Protective leases administrative and marketing office space in approximately 60 cities including approximately 53,264 square feet in Birmingham, with most leases being for periods of three to ten years. The aggregate annualized rent is approximately $10.8 million.
DECEMBER 31 -------------------------------------------------------------------------------- 2002 2001 2000 1999 1998 -------------------------------------------------------------------------------- BALANCE SHEET DATA Total assets............................ $21,787,568 $19,582,503 $15,041,781 $12,862,097 $11,896,520 Total debt(3)........................... $ 4,264 $ 8,291 $ 12,315 $ 16,338 $ 23,261 Total stable value contract and annuity income balances(4)................... $ 4,198,070 $ 3,907,892 $ 3,385,092 $ 2,915,417 $ 2,952,030 Share-owner's equity.................... $ 2,285,284 $ 1,883,333 $ 1,539,955 $ 1,236,495 $ 1,312,832 Share-owner's equity excluding accumulated other comprehensive income(5)............................ $ 2,049,370 $ 1,830,165 $ 1,591,325 $ 1,382,575 $ 1,257,776
CONDITION AND RESULTS OF OPERATIONS Protective Life Insurance Company (Protective) and its subsidiaries provide financial services through the production, distribution, and administration of insurance and investment products. Protective is a wholly-owned subsidiary of Protective Life Corporation (PLC), an insurance holding company whose common stock is traded on the New York Stock Exchange (symbol: PL). Protective operates business segments each having a strategic focus which can be grouped into one of three general categories: life insurance, retirement savings and investment products, and specialty insurance products. The life insurance category includes the Life Marketing and Acquisitions segments. The retirement savings category includes the Stable Value Products and Annuities segments, and the specialty insurance products category includes the Asset Protection segment. In addition, Protective has another business segment referred to herein as the Corporate and Other segment.
Protective has a deferred policy acquisition costs asset of approximately $89 million related to its variable annuity product lines with an account balance of $1.7 billion at December 31, 2002. Protective monitors the rate of amortization of the deferred policy acquisition costs associated with its variable annuity product line. The methodologies employ varying assumptions about how much and how quickly the stock markets will recover from their current depressed levels. The primary assumptions used to project future profits as part of the recoverability analysis include: a long-term equity market growth rate of 8%, reversion to the mean methodology with a reversion to the mean cap rate of 13%, reversion to the mean period of 5 years, and an amortization period of 20 years. A recovery in equity markets, or methodologies and assumptions that anticipate a recovery, result in lower amounts of amortization, and a worsening of equity markets result in higher amounts of amortization.
Establishing an adequate liability for Protective’s obligations to its policyholders requires the use of assumptions. Liabilities for future policy benefits on traditional life insurance products requires the use of assumptions relative to future investment yields, mortality, persistency and other assumptions based on Protective’s experience, modified as necessary to reflect anticipated trends and to include provisions for possible adverse deviation.
Protective also establishes liabilities for guaranteed minimum death benefits (GMDB) on its variable annuity products. The methods used to estimate the liabilities employ assumptions about mortality and the performance of equity markets. Protective assumes mortality of 60% of the National Association of Insurance Commissioners 1994 Variable Annuity GMDB Mortality Table to reflect improvements in mortality since the table was derived and other factors. Future declines in the equity market would increase Protective’s GMDB liability. Differences between the actual experience and the assumptions used result in variances in profit and could result in losses.
PERCENTAGE YEAR ENDED DECEMBER 31 AMOUNT INCREASE (DECREASE) --------------------------------------------------------------------------------------- (IN THOUSANDS) 2000 $489,835 22.9% 2001 618,668 26.3 2002 782,854 26.5
In 2001, premiums and policy fees increased $128.8 million or 26.3% over 2000. Premiums and policy fees in the Life Marketing segment increased $21.2 million due to increased sales. Premiums and policy fees in the Acquisitions segment are expected to decline with time (due to the lapsing of policies resulting from deaths of insureds or termination of covers) unless new acquisitions are made. In January 2001, the Acquisitions segment coinsured a block of individual life insurance policies from Standard Insurance Company (Standard), and in October 2001, acquired Inter-State Assurance Company (Inter-State) and First Variable Life Insurance Company (First Variable) from Irish Life & Permanent plc. These transactions resulted in an $86.8 million increase in premiums and policy fees. Premiums and policy fees from older acquired blocks declined $7.2 million in 2001. The decrease in premiums and policy fees from the Annuities segment was $2.0 million due to a decline in variable annuity management fees caused by the general decline in the equity markets. Premiums and policy fees from the Asset Protection segment increased $29.6 million primarily due to increased sales in its service contracts. Premiums and policy fees relating to various health insurance lines in the Corporate and Other segment increased $0.6 million.
DERIVATIVE FINANCIAL ALL OTHER YEAR ENDED DECEMBER 31 INSTRUMENTS INVESTMENTS ---------------------------------------------------------------------- (IN THOUSANDS) (IN THOUSANDS) 2000 $ 2,157 $(16,756) 2001 (1,718) (6,123) 2002 (12,959) 12,314
Each quarter Protective reviews investments with material unrealized losses and tests for other-than-temporary impairments. Management analyzes various factors to determine if any specific other than temporary asset impairments exist. Once a determination has been made that a specific other-than-temporary impairment exists, a realized loss is recognized and the cost basis of the impaired asset is adjusted to its fair value. An other-than-temporary impairment loss is recognized based upon all relevant facts and circumstances for each investment. With respect to unrealized losses due to issuer-specific events, Protective considers the creditworthiness and financial performance of the issuer and other available information. With respect to unrealized losses that are not due to issuer-specific events, such as losses due to interest rate fluctuations, general market conditions or industry-related events, Protective considers its intent and ability to hold the investment to allow for a market recovery or to maturity together with an assessment of the likelihood of full recovery. See also “Liquidity and Capital Resources - Investments” included herein.
Other income consists primarily of revenues from Protective’s direct response business, service contract business, non-insurance subsidiaries and rental of space in its administrative building to PLC. In 2001, revenues from Protective’s direct response business and service contract business increased $2.0 million and $0.5 million, respectively. Income from other sources increased $0.9 million. In 2002, revenues from Protective’s service contract business increased $4.7 million. Income from all other sources decreased $1.8 million.
Income Before Income Tax Management evaluates the results of Protective’s segments on a before-income-tax basis as adjusted for certain items which management believes are not indicative of Protective’s core operations. Segment operating income (loss) excludes net realized investment gains and losses and the related amortization of deferred policy acquisition costs and gains (losses) on derivative instruments because fluctuations in these items are due to changes in interest rates and other financial market factors instead of mortality and morbidity. Also, operating segment income (loss) excludes any net gains or losses on disposals of businesses, discontinued operations, extraordinary items, the cumulative effect of accounting changes, and any other items, that, in each case, are neither normal nor recurring. Although the items excluded from segment operating income (loss) may be significant components in understanding and assessing Protective’s overall financial performance, management believes that operating segment income (loss) enhances an investor’s understanding of Protective’s results of operations by highlighting the income (loss) attributable to the normal, recurring operations of the insurance business (i.e., mortality and morbidity), consistent with industry practice. However, Protective’s segment income (loss) measures may not be comparable to similarly titled measures reported by other companies. Segment income (loss) should not be construed as a substitute for net income (loss) determined in accordance with accounting principles generally accepted in the United States of America (GAAP). “Total income from continuing operations before income tax” is a GAAP measure to which the non-GAAP measure “total operating income” may be compared. Unlike total operating income, total income before income tax includes net realized investment gains and losses, the related amortization of deferred policy acquisition costs and gains (losses) on derivative instruments.
---------------------------- (1) Income from continuing operations before income tax excluding realized investment gains and losses and related amortization of deferred policy acquisition costs.
In the second quarter of 2002, Protective discovered that it had overpaid the reinsurance premiums due on certain life insurance policies, and indicated that it would be seeking recovery of approximately $94.6 million from several reinsurance companies.
