The company's business operations are performed in leased facilities located at 604 Locust Street, 699 Walnut Street, 700 Locust Street and 312 Eighth Street in Des Moines, Iowa and at 1001 Jefferson Street in Wilmington, Delaware. In addition, the company has leased a facility at 230 Park Avenue in New York to carry on business through First Golden American Life Insurance Company of New York, licensed in January 1997. All owned properties consist of real estate held for investment purposes or acquired through foreclosure. Property and equipment primarily represent leasehold improvements at the company's headquarters and at various agency offices, office furniture and equipment and capitalized computer software and are not considered to be significant to the company's overall operations. Property and equipment are reported at cost less allowances for depreciation. The company believes that its present facilities are adequate for its current needs, but has entered into agreements with a developer to develop and lease a 200,000 square foot office building in downtown Des Moines, Iowa to house its Des Moines based operations with occupancy to begin in the third quarter of 1997.
The purpose of this section is to discuss and analyze the company's consolidated results of operations, financial condition and liquidity and capital resources. This analysis should be read in conjunction with the consolidated financial statements and related notes which appear elsewhere in this report. The company reports financial results on a consolidated basis. The consolidated financial statements include the accounts of the company and its subsidiaries, all of which are wholly owned at December 31, 1996. The company's primary subsidiaries are Equitable Life Insurance Company of Iowa ("Equitable Life"), Golden American Life Insurance Company ("Golden American") and USG Annuity & Life Company ("USG").
On August 13, 1996, Equitable of Iowa Companies ("Equitable") acquired all of the outstanding capital stock of BT Variable, Inc. ("BT Variable") and its wholly-owned subsidiaries, Golden American and Directed Services, Inc. ("DSI") for $144,000,000. Golden American is a Delaware stock life insurance company and DSI is a New York corporation and registered broker/dealer and investment adviser. The purchase price consisted of $93,000,000 in cash paid to Whitewood Properties Corporation (parent of BT Variable) and $51,000,000 in cash paid to Bankers Trust (parent of Whitewood) to retire certain debt owed by BT Variable to Bankers Trust. The funds used in completing the acquisition were obtained primarily through a recent offering of securities undertaken by Equitable of Iowa Companies Capital Trust (the "Trust"), an affiliate of Equitable, the proceeds of which were loaned to Equitable in exchange for subordinated debentures issued by Equitable to the Trust. Additional funds were provided by reducing short-term investments of Equitable and its insurance subsidiaries. Funds provided by Equitable's insurance subsidiaries were transferred to Equitable in the form of dividends paid.
The table above includes premiums for Golden American since August 13, 1996. As a result, the premiums provide insight into the reported results of operations. However, the significant increase in variable annuity premiums is primarily attributable to the acquisition of Golden American and significant growth in sales of Equitable Life's variable annuity products. The following table is provided on a pro forma combined basis including Golden American premiums for each of the years ended December 31, 1996, 1995 and 1994.
On a pro forma combined basis, total annuity and life insurance premiums increased 21.6% to $2,080,399,000 in 1996 compared to a decrease of 16.2% to $1,710,450,000 in 1995 from $2,041,765,000 in 1994. Fixed annuity premiums declined for the reasons cited above. Equitable Life introduced its variable annuity product in the fourth quarter of 1994 and premiums from this product have grown dramatically over the last two years although year over year percentage increases have declined due to increases in the amount of in force attributable to this product. Sales of Golden American's variable annuities declined in 1995 primarily due to poor performance of the underlying investment funds. During 1995, the fund offerings underlying Golden American's variable products were improved and a fixed account option was added. These changes have contributed to the significant growth in Golden American's variable annuity premiums from 1995 to 1996. The company expects variable annuity premiums to continue to grow as it expands and diversifies its product offerings and distribution channels, but year over year percentage increases will decline as the amount of variable annuities in force increases. Equitable Life and USG offer interest-sensitive and traditional life insurance products. Golden American offers only variable products, including variable life insurance, and sales of this product are impacted by many of the same factors as variable annuities, including a strong stock market, low interest rates and a flat yield curve. On a pro forma combined basis, fixed annuities accounted for 60.4% of total premiums, variable annuities accounted for 32.9% and life insurance accounted for 6.7% during 1996. Premiums, net of reinsurance, for variable annuity and variable life products from significant sellers on a pro forma combined basis for the year ended December 31, 1996 are as follows: Paine Webber, $136,000,000 or 19%; Smith Barney, $162,000,000 or 23%; Locust Street Securities, Inc., an affiliate, $86,000,000 or 12%; and Primerica Financial Services, $69,000,000 or 10%.
Net investment income increased 11.6% to $715,579,000 in 1996 compared to an increase of 22.3% to $641,094,000 in 1995 from $524,411,000 in 1994 as increases resulting from growth in invested assets were partially offset by a decline in portfolio yield. Excluding Golden American, net investment income increased 10.7% in 1996. The effective average annual yield on assets invested to support policy accounts for interest-sensitive products, including annuities, universal life-type policies and participating life policies, was 8.46% in 1996 compared to 8.60% in 1995 and 8.62% in 1994. The company's total investment portfolio, excluding policy loans, had a yield at amortized cost of 8.2% at December 31, 1996 compared to 8.3% at December 31, 1995 and 1994. During 1996, the company had realized gains on the disposal of investments, which were generated primarily from calls and repayments of fixed maturities, of $16,255,000 compared to realized gains of $9,524,000 in 1995 and $19,697,000 in 1994.
