In 2004, the Company adopted Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts”, the effect of which was recorded as a cumulative effect of accounting change. In 2001, the Company adopted Emerging Issue Task Force Issue 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”, the effect of which was recorded as a cumulative effect of accounting change.
The results of operations for 2004, 2003 and 2002 are affected by the agreement with AIG SunAmerica Asset Management Corp. (See Notes 12 of the Notes to Financial Statements).
In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements contained in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission (the “SEC”). Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, or other developments. Statements using verbs such as “expect,” “anticipate,” “believe” or words of similar import generally involve forward-looking statements. Without limiting the foregoing, forward-looking statements include statements which represent the Company’s beliefs concerning future levels of sales and redemptions of the Company’s products, investment spreads and yields, or the earnings and profitability of the Company’s activities.
Forward-looking statements are necessarily based on estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond the Company’s control and many of which are subject to change. These uncertainties and contingencies could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable developments. Some may be national in scope, such as general economic conditions, changes in tax law and changes in interest rates. Some may be related to the life insurance industry generally, such as pricing, competition, regulatory developments and industry consolidation. Others may relate to the Company specifically, such as credit, volatility and other risks associated with the Company’s investment
The Company has one business segment, annuity operations, which consist of the sale and administration of deposit-type insurance contracts, such as fixed and variable annuity contracts and universal life insurance contracts. The Company focuses primarily on the marketing of fixed annuity contracts. The Company’s variable annuity products offer investors a broad spectrum of fund alternatives, with a choice of investment managers, as well as guaranteed fixed-rate options (“Fixed Options”).
On February 1, 2004, the Company entered into an administrative services agreement with its affiliate AIG SunAmerica Asset Management Corp. (“SAAMCo”), whereby SAAMCo pays to the Company a fee based on a percentage on all assets invested through the Company’s variable annuity products in exchange for services performed. SAAMCo is the investment advisor for certain trusts that serve as investment options for the Company’s variable annuity products. Amounts paid or accrued to the Company under this agreement totaled $1.5 million in 2004 and are included in variable annuity policy fees in the statement of income and comprehensive income. A fee of $0.2 million, $1.6 million and $1.8 million in 2004, 2003 and 2002, respectively, was paid under a different agreement that expired in early 2004.
The Company considers its most critical accounting policies those policies with respect to valuation of certain financial instruments, amortization of deferred acquisition costs (“DAC”) and other deferred expenses and valuation of the reserve for guaranteed benefits. In the implementation of each of the aforementioned policies, management is required to exercise its judgment on both a quantitative and qualitative basis. Further explanation of how management exercises that judgment follows.
VALUATION OF CERTAIN FINANCIAL INSTRUMENTS: Gross unrealized losses on debt and equity securities available for sale amounted to $13.5 million at December 31, 2004. In determining if and when a decline in fair value below amortized cost is other than temporary, the Company evaluates at each reporting period the market conditions, offering prices, trends of earnings, price multiples, and other key measures for investments in debt and equity securities. In particular, for debt securities, the Company assesses the probability that all amounts due are collectible according to the contractual terms of the obligation. When such a decline in value is deemed to be other than temporary, the Company recognizes an impairment loss in the current period operating results to the extent of the decline (See also discussion within “Capital Resources and Liquidity” herein).
The Company adjusts amortization of DAC and other deferred expenses (a “DAC unlocking”) when estimates of future gross profits to be realized on its annuity policies are revised. Increases in future EGPs may result from higher interest spread and/or lower surrender rate assumptions, while decreases in future EGPs may result from lower interest spread and/or higher surrender rate assumptions. DAC amortization for the current period is reduced when future EGPs are increased and amortization is increased when future EGPs are decreased. Approximately 69% of the Company’s DAC balance at December 31, 2004 related to fixed annuity contracts and universal life insurance contracts and 31% related to variable annuity contracts.
RESERVE FOR GUARANTEED BENEFITS: Pursuant to the adoption of Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”) which was adopted on January 1, 2004, the Company is required to recognize a liability for guaranteed minimum death benefits and other guaranteed benefits. In calculating the projected liability, five thousand stochastically generated investment performance scenarios were developed using the Company’s best estimates. These assumptions included, among others, mean equity return and volatility, mortality rates and lapse rates. The estimation of cash flow and the determination of the assumptions used require judgment, which can, at times, be subjective.
NET INCOME totaled $23.4 million in 2004, compared with $16.9 million in 2003 and $6.8 million in 2002.
CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET OF TAX reflected the adoption of SOP 03-1 on January 1, 2004. The Company recorded a loss of $2.0 million, net of tax, which is recognized in the statement of income and comprehensive income as a cumulative effect of accounting change for the year ended December 31, 2004.
Net investment spread totaled $66.3 million in 2004, $43.0 million in 2003 and $38.7 million in 2002. These amounts equal 2.11% on average invested assets (computed on a daily basis) of $3.14 billion in 2004, 2.04% on average invested assets of $2.11 billion in 2003 and 2.68% on average invested assets of $1.44 billion in 2002. The increase in the net investment spread rate was primarily due to the decline in overall rates paid in 2004 compared to 2003, as the Company issued new fixed annuity contracts at rates below the prior year average rates.
Growth in average invested assets resulted primarily from sales of Fixed Options since the latter half of 2003. Sales of fixed annuity contracts and Fixed Options totaled $444.9 million in 2004, $1.29 billion in 2003 and $400.0 million in 2002, and are primarily deposits on fixed annuity contracts. On an annualized basis, these deposits represent 17%, 84% and 31%, respectively, of the related reserve balances at the beginning of the respective periods. The Company’s sales of fixed annuity contracts have declined throughout 2004 as new competitors entered the bank annuity market. New competitors often accept low returns to gain market share, but often increase their spreads as the volume strains their capital and they return to more rational pricing targets. We expect our market share in New York to increase as these competitors offer rationally priced products.
Net investment spread includes the effect of income earned or interest paid on the difference between average invested assets and average interest-bearing liabilities. Average invested assets exceeded average interest-
bearing liabilities by $177.5 million in 2004, compared with $113.2 million in 2003 and $108.7 million in 2002. The difference between the Company’s yield on average invested assets and the rate paid on average interest-bearing liabilities was 1.92% in 2004, 1.83% in 2003 and 2.35% in 2002.
Interest expense (and the related rate paid on average interest-bearing liabilities) totaled $101.0 million (3.41%) in 2004, $76.7 million (3.84%) in 2003 and $58.7 million (4.39%) in 2002. Interest-bearing liabilities averaged $2.96 billion during 2004, $2.00 billion during 2003 and $1.34 billion during 2002. The decline in overall rates paid in 2004 compared to 2003 resulted primarily from the impact of a lower interest rate environment, as the Company issued and renewed new fixed annuity contracts at rates substantially below the prior year average rates.
NET REALIZED INVESTMENT GAINS (LOSSES) totaled $2.7 million of losses in 2004, compared with $2.4 million of gains in 2003 and $10.0 million of losses in 2002 and include impairment writedowns of $0.8 million, $3.1 million and $9.5 million, respectively. Thus, net realized losses from sales and redemptions of investments totaled $1.9 million in 2004, compared with net realized gains of $5.5 million in 2003 and $0.5 million of losses in 2002.
The Company sold or redeemed invested assets, principally bonds and notes, aggregating $630.1 million in 2004, $715.0 million in 2003 and $370.9 million in 2002. Sales of investments result from the active management of the Company’s investment portfolio. Because redemptions of investments are generally involuntary and sales of investments are made in both rising and falling interest rate environments, net gains and losses from sales and redemptions of investments fluctuate from period to period, and represent 0.06%, 0.26% and 0.04% of average invested assets for 2004, 2003 and 2002, respectively. Active portfolio management involves the ongoing evaluation of asset sectors, individual securities within the investment portfolio and the reallocation of investments from sectors that are perceived to be relatively overvalued to sectors that are perceived to be relatively undervalued. The intent of the Company’s active portfolio management is to maximize total returns on the investment portfolio, taking into account credit, option, liquidity and interest-rate risk.
The Company has encountered increased competition in the variable annuity marketplace during recent years and anticipates that the market will remain highly competitive for the foreseeable future. Also, from time to time, federal initiatives are proposed that could affect the taxation of annuities (see “Regulation”).
UNIVERSAL LIFE INSURANCE POLICY FEES, NET OF REINSURANCE amounted to $5.4 million in 2004, $5.3 million in 2003 and $6.3 million in 2002 and are net of reinsurance premiums of $7.3 million, $7.1 million and $6.1 million, respectively. Universal life insurance policy fees consist of mortality charges, up-front
PREMIUMS ON REINSURANCE CONTRACT totaled $6.6 million in 2004 as compared to no premiums in 2003 and 2002. The increase in 2004 was due to the Company entering into a reinsurance contract effective November 1, 2004.