Protective continues to make progress toward recovery of the overpayments. Approximately $36.6 million had been received as of February 28, 2003. Protective is continuing to work with the reinsurers in an effort to collect the entire overpayment, plus interest where appropriate. With respect to one reinsurer, arbitration proceedings are currently pending. At December, 31, 2002, Protective had recorded cash and receivables totaling $69.7 million, which reflects the amounts received and Protective’s current estimate of amounts to be recovered in the future, based upon the information available.
The corresponding increase in premiums and policy fees resulted in $62.5 million of additional amortization of deferred policy acquisition costs in 2002. The amortization of deferred policy acquisition costs takes into account the amortization relating to the increase in premiums and policy fees as well as the additional amortization required should the remainder of the overpayment not be collected. The Life Marketing segment’s pretax operating income thereby increased $7.2 million (in addition to the increase noted above), which is the difference between the premiums recorded and the amount of such additional amortization.
In 2001, the Acquisition segment’s pretax operating income was $69.3 million, $15.6 million above 2000. The Standard coinsurance transaction and the acquisition of Inter-State and First Variable resulted in a $15.9 million increase in earnings. Earnings on older acquired blocks of policies declined $0.3 million. In 2002, the segment’s pretax operating income was $96.4 million, $27.2 million above 2001. The Conseco and Standard coinsurance transactions and the acquisitions of Inter-State and First Variable resulted in a $24.7 million increase in earnings in 2002. Earnings on older acquired blocks of policies increased $2.5 million.
The Stable Value Contracts segment had 2001 pretax operating income of $33.2 million, $1.9 million above 2000. This increase is primarily due to an increase in average account balances of $523 million. Operating spreads in 2001 were 10 basis points lower than 2000 due to lower investment income. Realized investment losses associated with this segment in 2000 were $6.6 million as compared to gains of $7.2 million in 2001. As a result income before income tax was $24.7 million in 2000 and $40.4 million in 2001. The Stable Value Contracts segment’s 2002 pretax operating income was $42.3 million, $9.1 million above 2001. This increase is due primarily to higher account balances and operating spreads. Average account balances were $3.9 billion in 2002 compared to $3.5 billion in 2001. Operating spreads averaged 107 basis points in 2002 compared to an average of 90 basis points in 2001. Realized investment gains associated with this segment in 2001 were $7.2 million as compared to losses of $7.1 million in 2002. As a result, total income before income tax was $40.4 million in 2001 and $35.2 million in 2002.
In accordance with statutory accounting practices prescribed or permitted by regulatory authorities (which require the assumption that equity markets will significantly worsen), Protective and its insurance subsidiaries reported GMDB related policy liabilities and accruals of $24.7 million at December 31, 2002.
The Asset Protection segment’s core lines of business are credit insurance and vehicle and marine service contracts. The results of the Asset Protection segment are being significantly affected by general economic conditions and conditions in the automobile industry. The segment’s claims and corresponding loss ratios have increased in the current economic environment. In addition, the segment is exiting certain ancillary lines of business, which are not core to either the credit insurance or service contract business.
The Asset Protection segment’s 2001 pretax operating income was $35.7 million, $0.9 million above 2000. Higher loss ratios in the segment’s ancillary lines reduced income by $6.5 million in 2001. This decline was offset by a change in estimate of $6.7 million with respect to reserves in certain credit lines. The segment’s 2001 results also include income of approximately $2.0 million from the sale of a small insurance subsidiary’s charter. All other items reduced 2001 operating income by $1.3 million.
The Corporate and Other segment consists primarily of net investment income on unallocated capital, interest expense on substantially all debt, several lines of business which Protective is not actively marketing (mostly health insurance), and other operating expenses not identified with the preceding business segments (including interest on substantially all debt). In 2001, the segment had pretax operating losses of $22.4 million compared to operating losses of $19.4 million in 2000. In 2002, the segment had pretax operating losses of $19.3 million, $3.1 million less than 2001. The increase relates to a $13.4 million increase in investment income allocated to the segment, which was partially offset by $4.1 million less income from the cancer line of business and higher corporate expenses.
Management's current estimate of the effective income tax rate for 2003 is between 33.5% and 34.5%.
Change in Accounting Principle On January 1, 2001, Protective adopted Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities." The adoption of SFAS No. 133 resulted in a cumulative after-tax charge to net income of approximately $8.3 million. The adoption of SFAS No. 133 also resulted in a cumulative after-tax increase to other comprehensive income of approximately $4.0 million.
The following table sets forth net income from continuing operations before extraordinary loss and cumulative effect of change in accounting principle for the periods shown:
Known Trends And Uncertainties The operating results of companies in the insurance industry have historically been subject to significant fluctuations. The factors which could affect Protective’s future results include, but are not limited to, general economic conditions and the known trends and uncertainties which are discussed more fully below. Please also refer to “Other Developments” herein.
Protective is exposed to many types of risks that could negatively affect its business. There are many types of risks that Protective is exposed to in its businesses. For example, Protective is exposed to the risks of natural disasters, malicious and terrorist acts, computer viruses, and other perils that could adversely affect Protective’s operations. While Protective has obtained insurance, implemented risk management and contingency plans, and taken preventive measures and other precautions, no predictions of specific scenarios can be made nor can assurance be given that there are not scenarios that could have an adverse effect on Protective. A natural disaster or an outbreak of an easily communicable disease could adversely affect the mortality or morbidity experience of Protective or its reinsurers. Similarly, a computer virus could affect the data processing systems of Protective or its business partners, destroying valuable data or making it difficult to conduct their business. Additionally there are scenarios that could have an adverse effect on general economic conditions, and thus on Protective.
Protective’s ability to compete is dependent upon, among other things, its ability to attract and retain distribution channels to market its insurance and investment products, its ability to develop competitive and profitable products, its ability to maintain low unit costs, and its maintenance of strong ratings from rating agencies.
A ratings downgrade could adversely affect Protective’s ability to compete. Rating organizations periodically review the financial performance and condition of insurers, including Protective and its insurers subsidiaries. A downgrade in the ratings of Protective and its insurers subsidiaries could adversely affect Protective’s ability to sell its products, retain existing business, and compete for attractive acquisition opportunities.
Rating organizations assign ratings based upon several factors. While most of the factors relate to the rated company, some of the factors relate to the views of the rating organization, general economic conditions and circumstances outside the rated company’s control. Protective cannot predict what actions the rating organizations may take, or what actions Protective may be required to take in response to the actions of the rating organizations, which could adversely affect Protective.
Protective’s results may be negatively affected should actual experience differ from management’s assumptions and estimates. In the conduct of business, Protective makes certain assumptions regarding the mortality, persistency, expenses and interest rates, or other factors appropriate to the type of business it expects to experience in future periods. These assumptions are also used to estimate the amounts of deferred policy acquisition costs, policy liabilities and accruals, and various other components of Protective’s balance sheet. Protective’s actual experience, as well as changes in estimates, is used to prepare Protective’s statements of income.
Higher interest rates may create a less favorable environment for the origination of mortgage loans and decrease the investment income Protective receives in the form of prepayment fees, make-whole payments, and mortgage participation income. Higher interest rates may also increase the cost of debt and other obligations having floating rate or rate reset provisions and may result in lower sales of variable products.
In the second quarter of 2002, Protective discovered that the rates payable on certain life insurance policies were incorrectly entered into its reinsurance administrative system in 1991. As a result, Protective overpaid to several reinsurance companies the reinsurance premiums related to such policies of approximately $94.6 million over a period of 10 years beginning in 1992. Although the recoverability of amounts overpaid cannot be assured, Protective is seeking recovery of the overpayments and has already received refunds from some of the reinsurance companies.
Insurance companies are highly regulated. Protective and its insurance subsidiaries are subject to government regulation in each of the states in which they conduct business. Such regulation is vested in state agencies having broad administrative power dealing with many aspects of the insurance business, which may include premium rates, marketing practices, advertising, policy forms, and capital adequacy, and is concerned primarily with the protection of policyholders rather than share owners. From time to time, regulators raise issues during examinations or audits of Protective and its insurance subsidiaries that could, if determined adversely, have a material impact on Protective, and Protective cannot predict whether or when regulatory actions may be taken that could adversely affect Protective or its operations.