Other income increased 33.7% to $25,869,000 in 1996 compared to an increase of 10.5% to $19,353,000 in 1995 from $17,520,000 in 1994. These increases are primarily attributable to higher income from sales of investment products by the company's broker/dealer operations and advisory fees related to management of the company's variable products. These increases are partially offset by higher commissions paid to registered representatives and accounting, custodial and administrative expenses of variable products operations included in other expenses below, and thus had a minimal impact on income.
At December 31, 1996 and 1995, the effective annual yield on assets, credited rate and interest spread were as follows:
The base interest credited rate represents the average interest rate credited to policy accounts for interest sensitive products, including annuities, interest sensitive life policies and participating policies. The total interest credited rate includes first year bonus interest credited to certain policies.
Most of the company's annuity products have surrender charges which are designed to discourage early withdrawals and to allow the company to recover a portion of the expenses incurred to generate annuity sales in the event of early withdrawal. Withdrawal rates have been impacted by several factors. (1) The company expected and has experienced an increase in withdrawals as its annuity liabilities age. (2) Withdrawals tend to increase in periods of rising interest rates as policyholders seek higher returns on their savings. (3) A block of annuity policies sold in 1988 and 1989 primarily by stockbrokers contained a five-year surrender charge and a portion also contained a five-year interest guarantee. The company planned for, and experienced, higher surrenders related to this block of business. The impact of the higher withdrawal levels on this block of business was reflected primarily in the 1994 financial statements and to a smaller degree in 1995. At December 31, 1996, all policies originally issued from 1988 through December 1991 with a five year interest guarantee represent approximately 1.1% ($77 million) of the company's fixed annuity liabilities. The company has implemented a hedging program which uses certain derivative instruments (interest rate caps and swaptions) to reduce the negative effect of increased withdrawal activity which may result from extreme increases in interest rates (see further discussion of the hedging program in the financial instruments section below).
The following table summarizes the annual annuity withdrawal rates and the life insurance lapse ratios for the years ended December 31, 1996, 1995 and 1994.
Other expenses increased 146.1% to $21,340,000 in 1996 compared to a decrease of 13.6% to $8,672,000 in 1995 from $10,035,000 in 1994. The increase in other expenses resulted from increased commissions paid to registered representatives selling investment products through the company's broker/dealer operations and accounting, custodial and administrative expenses of variable products operations.
On July 23, 1996, Equitable of Iowa Companies Capital Trust ("the Trust"), a consolidated, wholly-owned subsidiary of the company issued $125,000,000 of 8.70% Trust Originated Preferred Securities (see Liquidity and Capital Resources section below for a discussion of this transaction). Pre-tax distributions to the holders of these company-obligated, mandatorily- redeemable preferred securities totaled $4,833,000 in 1996.
Average shares outstanding totaled 31,904,734 in 1996 compared to 31,709,032 in 1995 and 31,612,675 in 1994.
In 1996, the acquisition of Golden American diluted earnings by 8 cents per share, including operations of BT Variable and subsidiaries for the period August 13, 1996 through December 31, 1996 and related financing costs. The acquisition is currently expected to dilute 1997 operating earnings per share by 6 to 10 cents per share. Subsequent to 1997 the acquisition is expected to have a positive impact on earnings per share as opportunities are available to market fixed products through Golden American's distribution channels, expand the distribution of variable products and achieve expense efficiencies. See "Cautionary Statement Regarding Forward-Looking Statements" below.
Investment Portfolio Summary: To support the company's fixed annuities and life insurance products, cash flow was invested primarily in fixed maturity securities. At December 31, 1996, the company's investment portfolio was comprised of the following:
SFAS No. 115 requires the carrying value of fixed maturity securities classified as available for sale to be adjusted for changes in market value, primarily caused by interest rates. While other related accounts are adjusted as discussed above, the insurance liabilities supported by these securities are not adjusted under SFAS No. 115, thereby creating volatility in shareholders' equity as interest rates change. As a result, the company expects that its shareholders' equity will be exposed to incremental volatility due to changes in market interest rates and the accompanying changes in the reported value of securities classified as available for sale, with equity increasing as market interest rates decline and, conversely, decreasing as market interest rates rise.
Due to this potential for distortion in shareholders' equity, fair value disclosure is provided in Note 5 of the accompanying Consolidated Financial Statements. SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires disclosure of fair values for selected financial instruments but does not require disclosure of fair value of life insurance liabilities. Although the company's life insurance liabilities are specifically exempted from this disclosure requirement, estimated fair value disclosure of these liabilities is provided in an effort to more properly reflect changes in shareholders' equity from fluctuations in interest rates.
The percentage of the company's portfolio invested in below investment grade securities increased during 1996. At December 31, 1996, the amortized cost value of the company's total investment in below investment grade securities consisted of investments in 93 issuers totaling $733,182,000, or 7.8%, of the company's investment portfolio compared to 92 issuers totaling $574,284,000, or 7.0%, at December 31, 1995. The company intends to purchase additional below investment grade securities, but it does not expect the percentage of its portfolio invested in below investment grade securities to exceed 10% of its investment portfolio. At December 31, 1996, the yield at amortized cost on the company's below investment grade portfolio was 9.1% compared to 8.1% for the company's investment grade corporate bond portfolio. The company estimates that the fair value of its below investment grade portfolio was $731,363,000, or 99.8% of amortized cost value, at December 31, 1996.
