The following is management's discussion and analysis of financial condition and results of operations of SunAmerica Inc. (the "Company") for the three years in the period ended September 30, 1994.
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING FOR INCOME TAXES totaled $165.3 million or $3.58 per common share in 1994, compared with $127.0 million or $2.75 per common share in 1993 and $76.8 million or $1.80 per common share in 1992. The cumulative effect of the change in accounting for income taxes resulting from the implementation of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," amounted to a nonrecurring non-cash charge of $33.5 million or $.81 per common share in 1994. Accordingly, net income amounted to $131.8 million or $2.77 per common share in 1994.
NET INVESTMENT INCOME, which is the spread between the income earned on invested assets and the interest paid on fixed annuities and other interest-bearing liabilities, increased to $294.5 million in 1994 from $263.8 million in 1993 and $219.4 million in 1992. These amounts represent net investment spreads of 3.30% on average invested assets (computed on a daily basis) of $8.92 billion in 1994, 3.15% on average invested assets of $8.38 billion in 1993 and 2.81% on average invested assets of $7.80 billion in 1992. These improvements in net investment income primarily resulted from reductions in interest rates paid on all interest-bearing liabilities and increases in the excess of average invested assets over average interest-bearing liabilities, partially offset by declines in investment yield. The excess of average invested assets over average interest-bearing liabilities amounted to $647.1 million in 1994, $456.0 million in 1993 and $115.4 million in 1992.
Total interest expense aggregated $463.7 million in 1994, $490.6 million in 1993 and $543.6 million in 1992. The average rate paid on all interest-bearing liabilities fell to 5.60% (5.43% on fixed annuities) in 1994 from 6.19% (6.11% on fixed annuities) in 1993 and 7.07% (6.92% on fixed annuities) in 1992. These declines in rates were primarily due to a decline in prevailing interest rates that began during the latter half of fiscal 1992 and continued into the first half of fiscal 1994. This was reflected in a corresponding decline in the average crediting rate on annuity contracts, the majority of which reprice annually as interest rate guarantees are renewed. Interest-bearing liabilities averaged $8.27 billion during 1994, compared with $7.92 billion during 1993 and $7.69 billion during 1992.
Investment income totaled $758.2 million in 1994, $754.4 million in 1993 and $763.0 million in 1992. Investment income has been relatively stable over the three year period as increases in earnings from average invested assets have been offset by declines in investment yield. The yield on average invested assets declined to 8.50% in 1994 from 9.00% in 1993 and 9.78% in 1992. These yields are computed without subtracting net realized investment losses. If net realized investment losses were included in the computation, the yields would be 8.26% in 1994, 8.75% in 1993 and 9.06% in 1992.
The Company has enhanced investment yield since 1992 through Dollar Rolls, whereby the proceeds from sales of MBSs are invested in short-term securities pending the contractual repurchase of substantially the same securities at discounted prices in the forward market. The Company has been able to engage in Dollar Rolls due to the market demand for MBSs for formation of CMOs, which was particularly high in 1993. The Company recorded $15.6 million of enhanced yield on a weighted average volume of $1.05 billion of such transactions during 1994, compared with $21.0 million of enhanced yield on a weighted average volume of $1.01 billion during 1993 and $5.4 million of enhanced yield on a weighted average volume of $383.2 million during 1992. The decline in enhanced yield relative to the volume of Dollar Rolls in 1994 is primarily due to a narrowing of market spreads on such transactions.
In addition, the Company has enhanced investment yield since 1992 through total return corporate bond swap agreements (the "Total Return Agreements"). The Company recorded income of $1.3 million on the Total Return Agreements during 1994, compared with $14.6 million recorded during 1993 and $12.3 million recorded during 1992. The reduction in income recorded on the Total Return Agreements during 1994 resulted primarily from declines in the market value of the underlying assets as a result of an increase in prevailing interest rates. The Company has also entered into certain interest rate swap agreements (the "Swap Agreements"). (See "Asset-Liability Matching" for additional discussion of Total Return Agreements and Swap Agreements.)
The GICs issued by the Company and Sun Life Insurance Company of America ("Sun Life of America") typically guarantee the payment of principal and interest at a fixed rate for a fixed term of one to ten years. In the case of GICs sold to pension plans, certain withdrawals may be made at book value in the event of circumstances specified in the plan document, such as employee retirement, death, disability, hardship withdrawal or employee termination. Sun Life of America imposes surrender penalties in the event of other withdrawals prior to maturity. Contracts purchased by state and local governmental authorities may also permit scheduled book value withdrawals subject to the terms of the underlying indenture. Contracts purchased by asset management firms either prohibit withdrawals or permit withdrawals with notice ranging from 7 to 270 days. In pricing GICs, the Company analyzes cash flow information and prices accordingly so that it is compensated for possible withdrawals prior to maturity (see "Financial Condition and Liquidity").
