Our home office is part of the Parent Group's home office complex in Northbrook, Illinois. The complex consists of several buildings with an aggregate of approximately 2.35 million square feet of office space on a 250-acre site. In addition, we operate from various administrative, data processing, claims handling and support facilities.
The locations from which the Parent Group exclusive agencies operate in the U.S. are normally leased by the agencies.
OPERATING INCOME is a non-GAAP measure used by management to supplement its evaluation of Net income. Operating income is "Income before cumulative effect of change in accounting principle, after tax excluding the effects of Realized capital gains and losses, after-tax," and Gain (loss) on disposition of operations, after-tax. In this computation, Realized capital gains and losses, after-tax is presented net of the effects of the Company's deferred policy acquisition cost ("DAC") amortization and additional future policy benefits, to the extent that such effects resulted from the recognition of Realized capital gains and losses.
Management believes that the supplemental Operating income (loss) information presented below allows for a more complete analysis of results of operations. The net effect of Realized capital gains and losses have been excluded due to their volatility between periods and because such data is often excluded when evaluating the overall financial performance of insurers. Operating income (loss) should not be considered as a substitute for any GAAP measure of performance. This method of calculating Operating income (loss) may be different from the method used by other companies and therefore comparability may be limited. A reconciliation of Operating income to Net income for the years ended December 31, is presented in the following table.
A reconciliation of Retail Operating income to Net income for the years ended December 31, is presented in the following table.
A reconciliation of Structured Financial Products Operating income to Net income for the years ended December 31, is presented in the following table.
Consolidated net income decreased 33.4% for 2002 compared to 2001 and 21.7% for 2001 compared to 2000. In both years, realized capital losses increased in both segments. Realized capital gains and losses totaled $(427) million in 2002, $(213) million in 2001 and $(26) million in 2000.
Consolidated revenues decreased 1.4% in 2002 compared to 2001 resulting from increased realized net capital loses and decreases in Premiums and Contract charges in the Retail segment. These declines were partly offset by an increase in Net investment income and Structured Financial Products Premiums and Contract charges.
Consolidated revenues increased 1.4% during 2001 compared to 2000 resulting from increased Net investment income and Premiums and Contract charges in the Retail segment. These increases were partially offset by an increase in realized capital losses and lower Premiums and Contract charges in the Structured Financial Products segment. Net investment income increased 9.7% primarily due to higher investment balances.
The Company has identified four of its accounting policies that, due to their nature, have required management to make assumptions and estimates that are significant to the consolidated financial statements at December 31, 2002. It is reasonably likely that changes in these assumptions and estimates could occur from period to period, and have a material impact on the Company's consolidated financial statements.
A brief summary of each of these critical accounting policies follows. For a complete discussion of the judgments and other factors affecting the measurement of these policies, see the referenced sections of the MD&A. There is also a complete summary of the Company's significant accounting policies in Note 2 of the consolidated financial statements.
INVESTMENTS - Fixed income securities include bonds, mortgage-backed and asset-backed securities, and redeemable preferred stocks. All fixed income and equity securities are carried at fair value and are classified as available for sale. The fair value of publicly traded fixed income and equity securities is based on independent market quotations. The fair value of non-publicly traded securities, primarily privately placed corporate obligations, is based on either widely accepted pricing valuation models which utilize internally developed ratings and independent third party data (e.g., term structures and current publicly traded bond prices) as inputs or independent third party pricing sources. The valuation models use indicative information such as ratings, industry, coupon, and maturity along with related third party data and publicly traded bond prices to determine security specific spreads. These spreads are then adjusted for illiquidity based on historical analysis and broker surveys. Periodic changes in fair values are reported as a component of Accumulated other comprehensive income on the Consolidated
There are a number of risks and uncertainties inherent in the process of monitoring impairments and determining if impairment is other than temporary. These risks and uncertainties include the risks that:
When derivatives meet specific criteria, they may be designated as accounting hedges and accounted for as fair value, cash flow, foreign currency fair value, or foreign currency cash flow hedges. The hedged item may be either all or a specific portion of a recognized asset, liability or an unrecognized firm commitment attributable to a particular risk. At the inception of the hedge, the Company formally documents the hedging relationship and risk management objective and strategy. The documentation identifies the hedging instrument, the hedged item, the nature of the risk being hedged and the methodology used to assess how effective the hedging instrument is in offsetting the exposure to changes in the hedged item's fair value attributable to the hedged risk, or in the case of a cash flow hedge, the exposure to changes in the hedged transaction's variability in cash flows attributable to the hedged risk. The Company does not currently exclude any component of the change in fair value of the hedging instrument from the effectiveness assessment. At each reporting date, the Company confirms that the hedging instrument continues to be highly effective in offsetting the hedged risk. Ineffectiveness in fair value hedges and cash flow hedges is reported in Realized capital gains and losses on the Consolidated Statements of Operations and Comprehensive Income. For
Derivatives are accounted for on a fair value basis, and reported as Other investments, Other assets, Other liabilities and accrued expenses or Contractholder funds. Embedded derivative instruments subject to bifurcation are also accounted for on a fair value basis and are reported together with the host contract. The fair value of the Company's exchange traded derivative contracts is based on independent market quotations. The fair value of non-exchange traded derivative contracts is based on either independent third party pricing sources or widely accepted pricing valuation models which utilize independent third party data as inputs. The change in the fair value of derivatives embedded in assets and subject to bifurcation is reported as Realized capital gains and losses. The change in the fair value of derivatives embedded in liabilities and subject to bifurcation is reported as Realized capital gains and losses or Life and annuity contract benefits. For further discussion of these policies, and quantification of the impact of these estimates and assumptions, see the Investments, Market Risk and Forward-looking Statements and Risk Factors affecting the Company sections of the MD&A.