Below investment grade securities have different characteristics than investment grade corporate debt securities. Risk of loss upon default by the borrower is significantly greater with respect to below investment grade securities than with other corporate debt securities. Below investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below investment grade securities usually have higher levels of debt and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The company attempts to reduce the overall risk in its below investment grade portfolio, as in all of its investments, through careful credit analysis, strict investment policy guidelines, and diversification by company and by industry.
The company's fixed maturity investment portfolio had a combined yield at amortized cost of 8.1% at December 31, 1996 and 8.3% at December 31, 1995.
Equity Securities: At December 31, 1996, the company owned equity securities with a combined cost of $48,857,000 and an estimated fair value of $77,181,000. Gross appreciation of equity securities totaled $28,559,000 and gross depreciation totaled $235,000. Equity securities are primarily comprised of the company's investment in shares of the mutual funds underlying the company's registered separate accounts and an investment in a real estate investment trust. The company's investment in the real estate investment trust had an estimated fair value of $61,339,000 and a cost basis of $35,024,000 at December 31, 1996. The estimated fair value of the company's investment is based upon conversion value. Conversion value is derived from the quoted market value of the publicly traded security into which the company's investment can be converted and the issuer's cash flow from operations. As such, changes in operating cash flows or the quoted market price of the issuer may result in significant volatility in the estimated fair value of the company's investment.
Mortgage Loans: Mortgage loans make up approximately 18.4% of the company's investment portfolio. The company resumed active mortgage lending in 1994 to broaden its investment alternatives and has continued to increase the lending activity. Mortgages outstanding increased to $1,720,114,000 from $1,169,456,000 during 1996. The company's mortgage loan portfolio, excluding farm loans, includes 561 loans with an average size of $3,066,000 and average seasoning of 3.6 years if weighted by the number of loans, and 1.9 years if weighted by mortgage loan carrying values. The company's mortgage loans are typically secured by occupied buildings in major metropolitan locations and not speculative developments, and are diversified by type of property and geographic location. At December 31, 1996, the yield on the company's mortgage loan portfolio was 8.3%.
Distribution of these loans by type of collateral is as follows:
At December 31, 1996, one mortgage loan with a carrying value of $41,000 was delinquent by 90 days or more. The company does not expect to incur material losses from its mortgage loan portfolio because of the historically low default rate in the company's mortgage loan portfolio and because the company has been able to recover 99% of the principal amount of problem mortgages that have been resolved in the last three years.
Real Estate: At December 31, 1996, the company owned real estate totaling $8,613,000, including properties acquired through foreclosure valued at $5,322,000.
At December 31, 1996, the company had no investments in default. The company estimates its total investment portfolio, excluding policy loans, had a fair value equal to 102.4% of amortized cost value for accounting purposes at December 31, 1996.
Any unrealized gain or loss on the instruments is off-balance sheet and, therefore, is not reflected in the financial statements. The following table summarizes the amortized cost, gross unrealized gains and losses and estimated fair value on these instruments as of December 31, 1996:
The decline in fair value from amortized cost reflects changes in interest rates and market conditions since the time of purchase.
Present value of in force acquired was established as a result of the recent acquisition of variable annuity and life insurance business in force on Golden American. At December 31, 1996, PVIF was $83,051,000 and amortization totaled $2,745,000 for the period from August 14, 1996 through December 31, 1996.
At December 31, 1996, the company had $1,657,879,000 of separate account assets compared to $171,881,000 at December 31, 1995. The increase in separate account assets is due to the acquisition of Golden American and growth in Equitable Life's variable annuity product. Golden American had separate account assets of $1,207,247,000 at December 31, 1996.
At December 31, 1996, the company had total assets of $12,569,679,000, an increase of 28.6% over total assets at December 31, 1995. The company's goal remains to grow assets at a three year average growth rate of 20%, excluding the impact of SFAS No. 115. See "Cautionary Statement Regarding Forward- Looking Statements" below. This three year average was 25% and 23% in 1996 and 1995, respectively.
Reserves for the company's annuity contracts, including separate account reserves for variable contracts, increased $2,574,633,000, or 36.2%, to $9,678,410,000. Life insurance reserves, including separate account reserves for variable life policies, increased $70,981,000, or 6.0%, to $1,259,671,000. At December 31, 1996, Golden American had reserves of $1,492,064,000. Excluding Golden American, reserves increased 13.9% in 1996.
Separate account liabilities increased $1,485,998,000 to $1,657,879,000 from December 31, 1995 due to the acquisition of Golden American and growth in Equitable Life's variable annuity product. Separate account liabilities attributable to Golden American totaled $1,207,247,000 at December 31, 1996. At December 31, 1996, the company had total liabilities of $11,548,880,000 compared to $8,878,914,000 at December 31, 1995, a 30.1% increase.
At December 31, 1996, stockholders' equity was $895,799,000, or $28.00 per share, compared to $893,932,000, or $28.14 per common share, at year end 1995. Unrealized appreciation of available for sale fixed maturity securities increased stockholders' equity by $76,387,000, or $2.38 per share, after adjustments to deferred acquisition costs and deferred income taxes, at December 31, 1996. At December 31, 1995, unrealized depreciation of available for sale fixed maturity securities, net of adjustments, increased stockholders' equity by $208,932,000, or $6.58 per share. The ratio of consolidated debt to total capital was 16.7% (17.8% excluding SFAS No. 115) at December 31, 1996, up from 15.0% (18.8% excluding SFAS No. 115) at year end 1995. The higher ratio is due to the issuance of additional commercial paper during 1996. At December 31, 1996, there were 31,988,410 common shares outstanding compared to 31,769,490 shares at December 31, 1995.
