The properties in Kansas City, Missouri are leased from Broadway Square Partners, LLP, a Missouri limited liability partnership, of which a corporation controlled by a related party is a partner, as described in Item 13, "Certain Relationships and Related Transactions - Other Transactions" of this Form 10-K. The Company considers its current facilities to be adequate for its current operations.
The historical financial information for the five years ended December 31, 2002 and at December 31, 2002, 2001, 2000, 1999 and 1998 has been derived from the audited consolidated financial statements of the Company. The selected consolidated financial data set forth below is qualified in its entirety by reference to and should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the Company's consolidated financial statements and the notes thereto included in this Form 10-K.
(1) On October 1, 1998, the Company acquired the 50% share of College Insurance Group, Inc. not previously owned by the Company. (2) Effective January 1, 2000, the Company disposed of a block of payroll- deduction life insurance business.
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 insurance industry generally, such as pricing competition, regulatory developments and industry consolidation. Others may relate to the Company specifically, such as credit, interest rate, volatility and other risks associated with the Company's investment portfolio. Although the Company believes that the expectations reflected in its forward-looking statements are reasonable, it cannot guarantee its future results, performance or achievements. The Company disclaims any obligation to update forward-looking information included in this Form 10-K.
The Company sells life insurance and annuity products, primarily universal life insurance and interest-sensitive whole life insurance (collectively referred to as "interest-sensitive life" or "universal life-type"), term life insurance, whole life insurance, flexible and single premium deferred annuities, single premium immediate annuities and equity-indexed annuities. The Company derives its revenues principally from:
One of the significant estimations inherent in the valuation of investments is the evaluation of other than temporary impairments. The evaluation for other than temporary impairments is a quantitative and qualitative process that is subject to risks and uncertainties in the determination of whether declines in the fair value of investments are other than temporary. The risks and uncertainties include changes in general economic conditions, the issuer's financial condition or near term recovery prospects and the effects of changes in interest rates. The Company's accounting policy requires that a decline in the fair value of a security below its amortized cost basis be assessed to determine if the decline is other than temporary. If so, the security is deemed to be impaired and, a charge is recorded in net realized capital losses equal to the difference between the fair value and amortized cost basis of the security. The fair value of the impaired investment becomes its new cost basis. The Company has a monitoring process involving investment and accounting professionals that identifies securities that, due to certain characteristics, are subjected to an enhanced analysis on a quarterly basis. The primary factors considered in evaluating whether a decline in value for corporate issued securities is other than temporary include:
Retrospective adjustments of deferred policy acquisition costs and the cost of business acquired are made annually when the Company revises its estimates of current or future gross profits on universal life-type and annuity products, a process commonly referred to as "unlocking." For example, deferred policy acquisition costs are amortized earlier than expected when policy terminations are higher than expected or when investments backing the Company's policy liabilities are sold at a gain prior to their anticipated maturity. The Company recorded retrospective adjustments to these asset balances during both 2002 and 2001 as more fully discussed in the "Segment Results" and "Consolidated Year to Year Comparisons" that follow.
The Company regularly evaluates the recoverability of its deferred policy acquisition costs and cost of business acquired by comparing its current estimate of future profits to the unamortized asset balances.
Reserves for future policy benefits, policyholder funds and unearned policy revenues
The Company's insurance subsidiaries record as liabilities actuarially determined reserves which are calculated to meet the Company's future obligations to policyholders. The Company's reserves for future policy benefits of $821.6 million at December 31, 2002 on term life insurance and whole life insurance policies are calculated based on actuarially recognized methods using estimates of investment yields, mortality and withdrawals. These estimates are based upon the Company's historical experience and the historical experience of the life insurance industry as a whole. These reserves are computed at amounts that, with additions from estimated premiums to be received and with interest on such reserves compounded annually, are expected to be sufficient to meet the Company's policy obligations at their maturities, upon surrender of a policy or in the event of an insured's death. Changes in or deviations from the assumptions used in the calculation of the reserves for future policy benefits can significantly affect the levels of the Company's computed reserves and future results of operations.
