In October 2002, we entered into a lease agreement for office space in Duluth, Georgia. The initial lease term, as amended, is thirty-six months, with the option to extend the term an additional thirty-nine months, expiring in January 2009. Payments under this lease are $125,842 annually through October 2005. The lease payments are subject to an annual increase of approximately 3%. We do not own or lease any other properties.
Global Preferred provides reinsurance solutions for the life insurance and annuity industry. However, while the Reorganization Agreement is in effect, Global Preferred Holdings, Inc. and Global Preferred Re must obtain prior written consent from AEGON and GAC to enter into new reinsurance agreements. Our principal business objective is to align the long-term interests between independent marketing organizations and life insurance companies. Through these collaborative relationships, we believe both the IMOs and insurers benefit from mutually rewarding relationships based on aligned interests, a dedication to improving the quality of business written, and a focus on managing insurance and distribution risk for long-term economic rewards.
Although our reinsurance business is directed to us through these independent agent relationships, the life insurance and annuity policies that we currently reinsure are underwritten and issued by various ceding life companies. In the insurance industry, the term “ceding” refers to the use of reinsurance to transfer from one insurance company to another some or all of the risks associated with one or more insurance policies. We often refer to a life insurance company that reinsures life insurance and annuity policies through us as a “ceding life company.” The strength of our current reinsurance business is based on our historical relationship with the independent agents of World Financial Group.
Under a reinsurance agreement, the economic consequences of certain insurance risks are transferred from the ceding life company to the reinsurer. Depending upon the type of reinsurance agreement, these risks may include mortality, persistency, investment and expense. Key considerations in evaluating the risks include:
Renewable Term. Renewable term, also referred to as risk premium reinsurance, which includes monthly renewable term and yearly renewable term, is a plan of reinsurance in which the premium rates are not directly related to the premium rates on the original plan of insurance. Under renewable term reinsurance, the ceding life company reinsures a portion of the mortality risk with us. The amount reinsured in any one period is not based on the face amount of the policy, but rather on the portion of the
Modified Coinsurance. Modified coinsurance is similar to coinsurance except the ceding life company does not transfer the reserves or the invested assets related to the reserves. Modified coinsurance is used primarily for products that develop cash values and allows the ceding life company to retain the associated assets for investment purposes.
Reinsurance Expenses. Regardless of the type of reinsurance, our related expenses may include: (1) benefits, claims and settlement expenses, which represent our share of the payments made under the reinsured policies during the period, the change in claims in course of settlement and the change in claims incurred but not reported; (2) expense allowances paid to the ceding life company for expenses associated with the reinsured policies, including commissions and costs associated with underwriting, marketing, policy issue and maintenance; and (3) amortization of deferred acquisition costs, which are discussed in more detail below.
Net Income. Our profitability, in part, depends on the volume of policies reinsured and experience of the reinsured policies. Factors that affect the experience of the business include reinsured policy persistency, death claims and investment performance of the separate account balances. While death
Deferred acquisition costs are amortized over the lives of the underlying policies, in conformity with the terms of the reinsurance agreement. Under the renewable term agreements, deferred acquisition costs are amortized in proportion to the premium revenue related to the mortality risk reinsured. Such premium revenue is estimated using the same assumptions used for computing liabilities for future policy benefits. Such assumptions include estimates of expected investment yields, mortality, persistency and expenses applicable at the time the policies are reinsured. Original assumptions on renewable term business continue to be used in subsequent accounting periods to determine changes in the deferred acquisition costs unless a premium deficiency exists. Under the renewable term agreements, the amortization is in proportion to the ratio of premiums collected during the then current period to total anticipated premiums and is adjusted to reflect actual persistency of the insurance in force.
A material component of variable life and annuity product revenues is derived from the asset-based fees that have been assessed against the policy account balances, of which a considerable portion is invested in the equity markets. The volatility of equity market returns over the short-term can be significant without materially impacting long-term equity market returns. Historical equity market performance shows equity market volatility is much higher over short term horizons as compared to long-term horizons. The short-term volatility of the policy account balance would result in a proportional adjustment to all future expected gross profits if no other adjustments were made to account for the differences between long-term and short-term volatility. To account for the differences between long-term and short-term volatility, we utilize a “credibility approach.” Under this approach, the estimates of future expected gross profits are adjusted to recognize the effects short-term volatility and market yields have upon long-term yield expectations. We review our approach annually to determine if additional adjustments to amortization are necessary as a result of prolonged and/or severe negative or positive equity market performance. In such instances, the equity market performance must be sufficiently high or low to justify a belief that the effect of current market conditions on future expected gross profits should be more permanently reflected.