To enhance short term liquidity and back up its outstanding commercial paper notes, the company maintains a line of credit agreement with several banks. On May 10, 1996, the company amended its agreement to increase the line of credit to $300,000,000 and extend its term to May 10, 2001. The terms of the agreement require the company to maintain certain adjusted consolidated tangible net worth levels. "Adjusted consolidated tangible net worth" is defined as consolidated stockholders' equity, adjusted to exclude the effects of SFAS No. 115, less intangible assets. The most restrictive covenant requires the company maintain adjusted consolidated tangible net worth equal to or in excess of the sum of (1) $490,000,000, plus (2) 50% of consolidated net income from January 1, 1995 to the end of the most recent quarter, plus (3) net proceeds from the issuance of capital stock from January 1, 1995 to the end of the most recent quarter. At December 31, 1996, $303,660,000 of retained earnings were free of restrictions and could be distributed to the company's public stockholders.
Since Equitable of Iowa Companies is a holding company, funds required to meet its debt service requirements, dividend payments and other expenses are primarily provided by its subsidiaries. On August 12, 1996, Equitable Life paid a dividend of $24,000,000 to provide additional funding for the acquisition of Golden American. The ability of Equitable Life and Golden American to pay dividends to the parent company is restricted because prior approval of insurance regulatory authorities is required for payment of dividends to the stockholder which exceed an annual limitation. During 1997, Equitable Life and Golden American could pay dividends to the parent company of approximately $95,363,000 and $2,186,000, respectively, without prior approval of statutory authorities. The company's insurance subsidiaries have maintained adequate statutory capital and surplus and have not used surplus relief or financial reinsurance, which have come under scrutiny by many state insurance departments.
Pursuant to this shelf registration, on July 23, 1996, the Trust, a consolidated, wholly-owned subsidiary of Equitable, issued $125,000,000 of its 8.70% Trust Originated Preferred Securities (the "Preferred Securities"). Concurrent with the issuance of the Trust's Preferred Securities, Equitable issued to the Trust $128,866,000 in principal amount of its 8.70% Subordinated Deferrable Interest Debentures (the "Debt Securities") due July 30, 2026. The sole assets of the Trust are and will remain the Debt Securities and any accrued interest thereon. The interest and other payment dates on the Debt Securities correspond to the distribution and other payment dates on the Preferred Securities. The Debt Securities mature on July 30, 2026, with an option to extend the maturity an additional 19 years, and are redeemable by Equitable, in whole or in part, beginning July 30, 2001. The Preferred Securities will mature or be called simultaneously with the Debt Securities. The Preferred Securities have a liquidation value of $25 per Preferred Security plus accrued and unpaid distributions. As of December 31, 1996, 5,000,000 shares of Preferred Securities were outstanding.
Equitable has obligations under the Debt Securities, the Preferred Securities Guarantee Agreement, the Declaration of Trust, as amended, and the Indenture, as amended by the First Supplemental Indenture. These obligations, when considered together, constitute a full and unconditional guarantee by Equitable of the Trust's obligations under the Preferred Securities. Net proceeds of approximately $120,305,000 from the issuance of $125,000,000 of Preferred Securities were used to fund, in part, the acquisition of BT Variable, a New York Corporation which owns all the outstanding capital stock of Golden American and DSI.
As discussed in the Results of Operations section above, on August 13, 1996, Equitable acquired all of the outstanding capital stock of BT Variable from Whitewood, pursuant to the terms of the Purchase Agreement dated as of May 3, 1996 between Equitable and Whitewood. In exchange for the outstanding capital stock of BT Variable, Equitable paid the sum of $93,000,000 in cash to Whitewood in accordance with the terms of the Purchase Agreement. Equitable also paid the sum of $51,000,000 in cash to Bankers Trust to retire certain debt owed by BT Variable to Bankers Trust pursuant to a revolving credit arrangement. The funds used in completing the acquisition were obtained primarily through a recent offering of securities undertaken by the Trust, the proceeds of which were loaned to Equitable in exchange for subordinated debentures issued by Equitable to the Trust. Additional funds were provided by reducing short-term investments of Equitable and its insurance subsidiaries. Funds provided by Equitable's insurance subsidiaries were transferred to Equitable in the form of dividends paid. Subsequent to the acquisition, the name BT Variable, Inc. was changed to EIC Variable, Inc. ("EIC Variable").
The company's insurance subsidiaries operate under the regulatory scrutiny of each of the state insurance departments supervising business activities in the states where each company is licensed. The company is not aware of any current recommendations by these regulatory authorities which, if they were to be implemented, would have a material effect on the company's liquidity, capital resources or operations.
The company's insurance subsidiaries are assessed contributions by life and health guaranty associations in almost all states to indemnify policyholders of failed companies. In several states the company may reduce premium taxes paid to recover a portion of assessments paid to the states' guaranty fund association. This right of "offset" may come under review by the various states, and the company cannot predict whether and to what extent legislative initiatives may affect this right to offset. Also, some state guaranty associations have adjusted the basis by which they assess the cost of insolvencies to individual companies. The company believes that its reserve for future guaranty fund assessments is sufficient to provide for assessments related to known insolvencies. This reserve is based upon management's current expectation of the availability of this right of offset, known insolvencies and state guaranty fund assessment bases. However, changes in the basis whereby assessments are charged to individual companies and changes in the availability of the right to offset assessments against premium tax payments could materially affect the company's results.