The liability for universal life-type and annuity products of $2,896.6 million at December 31, 2002 represents the accumulated contract values, without reduction for potential surrender charges. Additions to the reserves for universal life-type policies are required when their balances, in addition to anticipated future net cash flows, including investment income, are insufficient to cover anticipated future benefits and expenses.
The Company follows the requirements of Statement of Financial Accounting Standards ("SFAS") No. 5, "Accounting for Loss Contingencies." SFAS No. 5 requires the Company to evaluate each contingent matter separately. The evaluation is a two step process: determining a likelihood of loss, and, if a loss is probable, developing an estimate of the potential range of loss. The Company establishes liabilities for these contingencies at its "best estimate," or, if no one amount within the range of possible losses is more probable than any other, the Company records an estimated liability at the low end of the range of possible losses. The majority of contingencies currently being evaluated by the Company relate to litigation, which is inherently difficult to evaluate and is subject to significant changes. See Item 3, "Legal Proceedings" in this Form 10-K for a discussion of the Company's significant litigation.
As shown in the above tables, the Company's growth over the last two years has primarily occurred in its asset accumulation operations segment. This growth has been derived from a combination of new sales and renewal premiums on annuity products. The reserve balances in the Company's life insurance operations segment, with the exception of the annuities, have remained fairly constant during the last two years; the Company has been able to issue sufficient new business to offset the surrenders, maturities and lapses in its older blocks of business.
The Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - an Amendment of FASB Statement No. 133," on January 1, 2001. In accordance with the transition provisions of SFAS No. 133, the Company recorded a net-of-tax cumulative-effect-type gain of $0.8 million in earnings to record all of its derivatives on the balance sheet at fair value.
The Company's equity-indexed annuity products credit interest to the policyholder's account balance based on a percentage (the "participation rate") of the change in external indices over a one or two year period (the "index period"). At the end of each index period, a new index period begins using the then-current account balance and the applicable external index value. The Company has the discretion to change the participation rate at the beginning of each index period, subject to any contractually-guaranteed minimums.
SFAS No. 133 requires each deposit relating to these equity-indexed annuities to be divided into two components: an embedded derivative component and a host contract component. The embedded derivative component represents the value of the policyholder's right to receive interest credits over the life of the policy. The host contract component represents the amount of each premium not allocated to the embedded derivative component. The Company records the changes in the values of the embedded derivatives in current earnings as a component of policyholder benefits. The host contract accretes interest at a rate sufficient to produce the maturity value of the host contract over a projected term. The interest accretion of the host contract is included in interest credited on policyholder funds on the Company's consolidated statement of income.
The Company manages its exposure to changes in the fair value of equity-indexed annuity embedded derivatives by purchasing exchange-traded and over-the-counter indexed call options and futures contracts on the same external index. Neither these assets nor the related equity-indexed annuity embedded derivatives are eligible for hedge accounting treatment under SFAS No. 133. The Company recognizes the change in fair values of these assets as a component of net investment income on its consolidated statement of income.
Prior to 2002, the Company reported a non-life insurance investments segment, which included real estate investment properties and other non-life insurance investments. The Company has determined that the investments that comprised this segment are no longer significant enough to warrant reporting it as a separate segment. All periods presented have been restated to include these investments with the other reconciling items.
Asset accumulation operations. Income before income taxes in the Company's asset accumulation operations segment increased $11.6 million, to income of $10.2 million for the year ended December 31, 2002 from a loss of $1.4 million for the year ended December 31, 2001. The improvement in profits in this segment in 2002 resulted from a decrease in amortization expense in 2002, an increase in net investment income in 2002, and reduced commission expense in 2002, partially offset by an increase in interest credited on policyholder funds in 2002. Revisions to estimates of future gross profits resulted in adjustments to the Company's deferred policy acquisition costs and cost of business acquired that decreased amortization expense by $3.0 million in 2002 and increased amortization expense by $3.1 million in 2001. The most significant revision to estimated gross profits in 2001 occurred as a result of changes in estimated policy benefits, including revisions made pursuant to the anticipated impact of the settlement of litigation in which the Company was a defendant. Investment income increased $8.5 million in 2002 compared to 2001 due to higher levels of policyholder account balances in 2002. Commission expense was $2.3 million lower in 2002 than 2001, primarily due to $1.4 million of expense accrued for commission bonus plans in 2001. Partially offsetting these increases in income was a $3.6 million increase in interest credited on policyholder funds in 2002 compared to 2001, resulting from an increase in the levels of policyholder funds, partially offset by a decrease in the rate of interest credited to policyholder funds in 2002.
