The Company’s executive offices and its principal office are in leased premises at 733 Third Avenue, New York, New York 10017. The Company, through an affiliate, also leases office space in Los Angeles and Woodland Hills, California.
deferred acquisition costs (“DAC”) based on a percentage of expected gross profits (“EGPs”) over the life of the underlying policies. EGPs are computed based on assumptions related to the underlying policies written, including their anticipated duration, net spreads earned during the life of the contracts, costs of providing policy guarantees and the level of expenses necessary to maintain the policies. The Company revises future DAC assumptions, referred to herein as a DAC unlocking, when estimates of future gross profits to be realized on its annuity policies are revised. Increases in future EGPs may result from higher interest spread and/or lower surrender rate assumptions, while decreases in future EGPs may result from lower interest spread and /or higher surrender rate assumptions. DAC amortization for the current period is reduced when future EGPs are increased and increased when future EGPs are decreased.
Net investment spread totaled $43.0 million in 2003, $38.7 million in 2002 and $37.8 million in 2001. These amounts equal 2.04% on average invested assets (computed on a daily basis) of $2.11 billion in 2003, 2.68% on average invested assets of $1.44 billion in 2002 and 2.65% on average invested assets of $1.43 billion in 2001. The decrease in the net investment spread rate was primarily due to the investment of new deposits into invested assets with shorter durations than the Company’s fixed rate liabilities. The components of net investment spread were as follows:
Growth in average invested assets resulted primarily from increased sales in the latter half of 2002 and in 2003 relating to the marketing of fixed annuities through an affiliate, AIG Annuity. Contributing to the increased sales in 2002 was higher demand for guaranteed fixed-return products, as investors sought security in an uncertain market environment. Changes in average invested assets also reflect sales of fixed account options of the Company’s variable annuity products, and renewal deposits on its universal life products (“UL Deposits”). Sales of fixed annuities and fixed account options (“Fixed Annuity Deposits”) and UL Deposits totaled $1.29 billion in 2003, $400.0 million in 2002 and $76.9 million in 2001, and are primarily fixed annuity deposits. On an annualized basis, these deposits represent 84%, 31% and 5% respectively, of the related reserve balances at the beginning of the respective periods. The increase in Fixed Annuity Deposits in 2003 is due primarily to increased sales relating to the marketing of fixed annuities through AIG Annuity.
Interest expense totaled $76.7 million in 2003, $58.7 million in 2002 and $63.1 million in 2001. The average rate paid on all interest-bearing liabilities was 3.84% in 2003, compared with 4.39% in 2002 and 4.70% in 2001. Interest-bearing liabilities averaged $2.00 billion during 2003, $1.34 billion during 2002 and $1.34 billion during 2001. The decline in overall rates paid in 2003 compared to 2002 resulted primarily from the impact of a declining interest rate environment, as the Company issued new fixed annuities at rates substantially below the prior year average rates. The decline in overall rates paid in 2002 compared to 2001 resulted primarily from the impact of a declining interest rate environment and the continued reduction of crediting rates on certain closed blocks of business.
million and $17.3 million, respectively. Thus, net realized gains from sales and redemptions of investments totaled $5.5 million in 2003, compared with net realized losses from sales and redemptions of investments of $0.5 million in 2002 and $2.0 million in 2001.
SURRENDER CHARGES on fixed annuity, variable annuity and universal life contracts totaled $1.7 million in 2003, $1.9 million in 2002 and $2.1 million in 2001. Surrender charge periods range from zero to nine years from the date a deposit is received. Surrender charges generally are assessed on withdrawals at declining rates. Withdrawal payments, which exclude claims and annuitization payments, totaled $185.9 million in 2003 compared with $212.9 million in 2002 and $257.3 million in 2001. These payments, when expressed as a percentage of average related reserves, represent 7.9%, 12.1% and 14.2% for 2003, 2002 and 2001, respectively.
AMORTIZATION OF DEFERRED ACQUISITION COSTS totaled $20.6 million in 2003 compared with $16.4 million in 2002 and $11.6 million in 2001. The increase in amortization in 2003 was primarily related to the substantial increase in fixed annuity deposits, as well as the impact of increased net investment gains, partially offset by a DAC unlocking. The increase in amortization in 2002 was primarily related to the impact of decreased net investment losses.
GUARANTEED MINIMUM DEATH BENEFITS on variable annuity contracts totaled $0.8 million in 2003 compared with $1.7 million in 2002 and $0.5 million in 2001. The decrease in 2003 in such benefits reflects the upturn in the equity markets in 2003. The increase in 2002 in such benefits reflects the downturn in the equity markets since 2000. Further downturns in the equity markets could increase these expenses.