The insurance regulatory framework continues to be scrutinized by various states, the federal government and the NAIC. The NAIC, in conjunction with state regulators, has been reviewing existing insurance laws and regulations. A committee of the NAIC proposed changes in the regulations governing insurance company investments and holding company investments in subsidiaries and affiliates which were adopted by the NAIC as model laws in 1996. The company does not presently anticipate any material adverse change in its business as a result of these changes.
A task force of the NAIC is currently undertaking a project to codify a comprehensive set of statutory insurance accounting rules and regulations. This project is not expected to be completed earlier than 1998. Specific recommendations have been set forth in papers issued by the NAIC for industry review. The company is monitoring and, through an industry trade association, actively participating in this process, but the potential impact of any changes in insurance accounting standards is not yet known.
In 1995, the NAIC adopted Guideline XXXIII, which, based upon liabilities at December 31, 1996, requires the company to increase annuity reserves in its statutory financial statements by approximately $23,000,000. The company has received approval from the Iowa and Oklahoma insurance departments for a three year phase in. The 1996 and 1995 statutory financial statements include an increase in fixed annuity reserves of approximately $7,200,000 and $8,100,000, respectively, pursuant to the requirements of the guideline. The guideline has no effect on financial statements prepared in accordance with GAAP.
Legislative and regulatory initiatives regarding changes in the regulation of banks and other financial services businesses and restructuring of the federal income tax system could, if adopted and depending on the form they take, have an adverse impact on the company by altering the competitive environment for its products. The outcome and timing of any such changes cannot be anticipated at this time, but the company will continue to monitor developments in order to respond to any opportunities or increased competition that may occur.
Derivatives: On June 20, 1996, the FASB issued an exposure draft of its Proposed Statement of Financial Accounting Standards "Accounting for Derivative and Similar Financial Instruments and Hedging Activities". This proposed standard, if adopted in the form presented in the exposure draft, would establish accounting and reporting standards for derivative and other similar financial instruments and for hedging activities which are significantly different than practices currently used by the company and others. The proposed standard would require the recognition of all derivatives in the statement of financial condition and would require that these instruments be measured at fair value. Changes in the fair value of the derivative would be recorded in the enterprise's Statement of Income in the period of change. If certain conditions are met, a derivative may be designated as (1) a fair value hedge, (2) a cash flow hedge, or (3) a foreign currency hedge. Changes in fair value of derivatives designated as fair value hedges would be recognized in earnings in the period of change along with the offsetting gain or loss on the hedged item. For a derivative designated as a cash flow hedge, the gain or loss from changes in fair value would be reported as a component of other comprehensive income (see below) outside of earnings in the period of change and recognized in earnings on the projected date of the forecasted transaction. Changes in fair value of foreign currency hedges would also be reported in other comprehensive income to the extent they offset foreign currency transaction gain or loss. Any excess gain or loss from changes in fair value of the foreign currency hedge would be recognized in earnings. In most cases, the criteria which must be met to qualify for "hedge" treatment are very restrictive and would preclude many common hedging practices in use today. Because of this concern, and the significant volatility in earnings and stockholders' equity which would result from application of the accounting required by the proposed standard, FASB received a large number of comment letters regarding this proposal, most of which were critical of the approach proposed by FASB. As a result of this and other aspects of FASB's procedural requirements for adoption of a new SFAS, FASB is considering various modifications to the accounting and reporting requirements proposed in the exposure draft. The impact on the company's financial statements of any change in accounting for derivatives cannot be estimated until the final form of such requirements is known.
On January 28, 1997, the Securities and Exchange Commission ("SEC") adopted new disclosure rules for derivative financial instruments. The new rules require expanded disclosure of accounting policies for derivatives in footnotes to financial statements, as well as disclosure of quantitative and qualitative information concerning market risk of derivatives and other financial instruments to be presented outside the financial statements. Quantitative disclosures regarding market risk sensitive instruments may be presented as a: 1) tabular presentation of fair value information and contract terms, 2) a sensitivity analysis presenting potential losses in future earnings, fair values or cash flows from hypothetical changes in market rates and prices, or 3) a value at risk presentation of the potential loss in future earnings, fair values or cash flows from market movements over a stated period of time and related probability of such loss. The company will be required to provide the new disclosures for the first time in its financial statements and Form 10K for the period ended December 31, 1998, although the SEC has indicated it expects the expanded accounting policy disclosures in current filings. The company has provided disclosures in its footnotes and Management's Discussion and Analysis which comply with the accounting policy disclosure requirements in addition to much of the required quantitative disclosures. The company is analyzing the rules for additional requirements and will provide required disclosures no later than in its December 31, 1998 financial statements.
4. Other factors affecting the performance of the company, including, but not limited to, market conduct claims and other litigation (including the matters described above in "Accounting and Legal Developments - Litigation" section), insurance industry insolvencies, stock market performance, investment performance of the underlying portfolios of the variable products, variable product design and sales volume by significant sellers of the company's variable products.
CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY - CONTINUED (Dollars in thousands, except per share data)
Organization Equitable Life, Golden American and USG offer various insurance products including deferred and immediate fixed annuities, variable annuities and interest sensitive, traditional and variable life insurance. These products are marketed by the company's career agency force, independent insurance agents, broker/dealers (including brokerage firms) and financial institutions. The company's primary customers are individuals.
Cash and Cash Equivalents For purposes of the consolidated statement of cash flows, the company considers all demand deposits and interest-bearing accounts not related to the investment function to be cash equivalents. All interest-bearing accounts classified as cash equivalents have original maturities of three months or less.
Property and Equipment Property and equipment primarily represent leasehold improvements at the company's headquarters and at various agency offices, office furniture and equipment and capitalized computer software and are not considered to be significant to the company's overall operations. Property and equipment are reported at cost less allowances for depreciation. Depreciation expense is computed primarily on the basis of the straight-line method over the estimated useful lives of the assets.
Future Policy Benefits Future policy benefits for fixed annuity and interest sensitive life products, are established utilizing the retrospective deposit accounting method. Policy reserves represent the premiums received plus accumulated interest, less mortality and administration charges. Interest credited to these policies ranged from 3.00% to 11.00% during 1996, 3.35% to 11.35% during 1995 and 3.50% to 11.35% during 1994. The unearned revenue reserve primarily reflects the unamortized balance of the excess of first year administration charges over renewal period administration charges (policy initiation fees) on fixed annuity and interest sensitive life products and unearned distribution fees discussed below. These excess charges have been deferred and are being recognized in income over the period benefited using the same assumptions and factors used to amortize deferred policy acquisition costs. The liability for future policy benefits for traditional life insurance products has been calculated on a net-level premium basis. Interest assumptions range from 2.75% for 1956 and prior issues to a 9.00% level, graded to 6.00% after twenty years for current issues. Mortality, morbidity and withdrawal assumptions generally are based on actual experience. These assumptions have been modified to provide for possible adverse deviation from the assumptions. Future dividends for participating business (which accounted for 1.5% of premiums and 8.5% of life insurance in force in 1996) are provided for in the liability for future policy benefits.
Dividends per Share of Common Stock For the years ended December 31, 1996, 1995 and 1994, the company paid dividends per share of $0.585, $0.525 and $0.465, respectively.
Dividend Restrictions The company's ability to pay dividends to its stockholders is restricted by certain debt covenants. The most restrictive covenant requires the company to maintain tangible net worth equal to the sum of $490,000,000 plus proceeds from any issuance of capital stock plus one-half of net income recognized subsequent to January 1, 1995. At December 31, 1996, retained earnings available for dividends aggregated $303,660,000. The ability of Equitable Life and Golden American to pay dividends to the parent company is restricted because prior approval of insurance regulatory authorities is required for payment of dividends to the stockholder which exceed an annual limitation. During 1997, Equitable Life and Golden American could pay dividends to the parent company of approximately $95,363,000 and $2,186,000, respectively, without prior approval of statutory authorities.
Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the preparation period. Actual results could differ from those estimates. Management is required to utilize historical experience and assumptions about future events and circumstances in order to develop estimates of material reported amounts and disclosures. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates and assumptions are (1) estimates of fair values of investments in securities and other financial instruments, as well as fair values of policyholder liabilities, (2) policyholder liabilities, (3) deferred policy acquisition costs and present value of in force acquired, (4) fair values of assets received and liabilities assumed in acquisition transactions, (5) net assets for pension and liabilities for postretirement benefits, (6) asset valuation allowances, (7) guaranty fund assessment accruals, (8) deferred tax benefits (liabilities) and (9) estimates for commitments and contingencies including legal matters, if a liability is anticipated and can be reasonably estimated. Estimates and assumptions regarding all of the preceding are inherently subject to change and are reassessed periodically. Changes in estimates and assumptions could materially impact the financial statements.
Reclassification Certain amounts in the 1995 and 1994 financial statements have been reclassified to conform to the 1996 financial statement presentation.
The change in unrealized appreciation (depreciation) on securities at fair value is as follows:
Fixed Maturity and Equity Securities Effective January 1, 1994, the company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". SFAS No. 115 requires companies to classify their securities as "held to maturity", "available for sale" or "trading". On November 15, 1995, the Financial Accounting Standards Board ("FASB") issued a special report allowing companies an opportunity to reassess the classification of their securities holdings pursuant to SFAS No. 115. In response to this opportunity, the company reclassified 100% of the securities in its "held to maturity" category to "available for sale" on December 1, 1995 to maximize investment flexibility. As a result of this reclassification, securities with combined cost totaling $5,250,921,000 and estimated fair value of $5,560,519,000 were transferred from the company's held for investment portfolio to its available for sale portfolio. This transfer caused the net unrealized investment gain component of stockholders' equity to increase by $138,795,000 (net of deferred income taxes of $74,735,000 and an adjustment of $96,068,000 to deferred policy acquisition costs). The company is not, however, precluded from classifying securities as held to maturity in the future. SFAS No. 115 requires the carrying value of fixed maturity securities classified as available for sale to be adjusted for changes in market value, primarily caused by interest rates. While other related accounts are adjusted as discussed above, the insurance liabilities supported by these securities are not adjusted under SFAS No. 115, thereby creating volatility in stockholders' equity as interest rates change. As a result, the company expects that its stockholders' equity will be exposed to incremental volatility due to changes in market interest rates and the accompanying changes in the reported value of securities classified as available for sale, with equity increasing as market interest rates decline and, conversely, decreasing as market interest rates rise. Due to this potential for distortion in stockholders' equity, fair value disclosure is provided in Note 5. SFAS No. 107, "Disclosures about Fair Value of Financial Instruments" requires disclosure of fair values for selected financial instruments but does not require disclosure of fair value of life insurance liabilities. Although the company's life insurance liabilities are specifically exempted from this disclosure requirement, estimated fair value disclosure of these liabilities is provided in an effort to more properly reflect changes in stockholders' equity from fluctuations in interest rates.
