on statutorily prescribed mortality and morbidity tables and interest rates. Reserves maintained also include unearned premiums, premium deposits, reserves for claims that have been reported but are not yet paid, reserves for claims that have been incurred but have not yet been reported and claims in the process of settlement. Generally, the Company maintains reserves on assumed reinsurance, but does not continue accumulating reserves with respect to that portion of policies or contracts that are reinsured with, or ceded to, other insurance companies. Reserves for assumed reinsurance are computed on bases essentially comparable to direct insurance reserves.
The reserves reflected in the Company's consolidated financial statements included herein are calculated based on GAAP and differ from those specified by the laws of the various states in which the Insurance Company does business and those reflected in the Insurance Company's statutory financial statements. These differences arise from the use of different mortality and morbidity tables and interest rate assumptions, the introduction of lapse assumptions into the reserve calculation and the use of the net level premium reserve method on all insurance business. See “Notes 1G, 1H and 8 to the Notes to the Consolidated Financial Statements.”
The Insurance Company sponsors a defined benefit plan covering employees who meet specified eligibility requirements. The reported expense and liability associated with these plans requires use of assumptions which include the discount rate, expected return on plan assets and rate of future compensation increases as determined by the Insurance Company. Management determines these assumptions based upon currently available market and industry data, historical performance of the plans and its assets. The actuarial assumptions used by the Insurance Company may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates or longer or shorter life spans of the participants. These differences may have a significant effect on the Company¢s consolidated financial statements.
During 2003, the actuarial assumptions used in the calculation of the Company's projected benefit obligation include the expected rate of compensation increases of 3.00%, a discount rate of 6.00% and an expected return on assets of 5.50%. The projected benefit obligation at December 31, 2003 is $13.6 million.
In February 2004, in contemplation of a voluntary termination of the Presidential Life Insurance Company Employees’ Retirement Plan, the Company adopted a resolution which "froze" the Plan as of February 18, 2004. This closed the Plan to new entrants and terminated the accrual of any future benefits under the Plan after such date. In addition to freezing the Plan, the Company approved a resolution to utilize 1971 Group Mortality Tables and a seven percent (7%) investment yield for use in computing actuarial calculations. The Company anticipates that a final decision regarding the termination of the Plan will be made in or about the second half of 2004.