DEFERRED POLICY ACQUISITION COSTS ("DAC") - The Company establishes a deferred asset for certain costs that vary with and are primarily related to acquiring business. For life insurance and investment-oriented business these costs, principally agents' and brokers' remuneration, certain underwriting costs and direct mail solicitation expenses, are deferred and amortized to income. Amortization of DAC is reflected on the Consolidated Statements of Operations and Comprehensive Income. All other acquisition expenses are charged to operations as incurred, impacting operating costs and expenses on the Consolidated Statements of Operations and Comprehensive Income.
If a change in the amount of EGP is significant, it could result in the unamortized DAC not being recoverable, resulting in a charge which is reflected as a component of Amortization of DAC. For quantification of the impact of these estimates and assumptions on the Company, see the Retail Segment, Structured Financial Product Segment, Forward-looking Statements and Risk Factors affecting the Company sections of the MD&A.
- - Premiums and deposits for the Retail segment increased 20.3% to $8.31 billion in 2002 primarily due to sales of fixed annuities, including the Allstate(R)Treasury - Linked Annuity. - - Separate Accounts assets for the Retail segment decreased 18.2% due to declines in account balances resulting from poor equity market performance during the year. - - Net income decreased 19.9% due to accelerated amortization of DAC, higher operating expenses and an increase in realized capital losses partly offset by a higher investment margin and an adjustment for prior year tax liabilities.
The Company's strategies include developing and delivering market-informed products and services, leveraging and building the Allstate brand in financial services, building profitable long-term relationships, and driving operational scale, efficiency and effectiveness. The Company will continue to extend the Allstate brand by using it in conjunction with more products and distribution channels. The Company will create greater awareness of the Company's services through advertising, public relations and by focusing on a consistent experience for customers and distribution partners. The Company intends to grow its business through a combination of organic growth, selective acquisitions, alliances and partnerships.
Summarized financial data and key operating measures for the Retail segment as of and for the years ended December 31, are presented in the following table.
The following table summarizes GAAP premiums and contract charges for the Retail segment.
Total Retail GAAP premiums decreased 14.7% in 2002 compared to 2001, due to declines in both traditional life insurance and other insurance products premiums. Traditional life premiums declined due to the Company entering a reinsurance agreement implemented January 1, 2002 which ceded certain of its direct-marketed credit life insurance products. Additionally, term life insurance sales decreased. Declines in other premiums are related to the Company not renewing certain direct marketing non-life credit insurance products.
In 2001, Retail GAAP premiums increased 6.7% compared to 2000 due to increases in both traditional life and other insurance products. The increase in traditional life was from new term insurance sales and renewal premiums being partially offset by declines in whole life business. The increase in other premiums is a result of modest increases in the accident and health premiums earned through the direct marketing channel.
Total Retail contract charges increased 3.9% during 2002 compared to 2001 due to growth in interest-sensitive life insurance account values inforce and contract charge rate increases. Average contract charges have trended upwards as customers have selected products with more riders and higher fees. Contract charges on variable annuities, which are generally calculated as a percentage of each account value ranging from .70% to 2.30%, decreased 2.3% compared to 2001 due to declines in account values as a result of poor equity market performance. Contract charges on Retail products increased 2.0% during 2001 from 2000 due to new sales, partly offset by declines in variable annuity account balances due to poor equity market performance.
The following table summarizes premiums and contract charges for the Retail segment by distribution channel.
PREMIUMS AND DEPOSITS for the Retail segment are summarized by product line in the following table.
Total Retail Premiums and deposits decreased 22.7% to $6.91 billion in 2001 from $8.93 billion in 2000. The decrease was due to declines in variable and fixed annuity sales. The decline in variable annuity sales was a reflection of the overall decline in the variable annuity market caused by poor equity market performance. The fixed annuity decline was a reflection of management decisions to curtail sales in selected distribution channels in order to meet targeted returns.
The following table summarizes Premiums and deposits for the Retail segment by distribution channel.
As a result of initiatives undertaken to expand the sales of financial services products through Allstate agencies, Premiums and deposits increased 39.8% in 2002 compared to 2001 and 22.4% in 2001 compared to 2000.
OPERATING INCOME for the Retail segment is presented in the following table.
INVESTMENT MARGIN, which represents the excess of investment income earned over interest credited to policyholders and contractholders, increased 7.1% during 2002 compared to 2001. The increase is a result of 17.8% higher portfolio balances at December 31, 2002 compared to December 31, 2001. The increase in 2002 was driven by sales of fixed annuities, less contract benefits, surrenders and withdrawals. The impact of this growth was partly offset by a decline in portfolio yields from lower market interest rates affecting the yield on the investment of funds from operations and investments and a shift to sales of investment products with lower investment margins, such as market value adjusted annuities ("MVAAs"). Investment margin increased 15.2% in 2001 compared to 2000 as a result of 11.5% higher portfolio balances at December 31, 2001 compared to December 31, 2000.
Mortality margin decreased 9.3% during 2001 compared to 2000 due to a higher incidence of mortality and morbidity, including $12 million related to the September 11 tragedies. The 2001 mortality margin also includes an increase in death benefits on variable annuity contracts over 2000.
Policy benefits paid include cash payments for variable annuity GMDBs totaling $58 million, $31 million, and $3 million in 2002, 2001, and 2000 respectively, net of reinsurance and other contractual arrangements. The increases over this three-year period reflect poor equity market performance.
The steep and sustained decline in the equity markets during 2002 changed the amount and timing of variable annuity EGP and resulted in the acceleration of variable annuity DAC amortization, often called "DAC unlocking," totaling $120 million. There was also a $32 million favorable DAC unlocking adjustment (deceleration of amortization) on fixed annuities, which resulted from primarily favorable investment margin, and a $6 million acceleration of amortization of DAC on interest-sensitive life products, which reflects the impact of the decline in equity markets on variable life contracts, for a net pre-tax acceleration of DAC amortization for retail products totaling $94 million in 2002. In addition, DAC amortization was reduced by $29 million as a result of improved persistency on fixed annuities and interest-sensitive life products and other recoveries. Declines in the equity market performance reduce future or expected fee income and may increase the exposure to GMDB policy benefits. Such events generally reduce EGP, which may in turn require further DAC unlocking of the variable annuity DAC asset. Future volatility in the equity markets of similar or greater magnitude may result in disproportionate changes in the amortization of DAC.