At December 31, 1996, net unrealized investment gains on fixed maturity securities designated as available for sale totaled $174,229,000. This appreciation caused an increase in stockholders' equity of $76,387,000 at December 31, 1996 (net of deferred income taxes of $54,164,000 and an adjustment of $43,678,000 to deferred policy acquisition costs). At December 31, 1995, net unrealized investment gains on fixed maturity securities designated as available for sale totaled $467,375,000. This appreciation caused an increase in stockholders' equity of $208,932,000 at December 31, 1995 (net of deferred income taxes of $113,503,000 and an adjustment of $144,940,000 to deferred policy acquisition costs). No fixed maturity securities were designated as held for investment or trading at December 31, 1996 or 1995. Short-term investments, all with maturities of 30 days or less, have been excluded from the above schedules. Amortized cost approximates fair value for these securities. At December 31, 1996, net unrealized appreciation of equity securities of $28,324,000 was comprised of gross unrealized appreciation of $2,244,000 on the company's investment in Equitable Life's registered separate account, gross unrealized appreciation of $26,315,000 on an investment in a real estate investment trust and gross unrealized depreciation of $235,000 on other equity securities. The company's investment in the real estate investment trust had an estimated fair value of $61,339,000 and a cost basis of $35,024,000 at December 31, 1996. The estimated fair value of the company's investment is based upon conversion value. Conversion value is derived from the quoted market value of the publicly traded security into which the company's investment can be converted and the issuer's cash flow from operations. As such, changes in operating cash flows or the quoted market price of the issuer may result in significant volatility in the estimated fair value of the company's investment. The amortized cost and estimated fair value of fixed maturity securities, designated as available for sale, by contractual maturity, at December 31, 1996, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Mortgage-backed Securities The amortized cost and estimated fair value of mortgage-backed securities, which comprise 35% of the company's investment in fixed maturity securities at December 31, 1996, by type, are as follows:
During periods of significant interest rate volatility, the mortgages underlying mortgage-backed securities may prepay more quickly or more slowly than anticipated. If the principal amount of such mortgages are prepaid earlier than anticipated during periods of declining interest rates, investment income may decline due to reinvestment of these funds at lower current market rates. If principal repayments are slower than anticipated during periods of rising interest rates, increases in investment yield may lag behind increases in interest rates because funds will remain invested at lower historical rates rather than reinvested at higher current rates. To mitigate this prepayment volatility, the company invests primarily in intermediate tranche collateralized mortgage obligations ("CMOs"). CMOs are pools of mortgages that are segregated into sections, or tranches, which provide sequential retirement of bonds rather than a pro-rata share of principal return in the pass-through structure. The company owns no "interest only" or "principal only" mortgage-backed securities. Further, the company has not purchased obligations at significant premiums, thereby limiting exposure to loss during periods of accelerated prepayments. At December 31, 1996, unamortized premiums on mortgage-backed securities totaled $4,805,000 and unaccrued discounts on mortgage-backed securities totaled $53,047,000.
Other Investment Information Investment Valuation Analysis: The company analyzes its investment portfolio at least quarterly in order to determine if the carrying value of any of its investments has been impaired. The carrying value of debt and equity securities is written down to fair value by a charge to realized losses when an impairment in value appears to be other than temporary. During 1996, no investments were identified as having an impairment other than temporary. During 1995, the company identified two below investment grade securities as having impairments in value that were other than temporary. As a result of those determinations, the company recognized pre-tax losses of $5,802,000 to reduce the carrying value of the securities to their estimated fair value. These securities were subsequently sold resulting in realized gains totaling $1,200,000 during 1995. During 1994, the company recognized a pre-tax loss of $619,000 to reduce the carrying value of one fixed maturity security to its estimated fair value. At December 31, 1996, one mortgage loan with a carrying value of $41,000 was delinquent by 90 days or more. The carrying value of investments which have been non-income producing for the years ending December 31, 1996 and 1995, totaled $239,000 related to a real estate property.
Hedging Program: During the second quarter of 1996, the company implemented a hedging program under which certain derivative financial instruments, interest rate caps and cash settled put swaptions ("instruments"), were purchased to reduce the negative effects of potential increases in withdrawal activity related to the company's annuity liabilities which may result from extreme increases in interest rates. The company purchased instruments, all during the second quarter, with notional amounts totaling approximately $600,000,000 in interest rate caps and $1,300,000,000 in cash settled put swaptions all of which were outstanding at December 31, 1996. The company paid approximately $21,100,000 in premiums for these instruments. The cost of this program has been incorporated into the company's product pricing. The instruments do not require any additional payments by the company. The agreements for these instruments entitle the company to receive payments from the instruments' counterparties on future reset dates if interest rates, as specified in the agreements, rise above a specified fixed rate (9.0% and 9.5%). The amount of such payments to be received by the company for the interest rate caps, if any, will be calculated by taking the excess of the current applicable rate over the specified fixed rate, and multiplying this excess by the notional amount of the caps. Payments on cash settled put swaptions are also calculated based upon the excess of the current applicable rate over the specified fixed rate multiplied by the notional amount. The product of this rate differential times the notional amount is assumed to continue for a series of defined future semi-annual payment dates and the resulting hypothetical payments are discounted to the current payment date using the discount rate defined in the agreement. Any payments received from the counterparties will be recorded as an adjustment to interest credited. The following table summarizes the contractual maturities of notional amounts by type of instrument at December 31, 1996:
Any unrealized gain or loss on the instruments is off-balance sheet and therefore, is not reflected in the financial statements. The following table summarizes the amortized cost, gross unrealized gains and losses and estimated fair value on these instruments as of December 31, 1996:
The decline in fair value from amortized cost reflects changes in interest rates and market conditions since time of purchase.