Income before income taxes in the Company's asset accumulation operations segment decreased $12.0 million, to a loss of $1.4 million for the year ended December 31, 2001 from income of $10.6 million for the year ended December 31, 2000. The reduction in profits in 2001 primarily resulted from an increase in amortization expense in 2001, a decrease in surrender charge income in 2001 and an increase in commission expense in 2001. Revisions to estimates of future gross profits resulted in adjustments to the Company's deferred policy acquisition costs and cost of business acquired asset that increased amortization expense by $3.1 million in 2001 and decreased amortization expense by $5.5 million in 2000. The most significant revision to estimated gross profits in 2001 occurred as a result of changes in estimated policy benefits, including revisions made pursuant to the anticipated impact of the settlement of litigation in which the Company was a defendant. Surrender charge income decreased $1.5 million from 2000 to 2001 due to a reduction in the levels of annuity surrenders in 2001. Commission expense was $1.4 million higher in 2001 than 2000, primarily due to $1.4 million of expense accrued for commission bonus plans in 2001.
The difference between the segment revenues and income before income taxes shown above and the amounts reported in the Company's consolidated financial statements appearing elsewhere in this Form 10-K result from items not allocated to specific segments. The significant reconciling items that are not allocable to a segment are:
Overview. Income before cumulative effect of a change in accounting principle increased $7.4 million, or 65.5%, to $18.7 million for the year ended December 31, 2002 from $11.3 million for the year ended December 31, 2001. The primary reasons for the increase in profits in 2002 compared to 2001 were restructuring expenses recorded in 2001 and a reduction in other operating expenses in 2002. The increase in profits in 2002 is also the result of lower increases to policy reserves in 2002 and a decrease in death benefits, net of reserves released on traditional death benefits, in 2002. Partially offsetting these increases to income was an increase in amortization expense in 2002 resulting from retrospective adjustments to deferred policy acquisition costs and cost of business acquired due to revised estimates of future gross profits on the Company's universal life-type and annuity products recorded in 2002 and 2001. The Company also recorded net realized investment losses in 2002 versus net realized investment gains in 2001.
The decrease in the fair value of the Company's call options and futures contracts was $1.2 million greater in 2002 than in 2001. The decreases in the fair value of these call options and futures contracts in both 2002 and 2001 were partially offset by the decline in fair value of the embedded derivative component of the Company's equity-indexed annuity liabilities, which is recorded as a reduction to policyholder benefits and referred to below under "Policyholder benefits."
Net realized investment gains and losses. Net realized investment losses increased $9.2 million, to a loss of $7.3 million for the year ended December 31, 2002 from a gain of $1.9 million for the year ended December 31, 2001. Net realized investment gains (losses) for the years ended December 31, 2002 and 2001 were derived from sales, market value adjustments or impairment write-downs of the following (in millions):
The increase in realized investment gains on fixed maturity securities in 2002 resulted from increases in gains on sales of fixed maturity securities, partially offset by an increase in impairment losses recorded by the Company in 2002. Realized investment losses in 2002 include losses on impairments deemed to be other than temporary of $9.3 million on fixed maturity securities and $3.6 million on equity securities. Realized investment losses in 2001 include losses on impairments deemed to be other than temporary of $2.1 million on fixed maturity securities. The Company also records changes in the market value of bonds classified as trading and short sale obligations as realized investment gains and losses. The increase in realized investment gains on other investments in 2002 resulted from the sales in 2002 of invested assets included in reinsurance funds held by reinsurer.
