Life Re's principal operations are conducted from approximately 51,000 square feet of leased office space located at 969 High Ridge Road, Stamford, Connecticut 06905. The lease with respect to such space expires on September 30, 2004. The rental expense paid by Life Re under the lease during 1996 was $.9 million.
(1) In November 1992, Life Re completed an offering of 10.6 million shares of its common stock (the "Offering") with net proceeds to Life Re totaling $100.6 million. At such time Life Re incurred new debt of $165.0 million under a credit agreement (the "1992 Credit Agreement") with a syndicate of banks. Life Re used the net proceeds of the Offering and the borrowings under the 1992 Credit Agreement to redeem all outstanding preferred stock and prepay all existing debt. Costs related to the prepayment were accounted for as an extraordinary charge. Effective November 2, 1995, Life Re amended and restated the 1992 Credit Agreement (the "1995 Credit Agreement"), resulting in the writeoff of related unamortized loan costs which was accounted for as an extraordinary charge.
The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions developed by management. Any adjustments to reported bases of assets or liabilities resulting from changes in estimates are reflected in earnings in the period the estimates are revised. Certain management estimates are based, in part, on information provided by ceding companies. As is usual in the reinsurance business, Life Re's ceding companies periodically update, refine and revise reinsurance information provided to Life Re. The financial effects resulting from the incorporation of revised data are reflected in earnings as changes in estimates.
Life Re is party to several reinsurance agreements for which transactions are denominated in Canadian currency. The assets and liabilities related to such reinsurance agreements are remeasured in U.S. dollars, the functional currency, at current exchange rates as of the end of each reporting period. Deterioration in the exchange rate of Canadian currency could have an adverse effect on results of operations. At December 31, 1996, Life Re had $37.2 million of net assets denominated in Canadian currency. Life Re has not engaged in hedging or any other activities to mitigate the effect on earnings of a deterioration in the exchange rate of Canadian currency.
Life Re's total policy revenues have increased in each year since 1992. However, should Life Re be unable to generate sufficient new business to offset the expected future decline in policy revenues associated with the current business in force due to lapsation and mortality, Life Re's results of operations could be adversely affected.
In 1996, Life Re derived approximately 60% of its policy revenues from the reinsurance of ordinary life insurance policies under agreements with ceding companies which cover new business to be written by the client and/or existing blocks of in force business. This business generally is written on a direct basis and is written under agreements with approximately 450 ceding companies. In 1996, forty-five ceding companies each accounted for at least $1.0 million of ordinary life reinsurance policy revenues and in the aggregate represented approximately 89% of Life Re's ordinary life reinsurance policy revenues.
The Company's group life reinsurance business, which accounted for approximately 5% of policy revenues in 1996, is written on a direct basis and generally is excess of loss and often includes experience rating provisions.
Policy acquisition costs increased by 17% in 1996 and 8% in 1995. These increases reflect the higher volumes of ordinary and group accident and health reinsurance business and the Transactions. As a percentage of policy revenues, policy acquisition costs were 25% in each of 1996, 1995 and 1994.
The effective federal income tax rate was 29% in 1996 compared with the statutory rate of 35%. The federal income tax expense is net of a $4.8 million tax benefit resulting from the reversal of a deferred tax valuation allowance in connection with the realized investment gain on the Nacolah transaction. In 1995 and 1994, the effective federal income tax rate was 35%.
Invested assets at fair value amounted to $1,833.2 million and $1,504.2 million at December 31, 1996 and 1995, respectively. The increase in invested assets in 1996 resulted from the Transactions partially offset by a decrease in unrealized investment gains. Net unrealized gains on invested assets totaled $39.7 million and $82.5 million at year end 1996 and 1995, respectively, and generally reflect the increase in interest rates from period to period.
Life Re's investment policy is designed to maintain a high quality portfolio, maximize current income, maintain a high degree of liquidity, and match the cash flows of the portfolio to the required cash flows of Life Re's liabilities.