Long-term Debt: In February 1995, the company issued $100 million of 8.5% notes, maturing on February 15, 2005, receiving net proceeds totaling $98,812,000, after expenses. The company has contributed $50 million of the proceeds to its insurance subsidiaries and has applied the remaining net proceeds to the repayment of outstanding commercial paper notes. Notes payable bearing interest at 9.3% totaling $49,996,000 at December 31, 1993 were repaid on June 1, 1994. Subordinated installment notes bearing interest at 9% totaling $218,000 at December 31, 1993 were repaid on January 3, 1994.
Interest is imputed on the unamortized balance of PVIF at rates of 7.70% to 7.80%. Amortization of PVIF is charged to expense and adjusted for the unrealized gains (losses) on available for sale securities. Based on current conditions and assumptions as to future events on acquired policies in force, the expected approximate net amortization relating to the beginning balance of the PVIF is as follows:
Income Tax Expense Income tax expenses (credits) are included in the consolidated financial statements as follows:
Income tax expense (credits) attributed to realized gains and losses on investments amounted to $5,689,000, $3,333,000 and $6,744,000 for the years ended December 31, 1996, 1995 and 1994, respectively. The effective tax rate on income before income taxes and equity income (loss) is different from the prevailing federal income tax rate as follows:
The Internal Revenue Service ("IRS") is currently examining, or has examined, the company's consolidated income tax returns through 1992. The 1993, 1994 and 1995 consolidated income tax returns remain open to examination. Management believes amounts provided for income taxes are adequate to settle any adjustments raised by the IRS.
Deferred Taxes The tax effect of temporary differences giving rise to the company's deferred income tax assets and liabilities at December 31, 1996 and 1995, is as follows:
The non-qualified stock options are compensatory, and require the accrual of compensation expense over the period of service from the date the options are granted until they become fully exercisable if market values exceed the option price on the measurement date. No expense was recognized during 1996. During the years ended December 31, 1995 and 1994, compensation (income)/expense of $(4,000) and $16,000, respectively, was recognized related to these options.
Postretirement Benefit Plans The company sponsors plans that provide postretirement medical and group term life insurance benefits to full-time employees and agents who have worked for the company for five years or had been hired, had attained age 50 and had a combined age and years of service of 60 or more before January 1, 1992. The medical plans are contributory, with retiree contributions adjusted annually, and contain other cost-sharing features such as deductibles and coinsurance. The accounting for these plans anticipates that the company's contributions will increase annually by the lesser of the health care inflation rate or 3%, with increases in excess of these amounts borne by the employee or agent. All payments of the liability for group-term life insurance are funded by the company on a pay-as-you-go (cash) basis. The company has chosen not to fund any amounts in excess of current benefits. The following table sets forth the amounts recognized in the company's consolidated balance sheet:
Vulnerability from Concentrations: The company has various concentrations in its investment portfolio (see Note 3 for further information). The company's asset growth, net investment income and cash flow are primarily generated from the sale of individual fixed annuity policies, variable products and associated future policy benefits and separate account liabilities. Substantial changes in tax laws that would make these products less attractive to consumers, extreme fluctuations in interest rates or stock market returns which may result in higher lapse experience than assumed, could cause a severe impact to the company's financial condition. The company has purchased interest rate caps and swaptions for its hedging program (see Note 4) to mitigate the financial statement impact of significant increases in interest rates.
12. SUMMARY OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) AND DIVIDENDS PAID ______________________________________________________________________________
We have audited the accompanying consolidated balance sheets of Equitable of Iowa Companies and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Equitable of Iowa Companies and subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 3 to the consolidated financial statements, in 1994 the company changed its method of accounting for certain investments in debt securities.
The accompanying financial statements of Equitable of Iowa Companies have been prepared by management, which is responsible for their integrity and objectivity. The statements have been prepared in conformity with generally accepted accounting principles appropriate in the circumstances and are not misstated due to material error or fraud. These statements include some amounts that are based upon management's best estimates and judgments. Financial information contained elsewhere in this annual report is consistent with that contained in the financial statements. In meeting its responsibility for the integrity of the financial statements, management relies on the company's system of internal control. This system is designed to provide reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. The company maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. The company's financial statements have been audited by Ernst & Young LLP, independent auditors. In connection with this audit, Ernst & Young LLP performed examinations in accordance with generally accepted auditing standards, which include a review of the system of internal control and assurance that the financial statements are fairly presented. Management has made pertinent records available to Ernst & Young LLP and, furthermore, believes that all representations made to Ernst & Young LLP during its audit were valid and appropriate.