Amortization expense. Amortization expense increased $27.3 million, or 63.6%, to $70.2 million for the year ended December 31, 2002 from $42.9 million for the year ended December 31, 2001. The primary reasons for the increase in amortization expense in 2002 were increases resulting from retrospective adjustments to deferred policy acquisition costs and the cost of business acquired and $7.4 million of amortization expense recorded in 2002 resulting from realized gains from the sales of fixed maturity securities supporting the Company's universal life-type and annuity liabilities.
Provision for income taxes. The provision for income taxes increased $0.3 million, or 5.3%, to $6.0 million for the year ended December 31, 2002 from $5.7 million for the year ended December 31, 2001. The effective tax rate was 24.5% in 2002 and 33.4% in 2001. The Company's effective tax rate in 2002 was lower than in 2001 due to a change in the estimate of the deferred tax liabilities.
Overview. Income before cumulative effect of a change in accounting principle decreased $3.6 million, or 24.2%, to $11.3 million for the year ended December 31, 2001 from $14.9 million for the year ended December 31, 2000. The primary reasons for the decrease in profits in 2001 compared to 2000 were an increase in death benefits, net of reserves released on traditional death benefits, a decrease in surrender charge income on closed blocks of universal life and annuity business, and restructuring expenses recorded in 2001. These decreases in profits were partially offset by lower amortization expense in 2001 resulting from the revisions of estimates of the future gross profits on certain of its universal life-type and annuity products and a decrease in amortization expense in 2001 resulting from lower surrender charge income in 2001.
Net realized investment gains and losses. Net realized investment gains increased $6.6 million, to a gain of $1.9 million for the year ended December 31, 2001 from a loss of $4.7 million for the year ended December 31, 2000. The Company recorded losses on short sale obligations during the years ended December 31, 2001 and 2000 of $1.6 million and $8.3 million, respectively. During the years ended December 31, 2001 and 2000, the Company recorded realized gains on equity securities of $4.6 million and $8.6 million, respectively. The Company also recorded realized losses on fixed maturity investments of $0.6 million and $5.5 million, respectively, during the years ended December 31, 2001 and 2000. Realized investment losses in 2001 include losses on impairments deemed to be other than temporary of $2.1 million on fixed maturity securities.
Other income. Other income decreased $3.7 million, or 34.3%, to $7.1 million for the year ended December 31, 2001 from $10.8 million for the year ended December 31, 2000. The primary reason for this decrease was a reduction in servicing revenue on blocks of business that have been permanently reinsured to other insurance companies.
Amortization expense. Amortization expense decreased $25.1 million, or 36.9%, to $42.9 million for the year ended December 31, 2001 from $68.0 million for the year ended December 31, 2000. The decrease primarily resulted from retrospective adjustments in 2001 to deferred policy acquisition costs and the cost of business acquired resulting from revisions of estimated future gross profits on blocks of universal life and annuity business. The revisions primarily consisted of changes in estimated policy revenues and benefits paid to policyholder account balances. Certain of these revisions resulted from the anticipated impact of settling litigation in which the Company was a defendant. As a result of these changes in estimates, the Company recorded retrospective adjustments during 2001 that increased the cost of business acquired asset by $21.4 million and decreased the deferred policy acquisition cost asset by $3.0 million, which had the effect of reducing amortization expense by $18.4 million in 2001.
Other operating expenses. Other operating expenses decreased $5.9 million, or 7.0%, to $78.5 million for the year ended December 31, 2001 from $84.4 million for the year ended December 31, 2000. Included in other operating expenses for the year ended December 31, 2001 was a $4.0 million increase in the allowance for receivables from agents that the Company has estimated to be uncollectible, $1.5 million of litigation costs and $0.8 million related to the costs of mailing notices to policyholders to comply with federal privacy regulations. The majority of the agent receivables deemed uncollectible were older balances on which related litigation was settled during 2001. Other operating expenses for the year ended December 31, 2000 included $5.6 million of costs associated with the settlement of lawsuits. The remaining $6.6 million net reduction in other operating expenses from 2000 to 2001 reflects the Company's continued efforts to reduce expenses and improve the efficiency of its operations.