A majority of the Company’s variable annuity products are issued with a death benefit feature, which provides that, upon the death of a contractholder, the contractholder’s beneficiary will receive the greater of (1) the contractholder’s account value, or (2) a guaranteed minimum death benefit that varies by product (the “GMDB”). The Company bears the risk that death claims following a decline in the financial markets may exceed contractholder account balances, and that the fees collected under the contract are insufficient to cover the costs of the benefit to be provided. In accordance with Generally Accepted Accounting Principles, the Company expenses such benefits in the period incurred, and therefore does not provide reserves for future benefits. However, effective January 1, 2004, the Company will be required to record a liability for GMDBs (see Note 2 of notes to financial statements).
INVESTMENTS AND CASH at December 31, 2003 totaled $3.17 billion, compared with $1.71 billion at December 31, 2002. The Company’s invested assets are managed by a subsidiary of AIG. The following table summarizes the Company’s portfolio of bonds and notes (the “Bond Portfolio”) and other investments and cash at December 31, 2003 and December 31, 2002:
THE BOND PORTFOLIO, which constituted 84% of the Company’s total investment portfolio at December 31, 2003, had an aggregate fair value that was $40.2 million greater than its amortized cost at December 31, 2003, compared with an aggregate fair value that was $35.0 million greater than its amortized cost at December 31, 2002. The increase in net unrealized gains on the Bond Portfolio during 2003 principally reflects the decline in prevailing interest rates and the corresponding effect on the fair value of the Bond Portfolio at December 31, 2003.
At December 31, 2003, the Bond Portfolio had an aggregate carrying value (i.e. fair value) of $2.66 billion and an aggregate amortized cost of $2.62 billion. At December 31, 2003, the Bond Portfolio included $2.40 billion of bonds rated by Standard & Poor’s (“S&P”), Moody’s Investors Services (“Moody’s”), Fitch (“Fitch”) or the National Association of Insurance Commissioners (“NAIC”), and $261.5 million of bonds rated by the Company pursuant to statutory ratings guidelines established by the NAIC. At December 31, 2003, approximately $2.50 billion of the Bond Portfolio was investment grade, including $652.7 million of U.S. government/agency securities and mortgage-backed securities (“MBS”).
The table on the following page summarizes the Company’s rated bonds by rating classification as of December 31, 2003.
Trading at a significant discount to par, amortized cost (if lower) or cost for an extended period of time;
Once a security has been identified as potentially impaired, the amount of such impairment is determined by reference to that security’s contemporaneous market price.
No impairment charge with respect to any one single credit was significant to the Company’s financial condition or results of operations and no individual impairment loss exceeded 10% of the Company’s net income for the year ended December 31, 2003.
At December 31, 2003, the Company’s Bond Portfolio had gross unrealized gains of $64.2 million and gross unrealized losses of $24.0 million. No single issuer accounted for more than 10% of unrealized losses.
At December 31, 2003, the fair value of the Company’s Bond Portfolio aggregated $2.66 billion. Of this aggregate fair value, approximately 0.3% represented securities trading at or below 75% of amortized cost. The impact of unrealized losses on net income will be further mitigated upon realization, because realization will result in current decreases in the amortization of certain deferred acquisition costs and decreases in income taxes.
Senior secured loans (“Secured Loans”) are included in the Bond Portfolio and aggregated $70.5 million at December 31, 2003. Secured Loans are senior to subordinated debt and equity and are secured by assets of the issuer. At December 31, 2003, Secured Loans consisted of $41.0 million of privately traded securities and $29.5 million of publicly traded securities. These Secured Loans are composed of loans to borrowers spanning 13 industries, with 26% of these assets concentrated in the electric industry, 21% concentrated in the food industry and 14% concentrated in each of financial institutions and transportation. No other industry concentration constituted more than 10% of these assets.
MORTGAGE LOANS aggregated $215.5 million at December 31, 2003 and consisted of 81 commercial first mortgage loans with an average loan balance of approximately $2.7 million, collateralized by properties located in 26 states. Approximately 45% of this portfolio was office, 21% was multifamily residential, 13% was retail, 12% was industrial, and 9% was other types. At December 31, 2003, approximately 27% of this portfolio was secured by properties located in California, approximately 12% by properties located in Texas, approximately 10% by properties located in both Michigan and New York and no more than 10% of this portfolio was secured by properties located in any other single state. At December 31, 2003, four mortgage loans had an outstanding balance of $10.0 million or more, which collectively aggregated approximately 22% of this portfolio. At December 31, 2003, approximately 20% of the mortgage loan portfolio consisted of loans with balloon payments due before January 1, 2007. During 2003, 2002 and 2001, loans delinquent by more than 90 days, foreclosed loans and restructured loans have not been significant in relation to the total mortgage loan portfolio.