SURRENDER CHARGES on fixed annuity, variable annuity and universal life insurance contracts totaled $3.0 million in 2004, $1.7 million in 2003 and $1.9 million in 2002. Surrender charge periods range from zero to nine years from the date a deposit is received. Surrender charges generally are assessed on withdrawals at declining rates.
AMORTIZATION OF DEFERRED ACQUISITION COSTS totaled $31.8 million in 2004, compared with $19.5 million in 2003 and $16.1 million in 2002. The increase in amortization in 2004 was primarily related to the increase in investment spread from a growing block of fixed annuity contracts, partially offset by the decrease in amortization related to the higher net realized investment losses.
With respect to its reinsurance agreements, the Company could become liable for all obligations of the reinsured policies if the reinsurers were to become unable to meet the obligations assumed under the respective reinsurance agreements. The Company monitors its credit exposure with respect to these agreements. Due to the high credit ratings and periodic monitoring of these ratings of the reinsurers, such risks are considered to be minimal.
CLAIMS ON REINSURANCE CONTRACT totaled $2.6 million in 2004 as compared to no claims in 2003 and 2002. The increase in 2004 was due to the Company entering into a reinsurance contract effective November 1, 2004.
GUARANTEED BENEFITS on variable annuity contracts totaled $1.2 million in 2004, compared with $0.8 million in 2003 and $1.7 million in 2002. These guaranteed benefits consist primarily of guaranteed minimum death benefits. Downturns in the equity markets could increase these expenses.
SHAREHOLDER’S EQUITY increased to $376.5 million at December 31, 2004 from $349.5 million at December 31, 2003, due to $23.4 million of net income and $3.6 million increase in unrealized gains, net of the effect on taxes and DAC and other deferred expenses.
INVESTMENTS AND CASH at December 31, 2004 totaled $3.82 billion, compared with $3.17 billion at December 31, 2003. The Company’s invested assets are managed by an affiliate. The following table summarizes the Company’s portfolio of bonds, notes and redeemable preferred stocks (the “Bond Portfolio”) and other investments and cash at December 31, 2004 and 2003:
THE BOND PORTFOLIO, which constituted 78% of the Company’s total investment portfolio at December 31, 2004, had an aggregate fair value that was $52.1 million greater than its amortized cost at December 31, 2004, compared with $40.2 million at December 31, 2003. The increase in net unrealized gains on the Bond Portfolio during 2004 principally reflects the decline in prevailing interest rates and the corresponding effect on the fair value of the Bond Portfolio at December 31, 2004.
At December 31, 2004, the Bond Portfolio had an aggregate fair value of $2.97 billion and an aggregate amortized cost of $2.92 billion. At December 31, 2004, the Bond Portfolio included $2.54 billion of bonds rated by Standard & Poor’s (“S&P”), Moody’s Investors Services (“Moody’s”) or Fitch (“Fitch”) and $427.6 million of bonds rated by the National Association of Insurance Commissioners (“NAIC”) or the Company pursuant to statutory ratings guidelines established by the NAIC. At December 31, 2004, approximately $2.86 billion of the Bond Portfolio was investment grade, including $791.0 million of mortgage-backed securities (“MBS”) and U.S. government/agency securities.
Another aspect of valuation pertains to impairment. As a matter of policy, the determination that a security has incurred an other-than-temporary decline in value and the amount of any loss recognition requires the judgment of the Company’s management and a continual review of its investments. In general, a security is considered a candidate for impairment if it meets any of the following criteria:
The Company has the ability to hold any security to its stated maturity. Therefore, the decision to sell reflects the judgment of the Company’s management that the security sold is unlikely to provide, on a relative value basis, as attractive a return in the future as alternative securities entailing comparable risks. With respect to distressed securities, the sale decision reflects management’s judgment that the risk-discounted anticipated ultimate recovery is less than the value achieved on sale.
Excluding the impairments noted above, the changes in fair value for the Company’s Bond Portfolio, which constitutes the vast majority of the Company’s investments, were recorded as a component of other comprehensive income in shareholder’s equity as unrealized gains or losses.