Provision for income taxes. The provision for income taxes decreased $1.9 million, or 25.3%, to $5.7 million for the year ended December 31, 2001 from $7.6 million for the year ended December 31, 2000. The Company's effective tax rate was 33.4% in 2001 and 33.7% in 2000.
In connection with the acquisition of The Victory Life Insurance Company in July 1995, Americo issued notes payable to the seller with face amounts aggregating $17.0 million. Of the $17.0 million face amount of notes payable issued to the seller, $5.0 million are scheduled to mature in 2015 and the remaining $12.0 million are scheduled to mature in 24 equal semi-annual installments, the first of which was due in 1995. On December 23, 2002, a subsidiary of Americo purchased the $5.0 million note due in 2015 and $6.0 million of the installment notes from the seller for $5.1 million, resulting in a gain of $1.3 million, which is included in other income in the consolidated income statement. The remaining installment note is recorded in the Company's consolidated financial statements net of $0.6 million unamortized discount, which assumes an effective rate of 11.5%.
The Company has accounted for its investment in the FHC preferred stock as an offset to its own preferred stock in stockholder's equity. Dividends on the Company's preferred stock and dividends received on the FHC preferred stock are both recorded directly to retained earnings.
The surplus debenture payment schedules have been approved by the Texas Department of Insurance. The surplus debentures contain restrictions that prevent United Fidelity from making principal and interest payments if the payments would reduce United Fidelity's statutory capital and surplus below an amount specified in the surplus debenture agreements. The most restrictive minimum capital and surplus requirement contained in the surplus debentures is $37.5 million. United Fidelity's capital and surplus at December 31, 2002 was $123.3 million. Any future payment of principal or interest on these surplus debentures will be limited by the ability of the subsidiaries of United Fidelity to pay dividends to United Fidelity and may be further limited by United Fidelity's RBC requirements.
In order to meet its obligations under the surplus debentures, United Fidelity uses funds generated by its insurance operations and dividends from its insurance subsidiaries. The ability of the insurance subsidiaries to pay dividends is subject to regulatory restrictions. The insurance holding company statutes of Texas, the state in which Americo's insurance subsidiaries are domiciled, regulate payment of dividends by an insurance company to its parent. Generally, without the consent of the Texas Department of Insurance, an insurance company domiciled in Texas may not pay dividends to its parent in excess of the greater of (i) the insurer's prior year statutory net gain from operations, and (ii) 10% of its prior year ending statutory capital and surplus, subject in either case to sufficient earned statutory surplus from which such dividends may be paid. Additionally, an insurance company domiciled in Texas is required to notify the Texas Department of Insurance prior to the payment of ordinary dividends. In addition, Americo Financial is considered commercially domiciled in California. As a result, Americo Financial is subject to similar regulations restricting its ability to pay dividends to United Fidelity under California law.
Currently, Americo anticipates that the capital and surplus of United Fidelity will not be sufficient to allow United Fidelity to make the principal payments on its surplus debentures scheduled in 2005 while leaving adequate capital and surplus in its insurance subsidiaries to support their current and anticipated level of operations. As a result, Americo expects that it will need to refinance its senior subordinated notes prior to their scheduled maturity in 2005. If the Company refinances its senior subordinated notes, it will seek approval from the Texas Department of Insurance to amend the surplus debentures to extend their maturity dates.
The Company believes that its investment portfolio will allow it to satisfy all existing contractual obligations to policyholders. At December 31, 2002, the Company's investment portfolio included the following investments classified as available for sale:
The Company believes these investments could be readily converted to cash.
During 2002, FHC made a capital contribution to Americo, consisting of $30.0 million of cash. Americo in turn contributed this same $30.0 million to United Fidelity. The purpose of the capital contribution was to increase the capital and surplus of the insurance subsidiaries.