POLICY LOANS totaled $35.3 million at December 31, 2003, compared to $36.1 million at December 31, 2002 and primarily represent loans taken against universal life insurance policies.
SECURITIES LENDING COLLATERAL totaled $154.8 million at December 31, 2003, compared to $29.6 million at December 31, 2002, and consisted of cash
collateral invested in highly rated short-term securities received in connection with the Company’s securities lending program. Although the cash collateral is currently invested in highly rated short-term securities, the applicable collateral agreements permit the cash collateral to be invested in highly liquid short and long-term investment portfolios. At least 75% of the portfolio’s short-term investments must have external issue ratings of A-1/P-1, one of the highest ratings for short-term credit quality. Long-term investments include corporate notes with maturities of five years or less and a credit rating by at least two nationally recognized statistical rating organizations (NRSRO), with no less than a S&P rating of A or equivalent by any other NRSRO.
There are risks associated with some of the techniques the Company uses to provide liquidity, enhance its spread income and match its assets and liabilities. The primary risk associated with the Company’s Dollar Roll Repos is counterparty risk. The Company believes, however, that the counterparties to its Dollar Roll Repos are financially responsible and that the counterparty risk associated with those transactions is minimal. It is the Company’s policy that these agreements are entered into with counterparties who have a debt rating of A/A2 or better from both S&P and Moody’s. The Company continually monitors its credit exposure with respect to these agreements. The primary risk associated with MBSs is that a changing interest rate environment might cause prepayment of the underlying obligations at speeds slower or faster than anticipated at the time of their purchase. As part of its decision to purchase such a security, the Company assesses the risk of prepayment by analyzing the security’s projected performance over an array of interest-rate scenarios. Once such a security is purchased, the Company monitors its actual prepayment experience monthly to reassess the relative attractiveness of the security with the intent to maximize total return.
The carrying values of investments that are determined to have declines in value that are other than temporary are reduced to fair value and, in the case of bonds, no further accruals of interest are made. The provisions for impairment on mortgage loans are based on losses expected by management to be realized on transfers of mortgage loans to real estate, on the disposition and settlement of mortgage loans and on mortgage loans that management believes may not be collectible in full. Accrual of interest is suspended when principal and interest payments on mortgage loans are past due more than 90 days. Impairment losses on securitized assets are recognized if the fair value of the security is less than its book value, and the net present value of expected future cash flows is less than the net present value of expected future cash flows at the most recent(prior) estimation date.
SOURCES OF LIQUIDITY are readily available to the Company in the form of the Company’s existing portfolio of cash and short-term investments, Dollar Roll Repo capacity on invested assets and if required, proceeds from invested asset sales. The Company’s liquidity is primarily derived from operating cash flows. At December 31, 2003, approximately $1.85 billion of the Bond Portfolio had an aggregate unrealized gain of $64.2 million while approximately $809.9 million of the Company’s Bond Portfolio had an aggregate unrealized loss of $24.0 million. In addition, the Company’s investment portfolio currently provides approximately $26.5 million of monthly cash flow from scheduled principal and interest payments. Historically, cash flows from operations and from the sale of the Company’s annuity products have been more than sufficient in amount to satisfy the Company’s liquidity needs.
In a declining rate environment, the Company’s cost of funds would decrease over time, reflecting lower interest crediting rates on its fixed annuities. Should increased liquidity be required for withdrawals, the Company believes that a significant portion of its investments could be sold without adverse consequences in light of the general strengthening that would be expected in the bond market.
GUARANTEES AND OTHER COMMITMENTS: At December 31, 2003, the Company has future obligations to purchase approximately $9.0 million of asset backed securities in the ordinary course of business. The expiration dates of these commitments are as follows: $4.0 million in 2004 and $5.0 million in 2007.
In July 2003, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Non traditional Long-Duration Contracts and for Separate Accounts” (“SOP 03-1”). FASB did not object to the issuance of SOP 03-1. This statement is effective for the Company as of January 1, 2004. Under SOP 03-1, variable annuity assets held in separate accounts will continue to be measured at fair value and reported in summary total on the Company’s financial statements, with an equivalent summary total reported for related liabilities, if the separate account arrangement meets certain specified conditions. The adoption of SOP 03-1 will not have a material impact on the Company’s separate accounts.
The Company’s financial statements begin on page. Reference is made to the Index to Financial Statements on page herein.