NET REALIZED INVESTMENT LOSSES totaled $21.1 million in 1994, $21.3 million in 1993 and $56.4 million in 1992, and include impairment writedowns of $55.9 million in 1994, $114.3 million in 1993 and $119.7 million in 1992. Therefore, net gains from sales of investments totaled $34.8 million in 1994, $93.0 million in 1993 and $63.3 million in 1992.
Impairment writedowns in 1993 include $11.8 million of provisions applied to mortgage loans that were restructured during 1993 and reduced to the aggregate appraised value of the underlying real estate, and $11.1 million of provisions applied to the Company's investment in a real estate-related separate account of Anchor National Life Insurance Company ("Anchor"), which separate account was liquidated through sales of underlying assets to affiliated and nonaffiliated parties during 1993. Impairment writedowns in 1993 also include $88.2 million of additional provisions applied to bonds. These bond writedowns include $25.0 million applied to certain IOs. IOs, a type of MBS used as an asset-liability matching tool to hedge against rising interest rates, are investment grade securities that give the holder the right to receive only the interest payments on a pool of underlying mortgage loans. As would be anticipated in a lower interest rate environment, the amortized cost of these IOs became impaired as a result of increased prepayments of the underlying loans. At September 30, 1994, the amortized cost, which is net of impairment writedowns, of the IOs held by the Company was $22.7 million and their fair value was $18.1 million.
aforementioned real estate-related separate account of Anchor. In addition, 1992 impairment writedowns include $26.3 million of provisions applied to Arizona real estate to reduce the carrying values of such properties to their estimated net realizable values based upon appraisals which reflected an intention to hold the properties for future development.
VARIABLE ANNUITY FEES are based on the market value of assets supporting variable annuity contracts in separate accounts. Such fees totaled $79.5 million in 1994, $67.5 million in 1993 and $57.7 million in 1992. Variable annuity fees have increased over the last three years principally due to asset growth from the receipt of variable annuity premiums and, during 1993, from increased market values. Variable annuity assets averaged $4.43 billion during 1994, $3.65 billion during 1993 and $3.05 billion during 1992. Variable annuity premiums, which exclude premiums allocated to the fixed accounts of variable annuity products, totaled $759.3 million in 1994, $796.9 million in 1993 and $590.2 million in 1992. Total variable annuity product sales, which include premiums allocated to the fixed accounts of variable annuities, aggregated $900.0 million in 1994, $860.8 million in 1993 and $676.1 million in 1992 (see "Growth in Average Invested Assets"). Though total variable annuity product sales rose modestly in 1994, variable annuity premiums declined, principally due to a rising demand for fixed-rate investment options, including the fixed accounts of variable annuities, as prevailing interest rates increased during the latter half of fiscal 1994. The Company has encountered increased competition in the variable annuity marketplace in 1994 and anticipates that the market will remain highly competitive for the foreseeable future.
TRUST FEES are earned by Resources Trust Company for providing administrative and custodial services primarily for individual retirement accounts, as well as for other qualified pension plans. Trust fees totaled $11.9 million in 1994, $10.9 million in 1993 and $11.0 million in 1992.
GENERAL AND ADMINISTRATIVE EXPENSES totaled $132.7 million in 1994, compared with $135.8 million in 1993 and $133.1 million in 1992, and represent 0.9%, 1.0% and 1.1% of average total assets for fiscal years 1994, 1993 and 1992, respectively. General and administrative expenses remain closely controlled through a company-wide cost containment program.
INCOME TAX EXPENSE totaled $74.7 million in 1994, $57.0 million in 1993 and $34.3 million in 1992, representing effective tax rates of 31% in all three fiscal years. These tax rates reflect the favorable impact of certain affordable housing tax credits.
SHAREHOLDERS' EQUITY decreased by $148.9 million to $961.1 million at September 30, 1994 from $1.11 billion at September 30, 1993, primarily as a result of $250.9 million of change in net unrealized losses on debt and equity securities available for sale charged directly to shareholders' equity. Book value per common share amounted to $18.90 at September 30, 1994, compared with $22.64 at September 30, 1993 and $14.54 at September 30, 1992. Excluding net unrealized gains and losses on debt and equity securities available for sale, book value per common share amounted to $22.58 at September 30, 1994, $20.16 at September 30, 1993 and $14.32 at September 30, 1992.