In addition, certain variable annuity policies we reinsure include a death benefit typically equal to the greater of (i) a return of premium or (ii) the highest level the policy account balance had accumulated over certain prescribed periods under the annuity policy. Upon the death of an annuity policyholder, we will incur a claim expense equal to the excess, if any, of the amount guaranteed under this provision over the then current policy fund value. The claim expense, as a percentage of the death benefit, tends to increase when equity markets decline and decrease when equity markets increase. The claim expense depends, in part, on the number and amount of death claims incurred. To account for the expense associated with these guaranteed minimum death benefits, we utilize an explicit method consistent with Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. Under this method, we may establish a guaranteed minimum death benefit (“GMDB”) liability if expected future claims expenses are not proportionate to future expected policy charges. Future expected gross profits are reduced to account for future expected claims expenses and adjusted for anticipated changes in the GMDB liability. The short-term volatility of the policy account balance will result in significant volatility in the expected claims expense and in the GMDB liability balance if no recognition is made to acknowledge differences between long-term yields and short-term volatility. Using a credibility approach, our explicit method recognizes the effect of long-term versus short-term volatility when accounting for guaranteed minimum death benefits. The implementation of SOP 03-1 did not have a material impact on our financial condition and results of operations in 2004 because the methodology to account for minimum guaranteed death benefits prescribed in SOP 03-1 resulted in liability and deferred acquisition cost balances that were materially consistent with the liability and deferred acquisition cost balances that resulted from the methodology we historically employed.
Realized gains or losses on sales of investments are included in income, as are write-downs of securities where declines in value are deemed to be other-than-temporary. In determining whether a decline in market value on our fixed income securities is other-than-temporary, we consider the cause of the impairment, the length of impairment, the amount of impairment as a percentage of the fair value of the security and other relevant information about the issuer or security. Although we utilize an independent investment manager to invest and manage our assets in accordance with our investment guidelines, we have the ability and intent to hold these securities until a forecasted recovery of fair value is at least equal to the amortized cost or until maturity. The cost of investment securities sold is determined based upon the specific identification method.
Under our reinsurance agreements with the ceding life companies, we currently reinsure variable life insurance and variable annuity policies on either a renewable term basis or a coinsurance and modified coinsurance basis. The policies we reinsure on a renewable term basis represented 58% of our reinsurance revenues for the year ended December 31, 2004. The policies we reinsure on a coinsurance and modified coinsurance basis represented 42% of our reinsurance revenues for the same period. Of the 42%, 24% relates to variable life insurance policies and 18% relates to variable annuity policies.
Premiums. Premiums decreased $584,000, or 3%, from $18.0 million for the year ended December 31, 2002 to $17.4 million for the same period in 2003. The majority of the premium decrease
was due to the decreased business in force under our renewable term agreements, which was partially offset by an increase in the average premium per policy. Policies in force decreased because the number of policy surrenders and lapses exceeded the number of new policies reinsured. Average premiums per policy increase as the insured grows older.
Reinsured Policy Revenues. Reinsured policy revenues decreased $1.1 million, or 8%, from $13.9 million for the year ended December 31, 2002 to $12.8 million for the same period in 2003. This decrease was primarily attributable to a decline in mortality and expense charges and asset-based allowances resulting from a decline in average account balances in 2003 as compared to the same periods in 2002 and the effect of policy surrender activity for our variable annuity business.
Net Investment Income and Net Realized Gain on Investments. Net investment income decreased $335,000, or 45%, from $742,000 for the year ended December 31, 2002 to $407,000 for the same period in 2003, primarily due to the decreased size of our fixed maturity securities portfolio during 2003 as compared to 2002. The decrease in our fixed maturity securities portfolio resulted from the sale of $9.9 million of fixed maturity securities in 2002, with $8.5 million of such amount being sold in December 2002. The proceeds of these sales were predominantly held in cash and cash equivalents during 2003. Net realized gain on investments decreased $406,000, from $428,000 for the year ended December 31, 2002 to $21,000 for the same period in 2003. The decrease was due to the sale of $9.9 million of fixed maturity securities in 2002 as compared to sales of only $421,000 of securities in 2003. Net realized gains are caused by a decline in market yields, which resulted in an increase in the fair value of the fixed maturity securities in our portfolio.