At December 31, 2004, approximately $2.13 billion, at amortized cost, of the Bond Portfolio had a fair value of $2.20 billion resulting in an aggregate unrealized gain of $65.6 million. At December 31, 2004, approximately $786.3 million, at amortized cost, of the Bond Portfolio had a fair value of $772.8 million resulting in an aggregate unrealized loss of $13.5 million. One issuer accounted for 14% of unrealized losses. No other single issuer accounted for more than 10% of unrealized losses. Approximately 42%, 16%, and 15% of unrealized losses were in the financial services, transportation, and telecommunications industries, respectively. No other industry accounted for more than 10% of unrealized losses.
The aging of the Bond Portfolio in an unrealized loss position at December 31, 2004 is shown below:
The valuation for the Company’s Bond Portfolio comes from market exchanges or dealer quotations, with the exception of non-traded securities. The Company considers non-traded securities to mean certain fixed income investments and certain structured securities. The aggregate fair value of these securities at December 31, 2004 was approximately $464.7 million. The Company estimates the fair value with internally prepared valuations (including those based on estimates of future profitability). Otherwise, the Company uses its most recent purchases and sales of similar unquoted securities, independent broker quotes or comparison to similar securities with quoted prices when possible to estimate the fair value of those securities. All such securities are classified as available for sale.
Senior secured loans (“Secured Loans”) are included in the Bond Portfolio and aggregated $113.1 million at December 31, 2004. Secured Loans are senior to subordinated debt and equity and are secured by assets of the issuer. At December 31, 2004, Secured Loans consisted of $60.7 million of privately traded securities and $52.4 million of publicly traded securities. These Secured Loans are composed of loans to borrowers spanning 8 industries, with 62% of these assets concentrated in the utilities industry, including one single issuer comprising 13%. No other industry concentration or single issuer constituted more than 10% of these assets.
MORTGAGE LOANS aggregated $276.9 million at December 31, 2004 and consisted of 78 commercial first mortgage loans with an average loan balance of approximately $3.5 million, collateralized by properties located in 27 states. Approximately 36% of this portfolio was office, 27% was multifamily residential, 15% was industrial, 15% was retail and 7% was other types. At December 31, 2004, approximately 25% and 12% of this portfolio was secured by properties located in California and New York, respectively. No more than 10% of this portfolio was secured by properties located in any other single state. At December 31, 2004, six mortgage loans had an outstanding balance of $10 million or more, which collectively aggregated approximately 33% of this portfolio. At December 31, 2004, approximately 24% of the mortgage loan portfolio consisted of loans with balloon payments due before January 1, 2008. During 2004 and 2003, loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
At December 31, 2004, approximately 12% of the mortgage loans were seasoned loans underwritten to the Company’s standards and purchased at or near par from other financial institutions. Such loans generally have higher average interest rates than loans that could be originated today. The balance of the mortgage loan portfolio has been originated by the Company under strict underwriting standards. Commercial mortgage loans on properties such as offices, hotels and shopping centers generally represent a higher level of risk than do mortgage loans secured by multifamily residences. This greater risk is due to several factors, including the larger size of such loans and the more immediate effects of general economic conditions on these commercial property types. However, due to the seasoned nature of the Company’s mortgage loan portfolio and its strict underwriting standards, the Company believes that it has prudently managed the risk attributable to its mortgage loan portfolio while maintaining attractive yields.
ASSET-LIABILITY MATCHING is utilized by the Company in an effort to minimize the risks of interest rate fluctuations and disintermediation (i.e. the risk of being forced to sell investments during unfavorable market conditions). The Company believes that its liabilities for Fixed-Rate Products should be backed by a portfolio principally composed of fixed-rate investments that generate predictable rates of return. The Company does not
have a specific target rate of return. Instead, its rates of return vary over time depending on the current interest rate environment, the slope of the yield curve, the spread at which fixed-rate investments are priced over the yield curve, default rates, and general economic conditions. Its portfolio strategy is constructed with a view to achieve adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability matching, liquidity and safety. The Company’s Fixed-Rate Products incorporate incentives, surrender charges and/or other restrictions in order to encourage persistency. Approximately 83% of the Company’s reserves for Fixed-Rate Products had surrender penalties or other restrictions at December 31, 2004.