INVESTED ASSETS at year-end totaled $9.28 billion in 1994, compared with $10.36 billion in 1993. The Company managed most of these investments internally. Invested assets declined by $1.08 billion during 1994, primarily as a result of a reduction in dollar-roll positions, as indicated by the $943.2 million decline in amounts payable to brokers for purchases of securities. Invested assets also declined as a consequence of the change in net unrealized losses on debt and equity securities available for sale charged directly to shareholders' equity.
The Company's general investment philosophy is to hold fixed maturity assets for long-term investment. Thus, it does not have a trading portfolio. Effective September 30, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" and, accordingly, began to carry the portion of its portfolio of bonds, notes and redeemable preferred stocks that is available for sale (the "Available for Sale Portfolio") at estimated fair value. The remaining portion of its portfolio of bonds, notes and redeemable preferred stocks is held for investment and continues to be carried at amortized cost.
BONDS, NOTES AND REDEEMABLE PREFERRED STOCKS, including those held for investment and the Available for Sale Portfolio (the "Bond Portfolio"), at September 30, 1994, had an aggregate amortized cost that exceeded its fair value by $321.0 million (including net unrealized losses of $329.0 million on the Available for Sale Portfolio). The fair value of the Bond Portfolio was $167.2 million above its amortized cost at September 30, 1993 (including net unrealized gains of $91.9 million on the Available for Sale Portfolio). The unrealized losses on the Bond Portfolio at September 30, 1994 principally resulted from increases in prevailing interest rates since September 30, 1993 and the corresponding effect on the Bond Portfolio.
Non-investment grade securities generally provide higher yields and involve greater risks than investment grade securities because their issuers typically are more highly leveraged and more vulnerable to adverse economic conditions than investment grade issuers. In addition, the trading market for these securities is usually more limited than for investment grade securities. The Company intends that its holdings of such securities not exceed current levels, but its policies may change from time to time, including in connection with any possible acquisition. The Company had no material concentrations of non-investment grade securities at September 30, 1994.
SENIOR SECURED LOANS are included in the Bond Portfolio and their amortized cost aggregated $719.0 million at September 30, 1994. Secured Loans are primarily originated by money center or investment banks or are originated directly by the Company. Secured Loans are senior to subordinated debt and equity, and virtually all are secured by assets of the issuer. At September 30, 1994, Secured Loans consisted of loans to 92 borrowers spanning 26 industries, with no industry concentration constituting more than 8% of these assets.
was secured by properties in any other single state. At September 30, 1994, there were no construction, takeout, farm or land loans and there were 22 loans with outstanding balances of $10 million or more, which loans aggregated approximately 25% of the portfolio. At the time of their origination or purchase by the Company, virtually all mortgage loans had loan-to-value ratios of 75% or less. At September 30, 1994, approximately 21% of the mortgage loan portfolio consisted of loans with balloon payments due before October 1, 1997. At September 30, 1994, loans delinquent by more than 90 days totaled $45.9 million and constituted 3.2% of total mortgages. Loans foreclosed upon and transferred to real estate in the balance sheet during fiscal 1994 totaled $6.0 million (0.4% of total mortgages).
ASSET-LIABILITY MATCHING is utilized by the Company to minimize the risks of interest rate fluctuations and disintermediation. The Company believes that its fixed-rate liabilities should be backed by a portfolio principally composed of fixed maturities 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 maturities are priced over the yield curve and general competitive conditions within the industry. Its portfolio strategy is designed to achieve adequate risk-adjusted returns consistent with its investment objectives of effective asset-liability matching, liquidity and safety.
The Company designs its fixed-rate products and conducts its investment operations in order to closely match the duration of the assets in its investment portfolio to its annuity and GIC obligations. The Company seeks to achieve a predictable spread between what it earns on its assets and what it pays on its liabilities by investing principally in fixed maturities. The Company's fixed-rate products incorporate surrender charges, two-tiered interest rate structures or other limitations on when contracts can be surrendered for cash to encourage persistency and discourage withdrawals. Approximately 78% of the Company's fixed annuity and GIC reserves had surrender penalties or other restrictions at September 30, 1994.
As part of its asset-liability matching discipline, the Company conducts detailed computer simulations that model its fixed-maturity assets and liabilities under commonly used stress-test interest rate scenarios. Based on the results of these computer simulations, the investment portfolio has been constructed with a view to maintaining a desired investment spread between the yield on portfolio assets and the rate paid on its reserves under a variety of possible future interest rate scenarios. In addition, the Company has designed its portfolio to limit the market discount from book value on the aggregate portfolio that might result from a sharp rise in interest rates. The cash flow obtained from MBSs helps to maintain the anticipated spread, while providing desired liquidity. At September 30, 1994, the weighted average life of the Company's investments was approximately four-and-one-half years and the portfolio had a duration of approximately three-and-three-fourths years.