Contractual Obligations. The following table summarizes the Company's long-term debt, operating lease and specified other contractual obligations at December 31, 2002 (in thousands):
Financial condition. Stockholder's equity increased $63.7 million, or 25.2%, to $316.0 million at December 31, 2002 from $252.3 million at December 31, 2001. The increase in stockholder's equity in 2002 was the result of net income of $18.7 million, an increase in net unrealized investment gains of $17.4 million and a capital contribution from FHC of $30.0 million. These increases in stockholder's equity in 2002 were partially offset by cash dividends paid to FHC of $2.4 million in 2002, net of dividends received on FHC preferred stock. Net unrealized investment gains in 2002 were recorded due to an increase in the market value of the Company's available for sale fixed maturities and equity securities. See note 4 to the Company's consolidated financial statements included elsewhere in this Form 10-K for further discussion of the components of the change in net unrealized investment gains.
The following table sets forth the composition of the Company's fixed maturity securities according to NAIC designations and Standard and Poor's and Moody's Investor's Service, Inc. ("Moody's") ratings at December 31, 2002 (in thousands):
(1) The ratings set forth above are based on the ratings assigned by Standard and Poor's and Moody's. If Standard and Poor's ratings were unavailable, ratings assigned by Moody's were used. If ratings assigned by Standard and Poor's and Moody's were not equivalent, securities were categorized in this table based upon the rating assigned by Standard and Poor's. Bonds not rated by Standard and Poor's or Moody's are classified for the purpose of the table according to the rating assigned to them by the NAIC as follows: NAIC class 1 is included in the "A" rating; class 2 in "BBB" and classes 3 through 6, "BB or below".
(3) Carrying amount is market value. The amortized cost of available for sale securities at December 31, 2002 was $1,634.5 million.
(4) Carrying amount is market value. The amortized cost of trading securities at December 31, 2002 was $37.1 million.
The Company's policy is to maintain a diversified investment portfolio in order to minimize concentration of risk associated with an individual industry sector. The following table sets forth the Company's government and corporate fixed maturity securities by industries that represent 4% or more of the total portfolio at December 31, 2002:
The Company's invested assets include a portfolio of marketable equity securities with a carrying value of $54.4 million at December 31, 2002. The only common stock holdings which represented more than 10% of the Company's marketable equity securities at December 31, 2002 were $24.2 million of common stock of DST Systems, Inc. and $5.8 million of common stock of Altria Group, Inc.
The Company manages the yield and cash flow variability of its MBS portfolio by:
At December 31, 2002, the Company's investment portfolio included $288.2 million of mortgage loans, which were collateralized primarily by multi-family apartments, office buildings and retail properties located in 28 states. Approximately 27% of the portfolio consisted of multi-family apartments, 23% consisted of office buildings, 27% consisted of industrial properties and 23% consisted of other types of properties. At December 31, 2002, approximately 18% of the Company's mortgage loan portfolio was secured by properties in Missouri, 12% by properties in Texas and 11% by properties in Florida. No more than 10% of the remaining portfolio was secured by properties in any one state.
At December 31, 2002, the Company's invested assets included $183.1 million of policy loans on life insurance and annuity policies. Policy loans are permitted to the extent of a policy's contractual limits and are fully collateralized by policy cash values.
Litigation. Americo and its subsidiaries are named in numerous pending actions as more fully described in Item 3, "Legal Proceedings". The plaintiffs in these actions generally are seeking indeterminate amounts, including punitive and treble damages, and these amounts could be large. There can be no assurance that any one or more of these matters, if adversely determined, will not exceed amounts provided for in the Company's consolidated financial statements or will not have a material adverse effect on the financial condition of the Company.
Because of the restrictions described above under "Financial Condition and Liquidity-Liquidity" that are applicable to surplus debentures and the restrictions on dividends to parents imposed by insurance holding company statutes, a materially adverse outcome in the litigation referred to above could affect the ability of one or more of the Americo's insurance subsidiaries to pay dividends or, in the case of United Fidelity, to make payments under its surplus debentures to Americo. Further, if an insurance subsidiary suffers a materially adverse outcome, the Company might need to contribute capital to the subsidiary so that it could continue to maintain applicable statutory surplus and risk-based capital requirements. See "Business-Regulation-General Regulation" and "Business-Regulation-Risk-Based Capital Requirements". Because Americo is a holding company whose own cash and cash equivalents are limited, Americo might have to dispose of some of its assets to address a significant judgment suffered by it or one of its subsidiaries. Also, a material adverse outcome could affect the ratings that Americo's subsidiaries receive from rating agencies, which could affect their ability to compete. See "Business-Competition and Ratings".