Amortization of Deferred Acquisition Costs. Amortization of deferred acquisition costs decreased $1.5 million, or 21%, from $7.0 million for the year ended December 31, 2002 to $5.5 million for the same period in 2003. The decrease in amortization primarily resulted from additional amortization in 2002 due to the then higher than expected surrender experience, including “unlocking” our near term surrender assumptions to reflect the increase in our surrender experience (akin to the then industry-wide surrender experience).
As of December 31, 2004, the fixed maturity portion of our invested asset portfolio had a dollar weighted average Moody’s rating of Aa2, an average duration of 2.9 years and an average yield to maturity of 4.1% before investment expenses.
The following table summarizes the composition of the fair value of our fixed maturity securities portfolio at the dates indicated by rating as assigned by S&P or Moody’s, using the higher of these ratings for any security where there is a split rating.
Operating Cash Flows. Under the renewable term reinsurance agreements, premiums typically vary in proportion with the expected mortality claims reinsured. Our cash inflows under the renewable term agreements are premiums for the mortality risk reinsured. Our cash outflows are reinsurance expense allowances and death benefit claims. The reinsurance expense allowances represent our share of acquisition
Net cash flows provided by (used in) investing activities were $9.3 million, ($15.0 million) and ($3.2 million) for the years ended December 31, 2002, 2003 and 2004, respectively. The cash flows used in investing activities of $3.2 million in 2004 primarily related to our purchase of $6.8 million of fixed maturity securities, which was partially offset by the sale of $1.0 million of fixed maturity securities and $2.0 million of equity securities and the maturities and principal payments of $700,000 on fixed maturity securities. The cash flows used in investing activities of $15.0 million in 2003 primarily related to our purchase of $14.3 million of fixed maturity securities and $2.5 million of equity securities. The cash flows provided by investing activities of $9.3 million in 2002 were the primarily the result of $10.5 million of proceeds generated from the sale and maturity of available for sale securities. We incurred no significant capital expenditures during 2004.
Financing Cash Flows. Financing cash flows relate primarily to activities associated with our capital position. Net cash flows used in financing activities were $1.1 million, zero and $5.0 million for the years ended December 31, 2002, 2003 and 2004, respectively. Cash flows used in financing activities in 2004 related to the principal payment due to Money Services for the five-year term note. There were no cash flows provided by or used in financing operations in 2003. Cash flows used in financing activities in 2002 related to the withdrawal of the registration statement in October 2002 for our proposed initial public offering of 9.5 million shares of common stock. The registration statement was withdrawn due to unfavorable market conditions. Cash flows used in financing activities resulted in $1.7 million of deferred offering costs expenses in 2002, offset by $577,000 of cash paid for deferred offering costs in 2001, which had been previously recorded as prepaid expenses on the consolidated balance sheet.
At December 31, 2004, we had written all of our reinsurance business in U.S. dollars. If, in the future, we write business in currencies other than the U.S. dollar, we intend to invest a portion of the premiums collected on the reinsurance contract in securities denominated in the same foreign currency as the premium received. We also intend to consider and evaluate our foreign currency exchange risk and hedge our exposure.
Certain statements made in this report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 and are subject to the “safe-harbor” provisions of that Act. Additionally, any written or oral statements made by us or on our behalf may include forward-looking statements that reflect our current views with respect to future events and financial performance. These statements may include, but are not limited to statements relating to reinsurance revenues, gross profits, cash flows, and net income in future periods. Such statements often include the words “believes,” “expects,” “assumes,” “predicts,” “continue,” “potential,” “should,” “could,” “can,” “may,” “will,” “proposes,” “anticipates,” “intends,” “plans,” “estimates,” “projects,” and variations or negations of such expressions or similar expressions. When we make forward-looking statements, we are basing them on our management’s beliefs and assumptions, using information currently available to us. Because such forward-looking statements involve risks, both known and unknown, and uncertainties, there are important factors
Our inability to consummate the transactions contemplated in the Reorganization Agreement;
Changes in economic conditions, including interest rate and equity market conditions, which could affect our investment portfolio and reinsured policy revenues.
Consolidated Statements of Stockholders’ Equity and Comprehensive Income for the years ended December 31, 2002, 2003 and 2004
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2003 and 2004