Additionally, a decrease in persistency may result in higher or more rapid amortization of deferred policy acquisition costs and thus higher unit costs, and lower reported earnings. Although many of Protective’s products contain surrender charges, the charges decrease over time and may not be sufficient to cover the unamortized deferred policy acquisition costs with respect to the insurance policy or annuity contract being surrendered. Some of Protective’s products do not contain surrender charge features and such products can be surrendered or exchanged without penalty. A decrease in persistency may also result in higher claims.
Protective’s investments are subject to market and credit risks. Protective’s invested assets and derivative financial instruments are subject to customary risks of credit defaults and changes in market values. The value of Protective’s commercial mortgage loan portfolio depends in part on the financial condition of the tenants occupying the properties which Protective has financed. Factors that may affect the overall default rate on, and market value of, Protective’s invested assets, derivative financial instruments, and mortgage loans include interest rate levels, financial market performance, and general economic conditions as well as particular circumstances affecting the businesses of individual borrowers and tenants.
Protective may not realize its anticipated financial results from its acquisitions strategy. Protective’s acquisitions have increased its earnings in part by allowing Protective to enter new markets and to position itself to realize certain operating efficiencies. There can be no assurance, however, that suitable acquisitions, presenting opportunities for continued growth and operating efficiencies, or capital to fund acquisitions will continue to be available to Protective, or that Protective will realize the anticipated financial results from its acquisitions.
Protective is dependent on the performance of others. Protective’s results may be affected by the performance of others because Protective has entered into various arrangements involving other parties. For example, most of Protective’s products are sold through independent distribution channels, and variable annuity deposits are invested in funds managed by third parties. Additionally, Protective’s operations are dependent on various technologies, some of which are provided and/or maintained by other parties.
The cost of reinsurance is, in some cases, reflected in the premium rates charged by Protective. Under certain reinsurance agreements, the reinsurer may increase the rate it charges Protective for the reinsurance, though Protective does not anticipate increases to occur. Therefore, if the cost of reinsurance were to increase or if reinsurance were to become unavailable, or if a reinsurer should fail to meet its obligations, Protective could be adversely affected.
2002 2001 2000 ---- ---- ---- Year Ended December 31 Adjusted net income: Income from continuing operations before extraordinary loss and cumulative effect of change in accounting principle $157,394 $143,501 $113,144 Add back amortization of goodwill, net of income tax 1,838 1,634 ----------------------------------------------------------------------------------------------------------------------------- Adjusted income from continuing operations before extraordinary loss and cumulative effect of change in accounting principle 157,394 145,339 114,778 Income (loss) from discontinued operations, net of income tax (9,856) 16,299 Loss from sale of discontinued operations, net of income tax (17,754) ---------------------------------------------------------------------------------------------------------------------------- Adjusted net income before cumulative effect of change in accounting principle and extraordinary loss 157,394 117,729 131,077 Cumulative effect of change in accounting principle, net of income tax (8,341) ----------------------------------------------------------------------------------------------------------------------------- Adjusted net income $157,394 $109,388 $131,077 =============================================================================================================================
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS No. 123.” SFAS No. 148 amends SFAS No. 123 to offer alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Protective adopted the fair value based method prescribed by SFAS No. 123 in 1995, therefore SFAS No. 148 will have no effect on Protective’s financial position or results of operations.
In July 2002, the American Institute of Certified Public Accountants proposed a new Statement of Position (SOP), “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.” Among other things, the SOP would establish the preferred method for estimating the GMDB-related policy liabilities and accruals. Based on information available at December 31, 2002, Protective believes its adoption of the SOP as proposed would result in an after tax cumulative effect of a change in accounting principle of approximately $5 million.
In May 2002, the Derivatives Implementation group of the FASB exposed for comment issue No. B36, “Bifurcation of Embedded Credit Derivatives” (DIG B36). DIG B36 would require the bifurcation of potential embedded derivatives within modified coinsurance and funds withheld coinsurance arrangements in which the terms require the future payment of a principal amount plus a return based on a specified proportion of the ceding company’s return on either its general account assets or a specified block of those assets. The proposed effective date of the implementation guidance in DIG B36 is for the first fiscal quarter beginning after June 15, 2003 and would be applied on a prospective basis. Protective is currently evaluating the impact of this pronouncement on its financial statements but does not anticipate a material impact on its financial condition or results of operations.
Liquidity and Capital Resources Protective’s operations usually produce a positive cash flow. This cash flow is used to fund an investment portfolio to finance future benefit payments. Since future benefit payments largely represent medium- and long-term obligations reserved using certain assumed interest rates, Protective’s investments are predominantly in medium- and long-term, fixed-rate investments such as bonds and mortgage loans.
Report of Independent Accountants........................................................... Consolidated Statements of Income for the years ended December 31, 2002, 2001, and 2000..... Consolidated Balance Sheets as of December 31, 2002 and 2001................................ Consolidated Statements of Share-Owner's Equity for the years ended December 31, 2002, 2001, and 2000........................................................ Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000.. Notes to Consolidated Financial Statements.................................................. Financial Statement Schedules: Schedule III-- Supplementary Insurance Information......................................... Schedule IV-- Reinsurance ................................................................. Schedule V - Valuation Accounts............................................................
As discussed in Note A of the Notes to the Condensed Financial Statements, effective January 1, 2002, and 2001, Protective adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” and effective January 1, 2001, Protective adopted Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities.”
DECEMBER 31 --------------------------------- 2002 2001 ASSETS ---- ---- Investments: Fixed maturities, at market (amortized cost: 2002 - $11,212,765; 2001 - $9,719,057). $11,655,465 $ 9,812,091 Equity securities, at market (cost: 2002 - $51,095; 2001 - $62,051)................. 48,799 60,493 Mortgage loans on real estate....................................................... 2,518,151 2,512,844 Investment real estate, net of accumulated depreciation (2002 - $1,099; 2001 - $1,452) 15,499 24,173 Policy loans........................................................................ 543,161 521,840 Other long-term investments......................................................... 210,381 100,686 Short-term investments.............................................................. 447,155 228,396 ------------ ------------ Total investments............................................................... 15,438,611 13,260,523 Cash.................................................................................... 85,850 107,166 Accrued investment income............................................................... 180,950 158,841 Accounts and premiums receivable, net of allowance for uncollectible amounts (2002 - $2,825; 2001 - $3,025).............................................. 50,544 55,809 Reinsurance receivables................................................................. 2,382,223 2,173,987 Deferred policy acquisition costs....................................................... 1,683,224 1,532,683 Goodwill, net........................................................................... 35,143 35,992 Property and equipment, net............................................................. 38,878 46,337 Other assets............................................................................ 259,627 219,355 Assets related to separate accounts: Variable Annuity.................................................................... 1,513,824 1,910,651 Variable Universal Life............................................................. 114,364 77,162 Other............................................................................... 4,330 3,997 ------------ ------------ $21,787,568 $19,582,503 ============ ============ LIABILITIES Policy liabilities and accruals: Future policy benefits and claims.................................................. $ 8,316,171 $ 6,974,685 Unearned premiums.................................................................. 781,008 901,653 ----------- ------------ Total policy liabilities and accruals.............................................. 9,097,179 7,876,338 Stable value contract deposits.......................................................... 4,018,552 3,716,530 Annuity deposits........................................................................ 3,744,000 3,248,218 Other policyholders' funds.............................................................. 141,336 132,124 Other liabilities....................................................................... 620,731 410,621 Accrued income taxes.................................................................... 36,859 125,835 Deferred income taxes................................................................... 206,845 72,403 Note payable............................................................................ 2,264 2,291 Indebtedness to related parties......................................................... 2,000 6,000 Securities sold under repurchase agreements............................................. 0 117,000 Liabilities related to separate accounts: Variable Annuity................................................................... 1,513,824 1,910,651 Variable Universal Life............................................................ 114,364 77,162 Other.............................................................................. 4,330 3,997 ------------ ------------ Total liabilities................................................................ 19,502,284 17,699,170 ============ ============ COMMITMENTS AND CONTINGENT LIABILITIES-- NOTE G SHARE-OWNER'S EQUITY Preferred Stock, $1.00 par value, shares authorized and issued: 2,000, liquidation preference $2,000.......................... 2 2 Common Stock, $1.00 par value, shares authorized and issued: 5,000,000..................................................... 5,000 5,000 Additional paid-in capital.............................................................. 846,619 785,419 Note receivable from PLC Employee Stock Ownership Plan.................................. (3,838) (4,499) Retained earnings....................................................................... 1,201,587 1,044,243 Accumulated other comprehensive income Net unrealized gains (losses) on investments (net of income tax: 2002 - $128,145; 2001 - $28,629).................................. Accumulated gain (loss) - hedging (net of income tax: 2002 - $(1,114))............... 237,983 53,168 Total share-owner's equity....................................................... (2,069) ------------ ------------ 2,285,284 1,883,333 ------------ ------------ $21,787,568 $19,582,503 ============ ============