(1) Other investment contracts include fixed annuities and all Retail other annuities.
OPERATING COSTS AND EXPENSES increased 12.4% during 2002 compared to 2001. The increase is due to investments in technology and advertising. The additional investments in technology relate to systems that will increase efficiencies and improve services through the Internet, and infrastructure investments to support the Allstate exclusive agents in selling registered investment products. Additionally, advertising expenditures were increased in 2002 to create greater awareness of Allstate as a financial services company. Operating costs and expenses increased 24.1% during 2001 compared to 2000 due to higher marketing, technology and distribution expenses incurred on similar growth initiatives. INCOME TAX EXPENSE ON OPERATIONS declined 27.7% in 2002 compared to 2001 due primarily to a $34 million adjustment for prior year tax liabilities that resulted primarily from Internal Revenue Service developments and examination of tax returns. In 2001, total income tax expense on operations declined 6.8% compared to 2000.
- The Company's ability to manage its investment margin is dependent upon maintaining adequately profitable spreads between investment yields and interest crediting rates on inforce business. As interest rates change or remain at historically low levels, assets may be reinvested at lower yields that compress investment margin. The Company has the ability to impact the investment margin by changing the interest crediting rates on flexible rate contracts. However, these changes could be limited by market conditions, regulatory minimum rates or contractual minimum rate guarantees on many contracts and may not match the timing or magnitude of changes in asset yields. The level of investment defaults may also affect investment income. The Company will continually monitor its risk limits related to credit quality and duration as well as monitor and adjust its crediting rates. - A portion of the Company's contract charge revenue is dependent upon the value of the accounts supporting its variable annuity and variable life products. Most account values for these products are invested, at the discretion of the contractholder, in Separate Accounts invested primarily in equities. Therefore, future equity market performance has a significant impact on contract charge revenue and benefit guarantees which are key drivers of the returns on these products. - Variable annuity DAC is amortized in relation to the present value of EGP over the estimated lives of the contracts. Future levels of EGP are highly sensitive to future equity market performance. Changes in the amount or timing of EGP may result in adjustments in the cumulative amortization of DAC. - In order to maintain an acceptable target return, the Company needs to design and sell products having interest crediting rates with adequate spreads to investment returns. If investments with appropriate maturity and risk adjusted returns to support pricing targets are not available, product sales will be restricted. For this reason, fixed annuity sales volume will vary in the future as dictated by market conditions.
PRE-TAX NET INVESTMENT INCOME increased 8.2% for the Retail segment in 2002 compared to 2001 after increasing 9.6% in 2001 compared to 2000. The increase in both 2002 and 2001 was due to higher portfolio balances, partially offset by lower portfolio yields. Lower portfolio yields were due to funds from operations and reinvestments being made at current market rates. Retail investment balances, excluding assets invested in Separate Accounts and net unrealized capital gains on fixed income securities, increased 17.8% as of December 31, 2002 from December 31, 2001, compared to an 11.5% increase from December 31, 2000 to December 31, 2001. The increase in both years was principally due to the receipt of Premiums and deposits less contract benefits and withdrawals during the periods. The average pre-tax investment yield in 2002 was 6.9% compared to 7.7% in 2001.
AFTER-TAX REALIZED CAPITAL LOSSES were $140 million in 2002 compared to $103 million in 2001 and $36 million in 2000. After-tax realized capital gains and losses are presented net of the effects of DAC amortization and additional future policy benefits, to the extent that such effects resulted from the recognition of realized capital gains and losses.
Summarized financial data and key operating measures for the Structured Financial Products segment as of and for the years ended December 31, are presented in the following table.
PREMIUMS AND CONTRACT CHARGES, included in financial results, represent GAAP premiums generated from structured settlement and immediate annuities with life contingencies which have significant mortality or morbidity risk. Contract charges are generated from interest-sensitive life products, structured settlement and immediate
annuities, and synthetic GICs for which deposits are classified as contractholder funds or Separate Accounts liabilities. Contract charges are assessed against the contractholder account balance for maintenance, administration, cost of insurance and surrender prior to contractually specified dates.
In 2002, premiums from structured settlement and immediate annuities with life contingencies totaled $415 million, an increase of 24.6% from $333 million in 2001. Premiums from structured settlement and immediate annuities with life contingencies decreased 17.0% for 2001 compared to $401 million in 2000. Under GAAP accounting requirements, only structured settlement and immediate annuities with life contingencies are recognized in premiums. Those annuities without life contingencies, called period certain, are recorded directly as contractholder funds and generate investment margins and contract charges. Market conditions and consumer preferences drive the mix of structured settlement and immediate annuities sold with or without life contingencies, which cause fluctuations in the overall level of premiums, resulting in volatility in reported revenues. Contract charges increased 4.2% to $25 million in 2002 from $24 million in 2001. Contract charges in 2001 increased 41.2% compared to $17 million in 2000 resulting primarily from increased contract charges related to structured settlement annuities without life contingencies.
PREMIUMS AND DEPOSITS for the Structured Financial Products segment are summarized by product line in the following table.
OPERATING INCOME for the Structured Financial Products segment is presented in the following table.
Investment margin increased 28.7% during 2001 compared to 2000. The increased investment margin is a result of growth in invested assets of 19.2% when compared to 2000. The growth in portfolio balances reflects the net growth of inforce business during the year from new sales less contract maturities and withdrawals.