At December 31, 1996, approximately $75.8 million (at fair value), or 4%, of Life Re's invested assets consisted of below investment grade securities. Life Re generally limits its investments in fixed maturities that are rated below investment grade, as these investments are subject to a higher degree of credit risk than investment grade securities. Life Re closely monitors its below investment grade securities as well as the creditworthiness of the portfolio as a whole. When fair values decline for reasons other than changes in interest rates or other perceived temporary conditions, the security is written down to its net realizable value. In 1996, 1995 and 1994, Life Re wrote down the value of certain securities by $0.5 million, $0.9 million, and $1.3 million, respectively. Life Re had no fixed maturities in default at December 31, 1996.
The results of operations and the financial condition of Life Re are significantly affected by the performance of its investments and by changes in interest rates. During a period of declining interest rates, if Life Re's investments are prematurely sold, called, prepaid or redeemed, Life Re would be unable to reinvest the proceeds in securities with comparable rates of return. During a period of rising interest rates, the fair value of Life Re's invested assets could decline. In addition, rising interest rates could also cause disintermediation which in turn could cause Life Re to be required to sell investments at prices and times when the fair values of such investments are less than their amortized cost. The Company believes that its traditional life insurance liabilities are not highly interest sensitive and, therefore, the effects of fluctuating interest rates on these liability cash flows are not significant. For interest sensitive liabilities, the Company utilizes asset/liability management to minimize the impact of changes in interest rates. Life Re has not engaged in hedging activities to mitigate the effects of interest rate changes on its invested assets.
The Company's obligations for policy benefit liabilities increased by 33% and 42% during 1996 and 1995, respectively. These increases resulted from the acquisition of REALIC and the Transactions and increased reinsurance of new and in force life insurance business. Policy benefits consist of the present value of net future benefits under traditional ordinary and group life insurance policies, account values under interest sensitive life and annuity contracts, group accident and health claim reserves, life claims payable and other miscellaneous liabilities. Through REALIC and the Transactions, the relative proportion of interest sensitive and annuity policy benefit liabilities to the total has increased significantly and, at December 31, 1996, totaled approximately half of the policy benefits under life insurance contracts.
Interest rates on the loans are variable and, subject to certain restrictions, Life Re may select the applicable interest rate index and the period of applicability.
The 1995 Credit Agreement contains certain covenants which, among other things, restrict under certain circumstances the payment of dividends and repurchase of treasury stock. Further, certain actions of Life Re are limited, including those related to mergers, acquisitions, indebtedness and investments. Life Re and its subsidiaries are required to meet certain financial ratios and maintain a minimum level of statutory surplus.
Under the stock repurchase program initially approved by the Company's Board of Directors during 1995, approximately 2.1 million shares have been purchased under a total authorization of 3.0 million shares. Life Re may use internally generated funds or borrowings under the 1995 Credit Agreement to finance additional purchases of shares, if any, under the repurchase program.
Debt to total capitalization (outstanding debt divided by outstanding debt plus shareholders' equity) decreased significantly during the last two years. As a percentage, these amounts were 30%, 33% and 42% at year-end 1996, 1995 and 1994, respectively. Management believes that, to best balance leverage and regulatory targets, a debt to total capitalization ratio in the range of 25-35% is appropriate.
Sources of liquidity are available to Life Re in the form of cash and short-term investments and, if necessary, the sale of invested assets. The Company also may borrow an additional $35.0 million under the 1995 Credit Agreement and may enter into reverse repurchase agreements to fund short-term cash needs. In addition to its debt servicing and dividend obligations, Life Re's financial obligations consist of policy benefit and acquisition costs, taxes and general operating expenses. During the next twelve months, management believes these obligations will be adequately provided for by policy revenues and investment income.
TexasRe relies primarily on dividends from LRCA to meet its obligations under the surplus debentures as well as to pay dividends to Life Re. TexasRe received dividends from LRCA during 1996, 1995 and 1994 of $14.9 million, $30.9 million, and $13.5 million, respectively.