NOTE NET ACCUMU- NOTE UNREALIZED RECEIVABLE GAINS LATED TOTAL ADDITIONAL FROM (LOSSES) GAIN SHARE- PREFERRED COMMON PAID-IN PLC RETAINED ON (LOSS) - OWNER'S STOCK STOCK CAPITAL ESOP EARNINGS INVESTMENTS HEDGING EQUITY ------------------------------------------------------------------------------------------------
Balance, December 31, 1999 $2 $5,000 $570,419 $(5,148) $ 812,302 $(146,080) $0 $1,236,495 Net income for 2000 129,443 129,443 Change in net unrealized gains/losses on investments (net of income tax - $45,887) 85,221 85,221 Reclassification adjustment for amounts included in net income (net of income tax - $5,110) 9,489 9,489 ----------- Comprehensive income for 2000 224,153 ----------- Capital contribution 81,000 81,000 Common dividend ($0.40 per share) (2,000) (2,000) Decrease in note receivable from PLC ESOP 307 307 --------------------------------------------------------------------------------------------- Balance, December 31, 2000 2 5,000 651,419 (4,841) 939,745 (51,370) 0 1,539,955 ----------- Net income for 2001 107,550 107,550 Change in net unrealized gains/losses on investments (net of income tax - $52,019) 96,607 96,607 Reclassification adjustment for amounts included in net income (net of income tax - $2,143) 3,980 3,980 Transition adjustment on derivative financial instruments (net of income tax - $2,127) 3,951 3,951 ----------- Comprehensive income for 2001 212,088 ----------- Capital contribution 134,000 134,000 Common dividend - transfer of subsidiary to PLC (See Note A) (2,052) (2,052) Preferred dividend ($500.00 per share) (1,000) (1,000) Decrease in note receivable from PLC ESOP 342 342 ---------------------------------------------------------------------------------------------- Balance, December 31, 2001 2 5,000 785,419 (4,499) 1,044,243 53,168 0 1,883,333 ----------- Net income for 2002 157,394 157,394 Change in net unrealized gains/losses on investments (net of income tax - $103,826) 192,819 192,819 Reclassification adjustment for amounts included in net income (net of income tax - $(4,310)) (8,004) (8,004) Change in accumulated gain (loss) - hedging (net of income tax - $(1,114)) (2,069) (2,069) ----------- Comprehensive income for 2002 340,140 ----------- Capital contribution 61,200 61,200 Preferred dividend ($25.00 per share) (50) (50) Decrease in note receivable from PLC ESOP 661 661 ---------------------------------------------------------------------------------------------- Balance, December 31, 2002 $2 $5,000 $846,619 $(3,838) $1,201,587 $237,983 $(2,069) $2,285,284 ==============================================================================================
December 31 ---------------------------------------------- 2002 2001 2000 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES Net income.............................................................................. $ 157,394 $ 107,550 $ 129,443 Adjustments to reconcile net income to net cash provided by operating activities: Realized investment (gains) losses................................................. 645 7,841 14,599 Amortization of deferred policy acquisition costs.................................. 239,490 154,383 149,574 Amortization of goodwill........................................................... 0 8,328 7,797 Capitalization of deferred policy acquisition costs................................ (437,325) (317,626) (338,685) Loss from sale of discontinued operations.......................................... 0 17,754 0 Depreciation expense............................................................... 10,409 11,651 9,581 Deferred income taxes.............................................................. 8,894 (40,970) 55,161 Accrued income taxes............................................................... (88,976) 139,016 13,715 Interest credited to universal life and investment products........................ 900,930 944,098 766,004 Policy fees assessed on universal life and investment products..................... (268,191) (222,415) (197,581) Change in accrued investment income and other receivables.......................... (303,497) (238,097) (158,107) Change in policy liabilities and other policyholder funds of traditional life and health products.................................................................... 493,714 444,119 499,674 Change in other liabilities........................................................ 93,368 132,497 (21,592) Other (net)........................................................................ 76,597 9,306 (35,103) ------------ ------------ ------------ Net cash provided by operating activities................................................... 883,452 1,157,435 894,480 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES Maturities and principal reduction of investments: Investments available for sale..................................................... 12,780,736 3,062,262 12,828,276 Other.............................................................................. 485,639 283,181 133,814 Sale of investments: Investments available for sale..................................................... 22,862,420 8,943,123 810,716 Other.............................................................................. 15,798 0 5,222 Cost of investments acquired: Investments available for sale..................................................... (37,145,100) (13,652,930) (14,369,630) Corporate owned life insurance..................................................... 0 (100,000) 0 Other.............................................................................. (475,733) (378,520) (463,909) Acquisitions and bulk reinsurance assumptions.......................................... 130,515 (118,557) (162,409) Purchase of property and equipment..................................................... (8,982) (10,099) (5,084) Sale of discontinued operations, net of cash transferred............................... 0 216,031 0 Sale of property and equipment......................................................... 48 70 0 ------------- ------------ ------------ Net cash used in investing activities....................................................... (1,354,659) (1,755,439) (1,223,004) ------------- ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES Borrowings under line of credit arrangements and long-term debt........................ 2,050,772 2,574,954 2,197,800 Capital contribution from PLC.......................................................... 60,785 134,000 81,000 Principal payments on line of credit arrangements and long-term debt................... (2,167,799) (2,457,979) (2,197,823) Principal payment on surplus note to PLC............................................... (4,000) (4,000) (4,000) Dividends to share owner............................................................... (50) (1,000) (2,000) Investment product deposits and change in universal life deposits...................... 1,687,213 1,735,653 1,811,484 Investment product withdrawals......................................................... (1,177,030) (1,315,179) (1,553,282) Net cash provided by financing activities................................................... 449,891 666,449 333,179 INCREASE (DECREASE) IN CASH................................................................. (21,316) 68,445 4,655 CASH AT BEGINNING OF YEAR................................................................... 107,166 38,721 34,066 ------------ ------------ ------------ CASH AT END OF YEAR......................................................................... $ 85,850 $ 107,166 $ 38,721 ============ ============ ============
(All dollar amounts in tables are in thousands) Note A - SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The accompanying consolidated financial statements of Protective Life Insurance Company and subsidiaries (Protective) are prepared on the basis of accounting principles generally accepted in the United States of America. Such accounting principles differ from statutory reporting practices used by insurance companies in reporting to state regulatory authorities. (See also Note B.)
ENTITIES INCLUDED The consolidated financial statements include the accounts, after intercompany eliminations, of Protective Life Insurance Company and its wholly-owned subsidiaries. Protective is a wholly-owned subsidiary of Protective Life Corporation (PLC), an insurance holding company. The consolidated financial statements also include the accounts of special trusts or entities that do not have substantive residual equity holders which bear risks and rewards of ownership, formed to purchase funding agreements issued by Protective.
On October 1, 2000, PLC transferred its ownership of twenty companies (that marketed prepaid dental products) to Protective. On May 1, 2001, PLC transferred its ownership of another five companies (that marketed prepaid dental products) to Protective. Protective has recorded these transactions on a pooling of interests basis whereby Protective’s financial statements reflect the consolidation of the contributed entities as if they had been wholly owned by Protective for all periods in which common control existed.
NATURE OF OPERATIONS Protective provides financial services through the production, distribution, and administration of insurance and investment products. Protective markets individual life insurance, credit life and disability insurance, guaranteed investment contracts, guaranteed funding agreements, fixed and variable annuities, and extended service contracts throughout the United States. Protective also maintains a separate division devoted to the acquisition of insurance policies from other companies.