MORTALITY MARGIN, which represents premiums and cost of insurance charges less related policy benefits, declined $12 million to a negative margin of $14 million in 2002 compared to 2001, and decreased $7 million
during 2001 as compared to 2000. The declines were due to a lower death rate than anticipated in the policyholder benefit liability assumptions for structured settlement and immediate annuities with life contingencies. For structured settlement and immediate annuities with life contingencies, a decrease in the death rate increases the number and cost of future contract benefit payments. Conversely, life insurance contracts are favorably affected by decreases in death rates because beneficiaries receive full death benefits but premiums are collected over a longer period of time than expected when the product was priced. The immediate annuities sold with a life contingency act as a hedge or offset to the risk of increased death rates. In determining premium rates, the Company uses underwriting and pricing guidelines with a long-term view of mortality rates. The effects of the mortality rate can cause benefit expense to fluctuate from period to period.
PRE-TAX NET INVESTMENT INCOME for the Structured Financial Products segment for 2002 was comparable to 2001, after increasing 9.8% in 2001 compared to 2000. Increased Structured Financial Products portfolio balances were partly offset by lower portfolio yields in both periods. In 2002, lower portfolio yields were due to investments made in a low interest rate environment and increased payments on interest rate swaps as part of the Company's asset/liability management strategy. Structured Financial Products portfolio balances, excluding assets invested in Separate Accounts and net unrealized capital gains on fixed income securities, increased 12.9% from December 31, 2002 compared to December 31, 2001, compared to an increase of 19.2% from December 31, 2000 to December 31, 2001. The increase in both periods was due to Premiums and deposits from inforce business less maturities and withdrawals. The average pre-tax investment yield in 2002 was 6.6% compared to 7.1% in 2001. AFTER-TAX REALIZED CAPITAL LOSSES increased to $138 million in 2002 compared to $47 million in 2001 and $4 million in 2000.
- - As the Company continues to receive Premiums and deposits, investment of these increased cash flows in available securities with acceptable risk-adjusted yields will be a focus. - - The Company expects to experience lower investment yields as positive cash flows from operations and investment activities are invested at market yields that are less than the average portfolio rate, and as the lower rate environment impacts securities with variable yields. - - The Company expects to incur realized capital losses while the corporate credit environment remains under pressure.
An important component of the Company's financial results is the return on invested assets. The Company's investment portfolios are segmented between the Retail and Structured Financial Products segments. The investment portfolios are managed based upon the nature of each respective business and its corresponding liability structure. The investment strategy for the Company is based upon a strategic asset allocation framework that takes into account the need to manage on a risk adjusted spread basis for the underwriting liability product portfolio and to maximize return on retained capital. Generally, a combination of recognized market modeling, analytical models and proprietary models is used to achieve a desired asset mix in the management of the portfolio. The strategic asset allocation model portfolio is the primary basis for setting annual asset allocation targets with respect to interest sensitive, illiquid and credit asset allocations as well as limitations with respect to overall below investment grade exposure and diversification requirements. On a tactical basis, decisions are made on an option adjusted relative value basis staying within the constraints of the strategic asset allocation framework. The Company believes it maximizes asset spread by selecting assets that perform on a long-term basis and by using trading to minimize the effect of downgrades and defaults. Total return measurement is used on a selective basis where the asset risks are significant (e.g., high yield fixed income securities, convertible bonds). The Company expects that employing this strategy will minimize interest rate market impacts on investment income. This strategy is also expected to provide sustainable investment-related income over time.
The composition of the investment portfolio at December 31, 2002 is presented in the table below. Also see Notes 2 and 6 of the consolidated financial statements for investment accounting policies and additional information.
Total investments increased to $52.67 billion at December 31, 2002 from $44.30 billion at December 31, 2001. This increase was due in part to amounts invested from positive cash flows from new sales and a 104.4% increase in net unrealized gains on fixed income securities from December 31, 2001 to $3.08 billion at December 31, 2002.
Total investment balances related to collateral primarily due to securities lending decreased to $1.24 billion at December 31, 2002 from $1.47 billion at December 31, 2001.
- Current public corporate spreads for 22 sectors in 16 quality categories are based on the Bloomberg fair market industrial yield curve and the median Lehman sector spreads over the Bloomberg industrial curve. - The 22 sectors include airlines, banking, basic industry, brokerage, capital goods, chemicals, communications, consumer cyclical - auto, consumer cyclical - services, consumer cyclical -others, consumer non-cyclical, electric, energy, finance companies, insurance, natural gas, other industrial, REITS, technology, telecommunications, transportation, and water. Since the water sector has no public market counterpart, sector spread for this sector is based on selected broker quotes and analyst estimates. - The 16 quality categories range from AAA to B3. - An additional 25 basis points are added to public corporate spreads to compensate for illiquidity. - Watch-list securities are conservatively priced at the lower of analyst price or an adjusted model price for a rating that is one category lower, and are capped at 100.
FIXED INCOME SECURITIES The Company's fixed income securities include bonds, such as municipal bonds, corporate publicly and privately placed bonds, mortgage-backed and asset-backed securities, and redeemable preferred stocks. All fixed income securities are carried at fair value and are classified as available for sale. Periodic changes in fair values are reported as a component of Other comprehensive income net of deferred taxes, certain life and annuity DAC and certain reserves for life-contingent benefits, and are reclassified to Net income only when supported by the consummation of a transaction with an unrelated third party or when declines in fair values are deemed other than temporary.
Fixed income securities issued by U.S. government and agencies of the U.S. government totaled $3.06 billion at December 31, 2002 compared to $2.23 billion at December 31, 2001. Approximately 99.3% of these securities are rated investment grade at December 31, 2002.