The Company is aware that prevailing interest rates may shift significantly and has strategies in place to manage either an increase or decrease in interest rates. In a rising interest rate environment, the Company's cost of funds would increase over time as it prices its new and existing interest-sensitive and investment products to maintain generally competitive market rates. The Company would seek to invest new and renewal premiums in investments that are high yielding and generally correspond to the duration of its liabilities. The Company believes that liquidity to fund withdrawals would be available through a combination of incoming cash flow, the sale of short-term or floating-rate instruments and maturing short-duration assets; therefore, the Company could avoid the sale of significant amounts of longer duration fixed-rate assets in an unfavorable fixed income market. In a declining interest rate environment, the Company's cost of funds would decrease over time, reflecting lower interest crediting rates on its interest-sensitive liabilities. However, the Company's interest-sensitive liabilities generally carry minimum interest guarantees of 3% on annuities and 3.5% to 4.5% on life insurance, and therefore, the rates at which the Company is required to credit interest to policyholders' accounts may not decline as much as the interest yield on the Company's invested assets. At December 31, 2002, $1,049 million of the Company's policyholder accounts were for policies on which the current interest-crediting rate was equal to the minimum guaranteed rate under the policy. In addition, redemptions of callable fixed-rate investments would likely increase in a declining interest rate environment, causing the Company to reinvest funds at lower yields. To mitigate this risk, the Company has reduced its investment in callable securities. 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.
To reduce the probability of unexpected increases in policy or contract surrenders, which would create a need for increased liquidity, the Company has structured its interest-sensitive life insurance and annuity products to include substantial surrender charges. At December 31, 2002, approximately 62% and 93% of the reserves for the Company's interest-sensitive life insurance and annuity products, respectively, were for policies with surrender charges or otherwise not subject to discretionary withdrawal by the policyholder. Similarly, at December 31, 2002, the aggregate cash surrender values of the Company's interest-sensitive life insurance and annuity products were approximately 88% and 90%, respectively, of the aggregate policyholder fund value.
The Company's equity-indexed annuity products credit interest to the policyholder's account balance based on a percentage (the "participation rate") of the change in external indices over a one or two year period (the "index period"). At the end of each index period, a new index period begins using the then-current account balance and the applicable external index value. The computation of the interest credit is based upon either a one or two year point-to-point calculation or upon a monthly averaging of the applicable index over a one-year period. Some of the Company's equity-indexed annuities allow the policyholder to select a fixed rate for some or all of the account balance. The Company may change the participation rate at the beginning of each index period, subject to any contractually-guaranteed minimums. Some of the products have an additional fee, ranging from 1% to 3%, which is deducted from the interest to be credited. In addition, some products apply an overall maximum limit, or cap, on the amount of interest credits that the policyholder may earn in any one index period. The minimum guaranteed contract values of the Company's equity-indexed annuities are equal to 75% to 90% of the deposits collected plus interest credited at an annual rate of 3% on a cumulative basis.
The Company manages its exposure to changes in the fair value of equity-indexed annuity embedded derivatives by purchasing exchange-traded and over-the-counter indexed call options and futures contracts on the same external index. Profitability on the portion of the equity-indexed annuity products tied to market indices is significantly impacted by the difference between the interest earned on investments and the sum of (1) the cost of underlying call options or futures contracts purchased to match the returns owed to policyholders and (2) the minimum interest guarantees owed to the contract holder, if any. The Company manages the cost of the call options and futures contracts through the terms of the equity-indexed annuities, which permit adjustments to the participation rates, fees or caps, subject to contractually-guaranteed minimums.