RECENTLY ISSUED ACCOUNTING STANDARDS On January 1, 2001, Protective adopted Statement of Financial Accounting Standards (SFAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS No. 133, as amended by SFAS Nos. 137 and 138, requires Protective to record all derivative financial instruments, at fair value on the balance sheet. Changes in fair value of a derivative instrument are reported in net income or other comprehensive income, depending on the designated use of the derivative instrument. The adoption of SFAS No. 133 resulted in a cumulative charge to net income, net of income tax, of $8.3 million and a cumulative after-tax increase to other comprehensive income of $4.0 million on January 1, 2001. The charge to net income and increase to other comprehensive income primarily resulted from the recognition of derivative instruments embedded in Protective’s corporate bond portfolio. In addition, the charge to net income includes the recognition of the ineffectiveness on existing hedging relationships including the difference in spot and forward exchange rates related to foreign currency swaps used as an economic hedge of foreign-currency-denominated stable value contracts. Prospectively, the adoption of SFAS No. 133 may introduce volatility into Protective’s reported net income and other comprehensive income depending on future market conditions and Protective’s hedging activities.
The following table illustrates adjusted income from continuing operations before cumulative effect of change in accounting principle as if these pronouncements were adopted as of January 1, 2000:
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS No. 123." SFAS No. 148 amends SFAS No. 123 to offer alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. Protective adopted the fair value based method prescribed by SFAS No. 123 in 1995, therefore SFAS No. 148 will have no effect on Protective's financial position or results of operations.
In November, 2002, the FASB issued FASB Interpretation No. (FIN) 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Others." FIN 45 clarifies the requirements of SFAS No. 5 "Accounting for Contingencies" relating to the guarantor's accounting for, and disclosure of, the issuance of certain types of guarantees. The initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. Protective does not expect FIN 45 to have a material effect on Protective's financial position or results of operations.
o Equity securities (common and nonredeemable preferred stocks)-- at current market value.
o Investment real estate-- at cost, less allowances for depreciation computed on the straight-line method. With respect to real estate acquired through foreclosure, cost is the lesser of the loan balance plus foreclosure costs or appraised value.
o Other long-term investments-- at a variety of methods similar to those listed above, as deemed appropriate for the specific investment.
As prescribed by generally accepted accounting principles, certain investments are recorded at their market values with the resulting unrealized gains and losses reduced by a related adjustment to deferred policy acquisition costs, net of income tax, reported as a component of share-owner's equity. The market values of fixed maturities increase or decrease as interest rates fall or rise.
2002 2001 ---- ---- Total investments....................................... $14,982,469 $13,157,623 Deferred policy acquisition costs....................... 1,776,421 1,553,786 All other assets........................................ 4,665,733 4,789,297 ----------- ----------- $21,424,623 $19,500,706 =========== ===========
Combinations of interest rate swap contracts, options and futures contracts are sometimes used as hedges against changes in interest rates for certain investments, primarily outstanding mortgage loan commitments and mortgage-backed securities. Interest rate swap contracts generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. Interest rate futures generally involved exchange traded contracts to buy or sell treasury bonds and notes in the future at specified prices. Interest rate options represent contracts that allow the holder of the option to receive cash or purchase, sell or enter into a financial instrument at a specified price within a specified period of time. Protective uses interest rate swap contracts, caps, and floors to modify the interest characteristics of certain investments and liabilities. Swap contracts are also used to alter the effective durations of assets and liabilities. Protective uses foreign currency swaps to reduce its exposure to currency exchange risk on certain stable value contracts denominated in foreign currencies, primarily the European euro and the British pound.
All derivatives are recognized on the balance sheet (in “other long-term investments” or “other liabilities”) at their fair value (primarily estimates from independent pricing services). On the date the derivative contract is entered into, Protective designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value” hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow” hedge), or (3) as a derivative either held for investment purposes or held as a natural hedging instrument designed to act as an economic hedge against the changes in value or cash flows of a hedged item (“other” derivative). Changes in the fair value of a derivative that is highly effective as - and that is designated and qualifies as - a fair-value hedge, along with the loss or gain on the hedged asset or liability that is attributable to the hedged risk (including losses or gains on firm commitments), are recorded in current-period earnings. Changes in the fair value of a derivative that is highly effective as - and that is designated and qualified as - a cash-flow hedge are recorded in other comprehensive income, until earnings are affected by the variability of cash flows. Changes in the fair value of other derivatives are recognized in current earnings and reported in “Realized Investment Gains (Losses) - Derivative Financial Instruments”in Protective’s consolidated statements of income.
Protective discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted transactions); (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is designated as a hedge instrument, because it is unlikely that a forecasted transaction will occur; (4) because a hedged firm commitment no longer meets the definition of a firm commitment; or (5) management determines that designation of the derivative as a hedge instrument is no longer appropriate.
On its foreign currency swaps, Protective recognized a $70.8 million pre-tax gain in 2002 while recognizing a $74.9 million foreign exchange pre-tax loss on the related foreign-currency-denominated stable value contracts. In 2001, Protective recognized an $8.2 million pre-tax loss on its foreign currency swaps while recognizing an $11.2 million foreign exchange pre-tax gain on the related foreign-currency-denominated stable value contracts. The net loss and net gain in 2002 and 2001, respectively, primarily results from the difference in the forward and spot exchange rates used to revalue the currency swaps and the stable value contracts, respectively. This net loss and net gain is reflected in “Realized Investment Gains (Losses) - Derivative Financial Instruments” in Protective’s consolidated statements of income.
Protective has entered into asset swap arrangements to, in effect, sell the equity options embedded in owned convertible bonds in exchange for an interest rate swap that converts the remaining host bond to a variable rate instrument. In 2002 and 2001, Protective recognized a $2.0 million and $12.2 million pre-tax gain, respectively, for the change in the asset swaps’ fair value and recognized a $7.8 million and $16.9 million pre-tax loss, respectively, to separately record the embedded equity options at fair value.
DEFERRED POLICY ACQUISITION COSTS Commissions and other costs of acquiring traditional life and health insurance, credit insurance, universal life insurance, and investment products that vary with and are primarily related to the production of new business, have been deferred. Traditional life and health insurance acquisition costs are amortized over the premium-payment period of the related policies in proportion to the ratio of annual premium income to the present value of the total anticipated premium income. Credit insurance acquisition costs are being amortized in proportion to earned premium. Acquisition costs for universal life and investment products are amortized over the lives of the policies in relation to the present value of estimated gross profits before amortization. Under SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments,” Protective makes certain assumptions regarding the mortality, persistency, expenses, and interest rates (equal to the rate used to compute liabilities for future policy benefits; currently 3.0% to 9.4%) it expects to experience in future periods. These assumptions are to be best estimates and are to be periodically updated whenever actual experience and/or expectations for the future change from that assumed. Additionally, relating to SFAS No. 115, these costs have been adjusted by an amount equal to the amortization that would have been recorded if unrealized gains or losses on investments associated with Protective’s universal life and investment products had been realized.
The cost to acquire blocks of insurance representing the present value of future profits from such blocks of insurance is also included in deferred policy acquisition costs. Protective amortizes the present value of future profits over the premium payment period, including accrued interest of up to approximately 8%. The unamortized present value of future profits for all acquisitions was approximately $542.5 million and $523.4 million at December 31, 2002 and 2001, respectively. During 2002, $62.5 million of present value of future profits was capitalized (relating to acquisitions and adjustments made during the year), a $2.1 million reduction came from the sale of a small subsidiary, and $41.3 was amortized. During 2001, $221.9 million of present value of future profits was capitalized and $42.1 million was amortized.