The fixed income securities portfolio contained $2.47 billion and $2.41 billion of asset-backed securities ("ABS") at December 31, 2002 and 2001, respectively. The ABS portfolio is subject to credit and interest rate risk. Credit risk is mitigated by monitoring the performance of the collateral. Approximately 83.5% of the ABS portfolio is rated in the highest rating category by one or more credit rating agencies. The ABS portfolio is subject to interest rate risk since the price volatility and ultimate realized yield are affected by the rate of repayment of the underlying assets. Approximately 30.8% of the Company's ABS portfolio is invested in securitized credit card receivables. The remainder of the portfolio is backed by securitized home equity, manufactured housing and auto loans.
At December 31, 2002, 91.8% of the Company's consolidated fixed income securities portfolio was rated investment grade, which is defined by the Company as a security having a rating from The National Association of Insurance Commissioners ("NAIC") of 1 or 2, a Moody's equivalent rating of Aaa, Aa, A or Baa, or a comparable Company internal rating.
The table above includes redeemable preferred securities with a fair value of $40 million and an unrealized loss of $1 million. It also includes 56 securities that have not yet received an NAIC rating, for which the Company has assigned a rating based on an analysis similar to that used by the NAIC. As of December 31, 2002, the fair value of unrated securities was $490 million including an unrealized loss of $14 million. Due to lags between the funding of an investment, processing of final legal documents, filing with the Securities Valuation Office of the NAIC ("SVO"), and rating by the SVO, the Company will always have a small number of non-rated securities.
EQUITY SECURITIES The Company's equity securities portfolio was $183 million at December 31, 2002 compared to $201 million in 2001. The decrease is attributable to general market declines and disposition of selected securities during the year. Losses are recognized for declines in the value of equity securities that are deemed other than temporary, and included in realized capital gains and losses.
The equity securities portfolio includes partnership investments where the Company has virtually no influence over the operating and financial policies of the partnership. These investments are accounted for using the cost method. Partnership investments where the Company has more than a minor amount of influence over the operating and financial policies of the partnership and an ownership interest less than or equal to 50% are accounted for using the equity method of accounting. The Company has not provided any guarantees to any partners or any other parties related to these investments. The majority of the Company's partnerships invest in either real estate or private equities.
There are a number of risks and uncertainties inherent in the process of monitoring impairments and determining if an impairment is other than temporary. These risks and uncertainties include the risks that:
The Company has an extensive monitoring process to identify fixed income and equity securities whose carrying value may be other than temporarily impaired. This process includes a quarterly review of all securities using a screening process to identify those securities whose fair value compared to cost for equity securities or amortized cost for fixed income securities is below established thresholds and time periods, or which are identified through other monitoring criteria such as ratings downgrades or payment defaults. Securities with an unrealized loss of greater than 20% of their cost for equity securities or amortized cost for fixed income securities for a period of six months or more, are identified through this process. The securities identified, in addition to other securities for which the Company may have concern, are evaluated based on facts and circumstances for inclusion on a watch list. Securities on the watch list are reviewed in detail to determine whether any other than temporary impairment exists.
The following table contains the individual securities as of December 31, 2002, with the ten largest unrealized losses.
The ten largest losses from sales of individual securities for the twelve-month period ended December 31, 2002 totaled $69 million with the largest being $18 million and the smallest being $4 million. A total of $2.5 million of those losses related to a security in a significant unrealized loss position (greater than or equal to 20% of cost for equity securities or amortized cost for fixed income securities) for a period of six or more consecutive months but less than twelve consecutive months prior to sale. The Company changed its intention to continue holding the security upon further evaluation.
The following list details the 10 largest realized losses from sales and other than temporary declines or write-downs, consolidated by issuer and all of its affiliates (therefore, multiple issuers and securities may be consolidated based upon affiliate and subsidiary relationships), the related circumstances giving rise to the loss and a discussion of how those circumstances may have impacted other material investments held.
Separate Accounts assets and liabilities decreased 18.1% to $11.13 billion at December 31, 2002 from $13.59 billion at December 31, 2001. The decrease was primarily attributable to declines in the fair value of the Separate Accounts' investment portfolios due to poor equity market performance, surrenders, withdrawals and contract charges, partially offset by sales of variable annuity contracts and transfers from the fixed account contract option to variable Separate Accounts funds. During 2002, sales of variable annuities continued to be adversely impacted by market volatility.
Absent any contract provision wherein the Company guarantees either a minimum return or account value upon death or annuitization, variable annuity contractholders bear the investment risk that the Separate Accounts' funds may not meet their stated investment objectives.
The Company purchases reinsurance after evaluating the financial condition of the reinsurer, as well as the terms and price of coverage. The Company reinsures certain of its risks to reinsurers under yearly renewable term, coinsurance, and modified coinsurance agreements. Yearly renewable term and coinsurance agreements result in the passing of a portion of the risk to the reinsurer. Generally, the reinsurer receives a proportionate amount of the premiums less commissions, and is liable for a corresponding proportionate amount of all benefit payments. Modified coinsurance is similar to coinsurance except that the cash and investments that support the liability for contract benefits are not transferred to the assuming company, and settlements are made on a net basis between the companies.
The Company cedes 90%, 80% or 60% of the mortality risk on certain life policies, depending upon the issue year and product, to a pool of eleven reinsurers. The Company also cedes 100% of the mortality and other risks related to product features of a portion of variable contracts. Since 1998, the Company has also ceded mortality risk on new business in excess of $2 million per life for individual coverage. For business sold prior to 1998, the Company ceded mortality risk in excess of $1 million or less per life for individual coverage.
Market risk is the risk that the Company will incur losses due to adverse changes in equity, interest, commodity, or currency exchange rates and prices. The Company's primary market risk exposures are to changes in interest rates and equity prices, although the Company also has a limited exposure to changes in foreign currency exchange rates.
The active management of market risk is integral to the Company's results of operations. The Company may use the following approaches to manage its exposure to market risk within defined tolerance ranges: 1) rebalance its existing asset or liability portfolios, 2) change the character of investments purchased in the future or 3) use derivative instruments to modify the market risk characteristics of existing assets and liabilities or assets expected to be purchased. For a more detailed discussion of these derivative financial instruments, see Note 7 to the consolidated financial statements.