The payments of dividends by TexasRe and LRCA are subject to restrictions set forth in Texas and Connecticut insurance laws and regulations (see Note 9 of "Notes to Consolidated Financial Statements"). Under Connecticut law, no dividend in an amount exceeding LRCA's earned surplus may be paid without prior regulatory approval. Approval has been received from the Connecticut Department of Insurance to define earned surplus for this purpose to include amounts of paid in surplus in excess of $125.0 million.
Life Re intends to continue its strategy of growth through i) increased reinsurance of ordinary life new business and ii) the expansion of Administrative Reinsurance(service mark) through purchases of in force blocks of insurance business and insurance companies.
In July 1996, Life Re entered into certain agreements with Aon Corporation ("Aon") and certain current and former affiliates of Aon. LRCA reinsures certain automobile credit insurance policies written after June 30, 1996 by an affiliate of Resource Financial Corporation ("RFC"), which is 80% owned by officers and employees of a former affiliate of Aon and 20% (voting and non-voting) owned by Life Re. In addition, Life Re invested $20.0 million in debt and preferred stock of an affiliate of RFC. The majority of the RFC business is retroceded.
The Company believes that consolidation within the insurance industry will continue as companies shed non-core businesses or exit the industry due to operating inefficiencies. Through Administrative Reinsurance(service mark), Life Re expects to participate in this consolidation as it has in place a licensed primary insurer with administrative capabilities with which to effect reinsurance or other acquisition transactions. However, this expansion may be adversely affected by such factors as the availability of capital, the types of business opportunities presented and the competition for such business.
Life Re anticipates financing ordinary reinsurance and Administrative Reinsurance(service mark) growth through internally generated funds. Also, the Company has available an additional $35.0 million under the 1995 Credit Agreement and, if necessary, could attempt to increase the existing facility or pursue other forms of financing. Alternative financing sources include debt and equity markets and the retrocessional marketplace.
Index to Financial Statements and Financial Statement Schedule Life Re Corporation and Subsidiaries
The management of Life Re Corporation has primary responsibility for preparing the accompanying financial statements and for their integrity and objectivity. The financial statements were prepared in accordance with generally accepted accounting principles applied on a consistent basis and are fairly stated in all material respects. The financial statements include amounts that are based on management's best estimates and judgements. Management also prepared the other information presented elsewhere herein and is responsible for its accuracy and consistency with the financial statements.
/s/ Chris C. Stroup Executive Vice President and Chief Financial Officer
We have audited the accompanying consolidated balance sheets of Life Re Corporation and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
The acquisition of REALIC in 1995 (Note 3) provided the Company with the ability to administer primary life insurance business through a third party administrator. Through this Administrative Reinsurance(service mark) platform, the Company acquired closed blocks of business by reinsurance agreement and by acquisition.
The Company is party to several reinsurance agreements for which transactions are denominated in Canadian currency. The assets and liabilities related to such reinsurance agreements are remeasured in U.S. dollars, the functional currency, at current exchange rates as of the end of each reporting period and the resulting adjustments are included in income. Such adjustments reduced net income by $282, $650 and $2,744 in 1996, 1995 and 1994, respectively. Deterioration in the exchange rate of Canadian currency could have an adverse effect on results of operations. At December 31, 1996, the Company had $37,194 of net assets denominated in Canadian currency. The Company has not engaged in hedging or any other activities to mitigate the effect on earnings of a deterioration in the exchange rate of Canadian currency.
Fixed maturities, consisting of bonds and redeemable preferred stocks, and equity securities, consisting of common and nonredeemable preferred stocks, are classified as available for sale and are reported at fair value. Unrealized gains and losses on available for sale securities are recorded directly in shareholders' equity with no effect on income. These amounts are net of deferred income taxes and valuation adjustments which represent the changes in amortization of deferred policy acquisition costs and value of business acquired that would have been recorded as a charge or credit to operations had the relating unrealized gains or losses been realized.