As part of its asset-liability matching discipline, the Company conducts detailed computer simulations that model its fixed-rate assets and liabilities under commonly used interest rate scenarios. With the results of these computer simulations, the Company can measure the potential gain or loss in fair value of its interest-rate sensitive instruments and seek to protect its economic value and achieve a predictable spread between what it earns on its invested assets and what it pays on its liabilities by designing its Fixed-Rate Products and conducting its investment operations to closely match the duration and cash flows of the fixed-rate assets to that of its fixed-rate liabilities. The fixed-rate assets in the Company’s asset-liability modeling include: cash and short-term investments, bonds, notes and redeemable preferred stocks, mortgage loans and policy loans. At December 31, 2004, these assets had an aggregate fair value of $3.31 billion with an option-adjusted duration of 4.7 years. The Company’s fixed-rate liabilities include fixed annuity contracts, Fixed Options and universal life insurance contracts. At December 31, 2004, these liabilities had an aggregate fair value (determined by discounting future contractual cash flows by related market rates of interest) of $2.96 billion with an option-adjusted duration of 5.4 years. The Company’s potential exposure due to a relative 10% decrease in prevailing interest rates from its December 31, 2004 levels is a loss of approximately $1.7 million, representing an increase in fair value of its fixed-rate liabilities that is not offset by an increase in fair value of its fixed-rate assets. Because the Company actively manages its assets and liabilities and has strategies in place to minimize its exposure to loss as interest rate changes occur, it expects that actual losses would be less than the estimated potential loss.
Option-adjusted duration is a common measure for the price sensitivity of a fixed-maturity portfolio to changes in interest rates. For example, if interest rates increase 1%, the fair value of an asset with a duration of 5.0 years is expected to decrease in value by approximately 5%. The Company estimates the option-adjusted duration of its assets and liabilities using a number of different interest rate scenarios, assuming continuation of existing investment and interest crediting strategies, including maintaining an appropriate level of liquidity. Actual company and contract holder behaviors may be different than was assumed in the estimate of option-adjusted duration and these differences may be material.
has reached or is near the minimum contractual guaranteed rate (generally 3%). Continual declines in interest rates could cause the spread between the yield on the portfolio and the interest rate credited to contract holders to deteriorate.
The Company has had the ability, limited by minimum interest rate guarantees, to respond to the generally declining interest rate environment in the last five years by lowering crediting rates in response to lower investment returns. See the earlier discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional information on the calculation of investment yield and net investment spread used by the Company’s management as a key component in evaluating the profitability of its annuity business. The trends experienced during 2004, 2003 and 2002 in the Company’s yield on average invested assets and rate of interest credited on average interest-bearing liabilities, compared to the market trend in long-term interest rates as illustrated by the average ten-year U.S. Treasury bond rate, are presented in the following table:
The Company seeks to enhance its spread income with dollar roll repurchase agreements (“Dollar Roll Repos”). Dollar Roll Repos involve a sale of MBS by the Company and an agreement to repurchase substantially similar MBS at a later date at an agreed upon price. No Dollar Roll Repos were outstanding at December 31, 2004. The Company also seeks to provide liquidity by investing in MBS. MBS are generally investment-grade securities collateralized by large pools of mortgage loans. MBS generally pay principal and interest monthly. The amount of principal and interest payments may fluctuate as a result of prepayments of the underlying mortgage loans.
There are risks associated with some of the techniques the Company uses to provide liquidity, enhance its spread income and match its assets and liabilities. The primary risk associated with the Company’s Dollar Roll Repos is counterparty risk. The Company believes, however, that the counterparties to its Dollar Roll Repos are financially responsible and that the counterparty risk associated with those transactions is minimal. It is the Company’s policy that these agreements are entered into with counterparties who have a debt rating of A/A2 or better from both S&P and Moody’s. The Company continually monitors its credit exposure with respect to these agreements. The primary risk associated with MBS is that a changing interest rate environment might cause prepayment of the underlying obligations at speeds slower or faster than anticipated at the time of their purchase. As part of its decision to purchase such a security, the Company assesses the risk of prepayment by analyzing the security’s projected performance over an array of interest-rate scenarios. Once such a security is purchased, the Company monitors its actual prepayment experience monthly to reassess the relative attractiveness of the security with the intent to maximize total return.
withdrawals would be available through incoming cash flow, the sale of short-term or floating-rate instruments or Dollar Roll Repos on the Company’s substantial MBS segment of the Bond Portfolio, thereby avoiding the sale of fixed-rate assets in an unfavorable bond market.
In a declining interest rate environment, the Company’s cost of funds would decrease over time, reflecting lower interest crediting rates on its Fixed-Rate Products. Should increased liquidity be required for withdrawals, the Company believes that a significant portion of its investments could be sold without adverse consequences in light of the general strengthening that would be expected in the bond market.