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible Assets." SFAS No. 141 supersedes previously issued guidance on accounting for business combinations. SFAS No. 141 eliminates the pooling-of-interests method of accounting for business combinations initiated after July 1, 2001 and also changes the criteria used to recognize intangible assets apart from goodwill.
The FASB issued SFAS No. 143 "Accounting for Asset Retirement Obligations" in August 2001 and SFAS No. 144 "Accounting for Impairment or Disposal of Long-Lived Assets" in June 2001. SFAS No. 143 requires that obligations associated with the retirement of a tangible long-lived asset be recorded as a liability when those obligations are incurred. The liability is initially measured at fair value and the cost is capitalized by increasing the carrying amount of the related long-lived asset. SFAS No. 143 is effective for financial statements for fiscal years beginning after June 15, 2002. The Company does not own long-lived assets of the type that will generally create retirement obligations. Therefore, the adoption of SFAS No. 143 will not affect the Company's consolidated financial statements.
SFAS No. 144 provides guidance on the accounting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" and amends Accounting Principles Board Opinion No. 30 ("APB No. 30") "Reporting Results of Operations - Reporting the Effects of Disposal of a Segment of a Business." SFAS No. 144 requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, entities are no longer required to include under "discontinued operations" operating losses that have not yet occurred. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The adoption of SFAS No. 144 did not have a significant effect on the Company's consolidated financial position or results of operations.
In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 rescinds prior statements that required the classification of gains or losses from the extinguishment of debt as extraordinary. As a result, gains or losses from extinguishments of debt will be classified as extraordinary only if they meet existing accounting criteria. SFAS No. 145 also rescinds SFAS No. 44 "Accounting for Intangible Assets of Motor Carriers" and amends SFAS No. 13 "Accounting for Leases" to require sale-leaseback accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also makes various technical corrections to existing pronouncements. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. As permitted by the adoption provisions of SFAS No. 145, the Company applied the guidance regarding the classification of gains from extinguishment of debt to the repurchase of some of the Company's notes payable in December 2002. These gains were not determined to be extraordinary.
In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This statement provides guidance on the recognition and measurement of liabilities associated with disposal activities. SFAS No. 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Consequently, the Company's consolidated financial statements for 2002 will not be affected by SFAS No. 146.
In November 2002, the FASB issued Interpretation 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 also expands the disclosures required to be made by a guarantor about its obligations under certain guarantees that it has issued. The initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements of FIN 45 were effective immediately. The Company has not issued any guarantees that are currently outstanding.
In January 2003, the FASB issued Interpretation 46 "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 requires companies that control another entity through interests other than voting interests to consolidate the controlled entity. FIN 46 applies to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest in after that date. The related disclosure requirements of FIN 46 are effective immediately. The Company does not expect FIN 46 to have a material impact on its consolidated financial position or results of operations.
In February 2003, the Financial Accounting Standards Board's Derivatives Implementation Group issued SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates both Interest Rate Risk and Credit Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument," or DIG Issue B36. DIG Issue B36 applies to modified coinsurance and coinsurance with funds withheld reinsurance agreements where interest is determined by reference to a pool of fixed maturity assets or a total return debt index. Such arrangements in which funds are withheld by the ceding insurer cause the reinsurer to recognize a receivable from the ceding insurer as well as a liability representing reserves for the insurance coverage assumed under the reinsurance arrangements. The Company does have reinsurance agreements under which it recognizes investment income based upon the return of a specified block of invested assets held by a reinsurer. DIG Issue B36 considers the receivable from the reinsurer to contain an embedded derivative that must be bifurcated and accounted for separately under SFAS No. 133. DIG Issue B36 is tentatively planned to be effective for quarters beginning after June 15, 2003. Currently, the Company does not account for such reinsurance receivables as having an embedded derivative which would be bifurcated and accounted for separately. The Company continues to evaluate the impacts of implementing DIG Issue B36; however, at this time, the Company is unable to estimate the effects on its consolidated financial statements.
The Company's audited consolidated financial statements for the three years ended December 31, 2002 and the related report of independent accountants thereon are set forth at pages to hereof and are incorporated herein by reference. Reference is made to the Index to Financial Statements on page herein.