As a component of investment strategy, the Company utilizes Swap Agreements to match assets more closely to liabilities. Swap Agreements are agreements to exchange with a counterparty interest rate payments of differing character (for example, fixed-rate payments exchanged for variable-rate payments) based on an underlying principal balance (notional principal) to hedge against interest rate changes. The Company generally utilizes Swap Agreements to create a hedge that effectively converts floating-rate assets into fixed-rate assets. At September 30, 1994, the Company had 25 outstanding Swap Agreements with an aggregate notional principal amount of $1.23 billion. These agreements mature in various years through 1998 and have an average remaining maturity of 27 months.
The Company also seeks to provide liquidity, while enhancing its spread income, by using reverse repurchase agreements ("Reverse Repos"), Dollar Rolls, Total Return Agreements and by investing in MBSs. Reverse Repos involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed upon price and are generally over-collateralized. Dollar Rolls are similar to Reverse Repos except that the repurchase involves securities that are only substantially the same as the securities sold and the arrangement is not collateralized, nor is it governed by a repurchase agreement. Total Return Agreements effectively exchange a fixed rate of interest on the notional amount for the coupon income plus or minus the increase or decrease in the market value of specified non-investment grade corporate bonds. MBSs are generally investment grade securities collateralized by large pools of mortgage loans. MBSs 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.
INVESTED ASSETS EVALUATION routinely includes a review by the Company of its portfolio of debt securities. Management identifies monthly those investments that require additional monitoring and carefully reviews the carrying value of such investments at least quarterly to determine whether specific investments should be placed on a nonaccrual basis and to determine declines in value that may be other than temporary. In making these reviews for bonds, management principally considers the adequacy of collateral (if any), compliance with contractual covenants, the borrower's recent financial performance, news reports and other externally generated information concerning the creditor's affairs. In the case of publicly traded bonds, management also considers market value quotations, if available. For mortgage loans, management generally considers information concerning the mortgaged property and, among other things, factors impacting the current and expected payment status of the loan and, if available, the current fair value of the underlying collateral.
DEFAULTED INVESTMENTS, comprising all investments (at amortized cost, net of impairment writedowns) that are in default as to the payment of principal or interest, totaled $56.2 million at September 30, 1994, including $10.3 million of unsecured loans and $45.9 million of mortgage loans. At September 30, 1994, defaulted investments constituted 0.6% of total invested assets at amortized cost and their fair value was equal to their amortized cost. At September 30, 1993, defaulted investments totaled $60.8 million, including $40.7 million of unsecured loans and $20.1 million of mortgage loans. At September 30, 1993, defaulted investments constituted 0.6% of total invested assets at amortized cost and their fair value totaled $56.3 million.
SOURCES OF LIQUIDITY are readily available to the Company in the form of existing cash and short-term investments, Reverse Repo capacity on invested assets and, if required, proceeds from invested asset sales. At September 30, 1994, approximately $1.57 billion of the Company's Bond Portfolio had an aggregate unrealized gain of $46.0 million, while approximately $5.10 billion had an aggregate unrealized loss of $367.0 million. In addition, the Company's investment portfolio also currently provides approximately $101.4 million of monthly cash flow from scheduled principal and interest payments.
In a declining rate environment, the Company's cost of funds would decrease over time, reflecting lower interest crediting rates on its fixed annuities and GICs. 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.
On a parent company stand-alone basis, SunAmerica Inc. (the "Parent"), at September 30, 1994, had invested assets with an amortized cost of $972.0 million (fair value, $941.8 million) and outstanding indebtedness of $472.8 million, comprising all of the Company's consolidated senior indebtedness. Additionally, as of September 30, 1994, the Parent had three GICs purchased by local government authorities that aggregated $265.4 million. The GIC agreements provided liquidity to the Company at a lower cost than other sources of liquidity with similar maturities. The Parent's annual debt service with respect to these debt and GIC obligations totals $75.2 million for fiscal 1995, $70.3 million for fiscal 1996, $70.2 million for fiscal 1997, $89.9 million for fiscal 1998, $198.9 million for fiscal 1999 and $909.1 million, in the aggregate, thereafter.
In addition to the Parent's stand-alone sources of liquidity, at September 30, 1994 there was approximately $57.9 million of dividends available to the Parent from its regulated life insurance subsidiaries. The Parent received dividends of $43.0 million in December 1993, $30.0 million in December 1992 and $25.0 million in December 1991 from Sun Life of America. The Parent also received dividends of $2.4 million in fiscal 1994, $4.7 million in fiscal 1993, $17.1 million in fiscal 1992 and $43.2 million in fiscal 1991 from its other directly-owned subsidiaries.