YEAR EXPECTED AMORTIZATION ------------------------------------------------------ 2003 $33,600 2004 32,400 2005 30,500 2006 29,100 2007 28,100
STABLE VALUE CONTRACTS ACCOUNT BALANCES Protective markets guaranteed investment contracts (GICs) to 401(k) and other qualified retirement savings plans, and fixed and floating rate funding agreements to the trustees of municipal bond proceeds, institutional investors, bank trust departments, and money market funds. GICs and funding agreements are generally contracts that specify a return on deposits for a specified period and often provide flexibility for withdrawals at book value in keeping with the benefits provided by the plan. Stable value contract account balances include GICs and funding agreements issued by Protective as well as the obligations of consolidated special purpose trusts or entities formed to purchase funding agreements issued by Protective. At December 31, 2002 and 2001 Protective had $2.2 billion and $1.7 billion of stable value contract account balances marketed through structured programs. Most GICs and funding agreements written by Protective have maturities of three to five years. At December 31, 2002, maturities of stable value contracts were $1.1 billion in 2003, $1.6 billion in 2004-2005, $1.3 billion in 2006-2007, and $59.2 million after 2007.
Other changes: Acquisitions and reserve transfers................................... 2,609 (6,166) 6,623 --------- --------- ---------
Assets and liabilities related to the discontinued lines of business of approximately $5.1 million and $6.7 million, respectively, remain at December 31, 2002.
DECEMBER 31 ---------------------------------------------- 2002 2001 2000 ---- ---- ---- Cash paid during the year: Interest on debt $ 987 $ 1,390 $ 3,310 Income taxes 125,039 27,395 25,638 ---------- ------------ --------- Noncash investing and financing activities Reduction of principal on note from ESOP 661 342 307 Acquisitions, related reinsurance transactions and subsidiary transfer Assets acquired 358,897 2,549,484 533,866 Liabilities assumed (489,412) (2,430,927) (371,457) ---------- ------------ --------- Net $(130,515) $ 118,557 $ 162,409 ========== ============ =========
Note B-- RECONCILIATION WITH STATUTORY REPORTING PRACTICES Financial statements prepared in conformity with accounting principles generally accepted in the United States of America differ in some respects from the statutory accounting practices prescribed or permitted by insurance regulatory authorities. The most significant differences are as follows: (a) acquisition costs of obtaining new business are deferred and amortized over the approximate life of the policies rather than charged to operations as incurred; (b) benefit liabilities are computed using a net level method and are based on realistic estimates of expected mortality, interest, and withdrawals as adjusted to provide for possible unfavorable deviation from such assumptions; (c) deferred income taxes are not subject to statutory limitations as to amounts recognized and are recognized through earnings as opposed to being charged to share-owners’ equity; (d) the Asset Valuation Reserve and Interest Maintenance Reserve are restored to share-owners’ equity; (e) furniture and equipment, agents’ debit balances, and prepaid expenses are reported as assets rather than being charged directly to surplus (referred to as nonadmitted assets); (f) certain items of interest income, such as mortgage and bond discounts, are amortized differently; and (g) bonds are recorded at their market values instead of amortized cost. The National Association of Insurance Commissioners (NAIC) has adopted the Codification of Statutory Accounting Principles (Codification). Codification changed statutory accounting rules in several areas and was effective January 1, 2001. The adoption of Codification did not have a material effect on Protective’s statutory capital.
Note C - INVESTMENT OPERATIONS Major categories of net investment income for the years ended December 31 are summarized as follows:
2002 2001 2000 -------------------------------------- Fixed maturities.................................... $ 673,393 $ 609,578 $ 529,990 Equity securities................................... 3,500 2,247 2,532 Mortgage loans...................................... 218,165 208,830 177,917 Investment real estate.............................. 881 2,094 2,027 Policy loans........................................ 37,463 31,763 14,977 Other............................................... 103,826 36,695 12,532 ---------- --------- --------- 1,037,228 891,207 739,975 Investment expenses................................. 57,169 52,104 47,894 ---------- --------- --------- $ 980,059 $ 839,103 $ 692,081 ========== ========= =========
2002 2001 2000 --------------------------------------------------------------------------- Derivative financial instruments $(12,959) $(1,718) $2,157 ----------------------------------------------------------------------------
GROSS GROSS ESTIMATED AMORTIZED UNREALIZED UNREALIZED MARKET COST GAINS LOSSES VALUES ---------------------------------------------------------- ---- Fixed maturities: Bonds: Mortgage-backed securities........... $ 3,709,118 $ 84,965 $ 33,759 $ 3,760,324 United States Government and authorities........................ 98,967 4,088 0 103,055 States, municipalities, and political subdivision.............. 94,022 4,009 0 98,031 Public utilities..................... 807,773 19,763 4,860 822,676 Convertibles and bonds with warrants........................... 96,951 7,423 6,184 98,190 All other corporate bonds............ 4,910,614 117,092 99,500 4,928,206 Redeemable preferred stocks............... 1,612 0 3 1,609 ----------- -------- -------- ----------- 9,719,057 237,340 144,306 9,812,091 Equity securities............................ 62,051 3,565 5,123 60,493 Short-term investments....................... 228,396 0 0 228,396 ----------- -------- -------- ----------- $10,009,504 $240,905 $149,429 $10,100,980 =========== ======== ======== ===========
ESTIMATED ESTIMATED AMORTIZED MARKET COST VALUES ------------- ------------ ---- Due in one year or less.......................... $ 844,795 $ 845,577 Due after one year through five years............ 2,678,879 2,742,360 Due after five years through ten years........... 2,601,183 2,765,927 Due after ten years 5,087,908 5,301,601 ----------- ----------- $11,212,765 $11,655,465 =========== ===========
At December 31, 2002 and 2001, Protective had bonds which were rated less than investment grade of $860.6 million and $421.3 million, respectively, having an amortized cost of $960.8 million and $499.9 million, respectively. At December 31, 2002, approximately $70.9 million of the bonds rated less than investment grade were securities issued in company-sponsored commercial mortgage loan securitizations. Approximately $1,968.1 million of bonds are not publicly traded.
At December 31, 2002, all of Protective’s mortgage loans were commercial loans of which 76% were retail, 8% were apartments, 7% were office buildings, and 7% were warehouses, and 2% were other. Protective specializes in making mortgage loans on either credit-oriented or credit-anchored commercial properties, most of which are strip shopping centers in smaller towns and cities. No single tenant’s leased space represents more than 3.1% of mortgage loans. Approximately 75% of the mortgage loans are on properties located in the following states listed in decreasing order of significance: Texas, Tennessee, Georgia, North Carolina, South Carolina, Alabama, Florida, Virginia, California, Mississippi, Pennsylvania, Washington, and Ohio.
Many of the mortgage loans have call provisions after 3 to 10 years. Assuming the loans are called at their next call dates, approximately $86.7 million would become due in 2003, $399.6 million in 2004 to 2007, and $355.0 million in 2008 to 2012, and $27.2 million thereafter.
At December 31, 2002, the average mortgage loan was approximately $2.1 million, and the weighted average interest rate was 7.5%. The largest single mortgage loan was $24.8 million.
For several years Protective has offered a type of commercial mortgage loan under which Protective will permit a slightly higher loan-to-value ratio in exchange for a participating interest in the cash flows from the underlying real estate. As of December 31, 2002 and 2001, approximately $475.5 million and $548.4 million respectively, of Protective’s mortgage loans have this participation feature.
Note E - DEBT Under revolving line of credit arrangements with several banks, PLC can borrow up to $200 million on an unsecured basis. No compensating balances are required to maintain the line of credit. These lines of credit arrangements contain, among other provisions, requirements for maintaining certain financial ratios, and restrictions on indebtedness incurred by PLC’s subsidiaries including Protective. Additionally, PLC, on a consolidated basis, cannot incur debt in excess of 40% of its total capital. At December 31, 2002, PLC had $30.0 million of borrowings outstanding under these credit arrangements at an interest rate of 1.92%.
Interest expense on debt totaled $1.4 million, $1.8 million, and $3.8 million in 2002, 2001, and 2000, respectively.
In June 2002, Protective coinsured a block of traditional life and interest-sensitive life insurance policies from Conseco Variable Insurance Company.
These transactions have been accounted for as purchases, and the results of the transactions have been included in the accompanying financial statements since their respective effective dates.