The costs of acquiring new reinsurance business which vary with and are directly related to the production of new business are deferred as policy acquisition costs and amortized. Costs deferred in connection with traditional life insurance products are amortized over the premium paying period of the related policies using assumptions consistent with those used to compute future policy benefits. For annuities and interest sensitive life insurance products, policy acquisition costs are amortized generally in proportion to the present value of expected gross profits from such products. Amortization is adjusted when current estimates of future gross profits are revised.
The value of business acquired represents an estimate of the present value of future profits expected from business in force at the time the Company acquired its insurance subsidiaries. It is amortized with interest based on assumptions developed at the acquisition date regarding the amount and incidence of future profits derived therefrom over the contract periods in relation to premiums for traditional life insurance and to gross profits for annuities and interest sensitive life insurance.
The Company accounts for federal income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities calculated using the tax rate in effect at the measurement date.
Primary earnings per share is computed using the weighted average number of common shares outstanding during the periods presented including, if applicable, the dilutive impact of common stock options.
On July 31, 1995, in a transaction accounted for as a purchase, the Company acquired 100% of the common stock of REALIC, formerly John Deere Life Insurance Company, from two wholly owned subsidiaries of Deere & Company for an adjusted purchase price of $33,335, including direct costs of the acquisition. The fair value of the assets acquired was $391,482 and liabilities assumed aggregated $358,147.
Years Ended December 31, 1995 1994 Revenues $504,821 $467,164 Net income $ 37,892 $ 41,541 Earnings per share $ 2.54 $ 2.68
As of June 30, 1996, REALIC acquired, for an adjusted purchase price of $16,433, 100% of the common stock of two subsidiaries of I.C.H. Corporation in a transaction accounted for as a purchase. The fair value of assets acquired, consisting primarily of invested assets, was $169,276, and the liabilities assumed, principally future policy benefits, aggregated $152,843. By December 31, 1996, these companies had been merged with and into REALIC.
On October 31, 1996, REALIC acquired, for a purchase price of $21,713, 100% of the common stock of New American Life Insurance Company from a subsidiary of General Accident plc. The fair value of assets acquired, consisting primarily of invested assets, was $136,135, and the liabilities assumed, principally future policy benefits, aggregated $114,422. At the purchase date, this company was merged with and into REALIC.
Effective July 1, 1996, the Company purchased 20% of the common stock of Resource Financial Corporation ("RFC") for $200 and on September 30, 1996, purchased $15,000 of preferred stock and $5,000 of long term debt of a wholly owned subsidiary of RFC. RFC and its subsidiary, Resource Life Insurance Company, were organized for the purpose of acquiring certain assets and operations from subsidiaries of Aon Corporation ("Aon"). RFC provides insurance product distribution and administrative and financial services for the retail automobile industry throughout the United States.
In connection with the foregoing transactions, the Company entered into an agreement whereby it pays contingent consideration for a period of five years to a subsidiary of Aon based on premiums produced through RFC subsequent to June 30, 1996.
Securities with a fair value of $110,246 at December 31, 1996 are owned by a ceding company and held in a dedicated portfolio in conjunction with an indemnity reinsurance agreement. Under the terms of the agreement, investment income, realized gains and losses and all other risks and rewards of ownership of the assets in the portfolio inure to the benefit or detriment of the Company. Accordingly, these assets, consisting of $109,895 of fixed maturities classified as available for sale and $351 of short-term investments at December 31, 1996, have been included as investments in the accompanying balance sheet. The portfolio is managed by the Company's primary investment advisor under guidelines approved by both parties to the reinsurance agreement, subject to the requirement that the statutory carrying value of the assets in the dedicated portfolio must be maintained by the Company in an amount at least equal to the statutory reserves on the reinsured business.
Securities with a fair value of $68,204 at December 31, 1996 were on deposit with various governmental insurance regulatory agencies to comply with applicable insurance laws.