The Company administers and oversees the investment risk management processes primarily through the Boards of Directors and Investment Committees and the Credit and Risk Management Committee ("CRMC"). The Boards of Directors and Investment Committees provide executive oversight of investment activities. The CRMC is a senior investment management committee consisting of the Chief Investment Officer, the Investment Risk Manager, and other investment officers who are responsible for the day-to-day management of investment risk. The CRMC meets at least monthly to provide detailed oversight of investment risk, including market risk.
The Company has investment guidelines that define the overall framework for managing market and other investment risks, including the accountabilities and controls over these activities. In addition, the Company follows investment policies that have been approved by the Board of Directors and that delineate the investment limits and strategies that are appropriate given the respective liquidity, surplus, product, and regulatory requirements.
The Company seeks to invest Premiums and deposits to generate future cash flows that will fund future claims, benefits and expenses, and that will earn stable margins across a wide variety of interest rate and economic scenarios. In order to achieve this objective and limit its exposure to interest rate risk, the Company adheres to a philosophy of managing the duration of assets and related liabilities. The Company uses interest rate swaps, futures, forwards, caps and floors to reduce the interest rate risk resulting from duration mismatches between assets and liabilities. In addition, the Company uses financial futures and other derivative instruments to hedge the interest rate risk related to anticipatory purchases and sales of investments and product sales to customers.
EQUITY PRICE RISK is the risk that the Company will incur economic losses due to adverse changes in a particular stock, mutual fund or stock index. At December 31, 2002, the Company had approximately $40 million in common stocks and $551 million in other securities with equity risk (including primarily convertible securities that are reflected as a
Based upon the information and assumptions the Company uses in its beta calculation and in effect at December 31, 2002, management estimates that an immediate decrease in the S&P 500 of 10% would decrease the net fair value of the Company's equity portfolio identified above by approximately $36 million, versus $51 million at December 31, 2001. The selection of a 10% immediate decrease in the S&P 500 should not be construed as a prediction by the Company's management of future market events, but only as an illustration of the potential impact of such an event.
Beta was determined by regressing the monthly stock price movements of the equity portfolio against movements in the S&P 500 over a three-year historical period. Portfolio beta was also determined for the domestic equity portfolio by weighting individual stock betas by the market value of the holding in the portfolio. The two approaches to calculating portfolio beta yielded virtually identical results. Since beta is historically based, projecting future price volatility using this method involves an inherent assumption that historical volatility and correlation relationships will remain stable. Therefore, the results noted above may not reflect the Company's actual experience if future volatility and correlation relationships differ from such historical relationships.
At December 31, 2002 and 2001, the Company had Separate Accounts assets with account values totaling $11.13 billion and $13.59 billion, respectively. The Company earns contract charges as a percentage of these account values. In the event of an immediate decline of 10% in the account values due to equity market declines, the Company would earn approximately $18 million and $21 million less in annualized fee income at December 31, 2002 and December 31, 2001, respectively.
Substantially all of the Company's variable annuity contracts inforce contain some type of GMDB. In general, the types of guarantees offered include a return of deposits, the highest anniversary value or a guaranteed compound earnings rate on the initial deposit over the contract period. To reduce its GMDB exposure resulting from further declines in the equity market, the Company entered into various derivative instruments during 2002 which economically hedged a portion of this existing risk. These instruments will hedge expected benefit payments through December 31, 2003. Separate from the current hedging program, the Company plans to enter into a new program during the first quarter of 2003. This program is intended to hedge substantially all future death claims on new business as it is written. At December 31, 2002 and 2001, the guaranteed value in excess of the contractholders' account value, payable if all contractholders were to die, is estimated to be $4.07 billion and $2.36 billion, respectively, net of reinsurance. The increase in this measure is attributable to the decline in equity markets during 2002. In both periods, approximately two-thirds of this exposure is related to the return of deposits guarantee, while the remaining one-third is attributable to a death benefit guarantee greater than the original deposits.
of extreme adverse market conditions. For example, in the event of an immediate decline of 10% in contractholders' account values as of December 31, 2002 due to equity market declines, payments for guaranteed death benefits would increase by an estimated $14 million during the next year. The selection of a 10% immediate decrease should not be construed as a prediction by management of future market events, but only as an example to illustrate the potential impact to earnings and cash flow of equity market declines as a result of this guarantee. Also, the Company's actual payment experience in the future may not be consistent with the assumptions used in its model.
GMIBs offered by the Company include the right to annuitize based on the highest account value at any contract anniversary date or a guaranteed compound earnings rate based on the initial account value over the specified contract period. The Company began offering these guarantees in certain of its variable contracts in 1998, therefore based on the contract specifications, these benefits will not be available for election by the contractholders until at least 2008. The guaranteed value in excess of contractholders' account values at December 31, 2002 and 2001, payable over the annuity period if all contractholders were to elect to annuitize, was estimated to be $607 million and $299 million, net of reinsurance, respectively. To calculate this measure, the current interest rate environment is utilized in the assumptions. The increase in this measure is attributable to the decline in the equity markets during 2002 as well as a decline in interest rates.
Growth in variable contracts in the future stemming from new sales will increase the Company's amount of overall exposure to equity price risk embedded in these contracts. An increase in the equity markets above December 31, 2002 levels will increase the contractholder returns on these products, thereby decreasing the risk of utilizing these guarantees on the inforce business. A decrease in the equity markets that causes a decrease in the variable contracts' account balances will increase the equity risk profile of the inforce business as is demonstrated in the December 31, 2002 measurements compared to the December 31, 2001 measurements disclosed and discussed above.