In February 2000, Protective entered into an arrangement related to the construction of a building contiguous to its existing home office complex. In connection with the arrangement Protective established a special purpose vehicle (SPV) that owns the building and leases it to Protective. The lease is accounted for as an operating lease under SFAS No. 13 “Accounting For Leases”. The SPV is funded and its equity is held by outside investors, and as a result, neither the debt nor the building owned by the SPV are included in Protective’s consolidated financial statements. Lease payments commence upon completion, which occurred January 31, 2003, and is based on then current LIBOR interest rates and the cost of the building. At the end of the lease term, February 1, 2007, Protective may purchase the building for the original building cost of approximately $75 million. Based upon current interest rates, annual lease payments are estimated to be $1.6 million. Were Protective not to purchase the building, a payment of approximately $66.8 million would be due at the end of the lease term.
Note I - PREFERRED STOCK PLC owns all of the 2,000 shares of preferred stock issued by Protective’s subsidiary, Protective Life and Annuity Insurance Company (PL&A). The stock pays, when and if declared, noncumulative participating dividends to the extent PL&A’s statutory earnings for the immediately preceding fiscal year exceeded $1.0 million. In 2002, PL&A paid a $50.0 thousand preferred dividend to PLC. PL&A paid a $1.0 million preferred dividend to PLC in 2001, and paid no preferred dividend during 2000.
Note K - OPERATING SEGMENTS Protective operates business segments, each having a strategic focus which can be grouped into three general categories: life insurance, retirement savings and investment products, and specialty insurance products. An operating segment is generally distinguished by products and/or channels of distribution. A brief description of each division follows.
Retirement Savings and Investment Products The Stable Value Contracts segment markets guaranteed investment contracts to 401(k) and other qualified retirement savings plans. The segment also markets fixed and floating rate funding agreements to the trustees of municipal bond proceeds, institutional investors, bank trust departments, and money market funds. Additionally, the segment sells funding agreements to special purpose entities that in turn issue notes or certificates in smaller, transferable denominations.
Specialty Insurance Products The Asset Protection segment markets credit life and disability insurance products through banks, consumer finance companies, and automobile dealers, and markets vehicle and recreational marine extended service contracts.
Protective uses the same accounting policies and procedures to measure operating segment income and assets as it uses to measure its consolidated net income and assets. Operating segment income is generally income before income tax, adjusted to exclude any pretax minority interest in income of consolidated subsidiaries. Premiums and policy fees, other income, benefits and settlement expenses, and amortization of deferred policy acquisition costs are attributed directly to each operating segment. Net investment income is allocated based on directly related assets required for transacting the business of that segment. Realized investment gains (losses) and other operating expenses are allocated to the segments in a manner which most appropriately reflects the operations of that segment. Unallocated realized investment gains (losses) are deemed not to be associated with any specific segment.
LIFE INSURANCE ----------------------------------- LIFE OPERATING SEGMENT INCOME MARKETING ACQUISITIONS ---------------------------------------------------------------------------------------------------------- Gross premiums and policy fees $ 642,852 $ 315,347 Reinsurance ceded (422,668) (76,333) ---------------------------------------------------------------------------------------------------------- Net premium and policy fees 220,184 239,014 Net investment income 208,451 252,147 Realized investment gains (losses) - - Other income 1,344 1,826 ---------------------------------------------------------------------------------------------------------- Total revenues 429,979 492,987 ---------------------------------------------------------------------------------------------------------- Benefits and settlement expenses 228,225 315,929 Amortization of deferred policy acquisition costs 117,836 35,245 Other operating expenses (41,501) 45,395 ---------------------------------------------------------------------------------------------------------- Total benefits and expenses 304,560 396,569 ---------------------------------------------------------------------------------------------------------- Income from continuing operations before income tax 125,419 96,418 Income tax expense Discontinued operations, net of income tax Change in accounting principle, net of income tax ---------------------------------------------------------------------------------------------------------- Net income ---------------------------------------------------------------------------------------------------------- Gross premiums and policy fees $ 542,407 $ 243,914 Reinsurance ceded (421,411) (61,482) ---------------------------------------------------------------------------------------------------------- Net premium and policy fees 120,996 182,432 Net investment income 178,866 187,535 Realized investment gains (losses) - - Other income 1,134 345 ---------------------------------------------------------------------------------------------------------- Total revenues 300,996 370,312 ---------------------------------------------------------------------------------------------------------- Benefits and settlement expenses 190,538 238,877 Amortization of deferred policy acquisition costs and goodwill 41,399 20,500 Other operating expenses (22,957) 41,684 ---------------------------------------------------------------------------------------------------------- Total benefits and expenses 208,980 301,061 ---------------------------------------------------------------------------------------------------------- Income from continuing operations before income tax 92,016 69,251 Income tax expense Discontinued operations, net of income tax Change in accounting principle, net of income tax ---------------------------------------------------------------------------------------------------------- Net income ---------------------------------------------------------------------------------------------------------- Gross premiums and policy fees $ 487,720 $ 134,099 Reinsurance ceded (387,907) (31,102) ---------------------------------------------------------------------------------------------------------- Net premium and policy fees 99,813 102,997 Net investment income 152,317 116,940 Realized investment gains (losses) - - Other income (1,379) (4) ---------------------------------------------------------------------------------------------------------- Total revenues 250,751 219,933 ---------------------------------------------------------------------------------------------------------- Benefits and settlement expenses 149,430 125,151 Amortization of deferred policy acquisition costs and goodwill 48,770 17,081 Other operating expenses (23,255) 24,077 ---------------------------------------------------------------------------------------------------------- Total benefits and expenses 174,945 166,309 ---------------------------------------------------------------------------------------------------------- Income from continuing operations before income tax 75,806 53,624 Income tax expense Discontinued operations, net of income tax Change in accounting principle, net of income tax ---------------------------------------------------------------------------------------------------------- Net income ---------------------------------------------------------------------------------------------------------- Operating Segment Assets Investments and other assets $4,193,732 $4,574,470 Deferred policy acquisition costs 973,631 438,092 Goodwill - - ---------------------------------------------------------------------------------------------------------- Total assets $5,167,363 $5,012,562 ---------------------------------------------------------------------------------------------------------- Investments and other assets 3,431,441 $4,091,672 Deferred policy acquisition costs 829,021 418,268 Goodwill - - ---------------------------------------------------------------------------------------------------------- Total assets $4,260,462 $4,509,940 ---------------------------------------------------------------------------------------------------------- (1)Adjustments to net income represent the inclusion of unallocated realized investment gains (losses), the recognition of income tax expense, income from discontinued operations, and cumulative effect of change in accounting principle. Asset adjustments represent the inclusion of assets related to discontinued operations.
SPECIALTY RETIREMENT SAVINGS AND INSURANCE INVESTMENT PRODUCTS PRODUCTS ---------------------------------------------------------------------------------------------------------- STABLE VALUE ASSET CORPORATE TOTAL CONTRACTS ANNUITIES PROTECTION AND OTHER ADJUSTMENTS (1) CONSOLIDATED ----------------------------------------------------------------------------------------------------------
- $ 30,127 $ 479,397 $ 44,600 - $ 1,175,943 - - (258,931) (8,168) - (686,108) ---------------------------------------------------------------------------------------------------------- - 30,127 220,466 36,432 - 489,835 $ 243,133 132,204 46,464 1,023 - 692,081 (6,556) 410 - - $ (8,453) (14,599) - 2,809 28,352 5,416 - 35,194 ---------------------------------------------------------------------------------------------------------- 236,577 165,550 295,282 42,871 (8,453) 1,202,511 ---------------------------------------------------------------------------------------------------------- 207,143 109,607 135,494 33,953 - 760,778 900 24,156 52,646 2,141 - 145,694 3,882 18,203 72,316 26,194 - 121,417 ---------------------------------------------------------------------------------------------------------- 211,925 151,966 260,456 62,288 - 1,027,889 ---------------------------------------------------------------------------------------------------------- 24,652 13,584 34,826 (19,417) (8,453) 174,622 61,478 61,478 16,299 16,299 - - ---------------------------------------------------------------------------------------------------------- $ 129,443 ----------------------------------------------------------------------------------------------------------
2002 2001 ----------------------- Projected benefit obligation, beginning of the year..................... $ 50,869 $45,538 Service cost - benefits earned during the year.......................... 3,724 3,739 Interest cost - on projected benefit obligation......................... 4,111 3,531 Actuarial gain (loss)................................................... 6,353 (357) Plan amendment.......................................................... 1,162 Divestiture............................................................. (2,165) Benefits paid........................................................... (2,878) (579) --------- -------- Projected benefit obligation, end of the year........................... 62,179 50,869 --------- -------- Fair value of plan assets beginning of the year......................... 44,024 40,822 Actual return on plan assets............................................ (7,845) (1,440) Employer contribution................................................... 16,149 5,221 Benefits paid........................................................... (2,878) (579) --------- -------- Fair value of plan assets end of the year............................... 49,450 44,024 --------- -------- Plan assets less than the projected benefit obligation.................. (12,729) (6,845) Unrecognized net actuarial loss from past experience different from that assumed................................................................. 28,252 10,213 Unrecognized prior service cost......................................... 1,886 2,026 --------- -------- Net pension asset recognized in balance sheet........................... $ 17,409 $ 5,394 ========= ========
2002 2001 2000 -------------------------------- Weighted average discount rate.......................................... 6.75% 7.25% 7.50% Rates of increase in compensation level................................. 4.50 5.00 5.25 Expected long-term rate of return on assets............................. 8.50 8.50 8.50
Prior to July 1999, upon retirement, the amount of pension plan assets vested in the retiree were used to purchase a single premium annuity from Protective in the retiree’s name. Therefore, amounts presented above as plan assets exclude assets relating to such retirees. Beginning July 1999, retiree obligations are being fulfilled from pension plan assets.