Years Ended December 31, 1996 1995 Net unrealized gains on securities $39,745 $82,510 Deferred federal income tax on net unrealized gains 13,910 28,879 Net unrealized gains 25,835 53,631 Adjustment to deferred policy acquisition costs and value of business acquired on interest sensitive life insurance products (1,508) (6,505) Deferred federal income tax benefit on adjustment (527) (2,277) Net adjustment (981) (4,228) Net unrealized appreciation of securities $24,854 $49,403
The amortized cost, unrealized gains and losses and estimated fair values of available for sale securities are as follows(see Note 2 for a discussion of the fair value of financial instruments):
Investments in any entity in excess of ten percent of shareholders' equity at December 31, 1996, other than investments issued or guaranteed by the U.S. Government, are as follows:
Years Ended December 31, 1996 1995 Deferred tax liabilities: Deferred policy acquisition costs $39,047 $20,996 Net unrealized appreciation of securities 13,910 28,879
The Company paid federal income taxes of $13,500, $13,145 and $18,400 in 1996, 1995 and 1994, respectively. At December 31, 1996 income taxes recoverable of $7,937 are included in other assets and at December 31, 1995 income taxes payable of $2,062 were included in other liabilities.
In 1995 and 1994, the effective income tax rate on income before federal income taxes and extraordinary charge did not vary materially from the statutory federal income tax rate. The realized gain on the sale of Nacolah in 1996 (Note 5) and other income permitted the utilization of tax net operating loss carryforwards available to Life Re Corporation and a corresponding reversal of the previously established deferred tax valuation allowance, resulting in a tax benefit of $4,775. This reduced the effective income tax rate in 1996 to 29%.
At December 31, 1996, the outstanding borrowings bear interest at an annual effective rate of 6.0%. Interest paid on outstanding loans was $8,774, $9,807 and $8,146 in 1996, 1995 and 1994, respectively.
The availability of funds to meet obligations, including dividends and debt service, is dependent, in part, on the ability of TexasRe to transfer funds to Life Re Corporation. The subsidiaries are subject to certain state laws and regulations which limit their ability to transfer funds and pay dividends. Generally, the subsidiaries may not, without prior regulatory approval, transfer cash dividends, loans or advances in any twelve month period in excess of the greater of the prior year's statutory operating income or 10% of capital and surplus at the preceding year end. Additionally, under Connecticut law, no dividend in an amount exceeding LRCA's earned surplus may be paid without prior regulatory approval. Approval has been received from the Connecticut Department of Insurance to define earned surplus for this purpose to include amounts of paid in surplus in excess of $125,000.
At December 31, 1996, 2,875,375 shares of authorized common stock are reserved for issuance under two stock option plans, the Life Re Corporation Stock Option Plan and the 1993 Non-Employee Directors Stock Option Plan. The plans provide for the granting to certain officers, employees and directors of nonqualified stock options or incentive stock options. Options are granted at no less than fair value on the date of grant for a period not in excess of ten years. They vest over periods of four to five years or in full upon the occurrence of certain events including a change in control of the Company.
FAS 123 requires the disclosure of pro forma information regarding net income and earnings per share as if the Company had accounted for its employee stock options under the fair value method of FAS 123. The fair value of the options for the pro forma disclosures which follows was estimated using a Black-Scholes option pricing model with the following assumptions for 1996 and 1995, respectively: risk-free interest rates ranging from 5.4% to 6.8% and 6.8% to 7.7%, respectively; dividend yields of 1.0% in each year; volatility factors for the expected market price of the Company's common stock of 25% in each year; and weighted-average expected life of the options of five years.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
Pro forma net income $53,116 $34,299 Pro forma earnings per share $3.82 $2.30
Exercise prices for options outstanding as of December 31, 1996 range from $16.63 to $38.63. The weighted-average remaining contractual life of those options is eight years.
The Company's policy generally is to require collateral from those retrocessionaires not authorized to conduct reinsurance business in Connecticut, LRCA's domiciliary state, in an amount at least equal to the statutory reserves reinsured. Collateral is provided in the form of letters of credit and trust agreements. Amounts receivable from one retrocessionaire at December 31, 1996 accounted for 10.5% of total amounts receivable on reinsurance ceded and is fully collateralized.
Certain reclassifications have been made to the prior year amounts to conform to the current year presentation.