At December 31, 2002, the Company had approximately $2 million in foreign currency denominated equity securities compared to approximately $5 million at December 31, 2001. At December 31, 2002, the Company had $1.43 billion of medium-term note liabilities denominated in foreign currencies versus $1.31 billion at December 31, 2001. All foreign currency denominated funding agreements have been swapped to U.S. Dollars and have insignificant residual currency risk.
Based upon the information and assumptions in effect at December 31, 2002, management estimates that, holding everything else constant, a 10% immediate unfavorable change in each of the foreign currency exchange rates to which the Company is exposed would decrease the net fair value of its foreign currency denominated instruments by approximately $0.2 million, versus $0.5 million at December 31, 2001. The selection of a 10% immediate decrease in all currency exchange rates should not be construed as a prediction by the Company's management of future market events, but only as an illustration of the potential impact of such an event. The Company's currency exposure is diversified across approximately 11 countries at both December 31, 2002 and 2001. The largest individual exposures at December 31, 2002 are to France (53%) and the UK (26%). The largest individual exposures were France (49%) and the UK (22%) at December 31, 2001. The Company's primary regional exposure is to Western Europe with approximately 98% at December 31, 2002 versus 99% at December 31, 2001.
The modeling technique the Company uses to report its currency exposure does not take into account correlation among foreign currency exchange rates or correlation among various markets (i.e., the foreign exchange, equity and fixed income markets). Even though the Company believes it to be unlikely that all of the foreign currency exchange rates to which it is exposed would simultaneously decrease by 10%, the Company finds it meaningful to "stress test" its portfolio under this and other hypothetical extreme adverse market scenarios. The Company's actual experience may differ from the results noted above if future experience does not correspond with the correlation assumptions that the Company has used or if events occur that were not included in the methodology, such as significant liquidity or market events.
SHAREHOLDER'S EQUITY increased at December 31, 2002 due to an increase in net unrealized capital gains, additional capital paid-in and retained income.
Shareholder's equity increased at December 31, 2001 compared to December 31, 2000 due to net income, a capital contribution from AIC and increased unrealized capital gains. AIC made a capital contribution to ALIC of all of the issued and outstanding Allstate Life Preferred Stock, Series B, resulting in an increase in additional paid-in capital of $117 million.
None of these ratings were changed during 2002. AIC's and ALIC's insurance financial strength ratings have remained at the same consistently high levels for the last five years. On a relative basis, these rating positions have improved in light of the significant volume of rating downgrades of other companies in the industry during 2002. Since February 2002, Standard & Poor's rating outlook for ALIC and its rated subsidiaries and affiliates has been "negative". In November 2002, Standard & Poor's reaffirmed the AA+ rating of ALIC, but left the outlook unchanged. In January 2003, A.M. Best Company newly assigned a "positive" rating outlook for AIC, ALIC, and selected affiliates.
The NAIC has also developed a set of financial relationships or tests known as the Insurance Regulatory Information System to assist state regulators in monitoring the financial condition of insurance companies and identifying companies that require special attention or action by insurance regulatory authorities. The NAIC analyzes data provided by insurance companies using prescribed financial data ratios each with defined "usual ranges." Generally, regulators will begin to monitor an insurance company if its ratios fall outside the usual ranges for four or more of the ratios. If an insurance company has insufficient capital, regulators may act to reduce the amount of insurance it can issue. ALIC and its insurance subsidiaries are currently not under regulatory scrutiny based on these ratios.
Premiums and deposits Reinsurance recoveries Receipts of principal, interest and dividends on investments Sales of investments Funds from investment repurchase agreements, securities lending, dollar roll and lines of credit agreements Inter-company loans Capital contributions from AIC
Reinsurance cessions and payments Operating costs and expenses Purchase of investments Repayment of investment repurchase agreements, securities lending, dollar roll and borrowings under lines of credit agreements Repayment of inter-company loans Dividends to AIC
The Company's operations typically generate substantial positive cash flows from operations as most premiums are received in advance of the time when benefit payments are required. These positive operating cash flows are expected to continue to meet the liquidity requirements of the Company.
Dividends to ALIC from its domestic insurance subsidiaries and dividends ALIC can pay to AIC are subject to restriction under the insurance company holding act of the insurance company's state of domicile. The payment of dividends by ALIC is limited by Illinois insurance law to formula amounts based on statutory net income and statutory surplus, as well as the timing and amount of dividends paid in the preceding twelve months. Based on the greater of 2002 statutory net income or 10% of statutory surplus, the maximum amount of dividends ALIC will be able to pay without prior Illinois Department of Insurance approval at a given point in time during 2003 is $315 million, less dividends paid during the preceding twelve months measured at that point in time. In the twelve-month period ending December 31, 2002, ALIC has paid total dividends of $48 million. Notification and approval of inter-company lending activities is also required by the Illinois Department of Insurance for those transactions that exceed formula amounts based on statutory admitted assets and statutory surplus.
The following table summarizes the Company's liabilities for interest-sensitive products by their contractual withdrawal provisions at December 31, 2002. Approximately 11.5% of these liabilities is subject to discretionary withdrawal without adjustment.
Established external sources of short-term liquidity include lines of credit, dollar rolls and repurchase agreements, which in the aggregate, could provide over $2.48 billion of additional liquidity at December 31, 2002. These transactions are subject to borrowing limits and collateral requirements in certain situations, which are monitored by the Company and reviewed regularly. ALIC and its subsidiaries also have access to approximately $56.0 billion of potential liquidity from their portfolios of marketable investment securities and the ability to issue new insurance contracts. A significant portion of the investment portfolio has favorable liquidity characteristics but with variation by asset class, including for example $12.36 billion of privately placed corporate obligations and $5.88 billion of mortgage loans.
All foreign currency denominated funding agreements have been swapped to U.S. Dollars.