2002 2001 2000 --------------------------------- Service cost............................................................ $ 455 $ 686 $ 736 Interest cost........................................................... 1,178 1,121 1,067 Amortization of prior service cost...................................... 16 19 19 Amortization of transition asset........................................ 37 37 Recognized net actuarial loss........................................... 71 233 194 Cost of divestiture and special termination benefits.................... 1,807 ------ ------ ------ Net pension cost........................................................ $1,720 $3,903 $2,053 ====== ====== ======
Note M - STOCK BASED COMPENSATION Certain Protective employees participate in PLC’s stock-based incentive plans and receive stock appreciation rights (SARs) from PLC.
Performance shares and performance-based stock appreciation rights (P-SARs) awarded in 2000, 2001, and 2002, and the estimated fair value of the awards at grant date are as follows:
YEAR PERFORMANCE ESTIMATED AWARDED SHARES P-SARS FAIR VALUE ------------------------------------------------------------------------------------------------------ 2002 192,360 $5,700 2001 153,490 40,000 4,900 2000 3,330 513,618 3,700
A performance share is equivalent in value to one share of PLC Common Stock. Each P-SAR will convert to the equivalent of one stock appreciation right (SAR) if earned. Of the 2000 P-SARs awarded, 68,392 have been canceled and 100,072 have been converted to SARs. The remaining 345,154 P-SARs will convert to SARs in 2004 if earned. The 40,000 P-SARs awarded in 2001 were not earned and have been canceled. The P-SARs, if earned and converted to SARs, expire 10 years after the grant date. At December 31, 2002, the total outstanding performance shares and P-SARs related to these performance-based plans measured at maximum payouts were 589,029 and 540,689, respectively.
Between 1996 and 2002 SARs were granted (in addition to the P-SARs discussed above) to certain officers of PLC to provide long-term incentive compensation based solely on the performance of Protective’s Common Stock. The SARs are exercisable after five years (earlier upon the death, disability, or retirement of the officer, or in certain circumstances, of a change in control of PLC) and expire after ten years or upon termination of employment. The SARs activity as well as weighted average base price for 2000, 2001, and 2002 is as follows:
SARS REMAINING CURRENTLY BASE PRICE OUTSTANDING LIFE IN YEARS EXERCISABLE ----------------------------------------------------------------------------- $17.44 580,000 3 580,000 22.31 376,323 7 183,823 31.26 50,000 8 0 31.29 12,500 8 2,500 32.00 480,000 9 0
The SARs issued in 2000, 2001, and 2002 had estimated fair values at grant date of $1.5 million, $0.6 million, and $3.7 million, respectively. The fair value of the 2002 SARs was estimated using a Black-Scholes option pricing model. Assumptions used in the model were as follows: expected volatility of 24.6% (approximately equal to that of the S&P Life and Health Insurance Index), a risk-free interest rate of 3.4%, a dividend rate of 2.0%, and an expected exercise date of 2008.
Note N - REINSURANCE Protective reinsures certain of its risks with, and assumes risks from other insurers under yearly renewable term, coinsurance, and modified coinsurance agreements. Under yearly renewable term agreements, Protective generally pays specific premiums to the reinsurer and receives specific amounts from the reinsurer as reimbursement for certain expenses. Coinsurance agreements are accounted for by passing a portion of the risk to the reinsurer. Generally, the reinsurer receives a proportionate part of the premiums less commissions and is liable for a corresponding part of all benefit payments. Modified coinsurance is accounted for similarly to coinsurance except that the liability for future policy benefits is held by the original company, and settlements are made on a net basis between the companies. A substantial portion of Protective’s new life insurance and credit insurance sales is being reinsured. Protective reviews the financial condition of its reinsurers and monitors the amount of reinsurance it has with its reinsurers.
Protective has reinsured approximately $216.1 billion, $169.5 billion and $126.0 billion in face amount of life insurance risks with other insurers representing $546.0 million, $565.1 million and $496.4 million of premium income for 2002, 2001, and 2000, respectively. Protective has also reinsured accident and health risks representing $61.5 million, $122.7 million and $125.8 million of premium income for 2002, 2001, and 2000, respectively. In 2002 and 2001, policy and claim reserves relating to insurance ceded of $2,304.9 million and $2,059.0 million, respectively, are included in reinsurance receivables. Should any of the reinsurers be unable to meet its obligation at the time of the claim, obligation to pay such claim would remain with Protective. At December 31, 2002 and 2001, Protective had paid $45.5 million and $46.4 million, respectively, of ceded benefits which are recoverable from reinsurers. In addition, at December 31, 2002, Protective had receivables of $66.1 million related to insurance assumed.
In 2002, Protective discovered that it had overpaid reinsurance premiums to several reinsurance companies of approximately $94.6 million. At December 31, 2002, Protective had recorded cash and receivables totaling $69.7 million, which reflects the amounts received and Protective’s current estimate of amounts to be recovered in the future, based upon the information available. The corresponding increase in premiums and policy fees resulted in $62.5 million of additional amortization of deferred policy acquisition costs in 2002. The amortization of deferred policy acquisition costs takes into account the amortization relating to the increase in premiums and policy fees as well as the additional amortization required should the remainder of the overpayment not be collected. As a result of the foregoing, Protective’s 2002 pretax income increased $7.2 million.
2002 2001 ----------------------------- ---------------------------- ESTIMATED ESTIMATED CARRYING FAIR CARRYING FAIR AMOUNT VALUES AMOUNT VALUES ---------- ---------- ---------- ---------- Assets (see Notes A and C): Investments: Fixed maturities......................... $11,655,465 $11,655,465 $9,812,091 $9,812,091 Equity securities........................ 48,799 48,799 60,493 60,493 Mortgage loans on real estate............ 2,518,151 2,826,133 2,512,844 2,671,074 Short-term investments................... 447,155 447,155 228,396 228,396
------------------------- (1) Allocations of Net Investment Income and Other Operating Expenses are based on a number of assumptions and estimates and results would change if different methods were applied. (2) Asset adjustments represent the inclusion of assets related to discontinued operations.
COL. A COL. B COL. C COL. D COL. E COL. F ------ ------ ------ ------ ------ ------ PERCENTAGE CEDED TO ASSUMED OF AMOUNT GROSS OTHER FROM OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES AMOUNT TO NET ------------ ------------ ----------- ----------- ------ Year Ended December 31, 2002: Life insurance in force........................... $248,994,479 $219,025,215 $21,523,110 $51,492,374 41.8% ============ ============ =========== =========== =====
Year Ended December 31, 2000: Life insurance in force........................... $153,371,754 $128,374,583 $17,050,342 $42,047,513 40.6% ============ ============ =========== =========== =====