(1) Approximately $5.67 billion (or 94.5%) of this balance relates to Synthetic GICs. Synthetic GICs are fee-based insurance products purchased by pension trusts to obtain book value treatment for their defined contribution plans. The coverage provides for a benefit payment in the event the plan experiences heavy withdrawal activity due to allowable participant initiated events. The product has been offered since 1996 without experiencing a call on the guarantee. Coverage is provided to approximately 110 companies with contracts ranging in size from $1 million to $707 million. The Company's underwriting activities closely monitor each arrangement. At December 31, 2002, the market value of the plan assets was valued on average at 103% of the book value of the guarantee. This ratio typically ranges from 99% to 101%. (2) Represents investment commitments such as private placements and mortgage loans.
The Company has inter-company agreements in place that relate to insurance, reinsurance, loans, capitalization and the performance of various services, generally at cost. All material inter-company transactions have appropriately been eliminated in consolidation. Inter-company transactions among insurance subsidiaries and affiliates have been approved by the applicable domiciliary state department of insurance as required under applicable laws.
The Company has not yet determined if this SPE meets the criteria to be considered a variable interest entity ("VIE") pursuant to the pending accounting guidance of Financial Accounting Standards Board ("FASB") Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities." A final assessment will be made as of July 1, 2003 in accordance with FIN No. 46.
At December 31, 2002, the SPE used to issue GMTNs had assets of $2.42 billion, liabilities of $2.33 billion and unrelated third party equity of $90 million. The funding agreements issued by the Company to the SPE are reported on the Company's Consolidated Statements of Financial Position as a component of contractholder funds.
The Company is subject to changing social, economic and regulatory conditions. State and federal regulatory initiatives and proceedings have varied and have included efforts to remove barriers preventing banks from engaging in the securities and insurance businesses, to change tax laws affecting the taxation of insurance companies and the tax treatment of insurance products which may impact the relative desirability of various personal investment products and to expand overall regulation. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
The Company sells its products through a variety of distribution channels including Allstate agencies. Consequently, the outcome of some legal proceedings that involve AIC regarding the Allstate agencies may have an impact on the Company.
AIC is defending various lawsuits involving worker classification issues. Examples of these lawsuits include a number of putative class actions challenging the overtime exemption claimed by AIC under the Fair Labor Standards Act or state wage and hour laws. These class actions mirror similar lawsuits filed recently against other carriers in the industry and other employers. Another example involves the worker classification of staff working in agencies. In this putative class action, plaintiffs seek damages under the Employee Retirement Income Security Act ("ERISA") and the Racketeer Influenced and Corrupt Organizations Act alleging that agency secretaries were terminated as employees by AIC and rehired by agencies through outside staffing vendors for the purpose of
Various other legal and regulatory actions are currently pending that involve the Company and specific aspects of its conduct of business. Like other members of the insurance industry, the Company is the target of an increasing number of class action lawsuits and other types of litigation, some of which involve claims for substantial and/or indeterminate amounts (including punitive and treble damages) and the outcomes of which are unpredictable. This litigation is based on a variety of issues including insurance and claim settlement practices. However, at this time, based on their present status, it is the opinion of management that the ultimate liability, if any, in one or more of these other actions in excess of amounts currently reserved is not expected to have a material effect on the results of operations, liquidity or financial position of the Company.
on stock option grants for the year ending December 31, 2003, the estimated impact to the Company's Consolidated Statements of Operations and Comprehensive Income is approximately $2 million, after-tax. The Company will be billed its proportionate share of this expense pursuant to the inter-company expense sharing agreement with AIC.
In November 2002, the FASB issued FIN No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." FIN No. 45 requires that upon issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligation it assumes under that guarantee. The disclosure provisions of FIN No. 45 are effective for financial statements ending after December 15, 2002. The adoption of the disclosure provisions of FIN No. 45 did not have a material impact on the Company's consolidated financial statements for the year ended December 31, 2002 (see Note 11). The provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The adoption of the remaining provisions of FIN No. 45 is not expected to have a material impact on either the Consolidated Statements of Financial Position or results of operations of the Company.
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities". FIN No. 46 addresses issues related to the consolidation of VIE. The effective date of this interpretation is the first fiscal year or interim period beginning after June 15, 2003. The Company has one SPE used to issue GMTNs to unrelated third parties. The Company is in the process of assessing whether this SPE meets the criteria to be considered a VIE, thereby requiring consolidation under FIN No. 46. The assets and liabilities of this SPE are currently included on the Consolidated Statements of Financial Position of the Company.
On July 31, 2002, the American Institute of Certified Public Accountants issued an exposure draft Statement of Position ("SOP") entitled "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts". The accounting guidance contained in the proposed SOP applies to several of the Company's products and product features. The proposed effective date of the SOP is fiscal years beginning after December 15, 2003, with earlier adoption encouraged. If adopted early, the provisions of the SOP must be applied as of the beginning of the fiscal year. Accordingly, if the SOP were adopted during an interim period of 2003, prior interim periods would be restated. A provision of the proposed SOP requires the establishment of a liability in addition to the account balance for contracts and contract features that provide guaranteed death or other insurance benefits. The finalized SOP may also require a liability for guaranteed income benefits. These liabilities are not currently recognized by the Company, and their establishment may have a material impact on the Consolidated Statements of Operations and Comprehensive Income depending on the market conditions at the time of adoption, but is not expected to have a material impact on the Company's Consolidated Statements of Financial Position.
On January 1, 2003, Northbrook Life Insurance Company ("NLIC"), one of ALIC's wholly owned subsidiaries, was merged into ALIC. Substantially all premiums, contract charges, interest credited, policyholder benefits and expenses of NLIC were already being ceded to ALIC under existing reinsurance agreements between ALIC and NLIC. ALIC is the surviving legal entity and NLIC no longer exists as an independent entity. In conjunction with the merger, two of NLIC's Separate Accounts, Northbrook Variable Annuity Account I and Northbrook Variable Annuity Account II, were merged with the Allstate Financial Advisors Separate Account I, a Separate Account of